A lesser known provision of the federal Tax Cuts and Jobs Act was the establishment of Qualified Opportunity Zones (QOZ), which allows taxpayers to temporarily defer (until 2026) tax on capital gains resulting from the sale of stock, real estate or other property if such gains are reinvested into a “qualified opportunity fund” (QO Fund) similar to a like-kind exchange under Section 1031.
However, unlike a 1031 exchange, any gains resulting from the taxpayer’s investment in the QO Fund may be permanently excluded if the taxpayer holds the investment for 10 years or more.
This program is still in its infancy, and significant uncertainty remains with respect to its practical implementation, making it difficult for investors, developers and property owners to fully understand these opportunities. While an in-depth discussion of the QOZ program is complex, boring and beyond the scope of this article, I have addressed below some common questions I’ve received regarding the real-world application of the QO program.
How is a QO Fund created? A QO Fund is defined as any investment vehicle organized as a corporation or partnership that (1) is organized to invest in QOZ property, (2) holds 90% of its assets in “QOZ business property”, and (3) self-certifies itself as a QO Fund. QO Funds can be a simple single-owner LLC or a much more sophisticated fund structure with multiple investors, fund managers and subsidiaries.
What types of investments can a QO Fund make? A QO Fund can directly purchase QOZ business property or it can do so indirectly through subsidiaries. If the QO fund invests through its subsidiaries, each subsidiary is required, among other things, to derive at least 50% of its income from an “active trade or business.”
Under current tax law, leasing real estate under a triple-net lease does not qualify as an active trade or business, so each subsidiary (or its partners) would need to take a more active role in the management of real property. With the exception of country clubs, massage parlors and certain “sin” businesses, any type of business or property is eligible for investment.
What about existing real estate? For real estate to qualify as QOZ business property, either (1) the original use of such property in the QOZ must have commenced with the QO Fund, or (2) the QO Fund must substantially improve the property. The “original use” requirement makes it difficult, if not impossible, for existing real estate to qualify as QOZ business property unless the QO Fund substantially improves the property.
Property is considered substantially improved if capital expenditures within 30 months of acquisition equal or exceed the property’s purchase price. Additionally, the 90% requirement prevents a QO Fund from holding more than 10% as cash or other liquid assets, which significantly impairs the QO Fund’s ability to finance capital improvement projects necessary to substantially improve its properties.
Can debt be used? Unlike aspects of a 1031 exchange, the QOZ program does not require the taxpayer to reinvest the actual cash proceeds from the deferred sale. Under current guidance, a taxpayer looking to defer $500,000 in gain could retain the sale proceeds, borrow $500,000 and invest the borrowed $500,000 into the QO Fund. The QO Fund may also borrow money to fund capital improvements, subject to the 10% limitation.
So how does this work? Let’s say a taxpayer sells property in 2018 and invests the proceeds in a QO Fund. If the taxpayer then sells its interest in the QO Fund in 2029, the taxpayer would recognize 85% of its 2018 gain in 2026 (thereby avoiding 15% of the 2018 gain) and would permanently exclude any gains in 2029 resulting from the increase in value of the QO Fund.
The permanent deferral of gains in the QO Fund will make this program very attractive to investors, but additional guidance is still needed. That help may be coming soon; the IRS is reviewing proposed rules, the last major hurdle before proposed guidance is released.
Editor’s note: Cal Rose is an attorney with Wright Lindsey Jennings in Rogers. The opinions expressed are those of the author.