By Kenneth H. Bridges, CPA, PFS July 2019
Included in The Tax Cuts and Jobs Act legislation enacted in late 2017 was new Internal Revenue Code Section 1400Z-2, “Special Rules for Capital Gains Invested in Opportunity Zones”. These new rules, often referred to as the “Qualified Opportunity Fund”, “QOF”, “Opportunity Zone”, or “OZ” rules provide taxpayers who have recognized a capital gain (1) the opportunity to defer tax on the gain until 2026, (2) the opportunity to have up to 15% of that gain permanently escape tax, and (3) the opportunity to permanently avoid any tax on the appreciation in the value of the reinvested gain after a 10-year holding period; provided the gain is invested in a “qualified opportunity zone” and you meet the other requirements of the statute. The purpose of this new tax incentive is to encourage investment in economically depressed areas.
The December issue of our newsletter was devoted to a review of these rules. Since that time (April 2019), the IRS has issued a 2nd set of proposed regulations which provide additional guidance. In this article, we will discuss the highlights of these more recent proposed regulations.
Sale of assets by QOF is okay – Initially, there was concern that an investor would need to sell the QOF units in order to take advantage of the permanent tax savings on appreciation, even though a sale of assets by the QOF would often make more sense. The proposed regulations alleviate this concern by providing that if you have had ownership in a QOF partnership or S-corp for at least 10 years, then you can elect to exclude from income the gain on a sale of assets by the QOF partnership or S-corp.
Reinvestment of sale proceeds by QOF – It is not necessary for the underlying QOZ asset to be held for at least 10 years in order to enjoy the QOF benefits. The QOF has up to 12 months to reinvest the proceeds from the sale of one QOZ asset into another QOZ asset, while the QOF investor’s clock continues to tick towards the requisite 10-year holding period. However, any appreciation in the asset which was sold prior to the QOF investor meeting the 10-year requirement may be taxable.
Grace period for investment of cash – A QOF is generally required to have at least 90% of its assets invested in QOZ property. The proposed regulations, however, permit the QOF to exclude contributed capital from the 90% test for up to 6 months, so long as invested in cash and equivalents. This rule, combined with the once-per-6-month testing dates and 31-month working capital exception for QOZ business subsidiaries, could potentially provide a QOF with a capital deployment period of up to 43 months.
Generous rules for meeting the 50% of gross income requirement – A QOZ business is one in which substantially all (70% or more) of the tangible property owned or leased by the entity is in a QOZ, at least 50% of the gross income of the entity is derived from the active conduct of business in the QOZ, and less than 5% of the assets are nonqualified financial assets (with a working capital exception). The business cannot be a golf course, country club, massage parlor, hot tub facility, suntan facility, racetrack or other facility used for gambling, or any store the principal business of which is the sale of alcoholic beverages for consumption off premises. There was initially much concern about how most types of operating businesses could meet the 50% test (e.g. a software company with global sales). The proposed regulations address these concerns by providing 4 ways in which a business can meet the 50% test: (1) at least 50% of the services performed by employees and independent contractors (as measured by hours) are performed in the QOZ; (2) at least 50% of the services performed by employees and independent contractors (as measured by compensation paid) are performed in the QOZ; (3) the tangible property of the business located in the QOZ and the management or operational functions performed in the QOZ are each necessary for the generation of at least 50% of the revenue of the business; or (4) based on all of the facts and circumstances, at least 50% of the revenue of the business is derived from the conduct of business in the QOZ.
Property vacant for at least 5 years – In order for tangible property to qualify as QOZ property, the “original use” of such (other than land) generally must commence with the QOF. The proposed regulations, however, provide that where a building has been vacant for at least 5 years prior to being purchased by the QOF, it will satisfy the original use requirement.
Special rule for IRC 1231 gain – IRC 1231 provides the very beneficial rule that a net loss from sale(s) of assets used in a business is treated as ordinary loss, while net gain from sale of such (subject to depreciation recapture and a 5-year lookback period) is treated as long-term capital gain. Because of the required netting, technically you cannot know for sure whether a gain will be treated under IRC 1231 as capital gain until the end of the year. Accordingly, the proposed regulations provide that the 180-day period for investment of a 1231 gain into a QOF does not start to run until the last day of the year.
Acquisition of QOF interest on the secondary market – It is not required that a QOF investment be acquired as a result of a capital contribution to a QOF. Such can be acquired from another person.
Carried interests – Impactful to QOF managers and real estate developers, the 2nd set of proposed regulations provides that investors receiving a carried interest for services rendered to the QOF are not eligible for any of the Opportunity Zone tax benefits. A “mixed fund” is instead created with a qualifying investment and non-qualifying investment (for the carried interest).
Partnership debt to be included in basis – The general rule of partnership taxation is that a partner’s basis in a partnership includes his or her allocated share of the partnership’s debt. The proposed regulations clarify that this rule will apply in the case of QOFs as well. However, because of how the partnership “disguised sale rules” will apply to a QOF, a leveraged distribution from the QOF to the investor within 2 years of investment may cause the investor to recognize gain and disqualify some portion or all of the investment from QOF benefits.
Inclusion events – The amount of gain that is deferred into a QOF (less the potential basis step-up of up to 15%) has to be recognized the earlier of 12/31/26 or the date of an “inclusion event”. In general, pretty much any transfer that results in a reduction in the investor’s equity ownership in the QOF (including gifts and charitable donations) will be an inclusion event. Some exceptions are made, however, including transfers by reason of death, transfers to a grantor trust, change to the tax status of a grantor trust by reason of death, and contribution to a partnership.
General anti-abuse rule – The proposed regulations provide a general anti-abuse rule whereby the IRS can recast a transaction as necessary to “achieve tax results that are consistent with the purpose” of the QOF rules. The preamble references as a specific example the purchase of agricultural land not qualifying where the QOF is merely holding the land as such with no additional investment in increasing the economic output of the land.
Kenneth H. Bridges, CPA, PFS is a partner with Bridges & Dunn-Rankin, LLP, an Atlanta-based CPA firm.
This article is presented for educational and informational purposes only, and is not intended to constitute legal, tax or accounting advice. The article provides only a very general summary of complex rules. For advice on how these rules may apply to your specific situation, contact a professional tax advisor.