If you have specific questions regarding the qualified opportunity zones, please don’t hesitate to get in touch. This “checklist” should not be relied upon, and is not being presented as, legal advice. This is a complex area of tax law and you cannot base your decisions on a cursory overview of the topic, such as this one.
Under the Tax Cuts and Jobs Act (Pub. L. No. 115-97 (2017)), additions were made to the Internal Revenue Code (the “Code”) to provide for tax benefits for investors that invest in Qualified Opportunity Zones (QOZs). These benefits include:
· Deferred recognition of capital gains for Qualified Opportunity Funds (“QOFs”);
· Reduction in amount of recognized deferred capital gains by an increase in basis; and
· Exemptions from taxation of appreciation in QOFs if requirements are met.
Below we have outlined some of the pertinent aspects of QOZ regulations and requirements in order to more succinctly present a checklist of requirements for the creation of a real-estate only QOF.
For clarity, we have omitted any reference or analysis to forming and capitalizing a QOF with an eligible gain, as this is outside the scope of this paper series. We have also not outlined the process of offering QOF investments for sale, for the same reason. These will be the subject of future writing series.
Real Estate-Only QOF
A real estate-only QOF must hold at least 90% of its assets in QOZ Property, and be formed in a US state or US possession if investing only in that possession, be taxed as a corporation or partnership, and be organized for the purpose of investing in QOZ Property.
To meet the 90% QOZ Asset requirement, the newly-formed QOF must hold 90% of its assets in QOZ Property as measured by the average percentage of QOZ holdings on the last date of both 1) the first six-month period of the taxable year of the fund, and 2) the taxable year of the fund. The valuation of the assets are determined by reference to either the QOF’s financial statement for that year or the QOF’s cost basis for the owned assets (cost of purchase) and values of lease payments for leased assets.
The investment must be an equity investment.
The QOF must be self-certified using Form 8996.
Qualified Opportunity Zones
QOZs are defined in Code Section 1400Z-1, which permits the designation of QOZs anywhere there is a 1) low-income community that: 2) is designated by a chief executive officer of a State (governor) and confirmed by the Secretary of the Treasury, or 3) is designated by the Secretary of the Treasury. The latest list and map of QOZs can be found here. For reference, “low income community” is defined in Code Section 45D(E).
Qualified Opportunity Funds (I.R.C. 1400Z-2(D)(1))
In order to qualify for benefits provided by the QOZ program, an investor must invest capital gains in a QOF; a QOF is an investment that holds at least 90% of its assets in a QOZ Property is:
Formed in a US state, the District of Columbia, or a US possession.
Formed in a US possession, is only investing in that possession.
Taxed either as a corporation or a partnership for federal income tax purposes. While limited liability companies taxed as partnerships are eligible or the program, single member limited liability companies are not eligible because they are disregarded (passthrough) entities for purposes of federal taxation.
Organized for the purpose of investing in QOZ Property.
90% QOZ Asset
A QOF must hold 90% of its assets in a QOZ Property, as measured by the average percentage of the holdings on the last date of both 1) the first six-month period of the taxable year of the fund, and 2) the taxable year of the fund. That is to say, assume a fund taxable in year 1, beginning on January 1. If on the last day of the first six-month period of the taxable year of the fund (June 30) the fund was 100% QOZ property and, on the last day of the taxable year of the fund (December 31) the fund was 80% QOZ property, there would be an average of 90% and the 90% QOZ Asset test would be satisfied.
Valuation of the assets are determined by reference to either the asset values reported on the QOF’s applicable financial statement for the taxable year or the QOF’s cost basis for owned assets and present values of lease payments for leased assets.
Investment in a QOF
The investment in a QOF must be an equity investment (This includes preferred stock or partnership interests with special allocations.) The investment cannot be a debt instrument or deemed contribution of money under Section 752(a) of the Code. The latest regulations permit an investor to invest cash or other property in a QOF.
Certification of QOFs
Taxpayer corporations or partnerships are tasked with self-certifying as a QOF using Form 8996 at the time the corporation or partnership files its annual tax return.
