This post was updated in March 2020.
The Qualified Opportunity Zone program, created by the Tax Cuts and Jobs Act of 2017, and contained in Section 1400Z-2 of the U.S. Internal Revenue Code of 1986, as amended (the Code), incentivizes investment in underserved communities. We believe our focused strategy and pipeline of Opportunity Zone transactions with institutional operators position us to deliver what we believe is an attractive portfolio of qualifying investments that also feature material tax benefits. Through our program, eligible investors can:
- Defer taxes on currently realized capital gain until the end of 2026.
- Reduce the amount of deferred taxes owed by up to 15% (or 10% for investments made in 2020 or 2021).
- Eliminate tax on capital gains from the sale or disposition of the investment if held for at least 10 years.
Investors who have recently joined our Qualified Opportunity Zone platform and have begun evaluating or investing in available transactions may be wondering, “What happens next, in terms of taxes?” We’ll cover the basics in this guide, which summarizes the U.S. federal income tax reporting and filing obligations associated with an investment in a Qualified Opportunity Fund (QOF) pursuant to the Qualified Opportunity Zone program.
We start with an illustration of major investment milestones, then provide a primer on IRS Form 8949, IRS Form 8997, and several sample filings.
*The recommendations contained herein are based on IRS Form 8949, IRS Form 8997, IRS Form 4797, and accompanying instructions and relevant guidance, as in effect as of March 1, 2020, and do not take into account a taxpayer’s specific circumstances which may affect tax reporting obligations. There is a risk that such tax returns and forms filed by taxpayers may have to be subsequently amended based on future official guidance and changes to the relevant forms. All investors should consult their tax or legal advisers prior to filing any tax returns relating to their investment in a Qualified Opportunity Fund and this guide should not be construed as tax advice to a particular investor or investors. Numerous uncertainties remain and interpretive ambiguities may emerge as taxpayers begin to apply the forms, instructions, and proposed and final regulations (see Disclaimer below).
Major investment milestones
To better understand the U.S. federal income tax reporting components of an investment in a Qualified Opportunity Fund, it can be helpful to first consider what a full investment life cycle may look like:
1. Capital Gains Realization Event – March 15, 2020
Taxpayer generates a capital gain and is eligible for tax benefits if the gain is reinvested into a Qualified Opportunity Fund within 180 days.
2. Investment + Deferral – March 15, 2020
Taxpayer invests an amount of cash equal to the gain into a Qualified Opportunity Fund and defers capital gain tax liability until the earlier of (i) the investment sale date or (ii) December 31, 2026.
3. Year 5 Tax Reduction – March 15, 2025
Deferred capital gains tax reduced by 10%.
4. Tax Recognition Date – Dec 31, 2026
Assuming that the asset has not yet been sold, taxpayer must report and pay the deferred capital gains tax liability, taking into account the reductions mentioned above.
5. Disposition + Elimination – On or after March 15, 2030
Since the asset has been held for 10 years, the investor may increase its basis in the investment to its fair market value at the time of sale, thereby eliminating federal capital gains taxes on such sale.
Let’s take a closer look at the tax reporting requirements for the first two milestones — liquidation and Qualified Opportunity Fund investment + deferral — which both involve IRS Form 8949.
A primer on IRS Form 8949
Generally, IRS Form 8949 is an existing form used to reconcile amounts of short- or long-term capital gains that were reported to the taxpayer and the IRS on Forms 1099-B or 1099-S (or any substitute statements) with the amounts reported by the taxpayer on his or her U.S. federal income tax return.
The IRS recently released updated instructions for the form which specify rules for eligible gains invested in a Qualified Opportunity Fund. When an investor files a U.S. federal income tax return for the year in which the capital gain otherwise would have been reported, the investor will attach an additional IRS Form 8949 to the return, reporting the election to defer all or a portion of such gain.
Different sections of the form are completed depending on the type of capital gain and cost basis being reported, including:
Part I — Used for reporting short-term capital gains (corresponding to capital assets held less than a year) and includes three check boxes:
- (A) for reporting short-term capital asset transactions for which the taxpayer received an IRS Form 1099-B (or substitute statement) showing that the basis of the capital asset was reported to the IRS. Such transactions typically include sales or exchanges of certain stock or other “covered securities” from a broker. For reporting purposes, these transactions may be aggregated by the taxpayer on IRS Form 8949, and do not require a code to be entered in column (f) or any adjustments in column (g).
