The 2017 Tax Cuts and Jobs Act is known for creating the Qualified Opportunity Zone (QOZ) program, which encourages real estate investors to invest in low-income communities with the intention to stimulate economic development and job growth. Under certain conditions, these private investments may be eligible for capital gains tax incentives. By investing realized gains in QOZs, investors can reduce capital gains tax liability or eliminate it altogether from future value appreciation on QOZ investments.
What about an existing owner of a business or investment property located in opportunity zones? There’s no rule prohibiting existing owners from taking advantage of QOZ tax benefits, but opportunity zone owners can expect to jump through a few extra hoops.
Requirements for Existing Property Owners in Qualified Opportunity Zones
The QOZ program can be complex — considering the potential tax benefits, it’s no surprise! As defined by the IRS, Qualified Opportunity Zone business property is a tangible property if:
- The Qualified Opportunity Fund (QOF) acquired the QOZ business property after December 31, 2017.
- The original use of the property in the QOZ commenced with the QOF or QOZ business. OR the property was “substantially improved” by the QOF or business.
- For 90% of the time, the QOF or QOZ business held the property, at least 70% of the use of the property was in a QOZ.
In addition to these basic requirements for existing property owners in a QOZ, there’s also the 20% related party rule.
The 20% Related Party Rule
The QOZ business property must be acquired from an unrelated person. If the QOZ business and selling entity are partnerships for tax reasons, the seller and the buyer will be considered related by the IRS if the same persons directly or indirectly own more than 20% of the capital interests or profit interests.
Therefore, an investor cannot sell property to a related party for gain to invest in a QOF. In addition, a QOF or QOZ business owned wholly or partially by a Fund cannot acquire property from a related party, under the 20% related party rule.
Ownership is determined under Code Section 267(b) by:
- Immediate family attribution: Brothers and sisters (whole or half-blooded), spouses, ancestors, and lineal descendants are considered to be related parties. In-laws are not included as immediate family.
- Common ownership of two related entities (such as a partnership or corporation): Such persons own more than 20% in value of the outstanding stock and/or more than 20% of the capital interests or the profits interests in the partnership(s).
This has caused investors quite a bit of confusion, especially in how a partner’s ownership interest is measured. If the IRS determines that a transaction is in violation of the 20% related party rule, the current owner or owners would not be able to invest any gain on the sale into a QOF. This gain would be immediately recognized.
Many investors take a conservative approach in fear of violating the 20% related party rule. Although it is possible for existing property owners to take advantage of the tax benefits offered by the Qualified Opportunity Zone program, expect to jump through some hoops.