Qualified Opportunity Zones: COVID-19 Deadline Extensions

Over the last few weeks, the IRS has provided taxpayers with extensions of time to file various tax returns and pay certain taxes. On April 9, 2020 the IRS issued Notice 2020-23, which further expands on past extensions and adds additional time to perform time-sensitive actions. Time-sensitive actions that have been extended include the 180-day period for investing qualified capital gains into a Qualified Opportunity Zone (QOZ) Fund. In addition, certain sections of the Internal Revenue Code already provide taxpayers built-in relief for deadlines if the taxpayer is affected by a presidentially-declared federal disaster. Consequently, by virtue of the president’s recent pronouncement that the COVID-19 pandemic is a federal disaster, QOZ businesses utilizing the working capital safe harbor may also have an extended deadline for deployment of capital. The declaration may also impact penalty relief for reasonable cause.

180-Day QOZ Fund Investment Period

Generally, taxpayers have 180 days to reinvest qualifying capital gains into a QOZ Fund pursuant to section 1400Z-2(a)(1)(A) of the Code. The mechanics of how this 180-day period is computed is discussed in prior blog post, and can get somewhat complicated for flow through entities. Now, pursuant to Notice 2020-23, if that 180-day period expires on or after April 1, 2020 and before July 15, 2020, that period does not expire until July 15, 2020. This extension of time is automatic and no election or other filing is required. Individuals, trusts, estates, corporations, partnerships and other non-corporate tax filers qualify for the extra time.

Working Capital Safe Harbor

The QOZ rules provide a QOZ business with a 31-month window in which it can maintain and deploy working capital funds to acquire, construct or rehabilitate tangible business property in the QOZ. The 31-month working capital safe harbor exists because qualifying as an QOZ investment is predicated on engaging in a trade or business inside of a QOZ, and some trades or businesses or startup businesses require a lead time for converting invested capital into assets to be used in the trade or business. If that QOZ business is located in a federally-declared disaster area, the period over which the invested capital is converted into assets could be delayed for reasons outside the control of the QOZ Fund. Treasury Regulation section 1.1400Z2(d)-1(3)(v)(D) provides the QOZ business an additional 24 months to complete the acquisition, construction and/or rehabilitation of the tangible business property if the QOZ business is located in a federally-declared disaster area. Notably, as of April 3, 2020 every state and most territories are subject to a disaster declaration, so most QOZ businesses should have an additional 24 months added to the working capital safe harbor period.

Reasonable Cause

A QOZ Fund is penalized if at least 90 percent of its assets do not consist of QOZ property. However, these penalties are waived if the QOZ Fund can show that such failure is due to reasonable cause. The related Treasury regulations do not define what constitutes reasonable cause. Other sections of the Code provide similar reasonable cause relief from penalties. In those cases, such relief is generally permitted where the taxpayer can show that the penalized failure was due to circumstances outside the control of the taxpayer. A failure to maintain the 90 percent investment standard for reasons related to COVID-19 may potentially qualify for this reasonable cause penalty relief.

If your QOZ Fund is experiencing any delays due to COVID-19, contact Varnum’s tax team to determine how that delay may impact the QOZ Fund’s qualifications.

QOZ Final Rules Part III: Additional Clarity for QOF and QOZ Business Qualifications

In this third installment of our series, we will discuss the new details provided to taxpayers regarding various tests to be met to qualify as a Qualified Opportunity Fund (QOF) and Qualified Opportunity Zone Business (QOZ Business). Some of these provide welcome clarity or flexibility to qualifying, but one places a new restriction on QOZ Business operations.

Triple Net Leases as Active Trades or Businesses

The proposed regulations provided that, solely for the purposes of determining whether a trade or business qualified as a QOZ Business, the ownership and operation – including leasing – of real property qualifies as an active conduct of a trade or business. The proposed rules, however, also provided that merely entering into a triple net lease with respect to real property owned by a taxpayer does not constitute an active conduct of a trade or business by such taxpayer. The Treasury Department and the IRS determined that, solely for purposes of determining QOZ Business qualification, triple net leases constitute inappropriately passive activities similar to holding publicly-traded stock or securities.

In reality, simply requiring the lessee of property to pay for certain costs of maintaining the leased property does not prevent a QOZ Business owner from actively participating in the leasing of the property.

For example, a taxpayer may meaningfully participate in the management or operation of the trade or business of the lessee. Similarly, an obligation to maintain certain structural or operating systems of a building would qualify as a meaningful capital obligation, while obligations to provide cleaning or groundskeeping services would qualify as meaningful operating obligations. Moreover, under the case law in Section 162, a deduction is permitted for ordinary and necessary expenses paid or incurred in carrying on any trade or business related to a triple net lease if the landlord, or an employee, agent or contractor of the landlord, performs the services related to the taxes, maintenance, insurance and similar fees even though the landlord receives payment for these services from the tenant.

In general, the final regulations confirm that merely entering into a triple net lease with respect to real property owned by a taxpayer does not constitute the active conduct of a trade or business by such taxpayer. To illustrate the application of this rule, the final regulations set forth examples describing a triple net lease as a lease arrangement pursuant to which the tenant is responsible for all of the costs relating to the leased property (for example, paying all taxes, insurance and maintenance expenses), in addition to paying rent. In an instance in which the taxpayer’s sole business consists of a single triple net lease of a property, the final regulations confirm that the taxpayer does not carry out an active trade or business with respect to that property.

However, the Treasury Department and the IRS note that, in certain cases, a taxpayer that utilizes a triple net lease as part of the taxpayer’s leasing business could be treated as conducting an active trade or business. Accordingly, the final regulations provide an example in which a lessor leases a three-story mixed-use building to three tenants, each of whom rents a single floor. In that example, (i) the lessor leases one floor of the building under a triple net lease but leases the remaining two floors under leases that do not constitute triple net leases, and (ii) the employees of the lessor meaningfully participate in the management and operations of those two floors. As a result, the example provides that the lessor is treated as carrying out an active trade or business with respect to the entire leased building notwithstanding that part of the property was leased in a triple net basis.

Nevertheless, this still does not clarify whether the taxpayer would be carrying out an active trade or business if all three floors were leased under triple net terms but the taxpayer was actively involved in the management and operations of all three floors. Rather, it appears that the final regulations retain the concept that leasing a building pursuant to a triple net lease does not constitute an active trade or business, notwithstanding any meaningful participation in the management and operation of the building. The opposite may be argued but it’s not clear whether such a position will hold water. Some investors may see this ambiguity as an opportunity, depending on their level of risk aversion.

