Forbes: Qualified Opportunity Zone Investments: Does It Make Sense During The Covid 19 Crisis?

The Qualified Opportunity Zone (QOZ) investments Final Regulations published a year ago made clear some of the ambiguities noted in the Proposed Regulations, but so much has changed since then there is a question whether it makes sense to invest in a QOZ fund.  QOZ investments remain a powerful, but uncertain, tax planning tool; but, one that any individual taxpayer who will realize large amounts of capital gains or an interest in impact investing, must consider. 

The Qualified Opportunity Zones date back to the Clinton Administration and are based on the prior Census Tracts, nominated by state governors and approved by the Treasury Department. These are locations where very little new private equity is invested in either businesses or properties. To encourage individual taxpayers to make new private equity investments in these depressed areas, the 2017 Tax Act added two income tax benefits for long term equity investments of new money in either property or businesses located in a QOZ. 

The first income tax benefit is that the capital gains tax due on realized capital gains invested in either in a Qualified Opportunity Zone Fund (QOF) or directly into a Qualified Opportunity Zone Business or Property (QOZB) is deferred until December 31, 2026. The cash must be invested not more than 180 days after the transaction and the investment cannot be sold or exchanged during that time. If the gains remain in the QOF or QOZB for five years, the taxpayer gets a stepped-up basis of 10%. If, the gains remain in for the full seven years, a stepped-up basis of an additional 5%, for a total stepped up basis of 15% applies.

The second income tax benefit for the individual taxpayer who invests realized capital gains in the QOF or QOZB gets is that, if they leave the funds in the investment for ten or more years, they can sell or exchange that investment without incurring any capital gains tax on the appreciation on the cash invested in the QOF or QOZB from the date of the investment. 

Both of these benefits depend on the taxpayer making the proper elections and the annual filing of disclosures with their federal income tax returns. 

The Proposed Regs. defines the type of taxpayers and type of gains eligible for this program, when the investments must take place, how to elect deferral, valuation of a Qualified Opportunity Zone Business, what a Qualified Opportunity Zone Fund or Business is, and what the effect of transfer of QOF or QOB interests other than by sale or exchange will be.

There are several businesses that are good fits within the Opportunity Zone program because they require significant investment capital relative to the purchase price of land or buildings, as well as having most deal returns generated upon disposition. As long as the sale of the investment occurs at least 10 years after the purchase, the investor will enjoy the QOZ tax benefits on the sale-generated gains.

Expect to see developments of brownfields, energy infrastructure projects (both traditional and alternative energy) and data centers as QOZ businesses. They are usually geographically flexible, and there may be numerous QOZ sites that fulfill the product criteria. Certain corporate expansion efforts — clinics and banking for example — that have traditionally not expended into these neighborhoods can also fall into this category as long as the QOF is not simply developing triple-net space, a nonqualified investment under the QOZ regulations.

New or expanding businesses with expensive mobile assets like trucks, airplanes, construction equipment or even semi-permanent solar power storage units might keep those assets in QOZs in order to enjoy QOZ tax benefits since the final regulations clarify how a business with mobile tangible property can qualify under the law. Depending on the asset and the business, there are certain requirements relating to the number of consecutive days that assets can be located outside of a QOZ. Many owner-operators and lessors of equipment will need real estate partners who can help develop solutions that can enable their operations to comply with the site-specific requirements.

Finally, QOZ lends itself to impact investing. Impact investing is where there is a financial investment in a business that provides a financial return and a social return.  Because of the deferral of the capital gains tax, and the ultimate tax-free return after 10 years on investments in the QOZ, the Fund lends itself to these investments that may not have as high an immediate return as other investments, but which have a greater impact on the community and greater return in the long run. This may be particularly useful as older generations seek to engage younger, and more idealistic, generations in business and investing. 

The final regulations on Qualified Opportunity Zone investments added some important clarification on how the investments work. The investments still require due diligence by both investors and their advisors. There is a chance that, even if the investment works perfectly, that the new administration raises capital gains rate. If the tax rates remain at or below the 38.6% proposed, then a realistic rate of return of  5.5% is needed to break even. Contact your tax planner to see if a QOZ investment makes sense for your realized capital gains.