The Tax Cuts and Jobs Act of 2017 (TCJA) introduced Qualified Opportunity Zones (QOZ), 1created to stimulate economic and property development in low-income communities in order to reduce poverty and increase employment. The program is immensely attractive to investors, because those who invest in QOZs using Qualified Opportunity Funds (QOFs) and hold their investment for the required time, ultimately benefit from deferral, and in some cases, forgiveness of tax on capital gains invested in QOZs.
Specifically, QOZs offer eligible taxpayers with capitals gains from the sale or exchange of property (with an unrelated person) three significant tax benefits. First, taxpayers may achieve permanent exclusion of up to 15% of their gain. Secondly, taxpayers may experience deferred recognition of the remaining 85% of gain until December 31, 2026. Finally, if taxpayers hold their investment for at least 10 years, post-acquisition gain is permanently and entirely excluded.
It is not surprising, then, that these incentives have generated immense interest throughout the public, private and non-profit sectors. And the interest and excitement are gaining momentum. Big players, including real estate investment firms and Silicon-valley start-ups, have already started raising capital for QOFs. These injections of capital into low-income QOZs are projected to result in dramatic increases of underlying land and building values in those areas. It’s a very exciting time in the tax world.
This article provides an introduction to the various terms and concepts necessary to understand the accompanying survey of the incentives themselves. This article also incorporates guidance from the recently issued proposed regulations.2 The proposed regulations are effective only once they are adopted as final regulations; however, these proposed regulations generally provide that taxpayers may rely on the proposed rulesnow if the taxpayer applies the rules in their entirety.3
Qualified Opportunity Zone
A QOZ is generally a “low-income community”4 population census tract, designated as a QOZ.5 However, if a tract is not low-income, it may still be designated as a QOZ if: (1) it is a tract adjacent to a low-income community already designated as a QOZ, and (2) the median household income in the tract is no more than 125% of the median household income of the adjacent low-income community.6 Designation as a QOZ remains effective from the date of designation through the close of the 10th calendar year beginning on or after the date of designation.7
Qualified Opportunity Fund
Per Internal Revenue Code (IRC) §1400Z-2(d)(1), a QOF is defined as any investment vehicle which is organized as a corporation or a partnership for the purpose of investing in QOZ property (other than interests in another QOF) that holds at least 90% of its assets in QOZ property.8 Only an “eligible entity” may certify itself as a QOF.
- Eligible Entity
An entity is eligible to be a QOF if: (1) it is organized in one of the 50 states, the District of Columbia, or the U.S. possessions, or (2) it is organized in a U.S. possession solely for the purpose of investing in QOZ property relating to a trade or business operated in the U.S. possession where it is organized.9 The proposed regulations clarify that “if a taxpayer that is classified as a corporation or partnership for Federal tax purposes is eligible to be a QOF, the taxpayer may self-certify that it is QOF.”10An entity makes the certification by attaching Form 8996, Qualified Opportunity Fund, to its timely filed income tax return. The form must be filed annually thereafter to report that the QOF continues to meet the necessary investment standard.
- Investment Standard
Again, as defined, a QOF must hold at least 90% of its assets in QOZ property. This is referred to as the QOF Investment Standard, or the 90% Test. Per IRC §1400Z-2(d)(1), this is determined by the average of QOZ property in the fund as measured on the last day of the first 6-month period of the fund’s tax year, and on the last day of the fund’s tax year.11 In the event that a QOF fails to meet the investment standard without showing reasonable cause, the QOF is subject to a penalty for each month it failed the requirement.12
- Qualified Opportunity Zone Property
Three categories of QOZ property exist: (1) QOZ stock, (2) QOZ partnership interests, and (3) QOZ business property.13 The first two categories require ownership in or operation of a QOZ business. The third category requires that the property is owned for use in such business.14
A QOZ business must meet all of the following requirements:
(1) substantially all of the tangible property owned or leased by the taxpayer is QOZ business property;15
(2) at least 50 percent of the total gross income of the entity is derived from the active conduct of such business,16
(3) a substantial portion of the intangible property of the entity is used in the active conduct of any such business,17
(4) less than 5 percent of the average of the aggregate unadjusted bases of the entity’s property is attributable to nonqualified financial property;18 and
(5) the entity must not operate a private or commercial golf course, country club, massage parlor, hot tub facility, suntan facility, racetrack or other facility used for gambling, or any store the principal business of which is the sale of alcoholic beverages for consumption off premises.19
Note that the proposed regulations provide safe harbors for determining compliance with the requirements.
