The 2017 Tax Cut and Jobs Act (2017 Act) created the federal Qualified Opportunity Zone program (QOZ or Program) effective in 2018 and operative for the next three decades. Beginning January 1, 2018, through December 31, 2026, individuals, corporations, REITs, and pass-through entities can sell a wide variety of appreciated capital assets and elect to reinvest the resulting capital gain into a Qualified Opportunity Fund (QOF). The federal tax impact of participating in a QOF includes deferring qualified gains for up to eight years and permanently exempting up to 15% of the original federal gain and 100% of the post-reinvestment gain – after holding the investment for seven and ten years, respectively.
Top 5 Things to Know about QOZ
While most of the focus is on real estate projects, the Program also provides significant potential benefits for taxpayers investing in active businesses that operate primarily within a QOZ. A future sale of an active business at multiples of 6 - to - 8 of EBITDA can easily eclipse a healthy real estate investment over that same period.
Taxpayers must roll all (or a portion) of their capital gains (short-term or long-term) into a QOF within 180 days of the capital gain being realized. The QOF must then timely invest the gain into undeveloped or developed real estate, a new or existing QOZ-based business, or into other QOZ property. Investors in various flow-thru entities (e.g., partnerships, S Corps, certain trusts and REITS) are deemed to receive their allocable share of taxable income on the last day of the entity’s taxable year, or December 31, for calendar year entities. Partners in partnerships that do not make the QOZ deferral election at the entity level can make the deferral election on their personal income tax return for their share of the capital gains on Form 8949. So most taxpayers with 2018 gains still have time to set up a QOF.
Be cautious of the many brokerage house QOFs which are being formed as they can trigger taxes in multiple states since only 28 states have adopted the federal provisions. Although all states have QOZ census tracts, the Program allows each state to elect whether or not they want to conform to the federal QOZ provisions. Governor Newsom recently announced selective conformity on limited housing and green tech projects. State law is varied and requires a very careful state-by-state analysis. As a result of California’s non-conformity, California taxpayers should carefully evaluate IRC Section 1031 structuring before making the plunge into a QOF.
Consider your future exit strategies when structuring the QOF especially when it comes to mixed-use projects or QOFs holding multiple assets that may be disposed of at different times. The way the law is currently written, investors must sell at the QOF level (vs. the subsidiary level) to fully benefit from the tax step-up at the 10-year holding period. Therefore, setting up a single QOF that holds multiple QOZ business assets can create some messy tax issues at the time of exiting the individual business assets.
Cities and states are very hungry for projects in these OZ census tracts so talk to their Economic Development personnel to determine the types of projects they are looking for, what vacant property is available and might already contain entitlements, and how the government agencies can assist in fast-tracking zoning, permits, etc. It is also worth exploring other tax and economic incentives that may be available in different locales.
The OZ program is a game-changer for developers, entrepreneurs, and other investors. There are still many open issues regarding the development process and how the Program will overlay with exiting and expanding operating businesses. Even so, taxpayers who have already sold an asset which generated a large capital gain should at least consider forming a QOF in order to “park” the gain within 180 days for future downstream investment once more regulatory guidance is provided.
For additional information about the OZ program, please contact Blake Christian, CPA/ MBT at Blake.Christian@hcvt.com or Alejandra Lopez at Alejandra.firstname.lastname@example.org. More information is also available at hcvt.com.
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