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Key takeaways:

  • The 2017 Tax Cut and Jobs Act included a long-term tax incentive for individuals to invest in economically distressed communities through Qualified Opportunity Zone funds (QOF).  
  • The initial regulations that apply to Qualified Opportunity Zones (QOZs) were open to interpretation. To answer questions that many investors have about the rules governing QOZs, the Treasury issued a second set of proposed regulations on April 17, 2019.

What this may mean for you:

  • While the new regulations help to clarify many outstanding questions investors may want addressed before investing in a QOF, the regulations are complex. We recommend that you talk to your legal, tax, and investment advisors before determining if these funds are right for you.

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The 2017 Tax Cut and Jobs Act included a long-term tax incentive for individuals to invest in economically distressed communities through Qualified Opportunity Zones (QOZs).  Initially the regulations that apply to QOZs were open to interpretation. To answer questions that many investors have about the rules governing QOZs, the Treasury issued a second set of proposed regulations on April 17, 2019. This update addresses investor questions that these new regulations help to answer. 

Though not final, investors may rely on the proposed regulations as long as a taxpayer “applies the rules in their entirety and in a consistent manner.” For more information on the basics of opportunity zones and the first set of regulations, see our accompanying Wealth Planning Updates. 

Individual investor’s questions

What’s the impact when interests in Qualified Opportunity Zone Funds (QOF) are gifted to other individuals or a trust? 

In general, if an investor gifts an interest in a QOF, it is considered an “inclusion event”, and will trigger recognition of the deferred gain.  The exception to this rule is that if an investor transfers their interest in the QOF to a trust that is treated as a “grantor trust” for income tax purposes.  Speak with your tax advisors before making any transfer of a QOF investment.  

The proposed regulations note that if the trust’s status changes to a non-grantor trust by election or some action by the Trustee or the trust grantor, then the deferred gain would be triggered at that point.  The exception to this rule is that if a trust changes to a non-grantor trust due to the death of the grantor (such as the passing of a revocable trust’s grantor), then the deferred gain is not triggered.

Is there a step-up in basis of their interest in a QOF if the investor dies before the new realization date? 

No, beneficiaries of a QOF do not receive a step up in basis on the deferred gain. The deferred gain is considered “income in respect to decedent” (IRD), which means it’s still taxable if the interest is sold before the realization date (i.e. 2026.) However, the proposed regulations allow the beneficiary to continue to defer the taxes until 2026 and maintain the decedent’s holding period for purposes of the 5 year, 7 year, and 10 year benefits.

What are the rules surrounding a QOF that sells QOZ property during the 10-year holding period?  

The new regulations provide that a QOF has a “12-month period beginning on the date of the distribution, sale, or disposition” of QOZ property to reinvest the proceeds into other QOZ property without the proceeds of the sale being treated as non-QOZ property (thereby causing the QOF to fail the 90 Percent asset test).  This rule clarifies that the sale of assets by a QOF does not jeopardize the investor’s holding period and allows a QOF to juggle multiple QOZ projects with different completion timelines or project durations.

What additional “inclusion events” could trigger the deferred capital gain prior to ten years? 

These events include: 

  1. Gifting your interest in a QOF (except to a grantor trust).
  2. Distributions to partners from the QOF that exceed the partner’s basis.
  3. Certain distributions from corporations to the extent they are treated as sales or exchanges; 
  4. Certain redemptions and liquidations; 
  5. Taxable distributions of a QOZ.
  6. If an inclusion event occurs, the taxpayer will include in gross income (minus the taxpayer’s basis) the lesser of (1) the fair market value of the investment that is being disposed; and (2) the proportional amount of the remaining deferred gain. 

There are more inclusion events and special exceptions to inclusion events that apply to different QOF situations involving S-corporations, partnership elections, and C-corporation provisions.  A discussion of the details of these inclusion events and the exceptions is beyond the scope of this article and QOF investors should seek the advice of legal and tax counsel for their specific situation.

Is a distribution from a QOF taxable? 

When a QOF distributes funds to its investors, such as excess profits for the year, then this distribution is taxable to the investor to the extent that the distribution exceeds the investor’s cost basis in the investment.  Each investor will initially have a $0 cost basis in the QOF investment.  An investor’s basis likely will increase when the QOF has taxable income from operations, utilizes outside debt financing, and upon reaching its 5-year, and 7-year anniversary dates.

