The Qualified Opportunity Zone (QOZ) program was created by the Tax Cuts and Jobs Act of 2017 to stimulate economic development and job growth in low-income communities across the United States, Washington DC, and the five U.S. territories by providing tax breaks to investors. The program generated considerable interest among investors, tax, legal and finance professionals, however, investors held back due to lack of clarity on various aspects of the program.
The IRS issued the final set of regulations on December 19, 2019, addressing the comments received in response to the previous two sets of proposed regulations which were issued in October 2018 and May 2019. The final regulations retain the basic approach and structure of the proposed regulations, with certain revisions and additional guidance.
Tax Incentives Offered by the Program
Eligible capital gains can be deferred with tax savings to the taxpayer until December 31, 2026 or until the investment in the Qualified Opportunity Fund (QOF) is sold or until an inclusion event occurs, whichever is earlier, if the original capital gains are invested in a QOF within 180 days of the sale of the asset.
- Gain from sale or exchange of assets between related parties as provided in the proposed regulations does not qualify.
- Investment in QOF must be an equity interest and cannot be a loan or another debt instrument.
- The deferred gain retains its attributes.
Step-up in Basis
The basis in the capital gains invested in the QOF is increased by:
- 10% if the taxpayer holds the QOF investment for at least 5 years, or
- 15% if the taxpayer holds the QOF investment for at least 7 years
Thus, the taxpayer can defer and effectively exclude up to 15% of the original capital gains from taxation.
The capital gain on the sale or exchange of the investment in the QOF can be permanently excluded from taxation if the QOF investment is held for at least 10 years.
Applicability of the Final Regulations
The final regulations are effective for taxable years beginning after March 13, 2020 which for calendar year taxpayers will be taxable years beginning on January 1, 2021.
For taxable years beginning after December 21, 2017 and before such effective date as above, the taxpayers have the option to either:
- Rely on the final regulations in its entirety in a consistent manner for all such taxable years, or
- Rely on the previous two sets of proposed regulations published in the Federal Register on October 29, 2018 and May 1, 2019 but only if relied in a consistent manner for all such taxable years.
- Eligible taxpayers include individuals, C corporations (including RICs and REITs), partnerships, S corporations, trusts and estates.
- Non-US investors that have capital gain effectively connected with a US trade or business would be generally eligible. Gain exempt from federal income tax under any applicable income tax treaty provisions would not be eligible unless such non-US investors irrevocably waive any such treaty benefits.
The final regulations affirm that an amount of gain would be eligible for deferral and investment in a QOF under the QOZ program if:
- It is treated as capital gain that would be recognized for federal income tax purposes before January 1, 2027, and
- It did not arise from a sale or exchange with a related party.
- Gain required to be recharacterized, redetermined, or recaptured as ordinary income is not eligible gain for purposes of section 1400Z-2 and the section 1400Z-2 regulations.
Step Transaction – Gains from Sales to, or Exchanges of Property with, a QOF or Qualified Opportunity Zone Business (QOZB)
The final regulations clarify that:
- Gains from sale to or exchange of property with an unrelated QOF will not be eligible gain for deferral if the taxpayer reinvests the proceeds from such sale or exchange back into the same QOF as a part of the same overall plan.
- Similarly, gains from sale to, or exchange of, property with an unrelated QOZB will also not be eligible if the taxpayer invests the proceeds into a QOF that owns that QOZB.
Step transaction doctrine and circular cash flow principles:
- Cash paid by the QOF or the QOZB ends back in the hands of the initial source as part of the overall plan.
- Such transfer of property cannot be treated as a sale or exchange but will be recharacterized as capital contribution for acquiring ownership interest.
- Property transferred in exchange for a qualifying investment is not QOZB property because QOZB property must be acquired by purchase.
Installment Sales and 180 Day rule
In general, the installment method allows taxpayers to report gain from a sale of property in the taxable year or years during which payments are received rather than in the year of the sale.
The final regulations add flexibility allowing taxpayers to elect to start the 180 day period either:
- On the date each payment under the installment sale is received for that taxable year, or
- On the last day of the taxpayer’s taxable year in which the gain would have been recognized under the installment method for a series of payments received during that year.
The final regulations further clarify that the above would be applicable even to installment sales that occurred prior to 2018.
Section 1231 Gain and 180 Day Rule
“Net” approach under proposed regulations
- Net section 1231 gain remaining after offsetting the section 1231 losses from the sale or exchange of section 1231 property of the trade or business determined at the end of the taxable year eligible for deferral.
