The newly created qualified opportunity zone (QOZ) development program has created great interest among investors, real estate developers and business owners in every state in the U.S. The program, created to help spur economic activity by investing in low-income neighborhoods in exchange for deferred capital gains, creates qualified opportunity funds (QOFs), which are partnerships or corporations formed specifically to invest in QOZs.
There are many factors to consider when determining whether to make the investment in QOFs. Investing your capital gains in a QOF can help defer taxes you’ll pay on the gains, but you’ll first need to understand the structure of the funds. With excitement growing among investors, we’ve highlighted 4 key considerations that you should know prior to investing:
- Direct and indirect (90 percent test)
- Substantial-all test
- Expanding current business
- Treatment of business with property/storage outside a QOZ
Before detailing each consideration, it’s important to understand QOZs and how you can save money. For more information, please see our related blog: Investors: Highway to the Opportunity Zone.
1. Direct and indirect (90 percent test)
The 90 percent test is applied by taking the average of the percentage of QOZ property held by the QOF on the last day of the first six-month period of the taxable year of the QOF and on the last day of the taxable year of the QOF. The QOF must also be certified by the U.S. Department of the Treasury.
If a QOF fails to meet the 90 percent test, it will be subject to a penalty for each month that it fails to meet the requirement. The amount of the penalty for each month will be the product of the excess of the amount equal to 90 percent of the QOF’s gross assets over the aggregate gross value of QOZ property held by the QOF, multiplied by the underpayment rate under Code Section 6621(a)(2) for such month (5 percent as of the date of this publication).
There is no penalty if the QOF’s failure to meet the 90 percent test can be shown to be due to reasonable cause. However, if there is a penalty and the QOF is a partnership, the penalty is taken into account proportionately as part of the distributive share of each partner. Even investors who have little control over the QOF’s investments would share in the penalty.
It should be noted that the 90 percent test applies to a QOF but does not apply to subsidiary partnerships or corporations in which the fund invests. The subsidiary entity must be a qualified opportunity zone business (QOZB) with substantially all (70 percent) of its property as qualified opportunity zone business property (QOZBP). If the subsidiary is a QOZB and the subsidiary is the only asset owned by the QOF, then the QOF will meet the 90 percent test.
2. Substantial-all test
To be considered an opportunity zone business, “substantially all” of the entity’s owned or leased tangible property must be qualified a QOZBP. Because the Act does not define “substantially all” for that purpose, the proposed regulations provide that, solely for the purpose of determining whether the tangible property is a QOZBP, the “substantially all” requirement is satisfied if at least 70 percent of the tangible property owned or leased by a trade or business is a QOZBP.
Under the statute, the rules for QOZBP apply to subsidiary entities only. The 90 percent asset test mentioned above only needs to be satisfied by the QOF. The regulations helpfully draw a bright line for the “substantially all” test, providing that the test will be satisfied if at least 70 percent of tangible property owned or leased by the business is QOZBP. Among other benefits, the 30 percent cushion provided by this rule allows a QOZ portfolio company to acquire a limited amount of tangible assets that do not satisfy the acquired-by-purchase requirement. This could include, for example, assets purchased from a related party, assets that have been acquired via a tax-free contribution to the QOZ portfolio company by a non-QOZ-fund partner or assets that will be used to support expansion activities outside the opportunity zone.
3. Expanding current business
A pre-existing entity is able to self-certify as a QOF, but the pre-existing entity must satisfy the requirements under Section 1400Z-2(d), which means that it cannot own a significant amount of tangible property that it acquired prior to Dec. 31, 2017.
In order to facilitate the certification process for a new entity and minimize the information collection burden placed on taxpayers, the proposed regulations generally permit any taxpayer that is a corporation or partnership for tax purposes to self-certify as a QOF, provided that the entity self-certifying is statutorily eligible to do so. The proposed regulations permit the Commissioner of Internal Revenue to determine the time, form and manner of the self-certification in IRS forms and instructions or in guidance published in the Internal Revenue Bulletin. It is expected that taxpayers will use Form 8996, QOF, both for initial self-certification and for annual reporting of compliance with the 90 percent test. It is expected that the Form 8996 would be attached to the taxpayer’s federal income tax return for the relevant tax years. The IRS released this form contemporaneous with the release of the regulations.
4. Treatment of business with property/storage outside a QOZ
A QOF must be an entity organized in one of the 50 states, the District of Columbia or a U.S. territory. If an entity is organized in a U.S. territory and not in one of the 50 states or the District of Columbia, the entity may be a QOF only if it is organized in order to invest in a QOZBP that relates to a trade or business operated in the U.S territory where it is organized.
Treasury’s explanation of these provisions acknowledges that it would allow an investment structure where as low as 63 percent of investment proceeds from a QOF could be invested in a QOZ tangible property. An example of this is as follows:
A QOF invests 90 percent of its investment funds in a QOZ business with the remaining 10 percent invested elsewhere. The QOZ business invests 70 percent of the funds it received (to meet the “substantially all” test) in tangible property located in the QOZ. Thus, 90 percent times 70 percent (or 63 percent) of the QOFs are invested in tangible property located in the QOZ.
Now that you’ve been introduced to the 4 considerations, you’re one step closer to determining whether investing in a QOZ is right for you. We are anticipating the issuance of additional guidance that may provide investors further clarity on the rules list above, so stay tuned.
Questions about this blog? Contact Eric L. McManus, CPA, at 440-449-6900 or email Eric.