The Federal Tax Cuts and Jobs Act (the “Act”), which became effective on January 1, 2018, created Qualified Opportunity Zones (QOZs) as a tool for promoting long-term investments in low-income communities. Through this program, investors are provided significant tax benefits for investing in businesses and in real estate located in QOZs. These tax benefits can include the deferral, the reduction, and the potential elimination of capital gain taxes.
Governors of all fifty states, the District of Columbia, and the five U.S. possessions have designated more than 8,700 QOZs, which consist of certain low-income community census tracts as well as certain tracts adjacent to low-income tracts. There is an interactive map showing Pennsylvania’s 300 QOZs on the website of the Pennsylvania Department of Community and Economic Development- dced.pa.gov/program-funding/federal-funding-opportunities/qualified-opportunity-zones.
Under the Act, an investor is eligible for QOZ tax benefits if the investor (i) recognizes capital gain, (ii) then invests cash in an amount equal to the capital gain in an entity that qualifies as a “Qualified Opportunity Fund” within 180 days of the date the gain is recognized, and (iii) then makes an election (on IRS Form 8949) to treat the investment as a QOZ investment.
The tax benefits available under the Act include the following:
- Deferral of tax on the rolled-over gain until the earlier of the date the investor sells his or her interest in an entity which is a Qualified Opportunity Fund or December 31, 2016.
- 10% of the investor’s roll-over gain is permanently eliminated if on or before December 31, 2026, the investor holds his or her interest in the Qualified Opportunity Fund (QOF) for at least five years. Another 5% of such gain is permanently eliminated if the investor holds his or her interest in the QOF on or before December 31, 2026, for a total of seven years (total gain elimination of 15%).
- If the investor holds his or her QOF interest for at least ten years, the investor will pay no tax on any gain recognized when the QOF interest is sold.
To be a QOF, an entity must satisfy three tests: (i) the entity must be organized as a corporation or partnership for tax purposes (a limited liability company will qualify since it can be treated for tax purposes as either a partnership or a corporation); (ii) the entity must be an entity formed for the purpose of investing either directly or indirectly (through a subsidiary) in QOZ Property; and (iii) at least 90% of the entity’s assets are invested in QOZ Property.
QOZ Property is defined as either an entity interest in a subsidiary partnership or corporation that operates a QOZ Business, or QOZ Business Property.
For a QOF’s subsidiary to be a QOZ Business, (i) at least 70%, of its tangible property must be QOZ Business Property, (ii) it must not be a golf course, country club, massage parlor, hot tub facility, suntan facility, racetrack, or other facility used for gambling, or any store the principal purpose of which is the sale of alcoholic beverages for off-premises consumption, (iii) no more than 5% of its assets can be nonqualified financial assets (e.g. cash, stock, bonds, partnership interests, and options etc.), (iv) at least 70% of its intangible assets must be used in the active conduct of its trade or business, and (v) at least 50% of its gross income must be from the active conduct of a trade or business.
QOZ Business Property is property purchased by a QOF or by a subsidiary of a QOF (which is a QOZ Business) from an unrelated person (related means more than 20% common ownership) after December 31, 2017. In addition, (i) the original use of such property in the QOZ must commence with the QOF or its subsidiary that is a QOZ Business, or (ii) the QOF or its subsidiary that is a QOZ Business must substantially improve such property.
There are a number of other technical requirements that must be met to qualify for the tax benefits relating to QOZs. The IRS is expected to issue additional regulations in the near future, and our office is closely following the developments relating to this new law. Please call us if you have any questions or if you need any assistance relating to Qualified Opportunity Zones and Qualified Opportunity Funds.