Qualified Opportunity Zones - A Potentially Powerful New Tax Incentive

by Kelley Drye & Warren LLP
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The recently enacted Tax Cuts and Jobs Act (the “Act”)[1] created a new program to spur economic development by providing investors with significant tax benefits for investments in designated low-income census tracts known as “qualified opportunity zones.”  Qualifying investments can include residential or commercial real estate or operating businesses that are located in qualified opportunity zones.  Over 8,700 low-income communities have been designated as qualified opportunity zones across all 50 states, five territories (American Samoa, Puerto Rico, Guam, the Virgin Islands, and the Northern Marianas Islands), and the District of Columbia.  Although this new tax regime raises several unanswered questions, the clock is ticking for investors to take advantage of these significant tax incentives.

Overview

Under the qualified opportunity zone program, investors can defer taxable gain on the disposition of any property by investing the gain in a “qualified opportunity fund” within 180 days of the sale of the property.  Deferred taxable gain can also be reduced by up to 15 percent if an investor holds an interest in a qualified opportunity fund for seven years or more.  Deferred taxable gain is recognized upon the earlier of December 31, 2026, or on the date on which an investment in a qualified opportunity fund is sold or exchanged.  An additional incentive allows an investor to avoid tax on the appreciation in a qualified opportunity fund if an investment is held for at least ten years prior to a sale of an interest in a qualified opportunity fund.

“Qualified opportunity zones” are low-income census tracts that were nominated by states and territories of the United States and certified and designated as qualified opportunity zones by the Secretary of Treasury.  The official list of designated qualified opportunity zones is available on the U.S. Department of the Treasury Community Development Financial Institution Fund’s website (https://www.cdfifund.gov/pages/opportunity-zones.aspx).

A corporation or partnership seeking to qualify as a qualified opportunity fund must be organized for the purpose of investing in “qualified opportunity zone property” (other than another qualified opportunity fund) and must hold at least 90 percent of its assets in qualified opportunity zone property.   “Qualified opportunity zone property” is either tangible property used in a trade or business of a qualified opportunity fund where the original use of such property commences with the qualified opportunity fund or which is “substantially improved” by the qualified opportunity fund or stock or partnership interests in U.S. corporations or partnerships whose only trade or business is a “qualified opportunity zone business.”

Investors must act quickly in accordance with the time constraints specified in the rules in order to receive all of the available tax benefits of the qualified opportunity zone program.  As a result, fund investors and fund managers are pressing the IRS and the Treasury Department to publish immediate and practical guidance on the unresolved aspects of investing in qualified opportunity zones.  It is expected that the IRS and the Treasury Department will release guidance soon.

Detailed Analysis

Investor Tax Benefits

The tax benefits of investing in a qualified opportunity fund are only available to an investor if the investor reinvests gains from sales or exchanges of property with any unrelated person in a qualified opportunity fund.  Investors can aggregate the gain realized from multiple sales of property apparently without limitation on the amount of gain eligible for deferral.  Importantly, however, gain deferral is only possible for sales occurring on or before December 31, 2026, and only to the extent of gain invested in a qualified opportunity fund within 180 days of the sale of such property.  If an investor makes an investment in a qualified opportunity fund within these time parameters, the investor can exclude from gross income the amount of gain so invested by making an election under Section 1400Z-2(a)(1). [2]

Up to 15 percent of the deferred gain can be permanently eliminated if the investment in the qualified opportunity fund is held for at least seven years.  After an investment in a qualified opportunity fund is held for five years, an investor’s tax basis in the qualified opportunity fund is increased by ten percent of the amount of gain initially reinvested in the qualified opportunity fund.  On the seventh anniversary date of an investment in a qualified opportunity fund, an investor’s tax basis in the qualified opportunity fund is increased by an additional five percent of the amount of gain initially reinvested in the qualified opportunity fund.

Gain that is invested in a qualified opportunity fund is ultimately recognized on December 31, 2026 under Section 1400Z-2(b) (unless recognized earlier by disposing of the interest in the qualified opportunity fund).  Accordingly, to achieve the full 15 percent gain reduction, an investor must invest gain in a qualified opportunity fund by December 31, 2019.  For the investor’s taxable year which includes December 31, 2026 (or for the investor’s taxable year which includes the date on which the investment in the qualified opportunity fund is sold, if earlier), the investor includes in gross income an amount equal to the excess of (A) the lesser of (1) the amount of gain reinvested in the qualified opportunity fund or (2) the fair market value of the investment on December 31, 2026 (or the date of the sale, if sooner) over (B) the investor’s tax basis in the investment.

