The Qualified Opportunity Zone (QOZ) program was created on Jan. 1, 2018, as part of the tax reform law commonly known as the Tax Cuts and Jobs Act (TCJA).
The QOZ program offers tax incentives for investors to invest in economically underserved areas, or federally designated QOZs, through Qualified Opportunity Funds (QOF).
Individuals, business operators, real estate developers, syndicators, sponsors, and funds can all participate in the QOZ program. However, while there was excitement about the potential of this new legislation at the time it was passed, there was no guidance on how it would really work. In fact, we did not receive sufficient clarity for the market to get comfortable with launching a higher volume of QOFs—corporations or partnerships designed to invest in QOZ properties —until a second set of proposed regulations was released on April 17, 2019.
Subsequent to the new guidance issued, the market has seen a significant uptick in the creation of QOFs to raise capital for the launch of real estate projects and business operations.
Looking Ahead with a Focus on Compliance
From a market perspective, we will see the number of QOFs and underlying Qualified Opportunity Zone Businesses (QOZBs) continue to grow. Commercial real estate developers in particular may be looking to create their own QOFs to fund projects in QOZs because of their ongoing needs for capital for their development projects. Start-ups and other business operators may see the opportunity to grow and sell their business 10 plus years down the road for a tax free gain.
It’s important to remember that getting the QOF structure in place and its related business up and running is only the first step. Once established, QOF operators and the QOZBs that they invest in will need to maintain certain compliance requirements in order to take advantage of the tax benefits.
The QOZ program comes with a lot of regulations. Ongoing monitoring, reporting and risk mitigation will be essential. Every QOF and QOZB created in 2019 and after will likely need some combination of the following for 2020 and beyond.
- Asset testing: Regulations stipulate that at least 90% of a QOF must be invested in Qualified Opportunity Zone Business Property (QOZBP). Additionally, a QOZB must have at least 70% of its total assets qualify as QOZBP. If these parameters are not met, the fund could be subject to monthly penalties. Periodic asset-testing is required to ensure compliance at the QOF and QOZB levels.
- Monitoring: If a 10-year holding period is met, a gain exclusion on the sale of the QOF is available for investors. That said, there are a litany of actions QOFs, QOZBs and their investors can take that would qualify as the sale of the QOF investment prior to the 10-year required hold that would be taxable, or that could disqualify the fund as a QOF. In addition, monitoring newly created guidance and future case law will be important to the management of QOFs and QOZBs.
- Audits: Although financial statement audits are not required by the QOZ regulations, investors and lenders may require one. In addition, in a capital raise scenario, the QOF may include a financial statement audit requirement in their offering memorandum to make their investment more marketable.
- Tax return preparation: Each QOF and QOZB will have tax return requirements, and each QOF will need a self-certification that is filed with their tax return.
Compliance with the statute and regulations should be a key focus when it comes to QOFs and QOZBs, as one of the leading concerns in the industry is the complex regulatory guidance that has been published and the uncertainty of what is yet to come. Having a knowledgeable advisor by your side during the life of your QOFs and QOZBs will help you address the regulatory and compliance needs, maintain your qualification as a QOF, and preserve the tax incentives for your investors.
If you have any questions surrounding the guidance related to the QOZ program, please feel free to reach out to Sean Haggerty at firstname.lastname@example.org or by phone at 816-945-5570.
Sean Haggerty is a Director based in the Kansas City office.
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