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Tax Benefits of Investing in QOFs: A New Tax Shelter Approved by Congress!

John Ransom, Argy Saccopoulos, and Brian Dethrow present insights on Qualified Opportunity Funds (QOF).

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Tax Benefits of Investing in QOFs: A New Tax Shelter Approved by Congress!

  1. 1. © Jackson Walker LLP 2018 JW.com A New Tax Shelter Approved by Congress! Jackson Walker, LLP John Ransom – Houston Argy Saccopoulos - Austin Brian Dethrow – Dallas See JW.com for contact info Tax Benefits of Investing in Qualified Opportunity Funds
  2. 2. AUSTIN | DALLAS | FORT WORTH | HOUSTON | SAN ANGELO | SAN ANTONIO | TEXARKANA • Big picture: A Qualified Opportunity Fund (QOF) is a corporation or partnership into which taxpayers can “roll over” capital gains and obtain tax deferral and gain exclusion. • A QOF must invest in specific geographic regions, or Opportunity Zones. Generally, these are low-income areas that was nominated by each state government and has been approved by the US Treasury. • The Opportunity Zones are now set. Interactive Opportunity Zone maps are available online (just Google “opportunity zone map”). What is a “Qualified Opportunity Fund”? 2
  3. 3. AUSTIN | DALLAS | FORT WORTH | HOUSTON | SAN ANGELO | SAN ANTONIO | TEXARKANA Texas Opportunity Zone Map 3
  4. 4. AUSTIN | DALLAS | FORT WORTH | HOUSTON | SAN ANGELO | SAN ANTONIO | TEXARKANA Austin Opportunity Zone Map 4
  5. 5. AUSTIN | DALLAS | FORT WORTH | HOUSTON | SAN ANGELO | SAN ANTONIO | TEXARKANA San Antonio Opportunity Zone Map 5
  6. 6. AUSTIN | DALLAS | FORT WORTH | HOUSTON | SAN ANGELO | SAN ANTONIO | TEXARKANA Houston Opportunity Zone Map 6
  7. 7. AUSTIN | DALLAS | FORT WORTH | HOUSTON | SAN ANGELO | SAN ANTONIO | TEXARKANA • Taxpayers can defer and reduce taxes on the “old” capital gains by rolling the “old” gains over into a QOF • Taxes on such gains are deferred until the earlier of • (1) when the QOF investment is sold or • (2) 12/31/2026 • Deferred gains are reduced • (1) by 10% if the investment is held for 5 years; • (2) by 15% if the investment is held for 7 years; or • (3) if greater, by any diminution in value of the QOF • In addition, any subsequent appreciation in the QOF is tax-free if the investment is held for at least 10 years What Tax Benefits are we Talking About? 7
  8. 8. AUSTIN | DALLAS | FORT WORTH | HOUSTON | SAN ANGELO | SAN ANTONIO | TEXARKANA • EXAMPLE: Assume the following facts • $15m is invested (in any asset, e.g., public company stock) over time. • Investments are sold in 2018 for $25m, triggering $10m of capital gain (long term 24% rate or short term 41% rate) • Taxpayer timely invests $10m in a QOF in early 2019 (pocketing the other $15m) • The $10m QOF investment appreciates at a rate of 7% for 10 years, and is then sold for $19.7m • Result: • Instead of paying capital gains taxes on $10m for 2018, taxpayer instead pays capital gains taxes on $8.5m of gain for 2026 (i.e., 15% is forever tax-free and 85% is deferred 8 years) • The additional $9.7m of appreciation in the QOF realized in 2029 is forever tax-free Note that unlike other congressionally approved tax shelters (e.g., 1031, 1045), only the gain is reinvested to achieve the full tax benefit. Tax Benefits Example 8
  9. 9. AUSTIN | DALLAS | FORT WORTH | HOUSTON | SAN ANGELO | SAN ANTONIO | TEXARKANA Item Like Kind Exchange Opportunity Zone Reinvestment amount Net sales price of old property Only gain amount on old property Like kind requirement Only real property to real property within United States Any capital gain from worldwide source invested in an OZ Escrow funds from 1st sale Yes No Leverage Net debt rules apply to determine taxable boot No net debt rule, can leverage investment. Replacement property designation 45 days to identify – property number and dollar limitations Not applicable Gain deferral period Until sale of new property Earlier of sale or 2026 (net of up to 15% gain exclusion) Appreciation in new property/business Taxed at sale unless do another LKE Not taxed if sale more than 10 years after gain deferral Partnership level sale of property LKE only by partnership, not partners If partnership doesn’t make OZ election, each partner can Like Kind Exchange Comparison 9
