1. Who Can Invest?
U.S. or foreign investors and pass-through entities recognizing U.S. capital gains.
2. What Type of Capital Gain Qualifies?
Long term and short term capital gains qualify.
Ordinary income and depreciation recapture cannot be used/apply (depreciation recapture is ordinary income). Gains from the sale of property used in a trade or business under Internal Revenue Code (“Code”) Section 1231 (i.e., real estate gains) will qualify. Such Section 1231 gains do not have to netted against Section 1231 losses as was the case in the Proposed Regulations, so the gross amount of such gains from any transaction can qualify for the benefit.
The capital gain can’t be generated by a sale of property to a related party (a Related party is determined under Code Section 267(b) and 707(b)(1) by substituting 20% for 50% each place it appears in Code Sections 267(b) or 707(b)(1)).
3. What are the Mechanics?
The taxpayer must invest proceeds from a sale resulting in capital gain in an entity that is a Qualified
Opportunity Fund (“QOF”) formed as a corporation or partnership (LLCs which own property in an Opportunity Zone are ok). Self-certification of QOF status is reported annually by the QOF on IRS Form 8996.
4. How Can One Organize a Qualified Opportunity Fund?
Two basic forms of organization:
- Form a QOF that directly invests in property in an Opportunity Zone (single QOF structure); or
- Form a QOF that owns stock in a corporation or an interest in a lower tier partnership (a QOZB
Partnership or QOZB Corporation) that owns the property or conducts the qualifying business.
A QOF cannot own an interest in another QOF.
A pre-existing entity can be a QOF, but the QOF must have acquired the property by purchase after 12/31/17 and the QOF must have made an election to be a QOF before it received deferred gain contributions from investors.
5. When Must the Investor Invest?
Within 180 days after the date of the sale or exchange of the asset that triggers a capital gain. Gains passed through or allocated to members or partners in LLCs or partnerships have different and more favorable time frames for reinvestment.
Partners can elect to reinvest gains within 180 days of the sale by the partnership or LLC or 180 days
from the due date of the partnership’s or LLC’s tax return (without extension).
6. What is the Tax or Economic Benefit?
Tax deferral and stepped up tax basis in the QOF investment held by taxpayer, but the original deferred gain is included in the investor’s income on 12/31/2026.
If the interest in a QOF is held for:
- 5 years: 10% of the deferred gain that resulted when the capital gain was realized (i.e., the sale or
exchange of the asset) is added to the tax basis of the QOF interest.
- 7 years: an additional 5% (a total of 15%) of the deferred gain that resulted when the capital gain
was realized is added to the tax basis of the QOF interest. This additional 5% exclusion can only
apply if the QOF investment was made by 12/31/19.
If the QOF interest is sold after 10 years or more, then the basis in the interest is adjusted (stepped up)
for 100% of the appreciation in value created after the interest was acquired up through the date of sale
or exchange (i.e., at exit).
Gains allocated by the QOF to the QOF investor from the sale of assets held by the QOF or QOZB
Partnership (or an S Corporation), after the ten year holding period is met, can be excluded from the QOF
Gains recognized by the QOF from the sale of Qualified Opportunity Zone Business Property during the ten year period can be reinvested in qualifying property by the QOF within twelve months to meet the 90% test discussed in Item (7) below.
This reinvestment rule does not apply to sale or exchanges of property by QOZB Partnerships.
In order to take advantage of the tax deferral benefits for the 7 year holding period, the QOF must be formed and funded on or before 12/31/19.
In order to take advantage of deferral benefits for the 5 year holding period, the QOF must be formed and
funded on or before 12/31/21.
Promoted or carried interests are not eligible for Qualified Opportunity Zone benefits.
7. How Does the Investment Remain Compliant with §1400Z-1 and 2?
A. If the QOF’s investment in the tangible property is made using a single QOF structure (with no
ownership in lower tier subsidiary QOZB Partnerships or QOZB Corporations), then the QOF’s
investment in “Qualified Opportunity Zone Business Property” must meet the following requirements:
i. The property must be used in a trade or business under Code Section 162 (mere triple net leases may not be sufficient).
ii. In the case of tangible property owned or leased by the QOF, during substantially all of
the QOF’s holding period (90% of such holding period), substantially all of the property’s
use must be in a Qualified Opportunity Zone (70% of such use must be in the “Zone”).