Sin Business Prohibition Expanded

Code Section 1400Z-2 defines the term QOZ Business as a trade or business that, in addition to other requirements, is not a business described in Code Section 144(c)(6)(B) (commonly referred to as a sin business). Section 144(c)(6)(B) lists as a sin business any (i) private or commercial golf course, (ii) country club, (iii) massage parlor, (iv) hot tub facility, (v) suntan facility, (vi) racetrack or other facility used for gambling or (vii) a store the principal business of which is the sale of alcoholic beverages for consumption off premises.

Notably, this prohibition relates to the definitional requirements for a QOZ Business and not a QOF. The definitional requirements of a QOF do not include such a prohibition on directly operating any sin businesses.

Because Section 1400Z-2 explicitly prohibits QOZ Businesses from operating sin businesses but does not set forth a similar prohibition for QOFs, the final regulations do not extend the prohibition on sin businesses, an issue of statutory construction discussed previously in this blog series. However, the Treasury Department and the IRS have extended this prohibition as it relates to QOZ Businesses.

The Treasury Department and the IRS agree that Section 1400Z-2 does not explicitly prohibit a QOZ Business from leasing its property to a sin business. However, they have determined that the purpose of sin business prohibition is to prevent QOZ Businesses from operating sin businesses, which a QOZ Business nonetheless could carry out simply by leasing its property to a sin business. This situation seems like a good candidate for a related party rule. Yet the final regulations prohibit any QOZ Business from leasing more than “5 percent” of its property to a sin business to ensure that the purpose is effectuated. The “5 percent” de minimis threshold is intended to reduce the risk of a QOZ Business inadvertently violating the sin business prohibition.

Measurement of Use for the 70 Percent Use Test

For tangible property to qualify as QOZ Business property, during at least 90 percent of the QOZ Business’s holding period of the property, substantially all of the use of that tangible property must be in the QOZ. The proposed regulations noted that the term “substantially all” means 70 percent and described the fraction used to determine this percentage. But they did not provide any guidance as to how such tangible property must be used in connection with the QOZ to be included in the numerator of that fraction.

The Treasury Department and the IRS determined that guidance regarding the meaning and application of the term “use” would be significantly helpful to taxpayers. As a result, the final regulations expand on this term and provide that tangible property of a trade or business is counted for purposes of satisfying the 70 percent use test (qualified tangible property) to the extent the tangible property is utilized in the QOZ in the performance of an activity of the trade or business that contributes to the generation of gross income for the trade or business.

In addition, many trades or businesses rely on delivery vehicles, construction equipment, service trucks and other types of mobile tangible property that operate both inside and outside a QOZ, or in multiple QOZs, to generate gross income. Previously, it was not clear how the 70 percent use test would be met for these types of mobile tangible property. To provide standards that more effectively respond to the day-to-day customary operation of trades or businesses, the final regulations set forth specific rules clarifying the application of the 70 percent use test to mobile tangible property. 

For example, the final regulations provide a safe harbor for tangible property utilized in rendering services both inside and outside the geographic borders of a QOZ. Under this safe harbor, a limited amount of such tangible property may be excluded from the general time of use calculation underlying the 70 percent use test. Specifically, the safe harbor permits up to 20 percent of the tangible property of a trade or business to be treated as satisfying the 70 percent tangible property standard if the tangible property is utilized in activities both inside and outside of the geographic borders of a QOZ, and if (i) the trade or business has an office or other fixed location located within a QOZ (QOZ office), and (ii) the tangible property is operated by employees of the trade or business who regularly use a QOZ office in the course of carrying out their duties and are managed directly, actively and substantially on a day-to-day basis by one or more employees of the trade or business at a QOZ office. But the tangible property must not be operated exclusively outside of the geographic borders of a QOZ for a period longer than 14 consecutive days for the generation of gross income for the trade or business.

In addition, the final regulations provide a similar safe harbor for short-term leased tangible property. Under this rule, tangible property leased by a trade or business located within the geographic borders of a QOZ to a lessee that utilizes the tangible property at a location outside of a QOZ is qualified tangible property if the following two requirements are satisfied. First, consistent with the normal, usual or customary conduct of the trade or business, the tangible property must be parked or otherwise stored at a location within a QOZ when the tangible property is not subject to a lease to a customer of the trade or business. Second, the lease duration of the tangible property (including any extensions) must not exceed 30 consecutive days.

Buildings Located on Brownfield Sites as Original Use Property

The final regulations also incorporate new rules regarding brownfield site redevelopment. A brownfield site comprises “real property, the expansion, redevelopment, or reuse of which may be complicated by the presence or potential presence of a hazardous substance, pollutant, or contaminant.” The Environmental Protection Agency has defined these sites as “abandoned, idled or under-used industrial and commercial facilities where expansion or redevelopment is complicated by real or perceived environmental contamination.” Cleaning up and reinvesting in these properties increases local tax bases, facilitates job growth, utilizes existing infrastructure, takes development pressures off from undeveloped, open land, and both improves and protects the environment.

Specifically, the final regulations provide that all real property composing a brownfield site, including land and structures located thereon, will be treated as satisfying the original use requirement if, within a reasonable period, investments are made to ensure that all property composing the brownfield site meets basic safety standards for human health and the environment. The final regulations also make clear that remediation of contaminated land is taken into account for determining if the land has been more than minimally improved, and that the QOF or QOZ Business must make investments into the brownfield site to improve its safety and environmental standards.

Substantial Improvement: Aggregation of Property for Calculation

In the May 2019 proposed regulations, the Treasury Department and the IRS requested comments regarding the relative strengths and weakness of determining whether tangible property meets the substantial improvement test based on an asset-by-asset approach, as compared to asset aggregation and similar approaches. Many commenters requested that the final regulations adopt an aggregate approach to determining substantial improvement, or otherwise permit taxpayers to elect such an approach. Similarly, other commenters requested that the final regulations permit asset aggregation based on (i) asset location within a QOZ, or (ii) whether the assets were acquired as part of the same transaction or business decision. In contrast, a commenter suggested that the final regulations adopt an approach similar to an integrated unit approach that treats two or more buildings or structures on a single tract or parcel (or contiguous tracts or parcels) of land that are operated as an integrated unit (as evidenced by their actual operation, management, financing and accounting) as a single item of property. The Treasury Department and the IRS also received several recommendations to retain the asset-by-asset approach set forth in the May 2019 proposed regulations.

Based on the strengths and weaknesses of each of these various approaches, the Treasury Department and the IRS have concluded that permitting asset aggregation to a limited extent is appropriate for carrying out substantial improvement determinations.

Accordingly, the final regulations set forth an asset aggregation approach for determining whether a non-original use asset (such as a preexisting building) has been substantially improved. Under the approach adopted by the final regulations, QOFs and QOZ Businesses can take into account purchased original use assets that otherwise would qualify as QOZ Business property if the purchased assets (i) are used in the same trade or business in the QOZ (or a contiguous QOZ) for which the non-original use asset is used, and (ii) improve the functionality of the non-original use assets in the same QOZ (or a contiguous QOZ). 

