Deferring Gain by Investing in Qualified Opportunity Zone Funds

Article Prepared by FGMK Tax Partner Perry Weinstein and Tax Manager Jeff Golds

One of the many changes in the Tax Cuts and Jobs Act of 2017 (the “TCJA”) is the creation of a new economic tool: the Qualified Opportunity Zone Fund.  This tool allows taxpayers to defer tax on capital gains from the sale of property to an unrelated party by investing in a Qualified Opportunity Zone Fund (a “QOF”), and potentially avoid any taxation on appreciation on the QOF investment.   On October 19, 2018, the Internal Revenue Service (“IRS”) and the U.S. Department of Treasury (“Treasury”) released of the first set of proposed regulations related to Qualified Opportunity Zones (“QOZs”) and QOFs (the “Proposed Regulations”).  These Proposed Regulations offer guidance taxpayer’s had been seeking before investing in and operating QOFs.  However, several important questions remain unanswered, and the IRS will ideally address these outstanding uncertainties in additional guidance in the near future.  

Qualified Opportunity Zones

Section 1400Z-1 of the Internal Revenue Code (the “Code”) lays out the procedure for designation of a QOZ.  A QOZ is any low-income census tract (a defined term under the law) designated by the chief executive officer of a state as a QOZ and approved by the Secretary of the Treasury.  Additionally, a census tract which is contiguous to a designated QOZ may also be designated as such as long as the median family income of the tract is not 125 percent greater than the contiguous low-income community.   The first set of QOZs were designated on April 9, 2018, and as of June 2018, every state had designated QOZs.  The locations of these zones are available through each state, as well as through the Community Development Financial Institutions Fund and can easily be found online. There is significant, but not complete, overlap with census tracts which are eligible for New Markets Tax Credit projects.

Qualified Opportunity Zone Funds

Section 1400Z-2 of the Code lays out the rules for QOFs.  A QOF is an investment vehicle organized and taxed as a corporation or partnership which is formed for investing in Qualified Opportunity Zone Property.  A QOF self-certifies as such by completing and filing new Form 8996 (Qualified Opportunity Fund) with its income tax return.  When self-certifying, the QOF entity must elect a tax year in which it will be treated as a QOF, as well as which month in such year the election will be effective.  Failure to select a month will result in the first month of the entity’s taxable year being the effective month.  Existing entities may elect to be treated as QOFs, and property held by an existing entity at the time of the election may be treated as Qualified Opportunity Zone Property as long as it meets all the necessary requirements (e.g., was acquired by the entity after December 31, 2017, was not acquired from a related party, etc.).  However, any investments in an entity prior to the effective date of the QOF election will not be treated as a QOF interest eligible for gain deferral or the 10-year election.  While property can be acquired by a QOF prior to the election being effective, investors in the QOF must wait until after the election to invest with gain to be deferred. 

The QOF must hold at least 90 percent of its assets in qualified opportunity zone property (using a weighted average approach described in the law) (the “90 Percent Test”).  The taxpayer reports its compliance with the 90 Percent Test on its filed income tax return.  The applicable testing date is the last day of the QOF’s tax year.  If the QOF is established less than six months into the tax year, the QOF will have an additional first year testing date as of the first six months of the fund.  The 90 Percent Test utilizes a weighted average calculation that is determined using the asset value as shown on the QOF’s Applicable Financial Statement (defined under Treas. Reg. Section 1.475(a)-4(h)), if the QOF maintains one, or the cost basis of such assets if the QOF does not maintain Applicable Financial Statements.  

Qualified Opportunity Zone Property is either:

  • Qualified Opportunity Zone Stock (presumably either a “C” or “S” domestic corporation);
  • Qualified Opportunity Zone Partnership Interest; or
  • Qualified Opportunity Zone Property.

