Q2 2019 - Qualified Opportunity Funds – Taxpayers with Capital Gains Should Evaluate This New Investment Initiative
- Jun 3, 2019
In an effort to incentivize investment with the help of the tax code, the 2017 Tax Cuts and Jobs Act (“TCJA”) created the so-called “Opportunity Zones” program. This program was created to “spur investment in distressed low-income communities throughout the country.” Over 8700 qualified opportunity zones (“QOZs”) – low-income community population census tracts -- were designated across all 50 states and U.S. possessions. Investments meeting certain criteria in those QOZs are entitled to significant tax benefits. These investments might be, for example, in real estate or in operating businesses in a QOZ. The qualified opportunity fund (“QOF”) is the vehicle through which investments are made in the QOZs. And, as discussed in this article, the “currency” for these benefits is the timely investment of capital gains into the QOZ program.
Since enactment, detailed proposed regulations have been issued by the Treasury Department and while these rules remain to be finalized, and additional guidance will inevitably be issued, enough is now known about the program for investors to make a reasoned evaluation of its potential benefits, and costs, on a case-by-case basis.
There are three significant federal income tax benefits potentially available to investors – (1) temporary deferral of tax on rolled-over gains; (2) permanent elimination of up to 15% of the tax on the deferred gain; and (3) the potential exclusion from tax on gain generated from the appreciation of investments within the QOF. These benefits can be obtained by individuals, corporations (including RICs and REITs), partnerships, S corporations, trusts and estates, as well as tax-exempt entities that realize a capital gain from activities that generate unrelated business taxable income (“UBTI”). Nonresidents should also be able to benefit from the QOZ regime.
Temporary Deferral of Tax on Gains. Capital gain from the sale or exchange of property to an “unrelated” party (20% or less ownership test) which is subsequently invested in a QOF is deferred until the earlier of December 26, 2026 or the date on which the investment in the QOF is sold or disposed (or deemed to be disposed). The investment in a QOF must be made within 180 days of the sale or exchange of property generating the capital gain to qualify for deferral. In applying the 180-day time period, special rules apply for partnerships and other pass-through entities as well as for the investors to whom these entities pass through income and other tax items. Specifically, a partnership may itself elect to defer all (or part) of a capital gain. If it does not elect to defer gain, a partner may elect its own deferral with respect to the partner’s distributive share of gain not deferred by the partnership. The partner’s 180-day period generally begins on the last day of the partnership’s tax year, or the partner may choose to begin his or her own 180-day period at the start of the partnership’s 180-day period, which begins from the date of the sale that gives rise to the capital gain being deferred.
The gain deferred can be any capital gain for federal income tax purposes, including short-term capital gains, long-term capital gains, collectibles gains, so-called net section 1231 gains and capital gain net income from IRC Sec. 1256 contracts. This includes, for example, gain from the the sale of stock and securities and tangible personal property (such as art work), as well as real property. Ordinary recapture income (i.e., reflecting depreciation recapture) cannot be deferred. Note that a gain from an IRC Sec. 1256 contract is not eligible for deferral if, at any time during the taxable year, one of the taxpayer’s IRC Sec. 1256 contracts was part of an offsetting positions transaction in which any of the other positions was not also an IRC Sec. 1256 contract. An offsetting positions transaction includes positions in closely held stock or other non-traded personal property and substantially offsetting derivatives (as well as actively traded property).
All of the deferred gain’s tax attributes are preserved through the deferral period and are taken into account when the gain is included in income. So, for example, if upon the initial sale the gain would have been short-term had the gain not been deferred, it will remain short-term when recognized; if the gain is generated by the sale of an IRC Sec. 1256 contract, gain as 60% long-term/40% short-term is continued.
The gain deferred cannot exceed the aggregate amount of gain invested by the taxpayer in a QOF during the 180-day period. If an investor makes an investment in a QOF in excess of the gain realized from recent sales or exchanges, that investment is treated as two separate investments for purposes of these rules, one that includes amounts covered by the QOZ program and a separate investment consisting of other amounts that are taxed outside of the QOZ program rules.
Tracing of funds is not required. Accordingly, an investor is not required to show how the capital gain proceeds were used to invest, but rather the amount of capital gain proceeds invested within the 180-day period.
Unlike IRC Sec. 1031 exchanges, which (i) require re-investment of the proceeds (and not just the gain, as with the QOF) for deferral treatment and (ii) are currently limited to real property as a result of the TCJA, this incentive provides a new opportunity for investors with low basis assets and serves as an important alternative for investors whose assets no longer qualify for IRC Sec. 1031 exchange treatment or who are unable to identify a like-kind asset. And, subject to the caveats just noted, there is no limitation on the amount of gain that can be deferred (or excluded as described below) under the QOZ program.