Finally, if an eligible entity chooses to use this approach, the purchased property will not be treated as original use property, and instead, the basis of that purchased property will be taken into account in determining whether the additions to the basis of the non-original use property satisfy the substantial improvement test. For example, if a QOF purchases and intends to substantially improve a hotel, the QOF may include original use purchased assets in the basis of the purchased hotel to meet the substantial improvement requirement if those purchased assets are integrally linked to the functionality of the hotel business. These original use purchased assets could include mattresses, linens, furniture, electronic equipment or any other tangible property. However, for purposes of the substantial improvement requirement, the QOF may not include in the basis of that hotel an apartment building purchased by the QOF that is operated in a trade or business separate from the hotel business.

The final regulations also provide that, for purposes of applying the substantial improvement requirement, certain buildings can be aggregated and treated as a single item of property (single property). Specifically, with respect to two or more buildings located within a QOZ or a single series of contiguous QOZs (eligible building group) that are treated as a single property, the amount of basis required to be added to those buildings will equal the total amount of basis calculated by adding the basis of each such building comprising the single property and additions to the basis of each building comprising the single property are aggregated to determine satisfaction of the substantial improvement requirement.

To clarify which buildings may be treated as a single property, the final regulations address eligible building groups located entirely within a parcel of land described in a single deed, as well as groups spanning contiguous parcels of land described in separate deeds. First, a QOF or QOZ Business may treat all buildings that compose an eligible building group and that are located entirely within the geographic borders of a parcel of land described in a single deed as a single property. In addition, a QOF or QOZ Business may treat all buildings composing an eligible building group that are located entirely within the geographic borders of contiguous parcels of land described in separate deeds as a single property to the extent each building is operated as part of one or more trades or businesses that meet the following three requirements: (i) the buildings must be operated exclusively by the QOF or by the QOZ Business; (ii) the buildings must share facilities or share significant centralized business elements, such as personnel, accounting, legal, manufacturing, purchasing, human resources or information technology resources; and (iii) the buildings must be operated in coordination with, or reliance upon, one or more of the trades or businesses (for example, supply chain interdependencies or mixed-use facilities).

Cure Periods and Reasonable Cause Relief

No relief is available to a QOF that discovered that the entity in which it invested failed to qualify as a QOZ Business. The 90 percent investment standard poses a high threshold with severe consequences for a trade or business that failed to qualify as a QOZ Business for a testing date.

The Treasury Department and the IRS agree that entities should be afforded appropriate relief to cure a defect that prevents qualification as a QOZ Business for purposes of the 90 percent QOZ property holding period, without penalty to the investing QOF. Accordingly, the final regulations provide a six-month period for an entity in which a QOF has invested to cure a defect that caused the entity to fail to qualify as a QOZ Business. The six-month cure period corresponds to the testing periods for both the QOZ Business and the QOF. The final regulations provide that during that six-month cure period, the QOF can treat the interest held in the entity as QOZ property. Upon the conclusion of the six-month cure period, if the entity again fails to qualify as a QOZ Business, the QOF must determine if the QOF meets the 90 percent investment standard, taking into account its ownership in the non-qualifying entity. If the QOF fails to meet the 90 percent investment standard, the final regulations provide that the QOF must determine the penalty applicable to each month in which the QOF failed to meet the 90 percent investment standard, including each month during and prior to the six-month cure period. Lastly, a QOZ Business can utilize a six-month cure period only once. However, in addition to this six-month cure period, a QOF can assert a defense to these penalties if the QOF shows that such failure is due to reasonable cause.

Part IV Preview

In the last installment of this series, we will focus on how the final regulations improve the ability of investors to divest of their interests in their QOZ investments.

QOZ Final Rules Part II: Foreign Investors and Longer Permitted Startup Periods

In this second installment of our series on the Qualified Opportunity Zone (QOZ) final regulations, we focus on clarifying who has capital gains eligible for deferral and the grace periods provided to startups holding working capital as a QOZ asset and substantially improving property.

Eligible Capital Gains for Foreign Persons and Tax-Exempt Entities

As noted briefly in Part I of this series, the final regulations clearly state that eligible taxpayers may only make a qualifying investment in a Qualified Opportunity Fund (QOF) using those capital gains that would have been (except for making the deferral election) taxable for federal income tax purposes. Thus, eligible capital gains must be recognized instead of merely realized. This approach also removes any limitation on the identity of a QOF investor.

For example, nonresident alien individuals and foreign corporations whose capital gains are effectively connected with a U.S. trade or business are subject to U.S. federal income tax and are therefore eligible QOZ investors with respect to those capital gains. Similarly, a domestic tax-exempt organization also qualifies with respect to an item of its capital gain to the extent the capital gain would be included in computing the organization’s unrelated business taxable income (such as rent received from debt-financed property).

On the other hand, foreign persons whose capital gains are not subject to U.S. federal income taxes by operation of a treaty or some other application of federal income tax law may not use such capital gains to make a qualifying investment in a QOF. Domestic organizations whose capital gains are not subject to federal income tax are in the same boat. This approach ensures that all domestic and foreign persons are eligible for the QOZ federal income tax benefits under the same universal condition: they must have capital gains that are subject to U.S. federal income tax.

To prevent foreign eligible taxpayers from taking inconsistent positions with respect to treaty benefits in the taxable year of deferral and the taxable year of inclusion, the final regulations provide that a foreign eligible taxpayer cannot make a deferral election with respect to an eligible gain unless the foreign eligible taxpayer irrevocably waives, in accordance with forms and instructions, any treaty benefits that would exempt that gain from federal income tax at the time of inclusion pursuant to an applicable U.S. income tax convention.

In the event that forms and instructions have not yet been published incorporating the treaty waiver requirement for a foreign eligible taxpayer for the taxable year to which the deferral election applies, the final regulations require a written statement waiving such treaty benefits to be attached to the taxpayers return. Eligible taxpayers other than foreign eligible taxpayers will only be required to make this treaty waiver if and to the extent required in forms and publications.

Another important clarification in the final regulations is how these rules affect partnerships that make the election to defer tax at the entity level. Many partnerships entities are unaware of the tax status of their partners, and do not generally have sufficient information about the tax treatment and positions of their partners to perform this analysis. So the Treasury Department and the IRS determined that it would be unduly burdensome to require a partnership to ascertain the extent to which a capital gain would be, but for a deferral election by the partnership, subject to federal income tax by all of its direct and indirect partners. Thus, in the case of partnerships, the final regulations provide an exception to the general requirement that gain be subject to federal income tax in order to constitute eligible gain.

