Mcle Self-study Article: Qualified Opportunity Zones: an Uneasy Path to Significant Tax Benefits

• Publication year: 2019
• Author: Alexander Y. Loshiloff and Kyle J. Recker

MCLE Self-Study Article: Qualified Opportunity Zones: An Uneasy Path to Significant Tax Benefits

Check the end of this article for information on how to access one MCLE self-study credit.

Alexander Y. Loshiloff and Kyle J. Recker

Alexander Loshiloff is special counsel at Coblentz Patch Duffy & Bass LLP in San Francisco, with over 20 years of general, transactional, and international tax experience. He was previously Senior Director for Tax Planning at one of the largest computer technology companies in the world and a tax partner at a large international law firm. Alex received his J.D. from the University of South Carolina School of Law.

Kyle Recker is a partner at Coblentz Patch Duffy & Bass LLP in San Francisco, where he advises institutional lenders, owners, developers, and investors in finance and real estate transactions. Kyle received his J.D., magna cum laude, from the University of Michigan Law School.

I. INTRODUCTION

Effective on December 22, 2017, as part of the Tax Cuts and Jobs Act, Congress enacted Sections 1400Z-1 and 1400Z-2 of the Internal Revenue Code.¹ Section 1400Z-1 allows the chief executive officer of each state and United States possession to nominate a limited number of primarily low-income population census tracts for designation as "qualified opportunity zones" ("QOZ"), and it authorizes the Secretary of the Treasury to certify such nominations and officially designate QOZs across the United States and its possessions. Section 1400Z-2 offers, under certain conditions, significant tax benefits to taxpayers who invest in QOZs.

According to the Internal Revenue Service (the "IRS"), QOZs "are an economic development tool—that is, they are designed to spur economic development and job creation in distressed communities."² On July 9, 2018, the IRS published an official list of over 8,700 QOZs in all 50 states, the District of Columbia, and five U.S. territories (879 of such QOZs are in California).³ A map of all designated QOZs, along with the instructions on how to find a QOZ by address and census tract number, can be found on the website of the Community Development Financial Institutions Fund of the U.S. Treasury Department.⁴ That fund, however, will not be able to provide confirmation that a specific property is in a QOZ, so an interested party will need to consult the official list.

The primary tax benefit of Section 1400Z-2 is the manner in which it affects the taxation of capital gains. In general, for U.S. individual taxpayers, long-term capital gains from the disposition of capital assets held for more than one year are currently taxed at preferential rates of 0%, 15%, or 20%, depending on a taxpayer's income tax bracket; short-term capital gains from the disposition of investments held for one year or less are taxed as ordinary income (there are presently seven marginal income tax brackets, with the highest rate at 37%).⁵ Capital gains may also be taxed by the state where the taxpayer lives. For corporations, under Code Section 11(b), the federal income tax rate currently is a flat 21% on both capital gains and ordinary income. Section 1400Z-2 modifies the above regime in three important ways.

First, a taxpayer can elect to defer tax on capital gain by investing the gain in a "qualified opportunity fund" ("QOF")⁶ within 180 days of the sale or exchange. The deferred gain will become subject to taxation on the earlier of (i) the date on which the investment in a QOF is sold or exchanged in a taxable transaction, and (ii) December 31, 2026.

[Page 6]

Second, if, prior to December 31, 2026, the QOF investment has been held for at least five years, there is a 10% exclusion of the deferred gain (in the form of a step-up in tax basis), and if held for at least seven years, there is an additional 5% exclusion (also in the form of a step-up in tax basis) for a maximum of 15% permanent tax exclusion of the initially deferred gain.

Third, if a taxpayer holds its appreciated investment in the QOF for at least 10 years (and makes an election at the time of sale to increase the tax basis in the investment to its fair market value), any gain on any post-acquisition appreciation in the value of the QOF investment is permanently excluded from tax.⁷

