The Tax Cuts and Jobs Act (P.L. 115-97), signed into law on December 22, 2017, created new U.S. federal income tax1 incentives for taxpayers that make certain investments in so-called "qualified opportunity zones" ("QOZs") through "qualified opportunity funds" ("QOFs"). The U.S. Treasury was given broad authority to issue regulations necessary to carry out the purposes of the QOZ provisions, but thus far guidance has been limited to some answers to frequently asked questions published by the Internal Revenue Service ("IRS") on its website.2 This client alert discusses the range of tax incentives that may be available for investments in QOZs (using QOFs), and select uncertainties that exist under current law pending further guidance from the U.S. Treasury and IRS.
1. What is a QOZ?
In general, a QOZ is an economically-distressed community within the United States (or its possessions) that has applied for such status and has been certified for such status by the U.S. Treasury. The deadline for application for QOZ status already has passed, so no further QOZs can be designated without further legislation. The U.S. Treasury has released a final list of all communities that have been approved for designation as QOZs in the country (which generally include all 50 states, the District of Columbia and various possessions), and those designations will remain valid until December 31, 2028.3
2. What are the Tax Benefits for Investments in QOFs?
For a taxpayer with gain4 from the sale or exchange of any property5 (in a transaction with an unrelated person) arising between December 22, 2017 and December 31, 2026, new Section 1400Z-2 provides three potential tax benefits to the extent that the taxpayer invests that gain (the "Gain Proceeds") in a QOF at some point within the 180-day period beginning on the sale or exchange date. These potential tax benefits include:
- deferral of taxation of the reinvested Gain Proceeds until December 31, 2026 (or the date of an earlier disposition of the QOF investment);
- if the QOF interest is held for at least 7 years, up to 15 percent of the gain may be permanently excluded from gross income by reason of a "step-up" in tax basis granted under the QOZ rules; and
- if the QOF interest is held for at least 10 years, gain attributable to any post-investment appreciation in the QOF interest is permanently excluded from gross income and, thus, tax-free to the taxpayer.
Notably, the tax benefits offered under new Section 1400Z-2 only extend to Gain Proceeds that are "rolled over" from the sale or exchange of property by the taxpayer, and any other amount invested in a QOF is not eligible for these benefits.
Each of the foregoing tax benefits available under the QOZ rules is described in more detail below.
a. Tax Deferral and Partial Exemption of Deferred Gain
The first two tax benefits apply to the gain recognized by a taxpayer on the sale or exchange of any property to the extent that the taxpayer invests the Gain Proceeds in an interest in a QOF during the 180-day period beginning on the date of the sale or exchange of such property (the "Deferred Gain"). If the requirements of Section 1400Z-2 are satisfied, the Deferred Gain is deferred and is not recognized until the earlier of the disposal of the taxpayer's QOF interest or December 31, 2026. At such time, the Deferred Gain (less any tax basis in the QOF interest) is included in the taxpayer's gross income, in an amount up to the fair market value of the QOF interest (less any tax basis in the interest). Following the recognition of Deferred Gain, the taxpayer's tax basis in the QOF interest is increased by the amount of the Deferred Gain inclusion. The character (i.e., ordinary income or short-term or long-term capital gain) of the Deferred Gain ultimately recognized is not changed by this deferral.
Under Section 1400Z-2, the taxpayer's initial tax basis in the QOF interest is zero. If, however, the QOF interest is held by the taxpayer for at least five years, the tax basis in such interest is increased by 10 percent of the Deferred Gain. Then, if the QOF interest is held by the taxpayer for another two years (for a total of seven years), the tax basis in such interest is increased by a further 5 percent of the Deferred Gain. These upward basis adjustments ultimately can result in the permanent exclusion of 10 percent or 15 percent, respectively, of the Deferred Gain from the taxpayer's gross income.
b. Exemption of Gain in QOF Interest
If a taxpayer sells the QOF interest after holding such interest for at least 10 years, the taxpayer may elect under Section 1400Z-2(c) to increase the tax basis of the interest to equal its fair market value on the date of the sale or exchange. This basis step-up election effectively allows the taxpayer to exclude all post-investment appreciation in the QOF interest from gross income. Alternatively, if the taxpayer has a loss in the QOF interest, the taxpayer can decline to make the election and claim the loss for tax purposes (subject to other applicable limitations).
As there is no time limit for the basis step-up election, a taxpayer presumably could hold its QOF interest indefinitely, and defer all the appreciation on an ultimate sale or other disposition. In such case, however, the QOF status of the investment may need to be maintained for the duration of the taxpayer's holding period. How the QOF qualification requirements will apply once the QOZ designations expire after 2028 is not clear.