An anti-abuse rule is included in the event that foreign persons who are not subject to federal income tax plan to enter into transactions including, but not limited to, the use of partnerships formed or availed of to circumvent the rule generally requiring eligible gains to be subject to federal income tax. A partnership formed or availed of with a significant purpose of avoiding the requirement that eligible gains be subject to federal income tax will be disregarded, in whole or in part, to prevent the creation of a qualifying investment by the partnership with respect to any partner that would not otherwise satisfy that requirement. The anti-abuse rule applies even if some of the partners in the partnership are subject to federal income tax.

This specific anti-abuse rule does not explicitly apply to S corporations. It’s unclear why, but perhaps the burden on an S corporation was not significant enough to extend it explicitly to S corporations, given the limitations on the number of shareholders permitted for S corporations and the presence of a general anti-abuse rule already introduced in the proposed regulations.

Safe Harbor for Reasonable Amounts of Working Capital

To be a Qualified Opportunity Zone Business (QOZ Business), for each taxable year, less than five percent of the average aggregate unadjusted bases of the business’ property can be nonqualified financial property, which includes various financial-type assets like cash, cash equivalents, debt, stock, partnership interests and options. However, that definition excludes reasonable amounts of working capital held in cash, cash equivalents or debt instruments with a term of 18 months or less. That safe harbor was included in the proposed regulations.

To qualify, the QOZ Business: (1) must have a written plan that identifies the working capital as property held for the acquisition, construction or substantial improvement of tangible property in the QOZ or the development of a trade or business in the QOZ; (2) must have a written schedule consistent with the ordinary business operations of the business that will use the working capital within 31 months; and (3) must substantially comply with the schedule. The proposed regulations allowed the 31-month period to be exceeded if the delay is attributable to waiting for government action.

The final regulations flesh out the circumstances in which that exception to the 31-month rule applies. If the failure to obtain a governmental permit is the reason for the delay and no other action could be taken to improve the tangible property or complete the project during the permitting process, then the safe harbor can generally be tolled for an amount of time equal to the time that the permit was delayed. In such case, the final regulations require that the application for such permit must be completed during the 31-month period.

To address other delays caused by circumstances outside the business’s control, the final regulations also permit an additional 24 months to be added to the initial 31 months if the QOZ is located in a federally-declared disaster if the project is delayed due to such disaster.

In addition, the final regulations provide clarification regarding how multiple overlapping or sequential safe harbors may be utilized, create a new working capital safe harbor applicable to single items of tangible property, and expand the benefits of qualifying for these safe harbors.

Two Working Capital Safe Harbors

Multiple overlapping or sequential applications of the working capital safe harbor were allowed by the proposed regulations, provided that each application independently satisfies all of the requirements (multiple safe harbor rule). But it was not clear whether the QOZ Business was required to be engaged in an active trade or business at the end of the first 31-month period. This lack of clarity presented issues for startup businesses as well as for very large, transformational projects.

Presumably the QOZ Business must be engaged in an active trade or business at the end of the safe harbor period because the final regulations do not specifically clarify that question or permit otherwise. Instead, they retain the multiple safe harbor rule and create an additional safe harbor rule, ostensibly to provide more time for a startup to reach the status of trade or business.

This second working capital safe harbor applies to a single item of tangible property. It can be utilized multiple times provided each application independently satisfies all of the safe harbor requirements. But this one is limited to a total safe harbor period of 62 months and has two additional prerequisites: (1) the working capital assets from an expiring 31-month period must be expended in accordance with the previously adopted plan; and (2) the subsequent infusions of working capital assets must form an integral part of the plan covered by the initial working capital safe harbor. Meeting the requirements of both of these working capital safe harbors provides the same benefits, which have been expanded from those provided by the proposed regulations.

New Working Capital Safe Harbor Benefit

In its proposed form, meeting the working capital safe harbor treated the working capital assets as qualifying as a reasonable in amount (and not nonqualified financial property, only a very limited amount of which is permitted). In addition, the income earned from qualifying working capital counted toward the 50 percent gross income test, and any intangible assets utilized as working capital counted toward the 40 percent use test.

The final regulations add another benefit to the safe harbors. The tangible property purchased, leased, or improved pursuant to the written plan for their expenditure count toward the 70 percent property test during the safe harbor period if the tangible property is expected to satisfy the QOZ Business property tests upon completion of their planned expenditure at the expiration of the safe harbor period. Thus, the final regulations permit assets covered by a working capital safe harbor to be treated as satisfying all of the requirements of QOZ Business property except the sin business prohibition during the safe harbor period, if the requirements of either of the working capital safe harbors are met.

However, there was a limit on how far the Treasury Department and IRS could expand the working capital safe harbor benefits. Only QOZ Businesses can utilize them.

QOF Are Not Permitted to Use Working Capital Safe Harbor 

As passed by Congress, Code section 1400Z-2 applies the 1397C(b) rules (i.e., the 50 percent gross income test, 40 percent intangible use test and 5 percent nonqualified financial property test) to QOZ Businesses but not QOFs. Unfortunately, 1397C(b) also provides the introduction of the working capital safe harbor into the QOZ regime. As such, it did not initially appear that the working capital safe harbor could apply to QOFs but only QOZ Businesses. That concerned practitioners and investors who requested that the final regulations permit QOFs to use the working capital safe harbors notwithstanding the inapplicability of the other 1397C(b) rules to QOFs.

The Treasury Department and IRS reviewed this issue and concluded that the statutory construction of 1400Z-2 prevented the issuance of any interpretive regulations applying the working capital safe harbor to QOFs. The statutory text simply did not allow it.

It has been our consistent recommendation to utilize a two-tiered structure (incorporating a lower-tier QOZ Business) when creating a QOF investment. The inability of a QOF to utilize the working capital safe harbors is another great reason to focus on the two-tier structure when investing in a QOZ.

Expansion of 30-Month Substantial Improvement Period

A QOZ Business must hold 70 percent of its property in the form of QOZ Business property. QOZ Business property includes tangible property that is not new but is used property that is substantially improved once acquired by the QOZ Business. The October 2018 proposed regulations provided a 30-month substantial improvement period of tangible property for purposes of applying the substantial improvement requirement. Under that proposal, tangible property is treated as substantially improved by a QOZ Business only if, during any 30-month period beginning after the date of acquisition of the property, additions to the basis of the property in the hands of the QOZ Business exceed an amount equal to the adjusted basis of the property at the beginning of the 30-month period in the hands of the QOZ Business.

