The Tax Cuts and Jobs Act (TCJA) created a new program that provides significant tax benefits to encourage investment, development, and redevelopment in low-income communities designated as qualified opportunity zones (“QO Zones”). The TCJA provides two significant tax benefits that provide taxpayers with an unprecedented opportunity to defer taxation of capital gains. First, taxpayers can defer recognition of capital gain for up to eight years if the gains are invested in a qualified opportunity fund (“QO Fund”) within 180 days. Second, taxpayers may permanently exclude post-acquisition gains on the investment in the QO Fund itself if it is held for at least 10 years. The new program is also expected to provide new opportunities for fund sponsors, managers, developers, innovation districts, urban and community planning organizations, local businesses, and other entities.
Many issues remain to be addressed regarding investments in, and operations of, QO Funds. On October 19, 2018, the Internal Revenue Service (IRS) released proposed regulations (REG-115420-18) and Revenue Ruling 2018-29 to address important issues relating to investments in QO Funds.
How Does the QO Zone Program Work?
To encourage investment in low-income communities, the program provides significant tax benefits to taxpayers who invest in QO Funds. Taxpayers have the opportunity to make two elections with respect to capital gains reinvested in a QO Fund. The first election allows the taxpayer to defer tax on gain from the sale of property that is reinvested in a QO Fund within 180 days of recognizing the gain, until the earlier of (i) the date on which the interest in the QO Fund is sold, or (ii) December 31, 2026. The deferred gain is preserved by giving the taxpayer a basis of zero in the QO Fund. If the interest in the QO Fund is held for 5 years, 10% of the deferred gain can be permanently excluded from income. If the investment is held for 7 years, 15% of the deferred gain is permanently excluded. The Code implements this permanent gain exclusion by increasing the taxpayer’s basis in the QO Fund by 10% of the deferred gain after 5 years and by an additional 5% of the original deferred gain after 7 years.
The second election allows a taxpayer to exclude any gain accruing after the acquisition of the equity interest in the QO Fund if the taxpayer holds the investment in the QO Fund for at least 10 years. This subsequent appreciation in the QO Fund is excluded by increasing the basis of the taxpayer’s investment in the QO Fund to the fair market value of such investment on the date the investment is sold.
This provision is much more liberal than other Sections of the Code that permit deferral of gain. The TCJA made like-kind exchanges available only for gains from real estate held for use in a trade or business, or for investment, and may require parking sales proceeds with a qualified intermediary or trustee. Deferral under Section 1202 applies only to qualified small-business stock. However, virtually any capital gain can be deferred through an investment in a QO fund, and proceeds need not be parked with a third party prior to investment in the QO Fund.
Taxpayers and the QO Zones themselves are not the only ones who will benefit from this new program. Fund sponsors, fund managers, developers, contractors, innovation districts, development agencies and organizations, and businesses organized in QO Zones will also benefit significantly from the new program, which will provide a ready source of investment capital and new opportunities. In addition, it may be possible for the benefits from capital being made available through the QO Zone program to be paired with other subsidies and benefits, such as tax credits, to enhance the financing available for developments and businesses in the community.
What Is a QO Fund?
A QO Fund is any investment vehicle that is organized as a corporation or partnership (including a limited liability company treated as a partnership for U. S. federal income tax purposes) for the purpose of investing in QO Zone property (other than another QO Fund) and that holds at least 90% of its assets in such property. QO Zone property includes any QO Zone stock (“QO Zone Stock”), QO Zone partnership interest (“QO Zone Partnership Interest"), or QO Zone business property (“QO Zone Business Property”).
An equity interest in a corporation or partnership will qualify as QO Zone Stock or a QO Zone Partnership Interest if it satisfies three requirements:
- it must have been acquired at original issuance solely in exchange for cash;
- at the time the stock or partnership interest was issued, the corporation or partnership was a qualified opportunity zone business (or, in the case of a new entity, was being organized for purposes of being a qualified opportunity zone business); and
- during substantially all of the QO Fund’s holding period for such stock or partnership interest, such corporation or partnership qualified as a qualified opportunity zone business (“QO Zone Business”).
