Funds With Benefits: Investing in Qualified Opportunity Zones: Are you up to date on the two sets of IRS-proposed rules on QOZs?

• Author: Ray, Jennifer

The Tax Cuts and Jobs Act (1) created qualified opportunity zones (QOZs) to spur economic development throughout the United States by providing tax benefits to investors who make qualifying investments in these zones. Thousands of population census tracts have been designated as QOZs. Under the QOZ program, taxpayers who timely roll over capital gains into equity investments in a qualified opportunity fund (QOF) can qualify for several tax benefits.

Because of the program's sweeping geographic scope, real estate developers, leasing companies, sports teams, retailers, tech companies, and many other operating businesses can find themselves within a QOZ and may be able to benefit from the QOZ program, either directly or because the program makes available additional sources of capital at favorable rates.

So far, the Internal Revenue Service has issued two sets of proposed regulations that would implement the QOZ program. This article briefly describes the tax benefits available under the QOZ program and a common investment structure and then addresses how, and how soon, an investor in a QOF can receive cash from its investment (either from a sale or exchange of the investment or from a distribution) without jeopardizing those tax benefits.

Overview of Benefits

The QOZ program offers both deferral and exclusion benefits to taxpayers making a qualifying investment in a QOF. A taxpayer makes a qualifying investment with respect to an amount of capital gain by investing that amount in a QOF during the 180-day period beginning on the date of the sale or exchange that gave rise to the capital gain. Assuming the applicable requirements are met, the taxpayer may receive three benefits:

1. The capital gain timely invested in a QOF may be deferred until December 31, 2026, at the latest.

2. Ten or fifteen percent of the invested gain may be permanently excluded, if the taxpayer holds the QOF investment for at least five or seven years, respectively, before December 31, 2026. This exclusion is effectuated through an increase in the taxpayer's basis in the QOF investment, as discussed below.

3. If the taxpayer holds the QOF investment for at least ten years, the taxpayer may increase its basis to fair market value at the time when the QOF is sold or exchanged, resulting in a permanent exclusion of any additional gains realized with respect to appreciation of the investment.

There is no limitation on the amount of gain that can be deferred or excluded.

Two-Tier Investment Structure

Based on the statute and the two sets of proposed regulations (2) that have been released so far, many QOZ investments have been made in a tiered partnership structure. The taxpayer may make an investment with respect to qualified capital gain in a QOF partnership, which in turn invests in a "qualified opportunity zone business" partnership (QOZB).

The statute requires that at least ninety percent of a QOF's assets be qualified opportunity zone property. An interest in a QOZB can qualify entirely as qualified opportunity zone property if, among other things, the QOZB operates a trade or business and at least seventy percent of the tangible property owned or leased by the QOZB in that business is qualified opportunity zone business property (QOZBP). QOZBP is tangible property used in a trade or business if the property was acquired by the QOZB by purchase after December 31, 2017; the original use of the property in the QOZ commences with the QOZB or if the QOZB substantially improves the property; and during substantially all of the QOZB's holding period for the property, substantially all of the use of the property was in a QOZ. (3) Thus, a QOZB generally has a seventy percent "good asset" threshold, whereas a QOF has a ninety percent "good asset" threshold.

This article will generally assume a two-tier structure in which a QOF partnership has invested in a QOZB partnership.

Sale or Exchange of QOF Interest After Ten Years

The full QOZ benefits are available to a taxpayer that holds a QOF interest for at least ten years from the date of investment. In that case, the taxpayer will have recognized eighty-five to 100 percent of its original deferred gain in 2026 but will have received basis in its QOF interest of 100 percent of the original deferred gain. Section 1400Z-2(c) (4) provides that upon sale or exchange of a QOF interest held for at least ten years, the taxpayer may elect to increase its basis further to the fair market value at the time of sale or exchange.

SALE OR EXCHANGE OF QOF INTEREST

The ten-year basis increase provided by Section 1400Z-2(c), together with a special deemed asset basis adjustment provided...