You have recently seen many articles or may have taken classes on Qualified Opportunity Zones. There is much discussion about whether the program will truly spur economic development or whether it is simply more tax breaks for wealthy developers. Much of the information we have read is confusing and sometimes inaccurate.
The QOZ program was an element of the Tax Reform and Jobs Act of 2017. It is designed to provide Americans who have capital gains built into assets they own some incentive to sell those assets and put their gains to work on economic development projects in the QOZs — low-income areas designated as in need of new development. There are presently more than $6 trillion in capital gains sitting on the sidelines in America. These gains are essentially trapped in the assets: The owners won’t sell the assets because they don’t want to pay tax on the gains.
This program is not a tax break for developers. It is a tax incentive for individual American investors. In fact, because developers typically deal with “dealer property” or “inventory,” they rarely have capital gains.
This program applies to investors across the board. It applies to the mom and pop who started a family business years ago but who now hesitate to sell because of the tax hit. It also applies to anyone who owns stocks or bonds who want to sell but refrain because of the taxes they’d face.
As a result, a massive amount of potential revenue sits on the sideline and is not productive.
How it works
There are three incentives in the program. The benefits to the investor apply if a person sells an asset for which there will be a long-term or short-term capital gain (such as stocks, bonds, businesses, partnerships, equipment or real property). The benefits also apply if the person reinvests the gain portion of the sales proceeds into a Qualified Opportunity Fund within 180 days, the QOF does business in a QOZ and the QOF spends the funds acquiring and improving the property within 30 months.
Of course, there are many more bells and whistles related to the program, but if these four elements are met, the following benefits come into play:
1) A deferral of the payment of tax on the capital gains until Dec. 31, 2026. This is not a waiver of the tax, it is a delay of the tax.
2) If the property is held for seven years, the investor receives a step up in basis for determining the amount of tax to be paid in 2026.
3) There is no tax on any gain accrued during the investment hold period if it’s held for a minimum of 10 years.
Versatility is key
One of the most important things about the QOZ program is just how versatile it can be. It applies to a husband and wife who want to buy property and build a building in an Opportunity Zone. It equally applies to the several-hundred-million-dollar funds that are being created all over the United States to acquire and improve or develop major improvements in QOZs.
Here’s an example scenario of the former:
A husband and wife bought technology stock for $10,000 some 20 years ago. The stock is now worth just over $1 million. They find a property in Bend that is in an Opportunity Zone and would like to build a duplex on it. The couple sell their stock and have a $1 million gain. They put their gain into a QOF they create for themselves.
The QOF buys the land for $200,000 and builds the duplex for $800,000, all within 30 months. They refinance the property, distribute the refinance proceeds and pay tax on $850,000 on Dec. 31, 2026 — about $202,000. Eleven years later, they sell the duplex for $2 million and don’t have to pay any tax on the $1 million in value that accumulated over the 11 years.
Without the Opportunity Zone program, the couple might not have sold the stock, the seller in Bend might not have sold their property, the duplex would not have been built and the original $1 million would not have been invested to create economic development in the community.
Of course, it can be more complicated. Often a QOF structure will be a security. It is a security if it is an “investment contract.” This means an investment of money, into a common enterprise, with the expectation of profit, based solely or primarily on the efforts of others. Many of the funds we’ve seen in the market, such as the $330 million QOF that Sturgeon Development Partners launched in December, are securities.
The Opportunity Zone program has been criticized by some as “being just another one of the “Trump tax cuts.” Not true. This program was conceived in 2015 by the Economic Innovation Group with the help of Facebook’s Sean Parker and former Obama administration senior economic advisor Steve Glickman.
The resulting early 2017 legislation was first proposed in the bipartisan Investing in Opportunity Act, which was introduced in the House and Senate with nearly 100 bipartisan congressional supporters. The support was not only politically diverse but regionally diverse as well. Because it did not move forward, it was simply packaged into the Trump tax reform act.
Some have also proposed that this program will deny the states substantial tax revenue. However, if the capital gains are never triggered because the owners of the assets refuse to sell, then the gains would never result in revenue to the states.
The QOZ program allows the revenue from the gains to be put to work improving our communities.
Creating a performing asset inside a zone will increase the tax base through new or improved businesses and properties. There will be income from operations that will be taxed. There will be increased property values, thus increasing real property taxes. The jobs created from the construction of assets and employment within the zone will increase the income tax base or even increase wages. Why keep investing in Walmart, Google, and other equities when you can physically direct how your investment dollars are used and invest with purpose in your community?
Article by Coni Rathbone and Jonathan McGuire | Mar 6, 2019
Coni Rathbone is a partner with Dunn Carney.
Jonathan McGuire, a tax manager with Aldrich CPAs + Advisors LLP
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