QOZ. QOF. QOZBP. Most individuals who own or provide services for commercial real estate have heard these terms floating around, nevertheless how many of us truly understand the opportunity and are in a position to use it to our advantage.
WHAT & WHY: QOZ & QOF
The Qualified Opportunity Zone (QOZ) Program is a tax incentive program introduced as part of the Tax Cuts and Jobs Act of 2017 (“TCJA”), designed to encourage long-term private sector investments in low-income census tracts and adjacent census tracts designated as “Qualified Opportunity Zones,” or “QOZs.” In return for their investment, the program provides considerable tax benefits to “Qualified Opportunity Fund” (QOF) investors if utilized properly. A “Qualified Opportunity Fund” or “QOF” investment vehicle is a specially formed entity that must invest at least 90 percent of its assets in qualified businesses or real property located in Qualified Opportunity Zones. When the QOZ Program was introduced in 2017, it was estimated that U.S. households and corporations had approximately $6.1 trillion in unrealized capital gains. The QOF program is essentially intended to “unlock” a portion of this massive figure that otherwise would not be reinvested in the near future due to tax exposure.
INVESTING IN A QUALIFIED OPPORTUNITY FUND
Investment in a Qualified Opportunity Zone, if done properly, provides investors (individuals or entities) with capital gains a means of tax deferral, reduction or elimination, depending on how long the QOF investment is held. The motivations to invest in QOFs are very similar to the reasons one would consider investing in a 1031 Like Kind Exchange. In order to invest in a QOF, an investor must have capital gains from the sale of real property (or anything else causing gains from a federal income tax perspective) to an unrelated third party, and the investor must reinvest within 180 days of the transaction causing the gain. Investing in a QOF offers the following distinct advantages for a long-term investor:
Opportunity Zone investing requires much more preparation and foresight than a 1031 Exchange, including proper organizational structuring and adherence to regulations. It also requires filing actions on the part of the QOF itself (IRS Form 8996) as well as the individual investor (IRS Form 8949) with federal income tax returns.
Unlike a 1031 Exchange that requires an investor to reinvest the entire net proceeds of the transaction causing the gain, investing in a QOF only requires the reinvestment of the gains itself (in 180 days or less). The investor is essentially allowed to “cash out” or retain whatever proceeds from the previous transaction are not capital gains.
QOF investors are able to defer their taxes through December 31, 2026 or, based upon when they sell their investment, before such date; however, the real benefits kick in for QOF investments held at least 5, 7 or 10 years for the following reasons:
- For those held at least 5 years, ending by December 31, 2026, the taxable capital gain amount through step-up in basis shall be reduced 10 percent.
- For those held at least 7 years, ending by December 31, 2026, the taxable capital gain amount through step-up in basis shall be reduced 15 percent.
- If held for 10 or more years, ALL capital gains federal taxes on the appreciation of a QOF investment shall be ELIMINATED.
QUALIFIED OPPORTUNITY ZONE PROPERTY (“QOZP”)
The QOZ Program is meant to stimulate new development in designated areas, not just enable the transfer of existing cash flow. Therefore, QOFs are expected to invest in new development and are not able to realize tax benefits from simply purchasing a property in an opportunity zone. In order to qualify as a QOZ Program (QOZP), a property or project must pass one of the following two tests:
- Substantial Improvement – Requires improvements equal to the QOF’s initial investment to an existing property over a 30-month period (i.e. if a QOF buys a property for $1 million it must “substantially improve” that property by at least $1 million within 30 months from purchase).
- Original Use – For new development projects being placed into service in a QOZ.
The majority of new multifamily QOZ investment has been in the form of new developments satisfying the “Original Use” requirement. Typically, a QOF will act as a developer to organize, oversee and finance a new apartment project, and the property becomes depreciable the day it is put into service.
An increasingly popular alternative method that QOFs are taking advantage of nationwide is to purchase a QOZP project prior to the date that property is put into service. This can mean purchasing a mostly or partially completed construction project or purchasing a completed multifamily project prior to the property obtaining a temporary certificate of occupancy. This method allows a QOF buyer to purchase an existing (or soon to be existing, under the IRS and local government sanctions) property, however, this carries the inherent risk of buying a property pre-stabilization and makes the buyer responsible for completing the certificate of occupancy process and 100 percent of the initial lease-up.
ENTER THE ZONE
Ultimately, an investor needs capital gains, correct IRS filing and transaction timing, proper QOF entity formation and a long-term investment plan in order to invest in an Opportunity Zone. Looking beyond an investor’s personal financial goals, the QOZ Program’s impact on targeted lower-income areas should confidently be immense and long-lasting. It will be extremely interesting to see how new development grows as the program matures.