Tax Benefits of Investing in Opportunity Zones

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1 Tax Benefits of Investing in Opportunity Zones Bradley J. Sklar ASCPA Montgomery, Alabama

2 Opportunity Zones Created as part of the Tax Cut and Jobs Act of 2017 Purpose of Opportunity Zones To generate investment in low income and economically distressed areas Potential developments including housing, retail, schools, healthcare, infrastructure, or transit Similar to incentives implemented in other countries and states Enterprise Zones (UK), Empowerment Zones (US) 2

3 Key Concepts Qualified Opportunity Zone Qualified Opportunity Fund Qualified Opportunity Zone Property Qualified Opportunity Zone Stock Qualified Opportunity Zone Partnership Interest Qualified Opportunity Zone Business Qualified Opportunity Zone Business Property 3

4 Tax Savings Deferral of taxes on capital gains invested in Qualified Opportunity Funds ( QOF ) until: Investment in QOF is sold, or Taxpayer s December 31, 2026 tax year (unless deferral is extended) Partial forgiveness of deferred capital gain after 5 years Additional forgiveness of deferred capital gain after 7 years If investment in QOF extends beyond 10 years, all future gain from QOF investment is excluded from income 4

5 Tax Savings Additional Benefits Taxpayers have full use of their capital gains for further investment Partial and total forgiveness of tax on such gains creates a higher return on investment Increased development in economically distressed areas Taxpayer must elect to defer gain on 2018 return Only one election permitted with respect to a sale or exchange Program is only in effect until December 31,

6 Tax Savings - Example Anita Savesometaxes sold her Apple stock on August 1, 2018, generating $1 million in capital gain. Instead of paying $238,000 on that gain (leaving her with $762,000), Anita can invest the full $1 million in a QOF. Anita makes that investment on December 23, At the time Anita makes her investment in the QOF, her basis is zero. After five years, the basis increase to 10% of the amount to be deferred or $100,000. After seven years, the basis increases to include an additional 5% of the amount to be deferred, or $150,000. 6

7 Tax Savings - Example Assume Anita sells her interests in the QOF for $2,000,000 on December 31, 2022, less than five years after making the investment. Investment (deferred gain): $1,000,000 Sales Price: $2,000,000 Basis: $0 Taxable Gain: $2,000,000 If Anita waits until December 31, 2023 (five years after her investment), Anita will reduce the gain recognized by $100,000. Investment (deferred gain): $1,000,000 Sales Price: $2,000,000 Basis: $100,000 Taxable Gain: $1,900,000 7

8 Tax Savings - Example If Anita waits until December 31, 2025 (more than seven years after her investment, Anita will reduce the gain recognized by $150,000. Investment (deferred gain): $1,000,000 Sales Price: $2,000,000 Basis: $150,000 Taxable Gain: $1,850,000 If Anita decides to hold her investment for the 10-year holding period, then on December 31, 2026 (more than seven years after the investment), she will have to recognize gain on the initial investment. Investment (deferred gain): $1,000,000 Basis: $150,000 Taxable Gain and New Basis: $850,000 8

9 Tax Savings - Example When Anita finally sells her interest in 2029 (more than 10 years after the investment), she will not have to pay taxes on any gains generated from her investment in the QOF. Investment (deferred gain): $1,000,000 Sales Price: $4,000,000 Basis: $4,000,000 Taxable Gain: $0 What if Anita loses money on her investment? Conference report suggests that taxpayers will be able to claim losses on their investments in QOF if basis exceeds sale price. 9

10 Tax Savings Practice Pointers Must make investment in QOF within 180 days of the sale or exchange creating the gain to be deferred. Proper election must be made on tax return. Taxes on the deferred gain (less any increases in basis) must be paid for the tax year ending December 31, Basis in QOF is then increased by gain recognized. If investment is held in QOF for at least 10 years, taxpayer must make an election to have the basis in the QOF equal the FMV of such investment on the date of sale of investment. 10

11 Qualified Opportunity Fund Anita s QOF must be properly invested in Qualified Opportunity Zone Property Failure to meet certain requirements results in a penalty. So, how to we identify the property? 11

12 Qualified Opportunity Zone Statutory Definition: A population census tract that is a low-income community that is designated as a Qualified Opportunity Zone Certified opportunity zones can be found on the IRS website: IRS will periodically publish an updated list of Qualified Opportunity Zones ( QOZ ) Rev. Proc outlines procedure for states to use to designate QOZs. 12

13 Qualified Opportunity Zone 13

14 Qualified Opportunity Fund Qualified Opportunity Fund: Any investment vehicle: That is organized as a corporation or partnership for the purpose of investing in QO Zone Property (can also be an LLC); and That holds at least 90% of its assets in QO Zone Property Currently, taxpayers self-certify completing a form that will be released by the IRS However, IRS will be issuing regulations to describe how to certify QOFs 14

