The Tax Cuts and Jobs Act (Tax Act), enacted in December 2017, offers new tax incentives for taxpayers that invest through special investment vehicles known as "qualified opportunity funds" (QOFs) in certain economically distressed areas across the United States that have been designated as Qualified Opportunity Zones (QOZs). These tax benefits are further detailed in the September edition of The Advisor. Despite the significant tax benefits offered under the QOZ legislation, many investors were hesitant to make investments into QOZs until additional guidance was issued. On October 19, 2018, the US Internal Revenue Service (IRS) issued proposed regulations (Regulations) for QOZs that provide much-needed guidance, although a number of significant open questions remain.
Overview of QOZ Legislation
Investments in QOFs generally provide the following three tax incentives:
- Temporary deferral of taxable gain from the disposition of property to the extent invested in a QOF within 180 days. The deferred gain must be recognized on the earlier of (1) the date the QOF investment is disposed of and (2) December 31, 2026.
- Elimination of 10 to15 percent of the deferred gain if the taxpayer holds the QOF investment for at least five to seven years.
- Permanent elimination of gain on any post-acquisition appreciation with respect to a QOF investment held by the taxpayer for at least 10 years.
A QOF must be organized as a partnership or corporation (as determined for US federal income tax purposes) for the purpose of investing in QOZ Property (defined below). At least 90 percent of the QOF's assets must consist of QOZ Property (the 90% Test). A QOF that fails the 90% Test may be subject to penalties.
QOZ Property includes (1) certain tangible property located in a QOZ (QOZ Business Property) and (2) certain equity interests in a corporation or partnership (QOZ Subsidiary).
QOZ Business Property is tangible property that satisfies the following requirements:
- The QOF acquires the property by purchase from an "unrelated" person after December 31, 2017.
- The QOF uses the property in a trade or business.
- Either the "original use" of the property in the QOZ commences with the QOF or the QOF "substantially improves the property" by spending on improvements, during any 30-month period beginning after the property's acquisition, an amount exceeding the property's adjusted tax basis at the beginning of such period.
- During "substantially all" of the QOF's holding period for the property, "substantially all" of the property's use is in a QOZ.
A QOZ Subsidiary is a corporation or partnership that satisfies the following requirements:
- The QOF acquires its equity interest in the corporation or partnership after December 31, 2017.
- The corporation or partnership is a "QOZ Business," i.e., "substantially all" the tangible property owned or leased by it is QOZ Business Property, at least 50 percent of its gross income is derived from the active conduct of a trade or business and less than five percent of the average of its properties' aggregate bases is attributable to certain "financial assets."
The Tax Act left open a number of important issues, making it difficult for taxpayers to take advantage of the tax incentives under the QOZ regime. After much urging from taxpayers and tax professionals for additional guidance, the IRS issued the Regulations to provide further clarity on certain of these issues. Although the Regulations are not effective until finalized, investors and QOFs generally are permitted to rely on the Regulations immediately, provided they apply the Regulations consistently and in their entirety. Below is an overview of the most significant points addressed by the Regulations.
Requirements at the Investor Level
- Eligible Gain. The Regulations clarify that only recognized gain treated as capital gain, rather than ordinary income, for US federal income tax purposes is eligible for tax benefits under the QOZ regime.
- Use of Leverage to Invest in a QOF. There are no tracing rules requiring a taxpayer electing to defer capital gain to use the same cash from the capital-gain transaction to fund the investment in a QOF. A taxpayer simply is required to invest cash in the QOF equal in amount to the amount of capital gain intended to be deferred. Accordingly, a taxpayer should be able to leverage all or part of its investment in a QOF.
- Eligible Investors. Any taxpayer that recognizes capital gain for US federal income tax purposes is eligible for the tax benefits under the QOZ regime. As such, a broad range of entities can utilize this regime, including C corporations, regulated investment companies, real estate investment trusts, partnerships, S corporations, trusts, and estates.
- QOZ Investments by Partnerships. Where a partnership recognizes capital gain from the disposition of property, the partnership itself may elect to defer the tax thereon by investing such gain in a QOF within 180 days of the disposition. To the extent the partnership does not make such an election, the capital gain will be allocated to the partners therein, and the partners themselves may be permitted to make deferral elections on a partner-by-partner basis. In the case of a deferral election made by a partner, the 180-day period during which the partner will be required to invest in a QOF generally will begin on the last day of the partnership's taxable year. Alternatively, a partner may choose to begin the 180-day period on the date of the disposition by the partnership, which may be advantageous if the partner intends to invest in a QOF before the last day of the partnership's taxable year.
- Rollover of Gain to Another QOF. If an investor makes an election to defer gain under the QOZ regime and later sells its interest in the QOF, thereby subjecting the investor to tax on the deferred gain, the investor may make a second election to defer the gain generated from the sale of its QOF interest to the extent the investor makes a new QOF investment. However, this rule applies only if the investor disposes of its entire initial investment in the original QOF.
- Basis Step-Up. Under the Tax Act, a taxpayer that holds a QOF investment for at least 10 years may be entitled to a basis step-up equal to the fair market value of the investment when the taxpayer disposes of the investment, thereby eliminating gain on any post-acquisition appreciation with respect to the QOF investment. However, the QOZ designations are set to expire in December 2028. This expiration date has caused some concern over whether a QOF investment that hits its 10-year holding period after December 2028 could qualify for the basis step-up. The Regulations clarify that the expiration of the QOZ designations will not prevent taxpayers from qualifying for the basis step-up, provided the taxpayer disposes of its QOF investment by December 31, 2047. A taxpayer that does not dispose of its QOF investment by then will lose its ability to step up its basis to the fair market value. The Regulations also clarify that, although the proposed basis step-up rules are effective only with respect to dispositions of QOF investments occurring after the IRS adopts the proposed rules as final regulations, taxpayers generally can rely on and apply, these rules (even if the final regulations do not incorporate them), provided the taxpayer's 180-day period for making its QOF investment begins before the final regulations' date of applicability.
