By Debbie A. Klis
The Tax Cuts and Jobs Act of 2017 (TCJA) made substantial changes to many aspects of the Internal Revenue Code (IRC) including the creation of a program deemed by many to be the most transformative development in real estate and venture capital in many years. It encourages investment in economically distressed communities known as “Qualified Opportunity Zones” (QOZs) in all 50 states. The QOZ program grants favorable tax treatment for an unlimited number of investments in QOZs during the life of the program, unlike certain federal tax credits, which are available on a finite basis annually.
The singular goal of the program is to tap into trillions of dollars of unrealized capital gains to spur economic development and job creation in low-income communities designated as QOZs by the Treasury Department. The TCJA requires that QOZ investments occur through Qualified Opportunity Funds (QOF) rather than directly in a business or asset within a QOZ.
Structuring a Qualified Opportunity Fund
A QOF is an entity taxed as a partnership or corporation (including an LLC that is taxed as a partnership or corporation) that is organized to facilitate investments in QOZs on a tax-advantaged basis that will deploy at least 90 percent of its capital into qualifying investments in a QOZ. Newly enacted Section 1400Z-2 of the Internal Revenue Code of 1986, as amended (the Code), enacted by the TCJA, governs QOFs and permits self-certification as to “qualified” status by filing Form 8996 with the entity’s tax return.
On Oct. 19, 2018, the Treasury issued proposed regulations as additional guidance related to QOFs, and Form 8996. The proposed regulations provide that an entity must specify the month in which it will be first treated as a QOF in the Form 8996. Careful completion of the initial Form 8996 is essential because capital gain invested in an entity before its first month as a QOF is not a valid QOF investment. In addition, QOFs must file a newly completed Form 8996 annually with its tax return to report whether it has met the investment standard during its preceding tax year.
The TCJA requires that investors make an “investment” in a QOF, which means that subscribers must acquire an equity interest in a QOF in exchange for their respective contribution of eligible gain (a loan or commitment to tender capital in the future is not a valid investment). Moreover, investors can receive the full suite of tax benefits under the TCJA in connection with their interests even if their relative portion of appreciation in the underlying QOF’s assets are not proportionate to their capital invested. Likewise, in connection with a QOF manager’s eligibility for QOF tax benefits, although the proposed regulations do not address carried interests specifically, it is unlikely that managers would receive tax benefits without investing eligible gains.
A QOF’s investment strategy and objectives should be in sync with the TCJA’s intended purpose of stimulating positive growth within designated communities and procuring the prescribed tax benefits to its investors. A QOF’s operational strategies to maintain capital and achieve income and growth, must incorporate the inextricably linked investment restrictions requiring that at least 90 percent of its assets are comprised of “qualified opportunity zone property” (QOZP). A QOF’s remaining investments are not regulated.
QOZP falls in three categories, each of which is subject to a set of rules to qualify under the program:
Stock in a U.S. corporation provided the QOF acquires the stock at its original issue after Dec. 31, 2017 (directly or through an underwriter) from the corporation in exchange for cash, when the QOF acquires the stock, the corporation was a Qualified Opportunity Zone Business (QOZB) (or if newly formed, it is being organized for purposes of being a QOZB), and during substantially all of the QOF’s holding period, the corporation qualifies as a QOZB.
An interest in a U.S. partnership (capital or profits) provided the QOF acquires the interest after Dec. 31, 2017 from the partnership solely in exchange for cash, when the QOF acquires the interest, the partnership was a QOZB (or if newly formed, it is being organized for purposes of being a QOZB), and during substantially all of the QOF’s holding period, the partnership qualifies as a QOZB.
Tangible personal property that is used in a trade or business provided (a) the QOF acquired such property from an unrelated party after Dec. 31, 2017; (b) the original use of the property commenced with the QOF or the QOF substantially improves the property; and (c) the property was owned during substantially all of the QOF’s holding period in a QOZ.
According to the proposed regulations, the basis attributable to land is not used in determining whether substantial improvement to a building occurred; assume a QOF acquired property in a QOZ for $2 million and allocated $800,000 to an existing building and $1.2 million to land. The property would qualify as QOZP if the QOF incurs at least $800,000 in costs that are capitalized into the building’s basis within the 30-month period beginning the date the QOF acquired the property. Simply put, a QOF may invest in the construction of new buildings and the substantial improvement of existing buildings; in the case of an existing building, the QOF must invest more in the improvement than it paid to purchase the building and the development must be completed within 30 months of purchase.
Compliance with the 90 percent Asset Test
A QOF must demonstrate compliance with the 90 percent asset test on the last day of the first six-month period of the QOF’s taxable year and on its last day of the taxable year. The proposed regulations provide that the first 6-month period of the taxable year of the fund means the QOF’s first six months of the year and month in which it first requested QOF treatment, as it designated in its Form 8996. By way of example, a QOF formed in January of 2019 for which its principals chose March 2019 as its first month as a QOF – the first 90 percent asset-testing period for year one is Aug. 31 and the second is Dec. 31, 2019. Thereafter, the 90 percent asset test will occur on June 30 and Dec. 31.
To complete the asset test, the proposed regulations require that if a QOF has an “applicable financial statement” (defined in §1.475(a)-4(h)(1) of the Regulations), and it must use the asset values contained therein. Without an applicable financial statement, its asset values must be measured using the cost of each asset. At the Internal Revenue Service’s (IRS) open hearing on the proposed regulations on Feb. 14, 2019, witnesses testified that GAAP-based financial statements are too burdensome and may lead to unforeseen results such as a decline in an asset’s value over time due to depreciation required under GAAP. The testimony included suggestions that the final regulations permit QOZBs and QOFs to rely on a tangible asset’s unadjusted costs basis for the asset’s value despite the presence of the asset’s value in a financial statement.
QOF Timing Considerations
QOFs, and the QOZB in which the QOFs invest, have important timing considerations. First, the QOF may have as much as a six-month window to deploy its investors’ funds into a QOZB in order to remain compliant with the 90 percent-asset reporting test to the IRS. Second, to address the 5 percent non-qualified financial property limitation, the proposed regulations provide a 31-month safe harbor period commencing when the QOF contributes cash to a QOZB. The QOZB, which must have at least 70 percent of its tangible property (owned or leased) is QOZB property, can treat the contributions as working capital for disbursement during a 31-month period provided it designates the amounts in writing, maintains reasonable written schedule to deploy the funds, and uses the funds in a manner that is substantially consistent with the schedule. Additional regulatory guidance is expected regarding a QOF’s investment in a QOZ business property including with regards to the substantially all test to qualify as a QOZ business.
The third timing issue concerns exiting investments; for example, the proposed regulations did not address the mechanics of exiting investments in 2026 when the initial capit