- (B) for reporting short-term capital asset transactions for which the taxpayer received an IRS Form 1099-B (or substitute statement), but which did not show that the basis of the capital asset was reported to the IRS. Such transactions include sales or exchanges of certain assets other than covered securities from a broker for which an IRS Form 1099-B (or substitute statement) was received but did not show the basis of the asset or such basis was not reported to the IRS. For reporting purposes, these transactions may be reported separately by the taxpayer on IRS Form 8949 and require a code to be entered in column (f) and an adjustment to be made in column (g) in order to account for the basis which was not otherwise reported to the IRS.
- (C) for reporting short-term capital asset transactions for which the taxpayer did not receive an IRS Form 1099-B (or substitute statement). Such transactions may include sales or exchanges of securities or other capital assets from a non-broker.
Part II — Same as Part I but used for reporting long-term capital gains (corresponding to capital assets held over one year). Boxes (D), (E), and (F) correspond to boxes (A), (B), and (C) in Part I, respectively.
Note: Taxpayer may file IRS Form 8949 with only one of boxes (A), (B), or (C) in Part I checked, and only one of boxes (D), (E), or (F) in Part II checked. If a taxpayer has transactions which would require more than one of the boxes checked, multiple IRS Forms 8949 should be used.
Simplified sample form showing taxpayer reporting short- and long-term sales of stock
Reporting Opportunity Fund Deferrals
When electing to defer a capital gain through an Opportunity Fund, the taxpayer would report the capital gain on IRS Form 8949 in the standard manner, but include an additional IRS Form 8949 to report the deferral of capital gain in the following manner:
- Use Part I and check box (C) if deferring short-term capital gains
- Use Part II and check box (F) if deferring short-term capital gains
- Enter the Name and EIN of the Qualified Opportunity Fund in box (a) Description if property
- Enter date of investment in box (b) Date acquired
- Enter “Z” in box (f) Code
- Enter investment (amount) in boxes (g) Amount of Adjustment and (g) Gain or (loss)
Taxpayers who report other capital gains with either box (C) on Part I or box (F) on Part II checked may use the same IRS Form 8949 to report the deferral of capital gain as specified above.
Example 1: Taxpayer invests short-term capital gains equally into a single Qualified Opportunity Fund
Example 2: Taxpayer invests short-term capital gains into multiple Qualified Opportunity Funds
Example 3: Taxpayer invests short-term and long-term capital gains into a single Qualified Opportunity Fund
It’s important to note that investors should not expect to receive any tax forms or reports from Cadre, save for investor communications that Cadre will provide in the ordinary course to its investors. Therefore, investors should consult with their tax advisers regarding the obligation to report the appropriate amount of deferred gain on the Tax Recognition Date as well as tracking the investor’s basis in the Qualified Opportunity Fund interest.
Although the Opportunity Zone rules may be subject to additional guidance or technical corrections, the final regulations suggest that a taxpayer’s basis is otherwise subject to the normal adjustments associated with allocations of income and loss on the Qualified Opportunity Fund’s Schedule K-1.
Investors should also note that the Qualified Opportunity Fund itself will use a separate form (IRS Form 8996) to self-certify (i) that it is organized as a Qualified Opportunity Fund to invest in Opportunity Zone property, and (ii) on an ongoing basis, that it continues to meet the various requirements of Qualified Opportunity Fund status. Cadre and its advisers will handle the preparation and filing of this form.
A primer on IRS Form 8997
In addition to requiring taxpayers to report QOF investments on a transaction-by-transaction basis on IRS Form 8949, the IRS has recently introduced IRS Form 8997, essentially requiring taxpayers to report all QOF activity (including investments in QOFs and dispositions of equity interests in QOFs) on an aggregate basis. IRS Form 8997 must be filed by all taxpayers holding a QOF investment at any point during the during the tax year with their federal income tax return (including extensions). IRS Form 8997 consists of four parts, the instructions for which are described below:
- Part I: The taxpayer would report all of its QOF investments held at the beginning of its taxable year. If this information is any way different that what was reported on Part IV of the taxpayer’s IRS Form 8997 from the previous year, then the taxpayer must attach a written explanation of the change in QOF holdings. For each QOF investment held by the taxpayer at the beginning of its taxable year, the taxpayer should enter the applicable QOF’s EIN in column (a); the date the QOF investment was made in column (b); a description of the QOF investment in column (c); and in column (d) or (e), either the short- or long-term deferred capital gain invested into such QOF. The amounts entered in columns (d) and (e) should subsequently be added together and reported as total amounts.
