One of the many provisions of the Tax Cuts and Jobs Act passed in late 2017 was an exclusion from income for certain gains related to “Qualified Opportunity Zones” (QOZ). The legislation left many questions unanswered, leaving investors and fund organizers uncertain about how to move forward. Fortunately, the Treasury Department issued proposed regulations and a revenue ruling in October which answer many of those questions.
Background: To encourage investment in low income communities, the new law allows taxpayers to defer the gain on sale from any property to the extent the gain is reinvested in a “Qualified Opportunity Fund” (QOF). A QOF consists of a corporation or partnership organized for the purpose of investing in QOZ property. At least 90% of a QOF’s assets must be QOZ property used in an active trade or business, the original use of which begins with the fund. Alternatively, the QOF may “substantially improve” the property. There are QOZs in every state, the District of Columbia, and five US territories.
To access a map and/or list of the designated areas, see https://www.cdfifund.gov/Pages/Opportunity-Zones.aspx. The Joint Committee on Taxation gave this tax provision an estimated cost of $9.4 billion over five years which equates to more than $40 billion of QOZ investments between 2018 and 2022. Clearly, this is a big deal and you’re likely to hear more about it in the future. Here is a summary of the ground rules:
- Taxpayers may elect to defer gain recognized from the sale of property to an unrelated person to the extent the gain is reinvested in a QOF within 180 days after the property producing the gain is sold or disposed of.
- If the investment in the QOF is held for at least 5 years, the basis of the QOF is increased by 10% of the deferred gain.
- If the investment in the QOF is held for at least 7 years, the basis of the QOF is increased by an additional 5% of the deferred gain.
- The remaining deferred gain (85% if the QOF is held for at least 7 years) is recognized when the QOF is sold or disposed of, or on December 31, 2026, if earlier, but is limited to the fair market value of the QOF over the taxpayer’s basis in the QOF.
- If the investment in the QOF is held for at least 10 years, the taxpayer may elect for the basis of the QOF to be equal to the fair market value on the date of sale or disposition.
Example: Wanda sells stock on February 1, 2019 for a long-term capital gain of $100,000. On July 1, 2019 (within 180 days of the sale), Wanda purchases an interest in an LLC representing to be a QOF for $100,000. Wanda makes a valid election to defer the gain on sale of the stock and therefore reports no taxable gain on her 2019 tax return. This results in a beginning basis of zero for the QOF.
Iteration 1 – Wanda sells the QOF for $110,000 on July 1, 2022. Wanda must recognize a long-term capital gain of $110,000 in 2022, representing the original $100,000 deferred gain plus the $10,000 gain on the QOF. Note that even though this iteration does not result in gain exclusion, it does result in gain deferral for 3 years, which may be significant, especially if one has capital losses in the year of disposition.
Iteration 2 – Wanda sells the QOF for $110,000 on August 1, 2026 (more than 7 years after the purchase). Because she held the fund for at least 7 years, its basis is increased by 15% of the deferred gain, or $15,000. Wanda must recognize a long-term capital gain of $95,000 in 2022, representing the original $100,000 deferred gain less the basis increase of $15,000, plus the $10,000 gain on the QOF.
Iteration 3 – Wanda still owns the QOF on December 31, 2026. Wanda’s remaining $85,000 of deferred gain is subject to tax in 2026. Wanda sells the QOF on July 1, 2030 for $120,000 and makes a proper election for the basis in the QOF to be equal to the fair market value of the fund on the date of sale. Wanda recognizes no gain on the sale.
New Guidance Takeaways: The guidance covers details related to the operational rules for qualified opportunity zone property and qualified opportunity funds; the process for self-certifying a QOF; and a plethora of rules for investors. Here is a non-exhaustive list of what we think are some of the most important points for our readers:
- Taxpayers eligible to elect the tax benefits related to QOFs include individuals, C corporations (including regulated investment companies (RICs) and real estate investment trusts (REITs)), partnerships, and other pass through entities.
- The deferred gain must be capital gain, excluding for example income recaptured as ordinary, and including section 1231 gains taxed as capital gains.
- The QOF investment must be equity (not debt), and may include preferred stock or a partnership interest with special allocations.
- QOFs can include entities organized as LLCs which are taxed as partnerships, S corporations, or C corporations.
- QOFs can be collateral for a loan.
- Investments in a QOF can be rolled over into another QOF – i.e. gain from the sale of a QOF, to the extent recognized, can be deferred by reinvesting in a new QOF, but only if the taxpayer has disposed of the entire initial investment and a new deferral election is made.
- An election to step up the basis of a QOF held for at least 10 years can only be made if a deferral election was made when the QOF was purchased. To be clear, if no gains are deferred, an investment in a QOF provides no tax benefits under the new law.
- If a taxpayer invests an amount in a QOF in excess of its qualifying gains, the investment is treated as two separate investments – one qualifying for the deferral and related benefits and the other not qualifying for either benefit.
- Partnerships that realize capital gain are eligible to defer the gain at the partnership level or alternatively, partners are eligible to defer their share of the gain at the partner level. The partnership’s 180-day period begins on the date of sale, but a partner’s 180-day period begins on the last day of the partnership tax year. If however, the partner knows or receives information on both the date of the partnership’s gain and the partnership’s decision not to elect deferral itself, the partner can use the partnership’s date of sale for measurement of the 180-day period. Similar rules apply to S corporations, trusts, and estates.
- Although the QOZ designations themselves expire in 2028 (per the statute), the regulations confirm that taxpayers can still take advantage of the basis increase for investments in QOF investments made before June 29, 2027 and held for at least 10 years as long as the QOF is sold prior to January 1, 2048.
- A QOF can be a pre-existing entity as long as its QOZ property is acquired after December 31, 2017.
The Revenue Ruling issued simultaneously with the proposed regulations expounds on the “original use” requirement as it relates to land, and the “substantial improvement” requirement, as it relates to improvements to an existing building on land.
These rules as a whole are complex but provide tremendous opportunities for the right investors. Likewise, they provide opportunities for businesses to create and market QOFs to investors. As always, we’re here to help. Let us know what questions and insights you have.
Zirkle, Long & Associates