Qualified Opportunity Zones (QOZs) are economic development zones. To that end, they provide three significant tax breaks to encourage investor participation: capital gains moratorium until 2026 on capital gains reinvested into a QOZ; capital gain reduction of up to 15% on reinvested capital gains; and, most importantly, If the QOZ investment is held for at least ten years, there are no taxes on the appreciated capital gains.
However, there are caveats associated with each of these transactions. Investors must invest in QOZs through a Qualified Opportunity Zone Fund (QOF) or company. We suggest investors work with accounting and legal advisors who are knowledgeable about the laws since investors must follow the new IRS tax guidelines to the letter or risk losing eligibility for these benefits. Additionally, the Internal Revenue Service is scheduled to publish further guidelines on QOZ investments later this year or early in 2020.
Our goal in interviewing John Hoffman, a Chicago CPA with extensive knowledge of qualified opportunity zones, qualified opportunity funds, and other tax benefits, was to bring investors up to speed on the most current rules. As president and founder of Bracket Partners, Hoffman collaborates closely with the accounting firm Miller Cooper & Co.
- What Constitutes Eligible Capital Gains and How to Obtain It?
According to Hoffman, the QOZ program applies to a wide range of short-term and long-term capital gains. The IRS Form 8949 reports money invested in an opportunity zone fund. Here, filers must change their long-term and short-term capital gains. Direct capital gains include those from selling stocks and bonds, while indirect capital gains include those from selling a business or partnership, which are reported on Schedule K-1. All real estate capital gains transfers, whether made at the closing table or through a series of installment sales, are valid.
Depending on the circumstances, determining an investor’s actual amount of capital gains could be straightforward or difficult, as Hoffman puts it. To determine the amount of a capital gain or loss on publicly traded equities, one needs to refer to the cost basis information provided on broker statements. However, QOZs enjoy favorable tax status for company property under Section 1231 of the Internal Revenue Code. Investors must add all Section 1231 property transactions for the year and subtract any losses incurred to establish their taxable gain.
Finally, the Internal Revenue Service allows investors 180 days to participate in a qualifying opportunity fund to delay the net gain. They must reinvest gains on capital investments within six months, so timing your harvest is crucial. Hoffman recommends consulting an accountant for guidance on this matter. He advised that you consult an accountant before making any decisions of this nature. According to IRS and Treasury guidelines, the 180-day clock for most business and partnership profits begins on the last day of the tax year, which is usually December 31, 2019.
When a corporation or partnership does things throughout the year that will result in capital gains, that’s where it’s tough, says Hoffman, whether you hold shares of stock or a partnership interest in that corporation or partnership. When tax season rolls around, and firms start handing out Schedule K-1 forms, that’s when investors find out about it. In certain cases, K-1s are not available until the summer. He continued; this is a huge issue since you risk missing the 180-day timeframe. The summer is the typical time when you can obtain a K-1 visa. The risk of missing the 180-day window is high if that happens. Any investor considering putting money into an opportunity zone fund should keep an eye on this industry’s activity throughout the year.
- Why 2019 Matters for the Capital Gains Tax Cut
Shareholders of the QOZ Fund not only defer the date on which they must pay taxes on the invested amount until 2026 but also reduce their tax liability for that year. This accounting enhances the cost basis for the invested money, which minimizes the resulting capital gain. This “step-up” is 10% at the end of 2026 if the QOZ investment has been held for five years. It increases by a further 5% to 15% if the QOZ investment has been retained for seven years. The 15% tax credit for purchasing QOZ shares will expire after 2019.
The five- and seven-year counts commence when proceeds are invested. Suppose investors feel that a particular QOZ fund is not appropriately managing their money. In that case, they can move it to another QOZ fund after paying any applicable early liquidation penalties. This rollover investment, however, will reset the cost basis clock, and the investor will forego the opportunity for the maximum tax benefit, which is just one of the many reasons to pick a real estate fund manager carefully from the get-go.
Last, if the fund is dissolved before 2026 or shares are being passed as a gift to children, they must report the deferred gain in the tax year 2026. There will be a reconciliation of the deferred gain in 2027 when the actual tax amount is due, and they will make quarterly payments throughout 2026 to cover the deferred gain.
- What Ten Years of Tax-Free Appreciation Look Like
As a result, the most lucrative tax benefit from QOZs does not become available until 2026, after taxes on the initial wave of capital gains have been paid. Gains from the appreciation of a qualified opportunity zone investment are permanently exempt from taxation after the investment has been kept for ten years. (Once again, the taxpayer claims this exemption on Form 8949. The fund’s cost basis increases to its current market value for accounting purposes. From Hoffman’s perspective, he would argue that the benefit of the new gain is much more valuable than the benefits of the old gain. However, this advantage is also dependent on the QOF’s asset performance, which in turn is determined by the quality and experience of the fund manager.
He says that there’s no meaningful benefit for the rental income generated based on existing instructions. Rents are still taxable and could still be sheltered by depreciation. The common question is, how much do you think your initial investment will be worth in ten years? The program’s focus is principally on the properties’ long-term value growth. To put money into an extremely illiquid investment, where early withdrawal incurs heavy penalties, one must be quite certain to decide. Think about the results of the fund’s planned liquidation date, too. Holding assets for more than ten years may be warranted due to market conditions, or new investors may require more time to attain a 10-year benchmark. The program protects distributions until 2047, which is ten years following the first eligible investment of capital gains from 2026 plus up to 10 years to liquidate the fund, even though the qualified opportunity zone program will have ended by then.
Estate planning considerations must take into account the potential for long holding periods. Deferred gains may become taxable if an investor makes gifts to their children while still alive. However, a spouse, estate, or trust that inherits shares does not have to report them as capital gains.
Additional factors must be considered while investing in a Qualified Opportunity Zone. When it comes to taxes, for instance, individual states might opt to follow federal guidelines or not. Some states offer tax incentives, while others, like California and Massachusetts, may require you to pay state income tax. Investors who wish to gain additional management authority over their portfolios, ownership, or governance should seek out the counsel of both financial and legal experts before forming any businesses or trusts.
Last, real estate fund managers jeopardize their investors’ tax breaks by not having a compliance program to meet Treasury standards or a solid business plan to protect the investment capital and achieve the anticipated benefits. Due to the high risks involved in an opportunity zone deal, it is crucial to coordinate with investment partners, financial and tax advisors, and real estate fund managers.
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