Last week, the IRS released proposed regulations regarding investing in Qualified Opportunity Funds (“QOFs”).  Click here for a summary of the QOF regime that was enacted as part of the 2017 Tax Cuts and Jobs Act. The proposed regulations generally address three topics:

  1. The requirements for deferring gain recognition by investing in a QOF;
  2. Rules for corporations or partnerships to self-certify as QOFs; and
  3. The requirements for a corporation or partnership to qualify as a QOF.

Highlights of the proposed regulations include the following:

  • The proposed regulations provide that only capital gains are eligible for deferral. Where a sale results in both capital gain and ordinary income (such as depreciation recapture), a taxpayer can defer only the capital gain.
  • A partnership itself can elect deferral of eligible gain. To the extent the partnership does not elect, a partner in the partnership can elect deferral with respect to the partner’s distributive share of eligible gain.  The partner can make such an election within 180 days of the last day of the tax year in which the gain occurs.
  • The deferral election will be reported on a Form 8949. The self-certification to qualify as a QOF will be reported on a Form 8996.
  • The proposed regulations clarify that the exclusion of gain after holding a QOF investment for 10 years qualifies even after a Qualified Opportunity Zone (“QOZ”) designation expires. This was a concern raised by many commentators based on the statute.
  • Pre-existing entities may qualify as QOFs, subject to certain requirements.
  • A QOF may hold cash and other nonqualified financial property for up to 31 months (a “working capital safe harbor”) if the QOF has a written plan that identifies the property as held for acquisition, construction or substantial improvement of tangible property in the QOZ, a written schedule exists evidencing the use of the property, and the QOF substantially complies with the schedule.
  • The proposed regulations provide further guidance about how to qualify as a “QOZ Business.” In brief:  A QOF must hold 90% of its assets in “QOZ Property.”  QOZ Property is either (1) “QOZ Stock” (stock of a corporation that is a QOZ Business), (2) “QOZ Partnership Interest” (partnership interest in a partnership that is a QOZ Business), or (3) “QOZ Business Property.”  If the QOF invests in a QOZ Business (eg, stock or partnership interests) to meet this requirement, the proposed regulations provide that 70% of the tangible property of the subsidiary corporation or partnership must be held for use in QOZ Business Property.  The leniency of this rule makes it likely that QOF will use subsidiary entities to make investments.
  • The proposed regulations also clarify how a business will qualify as a QOZ business.

The IRS is soliciting comments on the proposed regulations and planning to issue additional regulations.  Investors should try to stay flexible as the rules in this new area may change.  Nonetheless, as the rules become clearer, investors can better evaluate the planning opportunities that investing in QOZs offer.

 

On October 19, 2018, the IRS released Revenue Ruling 2018-29, an eagerly awaited ruling addressing real estate investment in Qualified Opportunity Zones (“QOZs”). In brief, the Revenue Ruling holds that, for purposes of measuring whether a real estate investment is “substantially improved” so that it will qualify as “QOZ business property” and therefore will qualify for favorable tax deferral rules, the taxpayer uses his or her adjusted basis in the building as the measure and ignores his or her basis in the land.

The 2017 Tax Cuts and Jobs Act created an Opportunity Zone Program to encourage investments in economically distressed areas. Taxpayers who invest realized gains in Qualified Opportunity Funds (“QOFs”) (1) get to defer recognition of the gain (until the earlier of the date of sale of the QOF investment or December 31, 2026), (2) get a step-up in basis up to 15% (if the QOF interest is held for five to seven years), and (3) may exclude all of the gain due to the new QOF investment if they hold the investment for 10 years.

A QOF must hold at least 90% of its assets in “QOZ property.” For real estate investors, the investment generally must be QOZ business property, which is tangible property (including real estate) used in a trade or business that is purchased after December 31, 2017, and either the original use of the property began with the QOF, or the QOF “substantially improves the property.” Property is treated as substantially improved if, within 30 months of acquisition, the additions to the tax basis of the property exceed the original basis at the beginning of the 30 month period. In other words, if the investor makes improvements to the property that doubles its basis, then the property will qualify as “substantially improved.”

The statute is complicated and there have been a number of questions about the details of how to implement the QOZ rules. The IRS has issued proposed regulations and will issue more. Nonetheless, the Revenue Ruling is taxpayer-friendly and helpful because it makes clear that one ignores basis in land and uses only basis in the building in order to determine whether the QOZ property is substantially improved and thus qualifies for tax benefits.

