Five hidden gems in the federal opportunity zone program
It’s no secret that the opportunity zone (OZ) program has garnered tremendous attention from real estate developers and investors. Did you know it may hold even greater rewards for serial entrepreneurs, owners of existing improved commercial real estate and others investing in new or existing OZ-located businesses?
The Treasury Department’s latest set of OZ regulations (aka Tranche II) provided valuable guidance about how the program will operate for business operators, real estate developers and landlords. Tranche II also helped clear up confusion about many of the OZ mechanics, deadlines, holding periods and other nuances of this widely touted, but often misunderstood, capital gains deferral vehicle.
Sure, the OZ program has some complex elements and a few states have yet to conform, but it is also exceedingly flexible and impactful. Here are five of the most powerful, but less publicized uses of the OZ Program that might be highly beneficial for your clients:
1. Safety net for a “blown 1031 exchange”: a four-year replacement window
A taxpayer selling an appreciated real estate investment must use a special “accommodator” to escrow all proceeds from the sale. He or she must identify qualified replacement property within 45 days of the sale date. Since this requires taxpayers to close on the replacement property within 180 days, it can create tremendous timing pressure on taxpayers and force them to “overpay” for the replacement property or end up with property that is less than ideal. An OZ transaction will always give taxpayers additional time to make smart replacement property decisions.
For example, a taxpayer reporting a real estate gain on Form K-1 will generally have 180 days from year-end to invest in a qualified opportunity fund and will not have to identify a replacement property for years.
The OZ program can effectively provide a real estate investor with a replacement window of 48 months or more. That’s an attractive alternative to the highly restrictive 180-day replacement period for a traditional 1031 exchange. The extra breathing room can give a taxpayer the ability to execute a ground-up construction project as the replacement property — something that would be impossible to do via a traditional 1031 transaction. Another advantage of OZ programs over 1031 transactions is that OZ investors are only required/allowed to reinvest the capital gains from their original investment — not the entire proceeds. Thus, they can pocket their original basis and “ordinary.”
Remember: A gain from an OZ program reinvestment will be recognized in 2026 whether or not the replacement property is still held. Further, a 1031 structure for a real estate disposition will benefit residents of states that have not yet conformed to the OZ program, including California, Arizona, Hawaii, Massachusetts, Minnesota, North Carolina and Pennsylvania.
2. Holders of investments in dysfunctional partnerships
I’m sure you’ve seen cases in which family members and unrelated partners in an investment project see things differently over time. For example, let’s say a successful real estate rental property has appreciated dramatically and half of the investors want to cash-out. Let’s also assume the remaining investors want to structure a 1031 transaction and roll their gains and equity into a commercial property. A sale would trigger a gain for each partner and a 1031 would tie-up the equity for each partner. The partners would have to investigate complex alternative solutions, such as possibly splitting the property into “tenant in common” interests followed by a liquidation of the partnership before any sale took place.
In contrast, the OZ program allows the parties to sell their interests, and assuming the partnership does not elect OZ treatment at the entity level, the resulting gain would flow to each partner on their year-end Form K-1. Each partner would have the choice of either (a) taking their profit and running, or (b) electing under the OZ program to invest their individual gain into a QOF within 180 days. Voila! The equity holders are separated and at peace.
3. Ideal entity choice — not what it used to be
As many of you know, S corps have long been a preferred entity of choice along with LLCs and partnerships for business owners. While there are certain advantages to being an S corp, one significant downside is that when the company is sold or a shareholder dies, the “inside” tax basis of assets held in the S xorp retain their historic cost basis. So, a step-up is generally not possible for buyers unless the buyer and seller agree to make 338(h)(10) elections.
That’s why many taxpayers have avoided placing their appreciating assets into S corps. However, when taxpayers have appreciating assets stuck inside an S corporation, the OZ program may be an elegant solution for extracting those assets and avoiding future trapped appreciation.
For example, let's say an S corp holds an operating business and also owns the commercial building that houses the business. Let’s say the property has a tax basis of $1 million and a fair market value of $2.5 million. Let’s also assume the owners want to replace the current building with a new custom facility. The owners can clearly engage in a 1031 transaction within the S corporation. However, by selling the property within the S corporation and by electing OZ treatment at the shareholder level for the gain, the owners can effectively strip the asset from within the S corporation while deferring the gain until 2026. The property is now owned outside the S corporation. There will need to be some analysis and structuring under the related party rules, but there are options. In the event of a ground-up construction project, the shareholders can take up to 30 months or more to deploy the funds. Taxpayers must weigh this strategy against a 1031 exchange, which offers unlimited deferral of capital gains and also allows gain deferral for all states.
