Last July we sent out an Insight with information about Qualified Opportunity Zones. Everything in that article remains true but much has changed and/or been clarified by the Treasury Department since the original article. An update is in order. If you are not familiar with Opportunity Zones and Opportunity Funds I highly recommend you read the article from last year or any number of great resources online. The benefits of an opportunity fund investment can be substantial for the right situation. As always, I am not a licensed tax accountant, so please confirm with your tax professional to determine how you might specifically benefit from these tax codes.
First a refresher:
- Qualified Opportunity Zones (QOZ) and Qualified Opportunity Funds (QOF) were introduced in the Tax Cuts and Jobs Act of 2017
- Allows ANY realized gains from ANY asset to be reinvested in prescribed manners for tax savings
- Deferral of taxes owed on gains until the filing for the 2026 tax year
- Invested gains placed into QOF by end of 2019 and left invested for 7 years benefit from a 15% reduction in taxes owed
- Invested gains placed into QOF by end of 2020 and left invested for 6 years benefit from a 10% decrease in taxes owed
- Any gains realized on the re-investment are 100% tax free after the investment is owned for 10 years
- Qualified Opportunity investments can be made into real estate and/or businesses, so long as the real estate or business qualifies.
- This applies to Federal Taxes and many, but not all, state taxes.
- Qualification depends on certain levels of investments into business operations or property improvements.
- The re-investment of gains has to be done within 6 months of the realization of the gains.
- Money invested into a QOF does not have to be the cash received from the gains realized.
Key IRS Updates:
- Depreciation IS NOT recaptured. This is a huge benefit to the investor, especially if the investment is placed and structured correctly.
- New construction on land purchased with existing buildings (but not construction added on the existing buildings) has a much higher qualification hurdle than the high-level qualification definitions.
- Investors can receive non-income cash out of an investment after 24 months from the time of the investment.
Keys to Investing:
- Patience is key. This investment needs to be in place for at least 10 years and requires improvements to the property. Improvements take time and 10 years is a lot of time for performance ups and down.
- The Qualified Zones were identified to be part of this program for a reason. Finding quality investments can be challenging but it is important to not let the tail wag the dog.
- Making sure the investment sponsor understands the QOZ/QOF regulations. Their screw up can result in dramatic change in taxation.
- A “QOF”, or Qualified Opportunity Fund, doesn’t have to be anything fancy. It can be as simple as a single member, single asset LLC.
Ways to Play the Game:
- “Washing” Gains: Generally, higher percentages of equity versus debt leads to lower percentage investor returns, all within reasonable margins of safety of course. The benefits of QOF investing turn this paradigm on its head, at least for investors with considerable gains to shelter from taxes. By investing larger percentages of gains the tax benefit of that investment is enhanced. In some cases, if the investment is structured correctly and the percentage of gains is high enough, the QOF can do a cash out refinance after 24 months from the time of the investment. This will likely result in lower percentage investment returns in the QOF but frees up that cash completely un-handcuffed to be invested in any investment anywhere (or used for other matters).
- “Wash-sale rule”: Not to be confused with the term Washing Gains used above, the wash-sale rule prohibits selling securities to realize a loss and then buying those same (or substantially the same) securities back within thirty days. However, to the best of my research, there is no rule that precludes selling securities for a gain and then buying those securities back again immediately. Why would someone do this? Let’s say you purchased 10,000 shares of APPL in 2004. It cost you less than $20,000. The stock has gone mostly up since then and you never sold. Your $20,000 is now worth $2.43 Mil, otherwise known as a huge tax liability. You still like Apple as an investment but can take advantage of this QOZ loophole to reset your basis. You sell tomorrow and then buy back in the next day. You still maintain your APPL position but now have $2.4 Mil in gains. This means you need to make a $2.4 Mil investment into a QOF (investments can be done pro rationally, they are just taxed as such). To get the cash for the investment, and because you wanted out of them anyway, you can elsewhere sell the 50,000 shares of M (Macy’s) you purchase last November for $37/share at today’s price of $15.25/share. This frees up $750,000 of cash as part of the $2.4 Mil needed; AND provides a little over a $1 Mil in short term capital losses. Suddenly, 2019 is looking pretty good from a tax perspective. But what of the $2.4 Mil in gains? The Federal tax liability of $480,000 is deferred until the 2026 tax filing in 2027. This provides 6+ years for those funds to be invested. If a 12.5% IRR or better can be returned, that $480,000 provides enough in return to pay the taxes on the entire $2.4 Mil in gains. Plus, you would still have the $480,000. And this doesn’t take into account that if the investment is made in 2019 there would have already been an elimination of $80,000 through the basis step up ($50,000 if invested in 2020).
- Depreciate, Depreciate: Depreciation is always a benefit of real estate investing, but in most cases, and unless there is an ongoing reinvestment through 1031 exchanges all the way up to death, that depreciation eventually has to be recaptured. One of the most mind-blowing aspects of the QOZ rules is that the depreciation on a QOZ asset is never recaptured (assuming the full 10 year hold period). Assuming an appropriate investment can be identified, this means an investment made in 2019 can start producing income as early as 2021. In many cases the income for the entire holding period of 2021 until 2030 would be offset entirely by depreciation, meaning zero taxation. With income being taxed at a higher rate than gains the benefit is substantial. Certain types of real estate can further benefit from cost segregation, which dramatically pulls forward the benefits of depreciation earlier into the asset’s useful life. This is depreciation recapture elimination on steroids.
- Qualified Opportunity Unicorns: Business investing isn’t discussed often in the Insight, mostly because we currently have less expertise in that arena than we do in real estate assets. But I do invest in businesses and think it is something most investors should consider for their portfolio. One of the riskiest, but potentially most profitable, ways of investing in businesses is in early stage start-ups. Often time the entire investment is lost, but when a company does well it can turn into an investor’s home run. A small investment can result in a huge gain. Gains result in taxes, but they don’t have to. With appropriate foresight businesses can start up or move to qualified opportunity zones, thereby qualifying new investment into those businesses for the QOF benefits. Invest a little, make a lot, pay no capital gain on the liquidity event. Score!
As is probably evident, Altus is highly excited about QOZ/QOF benefits. With that excitement and our existing qualifying investments already underway, we have had the good fortune of becoming somewhat of experts in the field. If you have gains (or the potential of gains) that could be a beneficiary of this tax provision give us a call and we can discuss strategies for your specific situation.
(And stay tuned, we are working on an exciting qualifying opportunity in the Austin MSA – more information to follow in the coming weeks).
About the Author: Forrest Jinks is CEO of Altus Equity Group Inc and a licensed real estate broker. Forrest has decades of experience as principal in a variety of alternative investment segments including real estate (residential rehab, in-fill development, multi-family, office and retail), debt, and small business start-up (online marketing and site retail). He can be reached at firstname.lastname@example.org.