What should investors and opportunity fund managers be doing before year-end?
At this time of year, clients are no doubt asking you for suggestions about ways to mitigate their capital gains (and related taxes). Whether the gains are realized from the sale of real estate, stock or bond portfolios, artwork, collectibles or other tangible and intangible assets, they can benefit from the Qualified Opportunity Zone program.
Many clients have likely asked you about federal QOZ program, since a friend, work colleague or investment advisor may have suggested reducing their taxes through the QOZ program with great gusto.
Introduced as part of the 2017 Tax Cuts and Jobs Act, opportunity zones, when utilized correctly, can be used to defer gains from the sale of a wide variety of capital assets sold, ranging from the sale or disposition of raw land, developed real estate, stock or bond portfolios, artwork and other collectibles, Bitcoin or other cryptocurrencies, as well as other tangible and intangible assets. OZ investing is not just restricted to real estate gains as is the case with a 1031 exchange.
As mentioned in our earlier article about the hidden gems of the opportunity zone program, taxpayers who are generating capital gains from the aforementioned sources can earn a 10 percent tax basis increase in their QOF investment in year five and another 5 percent increase in year seven. That amounts to a cumulative 15 percent permanent tax reduction. Most importantly, gains accruing after the investment into the QOF will be 100 percent tax-free upon sale if the investment is held for at least 10 years.
If clients can achieve all these great tax benefits and help disadvantaged communities in one of the nation’s 8,700 federal opportunity zones, it sounds like a no-brainer. But if you have clients who are considering investing in the QOZ program or starting a Qualified Opportunity Fund (QOF) before year-end, don’t let them wait until the last minute.
Your clients’ deferred tax gains must be reinvested into a QOF within 180 days of recognizing the tax gain on sale. Note: There are beneficial timing rules for gains reportable from “flow-thru” entities such as partnerships, S Corps or non-grantor trusts. For an in-depth discussion of the 180-day rule, see our article Opportunity zone investing: Reinvestment requirements and the 180-day time frame.
Wasn’t there some kind of deadline at the end of June? Am I too late?
Yes and no. June 28, 2019 ushered in one of the first major 180-day deadlines within the QOZ program. By that date, any flow-through capital gains (including net Section 1231 gains) reportable on Dec. 31, 2018, had to be re-invested into a QOF. The deadline for re-investing non-1231 capital gains generated by a taxpayer from capital assets they held directly, rather than via a flow-through entity, would have started on the earlier closing date of such sales. The vast majority of gains we have seen so far this year are 1231 and K-1 capital gains — both of which will generally trigger the 180-day starting period on Dec. 31, 2019, for calendar year taxpayers. Under current regulatory guidelines, Dec. 31 is also the first date that investors can technically reinvest their net 1231 and flow-thru capital gains into a QOF.
Final regulations are expected to be issued in the next couple of months. This will likely result in another flood of QOZ investments. Dec. 31 is also the deadline for investment if a taxpayer wants to obtain the maximum 15 percent tax-free “step-up” in their QOF investment. Investments made after that date will be limited to a 10 percent step-up since the seven-year holding period will not be met by Dec. 31, 2026.
How strict is the 180-day deadline?
There is still some confusion within the OZ investment community about a taxpayer’s need to make an investment into actual replacement property during the 180-day period. Unlike a Section 1031 transaction, however, under the fairly liberal QOZ program, the simple act of funding a QOF within the 180-day period is sufficient to begin the 2026 tax deferral process. The secondary step of deploying the cash into QOZ business property (such as stock, partnership units or other qualified assets) is less of a mad rush and can be done over a period of 37 months or more.
For investors and fund managers who established a QOF earlier this year, there are a number of upcoming deadlines and additional structuring steps that must be undertaken. The following is a non-inclusive list of areas that OQF managers will need to pay special attention to before year-end.
1. Know your testing criteria
QOFs are required to hold at least 90 percent of their assets, on average, in a QOF business property (QOZBP). Missing this semi-annual test can trigger a penalty that is tied to the floating federal underpayment penalty rates — approximately 6 percent annually. That’s annoying, but not fatal to the QOF. Remember, QOFs are not eligible for the 31-month working capital safe harbor, so virtually every QOF will need to establish a QOZB to allow for long-term deployment of their funds.
