Qualified opportunity zones (QOZ) are quite possibly the largest tax savings tool out of the tax reform passed in December of 2017. In a previous article, we outlined some of the basics of what an opportunity zone is and why you should invest in them, but a recent update provides clarity on how to invest in a qualified opportunity fund (QOF).
The initial tax law on this program contained a number of grey areas that required further interpretation from the Treasury Department. In October 2018, the IRS issued proposed regulations and other guidance on how to qualify and utilize the tax benefits of the opportunity zones.
Here are the answers to some of the most relevant and important questions about how to invest in a qualified opportunity fund.
Who can invest in a qualified opportunity fund (QOF)?
The regulations proposed have clarified that any taxable entity is eligible. Therefore an individual, partnership, corporation or trust may elect to invest in a QOF.
Can I use ordinary income or other existing assets to invest in a QOF?
The IRS clarified that only capital gains are allowed to be subject to the deferral benefits and basis step-ups at the 5-, 7-, and 10-year holding periods. Therefore no items of ordinary income (wages, interest, dividends, business or rental income) are eligible to be deferred.
Can I hold the investment in perpetuity and get a basis step-up whenever I sell?
In the regulations there is a proposed end-by date to receive the 100% basis step up after holding the investment for 10 years. You must sell the investment by December 31, 2047. You will not be allowed to hold the investment in perpetuity.
I’ve invested into a QOF. Can I retain working capital in the fund while completing my investment?
The IRS proposed a pro-taxpayer safe harbor for retaining working capital. For property inside an eligible zone that a fund purchases with pre-existing assets in place, the fund must substantially improve the assets within 30 months of the investment (2 ½ years). To be substantially improved, you must double your initial investment in the asset(s). As projects can take time to design, permit, plan, or build, the proposed safe harbor allows a fund to maintain “reasonably necessary” working capital. Therefore you do not need to expend all cash in the investment on day one.
Defining "substantially improved"
In other guidance, the IRS ruled that land does not need to be substantially improved, which is a very pro-taxpayer determination. The question that was raised was that land is inherently permanent and the original use requirement thereby impossible to meet. Land would otherwise need to be substantially improved to qualify. The IRS has specifically exempted land from the substantial improvement rules, including land improvements, so that only structures need to be improved.
For example, assume a QOF purchases land and building inside an opportunity zone for $500,000. Assume the fair market value of the land is $200,000 and the building value is $300,000. To substantially improve property, only $300,000 of building improvements must be completed within 30 months from the date of purchase.
More on how to invest in a qualified opportunity fund
If you would like to pursue an investment in a qualified opportunity zone and setup a qualified opportunity fund, please contact one of our tax professionals at Aldrich. Our industry experts will be able to help you create the fund and ensure you are in compliance with this new and exciting opportunity.
Senior Tax Manager - Real Estate
Jonathan McGuire, CPA
Aldrich CPAs + Advisors LLP
Jonathan McGuire has over eight years of experience providing strategic tax planning and compliance expertise to private middle-market clients. He has a deep focus as a real estate accountant, working with investors, developers, realtors, property managers, and other professional service providers in real estate. He works with a wide range of property types ranging from…
- Real estate
- Partnership taxation
- Tax planning and compliance
- Certified Public Accountant
- Repair regulations
- Qualified Opportunity Zones
- Qualified Opportunity Funds