Code Sec. 1400Z-1, which was added by the Tax Cuts and Jobs Act (TCJA, PL 115-97), addresses the designation of population census tracts located in the 50 states, U.S. territories, and the District of Columbia as QOZs.
Code Sec. 1400Z-2 provides two main federal income tax benefits to “eligible taxpayers” that make longer-term investments of new capital in one or more designated QOZs through qualified opportunity funds (QOFs) and QOZ businesses (QOZBs) (qualifying investment). The first main federal income tax benefit is the ability of an eligible taxpayer, upon the making of a valid election, to defer until as late as December 31, 2026, the inclusion in gross income of certain gains that would otherwise be recognized in a tax year if the taxpayer invests a corresponding amount of such gain in a qualifying investment in a QOF within a 180-day statutory period. (Code Sec. 1400Z-2(a))
An eligible taxpayer may potentially exclude 10% of such deferred gain from gross income if the eligible taxpayer holds the qualifying investment in the QOF for at least five years. (Code Sec. 1400Z-2(b)(2)(B)(iii)) An additional 5% of such gain may be excluded from gross income if the eligible taxpayer holds that qualifying investment for at least seven years. (Code Sec. 1400Z-2(b)(2)(B)(iv))
The second main federal income tax benefit provided by Code Sec. 1400Z-2 is the ability for the eligible taxpayer, upon the making of a separate valid election, to exclude from gross income any appreciation on the eligible taxpayer’s qualifying investment in the QOF if the eligible taxpayer holds the qualifying investment for at least 10 years. (Code Sec. 1400Z-2(c))
A QOF is any investment vehicle that is organized as a corporation or a partnership to invest in QOZ property (other than another QOF), that holds at least 90% of its assets in QOZ property. (Code Sec. 1400Z-2(d)(1))
Generally, QOZ property is QOZ stock, a QOZ partnership interest, or QOZB property (QOZBP). (Code Sec. 1400Z-2(d)(2)(A))
QOZBP is tangible property used in a trade or business of the QOF if
- The property is acquired by purchase (as defined in Code Sec. 179(d) (2)) by the QOF after 2017,
- From a person that is not a related person (within the meaning of Code Sec. 1400Z-2(e)(2)),
- The original use of the property in the QOZ starts with the QOF (or the QOF substantially improves the property), and,
- During substantially all of the QOF’s holding period in the property (i.e., at least 90%), substantially all of the use of the property (i.e., at least 70%) is in the QOZ.
Leased property can also qualify as QOZBP. (Code Sec. 1400Z-2(d)(2)(D))
A QOZB is, in general, a trade or business in which substantially all of the tangible property owned or leased by the taxpayer is QOZBP. (Code Sec. 1400Z-2(d)(3))
Less than 5% of the property of a QOZB can be attributable to nonqualified financial property (as defined in Code Sec. 1397C(e)(1)). Otherwise, the business is not a QOZB. (Code Sec. 1400Z-2(d)(3)(A)(ii)) But a working capital safe harbor is available for businesses which hold 5% or more of nonqualified financial property. If the business develops a new business or acquires, constructs or rehabilitates tangible business property (including real property and other tangible property) used in a business operating as a QOF, then, in general, assuming the business otherwise meets the QOZB requirements, the business will be a QOZB. (Reg. §1.1400Z2(d)-1(d)(3)(v))
In addition, for a business to be a QOZB, a substantial portion of the intangible property of such entity must be used in the active conduct of the trade or business in the QOZ. ((Code Sec. 1400Z-2(d)(3)(A)(ii)))
The Code provides that certain businesses cannot be QOZBs. Those businesses are private or commercial golf courses, country clubs, massage parlors, hot tub facilities, suntan facilities, racetrack or other facilities used for gambling, or any store the principal business of which is the sale of alcoholic beverages for consumption off premises. (Code Sec. 1400Z-2(d)(3)(A)(iii) These businesses are sometimes referred to as sin businesses.
Code Sec. 1400Z-2(b)(1) provides that all gain to which Code Sec. 1400Z-2(a)(1)(A) deferral applies must be included in income in the tax year that includes the earlier of the date on which a QOF investment is sold or exchanged (inclusion event) or December 31, 2026.
The IRS has issued final regs that provide rules governing the extent to which taxpayers may elect the federal income tax benefits provided by Code Sec. 1400Z-2 for QOF investments. The final regs adopt, with modifications, the proposed regs issued in October 2018 and May 2019. See Final regs provide rules for investing in qualified opportunity funds (12/23/2019).
New frequently asked questions
Regarding the final regs, the IRS has released the following FAQs:
What types of gains may be invested and when?
Sales of business property—The proposed regs only permitted the amount of an investor’s gains from the sale of business property that were greater than the investor’s losses from such sales to be invested in QOFs, and required the 180-day investment period to begin on the last day of the investor’s tax year. The final regs allow a taxpayer to invest the entire amount of gains from such sales without regard to losses and change the beginning of the investment period from the end of the year to the date of the sale of each asset.
Partnership gain—Partners in a partnership, shareholders of an S corporation, and beneficiaries of estates and non-grantor trusts have the option to start the 180-day investment period on the due date of the entity’s tax return, not including any extensions. This change addresses taxpayer concerns about potentially missing investment opportunities due to an owner of a business entity receiving a late Schedule K-1 (or other form) from the entity.
Investment of Regulated Investment Company (RIC) and Real Estate Investment Trust (REIT) gains—The final regs clarify that the 180-day investment period generally starts at the close of the shareholder’s tax year and provides that gains can, at the shareholder’s option, also be invested based on the 180-day investment period starting when the shareholder receives capital gains dividends from a RIC or REIT.
