Since coming into effect in January 2018, Subchapter Z of the US Tax Code—also known as the opportunity zone provisions—has enabled investors to pour billions of dollars into a broad array of businesses, from real estate development companies to tech startups. Investments in qualified opportunity funds (QOFs) offer a number of distinct tax benefits, not the least of which is reduced capital gains tax liability. But the rules governing these investments are quirky, perplexing and—in some cases—severely restrictive.
While qualified opportunity zone (QOZ) property must make up at least 90% of the property of a qualified opportunity fund (QOF), only 70% of the tangible property of a qualified opportunity zone business (QOZB) need be QOZ property. While this might sound confusing on its face, this distinction can help a QOF maintain flexibility and obtain specific tax benefits. In this fourth of our series of articles on QOFs, we discuss the entities that qualify as QOZBs and whose interests qualify as QOZ partnership interests or QOZ stock.
The assets of a qualified opportunity fund (QOF) must be comprised of at least 90% qualified opportunity zone property (QOZ property). QOZ property is any of the following: (1) qualified opportunity zone business property (QOZB property), (2) qualified opportunity zone stock (QOZ stock) and (3) qualified opportunity zone partnership interest (QOZ partnership interest). (See our previous article for more detail on the requirements of a QOF.) As will be discussed below, QOFs generally should only own interests in the latter two assets because of the added flexibility they provide.
QOZ stock must be stock in a US corporation and a QOZ partnership interest must be an interest in a domestic partnership. The QOF must acquire the QOZ stock or QOZ partnership interest after December 31, 2017, at original issue from the entity and solely in exchange for cash. At the time the QOZ stock or QOZ partnership interest is issued, the entity must be a “qualified opportunity zone business” (QOZB) (or, in the case of a new entity, organized for purposes of being a QOZB). The entity must remain a QOZB for substantially all of the time the QOF holds the stock or partnership interest.
A QOZB is a trade or business in which at least 70% of the tangible property owned or leased by the corporation or partnership is QOZB property. QOZB property means tangible property used in a trade or business of the QOZB if (1) the property was purchased by the QOZB after December 31, 2017, (2) the original use of the property in a qualified opportunity zone (QOZ) starts with the QOZB, or the QOZB substantially improves the property, and (3) substantially all of the use of the property was in a qualified opportunity zone during substantially all of the time the QOZB held the property.
Recall that QOZB property is the first category of asset that may be owned by a QOF. One reason that a QOF is better served by owning QOZ partnership interests and QOZ stock is that a QOF that directly owns QOZB property must own QOZB property comprising at least 90% of its total assets, whereas a QOZB would only be required to own QOZB property comprising 70% of its assets.
QOZB property will be treated as substantially improved by a QOZB only if during any 30-month period beginning after the date of the property’s acquisition its basis is increased by an amount exceeding its initial cost basis. In the case of real property, the Proposed Regulations and Rev. Rul. 2018-29 make an important clarification. Even though land can never be put to first use by a taxpayer, the guidance from Treasury clarifies that the price paid for land is excluded for purposes of determining whether substantial improvement occurs. For example, if a QOZB acquires real estate, which includes a parcel of land with a value of $60,000 and a building with a value of $40,000, to substantially improve this property would require that the QOZB incur $40,000 of improvement to the building.
Additionally, at least 50% of the QOZB’s gross income must be derived from the active conduct of such business in a qualified opportunity zone; a “substantial portion” of the intangible property of the QOZB must be used in the QOZB’s trade or business within a qualified opportunity zone; and the average of the aggregate unadjusted bases of the QOZB property attributable to “nonqualified financial property” must be less than 5%.
A QOZB may not be used to provide, including the provisioning of land, for any private or commercial golf course, country club, massage parlor, hot tub facility, suntan facility, racetrack or other facility used for gambling, or any store the principal business of which is the sale of alcoholic beverages for consumption off the premises.
The advantages of a QOF investing in a QOZB include avoiding the need to invest in tangible property (versus the minimum 90% requirement for QOZB property investments). Thus, a QOZB can be comprised entirely of intellectual property. For example, a tech startup company located in a qualified opportunity zone could issue QOZ stock even if the vast majority of its assets are comprised of intellectual property. Moreover, to the extent the QOZB owns tangible property, only 70% of such property need be QOZB property. This flexibility on asset composition has led virtually all QOFs to invest through QOZBs.