Client Alert: Opportunity Zone Investment: Continued Vitality?
Date: September 06, 2023
By:
Kurt R. Magette
Because the time period for the initial deferral has become so short, one may question whether an investment in a QOF has continued viability. One potential consolation: if the capital gain is being allocated to the taxpayer from a 2022 partnership tax return and if certain stars align, such 2022 allocated gain might still be invested and create deferral. If these circumstances existed, the period of deferral before December 31, 2026, is functionally extended to include such 2022 gains.
One of the overlooked tax benefits of investing in a QOF is what I refer to as the “evergreen tax basis.” Please remember that the Regulations related to QOFs are Byzantine, complex, and often contradictory. However, the gist of an evergreen tax basis is: if a taxpayer (i) makes an investment in a QOF, (ii) holds his investment for 10 years or more; and (iii) does not sell or otherwise dispose of his investment and if no “inclusion event” occurs; then the taxpayer has a tax basis for federal income tax purposes equal to the selling price of his qualified investment. That benefit is as significant as it sounds. The QOF rules are designed for taxpayers to make long-term investments in qualified opportunity zones.
For example, assume a taxpayer has a capital gain on October 1, 2023, of $1,000,000. He invests $1,000,000 in cash in a QOF on October 1, 2023, and defers the $1,000,000 gain. The rules set the initial tax basis of his investment at $0, thus, preserving his gain in the event of a disposition or inclusion event. Let’s further assume that no disposition or inclusion event occurs before December 31, 2026, on which date the value of his investment is $1,500,000, and his tax basis remains $0. He must recognize $1,000,000 in long-term capital gain on December 31, 2026. Please note that this special gain inclusion is based on his investment being deemed to have a $0 tax basis and on his gain being limited to the deferred gain ($1,000,000 - $0 and not $1,500,000 - $0). His tax basis is now $1,000,000. Let’s again assume it remains at this figure until October 2, 2033, when he sells his investment for $6,000,000. He has no federal gain.
Because of some esoteric rules applicable to QOFs, the typical structure for a QOF is as a limited liability company taxable as a partnership. The QOF then invests in a lower-tier limited liability company taxable as a partnership (“Property Owner LLC”). Again, typically, the Property Owner LLC acquires land and builds commercial or residential real property used in a trade or business. When real property is involved, a 10-year hold seems quite achievable. Some are concerned that, with opportunity zones, the investment risk is heightened along with the risk that the property will need to be sold well before the end of the 10-year period. However, Virginia alone has 220 opportunity zones, and many of them are in areas that are being vastly improved. A rising tide raises all ships.
In addition, these rules are not limited to real property. A trade or business can locate within an opportunity zone and the investment of its owners may qualify under these rules. Now, certainly, the volatility of a single trade or business may increase the risk of its investors failing to meet the 10-year period. Some great candidates of businesses do exist that should allow their investors to meet the 10-year holding period, however. Plus, the single trade or business should be able to negotiate favorable lease terms from the landlord that just began renting its opportunity zone property. The stimulation of opportunity zones is the basic purpose of the rules.
So, yes, in the right circumstances, a QOF investment has continued vitality.
The information contained here is not intended to provide legal advice or opinion and should not be acted upon without consulting an attorney. Counsel should not be selected based on advertising materials, and we recommend that you conduct further investigation when seeking legal representation.