Last year’s tax bill created an incredible opportunity for tax-free investment. It permits investors to sell or exchange appreciated assets, invest the gain in just about any sort of venture within a geographically designated Qualified Opportunity Zone (QOZ), and receive substantial tax benefits as a result. The tax benefit comes in three pieces.
- First, deferral of taxes on the original gain: Any gain – of any character – recognized from the sale or exchange of appreciated assets can be “rolled over,” tax-free, into a QOZ business or fund, deferring until 2026 the tax that would otherwise be due on the gain. This is similar to the well-known 1031 like-kind exchange but much broader in its potential application because the requirements governing like-kind exchanges do not apply to QOZ investments.
- Second, reduction of taxes on the original gain: In 2026, 85 percent of the rollover gains will be recognized, and 15 percent generally will be tax-free.
- Third, and most significantly, permanent elimination of taxes on gain from the QOZ investment: Upon disposition of a QOZ investment that has been held ten years or more, all gains will be permanently tax-free.
Time is of the essence to capture the tax savings. QOZ investments can be made starting this year, and an investor only has six months to “roll over” a gain into a QOZ.
Qualifying investments must be made in the designated “zones,” which were historically lower-income areas. But there are some significant up-and-coming urban business and residential areas that qualify, and many rural areas also qualify. Many sweet spots aren’t obvious. In Texas, much of downtown Houston qualifies, as does a swath of East Austin, downtown San Antonio, and many parts of downtown Dallas that are currently having a resurgence of real estate activity.
A user-friendly QOZ interactive map tool is located here.
Which Businesses Could Qualify?
Several types of businesses potentially qualify as QOZ investments:
- Real estate development (office, warehouse, multi-family)
- New build
- Old construction with large renovations
- Manufacturing facilities
- Car dealerships
- Oil and gas drilling or mining
- Service businesses with little tangible property outside the QOZ—licensing business, ad agencies
Key Aspects to Note
The original gain must result from a sale to an unrelated party.
During the 10-year holding period for the QOZ investment, taxes must be paid on the operating income of the QOZ business. This is a potentially great use of the new 21 percent C Corp. tax rates.
Ninety percent of the QOZ assets must be tangible business property located in the QOZ.
Real property renovation investments must be big—essentially doubling the basis in that property—and have to be made within 30 months of initial purchase. As an example, this would include many multifamily developments in these zones.
Finance-driven businesses won’t qualify as a QOZ business (no more than 5 percent finance assets allowed, except for working capital).
A QOZ business cannot be recreational (golf, country club, massage, liquor stores).
Taxpayer has a $1m basis in business assets and sells it in 2018 for $3m, quickly reinvesting that $2m gain in a QOZ investment. Assume that new $2m investment in QOZ is worth $10m in 10 years.
In 2026 (i.e., 8 years later), that original gain becomes taxable, but as an additional inducement, the QOZ rules “erase” 10% of the taxpayer’s original gain at year five, and another 5% at year seven. Thus, in 2026, taxpayer recognizes 85%, or $1.7m, of the original $2m of gain and pays tax at the time (even if he continues to hold the QOZ property). No further taxes will ever be due on the 15% of the gain that has been erased.
More significantly, after 10 years, when the new QOZ investment is worth $10m, the taxpayer sells out. Under the QOZ rules, the taxpayer will pay no federal tax on that $8m gain.
Note that the above information is intended only to be a general outline; these materials have been prepared for informational purposes only and do not constitute legal advice.
As the Chair of Jackson Walker’s Tax practice, Brian Dethrow focuses on tax and business planning for complex corporate, partnership, family, and inter-generational transactions. Clients who count on Brian for their transactional and tax planning include sophisticated businesses – Fortune 500 to large family-controlled – and wealthy families. His broad experience with innovative tax and corporate planning, particularly involving the energy industry, spans M&A and partnership work, international tax, private equity funds, bankruptcy and insolvency tax planning, net operating loss preservation, workouts, business succession, asset protection, and gift and estate tax reduction strategies. In his practice, Brian has also worked with ultra-wealthy families on FLPs, charitable remainder and lead trusts, and family foundations. Brian has been recognized by The Best Lawyers in America for his work in tax law and has been listed among D Magazine‘s “Best Lawyers in Dallas” list since 2009.