The 2017 tax reform law referred to as the Tax Cuts and Jobs Act (TCJA) created a unique opportunity for investors to both defer and avoid capital gain taxes. Taxpayers can now realize substantial tax savings by investing in Qualified Opportunity Funds (QOF), which are designed to attract new investment into designated low-income communities or Qualified Opportunity Zones (QOZs).
Taxpayers take advantage of the QOZ program by selling an investment generating capital gains and reinvesting any portion of the gains into a QOF or other qualified investment within 180 days of the initial sale. So long as the conditions of the program are met, taxpayers can take advantage of up to three distinct tax benefits. They can elect to temporarily defer the capital gains tax on the sale of the initial investment until the earlier of the date the QOZ investment is sold or Dec. 31, 2026. If the QOZ investment is held for at least five years, the basis in the reinvested property is increased by 10 percent of the capital gain that would have initially been realized. If the investment is held more than seven years, the basis in the reinvested property is increased by another 5 percent. This provision results in a 15 percent permanent exclusion of the originally deferred gain. Finally, if the QOZ investment is held at least 10 years, the taxpayer can elect to step up the basis on the QOZ investment to its fair market value on the date the investment is sold, thereby permanently avoiding any post-acquisition gain.
While details of the QOZ program as enacted lacked clarity, the IRS has recently released proposed regulations that provide some clarity to previously unanswered questions. The following is a brief overview of the key elements of the law and the newly proposed regulations.
Which Gains Can Be Deferred?
Any gain from a qualifying investment sale that is treated as capital gains for federal tax purposes can be deferred. This includes short-term and long-term gains, as well as any gain resulting from a Section 1231 sale of real estate used in a trade or business and unrecaptured Section 1250 gain.
Any gains treated as ordinary income, such as recaptured depreciation, or gains resulting from a sale to a related person do not qualify.
Who Can Invest in a QOF?
Any taxpayer who would otherwise owe capital gains tax on the sale or exchange of an investment is eligible for the program.
Partnerships should consider their QOF investment options carefully as they have two options for taking the capital gains deferral election: at the partnership level or at the individual partner level. Taking the deferral at the individual level gives taxpayers more time to make a qualifying investment into a QOF or directly into a qualifying QOZ property or business. The 180-day window for partnerships to make the election begins on the date of the sale or exchange. For partners, the first 180-day window runs concurrently with the partnership’s, and the second window begins on the last day of the taxable year the investment was sold.
How Is the Capital Gains Deferral Elected?
Taxpayers will file the Form 8949 with their federal income tax return to elect the capital gains deferral on the qualifying investment into a QOF.
Does All of the Gain of the Investment Need to Be Reinvested in the Same QOF?
Proceeds from the sale of an investment can be split among several different QOFs or direct investments and still qualify for capital gains deferrals and the other QOZ benefits, as long as the QOF or direct investments are made within the 180-day window from the original investment sale.
Does the Election of the Capital Gains Deferral Affect Whether the Gain Qualifies as Short-Term or Long-Term Capital Gains?
The tax attributes of the capital gains will be the same at the end of the deferral period as they were when the taxpayer made the deferral election.
What Are Eligible QOZ Investments?
90 percent of the investments of a QOF (operated as a partnership or corporation) must be in Qualified Opportunity Zone Property (QOZP). QOZP includes QOZ stock, QOZ partnership interests or QOZ business property (QOZBP). Debt investments are not eligible for the QOZ Program. In the proposed regulations, the IRS clarifies that investments in QOFs must be equity interests and that capital structures that provide non-pro rata distributions are eligible investments.
QOZBP is any tangible property used in a trade or business acquired after 2017 that is substantially used in the QOZ or QOZ property that is substantially improved after acquisition.
The substantial improvement test is met if, during the 30-month period after the date of acquisition, additions to basis of the QOZ property equal or exceed the adjusted basis of the property at the beginning of the 30-month period (often referred to as the “doubling down” requirement). This appears to allow the QOF to use depreciated basis when calculating the doubling down amount. The proposed regulations clarify that the basis of the land is not part of the reinvestment requirement. Left unanswered is the case where the investment is in raw land.
