Many high-net-worth taxpayers are taking concentrated stock positions off the table in the face of uncertainty in the economy, financial markets, and state and federal law-making bodies. These large liquidity events are one reason why the federal Qualified Opportunity Zone program was introduced in the Tax Cuts and Jobs of 2017.
Part 1 of this article discussed which gains are eligible under the QOZ program, how the QOZ program compares to 1031 exchanges, and how the mechanics of gain deferrals work in terms of basis adjustment, reporting and exemptions. Here we’ll look at five more important aspects of the program, including the recommended legal structure, original use and rehab requirements, types of businesses that don’t qualify for QOZ investment, and the types of taxpayers best suited for the program.
Legal form of Qualified Opportunity Zone fund
If you have clients interested in starting their own QOFs, it’s essential to choose the right legal form for the fund and any second-tier entities holding the QOZ property to ensure optimal tax results from both an annual operations standpoint and an exit standpoint.
This is where you can provide tremendous value to clients, as it will require a careful analysis of the specific investors in the QOF, the types of property to be held by the QOF and the likely exit options. S Corps may be problematic investment vehicles for many QOF investments, and LLCs and partnerships will generally be the preferred choice for leveraged real estate projects.
Percentage of qualified property test and penalty
The QOF must generally hold at least 90 percent of its assets in Qualified Opportunity Zone property – which includes:
1. An interest in undeveloped QOZ real estate;
2. An interest in developed QOZ real estate, which meets the substantial improvement test (reinvesting 100 percent of the cost basis of the building within 30 months of acquisition); and,
3. QOZ property.
Mobile property, which may go outside the boundaries of a QOZ, will likely not qualify as QOZ property, but future regulations may provide some relief. Other business entities held by a QOF must hold at least 70 percent of QOZ assets. To the extent the percentages are too low, a variable penalty (currently 6 percent annualized) is assessed at each six-month testing date.
Business types not eligible
QOF investments into business entities that hold real estate or other QOZ property can also qualify as QOZ property. However, certain business entities that hold restricted assets are not eligible for investment, including liquor retailers, golf courses, massage parlors and tanning salons. A QOF apparently can invest directly in such property, but cannot invest in an entity holding one of these assets. Future regulations may modify this apparent oversight.
Real estate “original use” and rehab requirements
Taxpayers must generally be the “original” user of the QOZ property. In the case of improved real estate, the Tax Code and proposed regulations provide guidance that the taxpayer must invest at least 100 percent of the investor’s original cost basis in rehabbing the property. A concurrent revenue ruling issued with the proposed regulations allows bifurcation of the land and building investments, thereby lowering the rehab cost threshold. For example, let’s say your client invests $2 million in a QOF and the QOF then invests in real estate with an old commercial building on it. The land is worth $800,000 and the building is worth $1.2 million. Rather than being required to invest an additional $2 million in the project to meet the “original” user requirement, only $1.2 million of additional investment into the building is required.
Which clients should (and should not) invest in a QOF
If your client is setting up their own QOF, the deferred gain (theirs and any friend’s deferred gains) should be at least $1 million in order to justify the legal and administrative costs of formation. Investment firms will be setting up diversified “public” QOFs to take in smaller amounts, but you and your client will need to perform thorough due diligence in order to understand the legal and tax structure and the proposed reinvestment strategy of the fund — especially the state tax ramifications.
QOFs are not ideal for clients who are elderly or in poor health, no matter how large their gains or disposable income. Clients should have at least a 10-year investment horizon to justify the QOZ strategy. There may be limited situations in which a taxpayer utilized a QOF strictly for deferring the tax payment on a gain, but there are added costs and investment risks in the intervening years.
Even though the program offers all taxpayers significant tax savings, sometimes it’s not enough. For example, complex entitlement processes, financing issues or public pressure from NIMBYs can derail your clients’ projects. In a recent example, despite significant benefits for the local community, as well as benefits for Amazon, public pressure related to state-level tax breaks and subsidies forced Amazon to shutter its New York City relocation plans — which involved a QOZ.
There will be many open issues surrounding the QOZ program and additional guidance is expected in the near future. Still, taxpayers who have already sold an asset generating a large capital gain should consider forming a QOF in order to “park” the gain within 180 days for future reinvestment once more guidance is provided.
