The longer you hold qualified opportunity zone property, the greater the tax benefit.
To benefit from the tax advantages of opportunity fund investment, you need to follow numerous rules, many of which have been clarified through the Treasury Department’s new proposed regulations.
Since the enactment of the new tax law, real estate investors, tax professionals, and numerous others have been seeking clarification to the Opportunity Zone Program outlined in the new opportunity zone statute ( 26 U.S. Code § 1400Z-1 and 26 U.S. § 1400Z-2).
Last month, the Treasury Department issued proposed regulations that detail the timing of opportunity zone purchases, and the types of businesses and investments that qualify. In this post, we will highlight the program’s general investment rules and some of the guidance provided by the regulations.
The investment must be made through a “Qualified Opportunity Fund” (QOF)
The Opportunity Zones Program provides that capital gains may be deferred, reduced or forgiven for taxpayers who invest in designated opportunity zones. The original source of those gains may be from any source, including real estate investments, corporations, partnership interests, LLCs, stocks and bonds, etc. The new Proposed Regulations stipulate that these gains must be invested within 180 days, but not directly into opportunity zone property – all capital must be invested through a Qualified Opportunity Fund (QOF).
The QOF must be structured properly and must invest properly
Under 26 U.S. § 1400Z-2(d)(1), a QOF must be a U.S. partnership or corporation that holds 90% or more of its assets in qualified opportunity zone (QOZ) property. There are three types of QOZ property:
- Qualified opportunity zone stock,
- Qualified partnership interests, and
- Qualified opportunity zone business property.
Corporations and partnerships may self-certify as a QOF, provided that they are statutorily eligible to do so. Form 8996 “Qualified Opportunity Fund” may be used for initial self-certification and annual compliance reporting with the 90% asset test (pre-existing entities can qualify).
The QOZ property must have been purchased after December 31, 2017
To qualify for beneficial tax treatment, the QOZ property must have been purchased by the QOF, in cash, after December 31, 2017.
QOZ corporations and partnerships must be organized primarily for opportunity zone purposes
QOZ corporations and partnerships must have been organized for purposes of being a QOZ business at the time the stock or holdings were issued, and for substantially the entire holding period they must have qualified as a QOZ business. See Section § 1400Z-2(d)(2)(D)(i).
QOZ business property must originate or be “substantially improved” within the opportunity zone
The proposed regulations stipulate that for qualified opportunity zone business property, the original use of the property must start in the opportunity zone or the property must be “substantially improved” by the QOF within 30 months of purchase. Cash may be held by the QOF for 31 months (and still qualify as qualified opportunity zone business property), but only if pursuant to a written plan.
Note that for a building to be “substantially improved” it must be doubled in value. The basis attributable to land is not taken into consideration. Let say that you purchase property in an opportunity zone for $5 million that is comprised of land and a building. The raw land is valued at $4 million and the (ramshackle) building is worth $1 million. You put another $1 million to fix the building, essentially doubling its value. This qualifies as “substantial improvement.” See IRC § 1400Z-2[d][D][ii].
Substantially all of the QOZ business property use must be in an opportunity zone
During substantially all of the QOF’s holding period in QOZ business property, substantially all (70% or more) of the QOZ business assets (tangible property that it owns or leases) must be in an opportunity zone. The remaining 30% may be invested elsewhere with no loss in opportunity zone tax benefits.
Putting it all together
Let’s say someone with $10 million plans to invest their assets in real property. If they invest in a QOF that holds the real property directly, then at least $9 million (90%) of that property must be located in an opportunity zone to satisfy the 90% test. In the alternative, if the QOF invests that $9 million in a subsidiary QOZ business (corporation or partnership), that business would have to invest only $6.3 million in opportunity zone assets (70% of $9 million). In the latter case, only 63% of the taxpayer’s opportunity zone investment – $6.3 million of the $10 million – must be in opportunity zone assets, and the remaining 37% could be in “regular” investments, including investments in affluent areas. This reduces the risk of investing in economically-challenged areas and the hope is that it will encourage many to participate in the program.
In our final post, we will describe the process of investing in an opportunity zone.