Qualified opportunity funds were created as part of the Tax Cuts and Jobs Act (TCJA) signed into law in December 2017 to incentivize private investment in economically underperforming areas by providing tax benefits for investments through qualified opportunity funds (QOFs) that own property used in “opportunity zones” (QOZs). Investments in qualified opportunity funds can qualify for three principal tax benefits: (i) a temporary deferral of capital gains that are reinvested in a qualified opportunity fund within 180 days after the recognition of such gains (reinvested gain), (ii) an exclusion of up to 15% of such reinvested gain, and (iii) a permanent exclusion of all gain, other than reinvested gain, realized on an investment in a qualified opportunity fund that is held for a ten-year period. The U.S. Treasury Department has certified 150 QOZs in the State of Louisiana.
On April 17, 2019, the IRS issued additional proposed regulations with respect to QOZs and QOFs, addressing a number of concerns, including ten of the questions which had been presented in the wake of last October’s regulations. Under the new Internal Revenue Code section 1400Z-2 guidance has been issued in regards to gains that may be deferred as a result of a taxpayer’s investment in a qualified opportunity fund as well as special rules for an investment in a QOF held by a taxpayer for at least 10 years. These regulations provide much needed guidance on conducting a business in a QOZ, and they provide flexibility for QOFs that wish to purchase raw land, lease property to be used in their business, receive ongoing inflows of invested capital, or dispose of assets and reinvest the proceeds.
Here are the top 10 questions, in our opinion, with respect to QOF investment, answered by the IRS regulations proposed on April 17, 2019:
What is a “trade or business” for purposes of the opportunity zone incentive? The new guidance confirms that a QOF or Qualified Opportunity Zone Business (QOZB) is required to conduct a trade or business within the meaning of Internal Revenue Code Section 162. While ownership and operation, including leasing, of real property is considered active conduct of a trade or business, the new proposed regulations state that “merely entering into a triple-net lease with respect to real property owned by a taxpayer is not the active conduct of a trade or business.”
How do we decide when and how we can defer capital gains? The earlier round of proposed regulations allowed that gain from the sale of a Section 1231 asset (real or depreciable business property held for over one year) would be eligible for investment in QOFs because it is treated as capital gain. However, if a partnership sells such 1231 assets, whether capital gains are actually realized may not be known until year-end, as the gain to the partners must be netted against any capital losses from the sale of Section 1231 assets, making the 180-day post-sale window for investment of capital gains in QOFs problematic. The new proposed regulations provide that the 180-day window with respect to reinvestment in QOFs of the proceeds of the sale of such assets held in a business will begin on the last day of the tax year in which the asset is sold. For example, if a Section 1231 asset was sold on January 2, 2018, the 180-day window began December 31, 2018, and is open through June 30, 2019.
What is the definition of “substantially all” for purposes of qualified opportunity zone stock, partnership interest, and property? The new regulations provide the following clarification: for property to qualify as a Qualified Opportunity Zone Business Property (QOZBP), 90% of the use of the property must be in a QOZ for 90% of the QOF’s holding of that property. A QOZB must hold 70% of its property as QOZBP. If a QOF owns interest in a subsidiary business entity, that entity must meet the definition of a QOZB for 90% of the QOF’s holding of such interest.
Is raw land considered QOZBP? The regulations proposed in October of 2018 provided that, when land and a building are purchased together by a QOF or QOZB, the original-use requirement does not apply if the building is “substantially improved” (at a cost equal to or greater than the purchase price of the property) within a 30-month period following the purchase. Raw land acquisitions were not addressed. Under the new guidance, raw land does not need to be substantially improved to be considered QOZBP.
Can a QOF or QOZB lease property and have it meet the definition of QOZBP? The initial guidance provided that a QOF must purchase QOZBP, while a QOZB could either purchase or lease such property. Under the new guidance, both QOZBs and QOFs may either purchase or lease QOZBP. However, for leased property to qualify, the lease must be on “arms-length” terms, and must have been entered into after December 31, 2017. A lease is not required to satisfy the “original use” requirement, and substantial improvements need not be made to the lease.
What types of events will trigger deferred gain during an investor’s holding period in a QOF? Gain deferred due to reinvestment in a QOF is to be recognized on the earlier of December 31, 2026, or the date on which the QOF investment is sold or exchanged. Under the newly proposed regulations, deferred gain will be recognized when a taxpayer reduces his or her investment in the QOF, or when a portion of the investment is cashed out via a distribution of property with a fair market value above the taxpayer’s basis in the QOF.
Does an investor have to sell the equity interest in a QOF after ten years, or can the QOF sell its assets with the gain still being tax-free to the investor? One of the most favorable provisions of QOF investment is that, once an investor has held an interest in a QOF for ten years, any gain from the sale of such investment, provided the investment was made with previously deferred gain, can be excluded from the taxpayer’s income, and not be taxed as capital gains. The new proposed regulations provide that, for a QOF formed as an S-corporation or partnership which sells its assets, any partner or shareholder in the QOF can exclude capital gain allocated on the partner or shareholder’s K-1 resulting from the sale of QOZBP. However, if a QOF sells its assets before the ten-year investment period is reached, only capital gains resulting from the sale of QOZBP is excluded from the taxpayer/investor’s income for capital gains purposes.
What happens to an investor if a QOF sells some of its QOZBP during the ten-year holding period? Earlier proposed regulations did not address this with clarity. Under the new proposed regulations, a QOF will have 12 months to reinvest proceeds from the sale of QOZBP. If the proceeds are held in cash, cash equivalents or as debt instruments with an 18-month life (or less) until they are reinvested, they count toward the 90% rule, providing there is a business plan in place to reinvest those proceeds within the 18-month period.
How does an operating business pass the “more than 50% test?” Under the original proposed regulations, to qualify as a QOZB, at least 50% of business income had to be generated within the QOZ every year. However, the new proposed regulations provide that a business can qualify if at least 50% of the hours worked by employees and independent contractors are within the QOZ, or if at least 50%.of wages and payments are for services conducted within the QOZ. A business can also qualify if tangible property and management/operational functions performed in the QOZ generate at least 50% of the business’ gross income.
How does the “original use” test work if you purchase a yet-to-be completed building or a building that has been vacant for years? Generally speaking, property acquired within a QOZ must either have not been used within the QOZ before, or must be improved over a 30-month period. The improvements must equal or exceed the amount originally spent to acquire the property. Under the new proposed regulations, “original use” of tangible property begins when the property is placed into service for purposes of depreciation. If a property has been vacant for five years, the “original use” period starts over.
If you have any questions regarding investment in QOFs, and whether such an investment might be in your best interest, please click here to email me directly.
Until next Wednesday –