Opportunity Zones, created by the Tax Cuts and Jobs Act of 2017, provide opportunities for investors, as well as for residents of designated economically distressed communities. A second set of proposed regulations, released on April 17, contains some taxpayer-friendly answers to prior questions relating to Qualified Opportunity Funds (QOFs), which are partnerships or corporations set up for investing within a Qualified Opportunity Zone (QOZ).
Potential tax benefits are now offered to encourage QOZ investing. For instance, investors with capital gains may be able to partially or completely defer tax on such gains, if they invest in a QOF. In addition, after a holding period of at least 10 years, gains from a QOZ asset sale may be excluded from income and thus avoid tax.
To be eligible for such favorable tax treatment, investments must be made in QOZ assets, including real estate, which are either substantially improved or have their “original use” in that community. The substantial improvement test will be met if an amount equal to or greater than the purchase price (excluding the value of land) is invested in the property.
In order for the substantial improvement qualification to be met, an amount equal to or greater than the purchase price (excluding the value of land) must be invested. If a QOF buys eligible property for $10 million, with $2 million allocated to the land, the QOF must spend an additional $8 million on the building in order to meet this requirement.
The new proposed regulations have a favorable solution to this possible dilemma. Instead of the substantial improvement hurdle, the “original use” requirement can be used if the building was vacant for an uninterrupted five-year period, prior to being purchased by a QOF or by a Qualified Opportunity Zone Business (QOZB).
In addition to the issue of vacant structures, the recent regulations also cover vacant land. By definition, land cannot be improved, so the substantial improvement requirement could not be met. Similarly, the original use test can’t be passed because of the permanent nature of land.
The new proposed regulations do not allow the five-year vacancy test to apply to purchases of land in a QOZ. However, these rules allow a land purchase to be treated as an eligible asset, if the buyer uses the land in a trade or business.
Use in a trade or business will be determined by the facts and circumstances, after the purchase. For example, “land banking”—speculative investment in land—won’t qualify for QOZ tax treatment. If there was no expectation or intent to make a substantial investment within 30 months after the acquisition by a QOF or a QOZB, tax benefits will be disallowed.
The initial set of regulations did not address whether QOZ tax benefits could be claimed by someone who receives a carried interest – an investment manager’s share of any profits in exchange for services rendered to the partnership. The April 17 proposed regulations clarify that only interests received for equity contributions would be eligible for QOZ tax treatment.
If QOZ investments are profitable, debt-financed distributions could provide excellent returns to investors. Encouragingly, the new proposed regulations state that distributions will not be treated as an “inclusion event” (recognition of deferred gain) if they do not exceed an owner’s basis in their partnership interest.
Conversely, if total distributions do exceed an investor’s basis, that would accelerate the investor’s deferred gain. Investors and QOF managers should be aware that distributions are subject to the disguised sales rules. Proper structuring is essential to avoid unintended tax consequences.
For anyone structuring a QOF, arguably the key issue is the requirement that the typical fund must hold a variety of assets, which presumably would have different target holding periods and capitalization requirements. To address possible concerns, the second round of proposed regulations spelled out how the 10-year holding requirement will be applied, in some situations.
If a multi-asset fund sells an asset for a capital gain (held for any period of time), investors who have held their investment in the QOF for 10 years or longer may make an election on their personal tax return, to exclude from income the gain reported on the K-1 they receive. Excluding unintended adverse tax consequences from the sale of their assets will presumably free fund managers to obtain full value for the assets held by their QOF.
In another scenario, if a QOF partner sells an interest in the QOF held for more than 10 years all of the gain from that sale will be excluded from income.
Prior to the April 17 regulations, there was some uncertainty about the tax treatment of disposition of QOZ property prior to 10 years. Could investors in a QOF continually defer recognition of income?
The new set of regulations clarify that the gain from such a sale will pass through to QOF investors, who must recognize income then. Nevertheless, there is no prohibition keeping an investor from making a new QOF investment and electing to defer that gain.
The second set of proposed regulations also give some clarity as to how a non-real estate operating trade or business located within a QOZ would need to be conducted in order to be eligible for the tax benefits, which will be the subject of a future article.