The IRS has issued proposed regulations that provide guidance under new provisions added by the Tax Cuts and Jobs Act (TCJA) related to Qualified Opportunity Funds (QOFs). Specifically, the guidance addresses the gains that may be deferred as a result of a taxpayer’s investment in a QOF, as well as special rules for an investment in a QOF held by a taxpayer for at least 10 years.
The regs also update portions of previously proposed regs to address various issues, including:
- The definition of “substantially all” in each of the various places it appears in the tax code;
- The timing and amount of the deferred gain that is included;
- The treatment of leased property used by a qualified opportunity business;
- The use of qualified opportunity zone business property in the qualified opportunity zone; and
- The “reasonable period” for a QOF to reinvest proceeds from the sale of qualifying assets without paying a penalty.
Qualified Opportunity Zone Basics
The TCJA now allows the designation of certain low-income community population census tracts as Qualified Opportunity (QO) Zones eligible for a number of favorable tax rules aimed at encouraging economic growth and investment in businesses within the zones. There are currently more than 8,700 communities in all 50 states, the District of Columbia and five U.S. territories that have been designated as QO Zones. They will retain those designations until December 31, 2028.
Investors can form private investment vehicles, known as qualified opportunity funds (QOFs), for funding development and redevelopment projects in the zones. The tax code provides temporary deferral of inclusion in gross income for capital gains reinvested in a QOF and the permanent exclusion of capital gains from the sale or exchange of an investment in the QOF.
In general, a QOF is an investment vehicle: 1) that’s organized as a corporation or a partnership for the purpose of investing in QO Zone property (other than another QOF) and 2) that holds at least 90% of its assets in QO Zone property.
QO Zone property includes: any QO Zone stock, any QO Zone partnership interest, and any “QO Zone business property”. QO Zone business property, in turn, is tangible property used in a trade or business of a taxpayer if:
- The property was acquired by the QO Zone business by purchase after December 31, 2017;
- The original use of the property in the QO Zone commences with the QOF or the QOF substantially improves the property; and
- During substantially all of the QOF’s holding period for the property, substantially all of the use of the property was in a QO Zone.
Under the tax code, tangible property used in a QOF’s trade or business is treated as substantially improved by the QOF only if, during any 30-month period beginning after the date of acquisition of such tangible property, additions to basis with respect to such tangible property in the hands of the QOF exceed an amount equal to the adjusted basis of such tangible property at the beginning of such 30-month period in the hands of the QOF.
In October 2018, IRS issued proposed regs on QOFs. However, these regs contained certain placeholder text, included less detailed guidance in certain areas that merely cross-referenced statutory rules, or lacked sufficient detail to address the issues involved.
The guidance notes there are situations where deferred gains may become taxable if an investor transfers their interest in a QO Fund. Here’s an example from the IRS: If the transfer is done by gift, the deferred gain may become taxable. However, inheritance by a surviving spouse isn’t a taxable transfer, nor is a transfer, upon death, of an ownership interest in a QO Fund to an estate or a revocable trust that becomes irrevocable upon death.
The proposed rules generally apply to tax years ending after the date the regulations are published in the Federal Register. However, taxpayers may generally rely on the rules (except for one provision that doesn’t apply until 1/1/28) if they apply them consistently and in their entirety.
The rules involving QOFs are complex. There will likely be more IRS guidance and many states are considering what they’re going to do about Qualified Opportunity Zones. Consult with your tax advisor if you’re interested in investing.