Tax incentives for investments in low-income communities are nothing new, but the law commonly known as the Tax Cuts and Jobs Act (TCJA) sweetens the pot for potential investors. The TCJA created the Qualified Opportunity Zone (QOZ) program, which offers capital gains tax deferrals for qualifying investments in low-income communities. Unlike similar programs that restrict investment uses and cap tax benefits, the QOZ program accepts a broad array of investment types and amounts. It also provides significant tax benefits, with the potential to permanently defer capital gains taxes in some instances.

Real estate developers (individuals or corporations), syndicators, sponsors or private equity funds can all participate in the QOZ program. Taking advantage of the full tax benefits available can be a little complex, however, in part because the TCJA legislation that created the program is rife with ambiguities. Additionally, investors will need to understand what opportunities meet the program’s stringent criteria. 

Ground Rules and Key Definitions

Investors can take advantage of the QOZ program by selling or trading virtually any investment and investing the capital gains from the sale or exchange into a Qualified Opportunity Fund (QO Fund) within 180 days of the sale or exchange of the existing investment. A QO Fund is a corporation or partnership organized to invest in QOZ property, and it must invest at least 90 percent of its funds in QOZ property. Eligible QOZ property is QOZ stock, a QOZ partnership interest, or a direct investment in trade or business property (TOB property) of a QOZ business. In the case of a QOZ stock or partnership interest, the corporation or partnership interest must be newly issued and acquired by the QO Fund solely for cash, and the corporation or partnership that issued the interest must operate a QOZ business.

According to FAQs released by the IRS in June 2018:

“To become a Qualified Opportunity Fund, an eligible taxpayer self certifies. (Thus, no approval or action by the IRS is required.) To self-certify, a taxpayer merely completes a form (which will be released in the summer of 2018) and attaches that form to the taxpayer’s federal income tax return for the taxable year. (The return must be filed timely, taking extensions into account.)”

To qualify as a QOZ business, substantially all of the entity's tangible property must be TOB property purchased after Dec. 31, 2017 and put into use as a result with the QO purchase. As an alternative to the original use requirement, the QO Fund or the underlying QOZ business could be used to substantially improve (defined as capital expenditures exceeding the original purchase basis during a 30-month period) an existing property, and substantially all of the use of the property must be in a QOZ. Additionally, a QOZ business must have a minimum of 50 percent of its gross income derived from the active conduct of a trade or business in the QOZ. Other provisions also apply to determine a QOZ business, including the type of business being operated.

Holding Periods for Deferral and Exclusion

Generally speaking, there is no minimum required holding period to take advantage of the QOZ program, but the longer the investor holds the QO Fund investment, the greater the benefits. Investments that meet the program’s criteria will have a capital gain deferral until the earlier of the amount of time the taxpayer holds the investment or Dec. 31, 2026. Investors who hold the QO Fund investment for at least five years will benefit from a basis increase equal to 10 percent of the original gain deferred (i.e., only 90 percent of the deferred gain invested in a QO Fund that held for at least five years will be subject to tax).  If investors hold the investment for at least seven years, their basis increase will be 15 percent (i.e., only 85 percent of the original deferred gain will ultimately be taxable).

A post-acquisition gain exclusion is available for QO Fund investments that satisfy a 10-year holding period. The taxpayer can then elect on the sale of the investment to have a basis of the QO Fund investment equal to its fair market value, resulting in none of the gain from the QO Fund investment being taxable when sold other than the aforementioned deferred gain recognized by Dec. 31, 2026.

Early Bird Gets the Worm

Investors looking to maximize the capital gain deferrals available will want to move quickly. The TCJA authorized the QOZ program only through Dec. 31, 2028, and it is uncertain whether a taxpayer is entitled to the capital gain exclusions after this date. Barring further changes, the latest date a taxpayer could make an investment that would qualify for a post-acquisition gain exclusion would be Dec. 31, 2018. Likewise, because the basis increase applies to the original deferral gain from the existing investment and because this deferred gain must otherwise be recognized by Dec. 31, 2026, the last date to make a QO Fund investment that is eligible for a basis bonus is Dec. 31, 2021 (for the 10 percent basis increase) or Dec. 31, 2019 (for the 15 percent basis increase).

A tax professional can help identify where QOZs are located in your area and what opportunities may be available to you. A complete listing of QOZs can be found online through the Treasury Department. For more information about the new QOZ program and its benefits, contact Paul Rosenkranz (310.268.2029) or your local CBIZ MHM tax professional.

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