Real estate developers, institutional investors, local governments, and virtually anyone with capital gains could reap significant benefits under the Qualified Opportunity Zone (QOZ) program, which Congress created as part of its sweeping tax reform package two Decembers ago. The program is designed to promote development in economically distressed areas throughout the U.S. by providing tax incentives for investors. There are still important questions that remain about it, and with the IRS postponing its hearing this month on proposed regulations, those questions will linger further into this year.
However, there are already dozens of large funds that have pooled together money to be invested in the program. In addition, there is a deadline at the end of this year that investors will need to hit to receive the full tax benefits. That combination means those looking to make the most of the program need to be ready to move this year. And one thing is already certain: The way the investments are structured will have a major impact on the availability of tax benefits under the program.
Background on QOZ Program
Generally, the QOZ program provides investors a tax incentive by deferring capital gains tax on realized gains from a sale if the gains are invested in a Qualified Opportunity Fund within 180 days of the sale, as we discussed in a previous client alert on this topic. The Qualified Opportunity Fund in turn invests in businesses or property within a QOZ, helping to spur investment in economically distressed communities.
The tax deferral ends, and a recognition date occurs, upon the date the investor sells its Qualified Opportunity Fund investment or December 31, 2026, whichever is earlier. On the recognition date, the amount of recognized gain is equal to the excess of (a) the lesser of the amount of deferred gain or the fair market value of the investment at sale, over (b) the taxpayer’s basis in the Opportunity Fund.
Initially, the investor’s tax basis in the Opportunity Fund is deemed to be zero. If the Opportunity Fund investment is held for at least five years, the basis is increased to 10 percent of the deferred gain. And if the Opportunity Fund investment is held for at least seven years, the basis is increased to 15 percent of the deferred gain. If the Opportunity Fund investment is held past December 31, 2026, the investor will be deemed to realize the deferred capital gains as of December 31, 2026, and will pay capital gains tax on the amount of recognized gains as of that date (determined as described above, with basis adjustments if applicable). The basis is then adjusted to equal the amount of the original Opportunity Fund investment. For those reasons, December 31 of this year is a key date for investors looking to maximize their deferred gain.
In addition, if the investor holds the Opportunity Fund investment for at least 10 years, the basis is deemed to be the fair market value of the Opportunity Fund investment and no capital gains tax will apply to the appreciation on the Opportunity Fund investment.
Benefits Across Industries
Real estate developers will be interested in the program because it could help them raise funds for new or refurbished projects in the Qualified Opportunity Zones, which cover parts of all 50 states, the District of Columbia, and five American territories. (You can find a full list of the designated zones here.) State and local governments could benefit from the program for that same reason – it could be a new source of investment for areas that have been difficult to develop.
In addition, a broad variety of investors are interested in the program, as is evidenced by the size of the large funds that have already pooled resources. Furthermore, financial institutions are benefitting from putting those funds together and charging fees for their efforts. While there are benefits to using a fund that has already been established, investors should also consider structuring their own funds with the help of counsel to maximize their returns.
The Proposed Regulations
On October 19, 2018, the IRS issued proposed regulations for the QOZ program, along with a draft of the form that Qualified Opportunity Funds will use to self-certify qualification for the program.
Under the proposed regulations, the IRS clarified that all capital gains – meaning both short- and long-term capital gains and gains that would have otherwise been recognized by the taxpayer by December 31, 2026 – are eligible for deferral through the QOZ program. Additionally, the IRS clarified that the clock for the 180-day period for investing the gains in the Qualified Opportunity Fund begins for most taxpayers on the date on which the gain would be recognized for U.S. federal income tax purposes. For partnerships, the proposed regulations provide that the first day of the 180-day period begins on the date the partnership sells or exchanges the asset. But if the partnership does not reinvest its gains in a QOZ program, then an individual partner may reinvest his or her gains, and the 180-day period for the partner begins on the last day of the partnership’s tax year in which such sale or exchange occurs. Alternatively, the partner may elect for his or her 180-day period to begin on the same date as the partnership.
At the taxpayer’s year-end for a year in which it made an investment into a Qualified Opportunity Fund, the taxpayer must attach a Form 8949 to its federal income tax return to make a deferral election. The IRS clarified that while a taxpayer cannot make multiple elections to defer the same gain concurrently with an election still in place, a taxpayer may elect to defer varying portions of gain realized from the same sale or exchange into different Qualified Opportunity Funds, so long as each investment into a fund is made during the applicable 180-day period. Additionally, a taxpayer may choose to fully exit one Qualified Opportunity Fund and reinvest the full amount of the original deferred investment amount in a different Qualified Opportunity Fund. In those cases, the 180-day period restarts on the day the taxpayer exits the first fund.
The proposed regulations also clarified that the taxpayer’s investment into a Qualified Opportunity Fund must be through an equity interest, and this may include preferred stock and partnership interests with special allocations. The IRS excludes, however, an investment in a fund through a debt instrument from qualifying for deferral under the program. A taxpayer may use its equity interest in the Qualified Opportunity Fund as collateral for a loan without running afoul of the proposed regulations.
