As part of the December 2017 Tax Cuts and Jobs Act, taxpayers can invest deferred gains from other activities into a fund (a “QOF”, or “Qualified Opportunity Fund”) targeted toward improving approximately 8,700 struggling “Opportunity Zones” nationwide, including many in Oakland, San Francisco, and rural parts of the East Bay. (Maps are available on U.S. Census website or otherwise. See http://dof.ca.gov/Forecasting/Demographics/opportunity_zones/ for California zones.)
A taxpayer must invest in a QOF within 180 days of selling an appreciated property, and the gain portion is deferred until December 31, 2026 or when the taxpayer sells their interest in the QOF asset, whichever is earlier.
Generally, the 180-day investment period begins on the day the gain would have been recognized for federal tax purposes. This can be advantageous for partnerships, since the partnership may choose to reinvest the gain at the partnership level, or partners may elect individually. If the partnership elects to defer the gain, then the 180-day period begins on the day the partnership would have recognized the original gain. However, if a partner makes the election, they can choose either to begin the investment period on the gain recognition date or, if more beneficial, the last day of the partnership’s tax year.
Funds should be placed in a discrete special purpose entity (e.g., an LLC) and not commingled with funds used for non-QOZ purposes, and 90% of a QOF’s assets must be QOZ property. Due to the various gain reductions allowed, if property is held long enough, the taxpayer may be subject to tax on as little as 85% of the deferred gain amount. Taxpayers are eventually subject to tax on the deferred capital gain in 2026 (subject to the reductions mentioned above), but any appreciation on the qualified opportunity fund investment held for 10 years or more is not taxable.
Proposed regulations were issued in October 2018 and invited public comment for a 60- day period. A discussion of those regulations and issues surrounding QOZ investments is beyond the scope of this website. Suffice it to say, QOF rules are complex and rapidly evolving. Taxpayers are cautioned to consult with their tax advisors to see whether this method of gain deferral could be right for them.
Another feature of the 2017 Tax Cuts and Jobs Act is the 20% non-corporate deduction on qualified business income. One requirement for the deduction is that the taxpayer operate a “trade or business.”
The IRS recently issued a proposed revenue procedure that provides for a safe harbor under which a qualifying rental real estate enterprise will be treated as a trade or business for purposes of claiming this 20% deduction for taxable years ending after December 31, 2017.
Rental real estate services for purposes of this revenue procedure include: (i) advertising real estate for rent or lease; (ii) negotiating and executing leases; (iii) verifying information contained in prospective tenant applications; (iv) collecting rent; (v) daily operation, maintenance, and repair of the property; (vi) management of the real estate; (vii) purchase of materials; and (viii) supervision of employees and independent contractors. These rental services may be performed by the owners themselves or by employees, agents, and/or independent contractors.
Note that commercial and residential real estate may not be part of the same enterprise, and to qualify for treatment as a trade or business under this safe harbor, the rental real estate enterprise must satisfy the following three requirements: (1) Separate books and records must be maintained to reflect income and expenses for each rental real estate enterprise; (2) at least 250 hours of rental real estate services must be performed each year; and (3) the enterprise must maintain contemporaneous records, including time reports, logs, or similar documents, regarding the rental real estate services performed.
As this “safe harbor” suggests, ownership and operation of triple-net properties (i.e., where the tenant pays all expenses and is responsible for its own management and maintenance of the property) will typically not qualify for the 20% deduction. Property owners should consider the tax implications of opting for triple let leases vs. more traditional gross or “industrial gross” leases.
Commercial landlords of “heath studio” have one less thing to worry about. Day v. Lupo Vine Street (22 Cal.App.5th 62) held that a commercial landlord who leases space to a “health studio” has no statutory or common law duty to maintain a defibrillator on the premises. While the California Health and Safety Code requires all “health studios” to maintain an automated external defibrillator on-site, a commercial landlord of this type of business does not fall within that definition.
But landlords should exercise caution when granting a purchase option in a lease. In Petrolink, Inc. v. Lantel Enterprises (21 Cal.App.5th 375), the court held that, once the tenant exercises its purchase option, the lease “ceases to exist” and instead, a binding contract of purchase and sale comes into existence between the parties, with the result that the former tenant’s obligation to pay rent under the lease also terminates(!), unless there is an express stipulation requiring continued rent payments after the tenant exercises the purchase option.
For lenders, MTC Financial, Inc. v. Nationstar Mortgage (19 Cal.App.5th 811) held that, when two deeds of trust are created and recorded concurrently, the recording numbers are not dispositive of which lien will have priority. Generally, the larger of the two (especially if it is for a mortgage vs. a home equity line of credit) will be presumed to have priority. Lenders should use caution (and give escrow officers specific instructions) about the order in which simultaneously-executed documents are to be recorded, and should consider including a statement of priority in bold-face letters in the instruments themselves.
And lenders making loans on condo or common-interest-development properties should be aware of Bear Creek Master Association v. So. Cal. Investors, Inc. (28 Cal.App.5th 809), which held that subsequently-recorded HOA assessment liens have priority over an already-recorded deed of trust where the recorded CC&R’s contain a subordination provision giving the lender notice of this claimed priority. Lenders would be well advised to make specific inquiry of the HOA about whether the borrower's assessment payments are current.
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