  10. 10. AUSTIN | DALLAS | FORT WORTH | HOUSTON | SAN ANGELO | SAN ANTONIO | TEXARKANA • The QOF investment from the previous example has an approximately 50% greater after-tax yield because of the QOF benefits (assume 25% tax rate and 7% interest factor) • QOF Yield Calculation • $10m is invested in cash, avoiding a tax payment of $2.5m in 2019. Of that amount, $375k of the tax is avoided forever, and the value of 8 years of deferral on the remaining $2.125m is about $885k. Therefore, the net amount invested, as reduced for these tax benefits, is about $8.74m. That amount accrues to $19.7m in the example, which is not further taxed. • After-tax yield: ~8.5% • Non-QOF comparison: • $10m (not reduced for any tax benefits) accrues to $19.7, but the $9.7m of gain is taxed, so the after-tax amount received in 2029 is $17.275m. • After-tax yield: ~5.7% Quantifying the Value of the Tax Incentives 10
  11. 11. AUSTIN | DALLAS | FORT WORTH | HOUSTON | SAN ANGELO | SAN ANTONIO | TEXARKANA • Only “capital gain” is eligible for OZ tax benefits. • QOF must purchase its assets after 12/31/17. Tax deferred asset acquisitions don’t count. • “Substantial improvement” required for used assets purchased which generally means doubling the investment in tangible property within 30 months of purchase. • Operating income is taxed under the usual rules. May have less depreciation shelter due to tax basis reduction for gain deferral. • Investment in a QOF must be made within the 180 days after the capital gain is recognized, not before. Things to be Aware of 11
  12. 12. AUSTIN | DALLAS | FORT WORTH | HOUSTON | SAN ANGELO | SAN ANTONIO | TEXARKANA • A tax partnership can make the OZ gain deferral election, but if it does not then each owner can do so. • Cash can be a qualifying asset for a QOF for the 90% asset test for up to 31 months, easing investment timing issues and the 180 day rollover period. • An existing entity can elect to be a QOF. • Land does not have to be improved to OZ business property, and land is not included in determining if a building has been “substantially improved”. Things of Interest 12
  13. 13. AUSTIN | DALLAS | FORT WORTH | HOUSTON | SAN ANGELO | SAN ANTONIO | TEXARKANA • Transactions with 20% or greater owners including carried interests and owners selling property to the QOF. • No investments in certain tax taboo businesses, such as golf courses, country clubs, massage parlors, gambling facilities, take out booze sales, etc. • Limitations on excess investment assets and use of intangibles outside an OZ. • Further technical guidance from the IRS. Things to Watch Out For 13
  14. 14. AUSTIN | DALLAS | FORT WORTH | HOUSTON | SAN ANGELO | SAN ANTONIO | TEXARKANA • Phantom income in 2026 for at least 85% of the deferred gain. If short-term gain was deferred, then short-term gain is recognized in 2026. • Making timely OZ elections. • Maintaining 90% investment standard in OZ property or businesses. • Choice of entity - corporation vs partnership. • FIRPTA withholding for non US sellers. • State income taxes may not follow the federal income tax rules. • Future tax rates may be different. Things to Plan for 14
