By Aman Badyal
On October 19, 2018, the IRS released much awaited guidance regarding tax incentives available pursuant to the recently enacted Qualified Opportunity Zone ("QOZ") program. QOZs were created as part of the Tax Cuts and Jobs Act passed late last year. This program presents 3 significant tax benefits, (i) taxpayers can defer capital gain taxes through December 31, 2026 if they rollover gains into a Qualified Opportunity Fund (a "QOF") within 180 days, (ii) investors holding a QOF interest for seven years can reduce their capital gains tax recognized on December 31, 2016 by 15%, and (iii) investors holding a QOF interest for ten or more years will pay no additional tax upon the sale of the QOF. A QOF is a partnership or corporation if 90% or more of its property is "Qualified Opportunity Zone Property."
For more information about the basics of the QOZ program please see our previous alert.
The new guidance answers many questions regarding QOZs but many remain to be clarified. Overall, the guidance is taxpayer friendly. A few key highlights include:
1. Eligible Gains
Taxpayers may only use the QOZ program to defer tax on gains that are treated as a capital gain for Federal income tax purposes. For example, gains from the sale of stock, property or other appreciated assets would be eligible but certain gains recharacterized as ordinary income pursuant to recapture rules may not be eligible. In addition, gains from sales between related parties are ineligible for deferral.
2. Partnerships and Other Pass-Through Entities
The proposed regulations include a tax favorable provision for owners of pass-through entities (e.g., partnerships and S Corporations). Like any taxpayer, a pass-through entity must reinvest its gains within 180 days of the sale to take advantage of deferral. However, if the entity chooses not to reinvest the gains in a QOF, the owner will have 180 days from the end of the entity's tax year to reinvest the gains individually. Therefore, if a pass-through entity recognizes an eligible gain early in one tax year, the owner could potentially further defer the deadline to invest in a QOF until the middle of the following tax year.
3. Land and Substantial Improvement
Generally speaking, QOFs must either invest in property that is new or substantially improved. However, in the case of real estate the IRS has provided a special rule. Only a building (or other real estate improvement) must be substantially improved, it is not necessary to substantially improve the land underlying the building. This means that real property is considered substantially improved if the building located thereon is substantially improved. For example, assume a QOF purchases a parcel of property for $1,000; the purchase price is allocated $400 to buildings/improvements and $600 to the land. If the QOF spends $400.01 rehabilitating the buildings/improvements, the entire $1,000 purchase price and additional $400.01 in rehabilitation expenditures may be treated as Qualified Opportunity Zone Property.
4. Working Capital
Cash is not generally a qualifying asset. However, the proposed regulations provide a working capital safe harbor where QOFs invest in Qualified Opportunity Zone Businesses that acquire, construct, or rehabilitate tangible business property, including real estate, in an opportunity zone. The safe harbor allows qualified opportunity zone businesses a period of up to 31 months to invest working capital if there is a written plan that details future use of the funds.
5. Minimizing Investments in QOZs
Qualified Opportunity Zone Property includes direct investments by a QOF as well as investments in certain business entities if substantially all of the entity's property qualifies. The guidance provides that, for this purpose, "substantially all" means 70%. Therefore, a QOF can invest 90% of its total assets in a qualifying business and qualify despite having only 63% (i.e., 90% x 70%) of its assets invested in Qualified Opportunity Zone Property.
6. Diversification and Monetization Strategies
The proposed regulations permit investors to use their QOF interests as collateral for a loan. The guidance also references basis increases resulting from debt incurred by the QOF and its subsidiaries. Therefore, through sophisticated tax planning, investors may be able to immediately diversify their investments and further monetize a portion of their QOF interest in a tax-free manner.
We expect the Qualified Opportunity Zone program to be an extremely useful tool for taxpayers with capital gains for the foreseeable future. The CKR Tax Department is actively developing customized strategies to maximize after-tax returns and increase enterprise value.
Should you have any questions or desire further insight, feel free to contact one of the members of our Tax Department: