The Tax Cuts and Jobs Act of 2017 added a new tax incentive called the Qualified Opportunity Zone (QOZ) program. This program allows taxpayers to defer paying tax on capital gains from selling an asset and also eliminate some of the tax on those gains. To take advantage of these benefits, investors must act before the end of 2019. The program applies to investments in specific communities designated as qualified opportunity zones.
The Department of Treasury released regulations for the QOZ program, giving investors confidence to move forward with investments, especially in real estate. The program provides four main tax benefits to investors, including the ability to defer capital gains from selling an asset by investing in a qualified opportunity fund (QOF). Investors are only required to reinvest the amount of the capital gain and can use the remaining amount for other purposes while still deferring the capital gain. If you invest in a Qualified Opportunity Fund (QOF), you can get tax benefits. You can eliminate up to 15% of your deferred gain in taxes if you hold your investment for a certain amount of time. But there are limitations and drawbacks. Your investment must be in exchange for cash or property, not for services. The tax benefits only apply to capital gains from selling an asset to someone unrelated to you. You have to invest within 180 days of making a gain. And if you don’t sell your investment by December 31, 2026, you’ll have to pay taxes on the deferred gain. There are some ways to get around these drawbacks, but it’s important to understand the rules before investing. Investor made a $9 million profit from selling stock. They invested that profit in a QOF and didn’t have to pay taxes on it. Over time, they eliminated some of the deferred profit from taxes. Eventually, they had to pay taxes on $7.65 million. When they sold the QOF interest after 10 years, they didn’t have to pay any taxes on the $20 million they got.
In the second example, the same thing happened, but the investor sold the stock before investing in the QOF. So they wouldn’t get the same tax benefits. Investor invested in QOF and saved $9 million in taxes. Investor’s son, A, received the QOF interest as a gift and had to pay taxes on it. When Investor died, A had to pay taxes on the QOF interest. If Investor sells property to A, the gain is not eligible for tax savings. To invest in a Qualified Opportunity Zone (QOZ), you can’t just buy the property directly. Instead, you have to invest in a Qualified Opportunity Fund (QOF) that meets certain requirements. The QOF needs to be set up for the purpose of investing in QOZ property and organized as a partnership or corporation. It also has to hold at least 90% of its assets in QOZ property. To invest in a QOF, you just need to make sure it meets these requirements and file a form with the IRS to certify its status. A QOF must meet the 90% asset test, which means that 90% of its assets must be in qualified opportunity zone business property (QOZBP) or equity interests in QOF subsidiaries. Cash is not considered QOZBP, so if more than 10% of the QOF’s assets are cash, it will fail the test. When investors put money into the QOF, it needs to be used to buy property or improve real estate in a qualified opportunity zone. However, if the QOF has too much cash and not enough property or real estate improvements, it won’t meet the 90% asset test. So, it’s important for the QOF to use the money from investors to buy or improve property within a certain time frame. The QOF needs to have 90% of its money invested in opportunity zones by December 31, 2019. They have $5 million in opportunity zone investments and $4 million in cash, which is not considered an opportunity zone investment. They won’t be able to invest the $4 million until after December 31, 2019, so they will fail the test. However, they can put the extra cash in a subsidiary and still pass the test as long as the subsidiary is also an opportunity zone business. To qualify as a QOF subsidiary, a business must meet certain requirements, including that 70% of its property must be located in an opportunity zone and used for business purposes. The business also must earn at least 50% of its income from activities within the opportunity zone. It cannot be primarily involved in certain “sin businesses,” like golf courses or selling alcohol to drink offsite. If the business leases property, there are additional rules to follow, particularly if the property is leased from a related party. If the business buys property from a related party, it must be careful to follow the rules. The investor owns most of the QOF subsidiary, which owns most of the QOF subsidiary’s equity interest. This means that when the QOF subsidiary bought Greenacre and the building from the investor, it doesn’t count as a qualified opportunity zone business property (QOZBP). However, if the QOF subsidiary leases Greenacre and the building from the investor, it does count as QOZBP. If you want to invest in real estate in a designated Opportunity Zone, there are rules about how much you have to improve the property. Generally, you have to double the amount of money you spent to buy the property by investing in improvements within 30 months. However, the rules are a bit different for raw land and vacant buildings. If the building has been vacant for at least five years, it doesn’t need to be substantially improved. Also, if the property is the first to be used for depreciation or amortization in the Opportunity Zone, it can still count as qualified Opportunity Zone business property. For example, if a QOF subsidiary spends $5 million to buy a building and land, they would have to spend more than $3 million in improvements to the building within 30 months to meet the substantial improvement requirement. To qualify as a Qualified Opportunity Zone Business (QOZB), at least 50% of the business’s income must come from actually doing business, like owning and operating real estate. Just renting out property doesn’t count.
Also, the business can’t have more than 5% of its money just sitting in the bank. But there’s a special rule that lets the business have extra cash for up to 31 months if it’s being used to develop the business, like buying or improving property in a Qualified Opportunity Zone.
Overall, the new rules give businesses more flexibility in how they use their cash to grow in these designated areas. The QOF subsidiary bought a building for $5 million and has $4 million left in cash to make improvements. They can ignore the cash for a test if they follow a schedule for spending it. If they spend the cash over the next 31 months as planned, they will meet the requirements to be a Qualified Opportunity Zone Business (QOZB). This program helps economically struggling areas and gives investors tax benefits. The rules for these investments are complex, so advisors need to make sure everything is done correctly. The new regulations provide some relief for qualified opportunity funds (QOFs) by allowing them to apply a 90% asset test without considering any investments received in the past six months. These regulations are part of the tax law and are meant to help businesses and investors in certain designated areas. Justin Wallace, a tax attorney, works with these kinds of transactions and helps clients understand and navigate the complex tax laws.
Source: https://www.floridabar.org/the-florida-bar-journal/the-yellow-brick-road-to-qoz-becomes-clearer/
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