Overview

The Tax Cuts and Jobs Act of 2017 introduced Opportunity Zones (OZs), a new community reinvestment tool designed to use tax incentives to promote long-term investment in qualifying urban and rural communities. Since then, the IRS has identified 8,700 Qualified Opportunity Zones (QOZs) in the United States, the U.S. Virgin Islands and Puerto Rico. This broad legislation is anticipated to benefit many stakeholders including individual taxpayers, developers, businesses, lenders, investors, fund sponsors and the impacted communities.

Thompson Hine has created a multidisciplinary team including lawyers from our Tax, Real Estate, Construction, Finance and Corporate practice groups, as well as professionals from our subsidiary, Project Management Consultants, who have considerable experience advising on incentives. This team collaborates to stay abreast of QOZ regulations and revenue rulings, prepares comments to the IRS and to Ohio officials with respect to pending state tax enhanced benefits to best promote our clients’ interests, and works closely with clients to determine how best to incorporate QOZ strategies into their business plans.

This multidisciplinary team guides our clients on planning and executing investments in businesses and properties located in QOZs and on the organization of and investment in Qualified Opportunity Funds (QOFs), through which the project level investments will occur. Our team provides legal analysis of how rules and regulations apply to specific investments in projects across the country and client objectives.

QOZ Basics
What Are QOZs?

Congress established OZs in the Tax Cuts and Jobs Act of 2017. Eligible census tracts were defined by the law and a process was devised for nomination and approval in early 2018. Across the country, 8,700 QOZs have been identified as the final tracts for the program. At this time, there are no provisions to add additional eligible census tracts. A mapping tool is available to see the QOZs and determine if an address is in a QOZ.

What Is a QOF?

A QOF is any investment vehicle organized as a corporation or partnership (including a multi-member LLC) with the purpose of investing in QOZ Property. Any individual or entity with capital gains may invest them within 180 days of realizing the gains. The capital gains must be from a transaction with an unrelated party, as defined for QOZs, and can include capital gains from the sale of stock, personal property or real estate (but excluding depreciation recapture taxed as ordinary income).

Taxes on the capital gains that are invested in a QOF are deferred until the earlier of the disposition of the investment in the QOF or December 31, 2026, with 10% and 5% increases at the five- and seven-year marks, respectively (resulting in up to 15% exclusion of deferred capital gains). Gains from the sale of an investment in a QOF (but not the deferred capital gains) held for at least 10 years will not be subject to federal income tax.

The capital gains cash amount must be invested in one or more QOFs through an equity interest issued by the QOF, whether common or preferred shares or a partnership interest with special allocations. An investor cannot purchase an outstanding interest in a QOF as a qualifying interest.

What Is QOZ Property?

The QOF must invest the capital gains amount in QOZ Property, which may be a QOZ equity interest or a QOZ Business Property (QOZ Property).

QOZ Equity Interest

Examples of QOZ equity interests include interests in partnerships or multi-member LLCs, or stock in C or S corporations, that meet these requirements:

  • The interest is acquired by the QOF after December 31, 2017 from a corporation, at its original issue, or directly from a partnership or multi-member LLC, into which the QOF makes the investments, solely in exchange for cash.
  • As of the time the entity interest was acquired, the entity was a QOZ Business (or, in the case of a new entity, it was being organized for purposes of being a QOZ Business).
  • During substantially all of the QOF‘s holding period for such interest, the entity qualified as a QOF business.

QOZ Business Property

QOZ Business Property is tangible property, used (through ownership or lease) in a QOZ Business, that meets the following requirements:

  • The tangible property was acquired by the QOF by purchase from a non-related party after December 31, 2017.
  • The property’s original use in the QOZ commences with the QOF, or the QOF substantially improves the property.
  • During substantially all of the QOF’s holding period for the property, substantially all of the use of the property was in a QOZ.
What Is a QOZ Business?

