Qualified Opportunity Funds
The Tax Cuts and Jobs Act of 2017 enacted two code sections pertaining to Qualified Opportunity Zones: Code sections 1400Z-1 and 1400Z-2. Code section 1400Z-1 provides for the designation of certain areas as Qualified Opportunity Zones and Code section 1400Z-2 provides for an election to defer certain capital gains if the proceeds of the gain are invested in a Qualified Opportunity Fund (“QOF”). Recently, proposed regulations were issued to provide guidance and clarify several issues raised by these new code sections that were not previously clear.
A QOF is a corporation or partnership which invests in Qualified Opportunity Zone property (other than another QOF) and satisfies the asset test, under which 90% of the fund’s assets must be Qualified Opportunity Zone property. Qualified Opportunity Zone property includes Qualified Opportunity Zone stock, Qualified Opportunity Zone partnership interest and Qualified Opportunity Zone business property.
A capital gain from a sale or exchange of property may be deferred at the election of the taxpayer if the gain is reinvested within 180 days in a QOF and the sale is not made to a related party. The capital gain will retain its attributes (i.e., long-term or short-term). The tax on the deferred capital gain will be due on the earlier of (i) the date of disposition of the interest in the QOF or (ii) 12/31/2026. The amount of deferred gain included in income at that time will be equal to the lesser of the excluded gain or the fair market value of the investment on that date if the investment was held for less than five years. The gain will be reduced if the investment is held for more than five years as discussed below.
The 180-day investment rule begins on the date of the sale or exchange of the property. Special rules apply to owners of pass-through entities, where the sale or exchange date may not be clear. For these taxpayers, the 180-day period begins as follows:
- For partnership/S Corporation owners: (a) on the last day of the entity’s tax year or (b) on the day of sale by the entity, at the election of the partner or shareholder.
- For capital gain dividends received by RIC and REIT shareholders: on the day the dividend is paid.
- For undistributed capital gains taxed to RIC or REIT shareholders: on the last day of the REIT or RIC’s tax year.
The proposed regulations clarify that only capital gains are eligible to be deferred. Therefore, if the gain is ordinary, no deferral is permitted, and the gain must be recognized in the year of the sale or exchange. It is not clear, however, if a Section 1231 gain would also qualify to be deferred. Additionally, the proposed regulations state that a related party must meet the definitions under section 267(b) and 707(b), replacing 50% with 20%.
The taxpayer will receive a greater tax benefit the longer the interest in a QOF is held:
- If the interest is held for five years, the deferred gain is discounted by 10%, meaning only 90% of the gain would be taxed.
- If the interest is held for seven years, the deferred gain is discounted by 15%.
- If the interest is held for 10 years, any additional post-acquisition gain due to appreciation in the value of the QOF can be eliminated under an election to treat the basis equal to the fair market value. This only applies when the interest is acquired with cash and cannot be acquired with other assets.
In order to benefit from the deferral of gain, eligible taxpayers must make an election. The election will be made on Form 8949 attached to the tax return for the year the gain would have been recognized.
Eligible taxpayers include:
- Corporations (including RICs and REITs)
- S corporations
Partnerships may make the election to defer the gain. If the election is made, the portion of the deferred gain is not allocated to the partners until the gain is recognized. However, if the partnership does not make the election, the gains are allocated to the partners based on their distributive shares, and each partner may elect to defer some or all of their eligible gain as determined at the partnership level. These rules also apply to an S corporation, a trust, or a decedent’s estate.
If a taxpayer makes the election but disposes of its interest in the QOF prior to 12/31/2026, a new 180-day period is created for investment in a new QOF in order to continue to defer the original gain. However, the entire initial investment must be disposed of. Otherwise, the gain is recognized on the date of the sale or exchange.
In order to be treated as a QOF, a corporation or partnership must self-certify as a QOF. This is done by filing Form 8996, which will serve both as the initial self-certification of the fund and annual reporting of compliance with the 90% asset test. Form 8996 will be attached to the federal tax return of the entity for each relevant year.
Self-certification allows the taxpayer to choose the first month of its initial tax year as a QOF. The QOF’s first month will default to the first month of its initial tax year if it fails to specify its first month. The 90% asset test is based on the average of the first six-month period of the tax year and the last day of the tax year. However, if the entity becomes a QOF after month 7 of a 12-month tax year, the 90% test only takes into account the assets on the last day of the tax year. Investments made before the entity’s first day of QOF are not eligible for the deferral election, and the valuation of the assets included in the 90% asset test will be based on applicable financial statements for the tax year. If not available, the cost of the assets will be used.
There is a benefit for the QOF to invest in Qualified Opportunity Zones through a business operating as a corporation or a partnership (QOZ business) rather than investing directly in a Qualified Opportunity Zone property. A QOZ business is an entity in which substantially all of the tangible property owned or leased by the business is Qualified Opportunity Zone property. For these purposes, “substantially all” means 70% of the tangible property. Through proper structuring, a QFO could effectively reduce the required asset test percentage by investing in a QOZ business.
To illustrate, assume a QOF will invest $10M into a qualified opportunity zone.
- If the QOF holds the real property directly, then 90% ($9 million) of the real property held by the QOF must be located within an opportunity zone.
- If the QOF invests in a subsidiary entity that holds the real property, then only 70% ($7 million) of the property must be located in an opportunity zone.
By having a subsidiary entity as the holder of the property, the QOF would only have to invest $7 million of its assets into a Qualified Opportunity Zone to receive the same tax benefit as if it held the property directly.