Latest Opportunity Zone Insights
Richard Welling on the Opportunity Zone Panel.
On Tuesday, April 23, 2019 the 13th Annual Real Estate Symposium: A View From The Top Revisited was held at UCLA’s Luskin Conference Center. The evening was filled with networking and discussions with panels of Southern California real estate investment experts. Richard Welling presented on the latest tax rules and insights related to Opportunity Zones. At the event, Richard Welling provided the following outline of the latest Opportunity Zone federal income tax considerations.
Internal Revenue Code Section 1400Z-2 provides two main tax incentives to encourage investment in qualified opportunity zones.
- The deferral of capital gains to the extent that a taxpayer elects to invest a corresponding amount in a Qualified Opportunity Fund (QOF). In addition, a portion of the deferred gain is excluded if the investment in the QOF is held for five or seven years.
- The taxpayer may elect to exclude from income the post-acquisition gain on investments in the QOF held for at least 10 years.
- Code Section 1400Z-1 and 1400Z-2 added by the 2017 Tax Cuts and Jobs Act Effective December 22,2017.
- Proposed regs. dated October 29, 2018.
- Executive Order 13853 of December 12, 2018, Establishing the White House Opportunity and Revitalization Council.
- Proposed regs. dated April 19, 2019 expanding on the October 2018 regulations.
Outline of April 2019 Proposed Regs. Impacting Real Estate
The Good –
- Real Property Straddling a Qualified Opportunity Zone. Real property located within the qualified opportunity zone should be considered substantial if the unadjusted cost of the real property inside a qualified opportunity zone is greater than the unadjusted cost of real property outside of the qualified opportunity zone.
- For leased property there is no –
- original use requirement or substantial improvement requirement.
- unrelated lessor requirement.
- QOF reinvestment rules –
- A QOF that sells its assets has 12 months to reinvest in a qualified asset.
- Sales or dispositions of assets by a QOF do not impact in any way investors’ holding periods in their qualifying investments or trigger the inclusion of any deferred gain.
- The QOF must follow the normal tax rules on recognizing any gain or loss on disposition of its assets.
- Sale proceeds awaiting reinvestment must held in cash, cash equivalents, or debt instruments with a term of 18 months or less.
- Clarifies the meaning of original use; not original use if previously depreciated or amortized by a non QOF.
- Structure vacant for at least five years will meet the original use requirement.
- Apparently, property previously held by a government agency, a nonprofit, or for personal use will qualify for original use treatment. Opportunity to purchase and lease back?
- Improvements made by a lessee to leased property satisfy the original use requirement and are considered purchased property.
- The ownership and operation (including leasing) of real property used in a trade or business is treated as active conduct of a trade or business for purposes of Section 1400Z-2(d)(3).
- Working Capital Safe Harbor –
- The written designation for planned use of working capital now includes the development of a trade or business in the qualified opportunity zone as well as acquisition, construction, and/or substantial improvement of tangible property.
- Exceeding the 31-month period does not violate the safe harbor if the delay is attributable to waiting for government action (assuming the application for which is completed during the 31-month period).
- Working capital must be held in cash, cash equivalents, or debt instruments with a term of 18 months or less.
- Special Rule for Section 1231 Gains – Because the capital gain from Section 1231 property is determinable only as of the last day of the taxable year, the 180-day period for investing such capital gain income from Section 1231 property in a QOF begins on the last day of the taxable year.
- Relief with Respect to the 90-Percent Asset Test – A QOF may apply the test without taking into account any investments received in the preceding six months. The QOF’s ability to do this, however, is dependent on those new assets being held in cash, cash equivalents, or debt instruments with terms of 18 months or less.
- Certain events may cause part or all of the deferred gain to be included in taxable income. For example,
- In general, a transfer of a QOF investment that reduces the taxpayer’s equity interest.
- Certain distributions.
- Certain changes in ownership of an S corporation or Partnership holding a QOF investment.
- Certain reorganizations.Certain events may cause part or all of the deferred gain to be included in taxable income. For example,
- The following is not considered an inclusion event:
- Neither a transfer of the qualifying investment to the deceased owner’s estate nor the distribution by the estate to the decedent’s legatee or heir is an inclusion event for purposes of Section 1400Z-2(b).
- Transfer to a grantor trust.
- Transfer to an entity that is disregarded for federal income tax purposes (e.g. SMLLC or revocable trust).
- Requirements for leased property used by a QOF
- Must be a “market rate lease.” This is determined under Code Sec. 482 regs.
- Special requirements if the lessor and lessee are related.
- The holding of land for investment does not give rise to a trade or business and such land cannot be qualified opportunity zone business property. Be cautious about certain uses of land (e.g. farming, parking lot, land banking), that may not conform to the intent of the law.