A QOZ Business is an active trade or business that meets the following requirements:

  • Substantially all of the tangible property used in the business must be QOZ Business Property.
  • At least 50% of the entity’s total gross income must be from the active conduct of a business in the QOZ (italicized words added by the proposed regulations).
  • A substantial portion of the intangible property is used in the active conduct of a business in the QOZ (italicized words added by the proposed regulations).
  • Less than 5% of the average of the aggregate unadjusted basis of the QOZ Business’s property is attributable to “nonqualified financial property” (e.g., cash, stock, partnership interests).
  • The QOZ Business does not include the operation of a golf course, racetrack, gaming facility, country club, suntan parlor, hot tub facility or establishments selling alcohol for off-premise use.

Important note: The instructions to IRS Form 8996 (used to elect QOF status) state that the QOF organizing documents are to include a description of the QOZ Business that the QOF expects to engage in, either directly or indirectly through the first-tier operating entity. For structuring purposes, if the QOF has the business (rather than just an interest in a partnership or corporation), it’s important to confirm that the QOF meets the QOZ Business requirements.

Why QOZ

QOZs were created by the Tax Cuts and Jobs Act of 2017 to incentivize investments in qualifying urban and rural areas. Individuals, partnerships and corporations with capital gains may deposit these funds into a QOF, which can be structured as a corporation or a partnership (or other pass-through entity) that holds at least 90% of its assets in QOZs. An investor has 180 days from the sale of an appreciable asset to invest capital gains into a QOF. The potential benefits of this investment include:

  • Deferral of capital gains taxes until the disposition of the interest in the QOF or December 31, 2026, whichever comes earlier.
  • Potential to avoid taxation on deferred capital gains by up to 15% (10% if the QOF interest is held for five years and 15% if held for at least seven years).
  • Permanent exclusion of all post-investment appreciation of the QOF interest through step-up in basis in the QOF interest if held for 10 or more years and sold by December 31, 2047.
  • Initial tax basis in QOF interest is zero; there is an increase in tax basis in the QOF interest by 10% of deferred gain at the five-year mark and additional 5% of deferred gain at the seven-year mark.
  • Might be possible to have QOF investors receive flow-through of any losses from a QOZ Business plus cash distributions without recapture income on a sale of the QOF interest after 10 years.

Important driver: Post-investment appreciation in value. As with any investment, an important factor with QOZs is the potential appreciation. The third tax benefit listed above is based solely on post-investment appreciation. The first two tax benefits can be valuable (provided capital gains rates do not increase to the point of cancelling out these benefits), but such benefits can be diminished if future appreciation is limited when compared to alternative non-QOZ investments. Anyone contemplating an investment in a QOZ for business expansion reasons or otherwise should consider the QOZ program, regardless of whether all tax benefits are available in full.

There are many rules and regulations that vary in accordance with the types of investments. Although to date the IRS has issued proposed regulations covering many, but not all, salient issues for investors to consider, the IRS did expressly permit taxpayers to proceed based on the proposed regulations.

QOZ TeamQOZ ResourcesSmartPaTH

Thompson Hine has been working diligently for years to lead innovation in the delivery of legal services. Among other accolades, we were ranked #1 in the category “Most innovative North American law firms: New working models” by The Financial Times for developing SmartPaTH®.

SmartPaTH is our comprehensive program that aligns service delivery with our clients’ needs. Essentially, SmartPaTH brings together legal project management, value-based pricing, flexible staffing and process efficiency. We use SmartPaTH to create realistic, detailed and reliable budgets; monitor performance against budget during the full course of an engagement; and offer a variety of value-based fee arrangements.

Our proprietary SmartPaTH systems and tools deliver not only cost control but a level of transparency and predictability that allows our clients to integrate our work into their budgets, forecasts and performance metrics.

SmartPaTH enables us to enhance our clients’ ability to manage legal projects in real time and to work with clients to develop data-based alternative fee structures including flat fees, retainers and other value-based fee agreements.