On October 19, 2018, the IRS issued highly-anticipated proposed regulations regarding qualified opportunity funds ("QOFs"), which were created as part of the 2017 Tax Act. The proposed regulations address several key issues related to the establishment of a QOF and the initial investments by taxpayers into such funds. The IRS also released a new explanatory Revenue Ruling and a draft QOF self-certification form with instructions. With this guidance, investors and QOF organizers are now in a position to take steps to implement investments under the QOF provisions.
Under the new QOF rules, taxpayers can invest gain proceeds into economically depressed areas known as qualified opportunity zones ("QOZs") and achieve:
- a deferral (and 10-15% reduction) of taxation on the original gains, and
- tax-free treatment of appreciation while invested in the QOF, achieved through a basis step-up to fair market value upon exit after at least 10 years in the QOF.
As an example, consider an investor who (i) sold an asset in January of 2019 generating $100 of capital gain, (ii) invested the $100 gain proceeds into a QOF within 180 days, and (iii) sold his or her interest in the QOF after more than ten years when its value had appreciated to $250. Only $85 of the original $100 of capital gain would be taxed as if it had been recognized on December 31, 2026, and the investment in the QOF would be stepped up to FMV basis of $250 upon exiting the QOF, generating zero additional tax liability for the investor.
For more details on the fundamentals of QOFs, see our prior alert, "Qualified Opportunity Zones - Waiting for Guidance."
Investing in a QOF
The proposed regulations take the position that only capital gains are eligible for deferral. The gains must result from an actual or deemed sale or exchange, or from any other gain includible in a taxpayer's computation of capital gain. The gain may not arise from a sale or exchange with a related person, applying a restrictive 20% relationship test. Any taxpayer that recognizes capital gain for federal income tax purposes is eligible to elect deferral: individuals, C corporations (including RICs and REITs), partnerships, S corporations, and trusts or estates. Partnerships and S corporations can elect to roll over gains into a QOF at the entity level, and if they choose not to, then partners or S shareholders, respectively, may individually elect deferral into a QOF.
Generally, taxpayers must invest qualified gains into a QOF within 180 days of the initial sale. The IRS has instructed taxpayers to use Form 8949 to elect gain deferral. If a partnership is making the election, the 180-day period begins on the date that the partnership sells or exchanges the asset. If a partner elects deferral, the 180-day period normally does not begin until the last day of the partnership taxable year in which the realization event occurred, which is the date on which the partner would otherwise recognize his or her allocable share of the gain. Analogous rules apply to other pass-through entities, such as S corporations.
The proposed regulations make clear that a taxpayer is permitted to make multiple elections for portions of gain from a single initial sale or exchange of property (e.g., the taxpayer could make several investments into different QOFs) as long as they are all within the 180-day period. Taxpayer funds that do not qualify or are not subject to a deferral election may be invested into a QOF, but must be treated as a separate investment, and are not eligible for the basis step-up after ten years or other QOF tax benefits.
The IRS has created new Form 8996 for QOFs to self-certify their status as QOFs, and to report semi-annual compliance with the 90% asset test. Both Form 8996 and Form 8949 should be attached to the taxpayer's relevant federal income tax return. The QOF may identify the taxable year and month it is to be first treated as a QOF. The proposed regulations clarify that there is no prohibition against using a pre-existing entity as a QOF (or as a subsidiary entity), provided that the pre-existing entity satisfies the relevant requirements.
While QOZ designations expire on December 31, 2028, taxpayers may make the basis step-up election after that point (until December 31, 2047). For example, the latest gain eligible for a deferral election would be recognized on December 2026, and the corresponding 180-day period would end in June 2027. The 10-year holding period would be achieved in June 2037 - the proposed regulations provide taxpayers ten years after that to elect the basis step-up in conjunction with a disposition of their investment at a gain.
