One year after a global lockdown triggered by the COVID-19 outbreak, the United States federal government has continued to be supportive towards stimulating the economy through aids for eligible businesses, schools and towards vaccine production and distribution. The pandemic has kept a lot of investors on their toes due to an increase in market volatility. Coupled with these happenings, there have been various speculations on the impact of the new Biden administration policies–– which officially began on January 20, 2020, on the economy.
If you invest in real estate through Qualified Opportunity Zone Funds (QOZF) or thinking to invest in Qualified Opportunity Funds (QOFs), you would most likely be concerned about how the recent economic situation would impact your returns, taxes and investment opportunities.
The 2017 Tax Cuts and Jobs Act (TCJA) provided an opportunity for investors to contribute towards developing economically distressed communities through Qualified Opportunity Zone (QOZ) investment opportunities. Generally, these communities are nominated by a state, the District of Columbia, or a U.S. territory. Some basic requirements for investments through qualified opportunity zone funds and qualified opportunity zone businesses are :
This requirement mandates taxpayers to invest gains from property sale in a QOF within a 180-day window starting from the date of the sale or exchange in order to qualify for capital gains tax deferral provided that the gain does not exceed the aggregate amount invested by the taxpayer in the Qualified Opportunity Fund.
For a tangible property to qualify as an opportunity zone business property, it has to be used in a trade or business of the QOF and satisfy the substantial improvement requirement. This requirement provides that the original use of tangible property in the qualified opportunity zone acquired after 2017 must begin with the QOF or the QOF must substantially improve that property. Meeting the substantial improvement requirement is contingent on the additions to basis –– with respect to the qualified opportunity fund property –– held by the QOF during any 30-month period beginning after the date of acquisition, exceeding the adjusted basis of that property at any period starting from the 30-month substantial improvement period.
A QOF as an investment vehicle could be a corporation or a partnership for the purpose of investing in qualified opportunity zone property and not another QOF. The ninety-percent investment standard requires a QOF to hold at least 90 percent of its assets in qualified opportunity zone property.
The average percentages of the QOF’s qualified opportunity zone property on the semi-annual testing dates must equal at least 90 percent of the QOF’s assets. If a QOF fails to meet this requirement and the average of the percentages of its qualified opportunity zone property on the testing dates does not equal at least 90 percent of the QOF’s assets, they would be subject to a penalty for each month it fails the requirement. If the failure is due to a reasonable cause, the penalty may not be imposed.
For Qualified Opportunity Zone Businesses (QOZB), there is a requirement to have less than five percent of the average of the properties aggregate unadjusted bases attributable to non-qualified financial property excluding some certain working capital assets such as cash and cash equivalents from non-qualified financial property or reasonable amounts of working capital that are held in cash, cash equivalents, or debt instruments with a term of 18 months or less.
A working capital safe harbor was provided for QOZBs to allow for treating certain amounts of working capital as reasonable provided certain requirements are met. Through a written schedule, a QOZB can be allowed to utilize the expenditure of the working capital assets within 31 months of receiving the assets.
However, the working capital safe harbor period can be extended to a maximum 62-month period for certain reasons such as, if the qualified opportunity zone business is in a qualified opportunity zone within a federally declared disaster. Then, the qualified opportunity zone business may have additional time to a maximum of 24 months to use its working capital assets, subject to meeting the working capital safe harbor requirements. Given this, a qualified opportunity zone business located in a qualified opportunity zone, within a federally declared disaster, may have up to a maximum 86-months to expend reasonable working capital assets.
Selling off or disposing some or all of the qualified opportunity zone property in a QOF would result in proceeds or possible capital gains. If some or all of the proceeds in qualified opportunity zone property is invested by the QOF by the last day of the 12-month period from the date of the sale, or disposition, the reinvested proceeds can be treated as qualified opportunity zone property towards fulfilling the ninety-percent investment standard. This also applies if there is a distribution of the QOF’s qualified opportunity zone stock that qualifies as a return of capital.
However, there are requirements that need to be met for this treatment to be applicable in QOFs. The period before the proceeds from the sale, disposition or distribution is reinvested in qualified opportunity zone property, they have to be continuously held in cash, cash equivalents, or debt instruments with a term of 18 months or less. If any reinvestment plans in a qualified opportunity zone property is delayed as a result of a federally declared disaster, the QOF may get additional time up to a maximum of 12 months to reinvest the proceeds, subject to the QOF sticking to the original investment plan.
