By Rolando Garcia, JD, CPA, Tax Director, Doeren Mayhew CPAs and Advisors

Created to encourage economic growth and investment in low-income and economically distressed communities, the Tax Cuts and Jobs Act brought a new tax incentive for investors to consider – Qualified Opportunity Funds (QOF). With this new incentive, taxpayers, including individuals, C corporations, S corporations, partnerships, and trusts and estates, are now able to defer paying tax on capital gains by investing them into a QOF, which in turn invests those funds within a Qualified Opportunity Zone (QOZ).

While the interest level from investors was initially high, so was the uncertainty. However, with two sets of proposed regulations issued in 2018 and 2019, these uncertainties were lifted. As a result, financial advisors, developers and taxpayers have begun exploring how to take advantage of this tax-friendly investment opportunity.

Opportunity Zone Tax Benefits

There are three key tax benefits investors gain from investing in a QOF, including:

  1. Deferring the tax on any eligible capital gain until Dec. 31, 2026, if that gain is invested by the taxpayer in an QOF within 180 days from the date the gain was recognized;
  2. Reducing up to 15% of eligible gains invested in a QOZ depending on the investor’s holding period, namely 10% if the investor holds the qualifying investment for at least five years, and an additional 5% if the investor holds the investment for an additional two years; and/or
  3. Increasing the tax basis of their interest in a QOF to fair market value on the date of sale if they hold their interest in the fund for at least 10 years, meaning the investor should not recognize gain on the sale of its qualifying investment.

QOF Requirements

To help ensure the QOFs ultimately deploy capital into a Qualified Opportunity Zone Business (QOZB), these are the requirements, generally, to consider:

  • Measurement date: With regards to the 180-day requirement, taxpayers yielding a capital gain through a pass-through entity can choose the measurement’s start date. The pass-through may elect to defer that gain at the pass-through level or through its partners (in the case of a partnership), who could elect a start date.
  • QOF structure: A QOF may be organized as a corporation or partnership, and may be a newly formed or pre-existing entity. While a QOZB must operate within a QOZ, a QOF does not need to be located in a QOZ.
  • Asset requirements: A QOF must have at least 90% of its assets invested in a QOZ property, which can be via stock, partnership interests or business property. This is measured as the average of the QOZ property held in the QOF on the last day of the first 6-month period of the QOF’s taxable year and on the last day of the QOF’s taxable year. Failure to meet this test will result in a penalty for each month that it fails to meet the threshold.
  • Qualified Opportunity Zone Business Property (QOZBP) use: If the QOF investment is directly in property, this option permits a QOF to directly operate a QOZB which uses the QOZBP, so long as at least 70% of such property is used within a QOZ for at least 90% of the time that the QOF owned the property.

A QOF may also indirectly meet the 90% threshold by conducting a QOZB through a subsidiary by holding QOZ stock or partnership interest.

  • Quantitative Tests: If you’re conducting a QOF investment through a subsidiary corporation or partnership, there are a series of quantitative tests to consider, including:
    1. 50% of gross income test: Met when the at least 50% of following activity happens within the QOZ:
      • Services (based on hours or the amount paid) for the business by its employees and independent contractors are performed
      • The gross income of the trade or business is derived from the location of the tangible property and in performance of management or operational functions
      • The gross income of a trade or business is derived from the active conduct of a trade or business in a QOZ
    2. Active trade or business test: Section 162 provides the roadmap for how this should be interpreted in the QOZ context. Importantly, the proposed regulations make it clear that the operation (including leasing, but only if not solely triple net leasing) of real property is deemed to be the “active conduct of a trade or business.”
    3. Nonqualified financial property test: No more than 5% of the aggregate unadjusted bases of the property of the trade or business can be attributed to “nonqualified financial property”, which includes debt, stock, partnership interests, options, futures, forwards, warrants, swaps, etc. However, it does NOT include “reasonable amounts” of “working capital assets” held in cash, cash equivalents, or debt instruments with a term of 18 months or less.

Gain Recognition

As mentioned above, gain is recognized on the earlier of the date that the QOF investment is sold or exchanged, or on Dec.31, 2016. “Sold or exchanged” includes any transaction that reduces the QOF investor’s equity interest, including:

  • A taxable disposition of the qualifying investment
  • A transfer by a partner of an interest in a partnership that itself directly (or indirectly solely through other partnerships) holds a qualifying investment (except in limited cases)
  • A transfer by gift of a qualifying investment
  • Certain non-recognition transactions related to liquidating or transferring qualifying QOF stock

Act Now

There are several watershed dates in the QOZ regime, including Dec. 31, 2019. Why? In order to get the full 15% tax reduction on eligible gains, QOZ investments needs to be made on or before Dec. 31, 2019.

As you approach year end, now may be the time to explore how opportunity zones can help improve your overall tax strategy. To learn more, contact Doeren Mayhew’s dedicated Tax Group today.