3. What are the Requirements for Investment in a QOF?
The QOZ tax benefits are available only for a sale or exchange of property between a taxpayer and an unrelated person, which is defined in Section 1400Z-2, and which, very generally, would exclude family members and entities in which the taxpayer directly, indirectly or constructively holds a 20 percent-or-greater interest. Such tax benefits are not limited to any particular type of taxpayer and, thus, could extend to an individual or a corporation. A foreign person with gain from the sale of property that is considered to be "effectively connected" with the conduct of a U.S. trade or business also may avail itself of the tax benefits of Section 1400Z-2.6
As previously mentioned, the tax benefits of the QOZ rules are available only for QOF investments made out of Gain Proceeds generated from the sale or exchange of property during the period beginning 180 days prior to the QOF investment. Nevertheless, the cash invested in the QOF does not need to be specifically traced to the Gain Proceeds from the sale or exchange. If the taxpayer also invests cash other than Gain Proceeds in the QOF, Section 1400Z-2 bifurcates the investment and denies QOZ tax benefits for the portion of the QOF investment not attributable to Gain Proceeds.
4. What are the Requirements for Qualification as a QOF?
A QOF is defined in Section 1400Z-2 as any investment vehicle organized as a corporation or partnership7 (which apparently can be domestic or foreign) for the purpose of investing in "QOZ property" (defined below). In order to qualify, a QOF must hold at least 90 percent of its assets in QOZ property, determined for each taxable year by generally averaging the QOF's percentage of QOZ property assets on (1) the last day of the first six-month period of the QOF's tax year and (2) the last day of its tax year.8 Whether the IRS will allow any additional grace period to allow initial deployment of QOF investment funds is a question that awaits further guidance.
The "90 percent of assets" requirement essentially means that most traditional investment funds with diversified assets pools will not be able to qualify as QOFs. As such, if those funds want to pursue QOZ tax benefits for investors, consideration will need to be given to alternative investment structures. Given that a QOF can be a separate corporation or partnership, however, an investment fund conceivably could hold an interest in a lower-tier QOF for the benefit of its investors, or could form "side-car" structures for investors with Gain Proceeds available for investment. Additionally, a corporation or partnership whose sole asset consists of a single QOZ property would qualify.
5. What Constitutes QOZ Property?
Section 1400Z-2 broadly identifies three types of QOZ property:
- Stock held by a QOF in a lower-tier domestic corporation invested in a QOZ ("QOZ stock");
- Partnership interests held by a QOF in a lower-tier domestic partnership invested in a QOZ ("QOZ partnership interest"); and
- QOZ business property directly held by a QOF.
Each type of QOZ property has its own requirements, as described further below.
In order to qualify as QOZ stock or a QOZ partnership interest, the investment must initially be made in 2018 or later, directly from the issuer (or an underwriter, in the case of QOZ stock) and solely for cash. At the time of acquisition, the issuing entity must be a "QOZ business" (defined below) (or, in the case of a new entity, such entity must be organized for purposes of becoming a QOZ business), and during substantially all of the QOF's holding period for the QOZ stock or QOZ partnership interest, the relevant entity must continue to qualify as a QOZ business. "Substantially all" is not defined for this purpose, so further guidance will be required in order to best determine whether a particular investment can qualify as QOZ stock or a QOZ partnership interest.
A QOZ business is described as a business in the designated QOZ (1) in which substantially all of the tangible property owned or leased by the taxpayer is "QOZ business property" (defined below); (2) which satisfies certain gross income and asset requirements relating to the extent of operations in the QOZ; and (3) which is not engaged in certain listed "leisure" activities (e.g., private or commercial golf courses, country clubs, massage parlors, hot tub facilities, suntan facilities, racetracks or other facilities used for gambling, or any stores the principal business of which is the sale of alcoholic beverages for consumption off premises). In cases where the business is new, there is an open question as to whether the IRS will provide any grace period to meet the requirements for qualification as a QOZ business.
QOZ business property is described as tangible property used in a trade or business by the QOF which is acquired by the QOF by purchase (not including a purchase from a related person or through a like-kind exchange, but possibly including a lease) in 2018 or later.9 The original use of such property in the QOZ must commence with the QOF, or the QOF must substantially improve the property, and during substantially all of the QOF's holding period for such property, substantially all of the use of such property must be in a QOZ. Once again, what rises to the level of "substantially all" is not defined for this purpose and awaits further guidance.
If you have any questions, or otherwise would like further information on this topic, please do not hesitate to contact us.
1 All "tax" references herein are to U.S. federal income tax.
2 See https://www.irs.gov/newsroom/opportunity-zones-frequently-asked-questions
3 See https://www.cdfifund.gov/Pages/Opportunity-Zones.aspx. This website also includes a map that shows the locations of the QOZs throughout the U.S.
4 It is unclear from the statute itself whether gains that are characterized as ordinary income benefit from the QOZ program or whether such benefits are available only for capital gains. However, because the title of and legislative history to the statute refer to "capital gains," it may be risky to take the position that gains characterized as ordinary income (e.g., depreciation recapture) qualify, at least unless and until favorable guidance is issued on this point.
5 Including, presumably, tangible or intangible property.
6 If the property is a "U.S. real property interest," however, there is some uncertainty as to whether the "Foreign Investment in Real Property Tax Act" ("FIRPTA") rules can disallow the QOZ benefits.
7 Investment vehicles organized as limited liability companies that are classified as either corporations or partnerships for tax purposes would also qualify.
8 This semi-annual testing period effectively provides an initial six-month window for QOFs to acquire QOZ property.
9 As so defined, intangible property cannot be QOZ business property.
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