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Nov 2019
25
November 25, 2019

Can My Estate Plan Benefit from Opportunity Zone Investment?

By now you have probably heard about “qualified opportunity zones,” an investment option created by the 2017 Tax Cuts and Jobs Act (TCJA) to encourage investment in economically-distressed communities. Due to a lack of clarity in the Act’s initial regulations, many investors had taken a “wait and see” attitude toward this as an investment option, even though the best tax benefits are provided to those who invest before December 31, 2019.
 
A recently-issued set of proposed regulations provides clarification on many points in the program, and this has inspired renewed investor interest in this option. However, little has been published about how using this option could help or hinder your estate planning, and this is an important part of the decision to utilize this investment vehicle.
 
THE BASICS OF QUALIFIED OPPORTUNITY ZONES
 
What is a qualified opportunity zone (QOZ)? These are low-income communities, designated by each state, which provide investors with preferential tax treatment in exchange for long-term investments within the QOZ. You do not have to live or have a business in a QOZ to invest there.
 
What is a qualified opportunity fund (QOF)? QOZ investments must be made using a qualified opportunity fund (QOF), which is a partnership or corporation created for the purpose of investing capital gains into QOZs. A taxpayer that is a corporation or partnership (including some LLCs) for tax purposes can also self-certify as a QOF.
 
Who could invest in a QOZ? Benefits apply to those persons able to invest significant amounts of capital gains realized in a year.
 
How long do QOZ investments last? In order to provide significant benefits, the program encourages long-term investments in these communities, ideally at least five years. The longer the QOZ asset is held, the better the tax benefits.
 
What are the tax benefits of QOZ investing? There are three main benefits to taxpayers:
 
  • It allows taxpayers to defer paying tax on any capital gains that they have timely invested into a QOZ asset until the asset is disposed of or until December 31, 2026, whichever is earlier;
  • It provides a reduction in the taxes owed on the deferred capital gains:
    • of 10% if the QOZ equity interests are held for at least five years (investment made by 12/31/21);
    • of an additional 5% if the QOZ equity interests are held for seven years (providing a 15% reduction in taxes for investments made by 12/31/19); and
  • It allows for elimination of taxes on appreciation of the QOZ equity interests if they are held for at least 10 years. This is valid until 12/31/47.
 
How does an investment into a QOF work? Only the capital gains from a sale are eligible to be invested in a QOF, not the sale proceeds. Gains must be reinvested into a QOF within 180 days of the transaction that caused the gain. The QOF must then certify that it keeps 90% of its assets in QOZ property, but there are no requirements as to the number or diversity of the fund’s holdings so investors can tailor the fund to meet their interests or return requirements.
 
This investment provides the best tax benefits when assets are held for at least 10 years and are expected to appreciate in value, but you can recognize losses associated with an investment in a QOF.
 
ESTATE PLANNING BENEFITS FROM QOZ
 
1. Gifting QOZ interests to a Grantor Trust

A grantor trust is one in which the trust’s income is taxable to the grantor for income tax purposes. The IRS holds that a transaction between a grantor and a grantor trust is a “nothing” for tax purposes. As such, gifting to a grantor trust does not eliminate the tax benefits of QOZ investing. Important points for this gifting:
 
  • Termination of grantor trust status due to your death does not lose the QOZ tax benefits, but termination of grantor trust status for other reasons does.
  • When taxes on the deferred gain are due for 2026, they can be paid from assets outside of the trust (which equates to an additional tax-free gift to the trust).
  • The trust can use the holding period that dates back to your original QOF investment, allowing it to utilize the 10% or 15% tax reduction.
  • Since QOF assets held for more than 10 years do not incur capital gains tax on the post-acquisition appreciation, you can provide the next generation with tax-free growth.
 
2. Structuring a QOF with preferred and common equity interests

With this partnership structure:
 
  • The family’s senior generation keeps the preferred interests to provide a predictable stream of cash flow (these interests must be carefully structured to avoid inclusion in gross income).
  • The common interests are transferred to younger generations, shifting any future appreciation to them. This could be done using a generation-skipping trust, which has the benefits of being both transfer-tax-exempt and a grantor trust.
 
3. Gifting QOF interests to a GRAT

In the case of a grantor retained annuity trust (GRAT), the grantor makes a gift to the trust and retains an annuity interest approximately equal to the fair market value of the transferred asset. Assuming the asset grows more than is needed to pay the annuity back to the grantor, the future appreciation passes to the remainder beneficiaries (using grantor trusts) gift tax free.
 
Note that changing from grantor to non-grantor trust status causes the deferred gain to become immediately taxable (except if it is due to grantor’s death) – so remainder interests must pass to a grantor trust rather than to a non-grantor trust or directly to beneficiaries.
           
What happens if I pass away while holding a QOF investment?

The gains originally invested in the QOF investment are not eligible for a step up in basis upon death. However, neither transfer of a QOF investment to an estate at death nor distribution from an estate to heirs will cancel the deferment of the capital gains taxes or lose the tax-free gains from holding the asset for 10 years.
 
However, a sale or other disposal of the QOF investment by your heirs would be an “inclusion event,” where the deferred gain would become immediately taxable and would need to be included in gross income for your heirs. 
 
Considerations
 
  • You need to keep enough liquidity in the investment portfolio to pay the capital gains tax that is due at the recognition date in 2026 (and if the interest passes to beneficiaries of an estate, make sure they have enough liquidity to pay taxes in 2026).
  • Investors are expected to make a “substantial” investment into the QOZ asset within 30 months after purchase (or after start up if asset is a business). “Substantial” is generally interpreted to mean at least $1 of improvement for every $1 of purchase price.
 
If a QOZ investment is of interest to you, you still have time before the seven-year holding deadline passes on December 31st. Please contact William Lentine (248-784-5061 or wlentine@wnj.com) or Laura Jeltema (616-752-2161 or ljeltema@wnj.com) for more specific information on using a QOZ in your estate plan.

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