As part of the tax reconciliation act of 2017, Congress enacted an incentive to spur economic development and job creation in designated distressed communities, or Qualified Opportunity Zones (QOZ).
While the new incentive has received significant interest, lack of Internal Revenue Code (IRC) guidance in the plain statute has made many investors and funds wary about investing in QOZs. However, proposed regulations issued on October 19, 2018, provide preliminary guidance that can help taxpayers start making educated investments in QOZs.
Though further IRS guidance is expected in the coming months, here’s a look at the proposed regulations and their potential tax benefits for investors.
A QOZ is a designated distressed community where certain investments, for the purpose of economic growth, receive preferential tax treatment. As of November 2018, there are over 8,500 QOZs in the United States, District of Columbia, Puerto Rico, and the US Virgin Islands. See IRS Notice 2018-48 for an official list of all QOZs.
An investor can make a special type of deferred gain investment in a Qualified Opportunity Fund (QOF) in exchange for equity interest. A QOF is an investment vehicle set up as either a corporation or partnership that purchases eligible property.
To qualify for deferred tax treatment, an investor must recognize gain from a transaction that’s reported as capital gain. Related party transactions aren’t eligible for deferral. The taxpayer must then invest all or a portion of the realized gain cash proceeds in a QOF within 180 days.
Opportunities for Investors
An investor in a QOF generally receives a deferral of gain until the earlier of a sale of the QOF investment or December 31, 2026. Upon investment in the QOF, the investor will look to gain one or more of the following benefits:
- Deferral of tax on reinvested gains until the earlier of sale of the QOF investment or December 31, 2026.
- Where the investment is held for at least five years, the tax basis is increased by 10% of the capital gains reinvested.
- Where the investment is held for at least seven years, the basis is increased by an additional 5% for a total of 15% of the capital gains invested. The increase to tax basis will reduce gain on disposition of the investment or upon automatic gain recognition on December 31, 2026.
- Where the investment is held for at least ten years, any appreciation upon sale of the QOF interest is permanently deferred.
On December 1, 2018, a taxpayer invests capital gains of $1,000 in a QOF and then sells the investment for $2,000 on December 31, 2030. Because the taxpayer held the investment for at least seven years, the taxpayer recognizes $850 in capital gains ($1,000 original gain less 15%, or $150) on December 31, 2026. When the taxpayer sells the investment on December 31, 2030, the $1,000 of appreciation occurring during the term of the investment is permanently excluded from income tax.
The Qualified Opportunity Fund
Any taxpayer—such as an individual, trust, C corporation, or partnership—that recognizes capital gains is eligible to elect a deferral under the opportunity zone rules. To qualify, a taxpayer must invest in a QOF that meets certain requirements.
- Certification. The corporation or partnership must be a certified QOF. This is a self-certification process during which the QOF files a Form 8996, currently a proposed form, with its tax return.
- The 90% test. At least 90% of the assets of the QOF must consist of QOZ property.
If the QOF meets the above requirements, the taxpayer can select deferral tax treatment by choosing the deferral election on Form 8949. Further instructions regarding how to make the election are forthcoming.
To be classified as a QOF, directly and indirectly held trades or businesses must meet a series of specific criteria.
For purposes of the 90% test, it’s important to distinguish between a QOF’s direct ownership in QOZ property and a QOF’s ownership in QOZ property though QOZ stock or partnership interests.
If a QOF directly operates a trade or business and doesn’t hold any equity in QOZ stock or partnership interests, at least 90% of the QOF's assets must be QOZ business property. QOZ business property is tangible property held by a QOF, purchased after December 31, 2017.
The original use of the property must begin with the QOF, or the QOF must substantially improve an existing property. Property is considered substantially improved if the improvements double the tax basis of the originally acquired property within a 30-month period. The tax basis only includes depreciable assets and doesn’t include land. During the QOF's holding period for the property, substantially all of the property must be used in the QOZ.
A QOF’s ownership in QOZ property can be indirectly held through an investment in QOZ stock or QOZ partnership interest (QOF second-tier entity). In this case, the QOF can satisfy the 90% test if the QOF second-tier entity qualifies as a QOZ business. A QOF second-tier entity can be either a partnership or a corporation.
The QOZ second-tier entity must be acquired by the QOF after December 31, 2017. The QOF second-tier entity must also be a QOZ business when its equity interests are issued, and it must remain a QOZ business during substantially all of the QOF's holding period.
To be considered a QOZ business, the current rule stipulates a QOF second-tier entity must meet the following requirements:
- Substantially all of the tangible property must be QOZ business property. As previously mentioned, QOZ business property is tangible property purchased after December 31, 2017, that’s substantially improved within a 30-month period.
- Less than 5% of the average unadjusted basis in property can be attributable to nonqualified financial property.