If an investment in a qualified opportunity fund is held for at least ten years, an investor is entitled to elect under Section 1400Z-2(c) to increase its tax basis in the investment to an amount equal to the fair market value of such investment on the date that the investment is sold or exchanged.  Therefore, an electing investor can avoid any tax on the appreciation in the investment if the investment is sold ten or more years after the investor reinvests gain in the qualified opportunity fund.

Open Questions

It is unclear whether only capital gains are eligible for deferral or whether gain from a sale of property that would produce ordinary income (such as depreciation recapture) could also qualify for deferral.  Additionally, in the case of a partnership that sells property and realizes gain that is passed through to its partners, guidance is necessary to clarify whether the partnership or its partners make the gain deferral election.  There is also uncertainty for purposes of the ten-year fair market value election as to whether investors will be taxed on an investment in a fund that sells investments in qualified opportunity zone property and reinvests in other qualified opportunity zone property.  It appears that investors would indeed be taxable with respect to such interim gains, which may cause this new tax regime to be less attractive in the case of traditional investment funds that regularly buy and sell investments.

Formation and Operation of Qualified Opportunity Funds

Investors are eligible for the above-described tax incentives if their gains from sales of property to unrelated parties are invested in an entity that meets the definition of a “qualified opportunity fund” under Section 1400Z-2(d).  A “qualified opportunity fund” is any investment vehicle which is organized as a corporation or a partnership for the purpose of investing in “qualified opportunity zone property” (other than another qualified opportunity fund) and that holds at least 90 percent of its assets in qualified opportunity zone property (the “90-percent test”).  “Qualified opportunity zone property” is either “qualified opportunity zone stock,” a “qualified opportunity zone partnership interest,” or “qualified opportunity zone business property.”

“Qualified opportunity zone stock” is any stock in a domestic corporation if (i) such stock was acquired by the qualified opportunity fund after December 31, 2017, at its original issue (directly or through an underwriter) from the corporation solely in exchange for cash, (ii) as of the time such stock was issued, such corporation was a “qualified opportunity zone business” (or, in the case of a new corporation, such corporation was being organized for purposes of being a “qualified opportunity zone business”), and (iii) during “substantially all” of the qualified opportunity fund’s holding period for such stock, such corporation qualified as a “qualified opportunity zone business.”

A “qualified opportunity zone partnership interest” is any capital or profits interest in a domestic partnership if (i) such interest was acquired by the qualified opportunity fund after December 31, 2017, from the partnership solely in exchange for cash, (ii) as of the time such interest was acquired, such partnership was a “qualified opportunity zone business” (or, in the case of a new partnership, such partnership was being organized for purposes of being a “qualified opportunity zone business”), and (iii) during “substantially all” of the qualified opportunity fund’s holding period for such interest, such partnership qualified as a “qualified opportunity zone business.”

The term “qualified opportunity zone business property” means tangible property used in a trade or business of the qualified opportunity fund if (i) such property was acquired by the qualified opportunity fund from an unrelated person after December 31, 2017, (ii) the “original use” of such property in the qualified opportunity zone commences with the qualified opportunity fund or the qualified opportunity fund “substantially improves” the property, and (iii) during “substantially all” of the qualified opportunity fund’s holding period for such property, “substantially all” of the use of such property was in a qualified opportunity fund.  Property shall be treated as “substantially improved” by the qualified opportunity fund only if, during any 30-month period beginning after the property was acquired, additions to basis with respect to such property in the hands of the qualified opportunity fund exceed an amount equal to the adjusted basis of such property at the beginning of such 30-month period in the hands of the qualified opportunity fund.  Tangible property that ceases to be qualified opportunity zone business property shall continue to be treated as such for the lesser of (i) five years after the date on which such tangible property ceases to be so qualified, or (ii) the date on which such tangible property is no longer held by the qualified opportunity zone business.

A “qualified opportunity zone business” is a trade or business in which (i) “substantially all” of the tangible property owned or leased by the taxpayer is qualified opportunity zone business property (determined by substituting “qualified opportunity zone business” for “qualified opportunity fund” in each place it appears), (ii) at least 50 percent of its total gross income is derived from the active conduct of such business, (iii) a substantial portion of its intangible property is used in the active conduct of such business, and (iv) at least five percent of the average of the aggregate unadjusted bases of the property of such business is attributable to “nonqualified financial property” (i.e., debt, stock, partnership interests, options, futures contracts, forward contracts, warrants, notional principal contracts, annuities, and other similar property, with exception for reasonable amounts of working capital held in cash, cash equivalents, or debt instruments with a term of 18 months or less or accounts or notes receivable acquired in the ordinary course of a trade or business).   In addition, the business cannot be 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 premises.

