Ten Tips for Qualified Opportunity Zone Investing
November 05, 2021
By Kenneth Weissenberg
The Qualified Opportunity Zone (“QOZ”) tax incentive program was enacted as part of the Tax Cuts and Jobs Act of 2017. The program was designed to encourage investment in economically distressed areas throughout the U.S. and its territories. The program allows taxpayers to defer the tax on capital gains invested in Qualified Opportunity Funds (“QOFs”) until December 31, 2026; provides for a reduction in the deferred gain ultimately subject to tax if the investment is held for at least five to seven years; and effectively eliminates the tax on future gains of the investment if it is held for at least ten years. Here are ten tips for taking advantage of the QOZ program:
- Act Now. Investments in QOFs made before December 31, 2021, can qualify for a basis step-up of 10% of the amount of the deferred gain, effectively reducing the deferred gain subject to tax on December 31, 2026, by 10%. Investments made on or before December 31, 2019, qualify for a 15% basis step-up.
- The gain invested in a QOF must be invested into the QOF within 180 days from when the gain is recognized. Commitments to contribute capital in the future do not qualify if the actual contribution is not made within the 180-day period.
- Gains recognized via flow-through entities, such as partnerships and S corporations, are subject to special rules. If the flow-through entity does not invest in a QOF, the partner or shareholder can elect when to begin the 180-day period. The partner can elect to start the 180-day period on either (a) the date the sale is recognized by the entity; (b) the last day of the entity’s taxable year (generally December 31); or (c) the due date of the entity’s tax return for the year of sale, without regard to extensions (generally March 15).
- A QOF must have at least 90% of its assets invested in Qualified Opportunity Zone Property (“QOZP”) or Qualified Opportunity Zone Businesses (“QOZB”) on each of its bi-annual testing dates or be subject to penalties. Cash contributed within the prior six months is disregarded for purposes of this test. This means that money contributed to a QOF in the second half of the year does not need to be deployed until just prior to the next testing date (June 30).
- QOP must be either new property or substantially improved previously used property. Property that has been vacant for three years is treated as new property. For purpose of these rules, a property that was vacant for more than 80% of its rentable area is treated as vacant. There is a special one-year vacancy period for property that was vacant prior to and on the date that the parcel was designated as a QOZ and through the date on which the property was purchased by a QOF.
- For buildings (or other property) that were previously used or occupied, the property must be substantially improved within 30 months. For these purposes, land allocations are excluded and personal property additions to the property are included.
- Using a QOZB to develop new property or start a new business allows taxpayers 31 months to acquire and construct property under a written working capital plan. The 31-month period can be extended to the extent that significant additional capital is raised during the 31-month period. These extensions apply to each capital raise and can extend the working capital period to up to 62 months.
- A distribution of capital or refinance proceeds within two years of capital contributions will be treated as an inclusion event, triggering gain to the investors. Distributions beyond the two-year period from a partnership are not inclusion events.
- The return of capital in the event of a sale of an asset by a QOF or QOZB can be reinvested by the QOF into a QOZB within 12 months without triggering an inclusion event to the investors; it also maintains the holding period for the investors for the 7/5/10 year step-up rules. Gain on the sale of an asset is, however, taxable to the investors who are free to make new QOF investments with the proceeds into the existing fund or into a new fund.
- Depreciation deductions on property held by the QOF or QOZB can shelter the income in whole or in part from the QOF/QOZB. This depreciation is not subject to recapture if the investor holds the investment for ten years or longer.
These are but a few QOZ program nuances. There were several extensions and waivers in connection with COVID relief that are not covered above. As with any complex tax structure, proper planning and expert advice are essential to avoid pitfalls and ensure compliance with the QOZ rules.