CBIZ MHM Executive Education Series Update on Qualified
CBIZ & MHM Executive Education Series™ Update on Qualified Opportunity Zones – New Regulations Sean Haggerty, Bill Smith May 7, 2019 Questions? Email cbizmhmwebinars@cbiz. com 1
About Us • Together, CBIZ & MHM are a Top Ten accounting provider • Offices in most major markets • Tax, audit and attest and advisory services • Over 2, 900 professionals nationwide A member of Kreston International A global network of independent accounting firms MHM (Mayer Hoffman Mc. Cann P. C. ) is an independent CPA firm that provides audit, review and attest services, and works closely with CBIZ, a business consulting, tax and financial services provider. CBIZ and MHM are members of Kreston International Limited, a global network of independent accounting firms. Questions? Email cbizmhmwebinars@cbiz. com 2
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Disclaimer The information in this Executive Education Series course is a brief summary and may not include all the details relevant to your situation. Please contact your service provider to further discuss the impact on your business. Questions? Email cbizmhmwebinars@cbiz. com 5
Presenters Sean Haggerty is a Tax Director in the CBIZ MHM Kansas City office. Sean specializes in complex tax engagements, including consulting and planning support for entity structuring, Qualified Opportunity Zones, mergers and acquisitions, and emerging industries. He also represents clients under IRS exam and at appeals. Prior to joining CBIZ, Sean spent time in the Big Four and other Top Ten accounting providers as well as serving in various leadership roles in the industry. 816. 945. 5570 • shaggerty@cbiz. com Sean Haggerty, CPA CBIZ Tax Director Questions? Email cbizmhmwebinars@cbiz. com 6
Presenters Bill Smith is a managing director in the CBIZ National Tax Office. Bill monitors federal tax legislation and consults nationally on a broad range of foreign and domestic tax services for businesses and individuals. He is frequently sought after by a myriad of media outlets to comment on the changing tax environment and its effects on companies and individuals. He has authored numerous tax articles, edits the CBIZ MHM In. Touch newsletter and federal Tax Alerts, and lectures on a broad range of tax topics across the country. William M. Smith, Esq. Managing Director, CBIZ National Tax Office Questions? Email cbizmhmwebinars@cbiz. com 301. 961. 1943 • billsmith@cbiz. com 7
Agenda 01 Introduction 02 Revisiting General QOZ Rules 03 Operative Rules and the New Proposed Regs 04 What’s Next? Questions? Email cbizmhmwebinars@cbiz. com 8
INTRODUCTION Questions? Email cbizmhmwebinars@cbiz. com 9
Internal Revenue Code • Internal Revenue Code Sections 1400 Z-1 and 1400 Z-2 were passed as part of the Tax Cuts and Jobs Act to provide special rules for capital gains invested in opportunity zones. • Sections 1400 Z-1 and 1400 Z-2 seek to encourage economic growth and investment in designated distressed communities by providing Federal income tax benefits to taxpayers who invest in businesses located within these communities. • Section 1400 Z-1 provides the procedural rules for designating qualified opportunity zones and related definitions. • Section 1400 Z-2 provides tax incentives to encourage investment in qualified opportunity zones. Questions? Email cbizmhmwebinars@cbiz. com 10
Proposed Regulations Two sets of proposed regulations have been issued to provide guidance on the topic: • Reg-115420 -18 (26 CFR Part 0, 83 FR 54279)) was published on October 29, 2018, and • Reg-120186 -18 (26 CFR Part I) was published on April 17, 2019. The proposed regulations are open to comments from stakeholders and are subject to revision. Questions? Email cbizmhmwebinars@cbiz. com 11
REVISITING GENERAL QOZ RULES Questions? Email cbizmhmwebinars@cbiz. com 12
Tax Incentives for Capital Gains Invested in QOZs • Section 1400 Z-1 designates the low income communities that are defined by the term Qualified Opportunity Zone (“QOZ”). • The intent was to designate economically distressed, low income census tracts as QOZs. • There are more than 8, 700 census tracts designated as QOZs including some that are in high growth or adjacent to high growth areas that were already attracting significant investment in many major cities Examples: New York City (Brooklyn, Williamsburg, Midtown Manhattan), downtown Los Angeles, San Diego, San Jose, Seattle, Nashville, and Las Vegas. • A map of QOZs can be found here. Questions? Email cbizmhmwebinars@cbiz. com 13
