At the end of 2017, the Tax Cuts and Jobs Act added sections 1400Z-1 and 1400Z-2 to the Internal Revenue Code to create Qualified Opportunity Zones (QOZs) to encourage economic growth and investment in distressed communities. To incentivize this, the legislation authorized the deferral of tax on capital gains that are reinvested in these QOZs. With the issuance in October 2018 of the first proposed Treasury regulations to provide some guidance, the awareness of QOZs went into high gear.
Qualified Opportunity Zones were identified in 2018 in IRS Notice 2018-48; there are more than 8,700 QOZs across the United States, including 628 in Texas (six in Tarrant County and 18 in Dallas County). Absent new legislation, the currently designated QOZs are the only QOZs.
Investment in QOZs provides an opportunity to defer paying tax on capital gains arising from a sale or exchange of property. Unlike deferral through a 1031 exchange, this deferral is available for capital gains from the sale of “any property” (not just real estate) and does not require the use of qualified intermediaries or the other mechanisms required for a 1031 exchange. While there are parameters within which investments must be made, they are broader than for 1031 exchanges. An eligible taxpayer may defer gain reinvested in a QOZ until the earlier of (1) the sale of such investment or (2) Dec. 31, 2026. As additional incentives, if the investment is held for at least five years, then 10 percent of the deferred gain is eliminated, and if the investment is held for at least seven years, then a further 5 percent of the deferred gain is eliminated. Obviously, if an investment is held past Dec. 31, 2026, then the taxpayer will need to find funds to pay the tax on the original deferred gain, but if the investment is held for at least 10 years, then all gain from the new investment in the QOZ (but not the deferred gain from the original transaction) is eliminated.
To be eligible for deferral, the gain must arise from a sale or exchange that occurs on or before Dec. 31, 2026, although certain gains (e.g., depreciation recapture or straddle transactions) are expressly excluded. Unlike a 1031 exchange, the entire sale proceeds need not be reinvested in a QOZ to permit deferral of the gain, but only the amount of the gain to be deferred. If more than the deferred gain is invested, then only that portion of the investment attributable to the reinvestment of the deferred gain is entitled to the gain elimination benefits described above and the remainder is treated as a separate investment. Deferral does not recharacterize the original deferred gain; e.g., short-term capital gain will not be converted into long-term capital gain. And it is important to note that proceeds from a sale or exchange with a person who is related to the taxpayer will not be eligible for deferral by investment in a QOZ.
Investors eligible for deferral include individuals, partnerships, corporations, trusts and estates. If a partnership or other “pass-through” entity does not itself elect to defer some or all of the gain by investment in a QOZ, then the partners or other owners are themselves eligible to defer their share of gain by their own investment in a QOZ. An investment in a QOZ must be made within 180 days after the date of the underlying sale or exchange. For gain that is not deferred by a partnership or other pass-through entity, the 180-day period for the owners to elect to defer begins on the last day of the entity’s taxable year, but an owner may instead elect for such 180-day period to begin on the date of the sale or exchange by the entity.
The deferral investment by the taxpayer cannot be made directly in property, but must be made through a “qualified opportunity fund” (QOF), which is a U.S. entity taxed as a corporation or partnership (which would include a limited liability company that is not a single-member, disregarded entity). At least 90 percent of a QOF’s assets must be “qualified opportunity zone business property,” which is property purchased after Dec. 31, 2017, that is used in a trade or business within a QOZ and either (1) whose original use commenced with the QOF or (2) the QOF “substantially improved” the property, which requires additions to the property within the first 30 months after acquisition that exceed the QOF’s initial tax basis in the property. If the acquired property includes both land and improvements, then the
land is excluded for purposes of this test. Failure to meet this 90 percent test results in a monetary penalty but not disqualification as a QOF. It is vital to note that all equity interests, activities and properties must be acquired or commenced after Dec. 31, 2017; while an entity in existence prior to Dec. 31, 2017, is not prohibited from being a QOF if it otherwise qualifies, substantially all pre-2018 activities must be eliminated.
Instead of directly owning qualified opportunity zone business property, a QOF may own “qualified opportunity zone stock” or a “qualified opportunity zone partnership interest” in a U.S. corporation or partnership that directly conducts a “qualified opportunity zone business” (and thus is not another QOF). The equity must be acquired by the QOF in a direct issuance from the corporation or partnership (rather than as a transfer from an existing owner) after Dec. 31, 2017, and the acquisition must be solely for cash (rather than as an in-kind contribution). The entity must be an existing qualified opportunity zone business or, if a start-up entity, be organized for that purpose. Equity may be preferred stock, capital or profits interest in a partnership, or a partnership interest with special allocations, but debt is not eligible.
A “qualified opportunity zone business” is a trade or business (if not on a short list of prohibited businesses) that meets the following criteria:
• At least 50 percent of the total gross income of such entity is derived from the active conduct of such business.
• At least 70 percent of the property owned or leased by the trade or business is qualified opportunity zone business property.
• Less than 5 percent of the property is attributable to securities or other investment assets, although reasonable amounts of cash working capital or short-term debt instruments are permitted. Initial working capital raised for the acquisition, construction and/or substantial improvement of the property must be spent within 31 months of receipt in order to be deemed “reasonable.”
Additional Treasury regulations are expected to be proposed in the near future that will address issues reserved in the current proposed Treasury regulations, and the IRS has scheduled a hearing on the current proposed regulations for January 2019, so there is more guidance to come. In the meantime, the clock is ticking on this deferral opportunity.
Sean Bryan is a partner in the tax section at Kelly Hart & Hallman LLP.