Previously, it was unclear whether such property qualified as QOZ Business property while undergoing the substantial improvement. To alleviate this issue, the final regulations provide that tangible property purchased, leased or improved by a trade or business that is undergoing the substantial improvement process, but has not been placed in service or used in a trade or business, will be treated as used in a trade or business and as QOZ Business property during the 30-month substantial improvement period with respect to that property. Such treatment is only available if the property is reasonably expected to be substantially improved and used in a trade or business in the QOZ by the end of the 30-month substantial improvement period.

Part III Preview

In the next installment of this series, we will focus on the new clarity involving the rules for qualifying as a QOF and QOZ Business, including triple net leases as active trades or businesses, brownfield sites as original use property, and compliance with the substantial improvement rules when multiple items of property are being improved.

QOZ Final Rules Part I: More Flexibility to Invest Capital Gains

Qualified Opportunity Zones, a tax incentive created by the Tax Cuts and Jobs Act, offer certain deferrals of capital gains tax if the capital gains are invested in economically distressed areas. The basic rules for this incentive are codified in Internal Revenue Code Sections 1400Z-1 and 1400Z-2 but more guidance was necessary.

On October 29, 2018 and May 1, 2019, the U.S. Treasury Department and the IRS issued proposed regulations as an initial attempt to provide detailed guidance as to how Qualified Opportunity Zone investments could be made to obtain those tax benefits. On December 19, 2019, after considering public comment on those proposed regulations, the U.S. Treasury Department and the IRS issued final regulations implementing the Qualified Opportunity Zones tax incentive.

Over the next few weeks, we will explain the most important changes these final regulations provide and issue an updated version of our white paper. This is the first installment and focuses on the additional flexibility regarding when capital gains must be invested and the new guidance as to the type of capital gains that may be invested in Qualified Opportunity Zone Funds (QOFs).

Changes to the Investment Window

Generally, capital gains must be reinvested into a QOF within a period of 180 days which begins on the date the capital gain would be recognized for federal tax purposes. The final regulations allow that 180-day window to begin at additional times, providing investors more flexibility for investing capital gains into QOFs.

Pass-Through Gains

In the proposed regulations partnerships, S corporations, estates and trusts needed to make a QOF investment within 180 days of the date on which the entity recognized capital gain for federal tax purposes. Moreover, the 180-day window for the partners, shareholders and beneficiaries of these entities could begin on the date the capital gain is recognized by the pass-through entity or the last day of the taxable year for its owner.

The final regulations now provide an additional date on which the 180-day window can begin for partners, shareholders and beneficiaries—the due date of the entity’s tax return, not including any extensions.

This change addresses taxpayer concerns about potentially missing investment opportunities due to an owner of a business entity receiving a late Schedule K-1 (or other form) from the entity. Notably, a similar rule does not apply to a grantor trust because the grantor is treated as the owner of the grantor trust’s property for federal income tax rules. Therefore, the grantor does not need to wait for a Schedule K-1 to be prepared.

1231 Gains

The proposed regulations only permitted the amount of an investor’s gains from the sale of business property (section 1231 property) that was in excess of the investor’s losses from such sales to be invested in QOFs, which required the 180-day investment period to begin on the last day of the investor’s tax year. This created a significant impediment to investment of these capital gains.

The final regulations allow a taxpayer to invest the entire amount of gains from such sales without regard to losses and permit the 180-day investment period to begin on the date of the sale of the asset giving rise to the gain. Notably, the section 1245 and 1250 rules still apply to recharacterize 1231 gains as ordinary income; only those 1231 gains not recharacterized are eligible capital gains.

RIC and REIT Gains

The amount of capital gain dividends from a regulated investment company (RIC) and real estate investment trust (REIT) are determined after the end of the relevant tax year. Under the proposed regulations, the 180-day period for RIC and REIT shareholders begins on the date the shareholder receives a dividend, which could be more than 180 days before the end of the year. As a result, shareholders could be prevented from investing their capital gain dividends in a QOF during the 180-day window depending on when the capital gain dividend is received.

To address this issue, the final regulations change the date on which the 180-day investment period begins to the last day of the shareholder’s tax year. In addition, the final regulations permit the shareholder to elect to begin the 180-day investment period on the date the shareholder receives a capital gain dividend from the RIC or REIT.

Installment Sale Gains

The final regulations also provide additional flexibility with respect to the rules applicable to gains from installment sales. Generally, gains from an installment sale are required to be taken into account for federal tax purposes in the taxable year or years during which payments are received rather than the year of sale. It was not clear whether gains from an installment sale are able to be invested when received, even if the initial installment payment was made before 2018 or the year of sale. Therefore, there could be a single 180-day period for all income from the installment sale that begins on the date and year of the sale, or multiple 180-day periods, each beginning in the year during which a payment is received and income is recognized under the installment method.

The final regulations adopt the rule that the gain is to be invested when received and, to provide investors additional flexibility, accommodate beginning the 180-day period on either (i) the date a payment under the installment sale is received for that taxable year, or (ii) the last day of the table year the eligible gain under the installment method would be recognized. As a result, if a taxpayer defers gain from multiple payments under an installment sale, there may either be multiple 180-day periods or a single 180-day period at the end of the taxpayer’s taxable year.

Gains Subject to Deferral

Additional guidance is also provided for the types of capital gains that may be invested in QOFs.

Previously-Invested Gains

New flexibility is provided with respect to gains that were previously invested in a QOF. The preamble to the May 2019 proposed regulations explained that, upon disposition of a QOF interest, deferring the amount otherwise resulting from an “inclusion event” is permitted only if the investor has disposed of the entire initial QOF investment. This is due to the explicit prohibition in section 1400Z-2 on making a deferral election with respect to a sale or exchange if an election is already in effect with respect to the same capital gain

The final regulations acknowledge that a deferral election is no longer in effect for any capital gain arising from an inclusion event. As a result, such capital gain is considered new capital gain for which a new deferral election may be made if invested in another QOF. In other words, an investor no longer needs to dispose of their entire initial investment in a QOF to reinvest and defer capital gain arising from an inclusion event.

Only Gains Subject to Federal Income Tax

It was not clear from the proposed regulations whether the term eligible gains included capital gains realized by persons that are generally not subject to federal income tax with respect to those gains. That includes entities generally exempt from federal income tax and persons who are neither U.S. citizens nor U.S. residents (nonresident aliens, who are generally not subject to U.S. federal income tax).

The final regulations clarify that deferral of a gain under the Qualified Opportunity Zone tax incentive program is available only for capital gains that would be subject to federal income tax. So eligible capital gains for a tax-exempt organization are only those gains that are subject to the unrelated business income tax. Similarly, eligible capital gains for nonresident aliens are only those gains that are effectively connected with a U.S. trade or business.

At Last, More Guidance on Qualified Opportunity Zones, but Questions Still Remain

On April 17, 2019 the U.S. Department of Treasury issued the second round of proposed regulations to clarify the rules related to the Qualified Opportunity Zones (QOZs). These proposed regulations refine the application of Section 1400Z-2 of the Internal Revenue Code (the Code) and update the proposed regulations previously issued in October 2018. The proposed regulations:

  1. Define the term “substantially all” for purposes the qualifying amount of property to be held by a Qualified Opportunity Zone Business (QOZB) and qualifying holding periods;
  2. Describe the transactions that prematurely trigger gain recognition otherwise deferred by investment in QOZs;
  3. Explain how to determine both the timing and amount of deferred gain to be recognized; and
  4. Address how leased property used by a QOZB will be treated.

The following is a summary of some of the new rules found in the proposed regulations.

The definition of “substantially all” is still 70 percent for determining use of tangible property but is 90 percent for holding periods.

To qualify as a QOZB under the Code, “substantially all” of the tangible property owned or leased by the trade or business must be QOZ business property, as that term is defined in the Code. The October 2018 proposed regulations clarified that, for purposes of determining whether a partnership or corporation whose equity interests were owned by a Qualified Opportunity Fund (QOF) was a QOZB, the term “substantially all” meant at least 70 percent.

This was helpful but did not address the other uses of the phrase “substantially all” found in Section 1400Z-2. In particular, the definition of QOZ business property utilized this term twice, once to describe the amount of the property’s use by a QOF that must occur in a QOZ and once to describe the period of time over which the QOF must hold the property. As stated above, the October 2018 regulations provided guidance on the former but not the latter. There are more occasions when the term “substantially all” describes a holding period.

These new proposed regulations now confirm that the term “substantially all” still means 70 percent in the contexts related to use but a 90 percent threshold is imposed in the holding period context. In other words, to qualify as QOZ business property, 70 percent of the property’s use by the QOF must occur in a QOZ and this qualifying use must occur during 90 percent of the QOF’s holding period for such property.

The term “substantial portion” means 40 percent for determining use of intangible property

The newly proposed regulations provide guidance related to the term “substantial portion.” The term substantial portion is used to determine whether an entity owned by a QOF qualifies as a QOZB. In particular, for an entity to qualify as a QOZB, a substantial portion of the intangible property of a QOZB must be used in the active conduct of a trade or business in the QOZ. For this purpose, the term “substantial portion” means at least 40 percent.

Inventory in transit is still tangible property used in the QOZ.

Some taxpayers were worried that the time inventory was in transit from a vendor or a customer to a QOZ facility would not count towards the qualifying use requirement for QOZ business property because the inventory’s use was not always physically in the QOZ. Happily, the proposed regulations clarify that inventory, including raw materials, do not fail to be used in a QOZ solely because they are in transit from a vendor or to a customer not located in a QOZ for part of the time they are owned by the QOF. The IRS and Treasury’s position on this issue do not appear settled, however. Follow-up comments have been requested on whether the location of a warehouse should be relevant to determining use of inventory, among other issues.

The proposed regulations clarify that leased tangible property can be treated as QOZ business property for purposes of satisfying the QOF 90 percent test or the QOZB 70 percent/substantially all test in most cases if the following requirements are satisfied:

  1. The leased tangible property must be acquired under a lease entered into after December 31, 2017;
  2. Substantially all of the use of the leased tangible property must be in a QOZ during substantially all of the holding period for which the business leases the property; and
  3. The lease under which the lessee QOF or QOZB acquires rights must be a market rate lease.

Note that these requirements do not impose any original use requirement or substantial improvement requirement on leased tangible property. However, if the lessor is related to the lessee QOF or QOZB, two additional requirements are imposed. First, where the QOF or QOZB lessee is related to the lessor, the QOF or QOZB cannot make a prepayment to the lessor relating to the period of use of the leased tangible property that exceeds 12 months. This requirement operates to avoid improper allocations of investment capital to prepayments of rent. Second, if the original use of leased tangible personal property does not commence with the lessee in the QOZ, the lessee QOF or QOZB must become the owner of the tangible property (QOZ business property that is used in the same zone in which the leased property is used and has a value not less than the value of the leased personal property). The QOF or QOZB needs to acquire this property within 30 months of the date on which the lessee receives possession of the leased property.

Original use of QOZ business property in a QOZ is clarified.

Owned tangible property must be acquired by purchase after December 31, 2017 and have its original use in the QOZ or be substantially improved (among other requirements) in order to be QOZ business property. Leased personal property from a related party must have its original use in the QOZ or deal with the 30-month test described above. The proposed regulations now clarify that original use commences on the date on which a person first places the property in service in a QOZ for purposes of depreciation or amortization (or first uses it in the QOZ in a way that would allow depreciation or amortization if the person were the property’s owner).

Because of this guidance, it is clear that tangible property in a QOZ that is depreciated or amortized by a taxpayer other than the QOF or the QOZB prior to their receipt of the property will not satisfy the original use requirement. On the other hand, if the first person to acquire tangible property to be used in the QOZ and depreciate/amortize it is the QOF or the QOZB, this will satisfy the original use requirement. Used tangible property satisfies the original use requirement if it was not previously used within that QOZ in a manner that would have allowed it to be depreciated/amortized by any taxpayer.

Also, the proposed regulations provide additional guidance in the real property situation for QOFs and QOZBs working with vacant or unimproved land. Specifically, they state that if a building or structure in a QOZ has been vacant for at least five years, the purchased building or structure will satisfy the original use requirement. For unimproved land (e.g., potential farmland), the proposed regulations also give guidance. They state that unimproved land that is acquired by purchase in a QOZ is not required to be substantially improved in order for it to be QOZ business property if all other requirements are met. In this manner, a QOF’s acquisition of farmland for production of a crop could be treated as QOZ business property without requiring the QOF to invest a significant amount of additional capital therein to improve the land and increase its output.

Finally, lessee improvements to leased property satisfy the original use requirement up to the unadjusted cost basis under Code Section 1012.

QOFs are given time to reinvest the return of capital from QOZ property.

A QOF is defined as “any investment vehicle which is organized as a corporation or a partnership for the purpose of investing in QOZ property (other than another qualified opportunity fund) that holds at least 90 percent of its assets in QOZ property.…” The proposed regulations provide that proceeds received by a QOF from the sale or disposition of QOZ property (including QOZ stock, partnership interests or QOZ business property) are still treated as QOZ property for purposes of the 90 percent test as long as they are reinvested in QOZ property within 12 months of the sale or disposition and they are continuously held during such period in the form of cash, cash equivalents and/or short-term debt instruments. The Department of Treasury is still considering whether to create an analogous rule for QOF subsidiaries and has requested comments from practitioners on that issue.