Tax Incentives for Capital Gains Invested in QOZs • Recognition of capital gains for tax purposes is deferred until the earlier of December 31, 2026, or the date the investment in the opportunity zone is divested. • 10% of the deferred capital gain will be excluded if held for 5 years prior to December 31, 2026. • 15% of the deferred capital gain will be excluded from tax if held for 7 years prior to December 31, 2026. • If the Opportunity Zone investment is held for 10 years or more then the appreciation on the Opportunity Zone investment is tax free. Questions? Email cbizmhmwebinars@cbiz. com 14
Basis Adjustments for Investments in QOZs • The Taxpayer’s initial basis in a QOZ investment is zero. • The Taxpayer’s basis in its QOZ investment is increased automatically after the investment has been held for five years by an amount equal to 10% of the amount of deferred capital gain. • After the QOZ investment has been held for seven years the Taxpayer’s basis in its QOZ investment is increased automatically by an additional 5% of the amount of deferred capital gain. • As a result of capital gain recognition on December 31, 2026, the Taxpayer’s basis is stepped up to the full amount of capital gain originally invested. Questions? Email cbizmhmwebinars@cbiz. com 15
Example Taxpayer sells stock with a basis of $400 for $1, 000 in 2019. Absent an opportunity zone investment, the Taxpayer would pay capital gains tax on $600. The Taxpayer rolls the $600 capital gains into an OZ investment in 2019 and holds the investment until 2030. • In 2019 the Taxpayer pays no capital gains tax and has an OZ investment with $0 in basis. • After 5 years the OZ investment basis steps-up to $60, and after 7 years it steps up to $75. • The Taxpayer reports and pays tax on $525 ($600 - $75) in capital gains as of December 31, 2026. This causes the basis in the OZ investment to rise to $600. • In 2030, the Taxpayer sells the OZ investment for $1, 500. Both the $600 basis recovery and the $900 in appreciated value is received tax free. Questions? Email cbizmhmwebinars@cbiz. com 16
Other Basis Considerations • Qualified debt will increase the Taxpayer’s basis in a OZ investment structured as a partnership and debt-financed distributions are allowed to the extent the investor has basis in the OZ investment. • The 10% and 5% basis step-up is basis for all purposes and, for example, losses suspended under Section 704(d) would be available to the extent of the basis stepup. • When property rather than cash is contributed in exchange for equity in an OZ investment, the deferral election is limited to the tax basis of the property contributed. • If an investor receives value in their OZ investment in exchange for appreciated property or services performed, the full investment does not receive the benefits of the OZ investment and it is treated as a mixed funds investment. • The same goes for investments made with a mixture of capital gains dollars and non -capital gains dollars. The basis and other tax treatment of the mixed funds will be tracked separately (in a partnership context this ignores traditional unitary treatment). Questions? Email cbizmhmwebinars@cbiz. com 17
Qualified Opportunity Fund (QOF) To receive favorable tax treatment an investor must invest capital gains directly in a QOF. • A QOF is an entity organized to invest in QOZs that must be treated as partnership, a S corporation or a C corporation. It can be a REIT. • A QOF must “self-certify” annually that it is organized to invest in QOZs and that it meets the investment requirements of Section 1400 Z-2 by filing IRS Form 8996 with its tax return. • A QOF can invest in a Qualified Opportunity Zone Business (QOZB) that operates the business in the QOZ(s) or hold QOZB property directly. • There is no limit to the amount of QOFs and QOZBs one can create in an investment fund or business structure. Questions? Email cbizmhmwebinars@cbiz. com 18
OPERATIVE RULES AND THE NEW PROPOSED REGS Questions? Email cbizmhmwebinars@cbiz. com 19
QOF Investor Time Requirements An investor has 180 days from the date in which the capital gains were triggered to reinvest those capital gains into a QOF. • If the investor receives the capital gains from a flow through entity then they have 180 days from the last day of the entity’s taxable year to reinvest the capital gains into a QOF. • Section 1231 gains are required to be netted with Section 1231 losses to determine the amount, if any, of capital gains a taxpayer has. The 180 -day period for investing such capital gain income from Section 1231 property in a QOF begins on the last day of the taxable year. • Thus, gains from the sale of 1231 property today cannot be invested in a QOF until a 180 day window starting with December 31, 2019. • In effect it eliminates the possibility of investing 1231 gains from July through December each year. Questions? Email cbizmhmwebinars@cbiz. com 20
