The 2017 Tax Cuts and Jobs Act added a new tax provision to the Internal Revenue Code, Section 1400Z-2, which aims to provide big capital gains tax breaks to real estate and business investors who make investments in certain economically underdeveloped areas. To be entitled to the capital gains tax break, investors are required to invest proceeds that would be subject to capital gains tax, such as those from the sale of a business or stock, and timely invest them in a Qualified Opportunity Fund (QO Fund).
What Are the Potential Tax Breaks?
Section 1400Z-2 offers three major tax breaks to investors:
- A temporary deferral (up to eight years) of the capital gains tax that would have been due on the sale proceeds which are invested in the QO Fund;
- A 10 percent basis step-up of the investment in a QO Fund after five years and an additional step-up of 5 percent after seven years for a total basis step-up of 15 percent of the original investment amount; and
- A permanent exclusion of the accrued gain from the sale of the QO Fund investment if such investment is held for ten years. This permanent exclusion only applies to the gains accrued after the investment in the QO Fund.
What Is a Qualified Opportunity Fund?
A QO Fund is generally an investment vehicle which is organized as either a corporation or a partnership for the purpose of investing in Qualified Opportunity Zone Property (QOZ Property), and which holds at least 90 percent of its assets in QOZ Property. QOZ Property includes certain qualified corporate stock, partnership or LLC interests and business property.
A QO Fund may invest directly in qualified property (i.e., Qualified Opportunity Zone Business Property) or invest indirectly through a qualified corporation or partnership. If the QO Fund invests indirectly through a qualified corporation, partnership, or LLC, the underlying trade or business must own property substantially all of which is Qualified Opportunity Zone Business Property (QOZ Business Property).
QOZ Business Property is tangible property used in a trade or business, acquired from an unrelated party after Dec. 31, 2017, and used in the Qualified Opportunity Zone (QOZ). In addition, the entity must either be the original user of that property or substantially improve that property.
Approximately 8,700 different economically underdeveloped areas have been designated as a QOZ throughout the United States. A list of the designated QOZ may be found at Notice 2018-48.
What New Guidance Has the IRS Provided?
This tax provision has already spurred several prominent investors and hedge funds to form QO Funds and invest in QOZ Property. However, since Section 1400Z-2 is a relatively new addition to the Internal Revenue Code, many investors have been hesitant to act due to the lack of guidance and uncertainty in the area. Investors, among other concerns, have been worried about the “substantial improvement” requirement which requires the QO Fund to invest 100 percent of the cost of the acquired property in the renovation and/or improvement of such property.
On Oct. 19, the IRS issued Proposed Regulations and Revenue Ruling 2018-29 which provides some guidance to Section 1400Z-2. However, these Proposed Regulations and Revenue Ruling have not provided all the guidance investors and their tax practitioners have called for. More detailed regulations are already expected to be issued later this year.
Nonetheless, these proposed regulations and revenue ruling do provide some clarification. For example, the revenue ruling clarified that the value of the land is excluded from the determination of whether substantial improvement is made to the acquired property. For example, if a QO Fund were to purchase an apartment building and land for $1.5 million, with the building separately valued at $500,000, the QO Fund would be required to spend only $500,000 on renovations (the value of the building and not the entire purchase price) to satisfy the substantial improvement requirement. Since land is usually a significant cost in a project, this clarification by the IRS will allow for more investors to take advantage of these capital gains tax breaks and boost capital investment in economically distressed areas.
How Do the Tax Breaks Work?
The three major tax breaks outlined above is best explained through an illustration.
Facts and Assumptions
Assume in 2018 an investor sells stock for $35 million which has a $20 million tax basis. $15 million of the proceeds would be subject to capital gain tax. However, the investor timely invests the $15 million of capital gain in a QO Fund to defer the recognition of that capital gain. The investor will hold his QO Fund investment through Dec. 31, 2026 and anticipates selling his investment in 2028 (after 10 years) for $25 million.
Temporary Deferral of Capital Gain
Under the new tax section, the investor is entitled to temporarily defer the $15 million of capital gain until the earlier of: the sale (or exchange) of the QO Fund investment; or Dec. 31, 2026. Therefore, the investor would report $0 of capital gain on his 2018 tax return.
Basis Step-Up at Year Five and Year Seven
In year seven (i.e., 2025) the investor’s basis in the QO Fund will increase by 15 percent (or $2.25 million). As a result of this 15 percent basis step-up, on Dec. 31, 2026 the investor would recognize a capital gain from his initial stock sale of only $12.75 million rather than the original $15 million of capital gain. If the investor only holds his QO Fund investment for five years, then the basis of the QO Fund investment would increase by only 10 percent (or $1.5 million).
Permanent Income Exclusion
Since the investor expects to hold his investment in the QO Fund for ten years (until 2028), he will be entitled to a permanent income exclusion. In 2028 after holding his investment for 10 years, the investor will sell his QO Fund investment for $25 million. Upon the sale, the investor would have been required to recognize $10 million of capital gain. However, the investor will be required to recognize zero dollars from the sale of the QO Fund because the accrued value of the investment is permanently excluded from income under Section 1400Z-2.
In light of these big capital gains tax breaks, real estate and business investors have been eager to participate in QO Fund and invest in QOZ, but their enthusiasm has been dampened by the lack of guidance and uncertainty in this area. It is anticipated that $100 billion in private capital will ultimately be invested in QOZ. To ensure this level of investment, the IRS has scrambled to provide investors with the comfort they need to take the plunge and make significant investments in economically underdeveloped areas. These new proposed regulations are a step in the right direction.
Pauline Markey, a partner at Obermayer Rebmann Maxwell & Hippel, focuses her practice on U.S. federal income tax including corporate and partnership tax, tax-exempt entities, tax controversy, and executive compensation.