An entity seeking to qualify as a qualified opportunity fund is not required to obtain approval by the IRS.  The IRS has issued guidance on its website indicating that an entity self-certifies as a qualified opportunity fund by completing a form and attaching that form to the entity’s timely filed federal income tax return (taking extensions into account) for the taxable year.  The self-certification form is expected to be released shortly.

A qualified opportunity fund satisfies the 90-percent test if the entity holds 90 percent or more of its assets in qualified opportunity zone property determined by averaging the percentage of qualified opportunity zone property held in the fund as measured (A) on the last day of the six-month period of the taxable year of the fund, and (B) on the last day of the taxable year of the fund.  A qualified opportunity fund is subject to a penalty under Section 1400Z-2(f) for each month that it fails the 90-percent test (unless the failure is due to reasonable cause) in an amount equal to the product of (A) the excess of (1) the amount equal to 90 percent of its aggregate assets, over (2) the aggregate amount of qualified opportunity zone property held by the fund, multiplied by (B) the underpayment rate under Section 6621(a)(2) that is applicable for such month.

Open Questions

A qualified opportunity fund must be “organized as” a corporation or partnership, which may prevent other entities such as a limited liability company from qualifying under this new tax regime even if such an entity is classified as a partnership for federal income tax purposes.  Prior to the issuance of clarifying guidance, it would appear that limited liability companies may be ineligible to be qualified opportunity funds.

In addition, the term “substantially all” is undefined, but it is used multiple times throughout Section 1400Z-2.  For example, a partnership or corporation owned by a qualified opportunity fund must be a qualified opportunity zone business during “substantially all” of the qualified opportunity fund’s holding period of the equity interests in such entity in order for the equity interests to be qualifying property.  Moreover, to be a qualified opportunity zone business, “substantially all” of the leased or owned tangible property must be qualified opportunity zone business property.  Guidance will need to address what constitutes “substantially all” for purposes of the qualified opportunity zone regime.

Also, it is not clear under what circumstances tangible property can satisfy the “original use” requirement in order to be considered qualified opportunity zone business property if a third party has previously used the property prior to its acquisition by the fund.  Future guidance will also have to address how land could be qualified opportunity zone business property since land will undoubtedly have been previously used by a third party prior to its acquisition by the fund and it is not clear how land could be substantially improved under the definition.

Section 1400Z-2 also does not specify, for purposes of the 90-percent test, whether the percentage of a qualified opportunity fund’s assets that is qualified opportunity zone property is determined based on fair market value or adjusted or unadjusted tax basis at the relevant measurement date.

Observations

Qualified opportunity funds have already been established by fund sponsors to function as intermediaries between investors and investments in qualified opportunity zones.  Nevertheless, it would appear that a single investor can form a qualified opportunity fund and obtain tax benefits.  Indeed, due to the nature of the rules and the corresponding tax benefits, a qualified opportunity fund may be structured to hold a single property to maximize exit opportunities without tainting other qualifying investments.

The new qualified opportunity zone tax regime can potentially produce enormous tax benefits.  While Section 1031 like-kind exchanges also qualify for tax deferral, Section 1031 never provided a tax deferral opportunity with respect to gains realized in connection with the sale of stock, securities or partnership interests, and following enactment of the Act, Section 1031 tax deferral is now potentially applicable only with respect to real property.

The real estate community in particular is awaiting IRS and Treasury Department guidance on how real property can satisfy either the original use requirement or the substantial improvement requirement.  There is some concern that the substantial improvement test, which requires that property be substantially improved within 30 months of its acquisition, may present some obstacles to rehabilitation projects.  Unless the substantial improvement test is broadly interpreted by the IRS and the Treasury Department, the qualified opportunity zone program rules may tend to favor new development, which should not be subject to the 30-month requirement.

Prior to the issuance of additional clarifying guidance, there is some regulatory risk for current investments in qualified opportunity zones. 


[1]       The Act is formally known as “An Act to provide for reconciliation pursuant to titles II and V of the concurrent resolution on the budget for the fiscal year 2018,” P.L. 115-97.
[2]       All “Section” references are to the Internal Revenue Code of 1986, as amended.

 

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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