The ownership of Qualified Opportunity Zone Stock or Qualified Opportunity Zone Partnership Interest constitutes ownership in a Qualified Opportunity Zone Business.  A Qualified Opportunity Zone Business is a trade or business in which substantially all of the tangible property owned or leased is Qualified Opportunity Zone Business Property. The Proposed Regulations do not clarify whether or not, and to what extent, the rental of real property constitutes a “trade or business”.  As this question is not defined in the Code either, ultimately it has fallen on the courts to determine to what extent operating a rental property constitutes a trade or business.  Generally speaking, the more active an owner is in the management of a building, the more likely the rental of such building would constitute a trade or business.  For example, it is likely that ownership of a triple net lease property would not constitute a trade or business, whereas direct management of the day-to-day activities of the real property would.  Barring clarifying guidance from the IRS in the future, determination of whether real estate rental is a trade or business for QOF purposes will require a facts and circumstances analysis on a case-by-case basis. 

In addition to the trade or business requirement, a Qualified Opportunity Zone Business must derive at least 50 percent of its income from an active trade or business, must use a substantial portion of any intangible property owned in an active trade or business, and less than five percent of the business’s unadjusted basis in property may be attributable to financial property (e.g., cash or marketable securities).  

The Proposed Regulations provide a safe harbor with respect to the five percent financial property rule. Cash held as “working capital” will not be considered ineligible financial property as long as a written development plan detailing the use of the cash for acquisition, construction, and/or substantial improvement of tangible property exists, the plan calls for the use of all working capital within 31 months of acquiring the asset, and all working capital is in fact spent as detailed in the development plan (the “Working Capital Safe Harbor”).  Additionally, the Proposed Regulations clarify that any income derived from financial instruments held under the Working Capital Safe Harbor will count as income earned from an active trade or business.  As this is a safe harbor, it only provides for the guaranteed treatment of cash if held pursuant to its rules.  If a taxpayer submits an unrealistic construction schedule to which it does not adhere, the Working Capital Safe Harbor would be deemed ineffective and the business would not be considered a Qualified Opportunity Zone Business for purposes of the 90 Percent Test.  Similarly, a delay in construction that causes working capital to be held beyond 31 months would result in the inapplicability of the Working Capital Safe Harbor and could cause the cash to be treated as non-qualified financial property.  As a result, the Qualified Opportunity Zone Business utilizing the Working Capital Safe Harbor would cease to qualify for purposes of the 90 Percent Test.   However, the Code contains a “reasonable cause exception”, which allows a taxpayer to avoid application of the penalty for failure to meet the 90 Percent Test if the taxpayer can show that its failure to meet the 90 Percent Test is due to reasonable cause.  While a taxpayer who falls outside of the Working Capital Safe Harbor would not be able to avail itself of the safe harbor’s protection, it would still potentially be able to claim reasonable cause assuming the failure was due to circumstances outside of their control.  The Proposed Regulations request input as to whether the Working Capital Safe Harbor is sufficient to allow development to occur without running afoul of the five percent financial property limit. 

It should also be noted that, while the Proposed Regulations only provide the working capital safe harbor with respect to the five percent financial property rule for a Qualified Opportunity Zone Business, the preamble to the Proposed Regulations states that the working capital safe harbor exists for the 90 Percent Test at the QOF level as well.  There is therefore reason to believe the intent of the IRS is for the Working Capital Safe Harbor to apply both to QOFs, as well as cash held in a Qualified Opportunity Zone Business.  However, the IRS and Treasury need to issue additional guidance before this is clear. 

To qualify as Qualified Opportunity Zone Business Property the fund must acquire such property by purchase after December 31, 2017 and before January 1, 2026.  The original use of such property must commence with the QOF or the QOF must “substantially improve” the property, which means it must double its adjusted basis over 30 months, and substantially all (which, according to the Proposed Regulations, means 70 percent) of the use of such property must occur in the QOZ for substantially all of the QOF’s holding period.  The 70 percent substantially all standard is tested using the same applicable financial statement/cost basis rules as the 90 Percent Test.  For Qualified Opportunity Zone Businesses with multiple owners owning five percent or more the interest in such business, the 70 percent substantially all test will utilize the methodology (either applicable financial statement or cost basis) of the five percent owner that yields the highest use percentage.  

