Included in the 2017 tax reform law commonly known as the Tax Cuts and Jobs Act (TCJA) is a new and unique tax incentive program for investments in low-income communities. Unlike previous similar programs that restricted investment uses and capped the amount of the tax benefit, the new Qualified Opportunity Zone (QOZ) program provides unlimited tax benefits applicable to a much broader base of investments, and the number of targeted areas eligible for investments is also much greater. The TCJA legislation that created the QOZ program is rife with ambiguities, however, so taxpayers will need additional guidance to understand the full extent of the program's advantages.
Overview of QOZ Program
The primary benefit of the QOZ program is that taxpayers can defer tax on capital gains realized on the sale of virtually any kind of existing investment, so long as the gain portion of the sales proceeds is re-invested into a qualifying investment. The length of this gain deferral can last as long as the taxpayer holds the qualifying investment, but no longer than Dec. 31, 2026 (still a very generous deferral period). Further, taxpayers are eligible to receive two increments of additional basis in a qualifying investment simply by satisfying longer holding periods for the qualifying investment (we refer to this as basis bonus), which have the effect of permanently excluding from tax a portion of the original gain from the existing investment. And better yet, post-acquisition gains on a qualifying investments are eligible for total and complete exclusion from tax if a longer holding period in the qualifying investment is satisfied. However, the rules and time periods set up under the statute, likely for budgetary reasons, appear to make the practical availability of the post-acquisition gain exclusion and the basis bonus quite limited.
Before discussing the deferral period, it is important to layout the ground rules for what types of transactions are eligible for this tax benefit. To be eligible, the taxpayer must invest proceeds attributable to capital gains from the sale or exchange (to an unrelated person) of virtually any existing investment into a Qualified Opportunity Fund (QO Fund) within 180 days of the sale or exchange of the existing investment. A QO Fund is a corporation or partnership organized to invest in QOZ property. There is no minimum investment required into a QO Fund. As stated, generally the capital gain on any type of existing investment is eligible for deferral; however, the TCJA's legislative history indicates that the special benefits are available only for gains on the sale of non-zone assets (the final law does not say this). Assuming the legislative history applies to determine the final law, this still leaves capital gains realized on almost all forms of investments (such as publicly traded stock) as eligible for the special QOZ benefits.
A QO Fund must invest at least 90 percent of its funds in QOZ property. QOZ property is QOZ stock, a QOZ partnership interest, or a direct investment in trade or business property (TOB property) of a QOZ Business. In the case of a QOZ stock or partnership interest, the corporation or partnership interest must be newly issued and acquired by the QO Fund solely for cash, and the corporation or partnership that issued the interest must operate a QOZ Business.
To qualify as a QOZ Business, substantially all of the entity's tangible property must be TOB property purchased after Dec. 31, 2017. The original use of the TOB property must commence with the QO Fund or the underlying QOZ Business in the QO Zone. As an alternative to the original use requirement, the QO Fund or the underlying QOZ Business must substantially improve (capital expenditures exceeding the original purchase basis during a 30-month period) the property, and substantially all of the use of the property is in a QOZ. Additionally, a QOZ Business must have a minimum of 50 percent of its gross income derived from the active conduct of a trade or business in the QOZ. Other provisions also apply to determine a QOZ Business.
However, a QOZ Business cannot engage in a "sin" business — any private or commercial golf course, country club, massage parlor, hot tub facility, suntan facility, racetrack or other facility used for gambling, or any liquor store (not including restaurants that serve alcohol or bars).
QOZs are low-income census tracts nominated by the Governor or Chief Executive of each state including Washington D.C., and must be certified by the Treasury Secretary. Low-income tracts in Puerto Rico are automatically certified as of the date the TCJA was enacted. There are also limits on the number of tracts that can be certified. The nomination process has ended and the IRS is in the process of announcing the qualifying tracts. A map and list of all currently designated QOZ areas is available online and is updated as the IRS announces additional qualifying tracts.
Holding Periods for Deferral and Exclusion
As mentioned previously, there are various holding periods that entitle a taxpayer to the QOZ program benefits. The capital gain deferral on proceeds invested into a QO Fund from an existing investment ends on the earlier of the date that the taxpayer's investment in the QO Fund is sold or Dec. 31, 2026. For the gain deferral benefit, there is no required holding period per se. The first tranche of the basis bonus is available if the taxpayer holds the QO Fund investment for at least five years, in which case the basis bonus is equal to 10 percent of the original gain deferred. This means that only 90 percent of the deferred gain invested in a QO Fund that is held for at least five years would be subject to tax. The second tranche of the basis bonus is available if the taxpayer holds the QO Fund investment for at least seven years, in which case the basis bonus is equal to an additional five percent. This leaves only 85 percent of the original deferred gain as ultimately taxable. Remember also that gain reportable due to the Dec. 31, 2026 deadline may not have a liquidation or cash infusion event that would allow the entity to distribute cash sufficient to pay the tax on those gains.
Recall that taxpayers also are eligible to receive total gain exclusion with respect to post-acquisition gains in the QO Fund. The post-acquisition gain exclusion is available for QO Fund investments that satisfy a 10 year holding period. Once the QO Fund investment has been held for 10 years, the taxpayer can elect, upon sale of the investment, to have a basis in the QO Fund investment equal to its FMV. This results in no gain on the sale, other than any gain recognized on Dec. 31, 2026 with respect to the original gain deferral on the existing investment.
The length of these holding periods is problematic with respect to the temporary nature of the QOZ program, however. Under the TCJA, the QOZ areas will lose their designations after Dec. 31, 2028. It is therefore uncertain whether a taxpayer is entitled to the post-acquisition gain exclusion after this date, and because there is a 10 year holding period required, the latest date a QO Fund investment could be made is Dec. 31, 2018 to be entitled to the post-acquisition gain exclusion. This does not leave much time to make an investment that would be entitled to the post-acquisition gain exclusion, unless the IRS announces (or Congress enacts through additional legislation) guidance to clarify that this benefit will be available after Dec. 31, 2028. Separately, the basis bonus rules stipulate five- and seven-year holding periods. Because the basis bonus applies to the original deferral gain from the existing investment, and because this deferred gain must otherwise be recognized by Dec. 31, 2026, the last date to make a QO Fund investment that is eligible for a basis bonus is Dec. 31, 2021 (for the five-year holding period) or Dec. 31, 2019 (for the seven-year holding period).
The QOZ deferral rules provide new opportunities for the deferral or exclusion of gain on investments. However, the system is structured currently to reward those who invest early. A taxpayer who invests in a QO Fund on or before Dec. 31, 2018 who holds the investment for 10 years can exclude 15 percent of the pre-acquisition gain, defer 85 percent of the pre-acquisition gain until Dec. 31, 2026, and exclude all of the post-acquisition gain after the investment date. Lesser benefits are available for investments in QO Funds made after Dec. 31, 2018, and it is uncertain whether any benefit will be available for QO Fund investments made after Dec. 31, 2026. Still, the ability to defer pre-acquisition gain for investments rolled into QO Funds provides a powerful new incentive to taxpayers. For more information about the new QOZ program and its benefits, please contact your local CBIZ MHM tax professional.
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