QOF investors must invest in QOFs organized to invest in QOZ Property. QOZ Property can include:
QOZ Stock (IRC 1400Z-2(d)(2)(B))
If an entity is classified as a corporation for federal income tax purposes, then an equity interest (Stock) in the entity qualifies as QOZ Stock if:
The stock is acquired by a QOF after December 31, 2017, at its original issue, from the corporation in exchange for cash.
As of the issuance of the stock, the corporation is a QOZ Business or has been organized for the purpose of being a QOZ Business.
During 90% of the QOF’s holding period for the stock, the corporation is a QOZ Business.
QOZ Partnership Interests(IRC 1400Z-2(d)(2)(C))
If an entity is classified as a partnership for federal income tax purposes, then an equity interest in the entity qualifies as a QOZ partnership interest if:
The interest is acquired by a QOF after December 31, 2017 from the entity solely in exchange for cash;
As of the time the interest is issued, the entity is a QOZ Business or has been organized for the purpose of being a QOZ Business; and
During 90% of the QOF’s holding period for the interest, the entity is a QOZ Business.
QOZ Business Property (IRC 1400Z-2(d)(2)(D))
Tangible property used in a trade or business of a QOF or QOZ Business qualifies as QOZ Business Property if:
The property was acquired by the QOF or QOZ by purchase or lease after December 31, 2017;
During 90% of the QOF’s or QOB Business’ holding period or lease term for the tangible property, at least 70% of the use of the tangible property was in a QOZ.
For purchased tangible property, it was purchased from an unrelated party (no more than 20% common ownership between entities) and either
The original use of the property in the QOZ commences with the QOF or QOZ Business, or
The QOF or QOZ Business substantially improves the tangible property. Tangible property is “substantially improved” by the QOF only if, during any 30-month period beginning after the acquisition date of the property the QOF adds to the basis of the property an amount equal to more than the adjusted basis of the property at the beginning of the 30-month period. See Prop. Treas. Reg. §§ 1.1400Z2(d)-1(c)(8)(ii)(A) and 1.1400Z2(d)-1(d)(4)(ii)(A).
For leased tangible property:
The lease is market rate; and
If the lessor and lessee are related parties:
There is no prepayment of rent exceeding 12 months; and
If the original use of the leased personal property in the QOZ does not commence with the lessee, the lessee must purchase tangible property that is QOZ Business Property within 30 months of having a value not less than the value of the leased personal property.
An entity that issues stock or partnership interests to a QOF must qualify as a QOF Business for investors to receive the intended QOZ tax benefits. A trade or business is a QOZ Business if:
70% of the tangible property owned or leased by the trade or business is QOZ Business Property (Prop. Treas. Reg. § 1.1400Z2(d)-1(d)(3)(i), 2018 WL 5312325.);
For each taxable year, at least 50% of its gross income is derived from the active conduct of a trade or business in the QOZ; (Here “trade or business” is defined by the 2019 regulations as under Code Section 162 and related court cases – and provides that the ownership and operation (including leasing if not a triple-net lease) of real property qualifies as active conduct of a trade or business. The Supreme Court has interpreted “trade or business” for purposes of IRC § 162 to mean an activity conducted with “continuity and regularity” and with the primary purpose of earning income or making profit.)
2019 regulations have created four (4) distinct tests for a trade or business to meet this 50% threshold:
The total hours worked by employees (and independent contractors) inside of a QOZ must be at least 50% of the total hours worked by all employees (and independent contractors) of the trade or business;
The total dollars paid to employees (and independent contractors) for services performed within a QOZ must be at least 50% of the total dollars paid for services performed;
The management/operational staff and the tangible property of the business that is in the QOZ must be necessary to generate 50% of the company’s gross income; or
Other facts and circumstances. (This last safeharbor is, obviously, ambiguous. It has not yet been defined further and should not be relied upon until such time as it is.)
At least 40% of the trade or business’ intangible property must be used in the active conduct of the trade or business; and
The trade or business must have a schedule to spend working capital to the extent that more than 5% of its property is attributable to nonqualified financial property (e.g. long-term debt).