This alert focuses on a new incentive added to the tax code by the Tax Cuts and Jobs Act (TCJA), which applies to certain taxpayer gains reinvested in Qualified Opportunity Zones (each a QOZ). The purpose of this provision is to incentivize investments in low-income communities by allowing taxpayers to defer and exclude portions of these reinvested gains as well as to exclude, in certain cases, subsequent investment appreciation.
Highlights of the QOZ provisions include:
1. Deferral of certain gains invested in qualified QOZ investments until December 2026 (earlier if the QOZ investment is disposed of before December 2026);
2. Elimination of 10% of that deferred gain for holding periods of at least five years and 15% for holding periods of at least seven years;
3. Elimination of any gain on the appreciation (exclusive of the deferred gain) in the QOZ investment for holding periods of at least ten years.
Note that these tax benefits are available only for realized gains invested in a QOZ.
There are currently numerous uncertainties surrounding the QOZ provisions that have already limited the efficacy of the QOZ program. To read more about the open questions, click here for Part II. Clarifying regulatory guidance is authorized by statute and is expected in the near term.2
Since 1993, Congress has offered numerous incentives to invest in low-income or distressed communities, incentives ranging from credits, increased expensing, capital gains relief and tax-exempt financing. Opportunity zones are the latest incentive program, created by the TCJA and modeled on, and in some cases incorporating, several of its predecessors including the new markets tax credit program and empowerment zone and enterprise community programs.
At a basic level, the QOZ program offers three potential tax benefits:
Thus, at least 85% of the deferred gains rolled into the qualified QOZ investments will eventually be recognized, but there is potential substantial tax savings on the back end through the elimination of taxable gain on any appreciation in the QOZ investment. Consider the following examples of the mechanics of the QOZ provisions:
Example 1: Taxpayer realizes a $1M capital gain on the sale of stock on June 30, 2018, which it then invests in a qualified QOZ investment on July 1, 2018. The taxpayer sells the qualified QOZ investment on July 2, 2028 for $2M. The expected tax consequences under the QOZ provisions are as follows:
Example 2: Taxpayer realizes a $1M capital gain on the sale of stock on June 30, 2018, which it then invests in a qualified QOZ investment on July 1, 2018. The taxpayer sells the qualified QOZ investment on July 2, 2027 for $1.5M. The expected tax consequences under the QOZ provisions are as follows:
Example 3: Taxpayer realizes a $1M capital gain on the sale of stock on June 30, 2018, which it then invests in a qualified QOZ investment on July 1, 2018. The taxpayer sells the qualified QOZ investment on July 2, 2024 for $1.5M. The expected tax consequences under the QOZ provisions are as follows:
Example 4: Taxpayer realizes a $1M capital gain on the sale of stock on June 30, 2018, which it then invests in a qualified QOZ investment on July 1, 2018. The taxpayer sells the qualified QOZ investment on July 2, 2022 for $1.5M. The expected tax consequences under the QOZ provisions are as follows:
Timing of the investment is critical. Gains must be rolled over into qualifying QOZ investments within 180 days of the date of sale.5 Additionally, as the examples indicate, to realize the full benefits of the seven year holding period, investments must be made seven years prior to the December 31, 2026 realization date for the deferred gain, or by December 31, 2019.6
QOZ Investments – The Qualified Opportunity Zone Fund
Investment in a QOZ is made through an entity known as a qualified opportunity fund (QOF or Fund). The QOF, in turn, makes investments into qualified QOZ assets, termed qualified opportunity zone property, discussed in more detail below. Generally speaking, and subject to some uncertainty as noted below, the QOF is a corporation or partnership that is formed for the purpose of investing in QOZ assets (but not other QOFs) and that self-certifies itself as a QOF on a form the IRS is expected to provide this summer.7 It is recommended that the QOF’s operating agreement indicate its intent to be a QOF.