Example: On February 26, 2019, an individual U.S. taxpayer sells shares of stock to an unrelated party, giving rise to a capital gain of $10 million. The taxpayer elects to defer that gain and within the required 180-day period invests $10 million in a QOF. The taxpayer's initial tax basis in the QOF investment is zero. After five years, the basis is increased to $1 million, or 10% of the initially deferred gain of $10 million. After seven years, the basis is increased to $1.5 million, or 15% of the initially deferred gain of $10 million. On December 31, 2026 (assuming that the fair market value of the QOF investment is then at least $10 million), the Section 1400Z-2 deferral period will end, and the taxpayer will be required to recognize $8.5 million of capital gain at that time ($10 million of the initially deferred gain minus $1.5 million of the tax basis) (and at that time, the taxpayer will need to come up with cash to pay the tax on that gain). At that point, the tax basis in the QOF investment becomes $10 million ($1.5 million of the tax basis as increased at seven years, plus $8.5 million of the gain triggered at December 31, 2026). The taxpayer sells the QOF investment for $19 million on January 1, 2030. Because the taxpayer held the QOF investment for at least 10 years prior to the 2030 sale, the taxpayer can make the election to increase the tax basis in the QOF investment to its fair market value at the time of the sale. Provided that this election is made, the $9 million post-acquisition gain is permanently excluded from tax ($19 million sale price - $19 million tax basis = $0 taxable gain). There is no dollar limit on how much post-acquisition gain can be excluded.

Note that some states that impose personal and corporate income tax have not implemented rules similar to the federal QOZ/OQF tax regime (including, as of August 26, 2019, California), and in those states, a taxpayer would not be entitled to defer taxation of capital gains at the state level. The state income tax implications should be carefully considered before making the decision to invest in a QOF.

Although Section 1400Z-2 seems to be fairly simple on the surface, its provisions are far from clear in terms of how they should be read in relation to one another and how they fit into the overall context of federal income tax rules. Fortunately, the IRS has issued two sets of helpful proposed regulations on which taxpayers, with a limited exception noted below, are permitted to rely (hereinafter, the "Proposed Regulations," or "Prop. Treas. Reg. §").⁸ This article is not an exhaustive technical analysis of the applicable rules; rather, its main purpose is to serve as a general guide to assist investors and their lawyers in navigating the statute and the Proposed Regulations in a comprehensible and systematic manner. Section II of this article describes certain important rules applicable to investors and their investments in QOFs, and Section III of this article describes the requirements applicable to QOFs.

II. INVESTORS AND THEIR INVESTMENTS IN QOFS

A. Initial Investments

The types of taxpayers that are eligible for the tax benefits of Section 1400Z-2 include individuals, C corporations (including real estate investment trusts ("REITs")), partnerships, S corporations, trusts, estates, certain other pass-through entities, and limited liability companies taxed as corporations or partnerships.⁹

1. Qualifying Gains

For Section 1400Z-2 to apply, a taxpayer must have a capital gain from the sale to, or exchange with, an "unrelated person" no later than December 31, 2026.¹⁰ A taxpayer is allowed to invest less than all of the prior capital gain in a QOF and, in that case, only the part of the gain which was invested in the QOF would qualify for the tax benefits. Although a taxpayer is able to invest more than the prior capital gain, those additional funds will not qualify for the QOF tax benefits.¹¹ A taxpayer can invest its eligible gain in several QOFs.¹²

Under Section 1400Z-2, virtually any capital gain (long-term, short-term, collectibles, etc.) could qualify for QOF tax benefits as long as it is treated as capital gain for federal income tax purposes and would be recognized but for the deferral provisions.¹³ However, if a capital gain is derived from a transaction that is or has been part of an "offsetting-position transaction," a situation where the risk of loss from holding one position with respect to personal property is substantially diminished by holding one or more other positions with respect to personal property, such as a straddle, the capital gain will not be eligible for the QOF tax benefits.¹⁴ In addition, Section 1231 gains (gains on the disposition of certain business-use property) are eligible only to the extent of capital gain net income, which is defined as the excess of capital gains over capital losses with respect to all of the taxpayer's Section 1231 property, as calculated at the end of a taxable year.

[Page 7]

2. Eligible Interests

An eligible interest in a QOF is an equity interest issued by the QOF and may include preferred stock or partnership interests with special allocations. Debt instruments issued by a QOF to a taxpayer will not qualify; however, a taxpayer may use its QOF investment as collateral for a loan as part of a purchase-money borrowing or otherwise.¹⁵ The ability to borrow by using a QOF investment as collateral may be useful as it might allow taxpayers to obtain the cash needed to pay the tax on any gain that, as described above, will be automatically triggered on December 31, 2026.

An interest in a QOF that is taxed as a partnership (a "QOF partnership") which is received in exchange for services will not be eligible for the QOF tax benefits. If the...