Article written by:
Darci Congrove, CPA
Qualified Opportunity Zone Update
IRS Public Hearing Held on February 14
The 2018 tax filing season is in full swing, which means that tax professionals across the country are in the midst of applying the provisions of the 2017 Tax Cuts and Jobs Act to actual tax returns for the first time. One of the more interesting provisions included in that Act is Internal Revenue Code section 1400Z-2, the Qualified Opportunity Zone (QOZ). Established to encourage long-term capital investment and job creation in distressed communities, the QOZ has attractive tax deferral and exclusion provisions for investors.
As a brief overview of the QOZ, taxpayers may elect to defer the tax paid on capital gains that are invested in a Qualified Opportunity Fund (QOF) within 180 days of gain recognition. The QOF must invest 90% of its capital in QOZ Property. Taxpayers who hold investments in a QOF for longer than 5 years may exclude 10 percent of the original deferred gain from taxable income, and investments held for more than 7 years qualify for an additional 5 percent exclusion. The real benefit, however, is that post-acquisition appreciation on qualifying investments held in a QOF for longer than 10 years are permanently excluded from tax. For more details on the specific requirements of QOZ investments, see GBQ’s October Tax Alert here.
Treasury released the first set of Proposed Regulations in October 2018 with a 60-day period for practitioners and investors to provide public comments. On Thursday, February 14, the IRS held a public hearing on QOZs (postponed from January 10 due to the partial government shutdown). Witnesses at the hearing included people representing all facets of those potentially impacted by QOZs, ranging from economic development professionals to state and community economic development agencies and investment funds.
The hearing drew a crowd so large that many who were not scheduled to testify were turned away, which indicates that the QOZ program is viewed as a very attractive incentive. More than 20 witnesses gave testimony over a period of almost 5 hours. This testimony, as well as the more than 150 comment letters submitted, will help form future Regulations for QOZs. Most witnesses spoke favorably about the QOZ program, its significant tax incentives, and its potential to transform distressed areas across the country.
However, the hearing clearly identified the need for guidance from Treasury and the IRS on several common themes that are currently preventing investors and developers from proceeding with QOZ projects:
- Congress clearly intended for operating businesses to be beneficiaries of QOZ capital investment. As written, the Proposed Regulations provide a fairly clear roadmap for investments in real estate, but make it difficult for QOFs to invest in other types of businesses.
- In addition, the Proposed Regulations currently provide that a QOZ business must be at least 70% within a QOZ to qualify and at least 50% of its gross receipts must be from the conduct of its business within the QOZ. The latter provision may cause certain kinds of businesses, like manufacturers, to fail to meet the test.
- The QOZ rules require that QOFs deploy their investment capital within 6 months, and that the capital remain invested for 10 years in order to realize the full benefit of the tax exemption provisions. These rules may limit a newly-formed fund in its ability to raise capital, and make it impractical to form multi-asset funds, which allow investors to spread risk through diversification. These issues have the potential to limit the capital flow into QOF deals.
- An additional concern about the 10-year requirement is that some assets may necessitate liquidation prior to the expiration of that period. It is preferable that QOFs should be allowed to reinvest gains within a reasonable time in other QOZ Property without creating a taxable event.
- Another question is whether a project could refinance during the 10-year window and distribute the proceeds of the refinancing to investors without violating the 10-year holding period.
- The Proposed Regulations reference “original use property,” which requires clarification. Witnesses proposed that vacant land or property not in service for at least a year should satisfy the original use requirement in order to take advantage of the very real situation of idle or abandoned assets in distressed areas.
- Witnesses also requested that the IRS provide rules for clear reporting so that funds and investors can make well-informed decisions and there is a mechanism for tracking the effectiveness of the program.
The IRS officials at the hearing last week only listened. They did not provide any answers. IRS will continue to review the comments from the first round of Proposed Regulations and indicated that a second round is expected to be released “shortly.”
Two other recent developments that should be viewed favorably regarding the pace and focus on addressing QOZ issues in Washington:
- Congress sent a bipartisan letter to Treasury Secretary Mnuchin on January 24, 2019, which was signed by all of the original sponsors of the QOZ bill. The letter’s purpose was to clarify Congressional intent to create new jobs and higher wages in low-income areas throughout the country. This “comfort letter” can be used by Treasury in its rule-making process to support the language in the original legislation.
- IRS released instructions on how to implement QOZ Form 8996, which is the form that a QOF must use to certify that it is organized to invest in Qualified Opportunity Zone property and that it meets the requirement that at least 90% of the fund’s assets are invested in qualifying property. These instructions leave some questions unanswered, but signal that Treasury and the IRS are trying to address some of the key items in the legislation that concern taxpayers.
Overall, the QOZ program continues to be very attractive. It is more flexible than other tax incentives for economic development, it is a self-certification program, and more than 8700 census tracts across the country are included. Investors should exercise caution that most states have not yet indicated whether they will conform to federal law in the treatment of QOZs, so state treatment may vary.
GBQ will continue to monitor these issues and provide timely updates. For more information, or to understand how these rules may apply to you, please contact a member of the GBQ tax team.