As part of the comprehensive 2017 Tax Reform, Congress enacted a set of provisions originally introduced in the Investing in Opportunity Act. These provisions present investors with an entirely new taxpayer-friendly investment vehicle. Rolling over the gain proceeds from the sale of any property, presumably including stock or real estate (the “initial property”), into an investment in a qualified opportunity zone (“QOZ”) offers investors the chance to defer and reduce capital gains on that initial sale, and achieve a subsequent tax-free exit from the QOZ investment.
Again, the tax benefits start with a deferral of gain on the current sale of the initial property until December 31, 2026 if the gain proceeds from that initial sale are invested within 180 days in a Qualified Opportunity Zone Fund (“QOF”), or until the investor exits the QOF (if before December 31, 2026). If the proceeds remain in the QOF for at least five years, the basis of the investment is increased by 10% (which will reduce taxes by 10% on the gain from the sale of such initial property). If the proceeds are kept in a QOF for at least seven years, the basis is increased an additional 5%, providing an investor with a total tax savings of 15%. Critically, December 31, 2026 is a fixed recognition date, so gain proceeds from the sale of the initial property invested in a QOF after December 31, 2019 will be unable to reach the seven years required for the 15% benefit, and gain proceeds invested after December 31, 2021 will receive no basis increase, but they will still benefit from a significant deferral of taxation.
If the gain proceeds from the sale of the initial property are held in a QOF for at least ten years, the investor’s subsequent gains in the QOF are 100% tax-free, as the basis of the investment in the QOF is stepped up to fair market value when sold. Investors should remember that this does not prevent taxation of the gain on the sale of the initial property (which is deferred to December 31, 2026, as stated above), but rather it eliminates taxation on the entirety of subsequent gains accrued by the QOF investment.
A QOZ is, generally speaking, a federal census tract where more than 20% of the population lives below the poverty level, has been designated as such by the relevant state’s Governor, and such designation has been approved by the U.S. Treasury. A detailed interactive map of New Jersey’s opportunity zones may be found here.
Within 180 days of selling the initial property, the taxpayer must invest some or all of the gain proceeds in a QOF, a new type of fund with great flexibility because of its few structural constraints. Based on the relevant Committee Report, the certification process for a QOF will mirror that for a Community Development Entity under the New Markets Tax Credit Program; however the IRS website FAQ suggests that a fund will be able to self-certify as a QOF by completing a form and attaching it to its timely filed income tax return for the year, without requiring approval or any other action by the IRS. The QOF is required to invest at least 90% of its assets in QOZ property, which consist of: (i) investment in the stock of a corporation or a partnership interest holding a newly formed or existing business located in a QOZ or (ii) direct investment in QOZ business property, which means tangible property used in a trade or business of the QOF. A QOZ business must either make “original use” of the property in the QOZ or it must “substantially improve” the property for it to qualify as QOZ property. Property is “substantially improved” if, during a 30-month period, additions to the property’s basis exceed the property’s adjusted basis at the beginning of the period. Note that a QOF may not invest in another QOF.
An asset test is applied every six months to ensure the QOF satisfies the 90% requirement. A QOF’s failure to meet the 90% asset test will result in a monthly penalty based on the IRC Section 6621(a)(2) underpayment rate (5% per annum for September 2018). This rate is then applied to the excess of 90% of the QOF’s aggregate assets over the aggregate amount of QOZ property held by the QOF. In the case of a QOF that is a partnership, this penalty is taken into account proportionately by each partner as part of their distributive share. Note that this penalty is not imposed on the deferred tax, and is not imposed if the failure was due to reasonable cause rather than willful neglect. It is not clear at this time whether the penalty would continue if the fund has been disqualified.
Key Open Issues Awaiting Treasury Regulations
Many of the key issues relating to setting up and operating QOFs are unresolved pending Treasury’s issuance of regulations, which are not expected until late this year or even 2019:
- May both ordinary (e.g., recapture income) and capital gains realized on the sale of the initial property be deferred via investment in a QOF?
- May LLCs that qualify as partnerships be utilized as QOFs?
- Will Treasury provide for a reasonable start-up period for the initial investment of capital by the QOF before the 90% asset test is applied?
- With respect to the sale of QOZ business property held by a QOF, will Treasury provide for a reasonable time period for a QOF to reinvest returns or proceeds without negatively impacting the 90% asset requirement?
- With respect to triggering taxation, how will Treasury treat the sale of assets by the QOF as compared to the sale of the QOF interest by investors?
- Will Treasury establish permitted methodologies for measuring asset value for purposes of the 90% asset test?
- Will Treasury provide clarification of the “substantially all” tests with respect to:
- The qualification as a QOZ business for substantially all of the QOF’s holding period, and
- The requirement that substantially all of the use of QOZ property is within a QOZ?
At this time there are several hurdles facing taxpayers looking to invest in a QOF. The current lack of guidance until Treasury regulations are issued is alone a significant burden. The challenge of meeting the 180 day rule to reinvest the proceeds from a sale of the initial property is another significant stumbling block. 180 days is a short time period within which to select and invest in a QOF, or establish a QOF, which would then invest in a QOZ. Investors must also weigh the potential tax benefits against the investment risks of holding a long-term position in one or more opportunity zones, which by definition are located in economically depressed areas. The lengthy lock-up period during which capital needs to be invested in a QOF must also be considered when deciding whether to invest through a QOF.
We are happy to talk with current and potential clients who have questions on qualified opportunity zones, including how to roll over gain into a QOF, how to set up a QOF, or how to best structure investments in a QOZ to better allow a third-party QOF to invest in your property, but of course, for some of these issues we will need to wait for the forthcoming Treasury guidance.