Geoff Kayton, CPA
09.26.2018 | Client Alert
This alert focuses on a new incentive added to the tax code by the Tax Cuts and Jobs Act (TCJA), which applies to certain taxpayer gains reinvested in Qualified Opportunity Zones (each a QOZ). The purpose of this provision is to incentivize investments in low-income communities by allowing taxpayers to defer and exclude portions of these reinvested gains as well as to exclude, in certain cases, subsequent investment appreciation.
Highlights of the QOZ provisions include:
- Three potential tax benefits, two applicable to invested gains and one potentially applicable to appreciation in the QOZ investment itself:
1. Deferral of certain gains invested in qualified QOZ investments until December 2026 (earlier if the QOZ investment is disposed of before December 2026);
2. Elimination of 10% of that deferred gain for holding periods of at least five years and 15% for holding periods of at least seven years;
3. Elimination of any gain on the appreciation (exclusive of the deferred gain) in the QOZ investment for holding periods of at least ten years.
Note that these tax benefits are available only for realized gains invested in a QOZ.
- Designation of opportunity zones in all 50 states, the District of Columbia and five territories; 1
- Timing of the investment, which is crucial as gains intended to be invested in QOZ investments need to be rolled over within 180 days of the date the gains are realized. Additionally, as outlined below, to realize the full benefits of the QOZ provisions, QOZ investments need to be made by 2019 at the latest. Only gains realized before December 31, 2026 may be deferred, but gains realized after 2019 and 2021, respectively, will not qualify for the five or seven year holding period benefit, though the overall investment may nonetheless qualify for the ten year holding period advantage;
- Limited restrictions on the nature of the qualified opportunity zone investments, which generally must only consist of a trade or business that is comprised of assets, substantially all of which are, located in an opportunity zone. Certain entertainment-related trades or businesses are excluded from eligibility. But unlike some of its predecessor incentive investment programs, there is no restriction on residential housing in the QOZ provisions. Nor are there caps on the amounts that may be invested.
There are currently numerous uncertainties surrounding the QOZ provisions that have already limited the efficacy of the QOZ program. To read more about the open questions, click here for Part II. Clarifying regulatory guidance is authorized by statute and is expected in the near term.2
Since 1993, Congress has offered numerous incentives to invest in low-income or distressed communities, incentives ranging from credits, increased expensing, capital gains relief and tax-exempt financing. Opportunity zones are the latest incentive program, created by the TCJA and modeled on, and in some cases incorporating, several of its predecessors including the new markets tax credit program and empowerment zone and enterprise community programs.
At a basic level, the QOZ program offers three potential tax benefits:
- Deferral of certain gains invested in qualified QOZ investments (defined below) until the earlier of December 31, 2026 or the disposition of the QOZ investment;3
- Elimination of 10% of the deferred gains invested in qualifying QOZ investments held for five years, and elimination of 15% of the deferred gains invested in qualifying QOZ investments held for seven years;
- Elimination of gain on any appreciation realized on the qualifying QOZ investment if held for at least ten years,4 a holding period twice as long as the QOZ provision predecessors.
Thus, at least 85% of the deferred gains rolled into the qualified QOZ investments will eventually be recognized, but there is potential substantial tax savings on the back end through the elimination of taxable gain on any appreciation in the QOZ investment. Consider the following examples of the mechanics of the QOZ provisions:
Example 1: Taxpayer realizes a $1M capital gain on the sale of stock on June 30, 2018, which it then invests in a qualified QOZ investment on July 1, 2018. The taxpayer sells the qualified QOZ investment on July 2, 2028 for $2M. The expected tax consequences under the QOZ provisions are as follows:
- On December 31, 2026, the $1M deferred gain is recognized, but because the taxpayer’s holding period at that time exceeds seven years, 15% is eliminated (mechanically, through basis adjustments), leaving $850K of recognized gain. The taxpayer’s basis in the qualified QOZ investment is thus increased from zero to $1M.
- On July 2, 2028, the taxpayer realizes a $1M gain on the sale of the QOZ investment representing appreciation in the investment. None of this gain is recognized, however, because the taxpayer held the investment for more than ten years.
Example 2: Taxpayer realizes a $1M capital gain on the sale of stock on June 30, 2018, which it then invests in a qualified QOZ investment on July 1, 2018. The taxpayer sells the qualified QOZ investment on July 2, 2027 for $1.5M. The expected tax consequences under the QOZ provisions are as follows:
- On December 31, 2026, the $1M deferred gain is recognized, but because the taxpayer’s holding period exceeds seven years, 15% is eliminated through basis adjustments, leaving $850K of recognized gain. Mechanically, the taxpayer’s basis in the qualified QOZ investment is now $1M (the sum of the recognized $850K and the $150K in basis step ups).
