By Stephanie Friese and Christopher A. Steele
From the September/October 2019 Issue
Qualified Opportunity Zones (QOZs) represent the latest craze in the real estate and tax worlds. Less than two years after Congress amended the Internal Revenue Code to add QOZs, almost every major financial and real estate publication rave about them and their potential tax benefits. Some call QOZs “the most unbelievable tax break ever” and the “jackpot” of all tax-breaks. Due to all the hype surrounding QOZs, clients see them as an ever-present topic of discussion. Unfortunately, peeling back the layers of the QOZ provisions and regulations exposes the fact that QOZs do not afford a perfect fit for every individual holding an unrecognized capital gain. In fact, QOZs appear to be better suited for the minority of investors as opposed to the masses.
Our clients often ask whether a QOZ provides advantages over previously available strategies such as like-kind exchanges. Just as with any planning technique, comparison of the potential benefits of a QOZ to other tax deferral or elimination strategies—using the client’s specific circumstances to guide any decision—remains crucial. Surprisingly, like-kind exchanges often provide results superior to QOZs depending on the facts and circumstances.
The Internal Revenue Service (IRS) issued the first set of regulations on QOZs in October 2018, and the government issued a second set of regulations in April 2019. Combined with the Internal Revenue Code, the new regulations provide a basic framework for the creation and management of QOZs. Specifically, the IRS issued guidance to help Qualified Opportunity Zone Businesses qualify. For example, the second set of regulations clarify that taxpayers must use 70 percent of the business property in the QOZ and provide a safe harbor for inventory in transit. The second set of regulations provides clear guidance on inclusion of unrecognized gain invested in a QOZ in a taxpayer’s income in the event of a death, transfer to trust, sale, exchange and others. These regulations remain proposed, not final, and we expect further changes before they become final.
COMPARING LIKE-KIND EXCHANGES AND QOZs
With the passage of the Tax Cuts and Jobs Act, like-kind exchanges have now been limited to apply only to transactions involving real property, excluding all types of personal property such as equipment, vehicles, intellectual property, artwork and other personal and intangible business assets. This change may have a significant impact on like-kind exchanges which are a part of a larger transaction such as the sale of a business. According to the Congressional Record, Congress made the change because they felt as though the new 100 percent bonus depreciation and the increased Section 179 deduction were sufficient to deduct all of the cost of personal property, eliminating the need for the application of like-kind exchanges to personal property. However, it is important to note that the like-kind exchange changes are permanent, while the bonus depreciation changes are temporary and will decrease by 20 percent per year beginning in 2023.
QOZs provide three primary tax benefits: (i) deferral of capital gains for a specific period, not to extend beyond Dec. 31, 2026; (ii) up to a 15 percent increase in basis of the original unrecognized capital gains upon attaining certain “holding period” thresholds; and (iii) the potential for unlimited tax-free growth on the QOZ investment if the investment continues to appreciate in value and the gain remains invested for at least 10 years.
The current climate surrounding QOZs appears to focus on the third benefit, the tax-free growth on investments held for at least 10 years. However, investors should scrutinize fees associated with a given QOZ fund and the likelihood for a return on investment. Many new players in the QOZ arena promise tax-free growth, but the contracts reveal QOZ fund managers taking upwards of 30 to as high as 50 percent of the profits in exchange for administering the QOZ fund. Clients need to pore over the QOZ fund documents to develop a clear understanding of the true acquisition costs, which limit the tax-free growth benefit.
Also, investors in QOZs should clearly understand the nature of the investment. Unlike other investments, QOZ funds must invest at least 90 percent of the fund assets into a Qualified Opportunity Zone. The QOZs are determined by the Treasury Department and must be considered a “low-income community” in order to qualify. In other words, the QOZ must invest at least 90 percent of the fund assets into projects to develop land, property or businesses in a low-income community. The tax benefits aside, should a taxpayer commit assets to this particular investment for 10 or more years?
Like-kind exchanges similarly permit taxpayers to defer realized capital gains. Unlike QOZs, however, the like-kind exchange may completely eliminate the deferred gain. In a like-kind exchange, recognition of the deferred gain does not occur until the taxpayer sells a replacement property in a manner triggering recognition of the deferred gain. While like-kind exchanges do not offer a 15 percent increase in basis or tax-free growth on the original investment, holding the replacement property until death permits a full basis step-up under Section 1014 of the Internal Revenue Code. By eliminating any inherent gain in the replacement property, the benefit of a full step-up in basis likely exceeds the 15 percent basis increase and tax-free growth offered by QOZs. Additionally, consider whether the investment in the QOZ continues to appreciate to confer the benefit of tax-free growth.
In addition to tax benefits, QOZs offer some additional perks. For example, the QOZ regulations allow an individual to invest in a third party QOZ Fund, which allows a third party to assume all of the managerial duties of the fund. Additionally, taxpayers can use QOZs to defer gains on personal property or intangible property. An individual could also use a QOZ to save a failed like-kind exchange where the taxpayer did not identify a replacement property within the required 45 days.
Unlike QOZs, like-kind exchanges allow for depreciation of replacement property and access to liquidity through refinancing. Like-kind exchanges also have significantly fewer regulatory hurdles once the individual has completed the replacement property purchase. Finally, like-kind exchanges allow passive investment in a property while property purchased through a QOZ fund must be improved. If an individual prefers to purchase property and hold it for appreciation, investing in a QOZ is not an option.
Despite the current craze, QOZs do not offer a “one-size-fits-all” planning opportunity. In many cases, the like-kind exchange offers a superior option. As with any planning opportunity, the client and his or her advisors should carefully consider QOZs and like-kind exchanges, comparing the benefits and drawbacks of each. The headlines you see are not necessarily “fake news,” but, as with any tax planning opportunity, the devil is in the details.
Stephanie Friese is a shareholder in the Atlanta office of Chamberlain Hrdlicka and represents clients in various aspects of commercial real estate transactions including land acquisition, leasing, construction, financing and disposition.
Christopher A. Steele is a shareholder in the Atlanta office of Chamberlain Hrdlicka’s Trusts and Estates Practice. He counsels clients in a variety of tax, trust and estate matters, including planning for business owners.