15 Qualified Opportunity Zone Property Qualified Opportunity Zone Property: Property which is: Qualified Opportunity Zone Stock; Qualified Opportunity Zone Partnership Interest; or Qualified Opportunity Zone Business Property QOF QOZ Stock QOZ Partnership Interest QOZ Business Property 15

16 Qualified Opportunity Zone Stock Qualified Opportunity Zone Stock: Stock in a domestic corporation if: The stock is acquired by the QOF after December 31, 2017, at original issue, from the corporation, solely in exchange for cash (IRC 1400Z-2(d)(2)(B)(i)(I); At the time the stock was issued, the corporation was a QOZ Business (or, if a new corporation, being organized as a QOZ Business); and During substantially all of the QOF s holding period for the stock, the corporation qualified as a QOZ business. We will get to QOZ Business in a minute 16

17 Qualified Opportunity Zone Partnership Interest Qualified Opportunity Zone Partnership Interest: Any capital or profits interest in a domestic partnership if: The interest is acquired by the QOF after Dec. 31, 2017, from the partnership, solely in exchange for cash; As of the time the interest was acquired, the partnership was a QOZ business (or was being formed to be a QOZ Business); and During substantial all of the QOF s holding period for the interest, the partnership qualified as a QOZ Business (IRC 1400z-2(d)(2)(C) So what is a QOZ Business. 17

18 Qualified Opportunity Zone Business Qualified Opportunity Zone Business: Trade or Business in which substantially all of the tangible property owned or leased is QOZ Business Property; and At least 50% of income is derived from the active conduct of business; Substantial portion of intangible property is used in the active conduct of business; Less than 5% of average unadjusted basis of business entity s property is non qualified financial property; and Not a sin business Private or commercial golf course, country club, massage parlor, hot tub facility, suntan facility, racetrack, gambling facility, or store that sells alcoholic beverages for off premises consumption. 18

19 Qualified Opportunity Zone Business Examples of Qualified Opportunity Zone Businesses Opening a new business in an opportunity zone (restaurant, healthcare, manufacturing, technology) Renovation of commercial property in Opportunity Zone Expansion of existing business into an Opportunity Zone (but could require creation of a new partnership or corporation) Large expansion of existing business already within an Opportunity Zone No requirement to certify as OZ Business, but can request advice from IRS if unsure. 19

20 Qualified Opportunity Zone Business Property Qualified Opportunity Zone Business Property: Tangible property used in the trade or business of the taxpayer that meets these requirements: Property was purchased after December 31, 2017 Property is used in a QO Zone trade or business Original use of the property in the QO Zone trade or business commences with the purchase of the property or the property is substantially improved Substantially all of the use of the such property was in the QO Zone during substantially all of the QOF s holding period of the property. 20

21 Qualified Opportunity Zone Business Property How does a QOF substantially improve property? Substantially improves means that during the 30 month period beginning on the date of acquisition, additions are made to the property such that the basis of the property in the hands of the QOF at the end of the period exceeds the adjusted basis of the property at the beginning of the 30 month period. If property is purchased for $500,000, the QOF must spend at least $500,000 improving the property over a 30 month period. QOF can borrow money to substantially improve the property. 21

22 Qualified Opportunity Zone Business Property Original Use Property QOF purchases a lot in an Opportunity Zone and builds a housing development on that lot. QOF purchases vacant warehouse in opportunity zone and brings in a new commercial tenant. Substantially Improved Property QOF purchases existing housing development in Opportunity Zone. QOF must substantially improve the property within 30 months. 22

23 How Opportunity Zones Impact You Before investing in property in an Opportunity Zone, create a new partnership or corporation (QOF) to purchase this property to meet the 90% threshold and to attract additional investment Individual investors can create their own QOF to directly invest in Opportunity Zone Property rather than working through an Opportunity Zone Business, but Monitor the assets in the QOF to maintain compliance with the 90% threshold 23

24 How Opportunity Zones Impact You Consider creating a Qualified Opportunity Zone Business to use for purchasing QOZ Business Property Prepare a business plan to be reviewed by counsel, which includes land and building acquisition and timing Discuss other documents that may need to be prepared, such as private placement memoranda and subscription agreements Allocate responsibility of penalty if QOF fails to meet the 90% threshold requirement 24

25 Bradley J. Sklar Current Executive Board Member and Shareholder of Sirote & Permutt, P.C. Past co-chair of the Firm s Corporate and Tax Practice Group. Focuses on complex tax, entity and business planning transactions, including mergers, acquisitions, sales of businesses, sale and purchase structuring and funding of large real estate transactions, raising capital and navigation of state and local tax incentives. Counsels clients in tax and business planning and entity structuring for development and business structuring. Co-ordinates planning of transactions to maximize tax benefits, reduce risk and comply with tax law at local, state and federal levels, including incentive and economic development opportunities. WE RE THERE. ALWAYS.

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