On April 9, 2018, the Senate approved the first round of designated Opportunity Zones for 18 states, including California. Opportunity Zones were created as part of the Tax Cuts and Jobs Act (TCJA) to create investment opportunities in low-income communities nationwide. Qualified Opportunity Funds will be set up as investment vehicles in these communities as a way to direct investor money to distressed neighborhoods, thereby gentrifying these areas through capital improvements.
Qualified Opportunity Funds (“QOF”) would be set up as either partnerships or corporations and must hold at least 90 percent of their assets in Qualified Opportunity Zone property (“QOZ Property”) to be eligible. QOZ Property includes any stock, partnership interest, or business property. Business property is any tangible property used in a trade or business, located in the opportunity zone, and must fulfill one of two requirements:
- The original use of the property commences with the fund
- If the property is used, the Qualified Opportunity Fund must incur costs exceeding the property’s basis within 30 months from the date of the acquisition of such property. (e.g. QOF acquires used property for $1 million and incurs $1.5 million improving the used property within 30 months of acquisition).
Eligible taxpayers can self-certify to become a Qualified Opportunity Fund, however, the IRS has indicated that the guidance regarding the method of certification will not be released until summer 2018. Further guidance is expected soon for how to self-certify, along with how to file future tax returns or amend a previously filed 2017 tax return to reflect investments in Qualified Opportunity Funds.
Investors are given significant tax preferential incentives to invest their money in QOFs and the tax benefits amplify as their investment reaches the five, seven, and ten year mark. Individuals can take their capital gains from the sale of any investment (does not need to be a real estate investment), and reinvest the proceeds in a QOF within 180 days to defer the tax on the gain from sale until the earlier of December 31, 2026, or the sale or exchange of the Opportunity Fund investment. Additionally, the investor can invest his or her deferred capital gain in any Fund, i.e., not limited to zones in which he or she resides.
The taxpayer’s initial basis in the Opportunity Fund investment is $0, however, once the investment in the QOF is held for five years, the basis in the investment increases by ten percent of the gain originally deferred; and at seven years, the basis increases another five percent to reach an overall increase in basis by fifteen percent of the gain deferred. The basis step-up creates a permanent decrease in the taxable portion of the original gain deferred. Even better, if the Opportunity Fund investment is held for ten years or more, the taxpayer can make an election to step up the basis in the investment to its fair market value on the date of sale or exchange, thereby creating a permanent capital gains tax deferral. In other words, even if the property appreciates, the taxpayer will not be taxed on that appreciation.
Qualified Opportunity Funds build a bridge between investors seeking tax-preferential investment opportunities and lower income communities that need the monetary resources to rebuild commercial and residential properties.
As you can see, the sale of the original investment or the asset held by the QOF is not limited to real estate. The tax benefits for investors encourage a long-term investment in low income areas, steering potential revenue for the government directly towards other taxpayers that are in need.
Jackie Matsumura is a partner and the real estate industry group co-leader at BPM. Contact Jackie at [email protected] or 925-296-1035.
Lily Wang is an associate II in the tax group at BPM. Contact Lily at [email protected] or 415-677-4532.