Operation of QOF questions

Can a business operating within an Opportunity Zone qualify if revenue is received from customers outside the opportunity zone? 

At least 50% of the QOZ business gross revenue must be sourced from the active conduct of trade or businesses within the QOZ.  This second round of regulations provided three safe harbor exceptions which permit a QOZ business to remain qualified under the 50% “gross income requirement” test, if it meets one of the following:

  1. At least 50% of the services performed for the business are performed in the QOZ using employee and independent contractor hours .
  2. At least 50% of the services performed for the business are performed in the QOZ using the ratio of the amounts paid for the services to employees or independent contractors.
  3. The tangible property of the business is located in a QOZ and the management or operational functions performed in the QOZ are necessary for the generation of at least 50% of the gross income of the business.

What insight was provided regarding how businesses can meet the Working Capital Safe Harbor?

The Working Capital Safe Harbor regulation (introduced in the first round of proposed regulations) is helpful for QOZ projects that might take some time to develop. Such projects include those requiring property development, construction – including zoning changes and permits, or business development such as opening a franchise or other operating business.  The Working Capital Safe Harbor provides a 31-month window for a QOZ business to qualify for the 90% investment test as long as the business had a written plan laying out the plan, and presumes that the business will be working toward that plan.  The second round of proposed regulations add to the Working Capital Safe Harbor as follows:

  • That development of a trade or business also qualifies for the 31-month period (i.e. that the working capital safe harbor is not just for property and development projects).
  • That the working capital is actually used in a manner consistent with the written plan.
  • That delay of the business to implement before the end of the 31-month period is not a failure if the delay is the result of waiting for governmental action (such as local government zoning/permitting).
  • That a single business may have more than one working capital safe harbor plan and that these overlapping or sequential plans might be useful for different tranches of capital received by the QOZ business.

When do new investments in a QOF become subject to the QOF’s 90% investment test?

The regulations allow a QOF to disregard investments received within the prior 6 months so long as the QOF holds those investments in cash, cash equivalents, or debt instruments with terms of 18 months or less.  This allows a QOF to intake investments from taxpayers over time without needing to find immediate QOZ investments and provides a minimum of 6 months to locate a good investment.

What rules and guidance were established for valuing property? 

At a minimum, QOF’s may use the financial statement figures, or the unadjusted cost basis of the assets, if they don’t have a financial statement.  For leased property in a QOZ, the value is determined using the net present value of the lease payments using a discount rate percentage (Federal rate) that Treasury will provide.

What is the definition of “vacant property”?

In order for property to qualify as opportunity zone property, the original use must begin once the property is subject to depreciation or amortization.  The regulation allows for property to qualify, if it has been vacant for an uninterrupted period of 5 years subsequent to the new use within the QOZ.  The new original use begins on the date it is first used in the QOZ.

Real estate projects questions

What types of real estate activities (for example, triple-net leases) qualify as QOZ businesses? 

The proposed regulation states the ownership and operation of real property qualify as a trade or business.  However, the regulations state triple-net leases fail the definition.  Triple-net leases with respect to real estate owned by a taxpayer are specifically not classified as an active trade or business.

How can land meet the substantial improvement test?

Unimproved land does not need to be substantially improved.  However, it seems land needs to be more than minimally improved within the first 30 months after the date of purchase making clear that the practice of “land-banking” is not allowed.

What’s the treatment of property that straddles a QOZ and a non-QOZ?

The April regulations provide the necessary guidance to assist taxpayers in navigating this issue.  Under the proposed regulations, a property’s square footage would be the determining factor based on what ratio of the property is in versus out of the QOZ. So long as the square footage of the property in the QOZ is substantial compared to the property outside the QOZ and the property outside the QOZ is contiguous to part or all of the opportunity zone, then the property outside the opportunity zone is considered part of the property within the zone.

Next Steps

Even though the new regulations help to clarify many outstanding questions investors may want addressed before investing in a QOF, the regulations are complex. We recommend that you talk to your legal, tax, and investment advisors before taking the next step to determine if these funds are right for you.

All data is from IRS.gov unless otherwise noted.

Authors: Aaron Waites, Regional Wealth Planning Manager; Jason Walker, Senior Wealth Planning Strategist for Wells Fargo Private Bank; Michael Frost, Senior Wealth Planning Strategist for Wells Fargo Private Bank; Jennifer Proper, Senior Wealth Planning Strategist for Abbot Downing