This is a continuation of a prior QOZ article entitled “Summary of Changes Affecting Qualified Opportunity Funds.”
Click here to read the first article.
In December 2019, the Internal Revenue Service (“IRS”) updated and clarified much of the uncertainties in the QOZ regulations under the final rules (“Final Rules”). In addition, the IRS implemented various rules and safe harbor provisions to account for the adverse tax consequences for QOFs during the COVID-19 pandemic. Below are some of the highlights.
Qualifying Investments vs. Nonqualifying Investments
There is quite a bit of confusion as to whether nonqualifying investments are eligible for QOZ investments. The simple answer is no. Only deferred gains are eligible for QOZ benefits. An investor may invest nonqualifying assets into a Qualified Opportunity Fund (“QOF”), but any gain of QOF investments will be subject to general federal income tax rules instead of the deferred taxation available under the Final Rules.
Qualifying investments are, simply put, investments that are subject to tax as capital gains, whether short-term or long-term.
20% Related Party
Another common issue that is overlooked is the 20% related party test set forth in Section 1400Z-2(e)(2). The taxpayer must own no more than 20% of the equity interests in the QOZ Properties (“QOZP”) to satisfy the test. Implicitly, to receive the QOF benefit, the taxpayer must sell enough equity interests in the entity holding the QOZP to a third-party QOF, such that the taxpayer owns no more than 20%. The taxpayer must also consider reinvestments, additional capital contributions, redemptions, etc. to maintain the 20% related party test. Persons are related to each other as described in IRS Sections 267(b) or 707(b).
Section 1231 Asset
The IRS clarified that the Section 1231 Asset gain contribution is eligible as a qualifying investment even if it is immediately contributed. In other words, the taxpayer is not required to wait until the end of the year to account for the netting process. There is an added benefit in contributing a Section 1231 Asset: gain that is deferred for longer than a 5-year recapture window will expire, assuming no inclusion event occurs (see inclusion event section below).
Original Use Test
The IRS proposed that to satisfy the original use test with respect to vacant buildings, the building must be vacant, or not placed in service for purpose of depreciation, for the past five (5) years prior to the purchase of a QOZ property. Under the Final Rules, the year of vacancy has been cut to three (3) years, if the property is vacant after the area surrounding the property is designated as QOZ.
The three (3) year requirement is further cut down to one (1) year if the property is vacant on the date that the QOZ’s surrounding area is designated as QOZ.
Another common strategy in relying on the original use test is purchasing land for future use, as land is a non-depreciable asset.
Substantial Improvement Test
The property must be substantially improved within any 30-month period beginning from the date of acquisition. A QOF substantially improves a property if the QOF spends more money than the purchase price of the property. Under the Final Rules, a QOF may purchase other properties that satisfy the original use test if it improves the overall functionality of the substantially improved property. An example would be purchasing equipment, furniture, or other personal property that is attributable to substantially improving the property. Moreover, the IRS clarified that the expenditure must be based on the tax basis of the property, as opposed to the entire acquisition price.
The IRS provided flexibility to the 180-day rule for the investors contributing capital to a QOF. An investor must contribute their qualifying investment within the 180-day window to a QOF to take advantage of the tax benefits provided under the IRC. The commencement of the 180-day clock depends on the taxpayer.
- A taxpayer receiving eligible gain from a flow-through entity may elect the 180-day period (1) at the end of the year; (2) on the tax filing due date of the pass-through entity (excluding extension); or (3) date pass-through entity recognized the gain.
- A taxpayer receiving using installment sale gain may elect the 180-day period either (1) on the date each payment received; or (2) once at the end of the tax year.
- For a taxpayer receiving gain from publicly traded stock, the180-day period starts on the date of the trade (i.e., sale).
- For a taxpayer receiving Section 1231 gain, the 180-day period starts on the date of sale.
Under the Final Rules, the deferred gain must be recognized when (1) the taxpayer reduces their direct equity investment in QOF; or (2) cashes out a portion of their investment in the QOF by receiving a distribution in excess of the taxpayer’s basis in the QOF.
An exhaustive list of inclusion events (i.e., taxable event) can be found in Treasury Regulations Section 1.1400-Z2(b)(1).
COVID-19 Response and Impact
On April 9, 2020, the IRS issued Notice 2020-39 in response to adverse impacts against QOFs due to the ongoing COVID-19 pandemic. In short, the IRS stated that the working capital safe harbor was granted an additional 24-month extension. The 90% asset requirement was also waived if a QOF can show reasonable cause for failure to abide by the restriction. Moreover, the IRS granted a 12-month extension for reinvesting certain eligible gains.
Securities Law Implications
There are securities law implications in setting up a QOF. Most QOFs will likely rely upon Regulation D, a private investment exemption, to raise capital for purposes of deploying money into the QOZP. If a QOF is investing in businesses and/or interests of businesses, there may also be Investment Company Act and/or Investment Advisers Act implications. Please consult with your securities attorney on the securities law requirements with respect to a QOF.
The IRS has provided much clarity in the Final Rules while accounting for the COVID-19 pandemic. It will be interesting to see how QOFs will develop over the next ten years.