- 180-day period for such section 1231 net capital gain would begin at the end of the taxable year.
“Gross” approach under final regulations:
- Taxpayers allowed to invest the full amount of each eligible section 1231 gain without regard to any section 1231 losses.
- 180-day period for investing begins on the date of each sale or exchange that gives rise to the eligible section 1231 gain.
- The gross approach eliminates complexity and uncertainty in determining eligible gain for partnerships and S corporations that are eligible taxpayers.
- When the deferred section 1231 gain is ultimately recognized on December 31, 2026 or earlier upon an inclusion event, section 1231(c) will recapture net section 1231 gain in the year of inclusion by taking into account non-recaptured section 1231 losses only from the five most recent taxable years preceding the taxable year of inclusion.
- Investors need to consider reliance on proposed vs final regulations in this area for 2019 section 1231 gains.
RIC and REIT Capital Gain Dividends and 180 Day rule
- Generally the 180-day period for the RIC and REIT capital gain dividends begins at the close of the shareholder’s taxable year in which such capital gain dividend would otherwise be recognized.
- The final regulations provide flexibility to the shareholders to elect to begin the 180-day period on the day each capital gain dividend is paid to avoid the wait until the end of the taxable year.
- For undistributed capital gain dividends, the shareholders can elect to begin the 180-day period either on the last day of their taxable year in which such capital gain dividends would be recognized or the last day of the RIC or REIT’s taxable year.
Special 180-day Period for Partners, S Corporation Shareholders, and Non-Grantor Trust Beneficiaries
Under the proposed regulations, if any of the above pass-through entities with eligible gain chooses not to defer the gain at the entity level but to allocate such gain to its owners instead, then:
- The 180-day period for the owners generally begins on the last day of the pass-through entity’s taxable year, or
- The owners may elect to treat their own 180-day period regarding their distributive share of the gain as being the same as that of the pass-through entity.
The final regulations added to the flexibility by providing another option:
- Partners, shareholders of S corporations and beneficiaries of non-grantor trusts may elect to treat the 180-day period to begin on the due date of the pass-through entity’s tax return, not including any extensions.
QOZ Terms & Definitions
Qualified Opportunity Fund (QOF)
- May be formed as a partnership or a corporation for the purpose of investing in Qualified Opportunity Zone Property (QOZP) and may be newly formed or a pre-existing entity.
- Must hold average of 90% of its assets in QOZP measured semiannually. Cannot invest in another QOF.
- Must self-certify as a QOF by filing Form 8996 with its tax return for each year.
Qualified Opportunity Zone Property (QOZP)
- QOZ stock acquired in exchange for cash after December 31, 2017 if an entity is classified as a corporation and is a QOZB
- QOZ partnership interest acquired in exchange for cash after December 31, 2017 if an entity is classified as a partnership and is a QOZB
- Qualified opportunity zone business property (QOZBP)
Qualified Opportunity Zone Business Property (QOZBP)
Tangible property used in a trade or business of the QOF or QOZB if:
- Such property was acquired by the QOF or QOZB by purchase from an unrelated party after December 31, 2017;
- The original use of such property in the QOZ commences with the QOF or QOZB, or the QOF or QOZB substantially improves the property; and
- During at least 90% of the QOF or QOZB’s holding period for such property, at least 70% of the use of such property was in a QOZ.
Qualified Opportunity Zone Business (QOZB)
A trade or business that satisfies the following requirements is considered a QOZB:
- Acquires QOZ business property by purchase from unrelated parties
- Acquires (original use) or substantially improves the QOZ business property in the QOZ
- During at least 90% of the holding period of the tangible property at least 70% of the use of the property is in the QOZ
- Derives at least 50% of its gross income from an active trade or business in the QOZ
- At least 40% of intangible property is used in the active trade or business in the QOZ
- Less than 5% of the average aggregate unadjusted bases of the entity’s property is attributable to non-qualified financial property
- The business is not described in Sec 144(c)(6)(B) (excluded “sin” businesses)
- A trade or business of an entity is treated as satisfying the “substantially all” requirement above if at least 70% of the tangible property owned or leased by the trade or business is QOZBP.
Tangible property is treated as substantially improved by a QOF or QOZB only if, during any 30-month period beginning after the date of acquisition of such tangible property, the QOF or QOZB makes an additional investment of at least its original basis in the QOZBP. Land on which the building is situated is excluded from the substantial improvement requirement.
