This classic line from The Godfather, strangely comes to mind in light of a new federal program that allows for the deferral of capital gains taxes. “Leave the Taxes. Invest in the Property” is essentially the mantra of the recently enacted Qualified Opportunity Zone program (the “Program”). The Program, passed into law in December of 2017, as part of the Tax Cuts and Jobs Act, provides an investor with the ability to defer taxes on capital gains. It also provides an investor with the ability to reduce or even eliminate taxes on capital gains in certain instances.
The goal of the Program (26 U.S.C. §1400Z) is to encourage long-term investment in designated low-income communities called Qualified Opportunity Zones (“QOZ”). These are low-income census tracts nominated by a state’s governor and certified by the U.S. Treasury Department. There are 878 opportunity zones in California and 8,700 throughout the United States.
Unlike the requirements of a 1031 exchange, the Program does not have any “like-kind” exchange requirement. Instead the Program provides tax benefits to investors who receive short or long-term capital gains from any source (including real estate, stocks and bonds), and reinvests those gains (in certain cases, the gain recognized by a partnership may be reinvested by the partners in the partnership) in a “Qualified Opportunity Fund” within 180 days following the sale that generated those gains (in some instances, the 180 days may be triggered off of a later date).
A Qualified Opportunity Fund (“QOF”) is a corporation or partnership (and possibly a limited liability company treated as a partnership for federal income tax purposes) which holds at least 90% of its assets (the 90% threshold is tested and certified within 180 days after the QOF is qualified, and thereafter on the last day of each calendar year) in Qualified Opportunity Zone Business Property (“QOZP”), whether directly or as an equity (not debt) investment. “QOZP” includes both tangible property (including real estate) used in a business located in a QOZ as well as a business in which at least 70% of its assets are tangible property located in a QOZ, in each instance excluding certain “immoral” businesses.
Taxes on capital gains which are reinvested in a QOF within the requisite time period will be deferred until the earlier to occur of December 31, 2026 or the date of disposition of the QOF investment. If the QOF investment is held for at least five years, the basis of the reinvested capital gains will be increased by 10%, and if it is held for at least seven years, then the basis will be increased by a total of 15%. In each instance, the amount of capital gains will be determined using a basis equal to the lesser of the original basis (subject to any 10% or 15% basis increase) and the fair market value of the QOF investment.
If an investor holds his QOF investment for at least ten years, the tax basis of the investment will be adjusted to equal the fair market value of the QOF investment at the time of its sale, thus eliminating any capital gains thereon. While a QOZ designation lasts only until the end of the tenth calendar year following its designation, the Program provides that the beneficial capital gains treatment will inure to QOF investments until December 31, 2047.
The final terms of the Program are still being developed, but a revenue ruling and the first set of regulations, both released on October 19, 2018 by the Internal Revenue Service, have provided some clarity. Further guidance is expected by the end of this year. In the meantime, billions of dollars are being invested into QOFs waiting for the final rulings and eventual deployment into QOZs.
Susan Booth and Doug Praw are partners at Holland & Knight LLP. Learn more at hklaw.com.
Per Treasury Department Circular 230: Any U.S. federal tax advice contained in this article (including any references herein) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.
