The qualified opportunity zone (QOZ) program was created as part of the 2017 tax reform package. It offers attractive tax benefits to investors who reinvest capital gains in eligible economically distressed communities. The vehicle for making these investments is known as qualified opportunity funds (QOFs). In the months following the passage of the legislation, many investors and fund managers were hesitant to participate in qualified opportunity funds because of uncertainty over the meaning of some of the terms and operational requirements. Since then, the IRS has issued two sets of proposed regulations — in October 2018 and April 2019 — that provide clarity on many of these issues.
Some questions remain unanswered and further guidance may be required, though the proposed regulations should give investors and managers the reassurance they need to move forward. Time is of the essence, however. To make the most of the qualified opportunity zone program, investments should be made before the end of this year.
Three Significant Incentives
Investors who recognize capital gains and reinvest them in qualified opportunity funds enjoy three important tax benefits:
- Deferral of tax on those gains until the earlier of December 31, 2026, or the date the QOF investment is sold or otherwise disposed of,
- Reduction of gains by 10% for QOF investments held for at least five years and 15% for investments held at least seven years, and
- Permanent exclusion from income of post-acquisition gains on QOF investments held at least 10 years.
To qualify, a QOF investment must be made within 180 days after the sale or exchange of property that generates the gain. (Special timing rules apply to partnerships and other entities that pass-through gains and other tax items to their owners.) Note that to achieve the maximum 15% reduction, you must invest in a QOF by the end of 2019 to satisfy the seven-year holding period by the end of 2026.
Requirements for Qualified Opportunity Funds
A QOF is an entity that:
- Is classified as a corporation or partnership for tax purposes (including LLCs, S corporations and real estate investment trusts),
- Is organized for the purpose of investing in QOZ Property, and
- Holds at least 90% of its assets in QOZ Property, based on the average percentage on two testing dates (June 30 and December 31, for calendar-year funds).
Qualified opportunity funds may invest in QOZ Property in two ways. The first method is directly, by acquiring QOZ Business Property — that is, tangible property used by the fund in a trade or business in a QOZ. Or the QOF may invest indirectly, by acquiring an equity interest in a QOZ Business that meets certain requirements.
Tangible property is QOZ Business Property if: it’s purchased by a QOF or QOZ Business after 2017; its “original use” in the QOZ commences with the QOF or QOZ Business (or, alternatively, it’s substantially improved within 30 months after acquisition); and “substantially all” of its use is in a QOZ during “substantially all” of the holding period.
An organization qualifies as a QOZ Business if, among other things, substantially all of the tangible property it owns or leases is QOZ Business Property. The organization also must derive at least 50% of its gross income from the active conduct of a trade or business in a QOZ. It cannot be involved in specified “sin” businesses, including golf courses, massage parlors, gambling facilities, and liquor stores.
Highlights of the Proposed Regulations
The IRS is expected to issue additional guidance, but the proposed regulations should help fund managers evaluate qualified opportunity funds investment requirements, in the meantime. Here are some of the highlights:
Trade or business includes leasing. Ownership and operation (including leasing) of real property constitutes active conduct of a trade or business. However, “merely entering into a triple-net lease with respect to real property owned by a taxpayer” doesn’t qualify.
“Substantially all” defined. The regulations provide some objective thresholds for the term “substantially all” in the qualified opportunity zone statute. For example, to qualify as QOZ Business Property, at least 70% of tangible property’s use must be in a QOZ during at least 90% of the QOF’s holding period. A business qualifies as a QOZ Business if at least 70% of its tangible property is QOZ Business Property.
Original use clarified. As noted above, one requirement for QOZ Business Property is that its “original use” in a QOZ begins with the QOF or QOZ Business (unless the property is substantially improved). Under the proposed regulations, original use begins when a person first places property in service in a QOZ for depreciation or amortization purposes or first uses it in a manner that would allow depreciation or amortization if that person were the owner. Used property can satisfy the original use requirement if:
- It’s never been used in the QOZ (for example, the purchaser moves it into the QOZ), or
- It’s been unused or vacant for an uninterrupted period of five years or more.
Relief from 90% asset test. Fund managers were concerned that an influx of new investments shortly before one of the testing dates would cause them to fail the 90% asset test, though the proposed regulations allow qualified opportunity funds to apply the test without regard to cash, cash equivalents or short-term debt instruments (those with a term of 18 months or less) received for the qualified opportunity fund’s equity within six months before a testing date and held continuously through that date. Also, a fund’s sale of QOZ Property won’t cause it to fail the 90% test as long as the proceeds are held as cash, cash equivalents, or short-term debt and are reinvested in QOZ Property within one year.
Gain exclusion expanded. Under the qualified opportunity zone statute, it appears that taxpayers may only exclude post-acquisition gain on QOF investments held at least 10 years when they sell or otherwise dispose of their investments. The proposed regulations expand the exclusion to include an investor’s gain arising from the fund’s sale of QOZ Property after the 10-year holding period. By allowing investors to exclude gain on the sale of fund assets, the proposed regulations open the door to multi-asset qualified opportunity funds. However, the exclusion doesn’t appear to be available for assets sold by a QOZ Business in which a QOF invests. Also, taxpayers may not rely on this provision until the regulations are finalized.
Carried interest is ineligible. Fund equity received for services, such as a carried interest, isn’t eligible for QOF tax benefits.
Watch for Further Developments
If you’re considering establishing a QOF, keep abreast of further regulatory developments. As a result of the COVID-19 pandemic, the IRS has released Notice 2021-10 which extends the deadlines for Qualified Opportunity Funds (QOFs) and investors. Learn about the tax relief provided by Notice 2021-10 to QOFs and their investors here.
In the meantime, your Untracht Early advisor can help you evaluate the potential benefits, risks, and costs of these qualified opportunity funds.