Minimize existing capital gains taxes and generate tax-free capital gains
The Opportunity Zone (“OZ”) is suitable for investors who are looking to minimize existing capital gains taxes and generate tax-free capital gains over a ten-year time period. As part of The Tax Cuts and Jobs Act of 2017, a new tax benefit was created allowing the deferral of capital gains that are invested in Qualified Opportunity Zones (“QOZ”) to spur investment and economic growth in distressed communities.
What Is an Opportunity Zone?
OZ’s are special geographic districts designated by each state. Under the new legislation, taxpayers can defer tax on capital gains invested into Qualified Opportunity Fund (“QOF”) that purchase and improve real estate or businesses located in OZ’s.
As of June 14, 2018, the U.S. Department of Treasury and Internal Revenue Service announced the final round of OZ designations. There are more than 8,700 designated OZ across all 50 states and five U.S. possessions. Approximately 35 million Americans live in the communities designated as OZ.
OZ’s are intended to be advantageous for both distressed communities needing investment dollars and investors looking to minimize capital gain taxes;
Average poverty rate in OZ areas is 32% whereas the average U.S. census tract is 17%;
Median family income is less than 80% of the surrounding areas;
OZ’s that have already been approved can be seen on a map available at: http://eig.org/opportunityzones.
How It Works
A QOF must be organized as a U.S. corporation or partnership that holds at least 90% of its assets in one or more qualified Opportunity Zones.
Investments must be made in a QOF and be located in OZ’s to receive benefits.
Certified by the U.S. Treasury Department with an OZ designation
QOF investments are limited to equity investments in:
Businesses
Real estate - Subject to a substantial rehabilitation requirement
Business assets
QOZ property includes:
Newly issued stock
Capital or profits interest in a domestic partnership acquired/created after Dec. 31, 2017
Formed for the purpose of being a “QOZ business”
Partnership interests
Capital or profits interest in a domestic partnership acquired/created after Dec. 31, 2017
Formed for the purpose of being a “QOZ business”
Business property
Tangible property used in a trade or business of the QOF
QOZ business is defined as a trade or business in which:
Substantially all of the tangible property owned or leased is QOZ business property;
At least 50% of the gross income is derived from the trade or business; and
A substantial portion of any tangible property is used in the trade or business.
Note: Loans are not eligible for the tax incentives.
Why Should an Investor Allocate to a QOF?
The OZ program provides incentives to focus on community revitalization over the long-term while providing downside protection and low correlation to cycles. In addition to tax incentives, there are several reasons to include real estate in a multi-asset portfolio, including potential return enhancement, risk diversification, inflation hedge/protection, and low volatility.
Opportunity to rebalance portfolio and minimize tax liabilities;
Deferment of unrealized capital gains, up to 15% in step-up basis;
Exclusion of new capital gains tax on investment;
Tax benefits include increased expensing and depreciation; and
A genuine sustainable impact.
Reinvested Capital Gain Benefit?
U.S. investors currently hold $2.3 trillion in unrealized capital gains, representing a significant untapped resource for economic development.
How does a capital gain of $100 reinvested in 2018 perform over time?
An investor will have greater upside if the QOF holds the investments for at least 10 years. Over a 10-year investment period, an investor will have an increase value of 44% for every $100 of capital gains placed in to QOF than if they had chosen a traditional stock portfolio.(1)
Source: Economic Innovation Group
Comparing an Opportunity Zone to a 1031 Exchange?
Although investments are fact-dependent, unlike a 1031 exchange where proceeds need to be reinvested in a like-kind exchange, OZ investments include all eligible assets, (e.g., real estate and non-real-estate assets) and only capital gains need to be invested.
Other Tax Benefits?
Additional tax benefits from the Tax Reform Act can be combined with the OZ tax benefits to offset income.
100% Expensing: 100% expensing for qualified property placed in service before 2023; immediate expensing is then phased down by 20% each year until 2026.
Increased Expensing Cap: Raises the Section 1792 expensing cap from $500,000 to $1,000,000, and the phase-out threshold amount to $2,500,000.
