Qualified Opportunity Zones: More of Your Questions Answered
Earlier this month, we invited you to send us your Qualified Opportunity Zone questions in advance of a panel we hosted on the cutting-edge tax issues surrounding this new program, which offers major incentives for those investing in economically distressed communities.
Attendees packed the newly renovated Stroock Conference Center in New York’s Financial District for a wide-ranging conversation with Mayer Greenberg, Jeff Uffner, Kevin Matz and Micah Bloomfield.
The event’s time limits, however, prevented us from getting to every one of your questions – particularly those submitted by the hundreds of attendees who joined us via live webinar, which is available for replay free of charge by clicking on this link.
But you’re still in luck.
On Nov. 29, we’re co-sponsoring another event in Manhattan, during which our lawyers will share their insights on the upsides and pitfalls of this burgeoning investment area. (Click here for more information and to register.)
In the meantime, here are our answers to some of the questions our panel couldn’t address in-person in the prior discussion.
(This article is for general informational purposes only and does not constitute legal advice. As many are aware, the law in this area is still evolving and the answers below may be changed or revised by the issuance of supplemental regulations or other pronouncements by the Treasury Department or the Internal Revenue Service. Please contact a lawyer directly if you need guidance on these topics.)
How is research and development handled after the initial Qualified Opportunity Fund investment or a QOF set up to perform R&D?
There must be an active trade or business. Assuming that there is, R&D expenses (that do not lead to assets) would not be factored into the QOF’s ability to meet the asset test, as the asset portion of the QOZ Business test considers only the business’s tangible property. Note that unless the investor contributes non-rollover capital into the QOF, the investor will not generally have sufficient tax basis to claim deductions for the R&D expenses (assuming the QOF is formed as a tax partnership).
Are both short-term and long-term gains deferred?
Are the gains kept in the same form, or are they all made short-/long-term based on the time when the gains are realized?
Per the proposed regulations, they are the same form, so e.g., short-term capital gain remains short-term capital gain.
What is the risk to the investor if the QOF does not follow the rules (i.e. 90% rule), or falls out of compliance with such a rule at a later time?
Unclear. It would appear that the penalty is the QOF’s to bear. We have not seen any direct authority suggesting that the investor’s QOZ benefits would be jeopardized, although there are certain ambiguities surrounding the QOF reinvestment mechanics that have yet to be addressed by the Treasury Department.
If a short-term gain is invested in a QOF, is it then considered a long-term gain by the time 12/31/2026 comes to pay the tax?
No. (See third question above.)
If you have a gain that will be realized over a number of years (installment sale) would you need to invest the entire gain within 180 days of the initial transaction even though only a portion has been realized? I assume yes, but have not seen it directly addressed.
Unclear. The statute refers to the date of the sale or exchange, but the proposed regulations refer to the date upon which the gain is recognized (which in the case of an installment sale would be over time).
Does a loan (from rollover gains) made to a QOZ business to build a new manufacturing facility on QOZ property qualify as a qualified investment in an opportunity zone by the QOF?
No – a QOZ investor’s rollover gain must be an equity investment in the QOF for the investor to benefit. Note, however, that (at the QOF level) a QOF may use funds from any source to satisfy its asset requirements.
Does the law allow the QOF to churn properties within the fund as long as the profits are reinvested in the QOF?
Yes, assuming the QOF’s assets post-reinvestment continue to meet the 90% asset test (which is not necessarily simple). However, the QOZ benefits do not prevent taxable gain being recognized on interim sales by the QOF. So if the question is whether the QOF can engage in such sales without any potential adverse tax consequences, the answer is no. (Some practitioners anticipate that there may be further guidance from Treasury on this, but hard to say for sure.)
Can an existing LLC that’s already operating a business make an election to “convert” into a QOF so any new cash investments made into the business can benefit from QOF tax benefits (although the original investments would not benefit)?
Yes, provided it can meet the 90% asset test. (Remember that all qualifying assets must be acquired after 2017 by purchase and meet the original use or substantial improvement tests.)
If a QOF is sold during the year 5-year, 7-year or 10-year hold periods (with regard to each of the respective benefits), can an investor reinvest the funds into a new QOF and maintain the original timetable?
Likely not. The regulations do permit the rollover of a QOF investment into another QOF investment, but there is no authority on whether the holding period would “tack.” Accordingly, most practitioners seem to agree that the proper reading of the statute and regulations would not permit a tacked holding period.
Are there any restrictions on refinancing buildings in a zone? Any restrictions on refinance proceeds?
No explicit restrictions. However, QOZ investments have a zero basis, which can create challenges regarding distribution of the refinancing proceeds. The interaction between debt and basis (particularly in the case of a partnership, where partners are typically allocated basis for their respective share of partnership debt) has yet to be fully clarified by the Treasury Department. Most practitioners seem to think there will be some way in which partnership debt basis can provide the ability to distribute refinancing proceeds from a QOF, but this is one significant point on which further guidance is anticipated.
Hypothetical: “Client” owns “Land” worth $20M located in a QOZ (and Client has owned the Land for decades). Client desires to put the Land in a “JV” and develop the Land (probably through some sort of money or development partner), which Client expects could be worth substantially more once developed. I understand that Client cannot benefit from any gain deferral, because Client is not rolling capital gain into a QOF (i.e., they are contributing real property). Client could, however, draft the JV agreement in such a way that the entity will seek to qualify as a QOF at such time that a new partner invests in the JV (to attract a partner). There wouldn’t be any benefit to the JV self-certifying as a QOF until such partner came along, though, at which time the JV could, in effect, select the date it qualifies as a QOF. At that time, new partner would start their holding period under the QOF rules for any gain it invests in the JV within 180 days of its previous property’s disposition. Am I understanding the QOF rules correctly where the QOZ Property is contributed to the QOF (not purchased)?
Business property that is contributed to a QOF is not treated as QOZ Business Property: By definition, QOZ Business Property must be acquired by purchase after Dec. 31, 2017. However, the fact that the Land in your example does not qualify as QOZ Business Property does not strictly preclude the JV from otherwise satisfying the 90% test and qualifying as a QOF. While it is more difficult to make use of land historically owned by the “Client,” your desired objective may still be achieved through careful tax structuring and planning.
(Also, to the extent the question relates to the timing of the QOF election, the question writer’s understanding of that aspect appears to be generally correct.)