Guidance provided on whether certain dispositions of a QOF interest will trigger taxation of deferred capital gain.

According to the Code, deferred capital gains are taxed on the earlier of either the date of the sale or disposition of the QOF investment or December 31, 2026. The proposed regulations clarify that the term disposition includes any transfer of a qualifying QOF investment in a transaction to the extent that the transfer reduces the person’s equity interest in the QOF, except for a few specifically exempted transactions. These may include:

  1. Transfers in which the person receives property from the QOF as a distribution for federal tax purposes (e.g., a dividend or a partnership non-liquidating distribution);
  2. Transfers from an estate to a beneficiary following the death of the QOF investor;
  3. Transfers to a grantor trust or other disregarded entities that are not separate from the investor

Thus, gain trigger events may include, among other transactions, charitable donations and gifts of QOF interests, redemptions of QOF stock, distributions from a QOF partnership in excess of the partner’s basis in the QOF partnership interest and various reorganizations of QOF corporations. Be wary if you undergo a transaction like this and consult the proposed regulations to see if it is taxable.

Guidance on what constitutes the active conduct of a trade or business; some land can be located outside of the QOZ and still qualify.

The proposed regulations clarify that the term “active conduct of a trade or business” for purposes of the QOZ rules will refer to Code Section 162. As such, land is QOZ business property only when it is used in a trade or business within the meaning of Code Section 162. Specifically, owning land for investment purposes does not give rise to a trade or business in and of itself. If land is simply held by a QOF or QOZB for investment and is not utilized in some productive manner in connection with the QOF or QOZB’s active business, such land is not QOZ business property. The proposed regulations do clarify, however, that the ownership and operation (including leasing) of real property used in a trade or business is treated as the active conduct of a trade or business.

In addition, for purposes of satisfying the requirements under Code Section 1400Z-2 and 1397C(b)(2) (i.e., 50 percent gross income test), Code Section 1397C(b)(4) (i.e., intangible property test), and Code Section 1397C(b)(8) (i.e., minimal nonqualified financial property test), the proposed regulations provide new rules for land contiguous to a QOZ. If the amount of real property based on square footage within a QOZ is substantial when compared to real property outside of the QOZ that is contiguous to and/or part of the QOZ real property, all of the real property will be deemed to be located within the QOZ. For this purpose, there is substantiality for purposes of satisfying the requirements when the unadjusted cost of real property inside the QOZ is greater than the unadjusted cost of real property outside of the QOZ.

Substantial improvement of tangible property is measured on an asset-by-asset basis.

Under the proposed regulations, when an asset is substantially improved (related to qualification as QOZ business property) is determined on an asset-by-asset basis. This seems somewhat impractical depending on the number and type of assets. As such, the Treasury has requested comments on how an aggregate approach might be applied to determine substantial improvement.

Guidance provided for determining when a QOZB will be treated as deriving at least 50 percent of its total gross income from the active conduct of a trade or business in a QOZ.

QOZBs are required to derive at least 50 percent of their total gross income from the active conduct of a trade or business located in a QOZ. The rule caused confusion for operating businesses who had customers outside of the zone (e.g., if you sold products online or made products in the QOZ but had salespeople selling them to customers outside of the QOZ). The proposed regulations provide three default options for passing the 50 percent gross income test:

  1. At least 50 percent of the services in a tax year performed by employees and contractors (based on hours) are performed within the QOZ;
  2. At least 50 percent of the services in a tax year performed by employees and contractors (based on amounts paid for services performed) are performed within the QOZ; or
  3. The tangible property of the QOZB (that is in the QOZ) and the management or operational functions performed (for the QOZB in the QOZ) are each necessary to generate 50 percent from the gross income of the QOZB’s trade or business.

If a QOZB does not fall under one of the default options above, the QOZB can still meet the 50 percent gross income test if (based on facts and circumstances) at least 50 percent of the gross income is derived from the active conduct of a trade or business in the QOZ.

Guidance provided on QOF investment basis, basis step-ups and how to leave a QOF partnership entity after the 10-year holding period has run.

The Code states that an investor initially has a $0 basis in the QOF investment. The proposed regulations provide new guidance on how this rule works in practice when built-in gain or built-in loss property is contributed to a QOF partnership in exchange for an interest in the QOF. They also shed light on how to determine whether the interest an investor receives back is a qualifying QOF investment or a non-qualifying QOF investment. Finally, the preamble to the proposed regulations discuss what the $0 basis means for pass-through losses from the QOF that may be suspended under Code Section 704(d), noting that a tax loss that is suspended under Code Section 704(d) will be freed when the taxpayer has additional basis in its QOF interest. This could occur when the QOF has income to offset or when the basis step-ups happen in years five and seven.

When it comes to the 10-year holding period step-up in basis to fair market value (FMV), the proposed regulations clarify that an investor’s FMV basis step-up after the 10-year holding period will apply immediately before the investor sells the QOF investment. For partnerships and S corporation QOFs, an investor’s basis is adjusted to FMV after the 10-year holding period and the basis of the QOF’s assets are also adjusted. This avoids hot asset issues, along with the creation of capital losses and ordinary income on the sale of the QOF interest. In addition, if a taxpayer has held a QOF investment in a QOF partnership or S corporation for at least 10 years when the QOF disposes of its QOZ property, the investor can make an election to exclude from gross income some or all of the capital gain arising from such disposition on Schedule K-1 of the QOF and attributable to the qualifying investment. This may answer some questions about how asset sales are treated in a QOF.

Timing for more guidance from the IRS and Treasury.

The introduction to the proposed regulations clearly states that the IRS and Treasury expect to provide more guidance on QOZs within the next few
months. Expect that Form 8996 (used for initial QOF self-certification and annual reporting) will be revised for the 2019 tax year and beyond. The IRS and Treasury have also stated that they continue to seek information and comments on the QOZ rules.

Notwithstanding the guidance given in the latest proposed regulations, many questions remain. With respect to the reinvestment rule for QOFs, the IRS and Treasury are asking for comments on whether a similar rule should be provided for QOZBs, or whether QOFs and their investors should be exempt from the federal income tax consequences of selling QOZ property if such dispositions are reinvested in QOZ property within a reasonable timeframe. Hopefully, the IRS and Treasury will provide additional guidance soon.

Government Shutdown Impacts Qualified Opportunity Zones

Questions regarding the proposed regulations pertaining to Qualified Opportunity Zones remain unanswered due to the shutdown of the federal government. The IRS was scheduled to start taking comments on the draft regulations (which were first issued in October 2018) at a January 10 public hearing.  Due to the shutdown, those hearings are now on hold and will remain on hold until Treasury Department funding is fully restored and IRS employees return from furlough.