In response to the difficulties faced by many investors, the Internal Revenue Service (IRS) released the Notice 2021-10 on January 20, 2021. This release extended the relief for QOFs and their investors initially provided by Notice 2020-39 and also provided additional relief to help navigate around the requirements for the QOFs. The relief extensions are automatic and investors are not required to process any documentation.
The released Notice 2021-10 provided an extension for the 180-day investment window for QOF investors until March 31, 2021. This enabled investors who had the last day of the 180-day window to invest their eligible gains from sale proceeds fall between any time from April 1, 2020, through March 31, 2021 have the opportunity to still invest in QOFs. Although this relief is automatic, as an investor in QOFs, you will be expected to make a valid deferral election on your federal income tax return –– including extensions, for the applicable tax year that the gain is expected to be recognized.
As regards the 30-month substantial improvement period, If you hold a QOF property or qualified opportunity zone business property, the Notice 2021-10 relief allows that the period from April 1, 2020, and March 31, 2021 be disregarded in determining any 30-month substantial improvement period.
With the substantial improvement requirement, investors in QOFs are required to make improvements on a QOF property that increase their adjusted tax basis in the improved property within a 30-month window. The Notice 2021-10 relief essentially provides more time for investors to improve their QOF property and qualify for possible tax benefits.
Under Notice 2021-10, if an investment in QOF has the last day of the first six-month period of a taxable year or the last day of a taxable year fall between the period of April 1, 2020, and June 30, 2021, failure by the QOF to satisfy the ninety-percent investment requirement for the applicable tax year is considered to be from a reasonable cause. This relief is also automatic and requires that the QOF fill all lines on Form 8996 completely with respect to each affected taxable year. The completed Form 8996 would need to be filed with the federal income tax return (including extensions) for the affected taxable year(s).
The Notice 2021-10 relief provides that Qualified Opportunity Zone Businesses with working capital assets that are planned to be covered by the working capital safe harbor before June 30, 2021, receive not more than an additional 24 months. This extension includes any relief provided under the previously provided relief in Notice 2020-39 and allows for a maximum safe harbor period up to 55 months and in the case of start-up businesses, up to 86 months subject to the requirements of the working capital safe harbor.
Following the existing 12-month reinvestment period requirement, if your investment in qualified opportunity funds has a 12-month reinvestment period that includes June 30, 2020, your QOFs would receive not more than an additional 12 months (including any relief provided under Notice 2020-39). This essentially means a combined maximum reinvestment period of not more than 24 months to reinvest some or all of the proceeds received by the QOF either in the form of a return of capital or the sale or disposition of some or all of any qualified opportunity zone property, in qualified opportunity zone property. The condition that the QOF invests the proceeds in the manner originally intended before June 30, 2020 still applies.
These changes and updates for investments in QOFs may seem like a lot to process and implement, therefore it is advisable to employ the services of professional tax experts and accountants to provide clarity and more information that make it possible to maximize any potential tax benefits and opportunities.
Contact the Stax Capital team for more information on investments in qualified opportunity zone funds and businesses.
Capital gains in the United States are subject to tax when realized. As a real estate investor, this includes capital gains realized on property sold or exchanged. If you have sold or exchanged property resulting in any capital gains, you would be expected to report such gains in your tax return. However, you may be able to elect for a capital gains tax deferral if you opt to reinvest in like kind property or designated opportunity zone communities.
Two popular property investment vehicles that encourage long-term real estate capital investments are the 1031 Exchange and the Qualified Opportunity Fund (QOF). They spur up investments by providing capital gains tax incentives on the sale or exchange of property investments. The underlying concept behind 1031 exchanges and QOFs is the opportunity to defer taxes when capital gains from property sale are reinvested in property using either of these vehicles.
Qualified Opportunity Funds and 1031 exchanges operate with different requirements. While they arguably serve diverse purposes, the tax advantage associated with these two investments vehicles spur up real estate investments. Here's what investments in QOFs and 1031 exchanges entail.
The 1031 exchange gets its name from the Internal Revenue Code (Section 1031) which introduced a tax incentive for property capital gains when reinvested in a like kind property. This type of investment is sometimes referred to as a 1031 like kind exchange. When considering real estate investments through 1031 exchanges, it is important to be aware of the underlying rules that make your transaction qualify for capital gains tax deferral. Any mistakes may disqualify your property exchange transaction from being considered as a 1031 like kind exchange.
When you make a property sale, you’ll need to identify the reinvestment property within 45 days from the sale or exchange of your relinquished property. The new property or properties would need to be of like kind nature with the relinquished property. You will also be expected to make this reinvestment within 180 days from the sale of your relinquished property.
