Since the enactment of the Tax Cuts and Jobs Act (“Act”) at the end of 2017 and the subsequent release of the first round of proposed regulations in October 2018, many taxpayers and practitioners have been puzzling over various aspects of the Act’s Opportunity Zone tax incentives. Questions have abounded, including those surrounding how to form and structure the investment entity, a Qualified Opportunity Fund (QOF). Those questions then lead to others about owning Qualified Opportunity Zone Business Property (QOZBP) or a Qualified Opportunity Zone Business (QOZB) and selling or otherwise exiting a QOF investment. Many potential investors have delayed investment and are awaiting more detailed guidance before moving forward with QOFs.
New proposed regulations released by the government on April 17, 2019, and officially published May 1, 2019, answer most, but not all, of the questions. However, for many taxpayers, they provide enough guidance to begin reviewing investments designed to take advantage of the Opportunity Zone tax incentives.
This insight will outline some of the key provisions of the second round of proposed regulations following a quick summary of the Opportunity Zone tax incentives.
Opportunity Zones and Tax Incentives
The Qualified Opportunity Zone tax incentives are designed to encourage taxpayers to invest capital gains in economically distressed communities designated as “opportunity zones.” A map and list of the Qualified Opportunity Zone communities can be found here.
The tax incentives permit taxpayers to defer reporting capital gains generated from sales to unrelated parties as taxable income if the gains are reinvested in a QOF within 180 days after being realized (subject to special rules in the case of capital gains recognized by pass-through entities such as partnerships, S-corporations, trusts and estates). The reinvested gain amount is deferred until the QOF interest is sold, or, if earlier, December 31, 2026. The deferred capital gain amount can be reduced by 10% if the QOF investment is held for five years and by another 5% if held for seven years. In addition, if a taxpayer holds the interest in the QOF for at least 10 years, gains ultimately realized from the sale of the QOF investment can be tax-free.
Specific requirements are set forth in the statute including:
To illustrate the potential tax incentives, assume a taxpayer sells publicly traded stock generating a capital gain of $100,000 and, within 180 days of sale, invests that amount in a QOF during 2019. At the taxpayer’s election, none of the gain is subject to federal income tax in 2019. The taxpayer continues to hold the QOF investment through 2026, meeting the seven-year holding period for reducing the deferred gain amount by 15%. But, even though the taxpayer continues to hold the QOF investment past 2026, on December 31, 2026, the taxpayer recognizes $85,000 of the original gain from the 2019 sale taxed at the then current 2026 Federal capital gain rates. In 2030, after holding the QOF investment for 10 years, the taxpayer sells the QOF interest for $400,000, realizing a gain of $300,000. If the taxpayer properly elects, none of this gain is subject to federal income tax. The newly issued proposed regulations confirm that the excluded gain includes any depreciation recapture items. Note: state income tax consequences will vary by state and type of entity used by the QOF.
We recently put together a webinar highlighting the goals of the QOZ program, the potential tax incentives, requirements for qualification based on recently proposed regulations, and strategies for investing in and exiting a QOF.
Forming and Operating a QOF
A QOF is a self-certified entity that can be a partnership, corporation, S-corporation, RIC or REIT; it cannot be an entity disregarded for tax purposes, however. As noted above, equity investments in a QOF can qualify for the Opportunity Zone tax incentives to the extent they represent eligible capital gains from sales to unrelated parties (gains from sales to related parties will not qualify for the tax incentives). Investments in QOFs from sources other than eligible capital gains are permitted, but those investments do not qualify for the tax incentives.
Eligible capital gains include short-term capital gains, long-term capital gains and so-called section 1231 gains (from sales of business assets) among other types of gains. Ordinary gains and equity interests obtained for services do not qualify.
The most recent proposed regulations add more certainty and flexibility for taxpayers looking to form or invest in a QOF. Some of the key points of clarification follow:
Acquiring and Investing in QOZBP and QOZBs
90% of a QOF’s assets must be composed of QOZBP or interests in one or more QOZBs. The QOF self-certifies as a QOF by completing IRS Form 8996, and it uses this form for measuring the 90% asset test. The asset test is based on the average of a QOF’s assets on two dates—the last day of the first six months of a QOF’s tax year and the last day of the QOF’s tax year. (If a QOF has a tax year of less than six months, the test is done on the last day of the year.)
There are other requirements, some described above, that have been subject to uncertainty pending release of the second round of regulations. Key points addressed include:
Selling/Exiting a QOF Investment
Under the statute and first round of proposed regulations, the owner of an eligible interest in a QOF that has been held for 10 years can sell the interest and recognize no gain. The newly issued proposed regulations also provide that certain gains from a QOF’s sale of assets can also be excluded from taxable income provided the 10-year holding requirements are met.
In addition, the proposed regulations provide guidance on events other than a sale of a QOF interest that can trigger gain recognition. Highlighted below are some of the potential issues when considering a sale or other transfer of an interest in a QOF or a sale of QOF assets:
Existing Owners of Property or a Business in an Opportunity Zone
One common question concerns what opportunities exist for current owners of real property located in an opportunity zone. While just owning or selling the property does not provide any opportunity zone tax benefits, there are three distinct possibilities for an owner to consider in order to make use of the Opportunity Zone tax incentives. An owner could sell property to a QOF and roll over the gain into the QOF, but the owner must own 20% or less of the QOF to avoid the related party rules. Perhaps a more attractive option for a taxpayer wanting to maintain control is to lease the property to a QOF. If lease payments are based upon market-based rates, there are no related party prohibitions, although when related parties are involved, lease prepayments are forbidden and, in the case of leased tangible personal property, a QOF must acquire additional tangible personal property at least equal in value to the leased property. Finally, a taxpayer with otherwise qualifying gain could contribute real property to a QOF (in lieu of investing the gain), but, as discussed earlier, this may raise issues for the QOF regarding the status of the property as non-qualifying property.
Although there are still open questions, the second round of proposed regulations on Opportunity Zone tax incentives provide welcome guidance that will allow many investors and QOF developers to move forward with plans to form and operate QOFs. The Treasury Department has requested comments on several topics, so it will be important to monitor changes. In addition, states have taken varying approaches to conforming to the Opportunity Zone tax incentives and, in some cases, offer additional incentives for development in opportunity zones.
Please consult your Eide Bailly professional, Adam Sweet, Principal and Director of Eide Bailly’s Passthrough Entity Group or Joe Monty, Partner and leader of Eide Bailly’s Opportunity Zone Implementation Team, with any questions related to Opportunity Zone tax incentives and the new proposed regulations.