Opportunity Zone Series for Investors Part 3 of 4:
Key Inclusion Events
Part One of our Opportunity Zone (OZ) Series we provided an overview of the OZ incentives and Part Two discussed the capital gains tax incentives. In Part Three, we dive into the triggering events that you should avoid in order to meet the guidelines under the OZ regulations.
Join Cherry Bekaert’s Mark Cooter, partner, and Shannon Makosiej, senior manager, for a review of events that investors should avoid in order to keep the deferred gain deferred in a qualified opportunity fund (QOF). They will also provide examples of these type of inclusion events to further outline what investors should not be doing during the holding period.
Also, stay tuned for the last and final podcast in this series on final post 10-year dispositions and how it affects investors.
Related Podcasts
- Part 1: What You Need to Know About the Final Regulations and an Overview of What is to Come
- Part 2: Eligibility of Gains and Timing of Investment
SHANNON MAKOSIEJ: Hello and welcome to Cherry Bekaert's podcast for Real Estate and Construction, where we discuss developing trends and market dynamics as well as tax and accounting tips that may impact you and your business.
I am Shannon Makosiej, a tax senior manager in Cherry Bekaert's real estate group. I have over 20 years of experience in the real estate tax world.
My co-host is Mark Cooter, tax partner with the firm and the head of our Real Estate & Construction practice, and we're both coming to you from our office in Greenville, South Carolina.
In previous podcasts in this series, we've discussed the benefits of investing in an Opportunity Zone fund. These are often referred to as QOFs, which stands for Qualified Opportunity Fund.
We learned that an investor with capital gains can invest in a QOF and achieve three primary benefits. First, they can defer recognition of certain gains until December 31st, 2026. Second, they can permanently eliminate 10 to 15 percent of that gain, depending on the timing of their investment. Third, if they hold that investment for at least 10 years, they can avoid gain on the appreciation of the asset held in the fund.
Today we're going to discuss events that investors will want to avoid in order to keep the deferred gain actually deferred. The IRS calls these inclusion events, because they can cause the deferred income to be included sooner than planned in your income tax return.
While there are several requirements that must be met with QOF investments, these are the triggering events you'll want to avoid. Mark, can you tell us what our listeners and potential QOF investors should not be doing during that holding period to avoid having to include the deferred gain in income?
MARK COOTER: This is definitely an important issue for our listeners. There are many benefits of investing in a QOF, and those benefits are premised on the requirement that the same eligible taxpayer generally be treated as continuing to hold the same interest in the investment and thereby continue to bear the income tax results of holding that interest.
Specific inclusion events would constitute cashing out of that qualifying investment, so the investor wouldn't be in the same position they were in originally. The gain to which the deferral election applies is included in income in the taxable year of the earlier of the date of the inclusion event or December 31st, 2026.
These are items that may cause acceleration of that income before 2026 or may cause you not to receive the ultimate benefit of the QOF. The IRS provides guidance on what is considered an inclusion event and gives certain examples.
First, an event that reduces the investor's direct interest in the investment could be an inclusion event. This implies that a change in ownership of some kind could create an inclusion event.
Second, if the investor receives a distribution of the underlying property, so the QOF distributes the property it invested in to its investor and the property is no longer held by the QOF, that could create an inclusion event.
Third, if the investor claims the investment is worthless, that could create an inclusion event where the gain originally deferred is accelerated because the investor has taken a deduction for worthlessness.
Fourth, if the QOF loses its status as a QOF, the benefit can be lost. The QOF status is tested annually, and if the QOF fails to meet the Opportunity Zone regulations, you could lose the deferral benefit.
SHANNON MAKOSIEJ: Can you give us practical examples of what these inclusion events might look like in the life of our investors?
MARK COOTER: Sure. One example is a sale or liquidation of the underlying asset of the investment. If that asset is sold before the relevant tests are satisfied, the deferred income could be accelerated and included in income.
If a sale or liquidation occurs, one cure to consider is reinvesting into another QOF to defer the gain again. Your time clock for the 10-year holding period would restart, but the gain could be deferred. Another option might be a 1031 exchange, where you exchange proceeds into another qualified property, potentially avoiding recognition of the inclusion event.
Another inclusion event is a transfer by reason of gift. You cannot merely have someone step into the shoes of the original investor and maintain the same beneficial income tax rights under the program; it generally needs to be the same investor. There are exceptions, such as transfers to a grantor trust. A grantor trust may be ignored for income tax purposes and therefore ignored for Qualified Opportunity Zone regulations. However, care should be taken because if the grantor trust status terminates, that change could constitute an inclusion event and accelerate the deferred gain.
Death is not an inclusion event, but a beneficiary who receives the investment may be required to include the deferred gain in income at a later date. If the estate or the beneficiary sells the interest, that sale or liquidation could be considered an inclusion event.
A transfer due to divorce is another situation to avoid. Care should be given during divorce proceedings as to which assets are being split, and the original investor should consider continuing to own the QOF interest to preserve the benefits.
Changes that reduce or change direct ownership can be inclusion events. Examples include a conversion from an S corporation or C corporation to a partnership or a disregarded entity, or vice versa—converting from a partnership to an S corporation or C corporation. Those entity changes could be considered inclusion events.
Finally, liquidation of a corporate owner of a QOF may be an inclusion event. If a corporate owner liquidates, the corporate owner is treated as selling its underlying assets in that liquidation, and the QOF interest could be treated as sold, accelerating the gain.
Those are a few examples to consider and avoid so you do not have to include the income earlier or lose the benefits of your QOF.
SHANNON MAKOSIEJ: Thanks, Mark. Those are all important reminders for our clients as they navigate this opportunity.
Stay tuned for our next podcast, our fourth and final on QOFs, which will be released in the next couple of weeks, where Ron Wainwright and Jason Hoard talk with us about final post-tenure dispositions and how they affect investors.
In the meantime, if you have any questions or need further information, please visit us on the web at CBH.com. Goodbye.
