On October 19, 2018, the Treasury Department issued much-anticipated guidance on Qualified Opportunity Funds (QOFs) and investments in them. QOFs are very attractive investments for investors who have recognized capital gains from the sale of property. In general, an investor who recognizes capital gains and invests in a QOF within 180 days after the gain is recognized may potentially:
(i) defer the inclusion of those capital gains in income until 2026,
(ii) eliminate up to 15 percent of the deferred capital gain from tax, and
(iii) subject to a 10-year holding period requirement, permanently eliminate any gain from the appreciation in value of the investment in the QOF.
The regulations answer many of the “gateway” questions needed to effectively structure QOFs and investments in them.
The maximum benefits under these rules require investment by the end of 2019, so we anticipate a surge of interest in fund investments, particularly through the first half of 2019. A QOF must invest in a business or in property located in a Qualified Opportunity Zone ("QOZ"). The QOZs have all been designated, and many of the QOZs are located in areas that are very attractive to developers and potential business owners.
Key points of interest to funds
No pre-clearance. As anticipated, the regulations do not require any kind of clearance or certification from the IRS or any other governmental body to be a QOF. Funds will certify their continuing compliance with annual tax filings.
Working capital safe harbor. The regulations provide an important “safe harbor” rule that permits a QOF to hold working capital for up to 31 months without violating the rules for qualifying as a QOF. Without such a safe harbor, a QOF would not have been able to establish working capital reserves for the construction and rehabilitation of property.
Special rule for purchased land. Property that was previously placed in service (for example, an existing building) only qualifies as “good” opportunity zone property if the QOF “substantially improves” the property – meaning that it invests an amount at least equal to the purchase price of the property. In a Revenue Ruling issued alongside the proposed regulations, the IRS stated that a QOF can exclude land from this computation – so, for instance, if a QOF purchases a property for $3 million with land worth $2 million and a building worth $1 million, the QOF need only invest $1 million into improving the building.
QOZ business. QOFs can invest in QOZ businesses, as well as in individual properties. A business is a QOZ business if, among other requirements, “substantially all” of its tangible assets are QOZ property. The proposed regulations clarify that “substantially all” in this context requires that only 70 percent of the QOZ business’s tangible assets need to be QOZ property.
Provisions of interest to investors and fund managers:
Only capital gains may be deferred. Ordinary income (including ordinary income that is a part of the gain from the sale of an entire business) is not eligible for deferral. Any special character of capital gains (e.g. short-term vs. long-term) is retained and applied when gains are ultimately taxed.
Significant benefits for flow-through entity owners. Any person or entity that has capital gains may elect to defer gain by investing in a QOF. If a flow-through entity (i.e., an entity treated as a partnership, S corporation or trust for income tax purposes) has a capital gain at the entity level, the entity itself may elect to defer gain by investing in a QOF. Alternatively, if the entity does not invest in a QOF, then its owners may elect to defer any capital gain passed through to them by directly investing in a QOF themselves. The pass-through owners can start the 180-day investment window at the end of the flow-through entity’s tax year (in most cases, December 31 of the year in which gain is recognized) or they can elect to have a 180-day window running in parallel to that of the flow-through entity. This additional flexibility may be extremely useful to owners of pass-through entities.
No grandfathering. Unfortunately the regulations do not provide any “grandfathering” for investors who had capital gains in early 2018. Those investors are now past their 180-day windows – unless the gain was recognized by a pass-through entity, in which case the pass-through entity owners could still reinvest capital gains in early 2019 and elect deferral.
Roll-over. An investor in a QOF may in certain cases dispose of the QOF investment and acquire a new investment while continuing the deferral of capital gains from the original investment – and maintaining the potential for tax-free growth of the QOF investment.
All benefits limited to deferred capital gain investment. The benefits of investing in a QOF are only available to taxpayers who have recognized a capital gain and who invest in a QOF within the 180-day window for investment. An investor who has no capital gains, or a fund manager who receives a carried interest in a QOF, will remain taxable on any gains it ultimately realizes from its investment in the QOF.
Reliance. Although the regulations are only in proposed form, taxpayers may rely on the regulations so long as the regulations are applied in their entirety and in a consistent manner.
The proposed regulations address many “gateway” issues, but other important issues (such as the extent to which a QOF might be able to defer gains on sale of QOZ property if it reinvests in other QOZ property) remain unanswered. The Treasury Department has indicated that it intends to issue a second set of regulations to address many of these questions. Even with those unanswered questions, we believe that there is enough information to effectively implement and invest in QOZ structures.
