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November 20, 2018  |   By: Max Dilendorf, Rika Khurdayan and Gleb Zaslavsky

Limited-Time Tax Advantages for Investing in New York City Real Estate in a Qualified Opportunity Zone

The capital gains tax has long stood as a disincentive to the sale of stocks, art and collectibles, real estate, and other capital assets in the United States. In fact, according to the Economic Innovation Group, the amount of unrealized capital gains in the hands of U.S. individuals and corporations totals more than $6 trillion.

To encourage taxpayers to reinvest some of those funds in a socially responsible way, Congress created the Qualified Opportunity Zones Program (“QOZ Program”) as part of the tax-reform bill enacted in late 2017. Under the program, more than 8,000 low-income and neighboring Census tracts[1] have been designated as qualified opportunity zones (“QOZs”), including nearly 300 in New York City alone.

For a limited time, taxpayers who properly reinvest their capital gains in one of these zones can benefit from the following advantages:

  • Pay no tax on the capital gains reinvested until as late as 2027;
  • Receive a reduction of up to 15% in the amount of reinvested capital gains eventually taxed, depending on how long the new investment (“QOZ investment”) is held; and
  • Pay no income tax on further gains from the sale of the QOZ investment if it is held for at least 10 years.

However, to maximize their benefits under the QOZ Program, taxpayers must make an eligible investment in a QOZ by December 31, 2019. And to obtain any benefit under the Program, investors’ capital gains must be realized no later than December 31, 2026 and reinvested no later than June 2027.

Why Invest in a Qualified Opportunity Zone?

Taxpayers who properly reinvest capital gains in qualified opportunity zones can benefit from up to three distinct tax advantages:

  • Deferred Recognition of Reinvested Capital Gains. In general, capital gains must be recognized in the same year in which they are realized.[2] But capital gains that are reinvested in a QOZ don’t have to be recognized until the earlier of (1) the sale or exchange of the QOZ investment; or (2) December 31, 2026.[3]
  • Reduced Recognition of Deferred Gains. If the QOZ investment is held for at least five years, the taxpayer will receive a 10% reduction in the amount of reinvested gains subject to tax.[4] If the investment is held for at least seven years, that reduction is increased to 15%.[5]
  • Basis Adjustment Eliminating Tax on Gains from QOZ investment. If the QOZ investment is held for at least 10 years, then, once it is eventually sold, its basis will be equal to its fair market value on the date of sale.[6] As a result, the taxpayer will not owe any income tax on the sale, even if the investment has appreciated significantly by then.

Example: Robert sells stock and other assets during 2018, realizing $5 million in capital gains. He properly reinvests that $5 million in New York City real estate located in a QOZ. He holds that property until 2030, when he sells it for $11 million. Under the QOZ Program, he obtains the following benefits:

  • He pays no tax on his 2018 capital gains until 2027.
  • When he pays tax on his 2018 gains, he only has to recognize 85% of those gains, for a tax savings of $150,000.[7]
  • He pays no income tax on his $6 million in 2030 capital gains, for a tax savings of $1.2 million.[8]

Why Invest in New York City Real Estate?

New York City’s housing market has historically been more stable than that in other areas of the United States. For example, although the 2008 recession impacted the luxury real-estate market in New York City, average-priced homes were scarcely affected. On average, real estate in New York City appreciates around 6 to 8% per year.

The QOZ Program offers taxpayers the chance to leverage the historic strength of New York City’s real-estate market to obtain significant tax savings. Nearly 300 qualified opportunity zones have been designated in New York City, many in areas with promising opportunities for real estate investors. For example, QOZs cover parts of the following areas:

  • Brooklyn: Bushwick and Bedford-Stuyvesant.
  • Manhattan: Upper West Side, Lower East Side, and Midtown.
  • Queens: South Queens.

Another part of Queens merits special attention by prospective investors: Long Island City (“LIC”). LIC is home to multiple QOZs and, as announced in mid-November 2018, will soon be home to part of Amazon’s new East Coast headquarters. It is expected that Amazon’s LIC facility will employ 25,000 workers.

The impact of potentially thousands of new residents and billions of dollars in investment by Amazon make LIC a prime prospect for taxpayers interested in reinvesting capital gains in New York City real estate under the QOZ Program.

How Can Taxpayers Invest in a Qualified Opportunity Zone?

