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A CREDO TAX PLANNING STRATEGY SOLUTION

QOZ & OPPORTUNITY FUND: An Investor’s Tax Guide

This document delves into the workings of the Qualified Opportunity Zone (QOZ) program and the potential tax benefits it offers to investors. It serves as an essential guide for assessing whether investment in a QOZ aligns with your risk tolerance and your objectives for diversifying your portfolio, taking into account your current financial situation. This whitepaper is designed to provide investors with the necessary insights to make informed decisions about leveraging QOZs for both fiscal advantage and strategic investment diversification.

THE TAX BENEFITS

The potential tax savings within the Qualified Opportunity Zone (QOZ) program vary depending on its usage. Investors can utilize the program to exert more control over the recognition of capital gains, while contractors can leverage it to secure additional capital for new projects.

The appealing tax benefits of Opportunity Zone investments are particularly relevant under certain conditions. Real estate investors, enticed by the novel tax incentives of Opportunity Funds, must ensure that their decision to reinvest proceeds from capital gains is well-considered and informed.

There are three primary ways in which an investment in a Qualified Opportunity Fund can yield tax savings:

TAX DEFERRAL UNTIL YEAR 2026

A taxpayer who channels their investment into a Qualified Opportunity Fund within 180 days from the date of sale or exchange can opt to defer taxation on part or all of their capital gain. This deferral is strategically designed, with the taxable gain in the Qualified Opportunity Fund being recognized either on December 31, 2026 (applicable for the 2026 tax return filed in 2027), or upon the sale or exchange of the fund’s interest, whichever occurs earlier. This timing aspect is crucial for investors seeking to maximize the tax efficiency of their investments in Qualified Opportunity Zones.

STEP-UP IN TAX BASIS OF 10% OR UP TO 15% OF DEFERRED GAINS

Taxpayers who invest in a Qualified Opportunity Fund within a 180-day window starting from the date of their sale or exchange can choose to defer taxes on either a portion or the entirety of their capital gain. This deferral strategy is subject to a critical timing condition: the deferred taxable gain in the Qualified Opportunity Fund will be recognized on the earlier of two dates – December 31, 2026 (to be reported in the 2026 tax return filed in 2027), or the date when the taxpayer sells or exchanges their interest in the fund. Understanding this timing is key for investors looking to leverage Qualified Opportunity Zones for tax-efficient investment strategies.

ZERO TAX ON APPRECIATION

Investors who hold their property in a Qualified Opportunity Fund for a minimum of 10 years stand to benefit from a significant tax advantage: there is no tax on the appreciation of the property. Additionally, for these long-term investments, the cost basis is adjusted to match the fair market value on the date of sale or exchange. This framework emphasizes the value of long-term investment strategies within Qualified Opportunity Zones, where the duration of the investment directly enhances the tax benefits received.

AN ATTRACTIVE PROPOSITION FOR INVESTORS

THE QOZ INCENTIVE PROGRAM

Established in 2017 under the Tax Cuts and Jobs Act (TCJA), the Qualified Opportunity Zone (QOZ) program is designed to foster economic growth and job creation in underdeveloped communities. This initiative offers investors significant tax advantages, making it an increasingly attractive option in today’s economic landscape.

Investors are showing a positive outlook towards this program, recognizing its potential for delivering competitive returns and adding diversity to their portfolios. Beyond individual financial gains, the QOZ program is also seen as a crucial tool in recovering from the widespread economic and public health challenges posed by the Covid-19 pandemic.

For investors, the allure of venturing into new territories is amplified by the compelling tax benefits of QOZs. These include the ability to defer and reduce capital gains taxes from other investments, and in some cases, completely eliminate capital gains tax on the opportunity zone property itself. This combination of community development impact and tax efficiency makes QOZs an enticing option for forward-thinking investors.

 

 

IS THE QOZ INVESTMENT RIGHT FOR YOU?

