Tax Connections Newsletter – Spring 2019
Robert Swenson

Qualified Opportunity Zones: Powerful tax incentives for investors

Investors willing to make long-term investments in distressed communities now have a powerful tax incentive for doing so—the Qualified Opportunity Zone (QOZ) program, created by the Tax Cuts and Jobs Act (TCJA). The program allows investors who recognize capital gains to reinvest those gains in Qualified Opportunity Funds (QOFs) that, in turn, invest in one of nearly 9,000 designated QOZs throughout the United States and certain U.S. territories.

Investor uncertainty

After the TCJA was passed, investors were hesitant to create QOFs because of uncertainty about certain aspects of the program. However, in October 2018, the IRS issued proposed regulations—on which you can rely until final regulations come out—that provide welcome guidance on the subject. For the most part, the proposed regulations are quite taxpayer-friendly.

Investor benefits include:

  • Deferral of tax on the capital gain until the end of 2026 (or, if earlier, the date the QOF investment is disposed of);
  • A permanent, 10% reduction in the amount of capital gain, if the QOF investment is held for at least five years, plus an additional 5% reduction (for a total of 15%) if it’s held for at least seven year; and
  • No tax on capital gains attributable to appreciation of the QOF investment itself, provided it is held for at least ten years.

A QOF defined

The benefits described above are not available for direct investments in QOZs. Rather, you must invest through a QOF—a corporation or partnership (including an LLC taxed as a partnership) dedicated to investing in QOZs. To qualify, at least 90% of a fund’s assets must consist of “QOZ property.” Virtually anyone can create and manage a QOF, ranging from individuals who establish single-investor funds to defer capital gains to sponsors of multi-investor funds.

QOZ property includes QOZ business property—tangible property that is used by a trade or business within a QOZ and meets certain requirements. It also includes equity interests in corporations or partnerships that qualify as QOZ stock or QOZ partnership interests. To qualify, the entity must meet several requirements, including a requirement that “substantially all” of its tangible property (defined by the proposed regs to mean 70%) is QOZ business property.

Investment options

It is important to recognize that you can’t simply invest cash in a QOF and enjoy the tax benefits provided by the QOZ program. Rather, you must first recognize capital gain by selling or exchanging property and then essentially “roll over” some or all of the gain by reinvesting cash in a QOF within 180 days. You can use a QOF to defer gains from virtually any capital asset—real estate, publicly-traded stock, business interests, even artwork and other collectibles.

Maximize the benefits

To make the most of the QOZ program, you should invest in a QOF by the end of 2019. Why? Because the capital gain you roll over is deferred, at most, to the end of 2026, but to enjoy a permanent, 15% reduction in the amount of gain, you need to meet a seven-year holding period.

As noted above, there is a separate incentive that allows you to exclude from income 100% of the capital gain attributable to the appreciation of your investment in the fund, provided you meet a ten year holding period.

There was some confusion about this benefit, because all QOZ designations are scheduled to expire at the end of 2028, and it was unclear whether the exclusion would be available if the holding period extended beyond that date. Fortunately, the proposed regulations allow investors to exclude these gains so long as they are recognized before the end of 2047. This is a potentially significant benefit for long-term investors.

Be sure to work with advisors who are familiar with the QOZ program. The proposed regulations contain detailed, complex rules on structuring and operating QOFs, identifying eligible QOZ investments, and other elements of the program.

Getting in the zone

If you plan to sell property that will generate substantial capital gain, consider taking advantage of the QOZ program by reinvesting the gain in a QOF. If you are willing to hold the investment for seven years or more, the tax benefits can be worth your while.

Sidebar: Tax-free investment returns?

This example illustrates the potential benefits of investing in a Qualified Opportunity Fund (QOF).

On June 1, 2019, Alice sells her interest in ABC Co., realizing a $1 million capital gain. On August 1, 2019, she invests $1 million in XYZ Property Fund, a QOF that develops residential properties in a Qualified Opportunity Zone. Because she reinvests the gain within the 180-day window, she may defer the tax until the end of 2026 or, if earlier, the date she sells the investment. Alice sells her investment on August 1, 2026, for $1.5 million. Because she satisfies the seven-year holding period, she owes capital gains taxes on 1) 85% of her original $1 million gain ($850,000), and 2) her $500,000 gain on the sale of her interest in XYZ.

Suppose, instead, that Alice holds the investment for 10 years, selling it on August 1, 2029, for $2 million. She’ll still owe capital gains tax on the $850,000 at the end of 2026, but her $1 million gain on the sale of her interest in XYZ will be tax-free.

For more information, contact Rob Swenson at [email protected] or 312.670.7444. Visit ORBA.com to learn more about our Tax Services.

Getting your affairs in order when terminally ill

If you receive the diagnosis of a terminal illness, likely the last thing on your mind is estate planning. But, taking the time now to get your affairs in order can provide you and your family some peace of mind.

What to do first

Here are some (but by no means all) of the steps you should take if you or a loved one has a short life expectancy:

  • Gather Documents
    Review all estate planning documents, including your will, living trust and health care power of attorney. Make sure these documents are up to date and continue to meet your estate planning objectives. Modify them as appropriate.
  • Take Inventory
    Catalog all your assets and liabilities, estimate their value, and determine how assets are titled to ensure that they will pass to their intended recipients. For example, do you own assets jointly with your ex-spouse? If so, title will pass to your ex-spouse on your death. There may be steps you can take to separate your interest in the property and dispose of it as you see fit.
  • Review Beneficiary Designations
    Take another look at beneficiary designations in your IRAs, pension plans, 401(k) plans and other retirement accounts, insurance policies, annuities, deferred compensation plans and other assets. Make sure a beneficiary is named and that the designation continues to meet your wishes.
  • Review Digital Assets
    Ensure that your family or representatives will have access to digital assets, such as email accounts and online bank and brokerage accounts. You can do this by creating a list of usernames and passwords or by making arrangements with the custodians of these assets to provide access to your authorized representatives.

The next steps

Your estate planning advisor can help you through this difficult time. Working together, you can gain peace of mind that your family will be taken care of per your wishes.

For more information, contact Rob Swenson at [email protected] or 312.670.7444. Visit ORBA.com to learn more about our Tax Services.

Forward Thinking