By Thomas B. Eriksen, AttorneyThis article originally appeared in the January 18, 2019 edition of the Vancouver Business Journal.
The 2017 Tax Cut and Jobs Act (“Act”) enacted new tax incentives called Qualified Opportunity Funds (“QOF”) to encourage investment in areas of the country determined to be economically disadvantaged. The Act left many questions unanswered on how the QOF would be implemented by the IRS. In late 2018, the IRS issued proposed regulations and a revenue ruling that answered many of these questions.
The focus of the Opportunity Fund program is the concept of Qualified Opportunity Zones (“QOZs”), which are low-income census tracts nominated in the U.S. by governors of each state and certified by the Treasury Department. There are currently over 8,700 QOZs. There are two QOZs in Clark County, one along the Vancouver Waterfront, and one east of Washougal.
The new Internal Revenue Code (“IRC”) sections (Subchapter Z – Opportunity Funds) provide three distinct tax incentives intended to encourage investors to invest capital into low-income areas of each state.
Deferral of Capital Gains
The first tax benefit is the deferral of capital gains on the sale or exchange of a capital asset on or after January 1, 2018. The sale of any capital asset qualifies as long as it is sold to an unrelated party and the gains are reinvested in a QOF within 180 days of the sale of the capital asset. Subject to the possibility of a step-up in basis discussed below, recognition of the capital gains may be deferred until December 31, 2026. Under the recently released proposed regulations implementing IRC Section 1400Z-2, the IRS clarified that taxpayers eligible to take advantage of the deferral include individual taxpayers, corporations (including REITs and RICs), partnerships, and certain trusts. A partnership may elect to defer part or all of the gain at the partnership level. If the partnership does not elect to defer the gain, a partner may elect to defer part or all of the partner’s distributive share of the gain. Under the sunset provisions of the new tax law, the deferral election applies to capital gains recognized prior to December 31, 2026.
Step-up in Basis
The second tax benefit is the possible step-up in basis on the deferred gain. If the investor holds the Qualified Opportunity Fund investment for five years, the investor receives a 10% step-up in basis on the deferred capital gains. If the investor holds the Qualified Opportunity Fund investment two additional years, for a total of seven years, the investor receives an additional 5% step-up in basis, for a total of a 15% step-up in basis. Accordingly, for each $100 of deferred gain held in a Qualified Opportunity Fund investment for seven years or more, only $85 of that gain will ultimately be subject to capital gains taxation. The proposed regulations allow taxpayers to make the step-up in basis election until December 31, 2047, thus allowing the step-up in basis after the initial designation expires on December 31, 2028. This provides the investor the opportunity to hold the Qualified Opportunity Fund investment for the entire required 10-year holding period, plus an additional 10 years, and allows investors to acquire Qualified Opportunity Fund investments at any time prior to the December 31, 2028 expiration and still take advantage of the step-up in basis opportunity.
Exclusion of Gain
The third tax benefit of the new Opportunity Fund tax provisions is the possible permanent exclusion of all of the gain on the increase in value of the Opportunity Fund investment. If the Opportunity Fund investment is held for 10 years or more, all of the increase in value of the Opportunity Fund investment is excluded from capital gains taxation. In this scenario, the investor will pay capital gains tax on 85% of the capital gains deferred on the initial sale of the capital asset; however, any gains on the funds reinvested in the Opportunity Fund permanently avoid taxation.
An entity organized in the United States and treated as a corporation or partnership for U.S. tax purposes generally is eligible to be a QOF. Although there was initially some question, the proposed regulations confirm limited liability companies are eligible QOFs. Any QOF must hold at least 90% of its assets in QOZ Property.
Under the proposed regulations, an entity self-certifies as a QOF by filing IRS Form 8996 with its U.S. tax return each year.
90% Asset Test
The 90% asset test is a semi-annual test based on the average of the percentage of QOZ Property owned by the QOF. If the QOF fails to satisfy the asset test at the end of any month, the QOF is subject to a penalty equal to (1) the difference between 90% of its assets and the amount of its QOZ Property, multiplied by (2) the federal short-term rate plus 3%, unless the failure is due to reasonable cause.