While Qualified Opportunity Zones (QOZs) present an appealing investment opportunity, it’s crucial to fully understand their complexities before committing. Investors need to maintain their holdings in QOZs for at least 10 years to qualify for complete tax exemption on their investment gains. During this decade, the real estate market may experience fluctuations, which is a significant consideration. Additionally, potential changes in tax legislation and capital gains rates at the time of sale are vital factors to assess.

The latter sections of this paper will delve deeper into these aspects. With the expert guidance of professional legal and tax advisors like Credo CFOs & CPAs, investing in QOZs can unlock substantial potential. The United States boasts approximately 8,700 designated opportunity zones, each with unique strategic considerations. Our team at Credo specializes in helping investors explore and identify the most suitable zones for their investment, ensuring a clear understanding of why QOZs could be a valuable addition to your portfolio.

WHAT IS THE QOZ PROGRAM AND HOW DOES IT WORK FOR YOU?

Taxpayers have a 180-day window from the date of selling or exchanging a valuable asset to invest the realized capital gains into a Qualified Opportunity Fund, which in turn is invested in Qualified Opportunity Zone property. This timeline is crucial for deferring capital gains, including net Section 1231 gains. While both the principal and the capital gain can be invested in the fund, only the portion related to the capital gain qualifies for the additional tax exemption on appreciation offered by the Opportunity Zone investment.

The Opportunity Zone program allows for the sale of high-value assets like stocks and the reinvestment of proceeds into a Qualified Opportunity Fund, without the limitations of like-kind property investments found in other tax deferral strategies.

For taxpayers receiving reported capital gains through a flow-through entity such as a partnership, S-corporation, or trust/estate, the 180-day period for investment in a Qualified Opportunity Fund begins at the end of the calendar year in which the gain was realized. For instance, if a partnership realizes a capital gain in March, each partner’s 180-day period starts on December 31, giving them until June 28 of the following year to make their Qualified Opportunity Zone investment. This provision offers additional flexibility and time for strategic planning and investment.

WHAT IS A QUALIFIED OPPORTUNITY FUND?

A Qualified Opportunity Fund (QOF) is an investment vehicle, structured either as a corporation or a partnership, that is specifically designed to invest in properties located within Qualified Opportunity Zones. To comply with regulations, at least 90% of the fund’s assets must be held in such properties. Like any investment, the value of a stake in a QOF can fluctuate over time. Given the program’s focus on developing specific areas, it’s likely that a QOF will continue investing in the properties it holds, potentially generating cash flow once the funds are available.

However, investing in QOFs carries inherent risks, as these are relatively new tools in income tax planning and the long-term investment outcomes for taxpayers are still unfolding. Potential risks include market loss, liquidity risk, and company-specific risks, similar to those associated with various other investment types. These factors make QOF investments potentially unsuitable for all investors, emphasizing the need for careful consideration and risk assessment before committing capital to such ventures.

WHAT IS A QUALIFIED OPPORTUNITY ZONE PROPERTY?

A Qualified Opportunity Zone property is referred to the asset that falls in the category of a Qualified Opportunity Zone stock, a Qualified Opportunity Zone partnership interest, or a Qualified Opportunity Zone business property that was acquired after December 31, 2017, utilized in a Qualified Opportunity Zone trade or business, or ownership interest in an organization (stock and partnership interests) working with such tangible property.

The Qualified Opportunity Fund, in theory, must bring in additional property to be used in the Opportunity Zone. A fund that merely buys property that is currently in use in the zone will not be eligible unless it makes significant improvements (which must exceed the primary investment for the Qualified Opportunity Fund into the existing property in a 30-month period, taking into account that this investment merely applies to the amount that was paid for the building). Given these parameters, specific businesses like golf courses, country clubs, massage parlors, hot tub facilities, suntan facilities, race tracks or other facilities used for gambling, and liquor stores are not eligible Qualified Opportunity Fund investments.

