These final changes make it even easier for investors to take advantage of the substantial tax benefits.
Opportunity Zones are primarily economically-distressed regions introduced with the Tax Cuts & Jobs Act of December 2017.
When you invest in a Qualified Opportunity Fund (QOF) using capital gains from the sale of almost any asset (stocks, mutual funds, residential and commercial real estate, businesses, artwork, cryptocurrency, etc.) you can receive significant tax incentives including deferring and reducing payment of any capital gains tax on the original investment and eliminating any tax on capital gains generated by the new investment in a QOF.
Although the Opportunity Zone program was passed into law in 2017, there have still been some important elements of the legislation that were unresolved, leaving some investors reluctant to take advantage of the tax benefits. These topics have now been addressed.
While investors are no longer eligible for the maximum 15% reduction on their original capital gains tax, they can still receive a payment deferral and 10% reduction as well as eliminate capital gains taxes on their QOF investment. The new regulations published by the Treasury Department and the IRS on December 19, 2019 provided much needed clarity for investors who might be on the fence.
The 544-page document addresses some key concerns, including:
- How the aggregation of developments on one property meets the “substantial improvement” requirement
- The tax implications of pulling out of a QOF before the 10-year hold period is over
- Short-term and long-term capital gains, unrecaptured section 1250 gains, as well as section 1231 gains are eligible for tax deferral
- The change in the structure of the funds to allow for investment in multiple businesses or properties
What Do the New Opportunity Zone Regulations Mean for Investors?
If you have been considering an investment in a QOF but were deterred by the previous regulations or uncertain because of some ambiguity, here’s what you need to know about the new regulations:
Ability to Sell Individual Properties
In the past, investors were required to sell the entire QOF, including any LLC created by the QOF to hold the properties. Selling the underlying real estate assets was a concern for investors who wanted to exit early. While they may be able to reinvest the profits in other assets, doing so might create a taxable event.
With the new guidance it has been confirmed that QOFs can sell individual properties. The funds will be able to own a number of property LLCs, which can hold multiple assets. Investors can exit those assets without creating a taxable event or losing the Opportunity Zone tax benefits.
Redefinition of “Substantial Improvement” Threshold
The previous version only allowed alterations to an original building on an Opportunity Zone property to count toward “substantial improvement.” This required owners to essentially double the value of a property with the investment—which is not always easy to do when limited to a single property.
The final regulations allow additional buildings and developments that add value to the lot to be applied to the property in aggregate and count towards the improvement threshold.
If you had a building and wanted to add another one on the same lot, the addition wouldn’t be qualified as a substantial improvement in the past because you were not improving the original building. However, the new building will now count toward the threshold under the final regulations.
Clarifications on QOFs and QOZ Businesses
The earlier rounds of iteration did not provide clear definitions of QOFs and QOZ businesses.
The final version retains the general approach of the proposed regulations but provides additional guidance and clarity to the rules regarding QOZ business property including how an entity can become a QOF or QOZ business and how it can engage in a trade or business.
Also, it’s now easier to invest in vacant properties and brownfields, and section 1231 gains can be invested on a gross basis.
Clarifications Regarding Business Properties
The final regulations also include both a square footage test and an unadjusted cost test to help investors determine if a project is primarily located in a QOZ. They also extend the straddle rules to QOFs and QOZ businesses concerning the 70 percent use test.
In addition, the final regulations consider both the land and structures in a brownfield site redevelopment as original use property as long as the QOF or QOZ business make investments into the brownfield site to improve its safety and compliance with environmental standards.
Meanwhile, self-constructed properties now count toward the QOF’s 90 percent asset test and the QOZ businesses’s 70 percent asset test, opening up more investment opportunities in real estate development.
This material has been posted for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal or accounting advice. You should consult your own tax, legal and accounting advisors before engaging in any transaction.