An important part of the 1031 exchange is using an intermediary to facilitate the exchange of properties as this cannot be done directly.
An important factor in a like kind exchange is the value of properties being exchanged. If the sale proceeds of the disposed property exceed the fair market value of the new property or if there is any exchange that is not considered like kind in nature, this can result in capital gains being realized. These capital gains would be subject to tax.
The tax incentive through investments in a Qualified Opportunity Zone was introduced by the Tax Cuts and Job Act (TCJA) in 2017. Real estate investors can contribute to economic development by investing in Qualified Opportunity Zones (QOZs). In return, investors get tax advantages on eligible capital gains invested in these distressed communities.
When you invest capital gains in a Qualified Opportunity Fund, you may be eligible for tax deferral subject to all requirements being met. One key requirement is that the investment of capital gains must be made within 45 days from the date which the property is disposed and gains are realized. Also, it is important to note that the ownership interest in QOFs should be equity and not debt. For qualified investments in a QOF, capital gains tax can be deferred until the earliest of when sold or by December 31, 2026.
Asides a capital gains deferral, you may be able to reduce taxes on capital gains by 10% if you hold an investment in a QOF for at least 5 years. If your holding in a QOF is held longer for at least 7 years, your capital gains tax may be reduced by 15%.
The great part about property investments in a QOF is that investors may be eligible for a total tax elimination on capital gains realized from the disposal of your qualified investment in a QOF.
While the best capital gain reinvestment decision would depend on specific situations and the best optimal wealth management strategies, here’s what to consider when exploring capital gains reinvestments in either a 1031 like kind exchange or a Qualified Opportunity Fund.
Flexibility:
The flexibility of investing in either a Qualified Opportunity Fund or a 1031 exchange varies and may suit different investment goals. Investments in Qualified Opportunity Funds have to be in communities designated as QOZs while for 1031 exchanges, properties exchanged need to be of like kind in class and nature. As an investor, whatever option you decide to invest through would be limited based on these restrictions.
Also, Investments in QOFs are more flexible and can be done directly without the need for an intermediary. 1031 exchange investments on the other hand require the use of an intermediary. A property reinvestment is only deemed a qualified transaction for a 1031 exchange when property exchanged is carried out through a third party called a facilitator or an intermediary. The facilitator is responsible for collecting and transferring the sale proceeds as well as the reinvestment property.
Tax deferral:
While capital gains investments in 1031 exchanges and Qualified Opportunity Funds provide incentives for tax deferral, tax deferrals for QOFs are time sensitive. Tax deferrals from reinvestments in QOFs are on the earlier of a sale or exchange of a qualified investment or December 31, 2026. There are therefore uncertainties around this benefit for investors who need to hold their investments for longer.
In comparison, an eligible tax deferral on 1031 exchange investments comes into effect at any time of disposal of the reinvested property.
Tax elimination:
There is the possibility of tax elimination with investments in Qualified Opportunity Funds. This elimination may only be applicable after 10 years of holding qualified investments in a QOF and it is applied on the capital gains from sale of the interest in a QOF. An investment in property through a 1031 like kind exchange would usually not allow for tax elimination of gains after property sale or exchange.
Timeline:
One of the key rules for a capital gain reinvestment in property to qualify as a 1031 like kind exchange is that the new property has to be identified within 45 days after the sale or exchange of the disposed property. In addition to this rule, the sale or exchange of properties needs to be done within 180 days from the sale or exchange of the disposed property.
The requirements for investments in Qualified Opportunity Funds does not include a property identification timeline , however, the Internal Revenue Service (IRS) requires that reinvestment of capital gains are done within 180 days from when they are realized.
Reinvestment value:
The basic rule for capital gains reinvestments to qualify as a 1031 exchange is the reinvestment in like kind property. Any reinvestments in property that does not qualify as like kind or property with market value below the relinquished property may result in gains that are subject to tax. In this case, the entire principal and capital gains from a property sale may need to be fully reinvested to benefit the full tax deferral advantage.
For Qualified Opportunity Funds, there is no requirement to reinvest the principal from property sale. You can benefit from the tax deferral incentive that comes with investing in a Qualified Opportunity Zone by only reinvesting the capital gain from your disposed investment.
Capital gains:
Capital gains deferral through a DST are realized through property sale or exchange, while capital gains deferred through a QOF can be gotten through other forms of investment like stocks or bonds. This provides more opportunities for investors looking to manage their capital gains tax from a broader range of investment portfolios.