- At least 50% of the total gross income of the entity must be from the active conduct of a QOZ business.
- A substantial portion of the intangible property must be used in the active conduct of the QOZ business.
Additionally, the QOZ business must not be a private or commercial golf club, country club, massage parlor, hot tub or suntan facility, racetrack, gambling facility, or any store where principal business is sale of alcoholic beverages for off-premise consumption.
Proposed Regulations and Other Guidance
In October 2018, the IRS published proposed regulations and other administrative guidance to help clarify many uncertain aspects of investing in QOZs, including the following:
- The 90% testing dates
- Substantial improvements
- The substantially all test for QOF second-tier entities
- Safe harbor for QOF second-tier entities
- Reinvestment guidelines
- Capital gains
- Partner versus partnership deferral timing
Here’s a closer look at some of the additional guidance and an analysis of what this could mean for taxpayers investing in QOZs.
The 90% Test
As noted earlier, the 90% test requires at least 90% of a QOF’s assets consist of eligible QOZ property. Eligible QOZ property includes directly held QOZ business property, QOZ stock, and QOZ partnership interests.
The IRS’s regulations provide guidance on how to compute the 90% test for the first year of a QOF’s existence. A QOF can identify the taxable year in which it elects to become a QOF as well as the first month in that year to be treated as such. This is important for determining the beginning of the 90% asset testing dates. Note that only investments made in a QOF after the election will be considered qualified investments.
Issued contemporaneously with the proposed regulations, Revenue Ruling 2018-29 states that if QOZ property is acquired, substantial improvements need only be made to tangible property. The land value is excluded.
The Substantially All Test for QOF Second-Tier Entities
For purposes of the substantially all test for QOF second-tier entities, the proposed regulations define substantially all as 70%. In other words, for a second-tier entity, 70% of the tangible property must be QOZ business property. This is a significantly lower than the 90% test for direct investments in QOZ business property by QOFs.
Safe Harbor for QOF Second-Tier Entities
For purposes of the 5% financial assets test for QOF second-tier entities, the proposed regulations provide a safe harbor for QOF second-tier entities to allow these entities to hold cash in excess of the 5% limitation for up to 31 months if the cash is used as working capital.
To qualify for this exception, QOF second-tier entities must meet the following criteria:
- Have a written plan of capital deployment
- Present a schedule that demonstrates deployment within 31 months
- Deploy the capital within the demonstrated timeframe
A taxpayer may sell an interest in a QOF and reinvest in another QOF if the new investment occurs within 180 days of the inclusion-triggering disposition and the taxpayer has disposed of the entire initial investment. Special rules allow a deferring partner to decide if the 180-day period for capital asset dispositions in partnerships begins at the date of disposition or on the last day of the partnership’s tax year.
While not technically stated in the statute, the proposed regulations clarify that the QOZ rules apply to capital gains only. This includes short-term capital gains, Section 1231 gains and unrecaptured Section 1250 gains.
Partner Versus Partnership Deferral Timing
According to the regulations, a partnership may elect capital gain deferral. If the partnership doesn’t elect deferral, the proposed regulations allow a partner to do so, and the partner's 180-day period begins on the last day of the partnership's taxable year.
The IRS is expected to finalize the proposed regulations and issue additional regulations or other guidance that applies to opportunity zones. So far, it’s acknowledged the following ambiguities will be answered in future guidance:
- Substantially all. The phrase substantially all appears multiple times in this guidance, but it’s only defined for purposes of second-tier entities. Future regulations should define this term as it applies to other contexts.
- Deferred gain. There are ambiguities surrounding transactions that may trigger the inclusion of gain previously deferred.
- Reinvestment period. The reasonable period for a qualified opportunity fund to reinvest proceeds from the sale of qualifying assets is undefined.
- Investment standard. Administrative rules that apply when a qualified opportunity fund fails to maintain the required 90% investment standard need to be clarified.
- Reporting requirements. Additional clarification of information-reporting requirements is needed.
- Equity interests. Zero-basis issues need to be addressed in regard to equity interests in a partnership.
- Pre-existing entities. The proposed regulations clarify that there’s no prohibition to using a pre-existing entity as a QOF or a QOF second-tier entity if the pre-existing entity satisfies the existing requirements. However, pending future guidance or technical correction, it may be difficult for entities with existing property in a QOZ to qualify.
We’re Here to Help
There have been numerous inquiries on opportunity zones as investor interest in deferring capital gains increases. Enhanced awareness of qualified opportunity zones and exploring planning opportunities for capital gains can help investors fully benefit from the opportunities at hand.
The proposed regulations provide guidance that can help taxpayers start making educated investments in opportunity zones. However, further guidance is expected in the coming months.
To learn more about opportunity zones and gain access to developments as they unfold, contact your Moss Adams professional or visit our dedicated tax reform web page.