A QOZ business (QOZB) is a specifically defined term that varies depending on whether the QOZB is owned directly by an investor or QOF, or owned indirectly through a corporation or partnership investment of an investor or QOF.
In general, a QOZB is one where:
- Substantially all QOZBP is located in the QOZ (from 70 percent indirect to 90 percent direct ownership);
- At least 50 percent of the gross receipts are from the active conduct of the QOZB;
- A substantial portion of the intangible property is used in the active conduct of the QOZB;
- Less than 5 percent of the average unadjusted bases of property is attributable to nonqualified financial property; and
- The business does not include certain enterprises such as golf courses, country clubs and liquor stores.
At least one commentator has stated that the proposed regulations provide that items two to five above are limited or do not apply if the QOZB is directly owned; however, she indicates that was probably not the intended result. Regarding item two, it is very important to recognize that a QOZB selling outside of the QOZ will receive non-qualifying gross receipts. This provision skews the type of QOZBs toward smaller businesses selling locally within the QOZ and real estate. This rule puts a limitation on investment in job-producing businesses with significant sales outside the QOZ.
Nonqualified financial property includes cash, cash equivalents and certain debt instruments. The proposed regulations provide a working capital safe harbor to accommodate cash to be invested in or run the QOZB. As long as the QOZB has a written plan that identifies cash being held for a project and there is a written schedule for the use of that cash and the business substantially complies with that plan and schedule, the committed cash will be considered reasonable working capital for up to 31 months.
In addition to the federal tax rules for qualifying investments, direct investors or investment funds for multiple investors should seek advice on opportunities and restrictions on businesses, real properties and public/private partnerships (P3) under local government rules applicable in a QOZ.
Can Taxpayers Reinvest QOF Investments into Other QOFs and Still Qualify for the Capital Gains Deferral?
So long as the investment is made prior to Dec. 31, 2026, any investment proceeds from a QOF investment that are reinvested into another QOF will qualify for capital gains deferral.
How Does the Expiration Date of the QOZ Designation Affect the QOZ Program’s Tax Benefits?
So long as the investment in a QOF is made by June 29, 2027, the taxpayer can take advantage of the deferral of capital gains and step-up in basis. To take advantage of the post-acquisition capital gains exclusion, the taxpayer would need to hold the QOF investment until at least June 29, 2037 but no later than Dec. 31, 2047.
How Does an Entity Become a QOF?
Provided the program’s other requirements are met, the proposed regulations clarify that entities self-certify to become QOFs by filing the Form 8996 with their federal income tax return.
What Are a QOF’s Compliance Requirements?
The Form 8996 will be used to verify compliance with the requirement that 90 percent of the QOF’s investments are used to fund projects in QOZs. That requirement is calculated by measuring the percentage of QOZBP held in the fund at its taxable year’s six-month mark and last day of its taxable year, then taking the average of the two percentages. Entities failing to meet the 90 percent test will face monthly penalties.
Can LLCs and Pre-existing Entities Be Used for QOFs?
The proposed regulations clarify that an LLC taxed as a corporation or partnership can self-certify as a QOF with the Form 8996. A single-member LLC treated as a disregarded entity will not qualify, however.
Pre-established corporations can self-certify as QOFs so long as they did not acquire a significant amount of tangible property prior to Dec. 31, 2017.
A public hearing on the proposed regulations is scheduled for Jan. 10, 2019. The IRS is soliciting comments on all aspects of the proposals, including the definition of "original use" and "substantial improvement."
How to Apply QOZ Guidance
The proposed regulations provide guidance on how the IRS intends to apply the rules of the QOZ program. Taxpayers should note that the proposed regulations are not law until they are finalized; however, taxpayers may rely on the proposed regulations prior to finalization if they are relied upon in their entirety and in a consistent manner. For assistance in evaluating your QOZ opportunities, please contact us.