Qualified Opportunity Funds and 1031 exchanges provide means for managing capital gains tax. Both vehicles have tax advantages when certain rules and requirements are met. A 1031 like kind exchange may qualify for tax deferral and a holding in a QOF can lead to capital gains tax deferral, reduction or even elimination.
The decision to use either a 1031 exchange or a QOF is dependent on specific investment goals as well as preference. You can choose one vehicle over the other based on the flexibility of your investment transactions or the location of investment property that suits your preference.
Also this decision may be made based on the need to take advantage of possible tax reduction or elimination on property capital gains. Both investment vehicles are available to accredited investors who are deemed financially sophisticated to invest in non-publicly traded investments. The nature of investments in QOFs and 1031 exchanges make them complicated alternative investments and thus require assessment and advise from tax experts or investment advisors .
Finding the best investment partner as a real estate investor is very important. The best investment partner is one that works with you to understand the different investment options you have and provide effective investment strategies to help you reach your goals. Stax Capital provides years of experience and professionalism in alternative real estate investments. You can explore property investments through a 1031 exchange with Stax Capital. The Delaware Statutory Trusts vehicle offered by Stax Capital qualifies as 1031 like kind exchange through which you can reinvest your capital gains from property sale. We also offer real estate opportunities through Qualified Opportunity Funds that may be eligible for capital gains deferral, provided all requirements are met.
An alternative option that can be explored by real estate investors looking to diversify their portfolio and take advantage of possible tax benefits is the Qualified Opportunity Zone investment opportunity. Here are some of the important things to know about investing in Qualified Opportunity Zones through Qualified Opportunity Funds.
The 2017 Tax Cuts and Jobs Act (TCJA) brought about the Qualified Opportunity Zone (QOZ) investment opportunity to encourage capital investments in economically distressed communities. These communities are usually nominated by a state, the District of Columbia, or a U.S. territory.
Qualified Opportunity Zones can be found in all 50 states, the District of Columbia, and 5 United States territories. The Internal Revenue Service (IRS) provides a list of the locations classified as QOZs.
The capital investments in these zones are expected to boost economic development and spur up economic activities. As an investor, you are not required to live in these specified zones, you only need to invest eligible gains in the QOZs and elect for tax deferral benefits.
Qualified Opportunity Funds (QOFs)are investment vehicles set up solely for investing in Qualified Opportunity Zones. Investments in Qualified Opportunity Zones through Qualified opportunity Funds may be eligible for tax benefits. If you invest eligible gains in Qualified Opportunity Zones, you may be able to defer taxes on these gains.
You can make cash and non-cash investments such as property in a QOF, however, only qualifying investments may be eligible for tax deferral. In the case of property investment, the tax deferral would be limited to the basis of the property.
Qualified Opportunity Funds can be eligible partnerships or corporations or Limited Liability Companies (LLCs) set up to operate as partnerships or corporations with respect to federal income tax as long as they are set up for substantial investment in QOZ properties. To qualify as a QOF, 90% of the eligible entities’ assets should be in Qualified Opportunity Zone property.
An eligible QOZ property can be either of the following:
A qualified ownership interest held by Qualified Opportunity Funds in a partnership or corporation operating as a QOZ business (a Qualified Opportunity Zone stock) or,
Eligible Qualified Opportunity Funds’ tangible property utilized for business in a QOZ.
The properties for Qualified Opportunity Funds or qualifying ownership interest in a QOZ corporation or partnership have to be purchased after December 31, 2017. Also, the qualifying ownership interest has to be acquired with cash exchange.
In order to qualify as a tangible Qualified Opportunity Zone business property, the property has to either be used by the Qualified Opportunity Fund or QOZ business for trade or business purposes. Additionally, the property’s original use should have started with the Qualified Opportunity Zone business or QOF or it was substantially improved and used substantially for the Qualified Opportunity Fund or QOZ business purposes.
Certain entertainment properties and businesses located in QOZ such as clubs, liquor stores gambling facilities etc. may not qualify for Qualified Opportunity Funds’ investments.
The benefit received on a QOF qualified investment depends on the time period with which it is held. The increase in the Qualified Opportunity Fund basis gets higher the longer you keep your investment.
For example, the basis for a QOF investment held for at least five years increases by ten percent of the deferred gain, the basis increases even further by an additional five percent if held longer, for at least seven years.
If you decide to dispose of your interest in a QOF after 10 Years and you opt to increase its basis to the fair market value on the date of disposal, you may be eligible for permanent gain exclusion on the sale or exchange.
