A significant new tax incentive was added by the Tax Cuts and Jobs Act of 2017, which allows taxpayers to defer paying tax on capital gains from the sale of any asset and completely eliminate from federal income tax a portion of these deferred capital gains and all of the appreciation in certain investments. However, to maximize these tax benefits, investors must act before the end of 2019. This new program (QOZ program) provides these tax incentives for taxpayers investing in certain specified communities designated as qualified opportunity zones (QOZ). (1)
Following enactment of the QOZ program, the Department of Treasury released initial proposed regulations (initial regulations) on October 29, 2018, (2) and subsequently released additional proposed regulations (new regulations) on April 17, 2019. (3) While a number of questions regarding the QOZ program remain outstanding, the release of the initial regulations and new regulations have given investors and fund sponsors confidence to move forward with QOZ investments, especially investments in real estate. This article does not discuss all of the intricacies of the QOZ program, but instead, focuses on real estate investments under the QOZ program and provides a summary of the current state of the QOZ program following the release of the new regulations.
This article uses the following fact pattern to provide examples of the various QOZ program rules: investor previously purchased publicly traded stock (stock) for $1 million. On March 11, 2019, investor sells the stock for $10 million, triggering $9 million of capital gain. On September 5, 2019, the investor contributes $9 million to a qualified opportunity fund (QOF), which is taxable as a partnership for federal income tax purposes, and investor receives an 80% equity interest in the QOF.
Benefits to Investors
The QOZ program provides four principle tax benefits to investors (QOF investor). First, the QOF investor may defer capital gain from the sale of any asset sold to an unrelated party by timely investing in a QOF. (4) Importantly, and unlike a [section] 1031 (5) real estate exchange, a QOF investor is only required to reinvest the amount of the capital gain in the QOF. The QOF investor may use the remaining amount received from the sale of the asset--typically an amount equal to the taxpayer's basis in the asset--for any other purpose and still obtain deferral of all the capital gain.
The second and third benefit eliminate up to 15% of the QOF investor's deferred gain if the QOF investor holds its equity interest in the QOF (QOF interest) for the requisite time periods, which are accomplished through a basis step-up mechanism in the QOF interest. For example, the QOF investor eliminates 10% of the deferred capital gain if the QOF interest is held for at least five years and eliminates an additional 5% of the deferred gain if the QOF interest is held for at least seven years. (6) Finally, the QOF investor eliminates all federal income tax on the appreciation of the QOF interest if the QOF interest is held for at least 10 years. (7)
Limitations and Drawbacks to Investing
Although the QOZ program provides significant tax benefits, the program also provides a number of limitations and potential drawbacks to investing in a QOF. First, a QOF interest must be an equity interest (e.g., not debt) of the QOF and must be received in exchange for cash or other property. (8) The new regulations confirm that a QOF interest received in exchange for services does not qualify for the QOZ program benefits, which denies the QOZ program benefits for promotes and carried interest. (9)
Second, the QOZ program benefits are only available to the extent the QOF investor has capital gains from the sale of an asset to an unrelated party. (10) In other words, the program benefits are not available to the extent a sale or exchange triggers ordinary income (e.g., depreciation recapture), and any gain from the sale of an asset to a related party is similarly not eligible for the QOZ program benefits. For these purposes, certain family relationships and common ownership of more than 20% are deemed related. (11)
Third, the QOF investor must make its QOF investment within 180 days from the date on which the gain would be recognized for federal income tax purposes. (12) Owners in certain flow-through entities for federal income tax purposes (e.g., partnerships and S corporations) (flow-through entity), however, have additional flexibility. Specifically, if a flow-through entity does not elect to defer its capital gains, owners of the flow-through entity may choose to begin the 180-day period on either the last day of the flow-through entity's taxable year or when the flow-through entity itself would begin the 180-day period (i.e., the date the gain would be recognized for federal income tax purposes). (13)
Finally, and most importantly, the amount of deferred capital gain (less the potential 15% gain elimination discussed above) is recognized on the earlier of 1) December 31, 2026; and 2) the date on which the QOF interest is sold or exchanged. (14) Consequently, if the QOF investor has not otherwise recognized the deferred gain, the QOF investor will recognize all of the deferred gain (less the potential 15% gain elimination discussed above) in the year ending December 31, 2026, even if the QOF investor continues holding the QOF interest after such date. In this case, the QOF investor will have "phantom income" and may need to obtain funds from other sources to pay the tax due. However, subject to certain limitations, the new regulations permit the QOF to make distributions to QOF investors from a subsequent refinancing, which could be timed to coincide with this phantom income. (15)
The new regulations also accelerate recognition of the deferred gain upon certain "inclusion events," including events that are in the QOF investor's control (e.g., a gift of the QOF interest) and events that are not in the QOF investor's control (e.g., certain distributions from the QOF). (16) The new regulations also confirm that a transfer of a QOF interest upon...