As the pandemic continues to hinder the economy, Qualified Opportunity Zones may face new challenges around their use and their tax benefits.
Qualified Opportunity Zones (QOZ), introduced as part of the Tax Cuts and Jobs Act of 2017, incentivizes real estate investors and businesses to invest in economically distressed areas by offering them significant tax breaks. Nearly 10% to 12% of the United States is in one of these designated opportunity zones.
While the Internal Revenue Service (IRS) and the US Department of the Treasury released final regulations in December 2019, clarifying many outstanding questions, the onset of the COVID-19 pandemic has raised new questions and concerns among investors.
A Qualified Opportunity Fund (QOF) is a corporation or partnership that holds at least 90% of its assets directly or indirectly through an investment in a QOZ business partnership or corporation. And a QOZ business property is tangible property located and used in the QOZ, such as land, real estate, property, and equipment.
The main tax benefits of investing in a QOF are two-pronged:
1. Deferral of invested capital gains — The key to achieving the benefits of investing in a QOF is for the taxpayer to have realized capital gains and to invest those capital gains into a QOF within the prescribed 180-day period. These capital gains may come from the sale of any asset class that generates capital gains, such as stocks, securities, real estate, etc. The elimination of the gain on the sale of the QOF investment after meeting the 10-year holding period is determined based upon the proportion of the taxpayer’s initial investment in the QOF — attributable to deferred capital gains.
In order to take advantage of the 15% elimination of the invested capital gain, the investment into the QOF had to be made by December 31, 2019 in order to meet the 7-year holding period requirement that expires on December 31, 2026. To benefit from the 10% elimination of the invested capital gains, taxpayers have until December 31, 2021 to make an investment into a QOF.
2. Permanent elimination of capital gains on the sale of the QOF investment — If the investment in the QOF is held for at least 10 years, any gain on the sale of the interest of the opportunity zone fund is excludable from taxable income. It’s important to remember — the elimination of the gain on the sale of the QOF investment after meeting the 10-year holding period is determined based upon the proportion of the taxpayer’s initial investment in the QOF attributable to deferred capital gains.
A taxpayer can invest more than the gain realized, but the tax benefits are only available with respect to the investment made with deferred gains. So, if the taxpayer invests both deferred gains and other funds, the investment is treated as two separate investments, one to which the tax benefits apply and one to which they do not.
With the sudden, current decline in the market value of both equities and real estate, taxpayers now have less capital gains to invest in QOFs.
Current decline in asset value due to COVID-19
The major stock market indices have fallen between 25% and 30%, and real estate sales (also capital gain generators) have come to a standstill. Without capital gains to invest, the tax benefits of investing in a QOF cannot be realized. Further, investors may be less willing at this time to tie up capital for the 10 years needed to realize the full tax benefits. This is likely to be the case until there is a sustained and significant recovery in the equity markets.
Whether the QOF invests in an operating business or rental real estate, the investment in a QOF has to make sense from a business perspective. With the current shutdown and uncertain economic conditions, new deployment of capital into QOF operating businesses and rental real estate is likely to significantly decline for the next several months until there is clarity with existing economic conditions.
Opportunity zone investors want deadlines extended
Under the QOF rules, the fund has 30 months to substantially improve (double the cost of the property through renovations) or develop property (e.g., develop vacant land) in a QOZ in order for the asset to qualify and meet the QOF requirements. However, this deadline is becoming harder to meet as construction has been suspended in many areas throughout the United States, business supply chains are disrupted, and local authorities that approve building permits are shut down or are working remotely.
The Economic Innovation Group (EIG) has asked for an extension of the 180-day investment period and the 30-month development period. The EIG also requested confirmation that employees of QOZ businesses who are working remotely will still be considered to be performing services within the zone, in order to meet the requirement that half of the entity’s gross income is generated from services performed within the QOZ.