Elimination of up to 15% of the Tax on the Deferred Gain. Where deferred gain is used to invest in a QOF, the investor’s initial basis in the QOF is zero. Five years after investment in the QOF, the basis is increased to 10% of the deferred gain, thereby eliminating 10% of the taxable gain. After seven years, the basis is increased an additional 5%, resulting in a total of 15% elimination of tax on the deferred gain. The remaining deferred gain (or the fair market value of the investment if lesser) must be recognized on the earlier of the date on which the investment is sold or exchanged, or December 31, 2026.
Exclusion from Tax on Gain from Appreciated Assets. This is the key tax benefit. At the investor’s election, the investor can exclude any post-acquisition capital gains on an investment in a QOF if the investment in the QOF has been held for ten years or more. An investor can hold its investment in a QOF until December 31, 2047 and still receive the benefit of capital gain exclusion. Losses associated with investments in QOFs should be recognized as under pre-TCJA law. If a QOF partnership sells assets after the ten-year holding period has been satisfied, the partners can elect to exclude some or all of the gains realized from these qualified assets.
A QOF must be formed for the purpose of investing in QOZ property or businesses (other than another QOF). It may be a partnership, REIT, corporation, S corporation or LLC. An individual, trust, estate or single-member LLC cannot be a QOF.
One of the main requirements for a QOF is that at least 90% of its assets (determined at specified times twice a year) must be QOZ property. QOZ property is defined as: QOZ business property, QOZ stock and/or QOZ partnership interests. In effect, therefore, the investment can be direct (QOZ business property) or indirect (QOZ stock and QOZ partnership interests). The applicable rules differ somewhat depending on whether the investment is direct or indirect.
QOZ business property is tangible property used in a trade or business acquired by purchase after 2017 from an unrelated party, acquired in a QOZ, qualifying either through original use or “substantial improvement,” and, during substantially all of the QOZ’s holding period for such property, substantially all of the use of such property is in a QOZ. In order to be a “substantial improvement,” during any 30-month period beginning after the date of acquisition of qualifying property, improvements with respect to the property must exceed an amount equal to the adjusted basis of that property at the beginning of the 30-month period. So, if a building is acquired for $1 million, improvements totaling more than $1 million would need to be made during the requisite time period. And, in the case of building/land acquisitions, the substantial improvement test focuses on improvements only to the building; the QOF does not need to substantially improve the land as well. Special rules apply to leased tangible property.
QOZ stock and QOZ partnership interests are investments in, or ownership of, corporate stock or partnership interests in a QOZ business acquired after 2017 from the corporation/partnership solely in exchange for cash. A QOZ business requires that at least 70% of the tangible property owned or leased is located in a QOZ and at least 50% of the business’ gross income is derived from the active conduct of a trade or business in a QOZ. In order to satisfy this 50% gross income test, the following alternate safe harbors are provided: (i) at least 50% of the services performed (based on hours) for such business by its employees/independent contractors are performed within the QOZ; (ii) at least 50% of the services performed (based on amounts paid for the services) for the business by its employees/independent contractors are performed in the QOZ; and (iii) the tangible property of the business that is in a QOZ and the management or operational functions performed for the business in the QOZ are each necessary to generate 50% of the gross income of the trade or business. A “facts and circumstances” test applies if none of the safe harbors is met. These safe harbors should facilitate the development of businesses within QOZs.
A QOZ business cannot be a “sin business”—a golf course, country club, massage parlor, hot tub facility, suntan facility, racetrack or other facilities used for gambling, or any store where the principal business is the sale of alcoholic beverages for consumption off premises.
Carried interests and other promote structures (i.e., equity received for services) do not qualify for the QOZ/QOF tax benefits and are treated as a separate non-qualifying investment.
Failure to meet the 90% asset test will result in penalties; although that will generally not result in the loss of the tax benefits, significant penalties could damage investor returns.
A QOF that sells QOZ property prior to meeting the ten-year holding period can reinvest the proceeds within 12 months without the QOF failing the 90% asset test. This one-year rule is intended to allow QOFs adequate time in which to reinvest proceeds from the QOF asset sale.
State and local income tax implications need to be taken into account as well. State and local tax conformity with the federal QOZ provisions should be examined by investors in determining the state taxation of gains invested in QOZs. Investors in states conforming with the federal QOF provisions may receive state and local tax incentives similar to those available at the federal level. Investors residing in nonconforming states and localities may be unable to defer and reduce state and local taxation on the initial gains invested in QOFs and may also be required to recognize gain for state and/or local tax purposes on their eventual sale of the QOF investment.
EisnerAmper has a dedicated team advising clients on QOZ/QOF transactions and is monitoring new developments as they occur.
Engaging Alternatives - Q2 2019
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Richard J. Shapiro
Richard Shapiro, Tax Director and member of EisnerAmper Financial Services Group, has more than 40 years' experience in federal income taxation, including the taxation of financial instruments and transactions, both domestic and international.
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