The IRS has released more frequently asked questions (FAQs) regarding the tax deferral and capital gain exclusion possibilities of investing in a Qualified Opportunity Fund (QOF).
Qualified Opportunity Zones (QOZs) are eligible for a number of favorable tax rules aimed at encouraging economic growth and investment in businesses within the zone. A Qualified Opportunity Fund (QOF) is, generally, an investment vehicle that (i) is organized as a corporation or a partnership for the purpose of investing in QOZ property (other than another QOF) and (ii) holds at least 90% of its assets in QOZ property. Under IRC § 1400Z-2, taxpayers can elect to temporarily defer inclusion in gross income for capital gains reinvested in a QOF and the permanent exclusion of capital gains from the sale or exchange of an investment in the QOF.
In October 2018 and April 2019, IRS issued proposed regs that provide guidance under IRC § 1400Z-2 relating to gains that may be deferred as a result of a taxpayer’s investment in a QOF, as well as special rules for an investment in a QOF held by a taxpayer for at least 10 years.
The IRS has added to its website FAQs regarding QOFs and QOZs, including discussions of the following:
- Investor adjusting basis to FMV:
- Suppose an investor made an investment in a QOF. After holding it for at least 10 years, the investor sells or exchanges it. Can the investor adjust the basis of the investment to fair market value (FMV) as of the date of the sale or exchange? Yes, but only if the investor made the investment in connection with a proper deferral election. Also, the election must have remained in effect until that post-10-year sale or exchange. The FAQ points out that the election didn’t cease to be in effect solely because, on December 31, 2026, the investor had to include in income the gain that had been originally deferred when they invested in the QOF.
- Suppose an investor had ordinary gain from the sale of property in 2018. The investor invested the amount of that gain in a QOF. In 2029, the investor sells their interest in the QOF. The investor cannot adjust their basis to FMV because the gain (that was invested in the QOF) wasn’t capital gain. Therefore, their investment in the QOF wasn’t made in connection with a proper deferral election.
- List of QOZs. The FAQs point out that the list of designated QOZs can be found in Notice 2018-48, 2018-28 IRB 9 and Notice 2019-42, 2019-29 IRB. Further, a visual map of the census tracts designated as QOZs may also be found at IRS’s Opportunity Zones Resources webpage.
- How to become a QOF. To become a QOF, an eligible corporation or partnership self-certifies by filing Form 8996, Qualified Opportunity Fund, with its federal income tax return. Note that a limited liability company that chooses to be treated either as a partnership or corporation for federal tax purposes can organize as a QOF.
- QOF business property:
- The FAQs provide that, regarding “original use,” tangible property is original use on the date first placed in service in the QOZ for purposes of depreciation or amortization. Used tangible property satisfies the original use requirement if the property has not been previously placed in service in the QOZ.
- Inventory in transit can be QOZ business property. Inventory of a QOF, including raw materials, does not fail to be used in a QOZ solely because the inventory is in transit from a vendor to the QOF or from the QOF to a customer.