The proposed regulations provide that a QOF must determine the value of its assets by reference to financial statements the QOF files with the U.S. Securities and Exchange Commission or another U.S. federal agency, or other audited financial statements that are prepared in accordance with U.S. GAAP. If the QOF does not have GAAP financial statements, the QOF must use the cost basis of its assets for testing purposes.
QOZ Business Property
As noted above, QOZ Property includes QOZ Business Property and equity interests in QOZ Entities. Tangible property generally qualifies as QOZ Business Property if:
- the property is used in a trade or business;
- the QOF or a QOZ Entity acquires the property from an unrelated person after December 31, 2017;
- the property’s original use commenced with the QOF or a QOZ Entity, or the QOF or a QOZ Entity substantially improves the property; and
- substantially all of the use of the property is located in a QOZ during the QOF’s or QOZ Entity’s holding period.
An entity generally qualifies as a QOZ Entity if:
- the entity is treated as a domestic corporation or domestic partnership for U.S. tax purposes;
- the QOF acquired equity interests in the entity from the entity, solely in exchange for cash, after December 31, 2017; and
- both at the time the QOF acquired the equity interests, and for substantially all of the QOF’s holding period, the entity was engaged in a qualified opportunity zone business (a “QOZ Business”).
- “substantially all” of the tangible property the QOZ Entity owns or leases is QOZ Business Property (the proposed regulations define “substantially all” as 70%);
- at least 50% of the QOZ Entity’s gross income is from the active conduct of the business;
- a substantial portion of the QOZ Entity’s intangible property is used in the active conduct of the business;
- less than 5% of the average of the aggregate unadjusted bases of the QOZ Entity’s property is attributable to “nonqualified financial property”; and
- the QOZ Entity’s trade or business does not comprise certain sin businesses.
Some of the most important aspects of the proposed regulations include:
- 70% Asset Safe Harbor. An entity qualifies as a QOZ Entity only if, among other things, “substantially all” of the tangible property that it owns or leases constitutes QOZ Business Property. The proposed regulations define “substantially all” in this context to mean at least 70% of its tangible property.
- Working Capital Safe Harbor. The Code generally limits a QOZ Entity’s ability to hold “nonqualified financial property.” The proposed regulations provide a safe harbor under which a QOZ Entity may exclude working capital (i.e., cash, cash equivalents, and debt instruments (i.e., accounts receivable) with a term of 18 months or less) from the definition of “nonqualified financial assets,” as long as (1) the working capital is designated in writing for the acquisition, construction, and/or substantial improvement of tangible property in a QOZ, (2) there is a written schedule consistent with the ordinary start-up of a trade or business for the expenditure of the working capital within 31 months of receipt, and (3) the working capital is actually used in a manner that is substantially consistent with the written designation and schedule. Under the proposed regulations, any tangible property that is acquired, constructed, and/or substantially improved with this working capital and is expected to qualify as QOZ Business Property by the end of the 31-month safe harbor period generally qualifies as QOZ Business Property that is used in the active conduct of a trade or business during the safe harbor period.
- Safe Harbor for Improved Property. Tangible property qualifies as QOZ Business Property if (1) its “original use” begins with the QOF or a QOZ Entity or (2) within 30 months of acquiring the property, the QOF’s or QOZ Entity’s capital expenditures with respect to the property exceed its cost basis in the property. Under Revenue Ruling 2018-29, which was issued along with the proposed regulations, if a QOF or QOZ Entity purchases an existing building located on land within a QOZ, then (1) the “substantial improvement” test applies only with respect to the amount of cost basis attributable to the building (the amount of cost basis attributable to the land is disregarded), and (2) if the “substantial improvement” test is satisfied, then the entire cost basis (including cost basis attributable to the land), as well as the cost of the improvements, qualify as QOZ Business Property.
- Use of QOF Equity as Collateral. Under the proposed regulations, taxpayers may pledge QOF equity as collateral for a loan without jeopardizing the Opportunity Zone tax benefits.
- Eligible Gains. The proposed regulations clarify that only capital gains (long-term or short-term) are eligible to be deferred under the Opportunity Zone program.
- Reliance on Proposed Regulations. The proposed regulations generally are effective on or after the date they are finalized. However, taxpayers may rely on the rules in the proposed regulations, so long as the rules are applied in their entirety and in a consistent manner.