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There has been a lot of excitement from real estate investors around Qualified Opportunity Funds (QOF) over the last year. But many investors have been cautious to move forward due to the lack of official guidance.
Late last week the Department of Treasury finally released proposed regulations. These regulations provide enough clarity for investors to confidently move forward with their Opportunity Fund plans.
In this article, we will cover what, you, as a real estate investor need to know about the new regulations.
Clarifying "Substantial Improvement"
Real estate investors that acquire an existing structure must "substantially improve" the property within any 30-month window following its acquisition in order to qualify as "opportunity zone property". "Substantially Improve" means the QOF must make additions to the basis of the property that exceeds it's adjusted basis at the beginning of the 30 month period. In other words, the QOF must at least double the basis of the property.
These new regulations propose that only the building's basis needs to be taken into account when determining if a property has been "substantially improved". The basis of the land is not included.
For example, you buy a property in an Opportunity Zone for $150,000 and the building value is $100,000 and the land value is $50,000. The property will qualify as "substantially improved" if you add at least $100,000 to the building's basis within a 30-month window.
Also, the land is considered as qualified opportunity zone business property. This is important for the next section.
Clarifying "Substantially All"
To qualify as a QOF, the QOF must hold at least 90 percent of its assets in “qualified opportunity zone property”. This is defined as qualified opportunity zone stock, a qualified opportunity zone partnership interest, or qualified opportunity zone business property.
This 90% rule can be met if the QOF invests in an entity that qualifies as a qualified opportunity zone business. To be considered a qualified opportunity zone business, "substantially all", defined as 70%, of the business' owned or leased tangible property must be “qualified opportunity zone business property".
This opens up interesting opportunities as QOFs can invest 90% of its available capital into a subsidiary that owns only 70% of its assets in “qualified opportunity zone business property".
Only Capital Gains Count For Tax Deferral
The regulations confirm that short-term capital gains, as well as long-term capital gains, are eligible for tax deferral. However, depreciation recapture is not. It is also noted that the gains will retain their character when the deferral period is over (December 31, 2026, or date interest is disposed).
QOFs allow investors to step-up the tax basis of their QOF investment to its fair market value on the date that the investment is sold or exchanged, as long as they hold it for at least 10 years in a QOF. This 10-year exclusion means investors are exempt from capital gains tax on the gain from their investment in the QOF itself.
They also confirm that investments can be combined with non-tax deferred proceeds. However, only investments made with tax-deferred proceeds or a tax-deferral election will be eligible for the capital gains tax exclusion on gains from the QOF.
For example, you sell a stock and roll $100,000 in capital gains into a QOF with another $100,000, that is not from a capital gain. After 10 years, your total interest in the QOF appreciates to $300,000. Only the portion of the gain attributable to the $100,000 of deferred capital gain, or $50,000, is excluded from capital gains tax. You'll still have to pay capital gains tax on the other $50,000.
Capital Gains and Partnerships
Partnerships can make an election to defer their capital gains at the partnership level. The partnership then has 180 days from the last day of its taxable year to invest the gains in a QOF.
Alternatively, individual partners can elect to defer their share of capital gains from a partnership. They will have 180 days from the actual date of sale to invest in a QOF.
Clarifying Key Dates
Qualified Opportunity Zones (QOZ) will lose their designation after December 31, 2028, but the proposed regulations allow the basis step-up election until December 31, 2047. This means you can still be exempt from capital gains tax on your investment in the QOF until 2047.
In the original bill, investors have 180 days from the date they sell a capital asset to roll the gain into a QOF. The new regulations add more flexibility by allowing the QOF to hold these funds for up to 30-months as long as an investment plan for these funds exists.
Replacement of QOF Investment
Investors can sell their interest in a QOF and continue to defer their gain as long as they sell their entire interest and reinvest it in another QOF.
Updates for Self-Certification
The Bottom Line
While these regulations are not the final regulations, the IRS states, taxpayers "may rely on the rules in proposed § 1.1400Z-2(e)-1 with respect to investments and deemed contributions of money that occur before the final regulations’ date of applicability, but only if the taxpayer applies the rules in their entirety and in a consistent manner.", which should allow investors enough confidence to move forward with their Opportunity Fund plans.
However, even with these new regulations, Opportunity Funds are still new and complex, and should not be used without the guidance of your tax and legal advisors. For the full scoop on Opportunity Zones & Funds, check out The Real Estate Investor's Guide to Opportunity Funds.