A Primer on the Qualified Opportunity Zone Regulations

 A Primer on the Qualified Opportunity Zone Regulations

The December 2017 “Tax Cuts and Jobs Act” offers significant tax incentives for “qualified opportunity funds”  investing in “qualified opportunity zones” (“QOZ”)[1].  The Department of Treasury issued the first set of Opportunity Zone regulations on October 19, 2018 and a second set of opportunity zone regulations on April 17, 2019.  This note is not an exhaustive analysis of the tax benefits or the October 2018 or April 2019 regulations.  To be sure, the opportunity zone incentives, while intended to spur investment in low-income communities, are complex and investors should consult with their tax advisors before undertaking any investment structured to achieve opportunity zone tax benefits.

QOZ Investment Tax Benefits

Investors can defer tax on any prior gains invested in a QOZ Fund until the earlier of the date on which the investment in a QOZ Fund is sold or exchanged, or December 31, 2026.   If the QOZ Fund investment is held for longer than 5 years, there is a 10% exclusion of the deferred gain.  If held for more than 7 years, the 10% becomes 15%.  Second, if the investor holds the QOZ Fund investment or at least ten years, the investor is eligible for an increase in basis of the QOZ Fund investment equal to its fair market value on the date that the QOZ Fund investment is sold or exchanged.

Obtaining QOZ Tax Benefits.

Federal QOZ tax benefits are not available to all investors.  Rather the benefits are available to an investor who (i) invests in a Fund[2];  (ii) who recognizes a capital gain from the sale or exchange of property prior to December 31, 2026;  and (iii) reinvests cash up to the amount of such gain into a Fund within 180 days after recognition of the gain.  It does not appear that the capital gain must be related to an Opportunity Zone.

OQZ Eligible Investments.

A Fund may invest in three categories of QOZ property: (i) property in a QOZ;  (ii) qualified opportunity zone stock;  and (iii) a qualified opportunity zone partnership interest.

Qualified Opportunity Zone Property.

For purposes of the 90/10 test applicable to a  Fund, three categories of QOZ Property may be owned by the Fund:  (i) “QOZ business property” (“QOZ Business Property”), (ii) “QOZ stock” (“QOZ Stock”) in a corporation that qualifies as a “qualified opportunity zone business” (“QOZ Business”), and (iii) a “QOZ partnership interest”  (“QOZ Partnership Interest”) in a partnership that qualifies as a QOZ Business.  A key structural consideration for any Fund is that the Fund may own QOZ Business Property either directly in its own right, or indirectly through the ownership of QOZ Stock or QOZ Partnership Interests in lower-tier entities that meet the tests for a QOZ Business.  Somewhat surprisingly, the QOZ Business requirements applicable to QOZ Stock and QOZ Partnership Interests do not apply to the direct ownership of QOZ Business Property by a Fund, and there are other significant differences between the direct and indirect deal structures that reinforce the need for careful advance planning.

Qualified Opportunity Zone Business Property.

QOZ  Business Property is physical property used in a trade or business within a QOZ if (i) the property is acquired by the Fund after December 31, 2017 through a purchase from an unrelated person, (ii) “substantially all” of the use of the property is within QOZ, and (iii) either (A) the original use of the property in the QOZ must commence with the Fund or (B) the Fund must “substantially improve” the property (defined generally as incurring capital expenditures with respect to the property in an amount at least equal to the tax basis of the property at the beginning of any 30-month period after the Fund’s acquisition of the property;  i.e., effectively doubling the basis of the property within a 30-month period).

Qualified Opportunity Zone Stock;  Qualified Opportunity Zone Partnership Interests.

QOZ Stock and QOZ Partnership Interests are equity interest acquired by a Fund from a domestic corporation or domestic partnership for cash after 12/31/2017 (i.e., not by purchase from another stockholder or partner), provided that (i) the entity is a QOZ Business at the time the equity interest is issued to the Fund (or, in the case of a new entity, is being organized for the purpose of becoming a QOZ Business), and (ii) the entity must qualify as a QOZ Business during “substantially all” of the Fund’s holding period in the entity.

Qualified Opportunity Zone Business.

In order to qualify as a QOZ Business, the underlying entity in which the Fund owns QOZ Stock or a QOZ Partnership Interest (such entity, a “Lower-Tier Entity”) must meet the following requirements:  (i) “substantially all” of the tangible property owned or leased by the Lower-Tier Entity must be QOZ Business Property;  (ii) at least 50% of the Lower-Tier Entity’s gross income must be from the active conduct of a trade or business within a QOZ;  (iii) no more than 5% of the Lower-Tier Entity’s property (measured by cost basis) may consist of specified financial assets, subject to an exception for reasonable working capital reserves;  (iv) certain “sin” businesses are not permitted;  and (v) a substantial portion of any intangible property owned by the Lower-Tier Entity must be used in the active conduct of a trade or business within a QOZ.

At this time, Treasury has requested input from interested parties on the April 2019 regulations by July 1, 2019 before a public hearing on July 9, 2019.  Although the second set of regulations are not final, Treasury has indicated that investors may rely on the proposed regulations as they make QOZ investments- certainly the goal is to spur renewed interest in QOZs.

-----

[1] Qualified Opportunity Zones. 

Generally speaking, a qualified opportunity zone (“QOZ”) is a designated zone meeting certain low-income criteria that has been certified by the U.S. Treasury Department based on nominations by all 50 states, the District of Columbia and five U.S. territories.  In 2018, the Treasury certified over 8,700 qualified opportunity zones for purposes of the new program.

[2] Qualified Opportunity Funds.

A qualified opportunity fund (“Fund”) is an investment vehicle organized as a partnership or corporation for purposes of investing in QOZ property located in a QOZ and meeting certain business-related criteria.  At least 90% of the Fund’s assets must consist of QOZ Property, generally based on the average of the applicable asset percentages on a semi-annual basis.

-----

Article authored by Richard Buckley, Vice President & Corporate Counsel at Prudential Financial.