Section 1400Z-2(a) of the Internal Revenue Code of 1986 (the “Code”), enacted as part of the 2017 federal Tax Cuts and Jobs Act is designated to spark long-term capital investment into low-income and urban communities, now called the “Opportunity Zone Program.” Via the Qualified Opportunity Zone Program, developers and investors can tap into and reinvest their unrealized capital gains without paying capital gains for a period of time, if at all. Below is a brief fact sheet that can answer a client’s basic questions and concerns.

What is a Qualified Opportunity Zone?

A Qualified Opportunity Zone (“QOZ”) is an economically-distressed community where new investments, under certain conditions, may be eligible for preferential tax treatment. Localities qualify as QOZs if they have been nominated for that designation by the state and that nomination has been certified by the Secretary of the US Treasury. You can obtain a list of the designated QOZs for New Jersey and New York at the website address below.

What is a Qualified Opportunity Fund?

A Qualified Opportunity Fund (“QOF”) is an investment vehicle that is set up as either a partnership or corporation for investing in eligible property that is located in a QOZ and that utilizes the investor’s gains from a prior investment for funding the QOF.

What are the tax benefits of investing in a QOF?

Investors who invest capital gains into a QOF within 180 days of selling an asset can defer their capital gain taxes – that is, they will not need to pay tax on the amount of gain that is reinvested in the tax year that the gain occurred.  In addition, investors who invest capital gains into a QOF may reduce the tax by up to 15%.  The rules provide that capital gains invested in a QOF will receive a step up in basis of 10% if held for at least five years and by an additional 5% if held for at least seven years, excluding up to 15% of the original gain from taxation.

The law currently provides that the deferral of such gain terminates on December 31, 2026, so investors should be aware they will owe tax upon the earlier of the date the QOF investment is sold or December 31, 2026.  Investors should reserve funds or otherwise plan for the tax payment.

In addition to deferring tax on a realized gain, the law also provides that, if the investment in the QOF is held for at least 10 years, the gain accrued while invested is permanently excluded from taxable income upon the sale or exchange of the investment.

What kind of gains qualify to invest in a QOF?

Any long or short term capital gain is eligible for the tax treatment described above.

When does one need to invest into a QOF to receive maximum tax benefits?

Within 180 days from the date the asset is sold an investor must invest in a QOF to defer the capital gain on the sale of the asset. Thus, every investor’s clock will be expiring at different times and investors need to be aware of the following important deadlines:

  • December 31, 2019 – for investors who want to benefit from the 15% reduction in taxable gain, they must have held their QOF interest for 7 years by December 31, 2026.
  • December 31, 2021, for investors who want to benefit from the 10% reduction in capital gain.

How does one structure a QOF?

The QOF has to be a newly incorporated corporation or partnership that holds 90% of its assets in QOZ property. The Code defines a QOF as “any investment vehicle which is organized as a corporation or a partnership for the purpose of investing in a QOF.” Thus, when forming the QOF, include in the QOF organizational documents the required “purpose clause.” The Code is silent as to whether a QOF can be an LLC, but since LLCs with multiple members default to partnership status for tax purposes (and since an LLC can elect to be a corporation for tax purposes), LLCs should be a permitted type of legal entity for QOFs.

The Code allows “single tier” and “two tier” structures. Single tier is where the QOF holds the property directly.  Two tier is where the QOF holds an interest in a lower tier corporation or partnership, and the subsidiary entity holds the property. The two tier structure likely offers more flexibility by permitting the subsidiary entity to hold reasonable amounts of working capital, and having a lower threshold for measuring whether “substantially all” of its assets are held in QOZ property.

What is QOZ property?

QOZ property includes QOZ stock, QOZ partnership interests, QOZ business property, in each case located in QOZs.

Investing in a QOF and the 90% Test?

For QOFs that use the calendar year as their fiscal year, this means that the 90% asset test must be met on December 31.  It is expected that proposed regulations will clarify timing issues relating to the 90% test, and how quickly cash must be invested into QOZ property in order to qualify.  Investors need to carefully consider this issue when acquiring QOZ property so as to not flunk the 90% test.

Unknown issues possibly to be addressed in IRS guidelines soon to be releases:

There are still several issues relating to QOZs that have not yet been addressed. The IRS just released proposed regulations on some points (which we will summarize in a subsequent post).  The IRS is soliciting comments on the proposed regulations and planning to issue additional regulations.  Investors should try to stay flexible as the rules in this new area may change.

How are the tax benefits of QOZs different from like-kind exchanges under Code §1031?

