December 18, 2018
The Internal Revenue Service (“IRS”) released proposed regulations and a Revenue Ruling (Revenue Ruling 2018-29) providing guidance on the tax incentive enacted under The Tax Cuts and Jobs Act of 2017 (the “TCJA”) for Qualified Opportunity Zones (“QOZs”). Sections 1400Z-1 and 1400Z-2 of the Internal Revenue Code encourage investments in certain low income areas across the 50 states, the District of Columbia, and U.S. territories that have been designated as QOZs. Under the TCJA, taxpayers may defer capital gain by investing in Qualified Opportunity Funds (QOFs) that invest in the designated low income communities.
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 that maintains their interest in a QOF for at least five years will reduce ten percent (10%) of their deferred capital gains from federal income tax, and can reduce such deferred capital gain by fifteen percent (15%) if the investment in the QOF is held for at least seven years. The deferred capital gain will be recognized (reduced 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 their investment in a QOF by 2019, and in order to take advantage of the 10% reduction in gain, a taxpayer must make their investment in a QOF by 2021. If the taxpayer does not invest in a QOF by 2021, they will still be eligible for capital gain deferral until the earlier of the sale of their interest in the QOF or December 31, 2026, but they will not be able to take advantage of the 10% or 15% reduction on such capital gain.
A taxpayer that holds its 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 held for more than ten years, the taxpayer must have made a proper gain deferral election for its 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 on the exemption from U.S. federal income tax on the sale of an interest in a QOF that is held for more than ten years.
Eligible taxpayers 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 it may elect to commence its 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. Special rules for testing dates may apply for the first taxable year of a QOF’s existence.
In order to qualify as a QOF, the QOF must hold at least ninety percent (90%) of its assets in QOZ property, which consists of either QOZ business property or equity interests in an operating company that is either a corporation or a partnership and qualifies as a QOZ business. 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.
A QOZ business is a partnership interest or stock in a corporation acquired after December 31, 2017 for cash and the entity must be a QOZ business and qualify as such during substantially all of the QOF’s holding period of such equity interest. A QOZ business is a trade or business substantially all of which its tangible personal property is QOZ business property, at least fifty percent (50%) of its gross income is derived from the active conduct of a trade or business in the QOZ, a substantial portion of its intangible property is used in the active conduct of such trade or business, and less than five percent (5%) of its assets are nonqualified financial property (typically securities). In addition, the business cannot be a golf course, country club, massage parlor, hot tub facility, suntan facility, race track, gambling facility or liquor store. Pursuant to the proposed regulations, the “substantially all” requirement will be met if seventy percent (70%) of the tangible property owned or leased by a trade or business is QOZ business property.
The proposed Treasury Regulations have provided an incentive for QOFs to invest in QOZ business rather than owning QOZ business property directly, since the QOZ business only needs to have 70% of its tangible property owned or leased in a QOZ, whereas if the QOZ business property is owned directly, 90% of the property would need to be in a QOZ. Therefore, if a QOF invests 90% of its funds in a QOZ business that holds 70% of its property in a QOZ, the QOF would only have to effectively invest 63% of its assets in a QOZ.
The preamble to the proposed Treasury Regulations state that the IRS is working on additional guidance, including additional proposed regulations that are expected to address other issues for QOZs and QOFs, including the meaning of “substantially all” with respect to other aspects of QOFs and QOZs, transactions that may trigger the inclusion of gain that has been deferred, the reasonable period for a QOF to reinvest proceeds from the sale of qualifying assets without paying a penalty, administrative rules, and information reporting requirements.
The new rules for QOZs and QOFs should provide taxpayers with capital gains 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 comport with all federal income tax provisions.