Enacted December 22, 2017, the 2017 Tax Reform Reconciliation Act (the Act) includes a new tax incentive program for Houston opportunity zone fund commercial real estate investors. Internal Revenue Code Subchapter Z — Opportunity Zones — aims to promote investments in certain economically distressed communities. However, since Subchapter Z is highly complex, our research team put together the below 2019 Qualified Opportunity Zone Guide especially for Texas commercial real estate investors.
Please be aware that we are not accountants or attorneys, and this is not advice. As a result, we encourage you to seek the professional advice of a Certified Public Accountant (CPA) and Licensed Attorney.
Through the Opportunity Zone Program, investors can inject capital into low-income communities. The proposed outcome is promoting long term economic growth through a variety of investment vehicles. What’s more, investors may also receive significant tax benefits that include:
- A. Tax deferral for capital gain invested in a qualified opportunity fund (qualified Opportunity Zone fund),
- B. Elimination of up to 15% of the tax on the capital gain that is invested in the qualified opportunity fund, and
- C. Potential elimination of tax when exiting a qualified opportunity fund investment.
Furthermore, the Treasury Department issued additional proposed regulations and other guidance on October 19, 2018. Certain highlights of the proposed regulations are as follows:
- A. The proposed regulations clarify that almost all capital gains qualify for deferral.
- B. Generally, to qualify for deferral, the amount of a capital gain to be deferred must be invested in a Qualified Opportunity Fund. Specifically, the entity must be treated as a partnership or corporation.
- C. The Opportunity Fund must hold at least 90 percent of its assets in qualified Opportunity Zone property.
In addition to the proposed regulations, the Treasury and the IRS issued an additional piece of guidance to aid taxpayers in participating in the qualified Opportunity Zone incentive. Specifically, Rev. Rul. 2018-29 provides guidance for taxpayers on the “original use” requirement for land purchased after 2017 in qualified opportunity zones. In the end, this ruling addressed and resolved questions as to how a 00 Fund could “substantially improve” land.
Assuming the taxpayer holds its investment in the Qualified Opportunity Zone Fund until December 31, 2026, the gain subject to tax is the lesser of the fair market value of the property at the time of the event or the original deferred gain. So, taxpayers will need to value their interest in the Qualified Opportunity Zone Fund in order to capture the correct gain. Moreover, this incentive may be used as a complementary tool for investors who are also receiving NMTCs or Low-Income Housing Tax Credits.
About Houston Opportunity Zones
Ideally, Opportunity Zone investments will stimulate economic growth and transform certain parts of Houston. Governor Abbott believes that Houston’s Opportunity Zones represent billions of dollars in potential investments. In light of this, here are a few things to know about Houston’s Opportunity Zones:
- Houston has 150 Opportunity Zones.
- These areas will keep the O-Zone designation for 10 years.
- Texas Governor Greg Abbott has specifically highlighted areas impacted by Hurricane Harvey.
- The Rice-Kinder Institute for Urban Research created a Houston Opportunity Zones Map.
If you are interested in Houston Opportunity Zone investment opportunities, contact CXRE today.
In general, a good rule of thumb for life is don’t spend more money than you make. This is true if for individuals as well as corporations.
As a real estate investor, you should have a handle on how much money you have, how much you’re spending, and what your assets are worth. In order to keep track of these and other things, a good accounting system is crucial.
Good accounting practices allow investors to increase efficiency and streamline operations. In contrast, poor accounting practices make operations harder and slower. Not only that, but not tracking your real estate investment finances could lead to financial hardship.
As the saying goes, death and taxes are the only two certain things in life. For real estate investors and owners, taxes are an unavoidable part of life. Not only that, but so are new tax codes change.
A commercial real estate investment broker is expected on top of tax code changes for 2019 to best advise their clients. However, if you own a Houston commercial real estate investment, you should also stay current on tax laws and code changes. Not being aware of tax code changes could hurt you in the long run.
Houston’s Southwest Freeway is the busiest freeway in Texas and one of the nation’s busiest stretches of freeway. Also known as US-59, the submarket lies between Uptown and Greenway/Upper Kirby. It winds its way through Sharpstown on the way to Sugar Land. However, the area is more than a `pass-through’
Not only does it have plenty of office space, shopping, restaurants, entertainment, and healthcare, but it is also near Rice University, the Museum district, and West University Place.
