We don’t often use this space for technical strategy discussions. However, there’s a new planning tool that’s getting a LOT of attention right now, and we wanted to let you know that we’re incorporating it into TMN resources for you to discuss with your clients. In more cases than you might expect, it will wind up disappointing for clients. But you should still be prepared to discuss it intelligently and answer clients’ questions.

The Tax Cuts and Jobs Act focused most of its attention on flattening corporate tax rates, creating a new category of “qualified business income,” and lowering personal rates. But the 2018 legislation also introduced a new capital gains mitigation strategy in the form of Qualified Opportunity Zones (QOZs). The goal of this provision is to encourage investing in specific “economically distressed” communities.

This sort of targeting has been a longtime goal of many legislators. Representative Jack Kemp, who helped champion the 1986 tax reform, promoted the concept of “opportunity zones” throughout his career, and would be delighted to see them finally brought to life. Washington has previously authorized tax breaks for so-called “Empowerment Zones” and “Renewal Communities.” But the new program is far more expansive than previous efforts. The IRS has designated 8,700 QOZs, or about 12% of the country’s census tracts. Previous programs authorized just 40 empowerment zones and renewal communities.

The TCJA accomplishes the goal of promoting investment in opportunity zones in two ways: First, it lets you postpone tax on gains in any investment if you roll the proceeds into an approved Qualified Opportunity Fund (QOF). And second, you can exclude part or all of the gains you earn in the QOF itself if you hold the position long enough.

The first part of the legislation involves deferring tax on existing gains.

  1. You can defer tax on any appreciated property you currently have to sell. This can include real estate, business interests, publicly-traded securities, and mutual fund shares.
  2. You have 180 days from the date you sell your appreciated property to roll proceeds into the qualified opportunity fund.
  3. At this writing, we don’t yet know exactly how to report these transactions. The IRS has stated that you’ll make the election on the return for the year when you would have reported the gains if you hadn’t chosen to defer them.
  4. You don’t have to roll the entire proceeds of the sale into the QOF. You can pocket your basis and roll just the gain into the fund.

Of course, all good things someday come to an end — even tax deferral. Your original gain that you roll into the QOF becomes taxable when you sell the QOF or on December 31, 2026, whichever comes first. On that date, even if you haven’t sold your QOF, your gain on your original property becomes taxable, and you’ll need to be ready to pay the tax on your original gain with funds from another source.

Qualified opportunity zones expire completely on December 31, 2028. You’ll still be able to hold funds you’ve invested in before that date — you just won’t be able to make any new investments. (Of course, Washington can always choose to extend that deadline in future legislation.)

So, what exactly constitutes a qualified opportunity zone? The legislation authorized each state, plus the District of Columbia and U.S. possessions, to nominate census tracts where the median family income is under 80% of the statewide figure orwhere the poverty rate is at least 20% to participate in the program. The IRS published the final list on July 9, 2018 (which is why you may not have heard much about the program until now). You’ll find it in IRS Notice 2018-48.

These zones aren’t necessarily as blighted as you may think. For example, in November 2018, Amazon announced plans to establish a second headquarters in the Long Island City neighborhood of New York. The area is gentrifying fast, with gleaming new high-rise condos and apartments with stunning Manhattan views, and a median household income of $138,000. It’s also — you guessed it — a qualified opportunity zone.

Now that we understand qualified opportunity zones, what are qualified opportunity funds? Those are simply corporations or partnerships created for the purpose of investing in a QOZ and holding at least 90% of their assets in “QOZ property.” QOZ property, in turn, is tangible property, including real estate, acquired after December 31, 2017, which is first used within the zone by the fund, or which is “substantially improved” by the fund after acquisition. To substantially improve the property, the fund must increase the property’s basis by more than 100% within a 30-month period after the acquisition.

So, take your appreciated property, sell it, and roll part of the gain into a QOF to defer taxes. Are there any more advantages? Yes:

  1. If you hold your investment in a QOF for five years, you can increase your basis in the QOF by 10% of the deferred gain.
  2. If you hold your investment in a QOF for seven years, you can increase your basis in the QOF by 15% of the deferred gain.
  3. Finally, if you hold your investment in the QOF for 10 years, you can increase your basis in the QOF to the fund’s fair market value as of the date you sell or exchange it.