QOF Requirements • A QOF must hold at least 90% of assets in (1) equity interests of a QOZB, and/or (2) QOZB Property. • The assets need to be tested twice a year (at 6 months and at the end of the QOF’s fiscal year). • A QOF has 6 months to invest the capital it raises from investors. • A working capital safe harbor allows a QOF to hold cash at the QOZB level for up to 31 months so long as the QOZB: • has a specific written plan that identifies the property in the Zone to be improved or expenditures for the development of a trade or business, • follows an established written schedule for the deployment of such capital consistent with its ordinary operations, and • substantially complies with its written schedule. • The safe harbor will not be lost if delays are created by government action/inaction such as permitting during the 31 months as long as the application was completed during the 31 month period. Questions? Email cbizmhmwebinars@cbiz. com 21
QOF Reinvestment Requirements • A QOF is allowed to sell its QOZB Property before the 10 years is up as long as the proceeds are reinvested in QOZB Property within 12 months. • In the interim, if the proceeds are held as cash/cash equivalents or as debt instruments with a life of 18 months or less then the amount will count toward the 90% asset test. • The sale of such assets within the 10 year hold period won’t trigger the recognition of a deferred gain or blow the tax free appreciation component of the QOF investment, but the gain from the sale of the assets will flow through to the investors and be fully recognized. • If the investment has been held for 10+ years, such a sale by a QOF of its QOZB Property does not trigger taxable gain to the investors. Questions? Email cbizmhmwebinars@cbiz. com 22
Qualified Opportunity Zone Business (QOZB) • A QOZB is a trade or business in which substantially all (70%+) of its owned or leased tangible property is QOZB Property. • A substantial portion of its intangible property must be used in the active conduct of its business in the QOZ. • The trade or business cannot be a golf course, country club, massage parlor, hot tub facility, suntan facility, racetrack or other gambling facility, or any store the principal business of which is the sale of alcoholic beverages for consumption off-premises. • At least 50% of its gross income must be from the active conduct of a trade or business in a QOZ. • No more than 5% of the average unadjusted basis of its assets may consist of “non-qualified financial property”. Questions? Email cbizmhmwebinars@cbiz. com 23
Active Trade or Business • A QOF or QOZB is considered a trade or business if its conduct meets the standards of an active trade or business within the meaning of Section 162. • The ownership and operation, including lease activity, of real property by a QOF or QOZB is deemed to be the conduct of an active trade or business. • Merely entering into a triple-net-lease of the real property owned by the QOF or QOZB is not considered an active trade or business. Questions? Email cbizmhmwebinars@cbiz. com 24
50% Gross Income in QOZ • Three safe harbors to determine that at least 50% of gross income is from the active conduct of a trade or business in a QOZ: 1. If at least 50% of the hours spent by employees and independent contractors are within the QOZ, the test is satisfied. Thus, if a company's employees are all located in a QOZ, it doesn't matter where the customers are located, the business will meet the test. 2. If at least 50% of the amount paid by a business to employees and independent contractors are for services performed within a QOZ, the test is satisfied. Thus, a taxpayer can have employees outside the QOZ, provided at least half of the total compensation is paid to employees performing services within the QOZ. 3. If the tangible property located in a QOZ and the management or operational functions performed in the QOZ are each necessary for the generation of at least 50% of the gross income of the business, the test is met. • You can always argue facts and circumstances if outside the safe harbors. Questions? Email cbizmhmwebinars@cbiz. com 25