- QOZ Stock
Generally, per IRC §1400Z-2(d)(2)(B)(i), QOZ stock means domestic corporation stock if:
(1) it is acquired by a QOF after December 31, 2017, at its original issue from the corporation solely in exchange for cash,
(2) as of the date of issue, the corporation was a QOZ business (or, was being organized for the purposes of being a QOZ business), and
(3) during substantially all of the QOF’s holding period for such stock, the corporation is a QOZ business.20
- QOZ Partnership Interest
A QOZ partnership interest is a capital or profits interest in a domestic partnership subject to the following requirements:
(1) the partnership must be organized in the U.S., or it must be organized in a U.S. possession which conducts a QOZ business in that U.S. possession,21
(2) the interest is acquired by the QOF after December 31, 2017, from the partnership solely in exchange for cash,22
(3) as of the time the interest was acquired, the partnership was a QOZ business (or, was being organized for purposes of being a QOZ business); and23
(4) during substantially all of the QOF’s holding period for the interest, the partnership qualified as a QOZ business.24
- Qualified Opportunity Zone Business Property
QOZ business property means tangible property used in the QOF’s trade or business if:
(1) the property was acquired by the QOF by purchase after December 31, 2017,25
(2) the original property’s use in the QOZ begins with the QOF or the QOF substantially improves the property,26 and
(3) during substantially all of the QOF’s holding period for such property, substantially all of the property’s use was in a QOZ.27
The general rule is that a taxpayer who realizes gain from the sale or exchange of property and thereafter invests all or a portion of that gain into a QOF within 180 days of the date of the sale or exchange may elect to defer the invested gain until the earlier of: (1) the date of the sale or exchange of the QOF investment, or (2) December 31, 2026.28 Upon either event, the taxpayer recognizes gain, the amount of which is calculated by subtracting the basis in the investment from the lesser of: (1) initial amount of gain excluded, or (2) the investment’s fair market value on the date of the event that triggered inclusion.29 Note that taxpayer’s initial basis in a QOF investment held for fewer than five years is zero.30
However, longer holding periods result in bigger benefits. First, if an investment is held for at least five years, the taxpayer’s basis is increased by an amount equal to 10% of the amount originally elected to be invested and deferred-i.e. 10% of the deferred gain is permanently excluded.31 Second, if an investment is held for at least seven years, the taxpayer receives a 15% increase in basis-i.e. 15% of the deferred gain is permanently excluded.32 Finally, if taxpayer holds the investment for at least 10 years, the taxpayer may elect to increase the basis up to the amount of the fair market value of the investment on the date of sale or exchange of the investment-i.e. post-acquisition gain is entirely excluded.33 Significantly, the proposed regulations indicate that the character of the deferred capital gain as short-term or long-term (or §1250 gain) is preserved.34
Consider the following example:
In July of 2018, T realizes a $100 million capital gain on the sale of stock. On August 1, 2018, the entire $100 million is invested in a QOF. Concurrently, T elects to defer the gain. T’s initial basis in the QOF investment is zero.
On August 1, 2023 (the date upon which the asset has been held for five years), T’s basis in the QOF investment increases to $10 million.
On August 1, 2025 (the date upon which the asset has been held for 7 years), T’s basis in the QOF increases to $15 million.
On December 31, 2026, although T continues to hold the investment, T must recognize gain, the amount of which is calculated by subtracting the basis in the investment from the lesser of: (1) initial amount of gain excluded, or (2) the investment’s fair market value on the date of the event that triggered inclusion. Assume that on December 31, 2026, the FMV is $200 million. T recognizes $85 million of capital gain on December 31, 2026. Increasing T’s previous $15 million basis by the $85 million gain recognized results in a $100 million basis.
After holding the investment for 10 years, T sells the QOF investment for its FMV, which is then $250 million. T can elect to have basis equal FMV and recognize no gain on the sale.
Remarkably, the IRS has provided no cap on the amount of realized gain that an investor can obtain from a QOF investment.
In exchange for promoting economic development in low-income communities, investors today have an incredible opportunity to defer their capital gains, dramatically increase basis in their QOF investment, and ultimately abate future capital gains from the investment. It is important for investors to consult with a tax professional who understands the program’s rules and can provide sophisticate planning options to maximize an investor’s return.
If you would like to learn more about the Qualified Opportunity Zone Program and how it can benefit you, please contact us today at Frost & Associates, LLC.
1 Pub. L. No. 115-97, §13823(b).
2 REG-115420-18, 83 Fed. Reg. 54,279 (Oct. 29, 2018).
4 The applicable definition for “low-income community” is found in IRC §45D(e) in the context of the New Markets Tax Credit.