QOFs must meet a 90% asset test; specifically, it must maintain at least 90% of its assets in qualified QOZ property8, subsequently averaged and measured at the six month mark and the end of the QOF’s taxable year. Financial assets, aside from “reasonable amounts of working capital,” are generally not qualified assets, and as noted below, this arguably creates a six month investment window for excess cash – which may not be QOZ property (absent regulatory guidance to the contrary) – and can be problematic for longer-term real estate projects. Significant penalties may apply to the extent the asset test is not satisfied.
Qualified QOZ Property
Modeled on the enterprise zone and renewal community provisions, the QOZ provisions anticipate direct and indirect investments into QOZs and, specifically, three types of property acquisitions: corporate stock, partnership interests (capital or profits interests), or certain qualified business property (termed qualified opportunity zone business property). Each is subject to various limitations reflecting, among other things, the policy behind the QOZ provisions to attract “new” investments. Entity investments must meet the following criteria:
Note the requirements that the interests be acquired directly from the entity and solely for cash, as well as the “substantially all” requirement. The term “substantially all” is not defined in the statute.
Turning to eligible business property the QOF may acquire, qualified QOZ business property includes tangible property used by the QOF in a trade or business to the extent:
For this purpose, property is “substantially improved” if additions to basis “with respect to” such property during any 30-month period following acquisition exceed the adjusted basis at the beginning of such 30-month period. This is a relatively high standard, and higher than other distressed-area incentive programs require. And as noted below, the meaning of the term “original use,” particularly as it applies to non-vacant rental properties that are in use at the time acquired, is unclear and not defined in the statute.
Qualified QOZ Business
As noted above, qualified corporations and partnerships acquired by QOFs, or the QOF itself, must, either initially or ultimately, conduct a qualified opportunity zone business. For this purpose, a qualified QOZ business is a trade or business:
Additionally, generally less than five percent of the corporation’s or partnership’s asset’s basis may be attributable to certain “nonqualified financial property,” defined as debt, stock partnership interests and derivatives. As noted above, for this purpose, nonqualified financial property does not include reasonable amounts of working capital held in cash, cash equivalents or short-term (less than 18 months) debt instruments.
In addition to the requirements above, there are restrictions on the activities a QOF can engage in. Specifically, a qualified QOZ business cannot include a golf course, country club, massage parlor, hot tub facility, sun tan facility, racetrack or other gambling facility, or any facility or store whose principal business is the sale of alcohol for off premises consumption. Notably, and unlike its predecessor incentive program, the prohibited activities do not include residential housing.
Opportunity Zone Investments – Additional Notes
Several additional points re: QOZ investments:
As with many of the provisions of the TCJA, there are still many open questions and uncertainties, many basic. To learn more, go to: Qualified Opportunity Zones - The Uncertainties (Part II).
Questions? Contact Michael Eagan at 212.699.8831 | firstname.lastname@example.org or Dan Shapiro at 212.331.7634 | email@example.com or reach out to your Berdon tax advisor.
1See our 7/9/2018 Client Alert re: designation of opportunity zones - Opportunity Zones Created to Incentivize Investments in Low Income Communities. For an interactive map of the designated QOZs, see https://www.cdfifund.gov/Pages/Opportunity-Zones.aspx.
2 Proposed Regulations were sent to the OMB for its review on September 12, 2018.
3 As noted below, it is at this time somewhat unclear what types of gains can be invested in qualifying QOZ investments. The statute refers to gains from the sale of “any” property provided the sale is with an unrelated person, but the clear intent of the provision is to apply only to capital gains.
4 Mechanically, this is accomplished through an elective basis step up to FMV. If a loss is realized, the taxpayer simply forgoes the election and recognizes the loss.
5 Additionally, it should be noted that the gains rolled over into the QOZ investments must be realized from sales with unrelated parties.
6 Notably, a material concern to potential QOZ investors is liquidity planning for the tax liability due at the end of the deferral period if the investment is not monetized.
8 As noted below, there is uncertainty regarding the basis for measuring the asset test, e.g. asset basis or FMV.
9 This is the first mention in the statute of leased property, which may be a technical oversight. Though the statute refers to purchases from unrelated persons, there is no apparent policy rationale for excluding leases from unrelated persons from eligible qualifying QOZ property.