With regard to what costs must be considered in determining whether property has been “substantially improved”, the Proposed Regulations, as well as Revenue Ruling 2018-29, state that only the basis of a building is used to determine the adjusted basis of property for purposes of the “substantial improvement test”.  This means that land value is not considered, which lowers the threshold for substantial improvement. 

Additionally, a Qualified Opportunity Zone Business may not operate a so called “sin business”, which includes a 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.  While no regulations exist around the definition of a “sin business”, several other federal programs, including the New Market Tax Credit, reference the same definition of “sin businesses” and prohibit investment in these businesses as well.  Under these programs, only those businesses directly referenced as being a so-called “sin business” are prohibited: related businesses, (e.g., a brewery which produces beer) have not been treated as disqualified. 

Qualified Opportunity Zone Property does not need to be located in the same state as the QOF. A QOF may invest in any property in the United States which is located in a QOZ.  Additionally, unlike with the New Markets Tax Credit program, a QOF may invest in property eligible for Low Income Housing Tax Credits.  However, a QOF may not invest in another QOF.  Moreover, should a QOF fail to have at least 90 percent of its assets invested in Qualified Opportunity Zone Property, the QOF will be required to pay a monthly penalty (subject to possible reasonable cause exceptions) in the amount of the difference between 90 percent of the QOF’s assets and the percent of such assets invested in Qualified Business Property, multiplied by the Federal Short-Term Interest Rate plus three percent.  Regulations detailing the operation of this penalty are still forthcoming. In a situation where tangible property that originally qualified as Qualified Opportunity Zone Business Property ceases to qualify, it will continue to be treated as qualifying for up to five years from the date of disqualification.  In addition, Qualified Opportunity Zone Business Property will continue to be treated as such until December 31, 2047, even if the QOZ ceases to be designated, as long as the investment was made while the area was still a QOZ.  This means that investments made prior to the end of 2026 will still be able to enjoy the 10 year holding period election, even though all QOZ designations expire at the end of 2026.

Investing in a QOF

As described under Section 1400Z-2, a taxpayer who realizes any gain that would be treated as capital gain on the sale of property may invest the amount of cash equal to the gain invested in a QOF and defer the recognition of such gain until the earlier of sale or redemption of the QOF interest or December 31, 2026.  However, gain arising from a related party transactions or gains from the sale of property held in an offsetting-position (i.e. hedging) transaction may not be deferred through investment in an QOF.  Any type of interest in a QOF, other than debt, is considered an eligible interest.  This includes both preferred stock and partnership interests with special allocations. With respect to who may invest in a QOF, the Proposed Regulations clarify that a partnership or S-corporation may directly invest in a QOF to defer gain at the entity level, or may distribute the gain to the individual partners or shareholders who may invest in a QOZ individually. 

Such gain must be invested in a QOF within 180 days of the recognition of the gain by the taxpayer.  In most instances, this will mean the date the sale is consummated; however, if a pass-through entity sells property and distributes the gain to its partners (or shareholders), each partner (or shareholder) recognizes gain on the last day of the pass-through entity’s tax year, rather than the date of the sale.  Should the individual partner or shareholder prefer an earlier gain recognition date, however (e.g., the taxpayer is interested in investing the gain in a QOF prior to the end of the pass-through entity’s tax year), a partner (or shareholder) may elect to use the date the pass-through entity recognized the gain, rather than the last day of the entity’s tax year.  It should be noted that taxpayers who recognized capital gains in 2017 who invested such gain in a QOF within 180 days of recognizing the gains can amend their 2017 return with an attached Form 8949 (Sales and Other Dispositions of Capital Assets) and defer the gain.

Mechanically, the gain is deferred by making an election on Form 8949 and attaching such form to the taxpayer’s income tax return for the year the gain would have been recognized.  While the gain on the sale is at that point deferred, the taxpayer takes a basis of $0 in the QOF interest.  As a result, the taxpayer may recognize the lesser of the deferred gain or the fair market value (“FMV”) of the QOF interest at the time of its sale of such QOF interest.  This means that, if the investment loses value, the excess of the originally deferred gain will be eliminated entirely. 