- Part II: This section allows taxpayers to report capital gains from its current tax year that were invested in QOFs. For each investment of current year capital gains into a QOF, the taxpayer should enter the applicable QOF’s EIN in column (a); the date the QOF investment was made in column (b); a description of the QOF investment in column (c); and in column (d) or (e), either the short- or long-term deferred capital gain invested into such QOF. The amounts entered in columns (d) and (e) should subsequently be added together and reported as total amounts.
- Part III: If a taxpayer disposes of all or part of its equity interest in any QOF during the taxable year, then it must report any such transactions in Part III. For each disposition of an equity interest in a QOF, the taxpayer should enter the applicable QOF’s EIN in column (a); the date the QOF equity interest was sold or disposed in column (b); a description of the QOF equity interest sold or disposed in column (c); and in column (d) or (e), either the short- or long-term deferred capital gain now included in the taxpayer’s income due to the disposition or sale of the QOF equity interest. The amounts entered in columns (d) and (e) should subsequently be added together and reported as total amounts. If a taxpayer does not receive an IRS Form 1099-B with respect to its sale or disposition of a QOF equity interest, then it would check the applicable box in Part III.
- Part IV: A taxpayer will then report all of its QOF investments held at the end of its taxable year, including new investments made by contributing current year capital gains to QOFs and currently held investments in QOFs where the initial contribution of capital gains occurred in a prior year. For each QOF investment that it holds at the end of its taxable year, the taxpayer should enter the applicable QOF’s EIN in column (a); the date the QOF investment was made in column (b); a description of the QOF investment in column (c); and in column (d) or (e), either the short- or long-term deferred capital gain invested into such QOF. The amounts entered in columns (d) and (e) should subsequently be added together and reported as total amounts.
Note on Reporting Deferral of Section 1231 Eligible Gains
Taxpayers deferring eligible gains from the disposition of “Section 1231 Property” (typically depreciable property and real property used in a trade or business and held for more than one year) must, in addition to reporting the deferral on IRS Form 8949 in a modified manner, coordinate reporting the deferral on IRS Form 4797.
With respect to IRS Form 4797, directly under the line in Part I.2 reporting the sale giving rise to the Section 1231 gains to be deferred as a result of an investment in a QOF, the taxpayer should write “QOF investment to Form 8949” in column (a); leave columns (b)-(f) blank; and report the amount of Section 1231 gains invested into a QOF as a negative amount (in parentheses) in column (g).
With respect to IRS Form 8949, each QOF investment of Section 1231 gains will use two separate rows in Part I (short-term transactions) or Part II (long-term transactions), as applicable. For the first row, in column (a), the taxpayer should write “QOF INVESTMENT FROM FORM 4797”; leave columns (b)-(g) blank; and report the amount of the QOF investment from IRS Form 4797 (as discussed above) in column (h) as a positive number. For the second row, the taxpayer should enter the QOF’s EIN in column (a); the date of the QOF investment in column (b); leave columns (c)-(e) blank; enter code “Z” in column (f); and enter the amount of the deferred gain as a negative number (in parentheses) in column (g).
Note on State Tax Considerations
Whether the federal tax benefits stemming from the Qualified Opportunity Zone program will translate into state tax benefits (and the associated state-level information reporting requirements) will depend on whether and how a state conforms to the Code. Certain states have a regime of automatic conformity to the Code (e.g., Illinois and Colorado), whereas other states have a fixed-date conformity which has been updated since the enactment of the Qualified Opportunity Zone rules (e.g., Georgia, Maine, and Oregon). Some states have even introduced legislation to offer additional state tax incentives for Qualified Opportunity Fund investments separate and apart from a such state’s conformity to the Qualified Opportunity Zone regime.
Taxpayers in states which have not updated their Code conformity provisions to incorporate components of the legislation (e.g., California, Massachusetts) or which have affirmatively decoupled from the Qualified Opportunity Zone provisions (e.g., North Carolina) may lose out on state tax benefits stemming from the provisions and may face additional administrative and information reporting burdens.
For example, taxpayers filing state tax returns in a non-conforming state and making an investment into a Qualified Opportunity Fund which holds property located in the same state, may be required to recognize the capital gains invested into the Qualified Opportunity Fund in the year in which the gain is realized, and will not be granted any basis step-up for amounts invested and held in a Qualified Opportunity Fund. When the gain is ultimately realized at the federal level, taxpayers would want to ensure that such gain is not taxed by the state a second time. This mismatch between the federal and state tax treatment of Opportunity Fund investments necessitates that taxpayers keep detailed schedules separately tracking their federal and state tax treatment.