QOZB Property • To qualify as QOZB Property the property must be acquired after December 31, 2017 from an unrelated party using a 20% related party test. • QOZB Property must also be either: • Property in which the original use in the QOZ starts with the QOZB, or • The property is substantially improved by the QOZB • Property is treated as “substantially improved” if, during any 30 month period beginning after the acquisition of the property, additions to basis of the property exceed an amount equal to the adjusted basis of the property at the beginning of such period (the cost of the land is not included in this determination). Questions? Email cbizmhmwebinars@cbiz. com 26
Original Use • The original use of tangible property begins when any person/entity first places the property in service for purposes of depreciation, or if they could have depreciated the property had they been the owner for tax purposes. • This allows the opportunity for a QOF or QOZB to purchase a partially completed building in a QOZ, complete the construction and place it in service for depreciation purposes, or purchase a completed building pre. TCO/COO and place it in service • Property that has been vacant for 5 years is considered stale and the next taxpayer to place the property in service for depreciation purposes satisfies the original use test. • This allows for a similar concept as above. A QOF or QOZB could purchase a building pre-TCO/CCO that was vacant for 5 years that a developer has rehabilitated and it would qualify as QOXB Property. Or, if it was vacant but in good condition they could move in and start operating or lease the building out. Questions? Email cbizmhmwebinars@cbiz. com 27
What Can Be QOZB Property? • Raw land cannot satisfy the requirement that the original use begin in the QOZ, but raw land does not need to be substantially improved to qualify as QOZB Property. • However, an active trade or business needs to be conducted from that raw land • Leased property can be QOZB Property as long as the lease was entered into after December 31, 2017, and its terms are arms length. • The leased property does not need to satisfy the original use requirement and the QOF or QOZB does not have to substantially improve the leased property for it to qualify as QOZB Property. • Leases can exist between a QOF or QOZB and a related party, but: • the lessee cannot make a prepayment on the lease that exceeds 12 months, and • the property must satisfy the original use test, or during the 30 -month period beginning with the inception of the lease, the QOF or QOZB must acquire other tangible QOZBP with a value equal to the value of the leased property. Questions? Email cbizmhmwebinars@cbiz. com 28
Exiting a QOF Investment Before 10 Years • The investor loses the opportunity for tax free appreciation in the investment. • Gain that was deferred due to the reinvestment in a QOF is recognized on the earlier of December 31, 2026, or the date in which the investment is sold or exchanged. • Deferred gain must be recognized at any time a Taxpayer either: 1. Reduces their direct equity investment in the QOF, or 2. Cashes out a portion of their investment in the QOF by receiving a distribution of property with a FMV in excess of the Taxpayer’s basis in the QOF. Questions? Email cbizmhmwebinars@cbiz. com 29
Inclusion Events The April 2019 Proposed Regulations set forth inclusion events, which are not all inclusive, that would require a Taxpayer to recognize deferred gain as a sale or exchange of the QOF investment. • A sale of a direct interest in a QOF, a sale of a partnership with an interest in a QOF, and a holder of S corp stock in which the S corp experiences an aggregate change of 25% in ownership, • Termination or liquidation of the QOF, • Liquidation of a corporate owner of a QOF (to the extent Section 336 treats the QOF investment as having been "sold" in the liquidation), • Transfer of a QOF investment by gift, • A conversion of an S corporation investor in a QOF to a partnership or disregarded entity, • A redemption of an eligible interest by a QOF C corporation unless the redeemed shareholder was the sole shareholder. Questions? Email cbizmhmwebinars@cbiz. com 30
Inclusion Events (continued) • When an inclusion event occurs with a QOF structured as a C corp the amount of deferred gain recognized is equal to the excess of: • The lesser of FMV of the disposed interest divided by the FMV of the total qualifying interest multiplied by the remaining deferred gain or the FMV of the disposed interest. • Less the Taxpayer’s basis in the portion of the investment sold. • When an inclusion event occurs with a QOF structured as a S corp or partnership the amount of deferred gain recognized is equal to the lesser of: • The percentage of the investment sold multiplied by the remaining deferred gain, or • The gain that would have been recognized on a taxable sale of the portion of the investment in the QOF that was disposed of in the inclusion event. Questions? Email cbizmhmwebinars@cbiz. com 31
