Tax reform set up the qualified opportunity zone (QOZ) program to provide tax benefits to spur investment in low-income communities. Pandemic-related relief has extended several provisions of the QOZ program, including the 180-day re-investment period and the deadline to consume working capital assets if a QOZ business is in a federally declared disaster area.
Relief of the 180-day requirement applies to investors whose deadlines were to have fallen between April 1 and July 15.
An investor realizing capital gains from another investment can invest that gain into a QOF; the gain will be deferred until the interest in the QOF is sold or until Dec. 31, 2026. “The gains must have been realized within 180 days of the QOF purchase to be eligible for tax deferral. This is what’s been extended,” said Julia Carlson, founder and CEO of Financial Freedom Wealth Management Group in Newport, Ore.
The postponement has “reopened a few conversations with clients who were interested pre-Covid but got cold feet during Covid,” said Davin Carey, senior wealth advisor of Carey & Hanna Tax & Wealth Planners and a registered representative of Avantax Investment Services in Oxnard, Calif.
Carey said QOZs remain valuable tools for business-owner clients who recently sold businesses and who want to reduce and defer taxes while setting up potential future income and tax-free appreciation. Other interested clients may be in a position to exercise company stock plans without having an immediate need for the money.
To qualify as an OZ fund, 90% of the assets in the fund must be qualified opportunity zone property. “If the entity fails this test, they pay a penalty based on the shortfall,” said Maureen Aebi, tax manager at Sikich in Akron, Ohio. “An automatic time-limited exception for failing the test in 2020 is in consideration but isn’t currently available.”
A safe harbor allows a QOZ business 31 months to utilize working capital that’s held as cash. If the OZ fund is in a federally declared disaster area, the business may use up to an additional 24 months to consume its working capital assets. “This was in the tax regulations but ... became more relevant due to the pandemic,” Aebi said.
Still, QOZs have garnered limited interest. “There’s an interest from the real estate community, but many haven’t been able to raise money for their projects at the rate expected,” said Sean Haggerty, director at CBIZ MHM in Kansas City, Mo. “Most who decide not to invest in an OZ aren’t comfortable with the required 10-plus year hold period. Location can be an issue,” he said, adding that investors still wonder whether an investment in an OZ will appreciate.
“Investor interest has been underwhelming,” said Jeff MacDonald, New York-based head of fixed-income strategies for Fiduciary Trust International. “A major reason involves the lock-up period required for invested funds to realize the full benefits of the program. Ten-plus years is a long horizon for many investors. Limited liquidity and the need to source additional capital to pay the capital gains that the program mandates are due Dec. 31, 2026, represent a concern. Another strong reason we feel interest has been lower than expected is the limited vehicles for investors to access these investments.”
Real estate clients lean toward exchanges using Internal Revenue Code Section 1031 in succession until an owner is deceased, Carey said. “The heirs receive a step up in basis and reset of prior accumulation depreciation,” Carey added.
Although a 1031 requires reinvestment of the entire proceeds from the sale, the taxpayer has control over how long the gain is deferred, as well as no limitations on the location of the replacement property. “There is a step-up in basis at death in property acquired with a 1031,” Aebi said.
An advantage of OQZs is that, unlike with 1031s, capital gains do not have to be from like-kind assets. “It allows investors who are selling assets such as stocks, art or a business to reinvest these capital gains in OZ funds,” Carlson said, adding that since these funds are relatively new, they haven’t gained in popularity over real estate investment trusts.