Qualified Opportunity Zones: A Basic Summary
The Qualified Opportunity Zone regime offers taxpayers a once-in-a-generation chance to invest in designated geographical areas and potentially defer and reduce invested capital gains and pay no tax upon the sale of the new investment. The regime is very flexible and allows for investment in a wide variety of asset classes.
In order to illustrate how powerful this tax planning tool can be, we look to a simple example:
Tim owns Apple stock worth $2 million with a basis of $1 million. If Tim sold this stock today, he would have a $1 million gain, on which he would owe capital gains tax. However, if Tim invests this $1 million gain in a Qualified Opportunity Fund (“QOF”), Tim may be eligible for three tax benefits.
Three Tax Benefits from Investing Gains in a Qualified Opportunity Fund
Organization and Restrictions of Qualified Opportunity Funds
QOF formation and certification, in many circumstances, is relatively straight-forward. A QOF may deploy invested capital in a wide variety of projects, including real estate development and operating businesses. However, QOFs generally may not be used to invest in passive assets, such as publically traded securities.
In order to qualify for these generous tax benefits, a QOF must comply with a number of requirements. This article does not address all of these requirements in detail, but rather highlights some of the more important requirements and the policy considerations underpinning these requirements. Taxpayers should consult their tax advisors for advice concerning the full regalia of QOF requirements.
Better Understanding the Qualified Opportunity Fund
To make sense of the QOF regime’s requirements, it is helpful to keep the regime’s policy goals in mind. The regime is intended to be an economic stimulus program for “low income” areas. As such the regime is designed to require investors to deploy capital into long-term investments that result in cash infusions into these areas.
A QOF must hold 90% (or, in some cases, 70%) qualifying assets. Very generally, qualifying assets must be located in an opportunity zone and must be used in a trade or business. Such assets must be newly created assets or, if pre-existing, must be “substantially improved” by a QOF. To substantially improve an asset, a QOF must spend an amount equal to its original acquisition cost of the asset on improving the asset within 30 months of purchase.
Many QOF investors utilize the regime to invest in real estate development projects on a tax advantaged basis. In a common fact pattern, an investor realizes a capital gain and invests the gain in a QOF. The QOF can then purchase unimproved land and construct a new development on the land, or buy an existing building and substantially improve it. Also, a QOF could purchase an existing building that has been vacant for 5 years or longer or even purchase a newly constructed building that has not yet begun to be used (for example, after construction but prior to becoming occupied).
Other QOF investors see opportunity in using the QOF regime to invest in or start their own operating businesses. An investor or entrepreneur could fund a QOF with capital gains and use the capital to start a new business or substantially improve an existing one. A QOF could also be funded with a mixture of capital gains and other funds but tax benefits would only be available with respect to the capital gains invested. Further, an existing business that is not currently located in an opportunity zone may be purchased and moved into a zone and the assets of the business will be qualifying assets so long as they are substantially improved.
The IRS has released taxpayer friendly guidance on which businesses can be considered located within an opportunity zone. Very generally if any of the following conditions are met a business will be considered located within a zone; (1) if half of the dollars the business spends on employees relate to employees in a zone, (2) if half of a business’s employee hours occur within a zone, or (3) if half of a business’s management and assets are within a zone.
The IRS has also issued taxpayer favorable guidance allowing operating businesses to lease certain property and have such leased property count as a qualifying asset.
The prospect of being able to start a new or improve an existing business, build it for 10 years and then be able to sell it without paying tax is an extremely exciting tax planning opportunity. Investors and entrepreneurs should consult their tax advisors to determine if this tax planning technique is a good fit for their individual circumstances.
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