Similarly, QO Zone Business Property is tangible property that satisfies several requirements. First, the property must be acquired by purchase. Second, the original use of the property in the QO Zone must have commenced with the QO Fund, or the QO Fund must have “substantially improved” the property. Third, substantially all of the use of such property must be in a QO Zone.
What Is a QO Zone?
A QO Zone is a designated population census tract that is home to a low-income community. A designation as a QO Zone remains in effect for 10 years. On June 20, 2018, the IRS released a complete list and map of the more than 8,700 QO Zones. Missouri has QO Zones in St. Louis, St. Louis County, Bolivar, Branson, Butler County, Cameron, Cape Girardeau, Columbia, Dallas County, Excelsior Springs, Hannibal, Independence, Jackson County, Jefferson City, Jennings, Joplin, Kansas City, Kennett, Kirksville, Laclede County, Lafayette County, Lebanon, Maryville, Mexico, Monett, Montgomery County, Neosho, New Madrid County, Newton County, Pemiscot County, Potosi, Pulaski County, Randolph County, Ripley County, Saline County, Sikeston, Springfield, St. Joseph, Sugar Creek, Sullivan County, Sunrise Beach, Warren County, Warrensburg, Warsaw, Wayne County, and West Plains.
What Is a QO Zone Business?
QO Zone Businesses, to which a QO Fund's QO Zone Stock and QO Zone Partnership Interests must be connected, are businesses that meet all of the following criteria:
- Substantially all of the tangible property owned or leased by the taxpayer must be QO Zone Business Property;
- At least 50 percent of the total gross income of the business is derived from the active conduct of such business;
- A substantial portion of the intangible property of such business is used in the active conduct of any such business;
- Less than 5 percent of the average of the aggregate unadjusted bases of the property of the business is attributable to nonqualified financial property (which generally includes debt, stock, partnership interests, options, futures contracts, forward contracts, warrants, notional principal contracts, annuities, and other similar property); and
- The business cannot be a private or commercial golf course, country club, massage parlor, hot tub facility, suntan facility, racetrack or other facility used for gambling, or any store whose principal business is the sale of alcoholic beverages for consumption off premises.
On October 19, 2018, the IRS released proposed regulations (REG-115420-18) and Revenue Ruling 2018-29 to address important issues relating to investments in QO Funds.
Revenue Ruling 2018-29
This Revenue Ruling provides guidance on what it means for a property to have been “substantially improved” by a QO Fund. As noted above, property qualifies as QO Zone Business Property (which would count toward the 90% test) only if, among other requirements, the original use of the property in the QO Zone commences with the QO Fund or the QO Fund substantially improves the property. A substantial improvement means that capital expenditures to improve the property during the 30 months after acquisition equal at least the QO Fund’s initial tax basis in the property. For purposes of this test, the tax basis attributable to the land is not considered in determining whether the property has been substantially improved, meaning that no improvement to the land is necessary as long as the building is substantially improved. For example, if a taxpayer purchases real estate for $300, $100 of which is allocated to the building and $200 of which is allocated to the land, a $100 investment into the building within 30 months of the purchase will count as substantially improving the property.
The Proposed Regulations
The proposed regulations clarify the following issues. These regulations are generally proposed to be effective when they are adopted as final regulations. Taxpayers may, however, rely on various sections of the proposed regulations until final regulations are issued if the taxpayers apply the rules in their entirety and in a consistent manner.
Eligible Taxpayers. The proposed regulations clarify that taxpayers eligible to elect deferral under Section 1400Z-2 are those that recognize capital gain for federal income tax purposes, including individuals, C corporations (including regulated investment companies (RICs) and real estate investment trusts (REITs)), partnerships, and certain other pass-through entities.
Gains Eligible for Deferral. Although Section 1400Z-2 does not address whether both ordinary and capital gains are eligible for deferral, the proposed regulations clarify that only capital gains are eligible for deferral. A gain is eligible for deferral if it (i) is treated as a capital gain for federal income tax purposes, (ii) would be recognized prior to January 1, 2027, and (iii) does not arise from a sale with a related party. Eligible gains, therefore, generally include capital gain from an actual or deemed sale or exchange, or any other gain that is required to be included in a taxpayer’s computation of capital gain. On the sale of a partnership interest, any gain that would be treated as ordinary under Section 751 (relating to inventory and unrealized receivables) would not be eligible for deferral.