Changes and Clarifications in the Final Regulations
Original Use Test
- The proposed regulations provided that a building or other structure that has been vacant for at least five years prior to being purchased by a QOF or QOZB will satisfy the original use requirement.
- The final regulations reduce this vacancy period from 5 to 3 years for property that became vacant after the QOZ designation and add a special one-year vacancy requirement for property that was vacant prior to and on the date of the QOZ designation.
The final regulations clarify that real property, including land and buildings, is considered to be in a state of vacancy if the property is “significantly unused.” A building or land will be considered to be “significantly unused” if more than 80% of the building or land, as measured by the square footage of useable space, is not being used.
- Self-constructed property for use in the trade or business in the QOZ by QOF or QOZB will satisfy the “acquired by purchase” requirement.
Newly Constructed Buildings
- The final regulations clarify that newly constructed buildings or near complete buildings that have not been placed into service for the purpose of depreciation prior to their purchase will satisfy the “original use” requirement if the building is purchased after December 31, 2017 and is used in the trade or business of the QOF or QOZB that purchases it.
Substantial Improvements Test
- The final regulations clarify that the property will be treated as QOZBP during the 30-month substantial improvement period.
- The final regulations also clarify that assets that are purchased by the QOZB to satisfy the original use test may also count towards the substantial improvements test, if such assets are used in the same trade or business as the property being improved and improve the overall functionality of such property.
Aggregation of Property for Substantial Improvements Rule
- Buildings located on a single parcel and transferred in a single deed, or buildings on contiguous parcels not described on a single deed, are permitted to be aggregated, as if they were a single property subject to such properties being operated exclusively by the QOF or QOZB sharing facilities or significant business elements and in co-ordination with or reliance upon one or more trades or businesses.
62-month Working Capital Safe Harbor for Start-up Businesses
- The final regulations have created an additional 62-month working capital safe harbor for start-up businesses and clarify that, during the 62-month period, tangible property purchased, leased or improved by a QOZB with cash from the working capital safe harbor pursuant to a written plan will count towards the 70% asset test, and similarly, intangible property purchased or licensed likewise will count towards the 40% intangible property use test.
- Need multiple cash infusions during start-up phase for each separate 31-month period that are a part of an integrated overall business plan.
Property leased by a QOF or QOZB will be treated as QOZBP if the following two general criteria are satisfied:
- Leased tangible property must be acquired under a lease entered into after December 31, 2017.
- Substantially all of the use of the leased tangible property must be in a QOZ during substantially all of the period for which the business leases the property.
The proposed regulations:
- Do not impose an “original use” or “substantial improvement” requirement with respect to leased tangible property.
- Discuss the methodologies of lease valuations.
- Do not require leased tangible property to be acquired from a lessor that is unrelated to the QOF or QOZB that is the lessee under the lease. However, certain additional requirements are imposed on related party leases to qualify as QOZBP.
- Include a warning that, if at the time the lease is entered into, there was a plan, intent, or expectation for the real property to be purchased by the QOF for an amount of consideration other than the fair market value of the real property determined at the time of the purchase without regard to any prior lease payments, the leased real property is not QOZBP at any time.
The final regulations include additional requirements with respect to related-party leases:
- Lessee cannot make prepayment on the lease for a period exceeding 12 months.
- Personal property leased from related party will count as QOZBP if either:
- It meets the original use requirement, or
- The QOF or QOZB acquires other tangible property equal to the value of the leased property during the 30-month substantial improvement period starting with the inception of the lease.
Triple Net Leases
- The final regulations discuss two examples of triple net leases one in which the landlord entity owns a building in the QOZ and leases the entire building to one tenant under a triple net lease, under which the tenant is responsible for paying the real estate taxes, insurances costs and maintenance expenses. In this example of a pure triple net lease, the landlord entity is not treated as conducting an active trade or business in the QOZ for the purpose of section 1400Z-2.
- In the second example, the same landlord entity leasing one floor under a triple net lease to one tenant and two other floors to two different tenants but not under triple net leases, is treated as having a mixed use building and treated as conducting active trade or business in the QOZ for the purpose of section 1400Z-2.
Partial Disposition of QOF Interest
Gain is recognized upon disposition of QOF interest as a result of an inclusion event permitted to be deferred by making another qualifying investment in a QOF within 180 days of the inclusion event…
Under Proposed Regulations:
- Only if the taxpayer disposed of the entire original investment in the QOF.
- Second deferral election not permitted with respect to sale or exchange for which a previous deferral election was already in effect.
Under Final Regulations:
- Even if the taxpayer disposes only portion of the original QOF investment.
