Great excitement is greeting the U.S. Treasury’s first set of guidance on provisions in the 2017 tax law that encourage investment in Qualified Opportunity Zones, or QOZs, in return for deferral, basis adjustments and forgiveness of taxes on the investment’s principal appreciation.
After all, the proposed rules clear up some key uncertainties that were causing investors to hesitate. Even better, they articulate generous views of which types of taxpayers may benefit (most) and the capital gains they may use (most), and even extend the time allotted for reinvesting gains (under certain circumstances).
Such generous tax relief suggests investments in Qualified Opportunity Funds (QOFs) should be on your radar if you’re looking to defer taxes on significant gains achieved in this long bull market.
However, these investments come with a major caveat: The ideal investor would be comfortable holding for at least 10 years, subject to certain earlier principal distributions treated as a return of capital, to secure the largest benefit available: full forgiveness on gains generated in the QOF.
Additional guidance from the government has been helpful in key areas including clarification on the treatment of fund-level debt, fund-level reinvestments, and withdrawals/distributions.
The proposed rules, released October 19, 2018, are a major step and can be relied upon, even though final rules may differ.
Investors in general and real estate investors in particular are interested in QOZs because the potential tax incentives seem so large:
- The deferral of taxes on an unlimited amount of a capital gain if that gain is reinvested in a QOF within 180 days.
- The possibility to receive an effective forgiveness of 15% of the original gain after seven years of investment in the QOF.
- Deferral of taxes on the remaining 85% of the original gain until the interest in the QOF is sold or exchanged, or until December 31, 2026, whichever comes first.
- Forgiveness of all new capital gains arising from the QOF investment, as long as the investment is held for 10 years, is disposed of before January 1, 2048 and you make a specific election in tax filings.
These incentives left many prospective investors eagerly waiting to hear exactly how they could take advantage.
And now U.S. Treasury’s guidance clarifies several critical variables, including:
Types of taxpayers who can benefit
- The definition of taxpayers eligible for this investment is very inclusive. It covers nearly everyone, including individuals, C corporations (including regulated investment companies (RICs) and real estate investment trusts (REITs)), trusts, and certain pass-through entities such as S corporations and partnerships. In fact, if such a pass-through entity does not elect to defer taxation of a realized capital gain, there are rules that allow individual pass-through owners to do so on their own.
Kind of capital gains that are eligible
- Again, the rules are surprisingly generous. Most kinds of short- and long-term capital gains are eligible, including collectibles gain, capital gain dividends from RICs and REITs, and net gain from all Section 1256 contracts (e.g., regulated futures contracts). A few exceptions include capital gains arising from offsetting positions such as certain hedges (i.e., straddles) and a sale or exchange with a related person or entity. A second round of proposed regulations later clarified that gain from Section 1231 property is only eligible for deferral by investment in a QOF if it exceeds losses from Section 1231 property in that tax year.
When the 180-day clock starts
- The statute requires that, to be eligible for QOF tax benefits, investors must reinvest a capital gain into a QOF within 180 days of its realization. The guidance clarifies that the first day of the 180-day period is the date on which the gain would be recognized for Federal income tax purposes. It also offers examples of when the 180-day clock would start in different scenarios. For instance, the clock starts for:
- Stock sales—on the trade date
- Capital gain dividends from a RIC or REIT—when the dividend is paid
- Partners—on the last day of the partnership’s taxable year, unless the partner elects to use the date the partnership recognized the gain
Working capital “safe harbor” provision
- This rule offers taxpayers some welcome relief on timing of investments. The law requires that a QOF be 90 percent invested in qualified property as measured (generally) by the average on two testing dates:
- 1) the last day of the first six-month period of the fund’s taxable year and
- 2) the last day of the fund’s taxable year
That is a very short window to vet potential investments and meet the requirements of qualified property.
Under proposed regulations, investors still have to reinvest capital gain into a QOF within 180 days. However, QOFs that use and hold the equity in certain subsidiaries that qualify as QOZ businesses may qualify for a 31-month working capital safe harbor period to maintain cash positions and deploy the capital into the business at self-determined internals. This safe harbor makes it easier to qualify as qualified property for purposes of the 90% test. However, the QOF must have a written plan for acquisition, construction and substantial capital improvement of identified tangible business property and must in fact execute on the plan during that grace period.
Now? Later? Ever?
Among the first investors seeking to take advantage of the QOZ tax break are naturally those involved in single market deals, mainly real estate projects that already were in the pipeline, notes Katherine Rosa, Global Head of Alternative Investments for J.P. Morgan.
For a broader group of less-specialized investors to go full steam ahead, Rosa and her team are looking for more guidance, such as whether a fund-of-funds structure will be blessed, which would allow for more diversified investments.
More fundamentally, Rosa cautions, because QOZs are by their nature in areas that may require extra incentives to lure financing, investors need to carefully assess—independent from the tax benefits—the underlying risks of projects.
Might an investment in QOF work for you now or later? Please feel free to contact your J.P. Morgan advisor to discuss these and other investment opportunities.