Decisions, Decisions for Qualified Opportunity Zone Investors

The two-year anniversary of final regulations for the Qualified Opportunity Zone (QOZ) program is approaching, and many QOZ development projects are completed or nearing stabilization.  The deadline to invest an eligible gain into a QOZ Fund and receive the 10% step up in basis on the original invested gain is also imminent (December 31, 2021).

The final regulations provided two important exit strategies (and at the same time, entry plans) for QOZ investors.

1. Secondary market acquisition. Under this rule, an unrelated buyer with eligible gain can purchase an eligible interest in a Qualified Opportunity Fund (QOF) directly from an existing QOF owner, instead of contributing to a brand new QOF.
2. Pre-occupancy acquisition. Under this regulation, new projects developed within a QOZ, but not yet placed into service (for depreciation purposes), may be acquired by an unrelated buyer and satisfy the original-use requirement for QOZ business property.

These events, combined with the post-pandemic economic recovery, have many QOZ investors contemplating an exit of their original QOZ projects. If considering an exit of an QOZ investment, investors should consider the following:

• Is the current exit price worth generating a fully taxable gain before satisfying the 10-year holding period requirement?
• Will new investments be completed in time to fully utilize bonus depreciation on eligible assets before the generous bonus depreciation provisions phase out?  As a reminder, the 100% bonus depreciation amount remains in effect through January 1, 2023.  After that, the first-year bonus depreciation amounts decrease by 20% each year through January 1, 2027.
• Is the after-tax rate of return on the early exit from a QOZ investment, combined with the anticipated rate of return on a subsequent non-QOZ investment, greater than the after-tax rate of return of staying in the QOZ investment?

First, if QOZ property is sold within the 10-year holding period, the transaction will be treated as a fully taxable gain, which may include ordinary income from depreciation recapture. If the original QOZ investment is also fully liquidated, the investor will trigger an inclusion event that would cause the original deferred gain to be taxable. Either of these taxable gains may trigger significant tax liabilities to the taxpayer.  Alternatively, both capital gains from the property sales and inclusion event gains would allow investors the opportunity to defer the gains through reinvestment into new QOFs.

Second, one of the unsung benefits of the QOZ program is the ability to use the step up in basis to avoid depreciation recapture.  Combining this step up in basis with bonus depreciation and accelerated depreciation generated through a cost segregation study, the after-tax rate of return is substantially higher for a QOZ project than for a non-QOZ project

Lastly, the after-tax rate of return should be strongly considered when contemplating an early exit from a QOZ investment. Consider the following scenarios where an investor previously realized a $1,000,000 gain and deferred recognition by making a QOF investment. The investment is expected to earn an annual rate of return of 10%. The investor is considering an exit after three years, paying the tax, and using the after-tax proceeds for making a subsequent investment in a non-QOZ project. The second investment is also expected to earn an annual rate of return of 10%.

In this comparison, holding the QOZ investment for the full 10-year period produces approximately $632,000 more in after-tax cash flow than if the investment was sold early. In the “early exit” scenario, since the second investment is only held for seven years, the cash flow required to achieve the same after-tax cash flow as the “full hold” scenario is an equivalent rate of return of about 15% over the seven-year period.

A third scenario illustrates a variation on the “early exit” where the investor makes the subsequent investment into a QOZ structured vehicle. Returns for this scenario, while still producing stronger after-tax returns than the “early exit” scenario into a non-QOZ project, are still lower overall compared to the “full hold” scenario due to the tax paid on the early exit gains realized after three years.

QOZ investors need to consider all of their options when making decisions concerning their QOZ investments. 

Major thanks to Jeremy Siebert and Brian Duren for authoring this post.