Qualified opportunity zones provide estate planning options

By Joylyn Ankeney, CPA; Jonathan McGuire, CPA; and Meredith Scanlan, Aldrich CPAs and Advisors, Lake Oswego, Ore.

Editor: Michael D. Koppel, CPA (Retired)/PFS/CITP

The law known as the Tax Cuts and Jobs Act of 2017 (TCJA), P.L. 115-97, opened up a bevy of opportunities in tax and estate planning through the new qualified opportunity zone (QOZ) provisions. If they invest properly, enterprising taxpayers have a chance to simultaneously reduce current capital gains and defer recognition until Dec. 31, 2026. They also could potentially benefit from an unprecedented tax-free real estate investment opportunity in designated low-income neighborhoods. Investors with significant capital gains should investigate opportunities to reinvest their cash within designated QOZs to take full advantage of this tax boon.

QOZ program summary

The program's goal is to generate long-term investments in economically distressed communities across the United States, in zones designated by state governors and approved by the Treasury secretary. The final list of qualified tracts has already been published and can be found in IRS Bulletin No. 2018-28, p. 9. QOZs can be found in almost all segments of the market. As expected, many zones are in distressed cities and impoverished rural communities, but there are also plenty of zones in highly developed areas of major cities (see "The Top 10 Opportunity Zones in the US," Fundrise LLC, available at fundrise.com.

The program is relatively simple to get into, as no action is required by the IRS to establish a qualified investment, and the taxpayer need only attach a statement to a timely filed federal tax return. (However, the applicable IRS form has not yet been published.) To qualify for gain deferral, investors must reinvest capital gains into a qualified opportunity fund (QOF) within 180 days of the gain transaction. Qualified new property must be acquired from unrelated parties; related-party transactions are disqualified, though the definition of a related party is very narrow. For example, sales to siblings are not considered related-party transactions and may qualify.

QOFs must maintain 90% of their assets in QOZ property. Property can be held directly or by equity stake in a qualified opportunity zone business (QOZB). Typically, a QOZB is a newly created entity with qualified assets purchased after Dec. 31, 2017. The original use of the property generally must begin in the QOZ with the QOF, or the QOF must substantially improve the business property for use in the qualified improvement zone. To be substantially improved, the QOF must make additions to basis with respect to such property in excess of the amount of the QOF's original adjusted basis in the property.

Summary of tax benefits

In exchange for participating in this program, taxpayers can defer the recognition of any reinvested capital gains until the earlier of Dec. 31, 2026, or whenever the asset is sold. The tax benefits get better the longer the asset is held, with a 10% step-up in tax basis on the reinvested capital gains after holding the property for five years, and an additional 5% step-up in basis if the asset is held for seven years. To get the benefit of the full 15% basis adjustment, transactions need to be finalized by Dec. 31, 2019, so that property can be held for a full seven years before the capital gains tax becomes due in 2026.

The greatest benefit offered accrues at the 10-year mark. If the taxpayer holds the QOZ property for at least 10 years, the taxpayer may elect to treat the basis of the property as its fair market value on the date of the investment's sale or exchange. Thus, after 10 years, the taxpayer recognizes no gain on disposition of the property; i.e., there is a permanent exclusion of capital gains on the sale of an investment in an opportunity fund if it is held for at least 10 years. However, because the taxpayer must recognize the gain on the property on Dec. 31, 2026, only gain accruing after that point is excluded.

Taxpayers will be allowed to recognize losses associated with investments in QOZ funds (Sec. 1400Z-2), but the overall benefit of these new tax incentives will depend on the appreciation of real estate values. The program does not require funds to hold a specific number or diversity of holdings, allowing an astute investor to tailor a portfolio of investments with specific states, cities, or even neighborhoods that have the greatest potential for growth. In fact, the program has approved over 8,700 specified tracts in all 50 states, the District of Columbia, and five U.S. possessions (see Treasury Department news release, "Treasury, IRS Announce Final Round of Opportunity Zone Designations," available at home.treasury.gov.

Estate planning opportunities

It is important to note that Sec. 1400Z-2(e)(3) specifically states that the gain required to be recognized on the initial investment in QOZs will be treated as income with respect to the decedent (IRD) and will therefore also not be eligible for a stepped-up basis on death. The long-term benefit of nonrecognition of gain on investments held longer than 10 years still applies; the IRD applies only to the original deferred gain. The impact of the IRD does not make investing in QOZ property a bad estate planning option; it just needs to be taken into consideration.

Example: D has property with unrealized gain of $5 million and is trying to decide whether to sell it and reinvest the proceeds or hold onto it and let his son inherit it. The decision may come down to whether the property D owns is worth keeping indefinitely. Alternatively, if D knows he wants to sell the property with unrealized gains and he wants to reinvest the proceeds, investing in QOZ property may still provide tax benefits: The invested gain continues to be deferred for up to seven years, and the 10% and 5% basis adjustments apply at five and seven years, respectively. One concern here might be providing enough liquidity in the estate plan to pay the capital gains tax due at the seven-year recognition date.

Another planning point to note for clients is how to optimize the nontaxable appreciation on QOZ property. Just as intentionally defective grantor trusts are used to freeze value for transfer-tax purposes, QOZ investments provide an opportunity for long-term planning. When an estate plans for the difference between gifting high- and low-basis assets, it is planning for the difference between transfer tax and capital gains tax. If there is no capital gains tax to plan for on QOZ investments, gifting becomes more beneficial than before. Whereas before, a taxpayer might have burdened his or her children or grandchildren with sizable gains, now he or she could gift the same value and provide the next generation tax-free growth. In states with lower estate tax exemptions, this could be particularly beneficial to an estate plan.

Given how new the QOZ investments are, estate planning ideas have not yet been fully considered. Likewise, since there is a short window of opportunity for creating potential long-term benefits, QOZs may not be fully utilized for estate planning. However, with the chance for maximum benefit expiring at the end of 2019, it's important to start talking to clients now about QOZ investments.


Michael D. Koppel, CPA (Retired)/PFS/CITP, is a retired partner with Gray, Gray & Gray LLP in Canton, Mass.

For additional information about these items, contact Mr. Koppel at 781-407-0300 or mkoppel@gggcpas.com.

Unless otherwise noted, contributors are members of or associated with CPAmerica International.

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