Proposed Regulations for Qualified Opportunity Funds
The IRS has now issued two sets of proposed regulations for Qualified Opportunity Funds (“QOF”). As part of the Tax Cuts and Jobs Act, Congress established QOF as a new investment vehicle to spur economic development in certain distressed communities across America designated as Qualified Opportunity Zones (“QOZ”). Provided the requirements are met, reinvesting proceeds from certain capital gains into QOFs and QOZ businesses offers taxpayers the following tax incentives:
- At a minimum, taxation of the capital gains is temporarily deferred until the earlier of when the investment in the QOF is later sold or December 31, 2026.
- Additionally, depending on how long the QOF investment is held, a portion of the deferred capital gain and all appreciation in the QOF investment could be permanently excluded from taxation.
This article provides a broad overview of some of the more widely applicable clarifications from the second round of proposed regulations that were released in April (the “New Regulations”). Final guidance is forthcoming. For a more overall summary of investing in QOFs and the related tax incentives, please see our previous article: https://www.brownwinick.com/news-blogs/legal-news/defer-income-tax-on-capital-gains-by-investing-in-opportunity-zones.aspx.
Defining and Clarifying Key Terms
The New Regulations clarify some of the key phrases, such as “substantially all” and “original use.” The term “substantially all” is used in several contexts throughout Internal Revenue Code Section 1400Z-2. For example, one of the requirements for tangible property used in the trade or business of a QOF to qualify as QOZ business property (“QOZBP”) is that “during substantially all of the QOF’s holding period for such property, substantially all of the use of such property was in a QOZ.” The threshold percentage for “substantially all” is 90% for the percentage of the QOF’s holding period, while it is reduced to only 70% for testing the percentage of use of the property in a QOZ.
QOZBP requires that either “original use” begins with the taxpayer or when it is substantially improved by the taxpayer. The New Regulations clarify that “original use” of purchased property is generally based on when any person first places the property in service in a QOZ for purposes of depreciation or amortization, or first uses it in a manner that would allow depreciation or amortization if that person were the property’s owner. Further clarification is also provided to determine whether any of the following meet the definition of QOZBP: unused or vacant property, used property that has not been previously so used or placed in service in a QOZ, and improvements to leased property.
The New Regulations clarify what gains are eligible for deferral and exclusion. The only eligible gains from Section 1231 property are capital gain net income. This means that the taxpayer must first net all of its Section 1231 capital gains against all of its Section 1231 capital losses from all of its Section 1231 property. Furthermore, the New Regulations specify that the 180-day period to reinvest eligible capital gain net income from Section 1231 property into a QOF begins on the last day of the taxpayer’s taxable year. Remember that timing is essential to be able to take full advantage of capital gain deferral and exclusion.
Additionally, if a QOF sells QOZ property during the 10-year holding period, the QOF can reinvest the proceeds into other QOZ property within 12 months from the disposition so that the disposition does not cause the QOF to fail the 90-percent asset test.
Active Conduct for Start-Up Businesses
One of the requirements for QOZBs is that at least 50% of a QOZB’s total gross income be derived from the active conduct of a trade or business in the QOZ. To ensure that start-up QOZBs meet this requirement, additional safe harbors were added utilizing factors such as the total number of hours of service performed in the QOZ, amounts paid for services performed in the QOZ, and tangible property located in the QOZ.
Upon holding an investment in a QOF for 10 years, a taxpayer may elect to step-up the basis. The New Regulations clarify that when a QOF partnership interest is stepped up, the bases of the assets are also adjusted. If a taxpayer holds an interest in a QOF partnership or stock in a QOF S corporation, and the QOF disposes of QOZ property after the taxpayer’s 10-year holding period, the taxpayer may also elect to exclude some or all of the capital gain from the QOF’s disposition of QOZ property reported on the taxpayer’s Schedule K-1.
The New Regulations for QOF’s provide significant clarifications for setting up and investing in QOF. If you have been waiting to take advantage of this investment vehicle — whether as an investor or developer — now is the time to contact your BrownWinick attorney or one of our tax attorneys listed below:
This article was written for general informational purposes and summarizes the tax laws. As such, it should not be relied upon for compliance with the Internal Revenue Code.