Family offices, in their role as wealth-management advisors, are tasked with educating families and presenting them with the most tax-efficient options for transferring wealth, while also taking into consideration the lifestyle needs of the family. One area of interest and concern to family offices are Qualified Opportunity Zones (QOZ), as well as businesses located in such areas and Qualified Opportunity Funds (QOF). A QOF can be a powerful tax-savings tool if aligned well with long-term investment and philanthropic goals; however, it’s important to evaluate the overall economic risk and long-term capital commitment of investing in QOFs in order to realize the full tax benefits of the program. Taxpayers should also take into consideration any expiring tax attributes, such as tax credits or deductions as well.

Background

The Opportunity Zone program was created by the Tax Cuts and Jobs Act of 2017 to stimulate economic development and job growth in low-income communities across the United States, Washington DC, and the five U.S. territories by providing tax breaks to investors in a QOZ. Although it has generated considerable interest within family offices as an investment option, the actual commitment of capital has fallen short of expectations.

The tax incentives available to investors in a QOF are threefold:

• Tax deferral: Taxation of eligible capital gains can be deferred until Dec. 31, 2026, or until the investment in the QOF is sold, whichever is earlier, if the original capital gains are invested in a QOF within 180 days of the sale of the asset. Gains from the sale or exchange of assets between related parties, as provided in the proposed regulations, do not qualify. Investment in QOF must be an equity interest and cannot be a loan or another debt instrument. The deferred gain retains its tax attributes.
• Step-up in basis: The basis in the capital gains invested in the QOF is increased by 10% if the taxpayer holds the QOF investment for at least five years, or 15% if the taxpayer holds the QOF investment for at least seven years. Thus, the taxpayer can defer and effectively exclude up to 15% of the original capital gains from taxation.
• Permanent exclusion: The capital gain on the sale or exchange of the investment in the QOF can be permanently excluded from taxation if the QOF investment is held for at least 10 years.

The underlying intention of the statute is to revitalize certain under-developed areas designated as QOZs. Families that care about the social and community impact of their investments have the opportunity to participate in the economic improvement of these areas while also getting tax benefits. To be eligible to invest in a QOF, an investor must have gains taxable as capital gains for federal tax purposes. If the family has highly appreciated assets and has been considering selling such appreciated assets for liquidity, now is the time to unlock the cash and reinvest the gains into a QOF for optimal deferral and exclusion of gains, as per the rules governing the QOF.

The question: Is the family willing to sell their appreciated property and then reinvest the gains in riskier assets for future tax benefits, or do they want to hold on to their existing assets? Note that there are other options available, such as IRC section 1031 exchanges with the following notable differences:

With an IRC section 1031 exchange:  

• Tax deferral to the extent of sales proceeds invested.
• Considerations of taxable boot.
• Step-up in basis only upon death of the investor; older investors may want to use this exchange versus a QOF investment.
• Investments restricted to like-kind property.

With QOF investments:  

• Tax deferral available on investment of capital gains instead of the sales proceeds; better cash flow available to the investor.
• Incremental step-up in basis available after 5-year / 7-year / 10-year holding period.
• Investments need to be in a QOF.

Issues and Concerns for Family Offices

Family offices that want to retain control of a QOZ investment project may want to set up their own QOF. A QOF can be typically set up as a partnership or a corporation and is self-certified by filing Form 8996 with the tax return. There are, however, various requirements when it comes to managing and operating a QOF and QOZ business, and acquiring and holding QOZ business property (including but not limited to the 90% asset test semiannually, original use of tangible property acquired by purchase or substantial improvements with doubling of the original investment within a 30 month period, leased property from related parties, etc.). Keeping up with these requirements may become overwhelming to family offices, even if they have real estate experience in general.

Investing in a QOF created and operated by capital-management firms has its own advantages, including the following:

• Professional management.
• Diversified portfolio of assets.
• Risk management and mitigation through diversification.
• Some capital management firms may partner directly with family offices and local real estate developers with experience and a proven track record in order to obtain strong return on investment.

Liquidity issues.

Long-term locking of funds with limited liquidity during the investment period and/or deferral period could deter some families or individuals from investing in the QOF. Another consideration is that they should have availability of cash to pay the taxes on the deferred gains, which become taxable when the investment in the QOF is sold (or on December 31, 2026 if the investor holds the QOF investment through the entire deferral period). It appears that distributions from refinancing may solve the liquidity issues to some extent.

Transfer of ownership between family members.

Investors have to be cognizant of certain events (inclusion events) that can trigger the inclusion of the deferred gain into income.  The Proposed Regulations list several transactions that constitute inclusion events that trigger the recognition of deferred gain; they also describe how to compute the amount to be included once an inclusion event occurs. In general, an inclusion event or transaction is one that—

• has the effect of reducing or terminating the QOF investor’s direct (or, in the case of partnerships, indirect) qualifying investment for federal income tax purposes, or
• constitutes a “cashing out” of the QOF investor’s qualifying investment (in the case of distributions in excess of basis).

It may be noted that transfer of interest in a QOF by gift is also considered a trigger/inclusion event.

Exit Strategy

Investors should have a viable exit strategy at the end of the 10-year holding period, considering the following:

• Market fluctuations.
• Liquidity issues.
• Business Risk.
• Potential decline in property values due to large number of investors selling their investments all at once at the end of the 10-year holding period, causing a rush at the exit.

Business versus Real Estate

Although the major focus of QOF investments has been in the field of real estate, one must not ignore the potential of investing in operational business in developing areas, as the gain in the business may be much more than the gain in a real estate project. Yet there are several requirements that must be met under the QOZ program, including but not limited to—

• substantial use of assets and capital in the QOZ;
• the 50% gross receipts test, as prescribed by the proposed regulations;
• use of intangibles in the QOZ;
• 31-month working-capital safe-harbor requirements, etc.

While the tax benefits of the QOZ program are very enticing, they should not be the sole consideration in making investments. Investors should thoroughly evaluate the business purpose, the experience, past performance, and track record of real estate developers and capital management firms before taking the plunge.

General Anti-Abuse Rule

It’s worth noting that the Proposed Regulations contain a general anti-abuse rule, allowing the IRS to recast a transaction or a series of transactions that are inconsistent with the purposes of IRC section 1400Z-2 for federal income tax purposes, as appropriate,  to achieve tax results that are consistent with the purposes of IRC section 1400Z-2.

Shashi Singal, CPA, MSA, CA, is a principal at Grassi & Co. and brings over 15 years of diversified tax and accounting experience to the firm. Her expertise lies in review of tax returns, research projects, tax planning and projections, assisting with mergers, acquisitions and corporate re-structuring. Shashi works with clients primarily in manufacturing & distribution, wholesale and retail businesses, law firms, architecture and engineering firms, real estate, family partnerships and private foundations. Prior to joining Grassi & Co., Shashi worked at a regional firm for nine years and was part of their senior staff.  In her role, Shashi was responsible for planning and managing audits, reviews and compilations, preparation and review of tax returns, tax projections, financial statements, and budgets for clients in a wide range of industries including ERISA benefit plans. Outside of her role as principal, Shashi is very engaged within the firm by writing articles on emerging tax topics and issues, providing training sessions to the Grassi & Co. staff. She has participated in panel discussions on various tax topics including the NYSSCPA 2019 Qualified Opportunity Zones Symposium.