Qualified Opportunity Fund Requirements
The IRS clarified that the Qualified Opportunity Fund may be a corporation, partnership, or LLC that is taxed as a partnership. This means that a single member LLC cannot qualify as a Qualified Opportunity Fund. Additionally, the entity does not need to be created simultaneously with its election to be treated as a Qualified Opportunity Fund, as it may be a pre-existing entity. An eligible entity must attach the newly issued self-certification Form 8996 to its U.S. federal income tax return to initially qualify and then also attach Form 8996 annually, certifying compliance with the Qualified Opportunity Fund 90 percent asset rule, to continue to qualify as a Qualified Opportunity Fund.
The statute provides that at least 90 percent of a Qualified Opportunity Fund’s assets must consist of QOZ property, which includes QOZ business property and QOZ stock or QOZ partnership interests, if each subsidiary qualifies as a QOZ business. If the entity files a financial statement with a federal agency, such as the SEC, or if the entity has an audited financial statement prepared in accordance with U.S. GAAP, then the IRS will use the asset values as reported on the financial statement to determine if the 90 percent test is met. For the Qualified Opportunity Fund’s first taxable year, the IRS will measure whether the 90 percent test is met based on the average of (a) the assets held at the end of the first six-month period and (b) the assets held on the last day of the entity’s taxable year. The IRS imposes a penalty if the 90 percent test is not met.
The Qualified Opportunity Fund may invest directly into QOZ business property to satisfy the 90 percent asset test. The proposed regulations define QOZ business property as tangible property used in a trade or business of a Qualified Opportunity Fund, but only if:
- The property was acquired by purchase after December 31, 2017.
- The original use of the property in the QOZ coincides with the creation of the Qualified Opportunity Fund, or the fund substantially improves the property.
- During substantially all of the Qualified Opportunity Fund’s holding period for the property, substantially all of the use of the property was in a QOZ.
Alternatively, the Qualified Opportunity Fund may invest through an interest in a partnership or corporation, in which case each subsidiary must qualify as a QOZ business. If the subsidiary meets the definition of a QOZ business, then so long as the Qualified Opportunity Fund’s assets consist of at least 90 percent interest in these entities and/or QOZ business property, then the 90 percent test is satisfied.
The proposed regulations also provided clarity on what counts as a QOZ business. They define it as an entity in which:
- Substantially all of its tangible property, owned or leased, is Qualified Opportunity Zone business property.
- 50 percent or more of its gross income is derived from the active conduct of a trade or business.
- A substantial portion of any intangible property is used in the active conduct of a trade or business.
- Less than 5 percent of the average unadjusted basis of property is attributable to nonqualified financial property.
- The business does not operate a golf course, country club, massage parlor, hot tub facility, suntan facility, racetrack, gambling establishment, or a store that primarily sells alcohol for consumption off premises.
Under the proposed regulations, an entity must satisfy these requirements both (a) when the Qualified Opportunity Fund acquires its equity interest in the entity and (b) during substantially all of the Qualified Opportunity Fund’s holding period for that interest.
The proposed regulations provide significant clarity to the QOZ statute under the Tax Cuts and Jobs Act, however, many important questions remain unanswered. The IRS has provided that additional proposed regulations are to be issued in the near future. In regards to investor requirements, there are lingering questions regarding the 180-day period for investing in a Qualified Opportunity Fund and whether there will be any exceptions to the general rule. Additionally, it is unclear whether an investor may interject an additional entity between itself and the Qualified Opportunity Fund and still qualify for deferred tax treatment. The issue of what transactions trigger recognition of the deferred gain for an investor also remains outstanding.
In regards to the Qualified Opportunity Fund requirements, a fund can escape the penalty under the 90 percent test by showing “reasonable cause,” but currently there is no guidance on what constitutes reasonable cause. Another important issue outstanding is the tax treatment of any return on capital or proceeds from the sale of QOZ business property. Of significant concern is whether those items result in taxable income or roll into the investment as deferred items. The IRS has stated it intends to provide funds with a “reasonable period” of time to reinvest those amounts to avoid penalty under the 90 percent test.
In regards to the QOZ business property, there are many lingering questions regarding qualification under the statute and proposed regulations. To qualify, the property must be of original use by the fund or substantially improved by the fund. The IRS explained in a revenue ruling (2018-29) that due to the permanence of land it can never be of original use. That ruling also clarified that where there is a structure on the land, only the structure must be substantially improved. However, it remains unclear how the rules work with respect to the land.
Finally, the term “substantially all” is frequently used throughout the statute and the proposed regulations. The IRS provides in the proposed regulations that the term constitutes a 70 percent threshold solely for purposes of determining whether a QOZ business meets the requirement that substantially all of its tangible property is Qualified Opportunity Zone business property. The IRS has requested comment for how the term should be defined throughout the remaining instances in the statute and proposed regulations.
All facts and circumstances should be taken into consideration when structuring an investment in a QOZ. In addition to optimizing tax benefits under the QOZ program, a project may be structured to benefit from additional tax incentives such as the federal New Markets Tax Credit program. Counsel should be engaged who are familiar with these programs, who have a deep understanding of the complexities of corporate and partnership taxation, and who are experienced in establishing funds for investors, developers, and lenders.