Although the advantages of reinvesting capital gains in a QOZ may seem straightforward, the process for doing so is complicated by various technical rules. A full treatment of those rules is beyond the scope of the present article[9], but they include the following:

  • Eligible Gains. To qualify for deferral and the other benefits outlined above, capital gains must arise from the sale or exchange of property to an unrelated person, and the reinvestment must occur no more than 180 days after that sale or exchange.[10] In addition, some specific types of gain are explicitly excluded from eligibility.[11]
  • No capital gains realized after December 31, 2026 will be eligible for this program.[12] To benefit from the seven-year, 15% reduction, a QOZ investment must be made by December 31, 2019. To qualify for the exclusion of gain for QOZ investments held at least 10 years, the investment must be made by June 2027[13] and sold by December 31, 2047.[14]
  • Form of Investment. To be eligible for the benefits of investing capital gains in a qualified opportunity zone, the taxpayer must invest through a qualified opportunity fund, which is a domestic corporation or partnership[15] that has been formed for the purpose of making that investment and holds at least 90% of its assets in qualified opportunity zone property.[16]

Finally, for investments in New York City real estate, one more rule plays a critical role. Most investors will be purchasing an existing building, rather than a vacant lot. For an investment in existing property to qualify for the tax advantages outlined above, the building must be “substantially improved” (i.e., improvements must be at least equal in value to the basis in the building) within a 31-month period after purchase.[17]

Conclusion

Taxpayers who have been reluctant to sell capital assets out of concern over the resulting tax liability should consider participating in the QOZ Program. They should further consider the advantages of investing their gains in New York City real estate in doing so.

However, the QOZ Program will not last forever. Those who wish to benefit from its most advantageous provisions must reinvest their capital gains no later than December 31, 2019, and to participate at all, taxpayers must sell their capital assets by December 31, 2026, and reinvest the gains by June 2027.

Of course, because of the complexity of the QOZ Program, taxpayers interested in participating should conduct careful planning and thorough due diligence before selling assets or investing in a QOZ.

This article is provided for your convenience and does not constitute tax or legal advice. The information provided herein may not be applicable in all situations and should not be acted upon without specific tax or legal advice based on particular situations. Prior results do not guarantee a similar outcome.

Resources

[1] See 26 U.S.C. § 1400Z-1(a) – (b). A list and map of qualified opportunity zones are available at the Treasury Department’s Community Development Financial Institutions Fund’s website.

[2] Id. § 451(a).

[3] Id. § 1400Z-2(b)(1).

[4] Id. § 1400Z-2(b)(2)(B)(iii).

[5] Id. § 1400Z-2(b)(2)(B)(iv).

[6] Id. § 1400Z-2(c).

[7] Assuming no change in capital gains tax rates by then. In addition, capital gains deferred under the QOZ program maintain their tax attributes. Prop. Treas. Reg. § 1.1400Z2(a)-1(b)(5), 83 Fed. Reg. 54279, 54291 (October 29, 2018). For example, short-term capital gains will be taxed at ordinary rates, and capital gains from the sale of art or other collectibles will still be taxed at up to 28%. 26 U.S.C. § 1(h)(5). Accordingly, a taxpayer’s actual savings will depend on his or her unique circumstances.

[8] Assuming no change in capital gains tax rates by then.

[9] For a more detailed discussion, see How to Defer Capital Gains for Bitcoin by Purchasing Real Estate in a Qualified Opportunity Zone in New York.

[10] 26 U.S.C. § 1400Z-2(a)(1).

[11] See Prop. Treas. Reg. § 1.1400Z2(a)-1(b)(2), 83 Fed. Reg. at 54290.

[12] 26 U.S.C. § 1400Z-2(a)(2)(B).

[13] That is, 180 days after the last date for eligible capital gains, December 31, 2026.

[14] Prop. Treas. Reg. § 1.1400Z2(c)-1(b), 83 Fed. Reg. at 54292.

[15] Or another type of legal entity that is taxed as a corporation or partnership for federal income tax purposes, such as a limited liability company. Prop. Treas. Reg. § 1.1400Z2(d)-1(a)(1).

[16] 26 U.S.C. § 1400Z-2(d)(1).

[17] Id. § 1400Z-2(d)(2)(D). See also Rev. Rul. 2018-29, 2018-45 I.R.B. 765.

This article is provided for your convenience and does not constitute legal advice. The information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations. Prior results do not guarantee a similar outcome.

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