Installment sales—The final regs clarify that gains from installment sales are able to be invested when received, even if the initial installment payment was made before 2018.
Nonresident investment—The final regs provide that nonresident alien individuals and foreign corporations may make Opportunity Zone investments with capital gains that are effectively connected to a U.S. trade or business. This includes capital gains on real estate assets taxed to nonresident alien individuals and foreign corporations under the Foreign Investment in Real Property Tax Act rules.
When may gains be excluded from tax after an investment is held for a 10-year period?
Sales of property by a QOZB—In the proposed regs, an investor could only elect to exclude gains from the sale of qualifying investments or property sold by a QOF operating in partnership or S Corporation form, but not property sold by a subsidiary entity. The final regs provide that capital gains from the sale of property by a QOZB that is held by a subsidiary entity may also be excluded from income as long as the investor’s qualifying investment in the QOF has been held for 10 years. However, the amount of gain from such a QOF’s or its QOZBs’ asset sales that an investor in the QOF may elect to exclude each year will reduce the amount of the investor’s interest in the QOF that remains a qualifying investment.
Applicability to other gains—The final regs clarify that the exclusion is available to other gains, such as distributions by a corporation to shareholders or a partnership to a partner, that are treated as gains from the sale or exchange of property (other than inventory) for Federal income tax purposes.
How does a QOF determine levels of new investment in a QOZ?
Aggregation of property for purposes of the substantial improvement test—QOFs and QOZBs can take into account purchased original use assets that otherwise would qualify as qualified opportunity zone business property if the purchased assets:
- Are used in the same trade or business in the QOZ or a contiguous QOZ for which a non-original use asset is used, and
- Improve the functionality of the non-original use assets in the same QOZ or a contiguous QOZ.
Aggregation of property for purposes of the substantial improvement test (continued)—In certain cases, the final regs permit a group of two or more buildings located on the same parcel(s) of land to be treated as a single property. In these cases, any additions to the basis of the buildings in the group are aggregated to determine satisfaction of the substantial improvement requirement. Thus, a taxpayer need not increase the basis of each building by 100% as long as the total additions to basis for the group of buildings equals 100% of the initial basis for the group.
Vacancy period to allow a building to qualify as original use—The final regs reduce the five-year vacancy requirement in the proposed regs to a one-year vacancy requirement, if the property was vacant for at least one-year prior to the QOZ being designated and remains vacant through the date of purchase. For other vacant property, the proposed five-year vacancy requirement is reduced to three years. In addition, property involuntarily transferred to local government control is included in the definition of the term vacant, allowing it to be treated as original use property when purchased by a QOF or QOZB from the local government.
Leasing—The final regs provide several changes to leasing provisions in the proposed regs:
- State and local governments, as well as Indian tribal governments, will be exempt from the market-rate requirements for leased tangible property,
- Leases between unrelated parties are generally presumed to be at market rate terms, and
- Short-term leases of personal property to lessors using the property outside a QOZ may be counted as QOZBP.
Working capital safe harbor—The final regs provide several refinements to the working capital safe harbor:
- They create an additional 62-month safe harbor for start-up businesses to ensure that they can comply with the 70% tangible property standard, the 50% gross income requirement, and other requirements to qualify as a QOZB;
- They provide that a QOZB can receive an extra 24 months to use working capital if the QOZ is in a Federally-declared disaster area;
- They clarify that the safe harbor can only be used for a 62-month period and that amounts remaining at the conclusion of the period cannot be counted as tangible property for purposes of the 70% tangible property standard; and
- They allow a QOZB to treat equipment, buildings, and other tangible property that is being improved with the working capital as QOZBP that is “used in a trade or business” for purposes of the requirement that a QOZB must be engaged in a trade or business.
- In addition, the final regs provide that a QOZB not utilizing the working capital safe harbor may treat tangible property undergoing the substantial improvement process as being used in a trade or business.
Measurement of “use” for the 70% use test—The final regs provide that, if tangible property is used in one or more QOZs, satisfaction of the 70% use test is determined by aggregating the number of days the tangible property in each QOZ is utilized. Accordingly, the final regs set forth a clearer way for determining satisfaction of the 70% use test, including a safe harbor for certain tangible property used both inside and outside the geographic borders of a QOZ.
Determinations of location and “use” of intangible property—The final regs provide that intangible property qualifies as used in the QOZ if:
- The QOZB’s use of the intangible property is normal, usual, or customary in the conduct of the trade or business, and
- The QOZB’s use contributes to the generation of gross income for the trade or business.
Other clarifications regarding business property of QOFs or QOZBs:
- Real property straddling census tracts—The final regs include both a square footage test and an unadjusted cost test to determine if a project is primarily in a QOZ, and provide that parcels or tracts of land will be considered contiguous if they possess common boundaries, and would be contiguous but for the interposition of a road, street, railroad, stream or similar property. Importantly, the final regs also extend the straddle rules to QOFs and QOZBs with respect to the 70% use test.
- Brownfield sites—The final regs provide that both the land and structures in a Brownfield site redevelopment are considered to be original use property as long as the QOF or QOZB make investments into the Brownfield site to improve its safety and compliance with environmental standards.
- Self-constructed property—The final regs provide, in general, that self-constructed property can count for purposes of the QOF’s 90% asset test and the QOZB’s 70% percent asset test.
- De minimis exception for sin businesses—The final regs provide that a QOZB may have less than 5% of its property leased to a sin business. For example, a hotel business of a QOZB could potentially lease space to a spa that provides tanning services.
To continue your research on qualified opportunity zones, see FTC 2d/FIN ¶I-8820; United States Tax Reporter ¶14,00Z-14.
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