Proposed regulations help ‘green light’ QOZS
Initially, the Qualified Opportunity Zone provisions of the Tax Cuts and Jobs Act did not attract a great deal of attention. With past tax laws offering economic development zones and new markets tax credits, this just seemed like more of the same.
However, as tax practitioners started looking into the details, they started getting very interested. The QOZ rules offered not just deferral of gain, similar to like-kind exchanges, but also potential forgiveness of tax on gain. Then in the spring, the states started designating their QOZS. There were thousands of them, covering a significant percentage of the country, and including some areas where significant interest in development already existed. While like-kind exchanges were now limited to real property not held primarily for resale, the new QOZS were available to both real and personal tangible property. It was not long before QOZS became a hot topic.
Still, there was some reason for concern. The QOZS had some deadlines that made it look difficult to achieve some of the tax forgiveness. They did not permit direct investment but only through Qualified Opportunity Funds, which raised additional questions. As with many new tax provisions, there were a lot of definitional questions as well. Many taxpayers and their advisors were holding off until the Internal Revenue Service offered greater clarity, in spite of the fact that some of the deadlines seemed to push for quick action. The IRS issued proposed regulations on Oct. 19, 2018. The regulations on the whole appear very taxpayer-favorable. They answer a number of questions, while leaving others for later guidance. Still, the proposed regulations, which may be relied upon until final regulations are issued, appear likely to start moving significant sums of money into QOFS and then into QOZS.
States may designate Qualified Opportunity Zones that are a population census tract that is a low-income community. A state may designate up to 25 percent of such tracts as QOZS, and smaller states may designate not less than 25 tracts. Thousands of QOZS have been designated by the states. The law permits certain contiguous tracts that are not a low-income community to be designated as part of the QOZ. In urban areas, many areas that are already being gentrified are adjacent to low-income areas and have been included as part of a QOZ. The QOZ designations have helped to attract further interest in utilizing QOZS. Under current law, QOZS must be designated by 2028.
Qualified Opportunity Funds
The gain from a sale of property must be transferred to a Qualified Opportunity Fund within 180 days of the sale for deferral of the gain. The other proceeds from the sale need not be transferred to the QOF but may be. A QOF must be a partnership or a corporation. The proposed regulations clarify that an LLC taxed as a partnership also qualifies.
A QOF is required to have 90 percent of its assets held in QOZ property. The 90 percent threshold is basically tested twice a year. A QOZ business must have substantially all of its assets in the QOZ. The proposed regulations define “substantially all” as at least 70 percent. Therefore, combining the 90 percent and the 70 percent, it would be possible to have a valid QOF with only 63 percent of its assets in a QOZ.
The tax savings
Under current law, the deferral of tax on gain transferred to a QOF lasts until the earlier of the sale of the property or Dec. 31, 2026. The 2026 date may have been selected for budgetary reasons and it is possible that date could get extended by subsequent congressional action.
If the property is held in the QOF for at least five years, up to 10 percent of the tax on the deferred gain may be forgiven. If the property is held for at least seven years, an additional 5 percent of the tax on the deferred gain may be forgiven. However, with a 2026 end date, the gain would have to be placed in the QOZ by 2019 to be able to meet the seven-year deadline by 2026. Also, if the property is not sold by 2026, the taxpayer will have to come up with a source to pay the tax due on the deferred gain with the 2026 tax return. This obligation should be kept in mind when deciding how to invest the proceeds on the sale of the property other than the deferred gain.
If there is additional gain in the value of the property while it is held in the QOZ and the property is held in the QOZ for at least 10 years, a taxpayer may elect to treat the basis on the date of sale of its interest in the QOF as the fair market value of the QOF on the date of its sale, resulting in nonrecognition of gain on the appreciation in the QOF. The proposed regulations provide that, in spite of the 2028 deadline for designating QOZS, taxpayers have until Dec. 31, 2047, to meet the 10-year test.
The potential tax savings therefore include deferral of tax on the gain to as late as 2026, forgiveness of up to 15 percent of the tax on the gain, and potential forgiveness of tax on any additional appreciation in the value of the property while it is held in the QOF.
The tax forms
The IRS has issued a draft QOF self-certification form — Form 8996. The IRS is also expected to have the deferral election made on Form 8949.
Other clarifications in the proposed regs
The proposed regulations clarify that either the partnership can elect to defer gain on the sale of partnership property, or, if the partnership fails to act, each partner may elect to defer gain on the portion of the gain allocated to that partner.
The regulations clarify that a QOF can be set up to hold multiple properties or a separate QOF for each property. The regulations also clarify that, if a QOF sells property in a QOZ before Dec. 31, 2026, it can further defer gain by reinvesting the proceeds in a QOZ.
With respect to the treatment of land, unimproved land will not qualify. However, with respect to improved land, it is not necessary to segregate the gain associated with the land from the overall gain on the sale of the property. The proposed regulations seek additional comments on a variety of additional issues that will be addressed in subsequent regulations, expected before the end of 2018.
Qualified Opportunity Zones offer the potential not only for tax deferral, like the like-kind exchange rules, but also the potential for at least partial forgiveness of tax on the deferred gain and total forgiveness of tax on the gain while held in the QOZ. The tax benefits combined with the broad scope of available QOZS in the U.S. are likely to make QOZS a very attractive investment alternative.
Mark A. Luscombe, JD, LL.M, CPA, is principal analyst for Wolters Kluwer Tax & Accounting.