Opportunity Zones Tax Benefits Simplified
Investing in Opportunity Zones happens through qualified Opportunity Funds (O-Funds), the designated O-Zone
investment vehicles. The main Opportunity Zones Tax Benefits are:
Deferred Capital Gains Tax – You can sell current assets to invest taxable capital gains into O-Funds. Do this within 180 days of selling your assets and you avoid paying capital gains tax (at least until an O-Fund is divested or until December 31, 2026).
Basis Step-Ups – Basis step-ups increase your rolled-over capital gains: A five-year O-Funds holding brings a 10% basis step-up. A seven-year O-Funds holding brings an additional 5% (15% total).
Fewer Limits – Finally, there are fewer limits on O-Fund investments. There are no limits on the amount invested, the type of taxes you avoid, how much tax you avoid, and the amount of time that gains can compound tax-free.
Tax Exempt Potential – Holding O-Funds investment for at least 10 years lets them grow tax-free AND you are exempt from paying capital gains.
Spurring Investment and
Connecting with Communities
Opportunity Zones have the potential to spur investment and development in Houston. Furthermore, investing in Opportunity Funds connects investors to communities with real needs. In addition to the benefits to the people of Houston, Opportunity Zone investments offer tax benefits to investors.
For additional information on investment opportunities in Houston and in Texas, contact CXRE Group today.
Qualified Opportunity Zone Funds (QO Funds) must be formed as corporations or partnerships (LLCs which are taxed as partnerships are acceptable). These QO Funds can then invest in income-producing real estate located in Opportunity Zones. These properties could be apartment complexes, office buildings, or even shopping centers.
In order to meet the criteria of a QO Fund, it must meet the following conditions:
- • 90% of the assets held by the investment vehicle on the last day of the fund’s taxable year and the last day of the first six-month period of the fund’s taxable year)
- · must be qualified opportunity zone property (QOZ Property) within a QO Zone AND
- · the QO Fund must have acquired the property after December 31, 2017.
Furthermore, QOZ Property can also be qualified opportunity zone stock (QOZ Stock), qualified opportunity zone partnership interest (QOZ Partnership Interest), or qualified opportunity zone business property (QOZ Business Property).
CAPITAL GAIN DEFERRAL
Subchapter Z provides incentives for investments in qualified opportunity zones (QO Zones). It does so via temporary capital gain deferrals, but ultimately through permanent exclusion from gross income of capital gains. However, this is only possible if certain requirements are met. Under the new law:
- • gains from the sale or exchange of property by a taxpayer to an unrelated person, that is invested in a qualified opportunity fund (QO Fund – as defined below)
- • within 180 days of the sale of that property is excluded from gross income
- • until the earlier of the date the investment in the QO Fund is sold or December 31, 2026.
Moreover, the new law doesn’t require the total proceeds be reinvested into the QO Fund, only the gain. This is different from other tax deferral tools (such as like-kind exchanges). In the end, the deferred gain can be any gain – short-term, long-term, ordinary, Section 1231 gains – in connection with the disposition of property.
BASIS STEP UP
The taxpayer’s basis in the QO Fund is initially zero. Yet this will increase by 10% of the deferred gain if the investment is held for 5 years. This increases by an additional 5% if the investment is held for 7 years.
Therefore, if a gain on the sale of property is reinvested in a QO Fund within the required time frame, taxpayers can possibly decrease the taxable portion of the originally deferred gain by 15% (an overall basis step up of 15%) by holding the investment for up to 7 years.
CAPITAL GAIN EXCLUSION
For investments held for at least 10 years, the taxpayer will recognize no capital gain income on the appreciation of the asset from the time of the initial investment in the QO Zone through the sale of the investment (note they still will be required to pay tax on the initial gain used to fund the investment into the QO Fund).
Where the taxpayer invests both capital gain proceeds and cash from other sources into a QO Fund (fresh capital), the Act specifically states that the investment will be treated as two separate investments of which only the capital gain proceeds will be eligible for the 10 year capital gain exclusion (and basis boosts).
The following is a timeline of the mechanics of investing into a QO Fund:
Property is sold for a gain (example: publicly traded stock) for $150 which is comprised of $50 of cost basis and $100 capital of gain
Within 180 days, the $100 of gain is reinvested into a QO Fund
Taxpayer receives a step up in basis in connection with the original $100 of gain of $10 (10%). That is, now they will recognize a gain of no more than $90 from the original $100 of gain.
