Qualified Opportunity Zone – A Second Chance to Defer Capital Gains Taxes?

I have had the good fortune of helping real estate investors defer capital gains tax on the sale of certain appreciated real estate for nearly 20 years. In my experience, the most significant tax break the IRS offers is IRC Section 1031, commonly referred to as the 1031 Exchange rule. With it, if certain requirements are met, there is no limit on how much tax one can defer. The capital gains and associated depreciation recapture tax can be deferred until the taxpayer dies. At that point, the asset can be left to the heirs with a step-up in basis, eliminating the tax.

There is another option, however, for enjoying these same tax deferral benefits and it has become one of the most talked about opportunities in real estate investing today. It’s called the Qualified Opportunity Zone, or QOZ. The QOZ was a provision identified in the Tax Cuts and Jobs Act of 2017. It didn’t get much attention at the time, but that is now changing.

A QOZ is a designated community that is selected by a state Governor and certified by the US Department of Treasury. Typically, these are low income communities in need of investment dollars for new development. The government has offered significant tax advantages for developers and investors interested in participating in Opportunity Zones. In this article, I will focus on the potential tax advantages for an investor in a QOZ, how that compares to the tax advantages of a 1031 Exchange, and how and investor may get a second chance with an QOZ if they have had a failed 1031 Exchange within the last year.

For starters, the QOZ can be complicated. There have been multiple rounds of proposed regulations from the Treasury with the most recent round coming at the end of April 2019. If you made an investment in a QOZ fund before the new proposals came out, you should familiarize yourself with these new regulations. If you find you are not compliant on your end, or the QOZ fund or QOZ investment property is not compliant on the development end, the tax advantages may be compromised.

What are the potential tax advantages of investing in a QOZ?

First, if you are selling an appreciated asset, and you have a capital gain, you can defer the capital gains tax by investing the amount of the gain into a QOZ fund. You only need to invest the amount of the gain. You must invest within 180 days of realizing the gain. Unlike a 1031 Exchange, you do not need to deposit the sale proceeds with a Qualified Intermediary prior to investing in the QOZ Fund. It’s important to know, however, that this is a tax deferral strategy, not a tax elimination strategy. The capital gains tax will be due when the QOZ fund sells the property, or on December 31, 2026.

You can reduce the tax obligation if you stay invested in the QOZ fund for certain periods of time:

• If you stay in the QOZ fund for five years, you receive a 10% step up in basis.
• If you hold the QOZ fund investment for 7 years, you receive another 5% step up in basis.
• If you invest in a QOZ fund before December 31, 2019, you will have held the investment for the required seven years before the tax is triggered on December 31, 2026. You will have realized the maximum tax break, which is a 15% step up in basis.
• In addition, if you hold the QOZ Fund investment for ten years, you will pay no tax on the gain in your QOZ investment. This applies only to the original gain that you invested in the QOZ fund, not the return of Principal (Basis) from the original investment or any additional funds that may have been invested.

From this brief discussion you can see that one potential drawback to the QOZ fund investment is that you must pay your tax on December 31, 2026. Some QOZ funds are suggesting that they will finance or refinance the properties at that time. Loan proceeds could then be distributed to investors tax free. Investors could then use the money to pay the tax. Read that line carefully. Borrow money to pay your tax.

As I talk to both investors and sponsors about the QOZ funds, there seems to be this underlying assumption that the QOZ fund investments are going to perform as projected. This is a mistake. There will be underperforming properties. There will be properties that fail. If the sponsor can’t get financing, or sell a property from the fund, you must have outside resources available to pay the tax in 2026.

My suggestion is to choose your QOZ fund sponsor carefully. When I recommend a Delaware Statutory Trust investment to a 1031 Exchange investor, I explain that selection of the sponsor offering the DST investment is the most crucial decision you make. Invest with sponsors who have extensive, proven track records. This is the best way to mitigate the inherent risks associated with any real estate investment. The same thing applies with QOZ fund investments. There are proven, successful sponsors that will be offering QOZ fund investments. There will be people getting into the game with little or no experience. Choose carefully.

How would a QOZ fund offer you a second chance? If you were attempting a 1031 Exchange within the last 180 days and that exchange failed – either you failed to close on a suitable replacement property or you failed to even identify suitable replacement property – you would have a second chance to invest with the QOZ fund.

But you don’t need to have had a failed exchange. You may have sold a property with a gain and never set up a 1031 exchange. If the gain portion of those funds were still available, you may have a second chance with the QOZ fund investment. If avoiding paying the tax on your gain is that important to you – and I believe this is always the most important element – you may have a second chance by finding the right QOZ fund.

So, when considering an investment in a QOZ fund, remember these useful tips:

1. Invest in QOZ funds with experienced operators and sponsors
2. Avoid “blind pool” funds that have not yet invested in the QOZ properties. You can invest in the fund, but if the fund doesn’t invest in the QOZ before your 180 days, you can have a problem
3. Hire a Qualified Tax Advisor to vet the QOZ fund and make sure you’re doing everything properly

I can recommend an excellent law firm that has formed a special practice group dedicated to the QOZ. Several white papers are also available, and they can provide the most recent proposed regulations.

If you are interested in learning more about Opportunity Zones, please feel to contact me directly.