Non-Inclusion Events The same proposed regulations that set forth the inclusion events also set forth a list of events that would not trigger the recognition of deferred gain. • Liquidation of a corporate owner of a QOF if the liquidation is into a parent who owns 80% of the taxpayer, making the liquidation tax-free under Sections 332 and 337, • In general, the transfer of an investment in a QOF at death, • A contribution of a QOF interest to a grantor trust provided the taxpayer is the deemed owner of the trust, • The transfer of a QOF interest to a partnership in exchange for a partnership interest under Section 721, • Election or revocation of an S election, • Qualifying Section 381 transactions resulting from tax-free reorganizations. Questions? Email cbizmhmwebinars@cbiz. com 32
WHAT’S NEXT? Questions? Email cbizmhmwebinars@cbiz. com 33
What Should Investors Be Looking For? • Would you invest in the deal if the tax benefits didn’t exist? • Does the investment provide you tax free return of capital during the 10 year hold period? Is there a plan to distribute cash to you to pay the tax on the capital gains reported on December 31, 2026? If so what are the tax consequences to that distribution. • Will the investment be worth more in 10 years? Will the investment have enough appreciated value 10 plus years from now combined with the tax free nature of the return to outperform other investment opportunities available to you over the next 10 plus years? • What controls are in place at the investment level to maintain qualifications under the Opportunity Zone rules? Does the investment offer audited financial statements during its life? Questions? Email cbizmhmwebinars@cbiz. com 34
What Should Real Estate Developers & Funds Consider? • What structure and entity selection are you using? • Would you be involved with these projects/investments if the Opportunity Zone program didn’t exist? • What’s your plan to distribute capital to your investors during the 10 year hold period (i. e. to allow them to pay the tax on the capital gains reported on December 31, 2026)? What are the tax consequences to that distribution? • Will the real estate market be depressed 10+ years from now due to a large supply of opportunity zone property hitting the market? What’s your plan to mitigate this risk? Do you have a mechanism that would allow the investor to sell their QOF interest rather than being forced to sell the underlying property(ies) in what may be a down market? • What controls do you have in place to maintain qualification as a QOF/QOZB? Are you offering audited financials to your investors? Questions? Email cbizmhmwebinars@cbiz. com 35
What Should Business Operators Consider? • What structure and entity selection are you using? • Are you taking on investors or using your own capital gains? • Do you meet the active trade or business requirement? • Can you maintain appropriate business operations in one or more Opportunity Zones to continue to qualify as a QOF/QOZB during growth mode? • Is there an exit opportunity 10 plus years from now with an appreciated value? • What controls do you have in place to maintain qualification as a QOF/QOZB? Questions? Email cbizmhmwebinars@cbiz. com 36
What’s Next? • Taxpayers have the opportunity to comment on the proposed regulations. • There is still some uncertainty on certain nuances that Taxpayers would like • to see clarified. There are still items within the guidance that provide inconsistent treatment between QOFs and QOZBs that need some clarity. • A QOF that operates a business directly is required to have 90% of its assets as QOZB Property while a QOZB that operates a business only needs 70% of its assets to be QOZB Property. • A QOZB that operates a business must meet the 50% revenue from an active trade or business in an opportunity zone but a QOF that operates a business doesn’t have that requirement. • A QOZB has 31 months to deploy working capital in a real estate project, but a QOF doesn’t get the same benefit. • A QOZB cannot be a sin business, but there are no rules saying a QOF can’t be. Questions? Email cbizmhmwebinars@cbiz. com 37
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