4. Operating businesses — potential exit in 5 years rather than 10
When your clients hear “opportunity zone,” I’ll bet they start thinking about real estate. But, now that the new Tranche II regulations have clarified how qualified opportunity zone businesses (QOZBs) can deploy their funds under the working capital safe harbor rules, financial advisors are fielding a lot more calls about using the OZ program to start, purchase or move businesses into an OZ. The program designers and the Trump administration are big proponents of OZ operating businesses.
Did you know there are significant planning opportunities when establishing an operating business within a QOF? IRC Section 1202 (for qualified small business stock, or QSBS) provides for a substantial tax exemption on certain types of operating businesses [see Section 1202(e)(3) for excluded service companies and other businesses] that meet various statutory criteria. In general, the QSBS rules allow each taxpayer that is a non-corporate shareholder to exclude the greater of:
- $10 million of cumulative QSBS stock gain, or
- 10 times the taxpayer’s tax basis in the QSBS stock.
The QSBS rules are somewhat complex, but taxpayers can initially form the QOZB as an LLC that’s taxed as a partnership, which then converts to a C corp after startup losses have been incurred. This assumes that the C corp conversion occurs before the entity’s value grows to over $50 million dollars. Before electing into C corp status, taxpayers must evaluate the impact of double taxation and the loss of a tax step-up to the buyer in a sale transaction.
Within five years of becoming a C corp, the entity can be sold and up to 100 percent of the tax gain can be excluded, provided the gain doesn’t exceed any of the aforementioned limits. Some states, like California, do not conform. But in the majority of states, OZ investors enjoy two bites of the tax planning apple — with 1202 being operative as early as five years from formation. Granted, there is not an unlimited OZ gain exemption under the QSBS rules, but most investors will be very pleased with a $10 million exempt gain and the ability to exit after five years, rather than 10 years.
Many OZ census tracts also fall into federal, state and local tax incentive programs such as property tax, payroll tax, income tax breaks, government grants and employee training programs. Investors and fund managers should explore these additional tax mitigation opportunities.
5. Leveraging is your friend in the land of OZ
One of the many taxpayer-friendly issues that the Tranche II OZ regulations clarified was the way debt is treated in a QOF. When a QOF is formed as a partnership, the investor’s share of a mortgage or other liability is treated as a capital contribution/basis increase to the extent that the QOF (or underlying QOZ business) has debt that is allocated to the partners or members.
This basis increase allows QOF investors to claim tax losses flowing through the entity. The regulations also clarify that the debt layer is also eligible for a full step-up to fair market value in year 10.
For example, let’s say an investor rolls a $500,000 gain into a QOF and uses the funds to purchase raw land. Let’s also assume the investor gets a $2.5 million interest-only loan to build an office building and claims $800,000 in depreciation over the next 10 years. The investor’s tax basis is calculated as follows:
Tax basis in QOF:
Deferred gain deposited: $0*
Basis for debt allocated: $2,500,000
10% basis increase in year 5: $50,000
5% basis increase in year 7: $25,000
Basis increase for 85% gain in 2026: $425,000
Decrease for depreciation: <$800,000>
Year 10 QOF tax basis: $2,200,000
* Since the original tax gain is deferred, there is no basis increase until years 5, 7 and 10.
If the land and building appreciate to $4 million after a 10-year hold, then the full tax gain of $1.8 million ($4 million - $2.2 million) is fully exempt from federal tax. Even better, the $800,000 depreciation recapture is never recognized. The leverage allowed the investor to claim $800,000 in tax depreciation (worth about $320,000 at the 40 percent tax rate). The investor also received $1.5 million in net cash after paying off the debt — which is more than three times the original $500,000 equity investment. The investor also had to pay tax on 85 percent of their original deferred gain of about $127,500 ($425,000 x 30%) in 2026. As mentioned above, a 1031 exchange would provide a deferral until the actual sale date of the project.
These examples assume the investor’s state of domicile fully adopts the OZ program. See discussion of conforming and nonconforming states.
Just 18 months after being introduced as part of the sweeping Tax Cuts and Jobs Act of 2017, the OZ program is having a positive impact on underserved communities at the local, state and national level. Opportunities are vast for investors with capital gains, but the rules can be complex. More regulatory updates are coming after public comments on both sets of regulations. Always make sure your clients consult with their legal and financial advisors before embarking on an OZ investment journey.