OPPORTUNITY FUND TAX INCENTIVES EXPLAINED

Provided that all conditions above are met, investors may benefit from immediate tax deferral and substantial tax return on long-dated investments.

Any investment gain is subject to the gain deferral (like the sale of a valued stock or a business). It’s worth noting that the tax can’t be deferred for an indefinite period; it can only be deferred until the end of 2026. However, the tax savings may still be large. There is no need for an intermediary to qualify for deferral, and the taxpayer is given 180 days from the sale date to invest the gains in a Qualified Opportunity Fund.

The joint application of the “five-year, 10% basis increase” and the “seven-year, 5% basis increase” calls for the triggering of a taxpayer’s gain and a subsequent Qualified Opportunity Zone investment all occurring before the end of 2019. Taxpayers can still take advantage of the “five-year, 10% basis increase” until December 31, 2021.

SAMPLE INVESTMENT AND TAX BENEFITS COMPUTATION

As explained above, investors who hold their stakes in Opportunity Funds over the long term (like 10 years or more) accrue the greatest benefits. Here’s a sample computation outlining the key components of OZ benefits and comparing it with a non-OZ option. This comparison uses the after-tax capital gain amount that is eligible for investing. It also shows the rate of return that is needed on a non-OZ investment to gain the equivalent after-tax proceeds as that of the OZ investment after 10 years.

In this sample analysis, an investor invests $1.5 million at a projected annual increase in value of 12% with gross proceeds at the time of sale after 10 years is $4,658,772. Assuming there is no change in tax rates, a non-OZ investment needs to have an 18% annual increase in value to yield the same amount of after-tax cash proceeds after 10 years. Using the same assumptions but a future federal cap gain increase rate of 35% (from 20%), a 19.73% project return would be needed for the non-OZ investment to gain the same amount of cash as that of the 12% OZ investment.

PLEASE TAKE NOTE!

Keep in mind that there are tight time constraints for this program: you only have 180 days after selling an asset to reinvest the capital gain into a QOF. In addition, as per the current legislation, the ability to defer and reduce capital gains will sunset on December 31, 2026. This means that, in order to receive the 5-year hold basis step-up, you must reinvest by December 31, 2021.

QOZ INVESTMENT TIMELINE EXPLAINED

COMPARISON OF TRADITIONAL INVESTMENT VS QOZ INVESTMENT

The Opportunity Zone investment tool allows private investors to receive tax benefits by reinvesting capital gains into a Qualified Opportunity Fund (QOF) that in turn makes qualified investments in real estate or businesses located in distressed communities nationwide. Temporarily defer invested capital gains until date QOF investment is sold or December 31, 2026, whichever is earlier. After 10 years, permanently exclude capital gains on any appreciation of the QOF investment.

EXPLANATION OF THIS SAMPLE ANALYSIS

*Assumes investment is held for at least 5 years and a 10% step-up in basis is applied to original capital gain that was invested.

** Assumes 10-year holding periods, annual rate of investment appreciation of 10%, and a long-term capital gains tax rate of 23.8%.

Note: The amounts shown are not net of fees and carry in either the traditional investment or the QOZ investment. This is to illustrate the tax benefits of QOZ investments prior to any fee structures. Rate of return used only for illustrative purposes to demonstrate taxation concepts, and investors should not expect the returns shown.

CONSULT WITH CREDO

At Credo, we assist our clients in getting a better understanding of investing in Qualified Zone Opportunities and in helping them decide if it is the right option for them. As the QOZ program is quite new, many best practices are still being developed. Real estate activities for community development are likely to be very complex to handle because of the involvement of human capital and the requirement for public-private enterprises to acquire the layers of collaborative funding to be successful. Our team has the right set of advisors who are competent in evaluating potential QOZ investments while carefully considering the regulations, guidance, and updates from the IRS and the Treasury Department.

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