Qualified Opportunity Zone businesses (QOZBs), on the other hand are eligible for the working capital safe harbor and are only required to hold an average of 70 percent or more of their assets in QOZBP. This more relaxed test is critical for meeting the Qualified Asset tests. Unlike the QOF penalty structure, a QOZB that fails to meet the 70 percent test could invalidate both the QOZB and the QOF — and effectively blow up all of the OZ benefits. Final regulations may offer a correction period for QOZBs, but that is unclear at this point.
2. Establish your QOZB entity
As mentioned above, in order to be entitled to the lower 70-percent QOZBP threshold — and the 31-month working capital safe harbor — a QOZB (or multiple QOFs) must be formed underneath the QOF. The QOZB must be structured as either a corporation or a partnership and the QOZB cannot be a “disregarded entity” and obtain these benefits.
For QOFs formed earlier this year, it will be important to establish a QOZB within six months (in most cases) of certifying the parent entity as a QOF. The certification date needs to be on or before the date the QOF first received funds from a qualified investor.
3. Know your testing dates
In order to be compliant with the OZ program, the QOF must complete a semiannual 90 percent asset test. The QOF must prove that 90 percent of the assets currently in the fund are QOZBP. In the first year the fund is formed, the asset test will fall at the end of the six-month period which includes the month of certification. The asset test will also occur at year end, either calendar or fiscal year. The second set of regulations announced that the very first testing date will ignore funds that were received during the six-month period preceding the testing date. For example, if a fund is formed and certified in June, then the first testing date will be at the end of November. Therefore, this first testing date is considered a “freebie” since no penalties can generally be assessed.
The second asset testing date for a calendar year entity that was certified prior to August will then be Dec. 31. Taxpayers and fund managers must carefully monitor the fund’s asset mix prior to the testing date.
In year 2, the testing dates become regular and will always fall on June 30 and Dec. 31 for calendar year QOFs.
The asset test for a QOF is documented on IRS Form 8996. This form is used in the first year to “self-certify” that the QOF was established to participate in the QOZ program, as well as for the asset testing which is based on the monthly average ratios. If a 90 percent test is missed, the penalty will be imposed on the fund’s asset values multiplied by the difference between the actual QOZBP percentage and the 90 percent target. The penalty interest rate used is the interest rate for each calendar quarter, which the IRS determines during the first month in the preceding quarter. (See https://www.irs.gov/pub/irs-pdf/f8996.pdf for the Form 8996 and https://www.irs.gov/IRB for the rates that are published quarterly in the Internal Revenue Bulletin or subscribe to IRS Guidewire for news released of quarterly interest rates at https://www.irs.gov/uac/E-News-Subscriptions-2.)
4. Be careful how you invest your QOF and QOZB cash
Most QOFs and QOZBs will be holding large amounts of cash as they develop their business plans, begin their asset acquisitions and/or begin their construction spending. The April 2019 Tranche II Regulations limit the maturity period for fixed income instruments to investments with a maturity of 18 months or less. Longer maturities are ineligible and will be treated as a non-qualified OZ business property (5 percent limit) and may jeopardize meeting the 70 percent test.
5. Begin developing your business plan
Since QOFs established on June 28, 2019, or earlier and related QOZBs will have a Dec. 31, 2019, “real” testing date, fund managers will need to have a substantive business plan for the QOZB, including cash flow projections in order to allow the QOZB to treat cash held by the QOZBP as working capital — or eligible to be included in the numerator in measuring the 70 percent semiannual test.
Clearly money is continuing to pour into QOFs. While the majority of funds are going into real estate funds, there are a growing number of funds focusing on utilizing the OZ program to start, acquire or grow businesses that operate within Opportunity Zones.
Hundreds of QOFs with tens of billions in invested dollars were formed during the first half of 2019. An even larger number of funds are being formed now. Fund managers, attorneys and CPAs who work in this area will be very busy at year-end ensuring that the QOFs and QOZBs are compliant with the somewhat complex AOZ rules. Feel free to contact us if you’d like help deciphering the rules.