Eligible Interest. The proposed regulations clarify that an investment in a QO Fund must be an equity interest. Examples of equity interests are preferred stock and a partnership interest with special allocations. In the case of a partnership, the proposed regulations also clarify that an increase in a partner’s share of partnership liabilities, which is treated as a contribution of money under Section 752, does not result in an equity investment in a QO Fund.
Additional Deferral. If (1) a taxpayer acquires an original interest in a QO Fund in connection with a gain deferral election, (2) a later sale or exchange of that interest triggers an inclusion of the deferred gain, and (3) the taxpayer makes a qualifying new investment in a QO Fund, then the proposed regulations provide that the taxpayer is eligible to make an election to continue to defer the inclusion of the previously deferred gain. Deferring an inclusion in this situation is permitted only if the taxpayer has disposed of the entire initial investment. The complete disposition is necessary because the Code expressly prohibits the making of a deferral election with respect to a sale if an election previously made with respect to the same sale remains in effect. The general rule requiring reinvestment of the gain into a QO Fund within 180 days determines when this second investment must be made to support the second deferral election.
Deferral for Pass-through Entities. The proposed regulations provide rules that permit a partnership to elect deferral and, to the extent that the partnership does not elect deferral, allow a partner to do so. A partnership may elect to defer all or a part of a capital gain to the extent it makes an eligible investment in a QO Fund. If the election is made, no part of the capital gain is included in a partner’s distributive share. If the partnership does not make a capital gain deferral election, the capital gain is included in the partners’ distributive share. Each partner then has the option to make an election to defer its share of capital gain so long as the gain satisfies the eligible gain requirements, including not arising from a sale or exchange with a related party. The partner’s deferral is potentially available to the extent the partner makes an eligible investment in a QO Fund.
The partner’s 180-day period to invest the capital gain typically begins on the last day of the partnership’s taxable year because that is the day the partner would be required to recognize the gain if not deferred. However, the proposed regulations provide an alternative for situations where prior to the end of the partnership’s tax year, the partner knows that the partnership is not going to defer the gain. In that case, the partner may choose to begin its own 180-day period on the same date as the partnership’s 180-day period, which is generally the date on which the partnership sells the property to generate capital gain. The proposed regulations state that rules analogous to the partnership deferral rules apply to an S corporation, a trust, or a decedent’s estate and to their shareholders or beneficiaries, as applicable.
Deferral Election. Taxpayers will make deferral elections on Form 8949, which must be attached to their federal income tax returns for the taxable year in which the gain would have been recognized if it had not been deferred. The second election for the basis in the QO Fund interest that has been held for at least 10 years to be increased to its fair market value on the date it is sold is preserved until December 31, 2047. The latest gain that could qualify for deferral would be recognized at the end of 2026, meaning that the last day of the 180-day period to invest such gain in a QO Fund would be in late June 2027. A deferred gain would then achieve a 10-year holding period in late June 2037.
QO Fund Self-certification. Taxpayers are expected to use new IRS Form 8996 to self-certify an entity as a QO Fund and for reporting as to whether at least 90% of the QO Fund’s assets are invested in QO Zone property. Form 8996 must be attached to the taxpayer’s federal income tax return. The self-certification process for QO Fund status makes establishing a QO Fund significantly simpler than organizing a small business investment company or new markets tax credit fund.
QO Zone Business Property. The Code grants a QO Fund a reasonable period of time to reinvest the return of capital from investments in QO Zone property. For example, if a QO Fund shortly before a testing date sells QO Zone property or receives an infusion of cash, that QO Fund would have a reasonable amount of time in which to bring itself into compliance with the 90% investment requirement. Further proposed regulations are expected to provide guidance on this.
Working Capital Safe Harbor. The proposed regulations also implement a working capital safe harbor, which provides that cash and other financial property (stock, bonds, partnership interests, etc.) count toward the 90% test for up to 31 months if (i) there is a written plan for the use of the cash and financial property for the acquisition, construction, or substantial improvement of tangible property in the opportunity zone, (ii) the working capital will be spent within 31 months, and (iii) the business substantially complies with the plan.
Many issues remain regarding Qualified Opportunity Zones. The IRS has announced that it will be releasing additional published guidance, including additional proposed regulations, in the near future.