- The determination of whether the substantial improvement requirements is met, is made on an asset-by-asset basis.
- Anti-abuse rules
- To prevent the use of leases to circumvent the substantial improvement requirement for purchases of real property
- The Commissioner can recast a transaction (or series of transactions) for Federal tax purposes as appropriate to achieve tax results that are consistent with the purposes of Section 1400Z-2.
- Carried Interest – The share of gain attributable to the service component of the interest in the QOF partnership is not eligible for the various benefits afforded qualifying investments under Section 1400Z-2 and is not subject to the inclusion rules of Section 1400Z-2. This is the case with respect to a carried interest, despite the fact that all of the partnership’s investments might be qualifying investments.
Section 1400Z-2 versus Section 1031
- Section 1031- Must be exchange of real property for real property.
- Section 1400Z-2 may be used to defer (and partially eliminate) any type of capital gain.
- Section 1031 only defers gain. Section 1040Z-2 eliminates gain on “replacement property” held over 10 years.
- Under Section 1400Z-2 there is no:
- 45-day identification requirement.
- Need for qualified intermediary or funds held in escrow.
- Under Section 1031, the total fair market value of the exchanged property must be reinvested. Under Section 1400Z-2, only the gain is reinvested. The return of basis may be used for any purpose.
- Section 1031 replacement property does not have to be in an opportunity zone.
- Section 1031 exchanges defer the gain for both federal and California income tax purposes. Currently, California does not conform to Section 1400Z-2.
- A QOF cannot invest in another QOF. However, a QOF could be a party to a 1031 exchange.
Substantial Improvement Requirements for other than Original Use Property
- Must be made within 30 months of acquisition.
- Must exceed the adjusted basis of the property excluding land.
- Determined on a property-by-property basis.
- QOF investment more attractive for property with low value improvements and plenty of room for improvement/development. Not good for acquiring a well-maintained property on fully developed land.
- QOF may use working capital safe harbor to set aside funds earmarked for the improvement plan.
- Consider as part of long-term income and estate planning for investors. For example, what happens if individual investor dies while holding the QOF investment? Does the heir step into the shoes of the deceased investor for purposes of the “special rule for investments held for at least 10 years” under Section 1400Z-2(c)? What happens if the QOF investor is a partnership or S Corp. and one of the partners/shareholders dies while the flow through entity is holding the QOF investment?
- Consider as part of QOF investor’s state income tax planning.
- What state is the investor domiciled in?
- Is the investor planning on moving to another state?
- State tax Implications of where the opportunity zone property is located.
- Should high net worth investors create their own QOF or invest in third party QOF fund?
- Setting up own fund
- High minimum investment amount to justify administrative burden.
- More control and flexibility.
- No third-party fees or carried interest.
- Invest in third party QOF fund
- Professional management
- A self-created, closely held QOF may invest both directly in qualified opportunity zone business property and invest in a third-party qualified opportunity zone partnership interest.
- Both the lessor and lessee of property located in an opportunity zone may be QOF’s.
- The QOF investors tax basis in a QOF is zero. However, the QOF’s tax basis in the property it holds is generally the purchase price and may be subject to depreciation. For a QOF partnership, consider the tax implications of:
- Allocating losses to the QOF investor.
- Making distributions to the QOF investor.
- A partner’s tax basis in a QOF partnership is increased by his share of liabilities. Consider when determining how acquisitions and improvements will be financed (or later refinanced).
- In general, the activities of QOF and the QOF investors must be closely and regularly monitored to avoid any undesirable tax consequences (including penalties and interest).
- May combine the federal tax benefits of Section 1400Z-2 with other federal, state or local tax benefits, or non-tax incentives available to investors in certain low-income areas.
- Planning for how a taxpayer that already holds a business or other assets in an opportunity zone may benefit from Section 1400Z-2. Consider related party rules.
- QOF partnership agreement drafting considerations; does the QOF have both Section 1400Z-2(a) electing investors and other investors?
- Investment in QOF must be made in 2019 to meet the 7-year holding period by December 31, 2026.
- The deferred gain included in taxable income is limited to the fair market value of the QOF investment. Can the FMV be determined using lack of control or marketability discounts? May be beneficial to invest in multiple QOF’s.
- Under Section 1400Z-2(c) adjusting the tax basis of a QOF investment held for 10 years to the FMV on the sale date is elective. Therefore, if the tax basis is greater than the FMV, the QOF investor may take a loss if the sales price is less than the tax basis.
This summary should not be construed as tax advice and you should consult with your tax advisor and/or counsel regarding your specific circumstances.
If you have any questions or would like to schedule an appointment, please call us at (310) 697-1500.
Return to Insights