Eligible gains which include capital gains need to be invested within a given time period for gains to qualify for tax deferral. Also, these gains need to be invested for equity interest Qualified Opportunity Funds. Eligible gains from property sale qualify for deferral, given that they are invested in a QOF within the 180-day period from when the gain was made.
To elect to defer your capital gain, you do this through your federal income tax return. Eligible tax deferral of qualifying QOF investments is valid until the earliest of an inclusion event or until December 31, 2026.
An inclusion event for your qualifying investment in a QOF refers to situations when you terminate or reduce your investment by selling it or gifting it or through a liquidation of the Qualified Opportunity Fund.
When you decide to reduce or terminate your investment in Qualified Opportunity Funds, you would need to report the deferred gain on your tax return. This deferred gain at the time of inclusion would be determined by taking the lesser of your deferred gain or the QOF Investment’s fair market value and subtracting the basis in the Qualified Opportunity Fund Investment.
You also need to report any gain or loss on the disposal of your QOF investment. The gain or loss can be determined through the basis in the Qualified Opportunity Fund investment.
The benefits of investing in Qualified Opportunity Funds include:
Impact Investment Opportunity: Investing in Qualified Opportunity Funds may be attractive to investors passionate about making social and economic impact in their environment as QOFs target economic development in distressed communities.
Flexibility on eligible gains: The gains to be invested in a QOF for tax benefits are not restricted to capital gains from property sale. Eligible gains could also include gains from investments such as stocks or bonds.
Investment portfolio diversification: Accredited investors looking to diversify their portfolio can utilize the QOF vehicle.
Capital gain deferral: Eligible capital gains such as gains from property sale can be deferred if reinvested in a Qualified Opportunity Fund.
Capital gain reduction: The step-up basis for investment in Qualified Opportunity Fund allows you to reduce capital gain recognized on your interest in the QOF when sold or exchanged after at least five years of holding it.
Capital gain elimination: Capital gains of qualified investments in a Qualified Opportunity Fund may be eligible for total tax elimination when held for at least 10 years.
Illiquid investment: Property investments through Qualified Opportunity Funds are relatively illiquid as there are no public markets for these alternative investment types. Interests in QOF may take significant time to sell than traditional investment types such as shares and bonds.
Time bound benefits: To access the majority of the tax benefits from investing in Qualified Opportunity Funds, you need to meet the time limits required. This kind of investment may be suitable for only long-term investors.
Also, the December 31, 2026 timeline for tax benefits means to be eligible for the seven-year 15% basis increase, an investment in a QOF must have been made by December 31, 2019.
Gains not guaranteed: As with other types of investments, there is no guarantee for gains on properties invested through a QOF either through returns or capital appreciation.
Legal risks: There could be changes to laws and requirements for tax benefits as regards investments in Qualified Opportunity Funds. There is therefore no certainty on any changes or extension of these benefits’ deadline dates or requirements.
Non-qualifying investment: Making transfers or gifting your qualified investments in a QOF signifies an inclusion event and makes the investment non-qualified in the hands of the new owner. You would have to recognize any gains for tax purposes when this occurs.
As a taxpayer, you would need to meet the 180-days rule by investing any capital gains within 180 days when your investment was sold, and gains realized. To ensure that you meet this requirement, it is recommended to locate a QOF opportunity beforehand and make all the necessary research and inquiries.
Investing in Qualified Opportunity Funds usually involves complex processes and requires significant investment knowledge, hence you may need the professional services of a chartered professional accountant or a tax expert. This helps you understand the underlying benefits as well as the risks involved.
You could set up your own QOF or invest through established Qualified Opportunity Funds. Established Qualified Opportunity Funds provided by investment firms would generally have an investment agreement specifying liabilities, rights and obligations, also they usually have requirements on minimum investment amounts and sizes. Also, these investment opportunities may only be available to accredited investors.
The QOF you choose to invest in would manage your investments and provide any periodic returns based on the portion of your investment and any other specifications outlined in your investment agreement.
Qualified Opportunity Funds provide an alternative means of investing and diversifying through real estate property in Qualified Opportunity Zones. Qualifying investments in QOZ attract tax benefits, you can take advantage of these benefits if the necessary requirements are met.
Stax Capital specializes in providing access to Qualified Opportunity Funds. Our experience coupled with our effective investment strategies can help you access potential benefits through QOF investments. Find out more about our offerings on Qualified Opportunity Funds.
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