Code §1031 can only be used for real property used in a trade or business or held for investment, while the QOZ regime can be used to defer gain on the sale of any property, including stock or other capital investments.  Further, under Code §1031, taxpayers must generally invest in replacement property of equal or greater value than the property sold, whereas under the QOZ rules, the taxpayer need only invest the amount of the gain.  Also, the rules for the two statutes are different – with a qualifying Code §1031 like-kind exchange, all of the gain is deferred until the replacement property is sold, whereas with QOZ property, a portion of the initial gain is deferred, and the taxpayer may achieve a permanent elimination of any gain in the QOF if the investment is held for 10 years.  It is possible that a taxpayer with a failed Code §1031 exchange who is approaching the 180 day time limit could find it easier to invest in a QOF as an alternative.

 

Website address for opportunity zone list and map in NY & NJ

https://esd.ny.gov/opportunity-zones

https://www.state.nj.us/dca/divisions/lps/opp_zones.html

There have been sweeping changes to both the federal and New Jersey tax laws for the first half of 2018.  At the federal level, the elimination of the state and local tax (SALT) deduction, which for decades allowed people to itemize and deduct state and local income and property taxes from their federal bill is now being capped at $10,000.

It has been widely publicized that residents of states with high SALT such as New York and New Jersey will pay much more in overall taxes than those residents of states with no income and/or low property taxes. Northeast states attempting to counteract the impact of recent federal tax laws by forming associations to sue Washington or disguising property taxes as charitable contributions are seemingly ineffective solutions.  To compound the impact of the SALT limitation, New Jersey has recently increased its highest marginal rate to 10.75% for those families with income in excess of $5 million, enacted laws to impose a surtax on carried interests and increased corporate business tax rates.  For more details concerning New Jersey recent tax law changes, see our previous blog post here.

As the 2019 tax season gets underway, high net worth residents of New Jersey and New York will find significant increases in their annual state tax bills. Accountants should be the first to anticipate client questions as to whether a change in residency to states such as Florida could alleviate this increased state tax burden and to what extent state tax savings can be achieved while continuing to own a residence in New Jersey or New York.

The short answer is yes. A well counseled client who becomes a permanent resident of Florida can spend significant time in New Jersey and/or New York and maintain a residence here, but successfully avoid state taxes on non-New Jersey and New York source income. On the other hand, snowbirds, spending three to five months in Florida and the balance of their time in New Jersey / New York face serious exposure, including an audit resulting in an additional assessment of tax, interest and penalties by filing a non-resident return or no state tax return without meeting the statutory requirements for non-residency status.

There are many considerations in changing permanent residence from New York or New Jersey to a tax friendly state such as Florida in an effort to escape the harsh effects of these new tax laws. Aside from feasibility issues — such as whether telecommuting is a viable option and whether children and spouses are amenable to relocating — there needs to be a thorough tax analysis before making that decision to relocate as to whether: (i) changing residence will necessarily reduce state income tax (i.e., is the income sourced in New Jersey or New York); and (ii) if so, to maximize the level of preparedness in anticipation for what will likely be a residency audit from the New York and/or New Jersey tax authorities.

New York has one of the most sophisticated residency audit programs in the country.  New Jersey is also expected to ramp up its program in light of the most recent changes to its tax laws.  The purpose of a residency audit is to determine whether you correctly filed your non-resident or part-year resident income tax return or if no return is filed in the years immediately following a move outside of the state.  The likelihood of a residency audit is particularly high during the first year in which an individual files a non-resident tax return or no return at all.

Once audited, in making the determination of whether an individual is resident of New York or New Jersey, the auditor will first determine whether an individual is domiciled in New York or New Jersey.

If the auditor is persuaded a taxpayer has successfully changed his or her domicile from New York or New Jersey to a different state, that person can still be taxed as a “statutory resident” if he or she maintains living quarters in New York or New Jersey for substantially all of the year and spends more than 183 days in that state.

In a residency audit, the auditor will request EZ-Pass records, cell phone records, calendars, credit card and bank account statements along with travel records.

In addition, the auditor may also request utility bills, vehicle registration and voting registration in an effort to determine how strong your ties are to a specific location and whether you sufficiently abandoned your former domicile.

More intrusive steps may be taken when the auditor is not satisfied with the information that he or she has received and can even subpoena your records from third parties or depose you and/or your family members. If it is determined that you are a resident of a New York or New Jersey and you did not properly file a resident return, in addition to an assessment of unpaid tax, there can be substantial penalties and interest.  For example, in New York, the penalty for late filing is 5% of the tax due for each month (or part of a month) that the return is late, up to a maximum of 25%.  And the penalty for late payment is 0.5% of the unpaid amount for each month (or part of a month) it is not paid, up to a maximum of 25%.  New Jersey also imposes similar penalties for failure to file and failure to pay tax along with interest charges.

