Geoff Kayton, CPA
09.26.2018 | Client Alert
As with many of the provisions of the Tax Cuts and Jobs Act (TCJA), there are still a number of open questions and uncertainties, many basic, concerning Qualified Opportunity Zones, including:
- The nature of the gains that may be invested in a QOF. The statutory language refers to gains from “any” property, but the title to the statutory provision refers to “capital gains,” and the legislative history clearly reflects an intent for the provision to apply to capital gains. It is likely future guidance will limit the qualifying gains to capital gains, though it is not clear what that guidance will do in the case of recapture, for example.
- How to make the various elections provided for in the QOZ statute. The QOZ provisions contain several elective provisions including the initial deferral of gain upon investment in the QOF and the election to step up basis of the QOF investment to Fair Market Value (FMV) following a ten year holding period (presumably upon a sale). It is not clear how either election is made.
- Whether, in the case of gains realized by partnerships, the partnership must roll the gains into the QOF or the partner can roll its share of partnership gain into the QOF. A similar question is whether a group of investors with gains they’d like to roll into a QOZ investment can form a partnership which then invests in the QOF, or whether each investor has to invest in the QOF directly.
- The type of entity that can be a QOF. The statute refers to entities “organized as” partnerships or corporations, suggesting LLCs, even those taxable as partnerships or corporations may not qualify. While no policy reason exists for not allowing LLCs to qualify as QOFs, provided they are taxable as partnerships or corporations, the issue is nonetheless unclear absent regulatory guidance.
- The meaning of certain statutory terms is not clear and are not defined. For example, “original use” and “substantially all” are not defined. As noted above, to qualify as qualified opportunity zone business property, either an asset’s “original use” in the QOZ must begin with the QOF or, alternatively, the QOF must substantially improve the asset. While “substantially improve” is defined, original use is not, and its use in this context is unclear, particularly for example, in the case of rental properties that are in use and not vacant when acquired. The enterprise zone provisions, on which the QOZ provisions are modelled, contain a similar original use requirement, and under regulations interpreting those provisions, use prior to a one-year vacancy period is disregarded, and it is possible future QOZ regulations will adopt a similar provision.
“Substantially all” is used multiple times in the QOZ provisions. For indirect investments in to QOZs, corporate and partnership investees must be qualified opportunity zone businesses for substantially all of the QOF’s holding period. And to qualify as qualified QOZ business property, for substantially all of the QOF’s holding period for an asset, substantially all of the use of that asset must have been in a QOZ. Finally, a trade or business is a qualified QOZ business to the extent that, among other requirements, substantially all of the taxpayer’s assets are qualified QOZ business property. The term, however is not defined. Substantially all is used in many other code provisions, including the empowerment zone provisions, on which the QOZ provisions are based in part, which define it as 85%, so it is possible that future guidance will adopt that standard.
- The status of leased assets. As noted above, the QOZ provisions make one reference to leasing, specifically in the requirement that substantially all of the tangible property owned or leased by the taxpayer be qualified QOZ business property. The definition of qualified QOZ property, however, refers solely to purchases of property, and does not mention leases. This was possibly a drafting error as there is no clear policy reason why a lease from an unrelated person should not qualify as qualified QOZ property. Future guidance will need to clarify the treatment of leases for purposes of the QOZ provisions.
- For QOFs structured as partnerships or S corporations, the impact of sales by the QOF of its investments on the QOF investors. Though the QOZ provisions anticipate tax-free rollovers of QOF investments, it is possible such sales will trigger gain to the partners prior to either December 31, 2026 or a sale by the partner of their interest in the QOF.
- The tax rate on the deferred gain, when recognized, is unclear, if capital gains rates change between the time the investment in the QOF is made and the time the gain is recognized. The applicable rate is also unclear if, for example, the deferred gain is a short-term capital gain, but the investment in the QOF is long-term.
- A timing issue affecting qualification for the ten year holding period and possibly forcing the sale of the QOZ investment by December 31, 2028. By statute, the designation of the opportunity zones expires on December 31, 2028. Thus, at the conclusion of then ten year holding period for investments acquired subsequent to December 31, 2018, the assets may no longer reside in a designated QOZ making eligibility for the ten year holding period benefit somewhat uncertain for those investors.
- The basis on which the QOF asset test is measured – asset basis or FMV, for example – is unclear and will have to be provided for in regulatory guidance. Given the potentially significant penalty involved, this is an important issue.
- A “trade or business” is required, either by the QOF to qualify business property as qualified QOZ business property or by a corporation or partnership to be considered engaged in a qualified QOZ business. Establishing a trade or business for certain rental real estate activities can be uncertain, particularly in the case of ground leases and triple net leases.
- For QOF partnership interests, there is a question of whether in the case of disproportionate gain allocations, such as with respect to carried interests, the gain exclusion will be limited to the return of capital portion of an allocation.
- Also with respect to QOF partnership interests, it is unclear whether the QOF can make tax-free distributions of refinancing proceeds to its investors and other debt-financed distributions.
- It is also unclear whether a QOF investor must actually sell their QOF interest to realize the benefit of the gain exclusion or whether flow through gains may be excluded.
Many of these uncertainties are currently limiting opportunity zone investment, and regulatory guidance is both authorized and needed. Such guidance is on Treasury’s Priority Guidance Plan and is expected in the near term.1 Once regulations are published, more details will be available. We will continue to send updated information on the current events associated with these tax incentives.
For insights on the opportunities presented by Qualified Opportunity Zones, go to: Qualified Opportunity Zones – Invest in Low-Income Communities (Part I)
Questions? Contact Dan Shapiro at 212.331.7634 | firstname.lastname@example.org or reach out to your Berdon tax advisor.
1 Draft Proposed Regulations were sent to the OMB for its review on September 12, 2018.