By Scott D. Shimick
As part of the 2017 Tax Cuts and Jobs Act, Congress added Sections 1400Z-1 and 1400Z-2 to the Internal Revenue Code, creating the Qualified Opportunity Zone tax benefits. Owing in part to confusion over the provisions, the Qualified Opportunity Zone tax benefits have not been as widely publicized and discussed as most of the other provisions of the TCJA.
However, the IRS has recently issued proposed regulations and a Revenue Ruling that have brought clarity and interest to the Qualified Opportunity Zones.
Qualified opportunity zone benefits.
Congress’s purpose in creating the Qualified Opportunity Zone tax incentives was to promote private sector investment in economically distressed communities. Investors in the opportunity zones are eligible for the deferral of capital gains and possible reductions in total tax liability.
Investors in a Qualified Opportunity Zone Fund (QOZ Fund) can defer an unlimited amount of their capital gains. This deferral allows the investor to push back the recognition of capital gains to the earlier of (1) Dec. 31, 2026 and (2) the sale or exchange of the QOZ Fund investment.
The basis in the QOZ Fund property at the time of the sale or exchange is the fair market value of the QOZ Fund property. Therefore, if the QOZ Fund drops in value, then the gain is also reduced.
Longer-term investments will yield greater tax benefits. If an investor maintains the QOZ Fund investment for at least five years, the basis in the investment is increased by 10 percent. If the investor maintains the investment for at least seven years, the basis increase jumps to 15 percent. Therefore, by holding the investment for a longer period, not only is the gain deferred, but 10 percent to 15 percent of the gain is excluded.
Finally, the QOZ Fund may result in tax-free gains. If the QOZ Fund investment is held for ten (10) years, then the basis of in the investment is increased to its fair market value. Therefore, any gains that have accrued to in the investment over the 10-year period will be tax-free. This is one of the very unique benefits offered by the Qualified Opportunity Zone program.
Making an Investment in a Qualified Opportunity Zone Fund
Investors in a QOZ Fund may defer an unlimited amount of capital gain provided the gains are invested in a QOZ Fund within 180 days of the sale or exchange from which the capital gain arises. This is similar to a Section 1031 exchange.
However, the unique benefit here is that no decision on the investment in the QOZ Fund needs to be made at the time of the initial sale or exchange. Investors have the option of investing all or a portion of their capital gains from each specific asset sale.
Only cash can be contributed to the QOZ Fund. Contributions of property to the entity will not qualify for the tax benefits.
Investors can invest in currently existing QOZ Funds or can create their own QOZ Funds. In creating a QOZ Fund, an investor should be careful to note that a QOZ Fund cannot invest in another QOZ Fund. Therefore, if an investor chooses to create a QOZ Fund, the investments of such QOZ Fund will need to be directly invested into Qualified Opportunity Zone Property.
Qualified opportunity zone funds defined.
An investment in a QOZ Fund can be either a corporation or a partnership, which includes LLCs taxed as either corporations or partnerships. A QOZ Fund can be a pre-existing or newly-created entity. The QOZ Fund is self-certified as a QOZ Fund on the next tax return filed by the entity.
To qualify as a QOZ Fund, an entity must establish that at least 90 percent of its assets, calculated as the average of two semiannual testing dates, are Qualified Opportunity Zone Property (“QOZ Property”). QOZ Property consists of either (1) Qualified Opportunity Zone Business Property or (2) stock in a corporation or interests in a partnership that is primarily invested in Qualified Opportunity Zone Business Property.
The first testing date is the six-month anniversary of the entity electing to be treated as a QOZ Fund and the second is the last day of the taxable year. If the QOZ Fund election is made in the second half of the year, then the first testing date is the last day of the taxable year.
Defining Qualified Opportunity Zone Business Property is the key to understanding the QOZ Fund. Qualified Opportunity Zone Business Property (“QOZ Business Property”) is tangible property used in a Qualified Opportunity Zone trade or business (“QOZ Business”) if (1) such property is acquired by purchase after 2017, (2) the original use of the property in the Qualified Opportunity Zone commences with the QOZ Fund or the tested entity substantially improves the property, and, (3) during substantially all of the QOZ Fund’s holding period of the property, substantially all of the use of such property is in the Qualified Opportunity Zone.
For this purpose, a QOZ Fund substantially improves property if, during any 30-month period, the QOZ Fund makes capital expenditures with respect to such property at least equal to the property’s acquisition cost.
A QOZ Business is a trade or business: (1) in which substantially all of the tangible property (if any) owned or leased by the business is QOZ Business Property; (ii) at least half of the gross income is derived from the active conduct of a trade or business in the opportunity zone; (3) a substantial portion of the intangible property of the entity is used in the active conduct of such business; (4) less than 5 percent of the basis of the property of such business is attributable to “nonqualified financial property”; and (5) the entity does not engage in, or lease land to, certain businesses (these “sin businesses” include golf courses, country clubs, massage parlors, hot tub facilities, suntan facilities, racetracks, gambling facilities, and liquor stores).
For this purpose, the term “nonqualified financial property” includes debt, stock, partnership interests, and certain types of derivatives, but does not include cash and short-term debt instruments held as reasonable working capital.
Locations of opportunity zones.
Qualified Opportunity Zones are areas identified and targeted for the patient capital investor. The IRS has published a complete list of all the Qualified Opportunity Zones in Notice 2018-48. The list of available census tracts nationwide is nearly 200 pages long. This means that there is plenty of opportunity for investments.
Shimick is a partner at Whiteman Osterman & Hanna LLP, attorneys at law.