If you are a resident of New York or New Jersey and you are considering changing your residency (whether tax motivated or otherwise), it is important that you seek the advice of an experienced SALT counsel to fully understand the potential benefits, feasibility and most importantly, how to effectively prepare for what will likely be a residency audit twelve to eighteen months after you file a New York or New Jersey non-resident return or no state tax return.

This past weekend, as part of passing New Jersey’s 2019 budget, Governor Murphy signed into law a series of changes to the state tax laws. These changes have will have a disproportionate effect on the state’s highest earners and corporations. These affected taxpayers will undoubtedly look for alternative structures to mitigate the impact of the new laws.

This relatively small group of high earners pegged to contribute to this spending plan is still reeling from the stunning blow delivered to New Jersey residents by Congress through the virtual elimination of the SALT deduction. The only question that remains is how many members of that group will seek refuge to states that do not levy a personal income tax and have much lower property and franchise taxes.

How these aggressive tax policies will attract new corporations and high net worth persons to New Jersey is also of significant concern for the state’s long-term fiscal growth and prosperity.

Below is a list of changes to the Gross Income Tax, Sales Tax, Corporate Business Tax and a new Tax Amnesty Program that are intended to increase revenue to pay for the state’s new spending plan.

Gross Income Tax

  • Top income tax bracket of 10.75 percent for income exceeding $5 million.
  • Employers that are subject to the state’s income tax withholding requirements to withhold 15.6 percent on salaries and wages in excess of $5 million for tax year 2018.
  • Eliminates an exclusion from New Jersey source income (for nonresidents) for carried interest/income from providing investment management services and imposes a 17 percent surtax on such management income for Gross Income Tax and Corporation Business Tax purposes.
  • Eliminates tax exemption provided to pass-through entities receiving and selling Grow New Jersey credits.

Sales Tax

  • Sales tax nexus of: $100,000 in taxable sales or 200 or more separate transactions.
  • Sales tax collection and reporting requirements on a “marketplace facilitator,” which is defined to mean any person or business that provides a forum to a retailer to advertise, promote and list the retailer’s products and that also collects receipts from the customer and remits payment to the retailer.

Corporation Business Tax (CBT)

  • For corporations with allocated net income of more than $1 million annually other than public utilities, the new law imposes a surtax of 2.5% for tax years beginning on or after January 1, 2018 through December 31, 2019 and 1.5% for tax years beginning on or after January 1, 2020 through December 31, 2021.
  • For tax years beginning after December 31, 2016, the 100% dividends-received-deduction (“DRD”) for dividends paid to the taxpayer by one or more subsidiaries owned by the taxpayer (if more than 80% ownership defined by voting power) is reduced to 95 percent for 80 percent-owned subsidiaries.
  • The law also only allows a deduction for interest paid to a foreign related member if the related member is in a foreign country with a comprehensive US tax treaty in place and is subject to tax in the foreign country at an effective rate within three percentage points of the New Jersey rate.
  • The law changes the sourcing rules for certain service providers that operate in and out of New Jersey. Under the new law, the service is sourced to the location where the benefit is received and not where the service is performed. If the benefit is received in more than one state, reasonable approximation may be used. For individuals, the default sourcing rule is the customer’s billing address; for others it could be the location from where the services are ordered in the customer’s regular course of operations or the billing address if the location from where the order was made is unavailable.
  • No deduction is allowed for the deduction under IRC Section 965. This section requires a taxpayer to be taxed on a deemed dividend for deferred foreign income and provides for a deduction to achieve the lower repatriation tax rate. This deduction will not be relevant to the calculation of CBT. Likewise, the deduction provided in new IRC Section 199A, which acts to minimize income from flow-through entities, will have no effect on the CBT. Aside from clarifying the states’ position on these Federal changes, these will ensure that there is no reduction in revenue because of the new Federal tax laws.

Tax Amnesty

  • A 90-day tax amnesty period to run through no later than January 15, 2019.
  • Under the new amnesty program, any taxpayer with liabilities for returns due on or after February 1, 2009, can pay the tax, plus half the interest due as of November 1, 2018 and avoid any penalties with the exception of criminal and civil fraud penalties.

Many of our clients are evaluating the impact of the latest tax changes by asking their accountants to run individual and corporate projections to assess the impact for 2018, 2019 and beyond. Many are also contemplating taking up residence in lower tax jurisdictions such as Florida.

Our next blog post will detail the feasibility of achieving non-resident status (only paying tax on New Jersey source income) while maintaining a residence in New Jersey, but avoiding New Jersey tax on your worldwide income by becoming a permanent resident of Florida.