Qualified Opportunity Zones (QOZ) are the biggest tax break to come out of the 2017 Tax Cuts and Jobs Act. The program has already been a substantial wealth building tool for those who have already entered the qualified opportunity zone investment arena. However, many have been wary to move forward as we’ve had limited knowledge on the rules and operations of the program.
Qualified Opportunity Zone Breakdown
In April, the IRS and Treasury released the second round of proposed regulations which fills in many of the gaps that potential investors, fund operators and professional advisors were waiting for. For those who are not familiar with the QOZ program, it allows a potential investor to defer gain on the sale of capital assets until 2026, receive up to a 15% discount on those capital gains, and if the investment is held for 10 years, any appreciation on your original investment is tax-free. For a more detailed dive into the basics of qualified opportunity zones, check out these articles:
- How Qualified Opportunity Zones Can Save You Money
- How to Invest in a Qualified Opportunity Fund: Update on Qualified Opportunity Zone Investment from the IRS
New Opportunity Zone Regulation Summary
The second round of proposed regulations offer a clearer definition of the term “substantially all.” 90% of the time, 70% of the assets used in a QOZ must be qualified property. Qualified Property are assets acquired by purchase after Dec. 31, 2017 that have original use in the zone upon acquisition or is substantially improved.
An elaborate set of rules were created for measuring whether or not leased property qualifies as eligible property inside a zone. The basic rules are that the lease must be entered into after Dec. 31, 2017 and the terms of the lease must be at market rate at the time the lease was entered into. There are some related party considerations and valuation methods for the 90/70 percent tests that must also be met.
50% Gross Income Test
The first round of regulations presented a 50% gross income test which stated 50% of income earned by a QOZ business must have been earned in a zone. This, however, was very difficult to trace the income sourcing to a zone, so the IRS gave us three safe harbors to measure whether the 50% test is met:
- At least 50% of the services performed by employees and independent contractors are performed within the QOZ (based on hours), or;
- At least 50% of the services performed by employees and independent contractors are performed in the QOZ (based upon amounts paid for the services), or;
- The tangible property of the business located in a QOZ and the management or operational functions performed for the business in the QOZ are each necessary to generate 50% of the gross income of the trade or business.
These safe harbors are important as it allows operating trades or businesses to much more easily trace readily available data to meet the 50% test. Therefore, service businesses are looking at location of costs performing the work rather than from whom the work is being performed. Providers of goods can then look at the shipping point or where the orders are taken from and fulfilled rather than where the consumer is located.
Working Capital Safe-Harbor Revision
The working capital safe harbor has been revised allowing for a stoppage in the 31-month window due to government action or delays such as with permitting, impact studies, etc. The safe harbor also is on a rolling basis meaning each tranche of capital raised is subject to its own 31-month window. This allows for staging of investments and capital calls to keep a larger project going as cash is needed.
Section 1231 gain is required now to be netted with 1231 losses in a given year. These are the gains and losses associated with the sale of property used in a trade or business. 1231 gains are eligible for deferral into a QOZ investment, but the netting rules complicate timing of investment. Therefore, any 1231 gain is deemed to not be recognized until the end of the tax year for the investor. The 180-day investment window follows the end of the tax year for the net 1231 gain, not when the actual asset(s) are sold. This will require care in tax planning to not prematurely invest and whether or not to have a pass-through entity act as the investor rather than the individuals.
Taxpayers have been curious about creating liquidity to pay the tax in 2026 while attempting to meet the 10-year gain exclusion on the appreciated asset. The IRS has blessed the use of cash out debt-financing to allow partners in a fund to receive cash as an ordinary business event. Keep in mind that interest-tracing rules will apply, potentially resulting in a limited amount of deductible interest expense for the investor.
Lastly, and most importantly, the IRS provided the first glimpse into an exit strategy. The original statute’s plain language indicated that an investor would have to sell the interest in the opportunity fund to be granted the 10-year gain exclusion. With the most recent regulations, the proposal is to allow the gain exclusion from assets sold inside the fund. This gain will be excluded to the investors as long as the investor meets the 10-year hold requirement at the date of disposition of the assets in the fund. This allows a fund to have multiple investments in property and businesses without causing a liquidation event. This option allows a fund manager to choose when a particular investment is ripe and ready for harvesting without considering the other investments made.
If you have questions and would like to talk through the details on how you can utilize this tax safe-haven, contact me or one of our other qualified advisors at Aldrich. Our industry experts will be able to help you create the fund and ensure you are in compliance with this new and exciting opportunity.
Senior Tax Manager - Real Estate
Jonathan McGuire, CPA
Aldrich CPAs + Advisors LLP
Jonathan McGuire has over eight years of experience providing strategic tax planning and compliance expertise to private middle-market clients. He has a deep focus as a real estate accountant, working with investors, developers, realtors, property managers, and other professional service providers in real estate. He works with a wide range of property types ranging from…
- Real estate
- Partnership taxation
- Tax planning and compliance
- Certified Public Accountant
- Repair regulations
- Qualified Opportunity Zones
- Qualified Opportunity Funds