QOF Qualification - the 90% Asset Test
Only an entity classified as a corporation or a partnership may be a QOF, the latter of which includes multiple-member LLCs. At least 90% of QOF assets must be held in QOZ property, which includes QOZ stock, QOZ partnership interests, and QOZ business property (tangible property used in a trade or business of a QOF). For purposes of meeting the 90% test, the proposed regulations state that a QOF must use the asset values reported on its applicable financial statements for the taxable year, or the cost of the assets if the QOF has no such statements.
QOZ Business and QOZ Property
QOZ stock and partnership interests must hold qualifying QOZ businesses. As such, the lower tier corporation's or partnership's trade or business must: (i) be a QOZ business both (a) when the QOF acquires its interest in the entity and (b) during substantially all of the QOF's holding period for that interest, and (ii) be one in which substantially all of the tangible property owned or leased by the taxpayer is QOZ business property. If at least 70% of the tangible property owned or leased by a trade or business is QOZ business property, it is treated as satisfying the substantially all requirement.
If an entity qualifies as a QOZ business, the value of the QOF's entire interest in the entity counts toward the QOF's satisfaction of the 90% asset test. Thus, if a QOF operates a trade or business (or multiple trades or businesses) through one or more entities, then the QOF clearly can satisfy the 90% asset test if each of the entities qualifies as a QOZ business. If a QOF operates a trade or business directly and does not hold any equity in entities, at least 90% of the QOF's assets must be QOZ property. Obviously, the 70% threshold applied for QOF interests in entities is more taxpayer-friendly than the 90% asset test standard for direct holding of qualified opportunity zone business property.
The proposed regulations introduce a new working capital safe harbor for tangible business property, which, if certain conditions are met, allows business property such as cash to be held for up to 31 months without jeopardizing the requirement that less than 5% of the basis of property of a QOZ business consist of nonqualified financial property. To qualify: (i) there must be a written plan identifying the financial property as held for the acquisition, construction or substantial improvement of tangible property in a QOZ; (ii) the QOF must have a written schedule showing that the financial property will be used within 31 months; and (iii) the business must substantially comply with the schedule. It is unclear if this working capital safe harbor will be expanded by Treasury for the purpose of applying the more general 90% test for QOZ property.
Property only qualifies as QOZ business property if: (i) the property was acquired by purchase after December 31, 2017; (ii) the original use of the property in the QOZ commences with the QOF or the QOF substantially improves the property; and (iii) during substantially all of the QOF's holding period for the property, substantially all of the use of the property was in a QOZ.
Newly issued Revenue Ruling 2018-29 provides taxpayer-friendly guidance regarding the substantial improvement and original use tests when applied to the purchase of land with an existing building. The ruling provides that the underlying land is not included when determining whether substantial improvements (improvements equal to 100% or more of the initial cost basis) have been made to the building, nor must the land be somehow separately improved upon. Furthermore, the rules relating to original use within a QOZ do not apply to the land, as land only has a single perpetual use.
The IRS and Treasury are working on additional guidance including another set of proposed regulations. The new guidance is expected to address clarification of the types of transactions that may trigger the inclusion of gain that can be deferred under a QOF election, identification of the "reasonable period" for a QOF to reinvest proceeds from the sale of qualifying assets without incurring a penalty, the meaning of "substantially all" in each place where relevant, the original use requirement, administrative rules applicable when a QOF fails to maintain the required 90% investment standard, conduct that could lead to a decertification of a QOF, and information-reporting requirements.
The proposed regulations are not in final form. In the interim, taxpayers may generally rely upon the proposed regulations if they apply them in their entirety and in a consistent manner. As such, taxpayers have been given enough information to start taking advantage of the outstanding tax benefits available to taxpayers making investments in QOFs.
We would be happy to talk with current and potential clients who have questions on qualified opportunity zones, including setting up QOFs, rolling over gain into a QOF, satisfying the substantial improvement test for real estate, and structuring investments in a QOZ to better allow a third-party QOF to invest in a property.