Ok, let’s break that down into plain English. Let’s say you bought stock in Microsplat for $100,000. Now it’s worth $1,000,000, and you’d like to sell. But you don’t relish the thought of paying six figures in tax on that gain. (You could buy a couple of Teslas with all that money!) So you roll your $900,000 gain into a QOF on January 1, 2019. Your basis in the QOF, at that point, is zero, because it consists of untaxed Microsplat gain.

On January 1, 2024, you can increase your basis in that $900,000 QOF investment by $90,000, or 10% of the $900,000 gain you deferred when you sold the Microsplat. If you sell at that point, you’ll owe tax on the remaining $810,000 of Microsplat gain, plus any appreciation in the QOF above the original $900,000 investment.

On January 1, 2026, you can increase your basis in your $900,000 QOF investment by another $45,000, bringing the total increase to 15% of the $900,000 gain you deferred when you sold the Microsplat. If you sell at that point, you’ll owe tax on the remaining $765,000 of Microsplat gain, plus any appreciation in the QOF above the original $900,000 investment.

On December 31, 2026, you’ll owe tax on $765,000 of the Microsplat gain ($900,000 minus the $135,000 step-up in basis) whether you’ve sold your QOF or not. The good news is, at that point you’ll increase your basis in the QOF by the amount of gain you pay tax on. So, your basis in the QOF will now equal your original $900,000 Microsplat gain, even though you’ve paid tax on just $765,000 of it. If you sell your QOF, you’ll owe tax on any proceeds above your new $900,000 basis.

Finally, on January 1, 2029, you’ll meet the 10-year holding period. That means if you sell your QOF interest for, say, $1.9 million your basis will step up to that full $1.9 million amount. That, in turn, means you’ll pay no tax on the $1 million gain on the QOF itself.

Your chances to claim the 10% and 15% basis step-ups expire on January 1, 2027. That means, if you want to take advantage of the 10% basis step-up, you have to invest in the QOF by December 31, 2021 (in order to meet the five-year holding period requirement by December 21, 2026). If you want to take advantage of the 15% basis step-up, you have to invest in the QOF by December 31, 2019 (in order to meet the seven-year holding period requirement by December 31, 2026).

The tax advantages with QOZs and QOFs seem like an obvious draw. Who wouldn’t love a strategy that lets them defer tax on one investment and possibly avoid it on the replacement? But in the end, choosing to deploy assets in a QOF should be an investment decision. Is QOF investing really right for you? That really depends on how the fund you choose, and the assets it buys, fit within your overall portfolio.

The new law’s tax breaks will probably create a ton of demand for QOZ investments, and that alone should help boost returns. But will a QOF give you the liquidity or income you need from the proceeds of your original investment? If not, then don’t let the tax tail wag the investment dog. Remember, your real goal isn’t just to avoid taxes. (You can accomplish that just by not making any money!) Your real goal should be to make the right investment decision for your needs and circumstances — then find the most tax-efficient way to make it.

Here’s a second factor to consider, and this is the case with any tax deferral strategy. We know what the tax rules look like today, but we don’t know what they’ll look like on December 31, 2026, when tax on deferred gain is due. It’s at least plausible that rates will go up between now and then — in which case paying later actually means paying more.

There’s one final technical, but important, disadvantage buried in the fine print that you’ll need to consider before diving into a QOF. If you die while you own an investment in a QOF, any untaxed gain on the investment deferred into that fund is considered “income in respect of a decedent,” which is legalese for “income we didn’t tax you on while you were alive so we’re going to tax you on it now that you’re dead.” There’s no chance to benefit from the usual stepped-up basis that you would have enjoyed if you had just held your original investment until you died. So, before you commit to a QOF, you might want to ask yourself just how well you’re feeling, and whether you think you’ll be around long enough to exit from the fund before you get caught in that particular trap!

We’ll be adding a module to the TMN system discussing the opportunity when we roll out the 2019 updates, and including it in additional system resources as well. 

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