- Original deferral election treated to be no longer in effect as it relates to that portion of the investment which is partially disposed of as soon as the inclusion event is triggered.
The 180-day period for the second investment begins on the date of the inclusion event and the holding period begins from the date of the second QOF investment.
Acquisition of QOF Interest from a Person other than the QOF
- The proposed regulations permitted a taxpayer with an eligible gain to acquire interest in a QOF from a person other than the QOF.
- The final regulations clarify that there is no requirement that the transferor of such QOF interest should have also had eligible gain or have made a deferral election with respect to such gain.
The proposed regulations list several transactions which constitute inclusion events, meaning events that trigger the recognition of deferred gain and describe how to compute the amount to be included once an inclusion event occurs.
In general, an inclusion event or transaction is one that has the effect of:
- Reducing or terminating the QOF investor’s direct (or, in the case of partnerships, indirect) qualifying investment for federal income tax purposes, or
- Constitutes a “cashing out” of the QOF investor’s qualifying investment (in the case of distributions in excess of basis), or
- The claim of a worthlessness deduction in respect to a qualifying investment.
The final regulations, while retaining the general rules described above, provide further clarifications as follows:
- If a QOF is decertified either through voluntary self-decertification or involuntarily, then such decertification is an inclusion event that terminates the investor’s qualifying investment status in a QOF.
- The 5-year and 7-year basis increases should continue to apply to that portion of the deferred gain that has not been recognized as a result of inclusion events at the time of such basis increases.
Examples of Inclusion Events
- Taxable disposition such as a sale of all or part of the qualifying investment in a QOF
- Termination or liquidation of the QOF, since it ceases to exist for federal income tax purposes
- Conversion of a partnership to a corporation
- Redemption by QOF C corporation, unless the redeemed shareholder was the sole shareholder
- Gift of the qualifying investment in a QOF
- Transfer of a QOF interest between spouses incident to a divorce, as per section 1041
Examples that are NOT Inclusion Events
- The proposed regulations treated a more than 25% aggregate change in the ownership of an S corporation as an inclusion event for the S corporation’s deferred gain. The final regulations, however, eliminated this 25% aggregate ownership change rule.
- Contribution of a partnership interest in a QOF to another partnership in a Sec 721 transaction
- Conversion of an S corporation to a C corporation and vice versa
- Transfer of QOF interest to a grantor trust of which the taxpayer is the deemed owner
- Transfer of QOF interest at the taxpayer’s death is generally not an inclusion event, subject to certain exceptions
Basis of QOF interest
- The final regulations clarify that section 1014, which provides step-up in basis to fair market value for the property of the deceased in the hands of the beneficiaries upon death of the investor,does not apply to a qualifying investment in a QOF.
- The basis in the qualifying investment is zero, with a step-up in basis of 10% of deferred gain after a 5-year holding period, step-up in basis of a total of 15% of deferred gain after a 7-year holding period and basis adjustment to fair market value after the 10-year holding period.
Disposition of Investment after 10-year Holding Period
The proposed regulations provided that:
- If a taxpayer has held a qualifying investment in a QOF partnership or QOF S corporation for at least 10 years, and the QOF partnership or QOF S corporation disposes of QOZP after such 10-year holding period, the taxpayer may make an election to exclude from gross income some or all of the capital gain arising from such disposition reported separately on Schedule K-1 of the QOF partnership or QOF S corporation and attributable to the qualifying investment.
- If the QOF investor sells his or her QOF partnership interest or S corporation stock after 10 years, all of the gain may be excluded from income.
The final regulations:
- Expand the available gain exclusion to the sale of assets by not only the QOF but also the QOZB, which is a significant change to achieve tax efficient sale.
- Permit interests in QOZBs to be disposed of at different times and permit multiple gain exclusion elections corresponding to each sale.
- Clarify that the exclusion election applies to all gains such as section 1231 gain, depreciation recapture but not to ordinary income from sale of inventory.
- Require elimination of future tax benefits attributable to the reinvestment of proceeds from the sale of assets, the gain on which is elected to be excluded. For this purpose, the QOF is treated as distributing to each electing QOF investor its share of proceeds from the asset sales on the last day of the QOF’s taxable year, and the investor is deemed to have reinvested the same amount back into the QOF in exchange for a non-qualifying investment, thereby creating mixed-funds investments in the QOF.
If you have any questions about the benefits of investing in a Qualified Opportunity Zone and if this tax strategy is right for you, please contact your Grassi advisor or Shashi Singal, Tax Principal, at email@example.com.