The Opportunity Zone (OZ) Program has been around for almost 18 months now but as a result of complexities and open issues on exactly how taxpayers would participate and benefit, the program is now getting national traction and investment dollars. The OZ Program is the most powerful investment and diversification and economic development tool I have seen in four decades of tax consulting.
The OZ Program borrows elements from other long-standing tax provisions –
-Internal Revenue Code Section(IRC) 1031(Like Kind Exchange) which allows taxpayers to defer taxes on properly structured real estate swaps,
-Roth 401K’s/IRAs which allow taxpayers to build-up tax-exempt income after holding the Roth Account for at least five years, and
-The Federal New Market Tax Credit Program
In summary, the OZ Program allows taxpayers to rol over all or a portion of capital gains (long or short-term) income into a Qualified Opportunity Fund (QOF). The invested funds can then be deployed into real estate or an active business located in one of the 8,700 qualifying census tracts throughout the U.S. and U.S. territories. Following these steps allows the taxpayer to defer the tax on their original capital gain until December 2026. Depending on when the taxpayer rolls their gain, they may also be eligible for a reduction in their reportable gain of 10% to 15%.
The main benefit under the program comes after holding the QOF investment permanently for at least 10 years. At that time the fund can be sold and any appreciation since the original reinvestment permanently escapes federal taxation. Unlike California, the majority of states also allow this exemption to help stimulate local investment. Caution: California and a handful of other non-conforming states are still considering partial or complete OZ conformity. Also, some conforming states require reinvestment within their states to participate.
While the OZ Program has mainly caught the attention of real estate developers, it may hold even greater rewards for serial entrepreneurs and others investing in new or existing OZ-located businesses, as well as owners of existing improved commercial real estate.
In mid-April the Treasury Department issued their second set of OZ Regulations (Tranche II) which provided valuable guidance on how the program will operate for real estate developers, landlords, and business operators. While the program has some complex elements, it is also exceedingly flexible. Following are some of the less publicized uses of the OZ Program:
1. Safety Net For A “Blown 1031 Exchange” – A Four Year Replacement Window
A taxpayer selling and appreciated real estate investment must use a special “accommodator” to escrow all proceeds and identify qualified replacement property within 45 days of the sale date and then close on the replacement property within 180 days. This can create tremendous timing pressure and can force taxpayers to “overpay” for the replacement property. An OZ transaction will often give the taxpayer(s) additional time. For example, a real estate gain reported on a K-1 will generally have 180 days from year-end to invest in a QOF and no replacement property identification is required.
The OZ Program can effectively provide a real estate investor with a replacement window of up to 48 months or more – an attractive alternative to the highly restrictive 180-day replacement period for a traditional 1031 exchange. This can effectively give a taxpayer the ability to execute a ground-up construction project as the replacement property – an impossibility for a traditional 1031 transaction. Another advantage of the OZ Program gain will be recognized in 2026 regardless of whether the replacement property is still held. Furthermore, a 1031 structure for a real estate disposition will benefit residents of states that have not yet conformed to the OZ Program – these include: California, Arizona, Hawaii, Massachusetts, North Carolina and Pennsylvania.
2.Holders Of Investments In Dysfunction Partnerships
Family members and unrelated partners in an investment can often see things differently over time. For example, that great real estate rental has appreciated dramatically and half the investors want to cash-out. The other half would like to stricture a 1031 transaction and roll the gain and equity into a commercial property. A sale triggers gain to all partners and a 1031 ties up the equity into a commercial property. A sale triggers gain to al partners and a 1031 ties up the equity for al partners. Taxpayers would have to investigate complex alternative solutions such as splitting the property into tenant in common interests followed by a liquidation of the partnership before any sale takes place.
The OZ Program allows the parties to sell and then provided the partnership does not elect OZ treatment at the entity level, the resulting gain flows to each partner on their year-end K-1s. each partner can then either take their profits and run, or elect under the OZ Program to invest their gain into a QOF within 180 days. Viola! The equity holders are at peace.
3.Ideal Entity Choice – Not What It Used To Be
For the past few decades, S Corps were often a preferred entity of choice for business owners. While there are certain advantages, one significant down-side of an S Corporation is that upon sale or death of a shareholder the “inside” tax basis of assets held in the S Corp retained their historic cost basis. A step-up is possible for buyers when making a 338(h)(10) election.
Many taxpayers have avoided placing appreciating assets into a S Corp. However, in situations where taxpayers have appreciating assets stuck inside an S Corp, the OZ Program may provide an elegant solution for extraction.
