Qualified Opportunity Zones & Qualified funds to defer your gain

[Ashish Acharya]

I was doing a research for a customer and realized Bp community can also benefit from this. I personally believe, Qualified Opportunity zones almost as effective as 1031 exchange.  Trying to keep this simple and just the basics.  We are still waiting on some technical correction and clarification. 

The Tax Cuts and Jobs Act allows

A) Temporary deferral of inclusion in gross income for capital gains reinvested in a Qualified Opportunity Fund (QO Fund) and

B) Permanent exclusion of certain capital gains from the sale or exchange of an investment in the QO Fund.

A) Temporary deferral of inclusion in gross income for capital gains reinvested in a Qualified Opportunity Fund (QO Fund) 

Important points:

● No dollar limits

● Have to reinvest the capital gain within the 180 days

Have to include the excluded gain (reinvested gain) at the end of the deferral period which includes earlier of:

○ The date on which the investment is sold

○ Dec 31. 2026

● What gain is included? See example below.

○ Excess of (formula = Initial reinvested gain – basis of investment)

■ Gain excluded when reinvested in QO fund (or FMV of investment if lower) over

■ Basis in the investment.

○ Basis starts with Zero and increases in this order

■ Held for 5 years - 10% of gain reinvested

■ Held for 7 years - 15% of gain reinvested

■ Held for 10 years - 100% of gain reinvested

Thus, if held for 10-year, total capital gain that was reinvested is permanently deferred.

B) Permanent exclusion of certain capital gains from the sale or exchange of an investment in the QO Fund.

● If the investment is held for 10 years, the capital gain on the sale of the investment is excluded.

What is QO fund:

Corporation or partnership that invests in QO zone property that holds 90% of its asset in the QO zone.

A QO Zone property is property is:

● Domestic Stock

● Partnership interest

● Business property used in trade or business

Example:

A sells a property and realizes a gain of $1 million on Dec. 1, 2021. On Dec. 31, 2021 (i.e., a date within the 180-day period beginning on Dec. 1, 2021), A invests all of the $1 million gains in a QO Fund. If A makes the temporary deferral election, A does not include the $1 million of realized gain in his gross income for the 2021 tax year.

If A holds (Not sold) the investment in the QO Fund until Dec. 31, 2026, as the deferral period is over, A has to include the deferred gain in A’s gross income in 2026.

How much of the reinvested $1M would he include? Answer: 900,000

● Reinvestment amount = $1M

● Basis increase = 100,000 (10% of Reinvestment as held for 5 years.)

● Gain included = (Reinvested amount - basis increase) = 1M - 100,000= $900,000.

If A also sells the investment in QO Fund on Dec 1, 2031, 10 years later, he does not recognize any capital gain on the sale of his investment in QO fund.

If A sells the investment before 10 years, basis in the investment is based on the time it is sold:

Basis starts with Zero and increases in this order

■ Held for 5 years - 10% of gain reinvested

■ Held for 7 years - 15% of gain reinvested

Basis at 5 years = 100,000

Basis at 7 years = 150,000

Thus gain/loss is determined based on the FMV of the investment less the basis at the date of sale. If a date of sale was more than 10 later the initial investment, no capital gain is recognized.

[Stan Kaneshige]

It's also important to note that according to Sec 1400Z-2 (D) the property must be used in a trade or a business. The investor must start or have an "original use" of the property, which most likely means the investor will have to start a new business on the property or get a tenant that is starting a new business.

If the investor is purchasing a property that already has a business on it and chooses to either buy and continue that business or continue renting out the property to that existing business, they then have a 30 month period over which they must invest an amount that exceeds the adjusted basis at the beginning of the 30 month period for "substantial improvements". So for example, an investor buys a storefront property with a tenant in it for $500,000, continues to rent it to that tenant for a year and then decides to start his 30 month investment. Let's say the adjusted basis of the property is now $600,000. The investor now has 30 months to make at least $600,000 worth of improvements to the property.

Another factor to consider is that some businesses are disallowed, not unlike NMTC eligibility. For example an investor cannot have a business on the property that engages in any of the following “sin” businesses: any private or commercial golf course, country club, massage parlor, hot tub facility, suntan facility, racetrack or other facility used for gambling, or any store the principal business of which is the sale of alcoholic beverages for consumption off premises.

With these factors in mind, I would think caution would be in order for any investor looking to defer taxes through this program. There are still many gray areas for which the Treasury and IRS have not made clear regarding documenting and guaranteeing that the actual deferrals, cost basis reductions and permanent exclusions will be honored in any given business and property combination.

This alone has tempered my interest in Opportunity Zones. To think of what types of businesses and which specific areas within the LICs designated that could actually help defer investors CG taxes without actually becoming a loss seems daunting. 

I feel the only way to success would really be to devote oneself to the altruistic intent of the Opportunity Zones program by making meaningful connections to the community and learning what the biggest needs are, finding sponsors or organizations willing to run a business for profit or non-profit that would really be accepted and welcomed by the community. Partner with them to acquire an acceptable property within the designated areas that would house that business or organization.

It would require a lot of time and work, but would probably be the best way to avoid losing money on a property that would house a failing business or worse yet sit vacant and cause further blight to these already struggling communities.