As part of the 2017 Tax Cuts and Jobs Act (the “TCJA”), Congress created the Qualified Opportunity Zone (“QOZ”) tax benefits. Owing in part to confusion over the provisions, the QOZ tax benefits were not as widely publicized and discussed as most of the other provisions of the TCJA initially. However, with the proposed regulations issued by the IRS in October, and high-profile funds being created, Qualified Opportunity Funds have been mentioned more in the news. There are exciting tax benefits in these provisions that real property developers should be considering.
Qualified Opportunity Zone Benefits
Investors in opportunity zones are eligible for the deferral of capital gains and possible reductions in total tax liability. Investors in a Qualified Opportunity Fund (“QO Fund”) can defer an unlimited amount of their capital gains. This deferral allows the investor to push back the recognition of capital gains to the earlier of (a) December 31, 2026 and (b) the sale or exchange of the QO Fund investment.
Longer-term investments will yield greater tax benefits. If an investor maintains the QO Fund investment for at least five years, the deferred capital gain is reduced by ten percent. If the investor maintains the investment for at least seven years, the deferred capital gain reduction increases to fifteen percent. Therefore, by holding the investment for a longer period of time, not only is the gain deferred, but 10-15% of the gain is excluded.
Additionally, the QO Fund investment has the potential for tax-free gains. If the QO Fund investment is held for 10 years, then the basis of in the investment is increased to its fair market value. Therefore, any gains that have accrued in the investment over the 10-year period will be tax-free. This is one of the most unique benefits offered by the QOZ program.
Three Significant Benefits for Developers
There are three direct benefits to developers:
- Raising capital
- Marketing leases
The first benefit is the most obvious. If a developer has capital gains, they can directly invest in a QO Fund in an applicable project to take advantage of the QOZ tax benefits.
Investments in QOZ will also assist in raising capital. QOZ investments are high-profile projects because of the QOZ tax benefits. There aren’t any restrictions on a QOZ investment being solely developed from QO Fund proceeds. Therefore, a project in a QOZ can be both QO Fund investors and other cash investors. Given the tax benefits and the high-profile nature of these projects, developers can take advantage of the increased awareness to raise additional capital.
Finally, the third direct benefit is in “leasing up” properties – businesses who place tangible personal property in a QOZ qualify for the benefits. The QOZ business can be nearly any trade or business within the zone, but not necessarily within a new real estate development project or a QO Fund project. Thus, commercial real estate developers should be taking advantage of current projects in these zones, as well as prospective projects, by marketing the available space as ready for QOZ Businesses.
Establishing Qualified Opportunity Funds
Step One – Form a QO Fund
The first step to establishing a QO Fund is to form the fund. An investment in a QO Fund can be either a corporation or a partnership, which includes LLCs taxed as either corporations or partnerships. A QO Fund can be a pre-existing or newly-created entity. The QO Fund is self-certified as a QO Fund on the next tax return filed by the entity. The IRS has issued a draft, Form 8996, which is the form on which the self-certification is made (here is a link to that form: https://www.irs.gov/pub/irs-dft/f8996--dft.pdf.)
In addition to the formation of the entity that will become the QO Fund (assuming it is not a pre-existing entity) and the Form 8996, the QO Fund will need governance documents to ensure it operates as such. The requirements to be a QO Fund and the restrictions that protect the QO Fund from failure are drafted into this agreement. For an LLC, this would be an operating agreement. The operating agreement would affirmatively require that sufficient assets are invested only in QOZ. The operating agreement would restrict the manager of the LLC from taking any action that would threaten its status as a QO Fund.
Step Two – Fund the QO Fund
Investors in a QO Fund may defer an unlimited amount of capital gains, provided that the gains are invested in a QO Fund within 180 days of the sale or exchange from which the capital gain arises. If the capital gain event occurs in a partnership, but the partnership does not invest into a QO Fund, the individual partners can defer their allocated capital gains using a QO Fund. For these partners, the 180 days starts on January 1st of the following year, which is the deemed date of the allocation of the capital gain. Under the right circumstances, this gives partners upwards of over seventeen months to make the QO Fund investment.
Investors have the option of investing all or a portion of their capital gains from each specific asset sale. Only cash can be contributed to the QO Fund. To affect the funding, the investor would enter into a simple contribution agreement between itself and the QO Fund. Following the terms of this simple agreement, the investor would simply wire the money to the QO Fund’s account.
Step Three – Making the Investment
To qualify as a QO Fund, an entity must establish that at least ninety percent of its assets, calculated as the average of two semiannual testing dates, are Qualified Opportunity Zone Property (“QOZ Property”). QOZ Property consists of either:
- (a) Qualified Opportunity Zone Business Property; or
- (b) Stock in a corporation or interests in a partnership that are primarily invested in Qualified Opportunity Zone Business Property. The first testing date is the six-month anniversary of the entity electing to be treated as a QO Fund or the last day of the taxable year – whichever comes first.
No later than this testing date, the QO Fund must have invested nearly all of its cash in the QOZ Property. There is a safe harbor for investments to meet the testing date if the prospective project is not “shovel ready.” To ensure this is a valid QOZ Property investment, there must be a “written plan” in place, which must identify the cash as held for the acquisition, construction, or substantial improvement of the property in the QOZ. Additionally, the plan must have a written schedule, consistent with the ordinary course of business operations, that the cash will be used within 31 months. If there is a written plan in place and the QOZ Business substantially complies with the plan and schedule, then the cash will be considered to have been invested for purposes of the QO Fund testing.
Although it may seem daunting, using the QOZ tax benefits, and even creating a QO Fund, are worth the effort. As with most tax planning issues and opportunities, QOZ cannot be fully explained in a short article. Whiteman Osterman & Hanna LLP has experience creating QO Funds and advising clients in investing in QO Funds. For more information contact Scott Shimick at email@example.com or by telephone at (518) 487-7678.
Scott Shimick is a partner with Whiteman Osterman & Hanna LLP and a member of the Firm’s Federal and State Taxation, and Business, Corporate and Commercial Practice Groups. For the past 15 years, Mr. Shimick has been advising businesses on various tax planning strategies and representing clients before the IRS and the New York Department of Taxation and Finance with respect to audits and litigation. Mr. Shimick’s tax planning includes developing strategies for clients in mergers, acquisitions, and business dispositions--as well as advising on Qualified Opportunity Zones. Mr. Shimick is admitted to practice in New York and before the U.S. Tax Court and the U.S. District Court for the Northern and Western Districts of New York.