What are they?
Qualified Opportunity Funds (“QOFs”) are investment vehicles designed to encourage taxpayers that are sitting on appreciated assets to reinvest those gains in economically challenged areas. Investors receive favorable deferral and exemptions from tax subject to a variety of rules. The rules are designed to encourage long-term investment in improvements within the targeted communities.
Although there are some similarities between QOFs and like kind exchanges, Monetized Exchanges Trusts ("MET") and a variety of other tax tools, there are some stark differences between QOFs. It is important to note that not one tax strategy should be thought to the exclusion of all others. Sometimes, a combination of one or more strategies are the best result for a taxpayer.
Where are they?
There are more than 8,000 communities that have been designated. The communities have been selected by population census tracts and are more thoroughly itemized on the Community Development Financial Institutions Fund website.
When did they come about?
QOFs were part of the Tax Cuts and Jobs Act of 2017. Although passed on December 22, 2017, they have only recently begun to attract media attention because proposed regulations were only issued as recently as mid October, 2018. Until the Secretary of the Treasurer provided a little more clarity, taxpayers lacked sufficient clarity to feel “comfortable” moving forward.
How do they work?
QOFs give taxpayers partial tax forgiveness on eligible gains. Such forgiveness ranges from 10% to as much as 15% of the tax that would otherwise have been paid. The remaining 85% of tax can be deferred until December 31, 2026.
One exceptionally impressive benefit of QOFs is that taxpayers are strongly incentivized to maintain a long-term hold and sell strategy; by doing so, taxpayers can exclude post 2026 gains if the hold the investment long enough.
The statutes and proposed regulations can be summarized as to require (7) criterion. They are: 1) the right investment vehicle, 2) the right investment proceeds, 3) the right reinvestment, 4) the right location, 5) right types of assets, 6) the right type of use and 7) the right holding periods.
They are statutorily balanced with an eye on both public policy in order to insure the funds are used in the intended manner while minimizing bureaucratic red-tape. Additionally, if properly invested in, their inherent nature permits some applicable elements of risk diversification.
Proactive advisors will seek to insure that operating agreements permit flexibility in transferability amongst the designated areas permitting investors some component of marketability with respect to long-term held investments.
Who can use them and why?
Think outside the box! It is not just a simple tax provision. The following is only a handful of some of the more creative uses for which this vehicle should be considered:
1. Businesses that intend to develop exit strategies over the next 5 to 10 years
2. High wealth individuals receiving substantial qualified dividends
3. Businesses and shareholders wanting to revisit age-old tax problems that were not otherwise solvable by the historic tools that were available
4. Cannabis industries, or other expanding businesses, looking to reinvest their gains into other business units
5. High-growth businesses that wish to setup complex divestiture strategies
6. Research & Development companies intending to attract capital
7. Real estate developers- at virtually almost every phase of their real estate projects
8. Manufacturers that might have been contemplating outsourcing to foreign jurisdictions
9. Land use and development projects using public private partnerships
10. Pre-existing or new mobile home park landlords seeking to improve their facilities
11. Sophisticated merger and acquisition advisors seeking to bridge the gap in order to strike a deal
12. Complex tax advisors wishing to layer on additional tax-favored strategies
13. Baby boomers that want to exit their positions tax efficiently and invest in America
Consider the following hypothetic. A taxpayer has an appreciated asset worth $6MM which they bought for $1MM. Thus, they intend to sell it for a gain of $5MM. It is assumed that all proceeds will be invested at a 5% compounded annual growth rate.
Investor A pays $1MM of taxes on his $5MM capital gain; leaving him with a net $4 million to invest. After 10 years, Investor A will have approximately $5.8MM.
Investor B executes a 1031 Exchange – The entire $6MM is reinvested into a like kind exchange property. After 10 years, Investor B will have $8.3MM of after tax cash.
Investor C uses a QOF- $1MM of Investor C's capital is returned to him tax free. $5MM of the pre-tax gain is then invested into a QOF. Investor C meets all the requisite requirements of the QOF. He escapes $150,000 in tax. He defers $850,000 of tax over (7) years. He avoids tax on the appreciation subsequent to December 31, 2026. After 10 years, Investor C will have $9.2MM cash.
Compare & Contrast of 1031
Aside from the increased amount of cash available to Investor C, there are other notably favorable differences of using a QOF over a 1031 exchange. For example, Investor C 1) gets to enjoy the return of his million dollars without tax, 2) is not obligated to increase the amount they are at economic risk by buying a “bigger and more expensive property”, 3) escapes all subsequent tax on post 2026 appreciation and 4) (unlike Investor A) the QOF investor is not restricted to the sale and acquisition of only real property (an unfavorable change to the 1031 exchanges under the TCJA). Other advantageous and disadvantageous exist in contrast 1031 exchanges as well as other more exotic vehicles like MET’s and Private Annuity Trusts (PATS) or Deferred Trust Sales (“DST’s”).
Additional hearings are scheduled for January 10, 2019 whereby public input will be received and likely incorporated into the final regulations. There will be four teams. Those that dive in head first (to their dismay); those that dismiss these vehicles as a “scheme”; those that attempt to abuse the intended purpose of the statues and those that are responsible. Over time these vehicles will gain momentum, awareness, acceptance and be revised to dissuade abuse.
Why are we the experts?
This is a topic area of particular passion to our firm. We believe in the greater good and have invested substantial amounts of time both academically and socially to remain "in the know" and be on the forefront of tax developments but we believe this one is of major consequence.
We have been specially selected by the AICPA as subject matter experts on this topic. Specifically, we are slated to teach on the topic in June 2018 at the national AICPA ENGAGE conference and are in the process of writing a book on this topic which explores the interworking of this provision with other pre-existing aspects of the tax code. We have built and continue to build alliances with qualified professionals within the legal, political, academic, investment and regulatory environments. Our strategies employ a balanced interpretation of the statutory language and intended public policy. Further, we are advisors aimed at evaluating the entirety of economic decisions; not just tax.
KELLY ALLEN, CPA, CVA, ABAR, CFF, MAFF, MST