  15. 15. AUSTIN | DALLAS | FORT WORTH | HOUSTON | SAN ANGELO | SAN ANTONIO | TEXARKANA • Generally, any capital gain from any source can qualify for the QOF rollover treatment. The gain being rolled over need not have anything to do with Opportunity Zones or QOFs (e.g., Facebook stock gain qualifies). • This includes short-term capital gain, 1231 gains (subject to some uncertaintinty), 25% “unrecaptured section 1250 gain,” certain mark-to-market gain • However, it does not seem to include gain recaptured as ordinary income (e.g., depreciation recapture like from cost segregation) • Gain may be triggered intentionally in order to qualify for a rollover • Note that exchanges of real property must be carefully structured to avoid a Section 1031 like-kind exchange if the goal is to trigger gains to use in a QOF. Section 1031 is not elective. • The gain may not be triggered in a sale to a “related person” • Generally, this means that the seller cannot own more than 20% of the acquirer (and the seller and acquirer cannot have more than 20% common ownership) • These rules would permit, for example, a QOF rollover of gain on the sale of a warehoused investment to the QOF itself, so long as the transferor owns less than 20% of the QOF. • Partnership carried profits interest are considered in meeting the 20% threshold. • There is no problem with investing more than the amount of the capital gain rollover in a QOF, but the non-rollover portion of the investment will not qualify for the QOF tax benefits. Source of Gain Rollover 15
  16. 16. AUSTIN | DALLAS | FORT WORTH | HOUSTON | SAN ANGELO | SAN ANTONIO | TEXARKANA • Gain must be rolled over into the QOF within 180 days of realization. In the case of gain realized in a partnership, there is the option to start this 180-day clock on the day the partnership sells or the last day of the K-1. • Because the deferred gains are triggered on 12/31/2026, and because of the 5- and 7-year holding period requirements to qualify for the 10% or 15% “gain cutback,” there is an incentive to invest NOW. • Investments in QOFs on or after 12/31/2019 will never qualify for the full 15% cutback • Investments in QOFs on or after 12/31/2021 will never qualify for the 10% cutback • However, investments right up until 12/31/2026 will still defer rollover gain recognition until 12/31/2026, and such investments that are held for 10 years will still qualify for the exclusion of all subsequent appreciation inside the QOF. • Because the gain (less any cutback) is triggered on 12/31/2026 regardless of liquidity, taxpayers must plan for that tax payment. The QOF generally could borrow and make a tax-free distribution to fund the tax payment. Timing Issues 16
  17. 17. AUSTIN | DALLAS | FORT WORTH | HOUSTON | SAN ANGELO | SAN ANTONIO | TEXARKANA • A QOF must invest most of its assets in Opportunity Zone businesses or business property. • Generally, this means the investment is limited to tangible property used in Opportunity Zones that is newly placed in service or substantially improved, or equity interests in businesses focused on using such property. • A typical example would be an investment that substantially improves real property in an Opportunity Zone, but any tangible property that is newly placed in service or substantially improved can qualify. • Recent guidance has relaxed the “substantial improvement” test in the context of an investment in land + buildings in Opportunity Zones to make it especially easy to qualify when redeveloping Opportunity Zone structures (the improvement requirement with respect to the value of the land can be ignored). Limitations on a QOF’s investments 17
  18. 18. AUSTIN | DALLAS | FORT WORTH | HOUSTON | SAN ANGELO | SAN ANTONIO | TEXARKANA • Evolving Guidance: • A variety of open and uncertain tax issues exist for Opportunity Zones • Treasury has been remarkably pro taxpayer in the guidance issued to date. • Further guidance is expected. • Not Tax Advice: • These rules are complex and dependent on the facts and circumstances of each situation. • This presentation provides a general overview. It does not constitute tax advice and may not be used for the purpose of avoiding tax penalties. • Consult with your favorite tax advisor early and often. Evolving Treasury Guidance – No Tax Advice 18

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