A single Qualified Opportunity Fund investment might involve multiple states, forcing a taxpayer to assess the state tax considerations in the state where the fund and Qualified Opportunity Zone are located, and all of the states where the taxpayer is already paying taxes. Depending on whether all of these states conform to the program, the taxpayer might be required to include the capital gain in computing his or her tax liability in one state while deferring that same gain in a different state. Additionally, state apportionment treatment of capital gains varies from state to state and may also depend on whether the gain relates to the sale of tangible or intangible property. For conforming states, taxpayers should examine their apportionment factors to determine whether any gain deferral or non-recognition is properly reflected. Where a state includes net gains from the sale of capital assets in the sales factor and also conforms to the Qualified Opportunity Zone program, taxpayers should consider as to the year in which gains should be properly included in the apportionment factor. Furthermore, investment in a Qualified Opportunity Fund which owns property located in a state other than a state where the taxpayer is engaged in a trade or business may create concerns related to an expanded nexus leading to increased state tax filing requirements.
The laws relating to the Qualified Opportunity Zone program and associated filing requirements at both the state and federal levels are currently uncertain and subject to change. All investors are urged to consult their tax advisers to ascertain the applicable federal and state implications and filing requirements prior to making an investment into a Qualified Opportunity Fund and should not construe the above summary as tax advice on which they can rely in light of their particular circumstances.
Note on Investments Through Various Entity Types, Including Trusts
Investors may choose to choose to invest in a Qualified Opportunity Fund using an entity such as a limited liability company (LLC) or a trust. The reporting requirements associated with an investment structured in this manner are highly dependent on the federal tax classification of the entity and the investor’s particular circumstances. Investors using entities to enter a Qualified Opportunity Fund should consider the following:
- An individual may use a grantor trust to invest capital gains in a Qualified Opportunity Fund when such capital gains have either been incurred by the individual or the grantor trust.
- Generally, a “grantor trust” is a trust in which the grantor (i.e., the creator of the trust) retains one or more significant powers over the trust, such that the grantor effectively controls the governance and income of such trust. This determination is driven by the particular facts and circumstances of each trust, but significant powers giving rise to a grantor trust may include the grantor holding a reversionary interest in the corpus or income of the trust, a unchecked power of disposition of the beneficial enjoyment of the corpus or income of the trust, or certain administrative powers exercised by the grantor solely for the benefit of the grantor rather than the trust’s beneficiaries. Investors using a trust to enter a Qualified Opportunity Fund are strongly urged to consult the appropriate tax and legal advisers to determine, based on the particular facts applicable to such investor, the federal tax classification of the trust (including whether the trust is a grantor or complex trust) and how to structure such investment.
- For U.S. federal income tax purposes, the grantor or a beneficiary of the grantor trust is treated as the owner of the activity of the trust. As the deemed owner of the grantor trust, such individual must include the activity of the trust on his or her personal tax return. Therefore, if capital gains were incurred by an individual, but invested into a Qualified Opportunity Fund by the individual’s grantor trust, the individual would report the deferral of these capital gains on IRS Form 8949 in the ordinary manner.
- If the capital gains are incurred by the grantor trust, then the subsequent investment of these gains into a Qualified Opportunity Fund may be reported by the grantor trust on IRS Form 8949 in the ordinary manner.
- Example: Taxpayer realizes a capital gain as an individual and wants to invest such capital gain in a Qualified Opportunity Fund through a grantor trust set up for the benefit of Taxpayer’s child. Taxpayer and his or her spouse are joint filers and the spouse is the grantor of the trust. Unless the trust is treated as a complex trust for federal tax purposes (where the beneficiaries, rather than the grantor, are taxed on certain income received from the trust), Taxpayer should be able to invest in the Qualified Opportunity Fund through the trust.
- If an individual is a joint filer and incurs capital gains which are subsequently invested into a Qualified Opportunity Fund, then such individual may report such capital gains in the ordinary manner either on his or her individual IRS Form 8949 or on a joint IRS Form 8949 which also includes information concerning his or her spouse’s capital.
Limited Liability Companies
- The tax reporting obligations regarding an investment made into a Qualified Opportunity Fund through an LLC depend on the tax classification of the LLC. For federal tax purposes, an LLC may be either a regarded entity (e.g., a partnership or a corporation) or a disregarded entity. Typically, if an LLC has only one owner, it is treated by default as a disregarded entity unless an election is made otherwise. Such a single-owner LLC may file an election on IRS Form 8832 to be treated as a corporation. Accordingly, an LLC with more than one owner would be initially classified as a partnership, but may file an election on IRS Form 8832 to be treated as corporation.
