On Oct. 19, 2018, the U.S. Treasury Department and the Internal Revenue Service issued proposed regulations and other additional guidance regarding investing in Qualified Opportunity Funds (“QOFs”), a significant, new tax incentive program created by the 2017 Tax Cuts and Jobs Act. This program encourages investments in economically distressed and lower-income communities designated as Qualified Opportunity Zones (“QOZs”). Over 8,700 communities in all 50 states, the District of Columbia and five U.S. territories have been designated as QOZs.
In general, taxpayers may elect to defer the recognition of capital gain up to the amount of any capital gain invested in a QOF (the “QOF Investment”), provided that the amount of such capital gain is invested during the 180-day period beginning on the date such capital gain would have been recognized by the taxpayer. Specifically, the potential tax incentives include the following:
- Deferral of Initial Capital Gain. First, the taxpayer may elect to defer tax on the gain until the earlier of (a) the date the QOF Investment is sold or exchanged or (b) Dec. 31, 2026.
- Basis Step-Up in QOF Investment and Deferred Gain Recognition Reduction for QOF Investment’s Held for at Least Five or Seven Years. Second, if the taxpayer holds the QOF Investment for at least five years, the basis of such QOF Investment is increased by 10% of the original amount of the capital gain that has been deferred by investing in the QOF Investment, thereby reducing the amount of the deferred gain that the taxpayer is required to recognize and include in income by 10%. If the taxpayer holds the QOF Investment for at least seven years, the basis of such QOF Investment is increased by 15% of the original amount of such deferred gain, thereby reducing the amount of the deferred gain that the taxpayer is required to recognize and include in income by 15%.
- Special Tax Elimination Rule for QOF Investment’s Held for at Least 10 Years. Third, if the QOF Investment is held by the taxpayer for at least 10 years, the basis of such QOF Investment is increased to the fair market value of such QOF Investment on the date the QOF Investment is sold or exchanged, and the taxpayer is not required to recognize any gain.
To qualify for these tax incentives, the QOF must be a corporation or partnership organized for the purpose of investing (directly or indirectly) in “QOZ property” (other than another QOF) and at least 90 percent of the assets of which are QOZ property. “QOZ property” means property which is (i) QOZ stock; (ii) QOZ partnership interest, or (iii) QOZ business property. In general, a “QOZ business” is a certain trade or business in which substantially all of the tangible property owned or leased by the taxpayer is “QOZ business property.” “QOZ business property” means tangible property used in a trade or business of the QOF if (i) such property was acquired by the QOF by purchase after Dec. 31, 2017; (ii) the original use of such property in the QOZ commences with the QOF or the QOF substantially improves the property; and (iii) during substantially all of the QOF’s holding period for such property, substantially all of the use of such property was in a QOZ. Property is treated as “substantially improved” by the QOF only if, during any 30-month period beginning after the date of acquisition of such property, additions to basis with respect to such property owned by the QOF fund exceed an amount equal to the adjusted basis of such property at the beginning of such 30-month period owned by the QOF.
The proposed regulations provide clarity regarding a number of items including the type and timing of transactions that would qualify for the beneficial tax treatment provided for investments in QOFs. For example, some of the key issues addressed include the following:
- QOF Investments. The proposed regulations clarify that to qualify as an eligible interest in a QOF an investment in the QOF must be an equity interest in the QOF, including common stock, preferred stock or a partnership interest. Thus, an eligible interest cannot be a debt instrument within the meaning of Section 1275(a)(1) of the Internal Revenue Code of 1986, as amended (the “Code”).
- Eligible Taxpayers. The proposed regulations also clarify which taxpayers are eligible to defer the recognition of capital gain through an investment in a QOF and describe how different types of taxpayers may satisfy the requirement for electing to defer capital gain consistent with IRS rules. Eligible taxpayers include individuals, partnerships, certain pass-through entities and C corporations.
- Eligible Gains. The proposed regulations specify that only capital gains recognized no later than Dec. 31, 2026 are eligible for deferral. Accordingly, gain from the sale of business property (other than recapture, i.e., income related to prior depreciation deductions) and unrecaptured Code Section 1250 gain (i.e., gain on the sale of real estate that is taxed at a 25% rate for individuals) are eligible for QOZ deferral. In the case of a partnership, the rules allow either the partnership or its partners to elect deferral. Similar rules apply to certain other pass-through entities such as S corporations and their shareholders and estates and trusts and their beneficiaries.
- “Substantially All.” The proposed regulations also provide that if at least 70 percent of the tangible property owned or leased by a trade or business is QOZ business property, the requirement that “substantially all” of such tangible business property is QOZ business property is treated as satisfied if certain other requirements are met. Also, if the tangible property is a building, the proposed regulations provide that “substantial improvement” is measured based only on the portion of the purchase price attributable to the building (not attributable to the underlying land).
Although the regulations and guidance are only in proposed form and a number of questions remain unanswered, they still may be relied upon while awaiting final regulations if the rules are applied in their entirety and in a consistent manner.