Let’s say an S Corp holds an operating business and also owns the commercial building with a tax basis of $1 million and a fair market value of $2.5 million. The owners want to replace the current building with a new custom facility. They can clearly engage in a 1031 exchange inside the S Corporation. However, by selling the property inside the S Corporation and by electing OZ treatment at the shareholder level for the gain, the owners can effectively strip the asset out from inside the S Corporation while deferring the gain until 20126. The property is now owned outside the S Corporation. In the event of a ground-up construction project, the shareholders can take up to 30 months or more to deploy funds. Taxpayers must weigh this against a 1031 exchange which offers unlimited deferral and also allows deferral for all states.
4.Operating Business – Potential Exit In 5 Years Rather Than 10
The vast majority of focus on OZ planning and projects has been real estate development. However with the clarification in the Tranche II Regulations regarding how Qualified Opportunity Zone Businesses (QOZB) can deploy their funds under the Working Capital Safe Harbor Rules, there is now broader interest in using the OZ Program to start, purchase or move a business into an OZ.
There are significant planning opportunities when establishing an operating business within a QOF. IRC Section 1201 (Qualified Small Stock – QSBS) provides for a very substantial tax exemption on certain types of operating businesses [see IRC Section 1201(e)(3) for excluded service] and other businesses) that meet various statutory criteria. In general, the QSBS riles allow a taxpayer other than a non-corporate shareholder to exclude the greater of:
i $10,000,000 of cumulative QSBS Stock gain, or
ii 10 times the taxpayer’s tax basis in the QSBS stock
The QSBS riles are somewhat complex but taxpayers can initially form the QOZB as an LLC taxed as a Partnership and then convert to a C Corp after start-up losses have been incurred. Provided the C Corp conversion occurs prior to the value of the entity being in excess of $50 million dollars. Before electing into C Corp status taxpayers must evaluate the impact of double taxation and loss of a tax step-up to buyer in a sale transaction.
After 5 years from the entity becoming a C Corp, the entity can be sold and up to 100% of the tax gain can be excluded, subject to the aforementioned limits. Some states, like California, do not conform.
This provides OZ investors two-bites at the tax planning apple – with 1201 being operative as early as 5 years from formation. Granted, there is not an unlimited OZ gain exemption under the QSBS rules, but most investors will be pleased with a $10 million exemption gain and the ability to exit after 5 years rather than 10 years.
Many of these OZ census tracts also fall into federal, state and local tax incentive programs which can range from property tax, payroll tax, and income tax breaks, government grants or employee training programs. Investors and fund managers should explore these additional benefits.
5.Leveraging Is Your Friend In The Land Of OZ
One of the many taxpayer friendly clarifications in the Tranche II OZ Regulations involves debt in a QOF.
The regulations clarify that, for a QOF formed as a partnership, the investor’s share of a mortgage or other liabilities are treated as a capital contribution/basis increase to the extent the QOF or underlying QOZ business has debt, which is allocated to the partners/members.
This basis increase will allow the QOF investors to claim tax losses flowing through the entity. The regulations also clarify the debt layer is also eligible for a full step-up to fair market value in year 10. For example, if an investor rolls a $500,000 into a QOF and uses the funds to purchase raw land, gets a $2.5 million interest only loan to build an entire office building, claims $800,000 in depreciation over the next 10 years, then his tax basis is calculated ass follows:
Tax Basis In QOF:
Deferred gain deposited $0*
Basis for debt allocated $2,500,000
10% Basis increases in 5 years 50,000
5% Basis increases in year 7 25,000
Basis increase for 85% gain in 2026 425,000
Decrease for depreciation <800,000>
Year 10 QOF Tax Basis $2,200,000
- Since original tax gain is deferred, no basis increase increases until years 5,7 and 10
If the land and building appreciates to $4 million after a 10 year hold, then the full tax gain of $1,800,000 ($4,000,000 – $2,200,000) is fully exempt from the federal and the $800,000 depreciation recapture is never recognized. The leverage allowed the investor to claim $800,000 in tax depreciation – worth about $320,000 @ a 40% tax rate. The investor also receives $1,500,000 in net cash after paying off all debt – more than 3 times the original 500K equity investment. The investor also had to pay tax on 85% of the original deferred gain of about $127,500 ( $425,000 X 30%) in 2026. As mentioned above, a 1031 exchange would provide a deferral until the actual sale date of the project.
These examples assume the investors state of domicile fully adopts the OZ Program. Please contact me for a list of non-conforming states.
Have a request or question about Opportunity Zones?
Contact Blake Christian.