Unlike Section 1031 tax deferred exchanges, only the gain, rather than the entire sales price need be reinvested.  Furthermore, it appears that there is no need to escrow or otherwise set aside the gain proceeds.  The Proposed Regulations did not address this issue, however, so more clarity from the IRS and Treasury would still be helpful.

As an additional incentive to hold QOF investments long term, the Code provides that, after five years, the basis of the QOF interest will increase from $0 to 10 percent of the deferred gain.  Then, after seven years, the basis will increase by an additional five percent of the deferred gain.  If the QOF is still held by the taxpayer on December 31, 2026, the taxpayer will be required to recognize the deferred gain, capped at the FMV of the interest as of that date (less the stepped-up amounts, if applicable), and will take a FMV basis in the QOF interest.  However, at the taxpayer’s election, a QOF interest held for at least 10 years will have a basis of whatever the FMV of the QOF interest is on the day of the sale.  Should the taxpayer hold the QOF interest for at least 10 years and make the election, any appreciation of the QOF interest above the gain recognized at the end of 2026 would be tax free. 

Though unaddressed by the Proposed Regulations, it appears that a QOF could invest in property that would produce tax credits.  For example, a building could install solar panels on the roof and then allocate the Section 48 energy credits to the holders of the QOF interest.  In doing so, the QOF could produce current year tax benefits for the interest holders in addition to allowing for the long-term gain deferral. 

If a taxpayer invests funds that are not related to a deferred gain into a QOF, the taxpayer would receive a normal partnership interest/member interest in the fund: the deferral of gain and potential elimination of appreciation would not be available with respect to such interest (the “Standard Interest”).  As such, if an investor invests in a QOF, only a portion of which relates to a deferred gain, the investor will receive two distinct interests in the QOF, and only the interest related to the deferred gain will receive the special treatment described herein (the “Deferred Gain Interest”).  Furthermore, per the Proposed Regulations, a taxpayer who divests itself of less than its total interest in a QOF must use the first-in-first-out (“FIFO”) method in determining the treatment of the divested amount.  If a taxpayer has both a Standard Interest and a Deferred Gain Interest, the timing of their acquisition of such interests will determine whether or not deferred gain must be recognized.  While this is not necessarily a taxpayer favorable rule, the Proposed Regulations did provide another basis related rule that is favorable to taxpayers: any Section 752 imputed contributions will be disregarded for determining the basis of the taxpayer’s QOF interest.  This means that any loans taken on by the QOF will not result in a basis increase for the taxpayer.  While a taxpayer would typically desire an increased basis in a partnership or shareholder interest, the clarification benefits the taxpayer, as it clarifies that such treatment prevents recharacterization of a Deferred Gain Interest as a Standard Interest.  Prior to the Proposed Regulations, there had been thought that Section 752 imputed contributions would result in the taxpayer receiving a Standard Interest in the amount of such basis.  This would have resulted in the taxpayer realizing less appreciation tax free after making a 10-year election.  By disregarding Section 752 contributions, taxpayers will not be penalized for utilizing debt to construct or improve Qualified Opportunity Zone Property.  Similarly, the Proposed Regulations allow taxpayers to utilize their QOF interest as collateral for both business and personal debt taken outside of the QOF.  This allows taxpayers increased financial flexibility when choosing to invest gains in a QOF.

Example:  Investment in a QOF in 2018

An example of the how a taxpayer could take advantage of these rules is as follows.  A sells a building he owns on July 1, 2018 for $100,000.  The building had a basis in A’s hands of $50,000 at the time of the sale.  A immediately invests $50,000 in a QOF.  In 2018, A would not recognize the $50,000 of realized gain on the building (the “Deferred Gain”), and A would have an interest in the QOF with a FMV of $50,000 and with a basis of $0.