Investors, developers and community groups who were invited and prepared to provide feedback on the proposed regulations at the hearing now must wait. The IRS already received over 150 comments prior to the scheduled hearing in response to its request for feedback on the definitions of “substantial improvement” and “original use.” Ambiguity around these and other terms leaves investors uncertain about which projects may qualify for the program and  how investments can evolve over time without becoming disqualified from the tax incentive. The cancellation of the hearing delays the clarification of these definitions as well as other issues, and this could impact investor confidence in moving forward with potential projects.

Even so, there are deals building in the pipeline. More than 8,700 areas in economically distressed communities across the country have been designated as Qualified Opportunity Zones and potential targets for the estimated $6 trillion in idle capital gains in search of tax breaks. Varnum is actively assisting clients with creative deal structures that take advantage of the new tax incentive opportunity.

Please visit our Qualified Opportunity Zone Funds service page for more information on the evolving regulatory landscape governing these deals, or contact Fred Schubkegel, Katie Roskam or Mary Kay Shaver with any Qualified Opportunity Zone questions.

Qualified Opportunity Zones: A Significant Tax Benefit for Investors

The Tax Cuts and Jobs Act, passed in December 2017, contained new Internal Revenue Code Sections 1400Z-1 and 2 aimed at developing economic growth and business in certain designated, distressed, low-income communities around the country known as Qualified Opportunity Zones. The provision provides federal tax benefits to those investors who invest in funds and businesses that target the designated Qualified Opportunity Zone boundaries.

What Are Qualified Opportunity Zones?

A specific population census tract in a state can become a Qualified Opportunity Zone if it is nominated by a state and approved by the Treasury. Each state is allowed to designate up to 25 percent of the low-income communities in the state as Qualified Opportunity Zones. The designation of a Qualified Opportunity Zone generally remains in effect for 10 years, ending on the close of the tenth calendar year beginning on or after the date of designation.

In April 2018, the IRS announced new Qualified Opportunity Zones in 18 states. Submissions were approved for:

  • American Samoa
  • Arizona
  • California
  • Colorado
  • Georgia
  • Idaho
  • Kentucky
  • Michigan
  • Mississippi
  • Nebraska
  • New Jersey
  • Oklahoma
  • Puerto Rico
  • South Carolina
  • South Dakota
  • Vermont
  • Virgin Islands
  • Wisconsin

In Michigan, Qualified Opportunity Zones include parts of:

  • Detroit
  • Grand Rapids
  • Muskegon
  • Muskegon Heights
  • Newaygo
  • Big Rapids
  • Cheboygan
  • Standish
  • Tawas City
  • Alpena
  • Lansing
  • Benton Harbor
  • Holland
  • Bois Blanc Island
  • Kalamazoo
  • Dearborn
  • Marquette

For more information on finding the designated Qualified Opportunity Zones, please visit the U.S. Department of Treasury’s CDFI Fund website. The list will be updated as more Opportunity Zones are approved.

What Tax Benefits Apply to Qualified Opportunity Zones?

A taxpayer can temporarily defer taxation on certain capital gains that the taxpayer realizes in a sale or exchange of a capital asset to an unrelated party if the gain is reinvested in a Qualified Opportunity Fund. Qualified Opportunity Funds are generally investment vehicles, organized as a corporation or partnership, to invest in Qualified Opportunity Zone property (other than another qualified opportunity fund). At least 90 percent of such vehicle’s assets must be Qualified Opportunity Zone property. Qualified Opportunity Zone property includes Qualified Opportunity Zone stock, partnership interests or business property – basically, newly acquired business interests and business assets located, used and invested in the designated census tract area.

The exclusion for investing in a Qualified Opportunity Fund exists until the year on which such Qualified Opportunity Fund investment is sold or exchanged, or December 31, 2026, whichever occurs first. The maximum amount of the capital gain that may be deferred equals the amount invested in a Qualified Opportunity Fund by the taxpayer during the 180-day period beginning on the date of sale of the asset to which the deferral pertains. For amounts of the capital gains that exceed the maximum deferral amount, the capital gains are recognized and included in gross income.

At this time, additional guidance is needed to help explain some of the provisions for computing inclusion of deferred gain. The IRS has stated that guidance will be provided over the next few months. However, based on the current language, it appears that after the deferral period has run, and the gain deferred must be included in the taxpayer’s gross income computation, the amount of gain included equals the lesser of (1) the deferred gain amount or (2) the fair market value of the investment on the date the deferral period has run over the taxpayer’s basis in the investment. If a taxpayer’s investment in the fund has depreciated, fair market value would be used; otherwise, it is anticipated that deferred gain be used for this computation.

Special basis computation rules apply to the fund investment. The taxpayer’s basis in the Qualified Opportunity Fund investment is initially zero because the taxpayer is investing untaxed gain. However, the taxpayer can elect to increase the basis depending on whether the investment is held for five or seven years based on a percentage of gain deferred. Further, for investments held for 10 years, the basis of the fund investment is stepped up to fair market value. Because 10 years will not run by the time deferral expires in 2026, taxpayers who are still holding their interest in the fund on December 31, 2026 are required to recognize and pay taxes on the deferred gain at that time, subject to any increases in basis they may have received for holding the property for five years or more. The amount included in taxable income would be added to the taxpayer’s basis in the fund. Again, for taxpayers looking for a long term investment in a Qualified Opportunity Fund that plan to hold the investment beyond December 31, 2026 for at least a total of 10 years, a benefit arises from the step-up in basis in the fund equal to fair market value. These taxpayers are not taxed on any appreciation at the time the interest in the fund is sold or exchanged. Hence, the basis rules are beneficial, and for appreciating investments, the 10-year exclusion rule is a potentially substantial tax savings and permanent exclusion for post-acquisition capital gains on investments in funds. Based on the foregoing deadlines, a taxpayer should invest sooner rather than later in order to take advantage of the longest deferral period possible, as well as any basis increases.

How Do I Certify That I Am an Investor in a Qualified Opportunity Zone?

The IRS has stated they will be issuing a form that will allow taxpayers to self-certify as a Qualified Opportunity Fund. After completing the form, it must be attached to the timely-filed income tax return for the tax year. In addition, an investor may make an election to defer the gain from the sale or exchange of their capital asset to an unrelated party as long as it is reinvested in a Qualified Opportunity Fund during the 180-day period, in whole or in part, when filing his or her 2018 federal income tax return in 2019. Hence, taxpayers make the election to defer on the return on which the tax on that gain would be due if the taxpayer was not electing to defer it. 

If you have any other questions about Qualified Opportunity Zones or setting up a Qualified Opportunity Fund, please contact your Varnum attorney or any member of the Varnum Qualified Opportunity Zones Team.