Treasury recently released proposed regulations providing guidance to those looking to qualify for the new Qualified Opportunity Zone (“QOZ”) tax incentives created by the Tax Cuts and Jobs Act of 2017 (“TCJA”). Congress created this new tax incentive to encourage investments in certain low-income communities that have been designated as “Qualified Opportunity Zones.” In sum, the QOZ rules allow a taxpayer to defer tax on the gain from the sale of property if, within 180 days, the taxpayer invests in a Qualified Opportunity Fund (“QOF”).
The proposed regulations clarify the type of gain eligible for deferral, the manner in which taxpayers can make an eligible investment in a QOF, and various other matters related to taxpayers’ ability to defer gain under the QOZ rules.
Eligible Gain.
Generally, taxable gain is realized by a taxpayer upon the sale of real or personal property. However, the proposed regulations clarify that only “capital gains” are eligible for deferral under the QOZ rules whereas, “ordinary” gain is ineligible. The determination of whether gain is “capital” or “ordinary” depends on the taxpayer’s purpose for holding the subject property. Generally, gain from the sale of property held for investment is “capital gain,” whereas, gain from the sale of property held by a taxpayer regularly engaged in the purchase and resale of such property is “ordinary.” The proposed regulations also provide that gain is only eligible for deferral under the QOZ rules if: (a) the gain was not derived from selling property to a related party, and (b) the gain would have been recognized by the taxpayer but for the QOZ rules.
Eligible Investment in a Qualified Opportunity Fund.
If a taxpayer has “eligible gain” under the foregoing, such gain can be deferred under the QOZ rules if an amount equal to that gain is invested in a “Qualified Opportunity Fund” within 180 days. A Qualified Opportunity Fund is simply an investment vehicle that is (a) established as a corporation or partnership, and (b) organized for the purpose of investing at least 90% of its assets in certain eligible property (“QOZ
Property”) within a QOZ. QOZ Property includes tangible property purchased by the QOF and used in the QOF’s trade or business within a Qualified Zone so long as: (a) the original use of such tangible property commences with the QOF; or (b) the QOF “substantially improves” such tangible property within thirty (30) months.
For example, if the QOF purchases land and building within a qualified zone, the building’s original use did not commence with the QOF but rather, the use commenced with the prior owner(s), and the QOF must therefore “substantially improve” the building.
The proposed regulations explain that improvements are “substantial” if the cost of such improvements are equal to, or in excess of, the amount originally invested in the property. The cost of the land is disregarded for this purpose. So, if a QOF purchases land and building within a Qualified Zone for a purchase price of $1,000,000, and twenty percent ($200,000) of the purchase price is allocated to land and eighty percent ($800,000) is allocated to the building, the QOF would need to make at least $800,000 in improvements to the building within 30 months to be qualified property. For purposes of determining whether the QOF holds 90 percent qualified property, the proposed regulations provide that the QOF can hold reasonable amounts of working capital for a period of up to 31 months so long as the QOF has a written plan to spend the capital for the acquisition, construction, or substantial improvement of property within the qualified zone.
In addition to owning aforementioned qualified property directly, the QOF can acquire such property through a subsidiary entity or entities, and the proposed regulations clarify how those multi-tier QOF structures can qualify for gain deferral under the QOZ rules.
Other Guidance.
The proposed regulations also include a number of other guiding provisions, including:
- Procedures for taxpayers to self-certify entities as QOFs;
- Guidelines for designating when a QOF begins;
- Clarification on how the partners of certain pass-through entities can elect to defer gain under the QOZ rules; and
- Rules for electing QOF status for pre-existing entities.
In addition to the proposed regulations, Treasury and the IRS released draft Form on IRS Form 8996 for QOF self-certification, and Revenue Ruling 2018-29 which further explains the “original use” and “substantial improvement” requirements for purposes of qualifying as a QOF.
Conclusion.
The proposed regulations provide much needed clarity with respect to the new QOZ tax incentives, and additional guidance is expected in the near future. This guidance is especially relevant to taxpayers in Ohio and Northern Kentucky, as there are currently thirty-seven (37) Qualified Opportunity Zones throughout Hamilton County Ohio, and Boone, Campbell, and Kenton County Kentucky. A complete list of the Qualified Opportunity Zones can be found at https://www.cdfifund.gov/Pages/Opportunity-Zones.aspx.