5 IRC §1400Z-1(a). For a list of the designated Qualified Opportunity Zones, see Notice 2018-48, 2018-28 I.R.B. 9.
6 IRC §1400Z-1(e)(1).
7 IRC §1400Z-1(f).
8 Note that Prop. Reg. §1.1400Z-2(d)-1(a) alters the code language such that an eligible entity is one that is “classified” (rather than “organized”) as a corporation or partnership-thus, according to the proposed regulations, even an LLC-taxed as a corporation or a partnership-is certifiable as a QOF.
9 Prop. Reg. §1.1400Z-2(d)-1(e)(3).
10 Prop. Reg. §1.1400Z-2(d)-1(a).
11 Note that apparently “[t]he fund does not appear to have to meet the test separately on each testing date. Although the proposed regulations do not clarify the answer to this question, the draft Form 8996 does. Based on the questions and computations on that form, it appears that the QOF uses the average of the percentages of QOZP held at the end of the first six-month period and the end of the taxable year to determine whether there is a penalty imposed. On Form 8996 the QOF (1) computes the percentage of QOZP held on the last day of the first six-month period, (2) computes the percentage of QOZP held on the last day of the taxable year, (3) adds those two numbers, and (4) divides by two. If the result is equal to or more than .90, the penalty is zero. If the result if less than .90, the fund has to compute the penalty.” See Starczewski, “The Eagerly Awaited Opportunity Zone Regulations: What Do They Tell Us and What Do We Still Need to Figure Out”, 34 T.M. Real Estate Journal 214 (Nov. 7, 2018).
12 IRC §1400Z-2(f)(1).
13 IRC §1400Z-2(d)(2)(A); Prop. Reg. §1.1400Z-2(d)-1(c).
14 IRC §1400Z-2(d)(2).
15 IRC § 1400Z-2(d)(3)(A)(i).
16 IRC §1400Z-2(d)(3)(A)(ii) (reference to IRC §1397C(b)(2)).
17 IRC §1400Z-2(d)(3)(A)(ii) (reference to IRC §1397C(b)(4)).
18 IRC §1400Z-2(d)(3)(A)(ii) (reference to § 1397C(b)(8)).
19 IRC §1400Z-2(d)(3)(A)(iii) (reference to IRC §144(c)(6)(B)).
20 See IRC §1400Z-2(d)(2)(B)(ii) for exceptions.
21 IRC §1400Z-2(d)(2)(C)(iii).
22 IRC §1400Z-2(d)(2)(C)(i).
23 IRC §1400Z-2(d)(2)(C)(ii).
24 IRC §1400Z-2(d)(2)(C)(iii).
25 IRC §1400Z-2(d)(2)(D)(i)(I).
26 IRC §1400Z-2(d)(2)(D)(i)(II).
27 IRC §1400Z-2(d)(2)(D)(i)(III).
28 IRC §1400Z-2(a)(1), IRC §1400Z-2(b). Note that the proposed regulations provide that only “capital gain” qualifies for deferral through QOF investment. Prop. Reg. §1.1400Z2(a)-1.
29 IRC §1400Z-2(b)(2)(A).
30 IRC §1400Z-2(b)(2)(B)(i).
31 IRC §1400Z-2(b)(2)(B)(iii).
32 IRC §1400Z-2(b)(2)(B)(iv).
33 IRC §1400Z-2(c).
34 Prop. Reg. §1.1400Z2(a)-5.
Mary Lundstedt received her Juris Doctor from Thomas M. Cooley Law School in 2005, graduating magna cum laude. While in law school, Mary served as an editor for the Thomas M. Cooley Journal of Practical and Clinical Law. In 2006, she earned a tax LL.M. from NYU.
Prior to joining Frost & Associates, Mary practiced in corporate tax matters where she assisted clients in forming business entities and advised on tax consequences of business ventures. For several years, Mary was also a legal analyst and editor for the business entities, tax and accounting group at a leading legal publishing company.
Glen Frost is managing partner of Frost & Associates, LLC, a law firm headquartered in the Washington, DC metropolitan area. The firm focuses on Tax Controversy and Litigation, International Tax Matters, Tax Planning, Estate Planning, White-Collar Criminal Defense, and regulatory investigations by various government agencies including the Office of Foreign Asset Control (OFAC). Mr. Frost manages a team of attorneys, certified public accountants, enrolled agents, former IRS employees, certified fraud examiners, and other professionals.