Accelerated Depreciation: Expands first year accelerated depreciation for investment in qualified tangible property.
Qualified Opportunity Fund Frequently Asked Questions?
Qualified Opportunity Fund Social Impact / ESG Benefits?
QOF will enable investors to not only take advantage of favorable tax benefits but will help establish new norms for economic activity that are better aligned with economic, environmental and socially sustainable goals that benefit future generations.
One out of six Americans lives in low-income census tracts;
Despite impressive US employment gains, low-income census tracts have seen a net job loss;
Need for business growth and affordable housing within low-income census tracts is crucial;
Leading philanthropic organizations such as Kresge Foundation and Rockefeller Foundation are working with economic policy groups to define and implement programs for measuring the impact of OZ investments.
Treasury Proposed Regulation Update
On October 19, 2018, the Treasury Department and IRS issued highly-anticipated proposed regulations (“Proposed Regulations”) for Qualified Opportunity Zone investments. (2)
The Proposed Regulations provide additional guidance on several issues, including both fund related mechanics and investment related questions. Below is a brief overview of the Proposed Regulations most crucial to potential QOF investors:
Treatment of Eligible Gains
Only income treated as short-term or long-term capital gain under the Internal Revenue Code (“IRC”) section 1400Z-2(a)(1) is eligible for deferral.
Only capital gains are eligible for deferral under the OZ program.
When the original capital gain is realized by the taxpayer it will retain its original status i.e.., the short-term capital gain will remain short-term when realized.
Partnerships and other pass-through entities are eligible for special gains deferral.
The Proposed Regulations 180-day reinvestment period starts on the last day of the partnership’s or pass-through entity’s taxable year, rather than the sale date.
It is anticipated that taxpayers will elect to defer eligible gains on Form 8949 which would be attached to their federal income tax return for the taxable year.
Investments Held for at Least 10 Years
Under IRC section 1400Z-2(c), a taxpayer effectively eliminates any gain that might be realized upon the sale of interest, eliminating any federal tax liability after a 10-year holding period.
After the opportunity zones expire, the 10-year rule is still applicable if the sale occurs prior to December 31, 2047.
Taxpayers Eligible to Elect Deferral
Taxpayers include individuals, C corporations (including regulated investment companies and real estate investment trusts), S corporations, partnerships, trusts and estates.
Other Clarification - QOF requirements include:
Process for certifying a QOF and IRS forms;
Asset valuations for purposed of the 90% Qualifying Asset Test;
“Substantial Improvement” calculations and test to real property;
Safe harbor for working capital in QOFs.
The Treasury has scheduled a public hearing for January 10, 2019 and will accept comments on the Proposed Regulations in the interim. The Treasury is expected to subsequently issue final regulations. Note, the Proposed Regulations indicate that this guidance may be applied to transactions that occur before the final regulations are issued.(3)
Qualified Opportunity Funds (“QOFs”) are a particularly strong match for investors looking to minimize capital gains taxes, while generating further tax-free capital gains, over a ten-year period. The Proposed Regulations clarify opportunity zone investments, likely stimulating demand for QOFs as investors seek to maximize benefits under the relegations by investing prior to December 2019.
Special Thanks to Our Contributor
David Madrid
Director at Highmore
D: 415 501 0640
david.madrid@highmore.com
www.highmore.com
Highmore is a global alternative asset management firm investing in both public and private markets, directly and indirectly, across asset classes and investment structures.
The Highmore Opportunity Zone Fund will make qualifying real estate investments within Opportunity Zones focused on metropolitan areas with strong growth prospects that will raise land values and will increase real-estate demand and market liquidity.
Highmore will be focused on the institutional middle-market, and will be diversified by property type, geography, and operating partners.
Highmore’s real-estate operating partners have a long history and deep domain expertise across industrial, multi-family and office sectors working in their respective markets which qualify as Opportunity Zones.
Highmore will execute an opportunistic development strategy with transactions that have very low basis which would provide cushion given any future economic turbulence, while putting investors in a position to benefit from the strong growth in the market.