The hottest topic in the real estate industry today is the advent of Qualified Opportunity Tax Zones (QOZS’s). Legislatively created by the U.S. Congress in 2017 Job Act, QOZ’s intended purpose is to promote geographically targeted capital investment in disadvantaged rural and economically areas. In an effort to attract investment capital, and accomplish its legislative objectives, the legislation offers the investor several tax advantages when making a QOZ investment, including deferment of capital gains, elimination of depreciation cost recovery, and wavier of any capital gain realized in the specific QOZ investment. Each capital investment tax enhancement will be discussed herein.
Qualified Opportunity Tax Zone investments allow investors to defer payment of capital gains on their original investment amount until 2026. If the investment is made on or before December 31, 2016, the investor will receive a fifteen percent (15%) reduction in the amount of capital gains due on their original investment amount. For example, if an investor receives $100,000 of capital gain in 2019, the investor may defer any payment of capital tax on that $100,000 until 2016, if the investor re-invests that $100,000 in a QOZ investment before the end of the 2019 calendar year. In 2016, when the capital gains tax becomes due, the capital gains tax will be reduced by fifteen percent (15%). If the investor waits until after 2019 to make the original QOZ investment, in 2026 the capital gain will be reduced by ten percent (10%). To qualify for the benefit, the investor must keep their invested capital placed in the QOZ investment until 2026. Any cash-flow or dividends received from the QOZ investment, during the invested term, will be treated as ordinary gain. What makes this particular tax advantage so attractive is that the capital gains can be sourced from any investment vehicle. Invest capital gains can come from the sale of equities, bonds, real estate, etc. This distinguishes the QOZ investment from the 1031 Exchanges, where only “like-to-like” investment are allowed. Another significant tax advantage accruing to the QOZ investment is the possibility of eliminating any capital gain tax upon the disposition of the QOZ investment.
A QOZ investment held for ten (10) years, or more, may qualify for a waiver of capital gain tax treatment on the gain realized upon disposition. Using the above example, if an investor placed $100,000 in a QOZ real estate investment for ten years, and then realized a gain – say $50,000 – that gain would be tax free to the investor. Thus, the investor has enjoyed a reduction of the original capital gains due (2026) and an elimination of capital gains due on net proceeds received from the disposition of the QOZ investment vehicle. Yet another QOZ tax advantage may be the waiver of the recapture of any depreciable expenses deducted during the invested term.
Depreciation is a tax deductible expense. Most real estate investors are familiar with this tax advantage. The rationale for this deduction is that over a period of time tangible property, i.e., real estate, equipment, etc., declines in value due to physical wear and tear, together with functional and economic obsolescence. This reduction of value may be deducted as an expense to the taxpayer. The period of time over which this expense can be taken varies with property type. For example, residential real estate improvement can be deducted (straight-line) over a period of 39 years. Other types of real estate improvements can be deducted over a periods of 1- 27.5 years. Upon disposition, this deductible expense is “re-captured” – and a cost recovery tax rate is applied to the previously deducted depreciation. However, this “re-capture” may be waived when a QOZ investment is liquidated. Thus, the QOZ investor may receive a reduction in capital gains tax, an elimination of cap gains on disposition, and the elimination of depreciation taken over the invested term! In tandem, these tax advantages can be significant to the taxpayer.
As with any investment, the QOZ investment must be underwritten based on economic performance metrics and risk profile. The QOZ tax advantages will not turn a poor performing vehicle into a good investment. It is critical that an investment provide an adequate risk-adjusted return before the consideration of any tax advantage. The QOZ legislation simply creates tax benefits that can be layered onto the considered investment. The investor will also want to consider the type of investment entity within which the investment will be held. QOZ investments can be held within S corporations, Limited Liability Companies, and Investment Fund structures. The investor will want to consider which type of entity is best suited to achieve particular investment objectives. As always, before making a QOZ investment, the investor will want to consult with legal and tax counsel, as other requirements and guidelines exist.
Stan Wood is not an attorney or a tax accountant. Investors should consult with an attorney and tax advisors before undertaking a Qualified Opportunity Tax Zone investment. Nothing in this article is, or should be consider, a solicitation for capital or an investment.