Taxpayer receives a step up in basis in connection with the original $100 of gain of an additional $5 (5%). That is, now they will recognize a gain of no more than $85 from the original $100 of gain.
Tax on deferred gain of $85 is due (Assuming the fair market value of the interest in the fund is greater than $85).
Taxpayer would not owe any tax related to post acquisition appreciation on the interest in the fund
QUALIFIED OPPORTUNITY EXAMPLE ECONOMICS AND
COMPARISON TO OTHER INVESTMENTS
The following presents an investor’s after-tax funds available under different scenarios, assuming various holding periods, annual investment appreciation of 7%, and a long term capital gains rate of 23.8% (federal capital gains tax of 20% and the net investment income tax of 3.8%):
Investing in an QO Fund vs. Standard Stock Portfolio with a capital gain of $100 reinvested in 2018
INVESTMENT IN A STOCK PORTFOLIO
INVESTMENT IN A QO FUND
Total tax liability $
After tax funds $
Total tax liability $
After tax funds $
Difference in after tax annual rate of return
Taxpayer purchased Amazon stock in 2016 for $50 which is worth $150 in 2018. Taxpayer sells the stock and receives $150 in cash of which $50 is returned to the taxpayer and $100 is invested in a QO fund. The investor holds the investment in the 00 Fund for 10 years.
The taxpayer can defer the taxes owed on the $100 of gain until 2026. Further, because the investor will hold the asset for at least 7 years, a basis step up of $15 would be applied and this the tax due will be $20 ($85 times 23.8%) in 2026. Since the investment was held for 10 years, there will be no further tax due on the appreciation of the original $100 investment.
Total Tax: $20
After Tax proceeds: $176
Effective Tax Rate on original and QO Fund investment 10.2% ($20 divided by $196 of ending value)
Effective after-tax annual return: 5.8% (7% assumed annual return less tax leakage)
Assume the same facts as in example 1, but the investor only holds the 00 fund investment for 7 years. As in example 1, the investor can temporarily defer the tax owed on the original stock sale and will receive the same 15% step up in basis.
Thus, the investor will owe the same $20 in tax in the year of sale ($85 times 23.8%) based on the original capital gain; however, unlike example 1 because the investment in the QO Fund was not held for 10 years there will be no exemption from the appreciation on the investment.
Assuming the investment grows 7% annually, the taxpayer will owe an additional $15 ($61 of gain times 23.8%) of tax upon exit.
Total Tax: $35
After Tax proceeds: $126
Effective Tax Rate on original and QO Fund investment 21.7% ($35 divided by $161 of ending value)
Effective after-tax annual return: 3.3% (7% assumed annual return less tax leakage)
Assume the same facts as in example 1, but the investor only holds the 00 fund investment for 5 years.
As in example 1, the investor can temporarily defer the tax owed on the original stock sale but will receive only a 10% step up in basis. Thus, the investor will owe $21 in tax in the year of sale ($90 times 23.8%) based on the original capital gain.
However, unlike example 1 because the investment in the 00 Fund was not held for 10 years there will be no exemption from the appreciation on the investment.
Assuming the investment grows 7% annually, the taxpayer will owe an additional $10 ($40 of gain times 23.8%) of tax upon exit.
Total Tax: $31
After Tax proceeds: $109
Effective Tax Rate on original and QO Fund investment: 22.1% ($31 divided by $140 of ending value)
Effective after-tax annual return:1.8% (7% assumed annual return less tax leakage)
Opportunity Zone FAQs
If you’ve read the preceding information, but still have questions, below are a few FAQs about Opportunity Zones:
How can a partnership or corporation become a certified Qualified Opportunity Fund?
An eligible partnership or corporation must self-certify by completing Form 8996 (Qualified Opportunity Fund) with its federal tax return. This return must be filed in a timely manner, taking into account any extensions. For more details, consult the Form 8996 instructions.
Do investors need to live in Opportunity Zones to receive the tax benefits?
No. You don’t need to live, work, or operate a business within the Opportunity Zone.
Where are the Opportunity Zones are located? Is there a list of Opportunity Zones?
Where are the Texas Opportunity Zones located?
Click here for a full listing of all Texas Opportunity Zones.
Where do I find the census tract number for specific addresses?
The 11-digit census tract numbers (GEOIDs) can be found using the U.S. Census Bureau’s Geocoder.
I’ve already filed my tax return. Can I still defer tax on that gain?
Still have questions? Visit the IRS Opportunity Zones Frequently Asked Questions page to learn more.