The 2017 Tax Cut and Jobs Act (“Act”) enacted new tax incentives called Qualified Opportunity Funds (“QOF”) to encourage investment in areas of the country determined to be economically disadvantaged. The Act left many questions unanswered on how the QOF would be implemented by the IRS. In late 2018, the IRS issued proposed regulations and a revenue ruling that answered many of these questions.
The focus of the Opportunity Fund program is the concept of Qualified Opportunity Zones (“QOZs”), which are low-income census tracts nominated in the U.S. by governors of each state and certified by the Treasury Department. There are currently over 8,700 QOZs. There are two QOZs in Clark County, one along the Vancouver Waterfront and one east of Washougal.
The new Internal Revenue Code (“IRC”) sections (Subchapter Z – Opportunity Funds) provide three distinct tax incentives intended to encourage investors to invest capital into low-income areas of each state.
Deferral of Capital Gains
The first tax benefit is the deferral of capital gains on the sale or exchange of a capital asset on or after Jan. 1, 2018. The sale of any capital asset qualifies as long as it is sold to an unrelated party and the gains are reinvested in a QOF within 180 days of the sale of the capital asset. Subject to the possibility of a step-up in basis discussed below, recognition of the capital gains may be deferred until Dec. 31, 2026.
Under the recently released proposed regulations implementing IRC Section 1400Z-2, the IRS clarified that taxpayers eligible to take advantage of the deferral include individual taxpayers, corporations (including REITs and RICs), partnerships, and certain trusts. A partnership may elect to defer part or all of the gain at the partnership level. If the partnership does not elect to defer the gain, a partner may elect to defer part or all of the partner’s distributive share of the gain. Under the sunset provisions of the new tax law, the deferral election applies to capital gains recognized prior to Dec. 31, 2026.
Step-up in Basis
The second tax benefit is the possible step-up in basis on the deferred gain. If the investor holds the Qualified Opportunity Fund investment for five years, the investor receives a 10 percent step-up in basis on the deferred capital gains. If the investor holds the Qualified Opportunity Fund investment two additional years, for a total of seven years, the investor receives an additional 5 percent step-up in basis, for a total of a 15 percent step-up in basis. Accordingly, for each $100 of deferred gain held in a Qualified Opportunity Fund investment for seven years or more, only $85 of that gain will ultimately be subject to capital gains taxation.
The proposed regulations allow taxpayers to make the step-up in basis election until Dec. 31, 2047, thus allowing the step-up in basis after the initial designation expires on Dec. 31, 2028. This provides the investor the opportunity to hold the Qualified Opportunity Fund investment for the entire required 10-year holding period, plus an additional 10 years, and allows investors to acquire Qualified Opportunity Fund investments at any time prior to the Dec. 31, 2028, expiration and still take advantage of the step-up in basis opportunity.
Exclusion of Gain
The third tax benefit of the new Opportunity Fund tax provisions is the possible permanent exclusion of all of the gain on the increase in value of the Opportunity Fund investment. If the Opportunity Fund investment is held for 10 years or more, all of the increase in value of the Opportunity Fund investment is excluded from capital gains taxation. In this scenario, the investor will pay capital gains tax on 85 percent of the capital gains deferred on the initial sale of the capital asset; however, any gains on the funds reinvested in the Opportunity Fund permanently avoid taxation.
An entity organized in the United States and treated as a corporation or partnership for U.S. tax purposes generally is eligible to be a QOF. Although there was initially some question, the proposed regulations confirm limited liability companies are eligible QOFs. Any QOF must hold at least 90 percent of its assets in QOZ Property.
Under the proposed regulations, an entity self-certifies as a QOF by filing IRS Form 8996 with its U.S. tax return each year.
90 Percent Asset Test
The 90 percent asset test is a semi-annual test based on the average of the percentage of QOZ Property owned by the QOF. If the QOF fails to satisfy the asset test at the end of any month, the QOF is subject to a penalty equal to (1) the difference between 90 percent of its assets and the amount of its QOZ Property, multiplied by (2) the federal short-term rate plus 3 percent, unless the failure is due to reasonable cause.
The proposed regulations provide that a QOF must determine the value of its assets by reference to financial statements the QOF files with the U.S. Securities and Exchange Commission or another U.S. federal agency, or other audited financial statements that are prepared in accordance with U.S. GAAP. If the QOF does not have GAAP financial statements, the QOF must use the cost basis of its assets for testing purposes.
QOZ Business Property
As noted above, QOZ Property includes QOZ Business Property and equity interests in QOZ Entities. Tangible property generally qualifies as QOZ Business Property if:
- the property is used in a trade or business;
- the QOF or a QOZ Entity acquires the property from an unrelated person after Dec. 31, 2017;
- the property’s original use commenced with the QOF or a QOZ Entity, or the QOF or a QOZ Entity substantially improves the property; and
- substantially all of the use of the property is located in a QOZ during the QOF’s or QOZ Entity’s holding period.
For this purpose, a QOF or QOZ Entity generally is treated as having “substantially improved” the property if, within 30 months after acquiring the property, capital expenditures with respect to improving the property exceed the cost basis in the property.
An entity generally qualifies as a QOZ Entity if:
- the entity is treated as a domestic corporation or domestic partnership for U.S. tax purposes;
- the QOF acquired equity interests in the entity from the entity, solely in exchange for cash, after Dec. 31, 2017; and
- both at the time the QOF acquired the equity interests, and for substantially all of the QOF’s holding period, the entity was engaged in a qualified opportunity zone business (a “QOZ Business”).
- A QOZ Entity generally is treated as being engaged in a QOZ Business if:
- “substantially all” of the tangible property the QOZ Entity owns or leases is QOZ Business Property (the proposed regulations define “substantially all” as 70 percent);
- at least 50 percent of the QOZ Entity’s gross income is from the active conduct of the business;
- a substantial portion of the QOZ Entity’s intangible property is used in the active conduct of the business;
- less than 5 percent of the average of the aggregate unadjusted bases of the QOZ Entity’s property is attributable to “nonqualified financial property”; and
- the QOZ Entity’s trade or business does not comprise certain sin businesses.
Thomas B. Eriksen is an attorney with Jordan Ramis PC.