- On July 2, 2027, the taxpayer realizes a $500K gain on the sale of the QOZ investment. Because the taxpayer did not hold the QOZ investment for ten years, all of this gain is recognized.
Example 3: Taxpayer realizes a $1M capital gain on the sale of stock on June 30, 2018, which it then invests in a qualified QOZ investment on July 1, 2018. The taxpayer sells the qualified QOZ investment on July 2, 2024 for $1.5M. The expected tax consequences under the QOZ provisions are as follows:
- On July 2, 2024, the deferred gain of $1M is recognized (on the earlier of disposition date or December 31, 2026), but because the taxpayer’s holding period exceeds five years – not seven – ten percent of the gain – not 15% – is eliminated, leaving $900K. With the recognized gain and step up in basis for holding period, the taxpayer’s basis is $1M.
- Also on July 2, 2024, taxpayer realizes a $500K gain on the sale of the QOZ investment. Because the taxpayer’s holding period did not exceed ten years, all of this gain is recognized.
Example 4: Taxpayer realizes a $1M capital gain on the sale of stock on June 30, 2018, which it then invests in a qualified QOZ investment on July 1, 2018. The taxpayer sells the qualified QOZ investment on July 2, 2022 for $1.5M. The expected tax consequences under the QOZ provisions are as follows:
- On July 2, 2022, the deferred gain of $1M is recognized (on the earlier of disposition date or December 31, 2026), and because the taxpayer’s holding period neither exceeds five or seven years, the full amount is recognized. With the recognized gain, the taxpayer’s basis is $1M.
- Also on July 2, 2022, taxpayer realizes a $500K gain on the sale of the QOZ investment. Because the taxpayer’s holding period did not exceed ten years, all of this gain is recognized.
Timing of the investment is critical. Gains must be rolled over into qualifying QOZ investments within 180 days of the date of sale.5 Additionally, as the examples indicate, to realize the full benefits of the seven year holding period, investments must be made seven years prior to the December 31, 2026 realization date for the deferred gain, or by December 31, 2019.6
QOZ Investments – The Qualified Opportunity Zone Fund
Investment in a QOZ is made through an entity known as a qualified opportunity fund (QOF or Fund). The QOF, in turn, makes investments into qualified QOZ assets, termed qualified opportunity zone property, discussed in more detail below. Generally speaking, and subject to some uncertainty as noted below, the QOF is a corporation or partnership that is formed for the purpose of investing in QOZ assets (but not other QOFs) and that self-certifies itself as a QOF on a form the IRS is expected to provide this summer.7 It is recommended that the QOF’s operating agreement indicate its intent to be a QOF.
QOFs must meet a 90% asset test; specifically, it must maintain at least 90% of its assets in qualified QOZ property8, subsequently averaged and measured at the six month mark and the end of the QOF’s taxable year. Financial assets, aside from “reasonable amounts of working capital,” are generally not qualified assets, and as noted below, this arguably creates a six month investment window for excess cash – which may not be QOZ property (absent regulatory guidance to the contrary) – and can be problematic for longer-term real estate projects. Significant penalties may apply to the extent the asset test is not satisfied.
Qualified QOZ Property
Modeled on the enterprise zone and renewal community provisions, the QOZ provisions anticipate direct and indirect investments into QOZs and, specifically, three types of property acquisitions: corporate stock, partnership interests (capital or profits interests), or certain qualified business property (termed qualified opportunity zone business property). Each is subject to various limitations reflecting, among other things, the policy behind the QOZ provisions to attract “new” investments. Entity investments must meet the following criteria:
- Both the corporation and partnership must be domestic;
- The stock or partnership interests must be acquired solely for cash and directly from the entity (and in the case of the corporation, at original issue);
- The corporation or partnership must qualify as a qualified opportunity zone business (defined below); and
- During “substantially all” of the QOF’s holding period, the corporation or partnership was a qualified opportunity zone business.
Note the requirements that the interests be acquired directly from the entity and solely for cash, as well as the “substantially all” requirement. The term “substantially all” is not defined in the statute.
Turning to eligible business property the QOF may acquire, qualified QOZ business property includes tangible property used by the QOF in a trade or business to the extent:
- It is acquired by the QOF in a purchase transaction from an unrelated person after December 31, 2017;
- Either (1) the “original use” of such property in the QOZ begins with the QOF or (2) the QOF “substantially improves” the property; and
- That during “substantially all” of the QOF’s holding period, “substantially all” of the use of such property was in a qualified QOZ.
For this purpose, property is “substantially improved” if additions to basis “with respect to” such property during any 30-month period following acquisition exceed the adjusted basis at the beginning of such 30-month period. This is a relatively high standard, and higher than other distressed-area incentive programs require. And as noted below, the meaning of the term “original use,” particularly as it applies to non-vacant rental properties that are in use at the time acquired, is unclear and not defined in the statute.
Qualified QOZ Business
As noted above, qualified corporations and partnerships acquired by QOFs, or the QOF itself, must, either initially or ultimately, conduct a qualified opportunity zone business. For this purpose, a qualified QOZ business is a trade or business:
- In which “substantially all” (again, not defined) of the tangible property owned or leased by the QOF is qualified opportunity zone business property;9
- From the active conduct of which it derives at least 50% of its gross income;
- In the active conduct of which a “substantial portion” of the corporation’s or partnership’s intangible property is used;
Additionally, generally less than five percent of the corporation’s or partnership’s asset’s basis may be attributable to certain “nonqualified financial property,” defined as debt, stock partnership interests and derivatives. As noted above, for this purpose, nonqualified financial property does not include reasonable amounts of working capital held in cash, cash equivalents or short-term (less than 18 months) debt instruments.
In addition to the requirements above, there are restrictions on the activities a QOF can engage in. Specifically, a qualified QOZ business cannot include a golf course, country club, massage parlor, hot tub facility, sun tan facility, racetrack or other gambling facility, or any facility or store whose principal business is the sale of alcohol for off premises consumption. Notably, and unlike its predecessor incentive program, the prohibited activities do not include residential housing.
Opportunity Zone Investments – Additional Notes
Several additional points re: QOZ investments:
- Related Party Rules: the QOZ provisions contain several related party limitations. Thus, for example, gains eligible to be rolled over into a QOZ investment must have been realized in a sale with an unrelated person. Similarly, to qualify as qualified opportunity zone business property, an asset must be acquired by the QOF in a purchase from an unrelated person. For this purpose, the related party rules use a lower threshold – 20% rather than 50% – of relatedness.
- Cash Investments: the QOZ provisions anticipate non-qualifying investments (i.e. non-deferred gain investments) into QOF Funds by, essentially, bifurcating investments into deferred gain investments and non-qualifying investments. The tax benefits, however, apply only to the deferred gain investments. None of the tax advantages, including the ten year holding period benefit, apply to the non-qualifying investments.
- QOF Rolling Over Investments: the QOZ provisions also anticipate the fund being able to roll over its QOZ investments into other QOZ investments. Specifically, the statute authorizes regulations providing “reasonable time” for the QOF to reinvest proceeds received from the sale of QOZ assets. Presumably, proceeds rolled into other QOZ investments would be tax free.
Taxation of the QOF and Inside/Outside Basis: the QOF will presumably be taxable based on its entity classification, e.g. as a partnership or a corporation. Note that under the QOZ provisions, the investor’s outside basis in investment in the QOF is initially zero (and subsequently adjusted for deferred gain when ultimately recognized and any other basis adjustments under the QOZ provisions), thus creating inside/outside basis differences.
Six Month Asset Testing Window: including assets, however measured, at the six month mark of the QOF’s taxable year arguably requires the QOF to deploy new capital within six months or risk failing the asset test (because, as noted previously, cash may not be a qualifying QOZ asset). Again, this can be problematic for longer-term projects, such as real estate development projects where cash and cash equivalents may be significant asset for extended periods of time.
As with many of the provisions of the TCJA, there are still many open questions and uncertainties, many basic. To learn more, go to: Qualified Opportunity Zones – The Uncertainties (Part II).
Questions? Contact Dan Shapiro at 212.331.7634 | email@example.com or reach out to your Berdon tax advisor.
1 See our 7/9/2018 Client Alert re: designation of opportunity zones – Opportunity Zones Created to Incentivize Investments in Low Income Communities. For an interactive map of the designated QOZs, see https://www.cdfifund.gov/Pages/Opportunity-Zones.aspx.
2 Proposed Regulations were sent to the OMB for its review on September 12, 2018.
3 As noted below, it is at this time somewhat unclear what types of gains can be invested in qualifying QOZ investments. The statute refers to gains from the sale of “any” property provided the sale is with an unrelated person, but the clear intent of the provision is to apply only to capital gains.
4 Mechanically, this is accomplished through an elective basis step up to FMV. If a loss is realized, the taxpayer simply forgoes the election and recognizes the loss.
5 Additionally, it should be noted that the gains rolled over into the QOZ investments must be realized from sales with unrelated parties.
6 Notably, a material concern to potential QOZ investors is liquidity planning for the tax liability due at the end of the deferral period if the investment is not monetized.
8 As noted below, there is uncertainty regarding the basis for measuring the asset test, e.g. asset basis or FMV.
9 This is the first mention in the statute of leased property, which may be a technical oversight. Though the statute refers to purchases from unrelated persons, there is no apparent policy rationale for excluding leases from unrelated persons from eligible qualifying QOZ property.
Questions: Contact Dan Shapiro at 212.331.7634 |firstname.lastname@example.org or your Berdon tax advisor