Unimproved land used in a trade or business can qualify.
iii. Property must have its “original use” with the QOF or there must be a “substantial
improvement” of the property. A building that has been vacant for at least three consecutive years before being placed in service by the QOF can be an “original use” of the building and
the substantial improvement rules need not be met with respect to such vacant building.
(There is also a special one year vacancy rule).
iv. A substantial improvement means that the costs of improving the property are at least equal to the original cost basis of the property (excluding land cost if a purchase is made of an
existing building) and such improvements must generally be made within 30 months from the
date of the acquisition of the property.
v. The property must be acquired by “Purchase” as provided in Code Section 179(d)(2) (by
substituting 20% for 50% each place it appears in Code Sections 267(b) or 707(b)).
vi. 90% of the QOF’s total assets must be Qualified Opportunity Zone Business Property (which includes an interest in a lower tier QOZB Partnership described in (7)(B) below). The 90%
test is determined based on the average of the percentage of Qualified Opportunity Zone
Business Property on hand on the last day of June and December (the first year an asset
is held has a different rule). A QOF may choose to exclude from the 90% test contributions
made to the QOF during the prior six months for purposes of determining its compliance
with the 90% test, so long as the contribution is held in cash or cash equivalents. The single
QOF structure cannot easily accommodate intangible property nor are there specific rules
regarding working capital in single tier structures (the working capital safe harbor discussed below is not available to the QOF in the single tier structure).
vii. Property leased by the QOF or QOZB Partnership can qualify for purposes of the 90% asset test and there is no original use or substantial improvement requirement for leased property. With certain restrictions the leased property can also be leased from a related party.
viii. Unimproved land is generally not required to be substantially improved and can be a good
asset for purposes of the 90% test.
B. If the QOF invests in a lower tier QOZB Partnership that owns property the following requirements
must be met by the lower tier QOZB Partnership:
i. The QOZB Partnership interest must be owned by the QOF.
ii. A substantial portion of gross income (at least 50%) of the QOZB partnership must be
derived from the active conduct of business in the Zone. Three safe harbors and a facts and
circumstances test are provided for in the final Regulations for purposes of applying this test.
iii. A substantial portion of intangible property of the QOZB Partnership must be used in the
business (substantial portion means at least 40%).
iv. Nonqualified financial assets (cash, securities etc.) must be less than 5% of the average
of the aggregate unadjusted basis of the QOZB Partnership’s property. Under the working
capital safe harbor, working capital can be excluded from nonqualified financial assets for
31 months; see Item (11) below. Multiple 31 month safe harbor periods may apply when
additional equity contributions are made to the QOZB Partnership and the total working
capital safe harbor period can be extended to 62 months.
v. The business can’t be a golf course or sin business. (Code Section 144(c)(6)(B)).
vi. 70% of the tangible property owned or leased by the QOZB Partnership must be Qualified Opportunity Zone Business Property, meeting all the requirements of Item (7)(A) above,except the 90% test in Item (7)(A)(vi).
8. What are the Exit Strategy Options?
Excluding gain from the sale of the investment in the QOF after the ten year hold is one option to take
advantage of the ten year holding period exclusion. The exit of a QOF investor can also be effected by a
sale of Property by the QOF, a sale of the QOZB Partnership interest (or a QOZB Corporation’s corporate stock) held by the QOF or a sale of property by the QOZB Partnership itself.
9. When Does the Program End?
The ability to invest gains into a QOF and receive QOF benefits for any realized capital gain of an investor ends for any sale or exchange occurring after 12/31/26.
10. What is the “Substantial Improvement” Rule?
In order to meet the “substantial improvement” test, either the QOF, or the QOZB Partnership owned by
the QOF, must generally improve property to the extent of 100% of the original cost basis in the property within 30 months of acquisition of the property.
11. What are Other Issues Regarding the Use of Working Capital?
Working Capital Safe Harbor only applies to contributions made to the QOZB Partnership owned by the QOF and not the QOF itself.
If the QOF owns an interest in a QOZB Partnership, the QOZB Partnership, but not the QOF, can
benefit from the working capital safe harbor if:
i. The QOZB Partnership has a written plan that designates that the contributed funds are
being held for the acquisition, construction and “substantial improvement” of tangible
property or the development of a trade or business in the Zone.
ii. The QOZB Partnership has a written schedule for the planned use of working capital to be
used for such purposes within 31 months after it receives the funds. The 31 month period
can be extended for governmental inaction or delay. Also successive contributions may each
receive a 31 month safe harbor period if each meets all of these requirements.
iii. The amounts are actually used in a manner that is substantially consistent with the
designation and schedule.