On December 22, 2017, Congress passed the Tax Cuts and Jobs Act, which includes a new capital gains tax savings provision which some investors are referring to as a 1031 Exchange on steroids.
In a typical 1031 Exchange scenario, an owner of commercial real estate who sells and makes a profit can avoid the capital gains tax on the profit by reinvesting the entire sales proceeds into a new purchase of commercial real estate within 180 days of the original sale. For a 1031 Exchange, the seller cannot touch any of the sales proceeds and must hire an unrelated third party, known as a qualified intermediary, to hold the funds until the new property to purchase is found. The property which is ultimately purchased on the back end of the 1031 Exchange must be identified in writing to the qualified intermediary not later than 45 days after the original sale.
Then the qualified intermediary closes the sale on the new purchase for the investor. Any portion of the original sales proceeds not used by the qualified intermediary to purchase the new property is refunded to the seller and the seller incurs capital gains taxes on that portion of the sales proceeds.
On the other hand, with a Qualified Opportunity Zone investment, the seller of commercial property who makes a profit can invest the profits in a Qualified Opportunity Fund at any time within 180 days after the sale. The QL Fund is a corporation or partnership, which may be a newly formed entity which the seller owns and controls. Thus, the seller can at all times continue to have effective ownership and control over the profits from the original sale. No qualified intermediary is necessary.
In addition, with a QOZ investment the QO Fund must then invest these profits in a purchase of Qualified Opportunity Zone property. The QOZ Property can be either stock or a partnership interest in a business located in a QO Zone or the actual business property (i.e., real estate) in the QO Zone.
The QO Zone is the key. The QO Zones are governor selected areas within a state which meet the low income community rules under the statute. Only 18 states as of this writing have identified their QO Zones and have had them approved. Indiana is one of those states and the QO Zones in Indiana may surprise you. [Insert Link to Map] For example, most of downtown Indianapolis is included, which investors normally think of as prime investment real estate.
Investing in a QO Fund gives the investor three benefits:
- The investor will defer payment of capital gains tax on the original sale’s profits until December 31, 2026.
- The amount of capital gains tax on those original profits will be reduced by 10% if the QO Fund investment is held for at least 5 years and by 15% if the QO Fund investment is held for at least 7 years.
- On top of the reduction of the capital gains tax on the original profits noted in number 2, if the QO Fund investment in a QO Zone property is held for at least 10 years, then the investor will never pay a capital gains tax upon the sale of that QO Zone property.
Item number 3 above is what is getting investors excited. However, many investors have not taken the plunge yet because the IRS has not yet issued the regulations more fully explaining the QOZ rules. There are many open questions about the structuring required for the QO Funds and how broad of a definition the IRS will take for QOZ property.
We look forward to updating this blog once the regulations have been issued. We also look forward to working on many QO Funds with our clients.
DISCLAIMER: This is not intended to act as legal advice and does not create an attorney-client relationship. The contents of this blog is intended to provide a general guide to the subject matter. An investor should seek advice from an attorney and a CPA before investing in a QL Fund.
