This article appeared in the winter issue of Urban Land on page 72.
Tax legislation enacted last year created an innovative new tool for real estate finance and investment, and it could signal a geographic shift in real estate development for at least the next decade. This new tax law is designed to incentivize the reinvestment of an estimated $6.1 trillion in private, unrealized capital gains into designated low-income communities nationwide.
Under new Internal Revenue Code (IRC) Subchapter Z, certain U.S. census tracts have been designated as “qualified opportunity zones” (QOZs), and certain investments in a QOZ can yield significant federal income tax benefits. The law went into effect January 1, 2018, but U.S. Treasury Department regulations regarding the law were not issued until October.
Here is how it works: if a taxpayer sells an appreciated asset, such as stock, real estate, or some other capital asset, that taxpayer is normally liable for payment of a capital gains tax of up to 20 percent. Under the new tax law, the taxpayer may now defer payment of this capital gains tax liability by reinvesting it in a “qualified opportunity fund” (QOF) within 180 days of the sale.
If the QOF invests its capital in a QOZ for at least 10 years, the taxpayer/investor will have received a 15 percent tax break on the initial amount invested, and the investor’s share of capital profits in the QOF will be treated as 100 percent tax free.
QOFs present an immediate finance and investment planning opportunity. However, because the QOF program is flexible and scalable, it can be characterized and used in many ways. This article provides an overview of the rules and a basic example of the tax benefits, explains the potential implications for the real estate industry, and examines strategic planning considerations.
What Is a Qualified Opportunity Zone?
A QOZ is a tract of land so designated for a term of 10 years by the U.S. Treasury Department. Each state governor had until March 21, 2018, to nominate a limited number of low-income census tracts, and Treasury had until last June 18 to officially designate the QOZs in each state and U.S. territory. Thus, all 8,700 QOZs that ever will exist have already been established, and all are scheduled to expire on their 10th anniversary of designation, no later than December 31, 2028.
What Is a Qualified Opportunity Fund?
A QOF is any business entity organized for the purpose of investing in QOZ property and is treated as a corporation or partnership for federal tax purposes. The business entity simply self-certifies as a QOF on its first annual tax return. In order to receive the statutory tax benefits, the QOF must hold at least 90 percent of its assets in QOZ property—a percentage measured twice each year. QOZ property, as defined, includes both tangible business property, such as real estate, and intangible business property, such as an ownership interest in a QOZ business.
Under the initial regulations proposed by the Internal Revenue Service (IRS) on October 22, a business may qualify as a QOZ business under three conditions: 1) at least 70 percent of its tangible property is located in a QOZ, 2) it derives at least 50 percent of its gross income from business activity in the QOZ, and 3) it is not a golf course, country club, liquor store, massage parlor, or a hot tub, tanning, or gambling facility. Furthermore, a business already located in a QOZ is not prohibited from qualifying as a QOZ business.
The latest a taxpayer can invest a capital gain in a QOF is December 31, 2026. Although all QOZs are scheduled to expire by the end of 2028, the proposed regulations clarify that QOFs will continue to exist and receive the statutory tax benefits for investments made before the QOZ expiration date until the end of 2047. Thus, the benefit of partial exclusion phases out beginning December 31, 2019 and it ends on Jan 1, 2022. The benefit of temporary deferral ends on December 31, 2026. Any QOF investments made after December 31, 2026 can be made until QOZs themselves expire on December 31, 2028. Any QOF investments that were made prior to December 31, 2028 will continue to accrue non-taxable appreciation until December 31, 2047 at the latest.
The Tax Benefits of a QOF
The following is an example of the statutory tax benefits of a QOF.
On January 1, 2019, Allen sells an apartment building for a $1 million profit. Subject to the 20 percent long-term capital gains rate, Allen’s tax liability is $200,000. Rather than pay this amount to the IRS for his 2018 return, Allen forms a limited liability company as a QOF and elects to reinvest the $1 million profit into his QOF within 180 days of the sale.
Allen then uses the QOF to invest in multifamily real estate properties located in QOZs throughout the country.
On January 1, 2026, Allen elects to receive a 15 percent step-up in basis on his $1 million investment because he has held the investment for seven years, effectively reducing his deferred capital gain from $1 million to $850,000. Thus, Allen’s original capital gains tax liability is reduced from $200,000 in 2019 to $170,000 in 2026 (20 percent of $850,000).
On January 1, 2029, the QOF sells a portfolio of multifamily real estate assets, and Allen receives $5 million from the sale. Allen’s basis in the QOF is increased to $5 million, resulting in no tax on his $4 million profit.
In this scenario, Allen has achieved the full statutory tax benefits provided by investing in a QOF:
- an immediate deferral of his $200,000 capital gains tax liability in 2019;
- a 15 percent tax break on his capital gains tax liability in 2026; and
- a 100 percent federal income tax exclusion on his $4 million QOF profit in 2029.
Implications for the Real Estate Industry
While this new tax law could signal a considerable shift in real estate finance and investment for at least the next decade, it is not unprecedented: Congress has a history of creating real estate markets through changes in the federal tax code.
For example, a 1960 tax law added Subchapter M to the tax code, which was designed to give small investors access to income-producing real estate by authorizing real estate investment trusts (REITs). A 1934 tax law was designed to encourage real estate investment by authorizing deferral of capital gains tax in Section 1031 of the tax code, establishing the now familiar 1031 exchange.
QOFs will be viewed by many taxpayers as an attractive alternative to the 1031 exchange. Not only does the new law authorize deferral of an imminent capital gains liability, but it also allows taxpayers to recover their original basis in the property sold or exchanged and reinvest in QOZ property rather than like-kind real estate. A tax-free return on investment may similarly cause REITs to prioritize QOZ investments or accredited investors to view QOFs as an attractive alternative to REITs and traditional real estate private equity funds.
The proposed regulations also incentivize investment in real estate companies rather than in real estate buildings themselves. For example, if a $10 million QOF invests 100 percent of its assets in real estate directly, then at least $9 million (90 percent) of the property must be located within a QOZ.
However, if the QOF instead invests 100 percent of its assets in a real estate company that owns the project, then only $7 million (70 percent) of the property must be located within the QOZ. This strategy could allow the QOF to invest the remaining $3 million (30 percent) of its assets in property located outside QOZs and still achieve the full statutory tax benefits for its investors.
Strategic Planning Considerations
Although taxpayers and businesses are already forming strategies to use this new tax law in different ways, the operative term in qualified opportunity fund is qualified.
IRC Subchapter Z contains many examples of ambiguous language that is subject to interpretation, and the related rules being promulgated by the IRS contain many qualifiers as to what type of taxpayers are eligible for investment (i.e., corporations, shareholders, partnerships, partners, trusts, etc.); what type of gains are eligible for this preferential treatment; the timing of transactions necessary for satisfying the requirements of the statute; and certain rules related to the creation and continued qualification of a QOF. Penalties for noncompliance range from a monthly penalty to complete disqualification from the statutory tax benefits.
The complexities of compliance with federal and state securities laws add to the importance of evaluating this new tax law with your advisers.
ANDREW P. DOUP is a corporate attorney in the real estate practice group at Kegler Brown Hill + Ritter, based in Columbus, Ohio. He advises clients on debt, equity, and mezzanine financing, and qualified opportunity funds.