Example 1:  Sale in 2022

In the first scenario, A sells his QOF interest on July 1, 2022 for $50,000 to a third-party buyer in an arms-length transaction.  A would recognize gain on the sale of the QOF interest of $50,000, which is equal to the Deferred Gain.   Alternatively, if A sells the QOF interest for only $40,000, then A will recognize only $40,000 of gain, as A is required to recognize the lesser of the FMV at the time of sale, or the Deferred Gain.  Finally, if A sells the QOF interest for $60,000.  A would recognize $60,000 of gain in a two-step process:  1) A recognizes $50,000 of deferred gain in 2022, and takes a $50,000 basis in the QOF interest, and 2) A recognizes $10,000 of gain on the sale of QOF interest for the excess of the $60,000 sales price over his $50,000 basis.

Example 2:  Sale in 2024

In the second scenario, A holds his QOF interest for six years, and sells it on July 1, 2024 to a third-party buyer in an arms-length transaction.  A would now have a basis in the QOF interest of $5,000 due to the 10 percent basis step-up after five years.  Therefore, A would recognize $45,000 of gain in 2024 (the Deferred Gain less the stepped up basis).  Alternatively, if A sells the QOF interest for $40,000, A would have $35,000 in gain, which is the FMV at the time of the sale, less A’s $5,000 basis.

Example 3:  Asset held through December 31, 2026

In the third scenario, A is still holding his QOF interest on December 31, 2026.  A now has a basis in the QOF interest of $7,500 due to the 10 percent basis step-up after five years and additional five percent basis step-up after seven years. If the QOF interest has a FMV of $50,000, A would recognize $42,500 of gain at the end of 2026.  Alternatively, if the QOF interest only has a FMV of $40,000, A would recognize $32,500 of gain at the end of 2026, which is the FMV less his stepped-up basis.

Example 4:  Sale in 2029

Finally, A sells the QOF interest on July 1, 2029 for $100,000.  As A has held the QOF interest for more than 10 years, he makes the election under 1400Z-2(c) and takes a basis in the QOF interest of $100,000 at the time of the sale.  A therefore recognizes no gain on the appreciation of the QOF interest.  This is true regardless of what A’s basis was prior to the sale. 

Below is a chart summarizing the results described in the examples above:

 

 

Example

1

Example

2

Example

3

Example

4

Year

2022

2024

2026

2029

Basis in QOF

$0

$5,000

$7,500

$40,000*

Gain on $40,000 Sale

$40,000

$35,000

$32,500

$0

Gain on $50,000 Sale

$50,000

$45,000

$42,500

$0

Gain on $60,000 Sale

$60,000

$55,000

$52,500

$0

 

*For purposes of this table, assume the interest had a FMV of $40,000 at the end of 2026 and recognized gain of $32,500, resulting in a $40,000 basis prior to the sale in 2029.

Planning Ideas and Uncertainty

As the market develops around QOFs, various planning ideas have emerged as well.  An owner of real estate looking to develop a new property could sell its existing property and invest in a new property through a QOF.  The owner would still manage the new property the same way it managed the sold property but would now have the potential to avoid taxation on any appreciation of the new property.  Similarly, a business looking to open a new facility might open the facility in a Qualified Opportunity Zone and use a QOF to avoid tax on appreciation.  While the Proposed Regulations have provided helpful clarity, important questions remain. Will any restrictions be placed on the use of preferred stock or partnership interests utilizing special allocations?  What are the consequences of the QOF selling Qualified Opportunity Zone Property?  Does the “Working Capital Safe Harbor” apply at the QOF level for purposes of the 90 Percent Test, or only at the Qualified Opportunity Zone Business level?  Similarly, does the “sin business” limitation only apply at the Qualified Opportunity Zone Business level, meaning a QOF could own and operate a golf course or tanning salon, so long as it does so directly? 

While these questions, as well as others remain outstanding, it is anticipated that the release of the Proposed Regulations will signal the beginning of significant investments in Qualified Opportunity Zone property.  For taxpayers with significantly appreciated property, or looking to invest in developing areas, time is of the essence in determining whether a Qualified Opportunity Zone Fund would be an effective strategy.  Taxpayers considering QOFs should contact their FGMK, LLC consultant to further explore creative ways to benefit from this new law.

 

About FGMK

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