- If an LLC is treated as either a corporation or a partnership, it is regarded as an entity that is separate from its owners for federal tax purposes (but see the note below regarding entities owned jointly by spouses). Therefore, if an individual realizes an eligible capital gain, he or she cannot generally use an LLC in which such individual is a member (unless it is wholly-owned by him or her) to invest in a Qualified Opportunity Fund. However, if an LLC taxed as a partnership initially realizes the capital gain, special rules allow any member to invest in a Qualified Opportunity Fund in their own capacity. An LLC that is a regarded entity would file IRS Form 8949 to report capital gains invested into a Qualified Opportunity Fund in the ordinary manner. If the LLC is treated as a disregarded entity, then the sole owner of the LLC would file IRS Form 8949 and report the capital invested into a Qualified Opportunity Fund in the ordinary manner. Investors should consult with their tax and legal advisers to determine the federal tax classification of any entity through which investments could be made into a Qualified Opportunity Fund and how such investments may be structured.
- It should be noted that special rules apply to determine the federal tax classification of an LLC owned solely by an individual and his or her spouse. Under Revenue Procedure 2002-69, the IRS will accept the position that the LLC is either a disregarded entity or a partnership if it is a “qualified entity.” For these purposes, a “qualified entity” means that 1) the business entity is wholly owned by a husband and wife as community property under the laws of a state, 2) no person other than one or both spouses would be considered an owner for federal tax purposes, and 3) the business entity is not classified as a corporation for federal tax purposes. A change in the reporting position will be treated for federal tax purposes as a conversion of the entity. If an LLC is owned by husband and wife in a non-community property state, the LLC should file as a partnership. Investors should consult with their tax legal advisers as to whether they reside in a “community property” state and accordingly how Qualified Opportunity Fund investments can be structured.
- Example: Taxpayer realizes a capital gain as an individual and wants to invest the capital gain in a Qualified Opportunity Fund through an LLC which is treated as a partnership for federal tax purposes (the other partners in the LLC being Taxpayer’s relatives). The Taxpayer cannot contribute an amount of cash equal to the capital gain to the LLC and then have the LLC invest in the Qualified Opportunity Fund. Instead, Taxpayer may invest in the Qualified Opportunity Fund directly or through a disregarded entity.
The views expressed above are presented only for educational and informational purposes and are subject to change in the future. No specific securities or services are being promoted or offered herein.
This communication is not to be construed as investment, tax, or legal advice in relation to the relevant subject matter; investors must seek their own legal or other professional advice.
Performance Not Guaranteed
Past performance is no guarantee of future results. Any historical returns, expected returns, or probability projections are not guaranteed and may not reflect actual future performance.
Risk of Loss
All securities involve a high degree of risk and may result in partial or total loss of your investment.
Liquidity Not Guaranteed
Investments offered by Cadre are illiquid and there is never any guarantee that you will be able to exit your investments on the Secondary Market or at what price an exit (if any) will be achieved.
Not a Public Exchange
The Cadre Secondary Market is NOT a stock exchange or public securities exchange, there is no guarantee of liquidity and no guarantee that the Cadre Secondary Market will continue to operate or remain available to investors.
Opportunity Zones Disclosure
Any discussion regarding “Opportunity Zones” — including the viability of recycling proceeds from a sale or buyout — is based on advice received regarding the interpretation of provisions of the Tax Cut and Jobs Act of 2017 (the “Jobs Act”) and relevant guidances, including, among other things, two sets of proposed regulations and the final regulations issued by the IRS and Treasury Department in December of 2019. A number of unanswered questions still exist and various uncertainties remain as to the interpretation of the Jobs Act and the rules related to Opportunity Zones investments. We cannot predict what impact, if any, additional guidance, including future legislation, administrative rulings, or court decisions will have and there is risk that any investment marketed as an Opportunity Zone investment will not qualify for, and investors will not realize the benefits they expect from, an Opportunity Zone investment. We also cannot guarantee any specific benefit or outcome of any investment made in reliance upon the above.
Cadre makes no representations, express or implied, regarding the accuracy or completeness of this information, and the reader accepts all risks in relying on the above information for any purpose whatsoever. Any actual transactions described herein are for illustrative purposes only and, unless otherwise stated in the presentation, are presented as of underwriting and may not be indicative of actual performance. Transactions presented may have been selected based on a number of factors such as asset type, geography, or transaction date, among others. Certain information presented or relied upon in this presentation may have been obtained from third-party sources believed to be reliable, however, we do not guarantee the accuracy, completeness or fairness of the information presented.