Requirements at the QOF Level
- Self-Certification. QOFs will be required to file an IRS Form 8996 with the IRS on an annual basis to certify that they satisfy the applicable requirements.
- Effective Date of QOF Status. QOFs are permitted to identify, on the first IRS Form 8996 that they file with the IRS, which month they want their QOF status first to be effective.
- Existing Entities. The Regulations clarify that entities in existence prior to 2018 can qualify as QOFs. However, as noted above, a QOF must be organized "for the purpose of investing in QOZ Property," and 90 percent of a QOF's assets must consist of QOZ Property, which, as defined, includes only certain property acquired by a QOF after 2017. As such, it may be difficult, from a practical perspective, for an existing entity to satisfy all the technical requirements necessary to be treated as a QOF.
- 90% Test. As noted above, the 90% Test requires a QOF to ensure that at least 90 percent of its assets consist of QOZ Property in order to avoid penalties. This determination is made on an annual basis, by measuring the percentage of the QOF's QOZ Property at the end of each six-month period of the QOF's taxable year, and averaging these two amounts. The Regulations clarify that the 90% Test is based on the value of the QOF's assets, as provided in the QOF's "financial statements" (as defined for this purpose) or, if the QOF does not have "financial statements," the cost of the QOF's assets. The Regulations also clarify that the 90% Test does not apply to any portion of an entity's taxable year before its QOF status first is effective. An entity's testing dates for the taxable year in which it effects its QOF status will be either (1) the end of the six-month period after effecting its QOF status and the end of its taxable year (if the entity chooses any of the first six months in its taxable year to begin its QOF status) or (2) the end of its taxable year (if the entity chooses any of the last six months in its taxable year to begin its QOF status). For example, an entity with a calendar taxable year that chooses to begin its QOF status in April will have its first two testing dates on September 30 and December 31 of that year.
- QOZ Business Property. As mentioned above, QOZ Property includes certain tangible property that qualifies as QOZ Business Property. To qualify as QOZ Business Property, the "original use" of the property must commence with the QOF or the QOF must "substantially improve" the property (i.e., within any 30-month period after acquiring the property, the QOF must spend on improvements an amount exceeding the property's adjusted tax basis at the beginning of such period). The Regulations clarify the application of these rules in the context of a QOF's acquisition of an existing building and surrounding land. Under the Regulations, because the building is an existing building, its "original use" is not deemed to commence with the Fund and, therefore, the building must be substantially improved. The substantial improvement test will be measured based on the purchase price of, and improvements made to, the building alone. The QOF is not separately required to improve the surrounding land.
- QOZ Subsidiary. As mentioned above, QOZ Property includes equity interests in a QOZ Subsidiary that is a QOZ Business. An entity must satisfy three requirements to be a QOZ Business.
- First, less than five percent of the average of the aggregate unadjusted bases of the entity's property may be attributable to certain "financial assets," including stock and partnership interests, but excluding "reasonable" amounts of working capital. The Regulations provide a working capital safe harbor, pursuant to which working capital will be treated as "reasonable" if (1) the amount of working capital is designated in writing for the acquisition, construction and/or substantial improvement of tangible property in a QOZ; (2) there is a written schedule consistent with the ordinary start-up of a trade or business for the expenditure of such amount, and the schedule requires such amount to be spent within 31 months of the receipt thereof; and (3) such amount actually is used in a manner that is substantially consistent with the prior two requirements.
- Second, at least 50 percent of the entity's gross income must be derived from an active trade or business. The Regulations provide a safe harbor for income derived from reasonable working capital.
- Third, "substantially all" of the tangible property owned or leased by the QOZ Subsidiary must be QOZ Business Property. The Regulations provide a safe harbor for tangible property constructed via the expenditure of reasonable working capital amounts.
Note that a similar working capital safe harbor does not apply to a QOF that intends to own QOZ Business Property directly, rather than through a QOZ Subsidiary. Accordingly, the foregoing working capital safe harbor likely will incentivize QOFs to operate through QOZ Subsidiaries.
- "Substantially All" Requirement. The QOF requirements reference the term "substantially all" in several contexts. For example, to qualify as a QOZ Business, "substantially all" of the tangible property owned or leased by a QOZ Subsidiary must constitute QOZ Business Property. The Regulations clarify that the term "substantially all" means 70 percent for this specific purpose. However, the Regulations reserved on the term's meaning in other QOF contexts.
A number of significant open questions remain. For example, there is uncertainty regarding (1) whether, and to what extent, any failures by a QOF to satisfy its applicable requirements will lead to a decertification of the QOF's status; (2) the interplay between the QOF rules and the partnership income tax rules, particularly whether future guidance will allow the tax benefits under the QOZ regime to be triggered by a QOF's sale of its underlying QOZ Properties, rather than solely by an investor's sale of its QOF interest; and (3) whether states will adopt the QOZ regime for state-income-tax purposes.
Notwithstanding these open questions, the Regulations provide helpful guidance for making QOFs an attractive investment vehicle for investors and sponsors alike. Further guidance, including final regulations, should be forthcoming. We will, of course, keep our clients apprised of relevant developments as they emerge.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.