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.
Important 2019 Year-End Considerations
An important aspect of the QOZ tax incentive is that a taxpayer with a capital gain may invest the funds in a Qualified Opportunity Fund (QOF), and as long as the QOF invests those funds in a Qualified Opportunity Zone Property (QOZP), the taxpayer may defer the tax on the gain through the earlier of the sale of the property or December 31, 2026.
- A taxpayer who holds the QOZ-eligible property for at least five years will receive an increase in basis of 10%, effectively reducing the tax-payer’s capital gains tax by 10 percent.
- If the taxpayer holds the property for seven years, the tax-payerwill receive an additional increase in basis of 5 percent, for a total of 15 percent, effectively reducing the capital gains tax by 15 percent in total.
- The deadline to receive a 15 percent increase in basis is therefore December 31, 2019 (seven years before the deadline of December 31, 2026).
Some important points for real estate investments:
- An investor has 180 days from the time of recognizing a gain to invest in a QOF.
- AQOF must hold 90 percent of itsassetsinQOZP, determined by the average of:
- the percentages of QOZP assets held by the QOF on the last day of the first six-month period from the QOF election date, and
- those held on the last day of the QOF’s taxable year.
- Tax-payers who invest in a QOF during the second half of 2019 must arrange for the QOF to invest in QOZP by December 31, 2019, or the tax-payers could face a penalty (which is a monthly interest charge on the shortfall). If the QOZP has been identified, the simplest method to meet the 90 percent QOF requirement is for the QOF to invest the capital gains by December 31, 2019 into a new LLC or corporation that has documented the required necessary steps toward property acquisition and development (i.e., scheduled acquisition and construction date to meet the 31-month safe harbor criteria).
- The best advice for an investor is to select a project for your QOF investment prior to December 31, 2019. Please keep in mind that there will be many other taxpayer investors also looking for projects before year end, which could influence the market for such projects in the last months of 2019.
The IRS has received numerous recommendations to extend the six-month period for a QOF to invest in QOZP to satisfy the 90 percent test.
The IRS is expected to issue additional regulations by March 31, 2019; however, Treasury Secretary Steve Mnuchin has indicated that the next release will provide guidance for investments in QOZ businesses.
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 in 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.
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Tax Structuring, Compliance & Related Tax Matters
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Click the links below to access additional helpful resources related to Opportunity Zones:
- Mapping tool to determine if address is in an Opportunity Zone
- Special rules for capital gains invested in Opportunity Zones
- Form 8996
- Instructions for Form 8996
- Draft regulations for Opportunity Zones issued October 19, 2018
- Opportunity Fund Revenue Ruling 2018-29
- IRS Opportunity Zones Frequently Asked Questions
- House Bill 727
- Template form letter supporting HB 727
- IRS Tax Tip 2018-191, December 11, 2018
- Joint Committee on Taxation “General Explanation of Public Law 115-97,” December 20, 2018
- Economic Innovation Group – bipartisan public policy organization, founded in 2013 that facilitates The Opportunity Zones Coalition
- February 14, 2019 IRS/Treasury Public Hearing on October 2018 Proposed Regulations provided by Tax Analysts (www.taxnotes.com)
- Second set of proposed IRS guidance issued April 17, 2019
- IRS request for comments regarding Qualified Opportunity Fund Reporting and Expansion of IRS Form 8996
- Joint Committee on Taxation June 2019 Explanation
- July 9, 2019 IRS/Treasury Public Hearing on April 2019 Proposed Regulations provided by Tax Analysts (www.taxnotes.com)
- IRS Form 8997 Required to Track Capital Gain Investments in Opportunity Zone Funds
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- Qualified Opportunity Fund Investment Extension from IRS Doesn’t Grant Full Relief,
Qualified Opportunity Zones Update, September 28, 2020
- Ohio Budget HB 166 Contains Income Tax Credit for Investments in Qualified Opportunity Zone Funds,
Qualified Opportunity Zones Update, July 10, 2019
- New IRS FAQ Permits Section 1231 Gains Invested in a QOF During 2018 to Be a Qualifying Investment,
Qualified Opportunity Zones Update, July 1, 2019
- Treasury Comment Introducing Approach for Purchasers of Non-Qualifying QOF Interests to Have Qualifying QOF Interests,
Qualified Opportunity Zones Alert, July 1, 2019
- Comment Letter Submitted Regarding Round Two Guidance, June 19, 2019
- Hot Topics in Construction and Development – Cleveland/Webinar, June 13, 2019
- Opportunity Zone and Startup Tech Companies IRS Guidance: Round Two Summary,
Qualified Opportunity Zone Alert, May 9, 2019
- Opportunity Zone IRS Guidance: Round Two Summary,
Qualified Opportunity Zone Alert, May 7, 2019
- Opportunity Zones: What Are They and Why Should We Care?,
Qualified Opportunity Zones, March 13, 2019
- ISSUE LIST FROM 2-14-19 IRS HEARING ON OPPORTUNITY ZONE PROPOSED REGULATIONS,
Qualified Opportunity Zones, February 20, 2019