June 3, 2019
The Internal Revenue Service (“IRS”) has released additional proposed regulations for Qualified Opportunity Zones (“QOZs”) that were enacted under The Tax Cuts and Jobs Act of 2017 (the “TCJA”) The recently released proposed regulations are the second set of proposed regulations issued by the IRS regarding QOZs. Sections 1400Z-1 and 1400Z-2 of the Internal Revenue Code seek to encourage economic growth and investment in designated distressed communities that have been designated as QOZs by providing a Federal income tax benefit of capital gain deferral to taxpayers who invest new capital in businesses located within QOZs through Qualified Opportunity Funds (QOFs).
To be eligible for the capital gain deferral, taxpayers must invest in a QOF within 180 days beginning with the date of the sale or exchange giving rise to the capital gain and make an election on IRS Form 8949 for the taxable year in which the sale or exchange was made.
A taxpayer who maintains his interest in a QOF for at least five years will eliminate 10% of his deferred capital gains and can eliminate an additional 5% if the investment is held for at least seven years. The deferred capital gain will be recognized (after reduction by any of the above mentioned reductions) at the earlier of the sale or exchange of the taxpayer’s interest in the QOF, or December 31, 2026. In order to take advantage of the 15% reduction in gain, a taxpayer must make his investment in a QOF by 2019, and in order to take advantage of the 10% reduction in gain, a taxpayer must make his investment in a QOF by 2021. If the taxpayer does not invest in a QOF by 2021, he will still be eligible for capital gain deferral but without any reduction.
A taxpayer who holds an interest in the QOF for more than ten years will not be subject to taxation on the sale or exchange of their interest in the QOF itself. In order to qualify for the exemption from tax on the sale of an interest in a QOF, the taxpayer must have made a proper gain deferral election for his initial investment in the QOF. In addition, a zone’s designation as a QOZ will expire at the end of 2028, and taxpayers have until the end of 2047 to sell their investments in a QOF in order to avail themselves of this exemption.
Taxpayers eligible for gain deferral under the QOZ and QOF rules include individuals, partnerships, limited liability companies, S corporations, C corporations, other pass through entities including trusts, real estate investment trusts, and regulated investment companies. Partnerships, limited liability companies and S corporations may elect deferral at the entity level, or the partners, members or shareholders may make such election individually. A partnership, limited liability company or S corporation must elect to defer its capital gain within 180 days of realizing such gain, but its partners, members or shareholders may elect to defer such gain within 180 days of the last day of the taxable year in which such gain was realized, or they may elect to commence their 180 day period on the date of the capital gain realization.
A QOF may be a corporation, partnership or limited liability company that is treated as a corporation or partnership for tax purposes. A QOF may self-certify as a QOF by attaching IRS Form 8996 to its federal income tax return for all years that it is a QOF. The certification will be based on two six month testing dates in a QOF’s taxable year, based on either the asset values reflected on its financial statements in the case of an entity with audited financial statements, or based on the cost value of its assets in the case of an entity with unaudited financial statements.
Significantly, the newly proposed regulations provide that a transfer by gift constitutes the disposition of an equity investment in a QOF, and thus will trigger the recognition of capital gain, but the distribution of a qualifying investment to the beneficiary by an estate or by operation of law is not a gain recognition event. Similarly, neither the termination of grantor trust status by reason of the grantor’s death nor the distribution by the estate to the decedent’s heirs constitutes a disposition for the QOZ rules. It should be pointed out however, that the QOF investment is considered to be income in respect of a decedent.
QOZ business property is defined as tangible personal property that (i) was purchased from an unrelated party after December 31, 2017, (ii) the original use of such property in the QOZ begins when the QOF or the QOF substantially improves such property, and (iii) during substantially all of the QOF’s holding period for such property, substantially all of the property is in the QOZ.
The newly issued proposed regulations address the meaning of “substantially all” as it applies to various QOZ rules, the reasonable period for a QOF to reinvest proceeds from the sale of qualifying assets, transactions that may trigger the inclusion of gain that has been deferred, guidance on operating businesses, and other technical issues with regard to investing in a QOF, including items such as the definition of “original use”, as well as the application of a 50% income test, and a 90% asset test.
The new rules for QOZs and QOFs should provide taxpayers with significant tax planning opportunities, including deferral of both short-term and long-term capital gains, as well as the ability to eliminate capital gains on interests held in QOFs for more than ten years. Taxpayers should also confirm the state and local income tax consequences of QOZs and QOFs, as not all states have law that comport with all federal income tax provisions.