The final regulations for Qualified Opportunity Zone (QOZ) investments were published in December, and though they generally follow the proposed regulations of October 2018 and May 2019 they do clarify some of the ambiguities noted in the proposed regs. QOZ investments are a powerful—but due to politics, an uncertain—tax-planning tool, and are a strategy that any individual taxpayer who will realize large amounts of capital gains should consider.

QOZs date back to the Clinton Administration and are based on the prior census tracts, are nominated by state governors and are approved by the U.S. Treasury Department. These are locations where very little new private equity is invested in either businesses or properties. To encourage individual taxpayers to make new private equity investments in these depressed areas, the 2017 Tax Act added two income tax benefits for long-term equity investments of new money in either property or businesses located in a QOZ.

The first income tax benefit is that the capital gains tax due on realized capital gains invested either in a Qualified Opportunity Zone Fund (QOF) or directly into a Qualified Opportunity Zone Business or Property (QOB) is deferred until December 31, 2026.  The cash must be invested not more than 180 days after the transaction and the investment cannot be sold or exchanged during that time. If the gains remain in the QOF or QOB for five years, the taxpayer gets a stepped-up basis of 10%. If the gains remain in for the full seven years, there’s a stepped-up basis of an additional 5% for a total stepped-up basis of 15%.

The second income tax benefit for the individual taxpayer who invests realized capital gains in the QOF or QOB is if they leave the funds in the investment for 10 or more years they can sell or exchange that investment without incurring any capital gains tax on the appreciation on the cash invested in the QOF or QOB from the date of the investment.

Both of these benefits depend on the taxpayer making the proper elections and the annual filing of disclosures with their federal income tax returns.

The proposed regs define the type of taxpayers and type of gains eligible for this program, when the investments must take place, how to elect a deferral, the valuation of a Qualified Opportunity Zone Business, what a Qualified Opportunity Zone Fund or Business is, and what the effect of transfer of QOF or QOB interests other than by sale or exchange will be.

The final regulations follow the proposed regulations generally, but do make some specific changes:

• The date that an S. Corporation, partners of a partnership or beneficiaries of a trust must invest the gains in a QOF or QOB is not 180 days after the date of the transaction, but rather 180 days after the date that the S. Corp., partnership or trust must file its income tax return, excluding any extensions. 

• Transfer on death of an interest in a QOF or QOB is not considered to be a sale or exchange, and so does not trigger the inclusion of the gains in the estate’s tax return (though the deferred gains do not get an additional stepped-up basis as would ordinary equity investments in the estate).

• Grantor type trusts are eligible for deferral, so long as the grantor would have been eligible if the grantor had owned the interest directly.

• For investments in a QOF taxed as a partnership, the amount of the gains included in the partner’s tax return is the excess over the outside basis of the interest in the partnership. This outside basis starts at zero, but can be increased due to debt and net income taxable to the partner.

• The triggering of inclusion of a portion of the gains before the fifth year of the investment does not affect the stepped-up basis in the remaining invested gains which remain invested in the QOF or QOB.

• Neither a QSST election nor an ESBT election for subchapter S. Corporation stockholders, is an inclusion event. 

None of these final regulations change the due diligence questions that an investor and their advisor need to consider, including:

• The investor is an accredited investor,

• The investor files form 8949 annually,

• The investor is clear on the timeline for deferral and the stepped-up basis,

• The investor understands how the 180-day rule works,

• The investor understands how funds must be invested to qualify for deferral,

• The investor understands what is, and is not, an inclusion event,

• The investor understands the Related Party Rule, and

• The investor understands that, if leverage is used for the QOF or QOB, how that leverage will be applied to the stepped-up basis in years five and seven.

One uncertainty is that if the capital gains tax rate increases in the next seven years, where is the break-even point on the investments in the QOF or QOB? Does the taxpayer have the same amount of after-tax-cash in year seven as they would have if they had paid the tax in year one? Here is the breakeven point for various rates after seven years:

• If the tax rate rises to 38.6% (the lowest tax rate proposed by Senator Elizabeth Warren) the fund will break even in seven years at a return of 5.5%. 

• If the tax rate rises to 52.8% (the lowest rate proposed by Senator Bernie Sanders) the fund will break even in seven years at a return of 12%. 

• If the tax rate rises to 59.8% (the highest rate proposed by Sanders) then the fund will break even in seven years at a return of 19%. 

The final regulations on Qualified Opportunity Zone investments generally follow the proposed regulations, adding some important clarification on how the investments work. The investments still require due diligence by both investors and their advisors.

But keep in mind that if Sanders is elected and is able to raise the capital gains rate to 59.8%, the fund will be unable to generate a rate of return to break even in seven years. On the other hand, if the tax rates remain at or below the 38.6% proposed by Warren, a much more doable 5.5% return is all that is needed to break even.

As I said, a QOZ can be a powerful, if uncertain, tax tool for clients with realized capital gains.  

Matthew Erskine is managing partner at The Erskine Company LLC, which provides legal and fiduciary services for unique assets.