Opportunity Zone Investing
March 3, 2022
For taxpayers who have unrealized capital gains, an opportunity exists to defer and even exclude a portion of such gains from gross income if the taxpayer invests an equivalent amount in an entity known as a Qualified Opportunity Fund (QOF) created pursuant to Section 1400 Z-2 of the Internal Revenue Code (Code), which entity invests in a qualified business or property in an Opportunity Zone (OZ) designated in accordance with Section 1400Z-1 of the Code OZs, created by the Tax Cut and Jobs Act of 2017, existing in all 50 states, the District of Columbia and five US territories are designated by the Governor or equivalent in each jurisdiction pursuant to requirements in the Code. The goal of OZs is to incentivize investment in geographic areas that have not participated in the economic recovery since the Great Recession of 2008. As a result, 8,766 individual OZ census tracts have been designated and certified by Treasury.
Investors who realize capital gains within a 180 day period prior to investing an equivalent amount in a QOF which invests in a OZ will benefit first and foremost from the deferral of capital gain recognition until up to December 31, 2026. In addition,10% of such deferred capital gain may be excluded from gross income permanently if the equity interest in the QOF is held for a minimum of five years and an additional 5% may be excluded if the investment is held for a minimum of seven years because the investor is eligible to increase his cost basis in his investment by such amounts.
For investments in commercial or residential real estate to qualify, the properties must be “substantially improved” which requires development /improvement expenses to exceed the original acquisition cost. For investments in OZ businesses to qualify, the business must earn more than 50% of its gross income from activities within the OZ.
In addition, there is no capital gains tax due on the gain upon the sale of investments in a QOF that properly invested in an OZ if the opportunity zone investment is held for a minimum of 10 years. There is also no depreciation recapture for real estate investments.
Comparing OZ investments with the same return expectations subject to capital gains tax, the net after-tax return increases by 3% to 5% per year or a potential cumulative return difference of 34% to 62%.
While the funds are invested in an OZ, there may be additional benefits during the 10-year period.
First, accelerated depreciation may shield passive income.
Second, if leverage is used to fund a portion of the OZ investment, as those loans are refinanced, a return of capital is possible to investors. So long as it does not exceed the original investment, it will not be considered an inclusion event, and thus will not trigger a capital gain.
Of course, when considering a QOF investment, it behooves the investor to conduct the same rigorous due diligence he is advised to conduct when considering any private investment. Care must be taken that the QOF duly qualified for the available tax benefits and that the detailed reporting requirements in the Regulations will be met. More important the project must make sense apart from the available tax benefits. The manager must demonstrate qualified experience in developing the project or running the business. Are the management fees and profit participation of the Manager reasonable and comparable to similar investments?
The information contained above has been prepared by the Law Offices of Lawrence Pohly for general informational purposes and is not intended to constitute a legal opinion or provide legal advice, which is provided only to clients of the Firm who have a retainer relationship with the Firm. The Law Offices of Lawrence Pohly disclaims all liability to any person who relies to their detriment on the information contained herein. To ensure compliance with requirements imposed by the IRS under Circular 230, we inform you that any U.S. federal tax advice contained in this communication (including any attachments), unless otherwise specifically stated, was not intended or written to be used, and cannot be used, for the purpose of (1) avoiding penalties under the Internal Revenue Code or (2) promoting, marketing or recommending to another party any matters addressed herein.