Qualified Opportunity Zone Update: IRS Issues Additional Proposed Regulations
Tamara Partridge, CPA, MST and Justin Sylvan, CPA
The IRS has released a second set of proposed regulations on the new tax incentives for investments in Qualified Opportunity Zones (QOZs). The incentives, created by the Tax Cuts and Jobs Act, permit taxpayers to defer, reduce and even permanently exclude capital gains on their investments. The proposed regulations — most of which can be relied upon until final regulations are published — include several provisions that are favorable for real estate investors.
Incentives in a nutshell
Investors can form private Qualified Opportunity Funds (QOFs) for development and redevelopment projects in QOZs. The funds must keep at least 90% of their assets in QOZ property. Qualified opportunity zone property includes QOZ stock, QOZ partnership interests or a direct ownership interest in QOZ business property. QOZ business property includes new or substantially improved commercial buildings, equipment and multifamily complexes.
Investors can defer their short- or long-term capital gains on a sale or disposition of their investments as long as they reinvest the gains in a QOF within 180 days. The tax will be deferred until 1) the fund investment is sold or exchanged, or 2) December 31, 2026, whichever is earlier.
After five years, a QOF investor receives a step-up in tax basis for the investment equal to 10% of the original gain, meaning the investor will pay tax on only 90% of that gain. Two years later, the step-up jumps to 15%, further reducing the taxable portion of the original gain. If an investment is held in the QOF for at least ten years, post-acquisition gains are fully tax-exempt.
Real estate provisions
Real estate investors will find plenty to like in the proposed QOZ regulations. Here are some important issues to consider:
- Multiple Assets
The proposed regulations make clear that QOFs can invest in more than one asset, reducing the risk of pursuing a single failed project. This also allows funds to execute a rolling investment strategy through December 31, 2026, without holding a specific property for 10 years. If an asset is held for that long, the QOF can sell it, and investors will receive the step-up in basis tax-free (assuming certain requirements are satisfied), without selling their interests in the QOF.
- Active Conduct of a Trade or Business
At least 50% of a QOF’s income must come from the active conduct of a trade or business in a QOZ. The proposed regulations clarify that residential rental activities can qualify as a QOZ business and/or property if the QOF meets certain active management rules. On the other hand, entering a single triple-net lease for a property generally won’t qualify as an active trade or business, nor will holding property for investment.
- Unimproved Land
The proposed regulations provide that unimproved land in a QOZ that is acquired by purchase generally does not require substantial improvement (meaning additions to the basis must double) as long as it is used in a trade or business of a QOF or QOZ business. However, the new proposed regulations provide two exceptions. First, a QOF cannot rely on this rule if it purchases unimproved land with the intent not to improve the land by more than an “insubstantial amount” (this has not yet been specifically defined) within 30 months after acquisition. Second, if a QOF does not invest new capital into the land — or boost the land’s economic activity or output — the purchase could be treated as an acquisition of non-qualifying property under a general anti-abuse rule.
- Original Use
Among other requirements for QOZ business property— either its original use in the opportunity zone must commence with the QOF, or the QOF must substantially improve it. According to the regulations, the original use of tangible property starts on the date it is first placed in service in the QOZ for purposes of depreciation or amortization. But, if property has been unused or vacant for at least five years before purchase, original use commences on the date after that period when the property is first used or placed in service in the QOZ.
The proposed regulations are complex. They address many other critical issues for investors interested in taking advantage of the new tax incentives. Your financial advisor can help you make the most of the opportunity.
Sidebar: Beware: You could lose QOZ tax deferral
The proposed regulations identify several transactions that might trigger inclusion of deferred gains from QOZ investments. An “inclusion event” generally results from the transfer of a qualifying investment in a QOF if:
- The transfer reduces the taxpayer’s equity interest in the QOF for federal income tax purposes; or
- The taxpayer receives property (including cash) from a QOF in a transfer that’s treated as a distribution for federal income tax purposes.
The resulting gain can be included in gross income in the tax year of the inclusion event or the tax year that includes December 31, 2026.
The regulations include a non-exclusive list of 11 inclusion events, including certain distributions, taxable dispositions and non-recognition transfers, as well as transfers by gift and dissolution of the QOF. Each would reduce or terminate the QOF investor’s qualifying investment or, in the case of distributions, constitute a “cashing out” of the qualifying investment. A transfer “by reason of death,” however, is not an inclusion event.
Developer’s Yacht Deductions Run Aground
Michael J. Kovacs, CPA
Many businesses have stretched the definition of “marketing” to claim some questionable federal income tax deductions related to their boating hobby. A recent case involving a real estate developer illustrates how the IRS — and the U.S. Tax Court — generally see through these tactics.
Developer angles for a deduction
The court described the taxpayer in the case as a “serial entrepreneur.” His portfolio of businesses included several real estate developments and a beach amenities company in Florida.
In 2005, he paid about $2 million for a 67-foot fishing yacht. For the three years at issue, the taxpayer took the boat to several regional fishing tournaments, but it otherwise seldom left the dock. Nonetheless, he claimed yacht-related deductions on the tax returns for the beach amenities business of around $394,000, $127,000 and $113,000.
The IRS disallowed the deductions. It found, among other things, that the yacht expenses were not ordinary and necessary business purposes. The taxpayer appealed.
Court throws deductions overboard
The taxpayer contended that the yacht was a marketing tool for his real property businesses. Specifically, he claimed to get wealthy anglers on board at tournaments and entertain them. Though he had sales packets on board, there was no signage on the yacht advertising his resorts and no visitors’ log.
The court was not swayed by this argument. It distinguished between entertainment activities, which might have been deductible if directly related to the taxpayer’s business, and entertainment facilities, for which no deduction was allowable. (Note that the Tax Cuts and Jobs Act amended the applicable tax law to make all business entertainment expenses generally nondeductible.)
The taxpayer’s expenses, the court found, were for entertainment activities. It acknowledged that some anglers he met at tournaments later bought condos, but said “just because an activity generates some business doesn’t mean it can’t be entertainment” for tax purposes. The taxpayer was not a professional fisherman or even in the boat business. Thus, the tournaments were merely entertainment activities for him and his company.
Because the court also found the yacht was an entertainment facility, it normally would have proceeded to determine which of the deductions were entertainment activity expenses and which were entertainment facility expenses. But, it did not bother because the taxpayer had provided no credible evidence of a direct relationship between the expenses and the “active conduct” of any of his businesses, “especially the beach amenities business.” And, he had failed to adequately substantiate the expenses.
As a result of the disallowed deductions, the taxpayer faced additional taxes. Moreover, he avoided steep accuracy-related penalties only because the IRS made a technical error.
So what could he have done?
As a boater myself who represents many marina operators, I am asked this question all the time.
Since the taxpayer did own a “beach amenities” company, he could have used the boat for signage advertising the amenities business. (Here in Chicago, there is a sailboat with Miller Lite sails; I am sure the owner of the boat is paid for advertising by the company and deductsthe costs associated with the vessel.)
He could have offered the boat for charter and advertised the charter through his other businesses. If the boat were used more than 50% in business activities, he could have allocated the cost of maintaining the boat between deductible and nondeductible expenses.
As this article points out, contemporaneously maintaining a log of usage, much like keeping an auto mileage log for a car, would go a long way to proving the business usage of the vessel.
Your tax advisor can help you claim — and properly substantiate — business deductions that can withstand IRS scrutiny.