A great tax benefit enacted as part of the Tax Cuts and Jobs Act of 2017 is the Qualified Opportunity Fund (QOF).
Taxpayers who reinvest capital gains into one of these funds can defer federal income taxes on the reinvested capital gains, including Section 1231 gains from selling business assets that are taxable as capital gains, for up to eight years until the earlier of the date on which the qualified investment is sold or exchanged or December 31, 2026. In addition, the additional gain relating to the appreciation of the Qualified Opportunity Fund may be tax free, provided an election is made and the investment is held for more than 10 years.
If the QOF is held at least 5 years, 10% of the reinvested deferred gain will be tax free. If the QOF is held at least 7 years, an additional 5% of the reinvested deferred gain will be tax free. These adjustments are accounted for as tax basis adjustments — adding the tax free amounts to the taxpayer’s cost of the investment in the QOF.
The IRS issued proposed regulations for these funds during October, 2018. Now they have issued additional proposed regulations (REG-120186-18 to be published shortly in the Federal Register) and are asking for more feedback from the tax return preparation and consulting community. Another public hearing is scheduled for July 9, 2019 at 10 a.m.
The new proposed regulations provide answers to many questions relating to Qualified Opportunity Funds, and are mostly favorable to taxpayers. I can only cover a few highlights. My printout of the regulations and preamble is about 168 pages. Here are a few key points.
- The ownership and operation (including leasing) of real estate is the active conduct of a trade or business. A triple-net lease is not the active conduct of a trade or business. This broad acceptance of real estate leases as a trade or business only applies for applying the rules for Qualified Opportunity Funds.
2. Only net capital gains and net Section 1231 gains (from sales of business assets) that are taxed as capital gains qualify for deferral by reinvestment. Since net Section 1231 losses are taxed as ordinary losses, the 180-day reinvestment period for net Section 1231 gains begins at the end of the taxable year when the sale of Section 1231 property was closed.
3. If there is an “inclusion event”, any remaining reinvested deferred capital gains and Section 1231 gains will become taxable if the investment hasn’t already been held until December 31. 2026.
4. If an S corporation that invests in a QOF has aggregate change of ownership of capital interests of more than 25%, there is an inclusion event.
5. A conversion of an S corporation to a partnership or disregarded entity or a C corporation is an inclusion event.
6. A taxpayer’s transfer of a qualifying investment by gift, whether outright or in trust, is an inclusion event.
7. A taxpayer’s transfer of a qualifying investment to a revocable living trust (grantor trust) is not an inclusion event, because the trust is disregarded for income tax reporting and the taxpayer is considered to continue to own the investment. The trust becoming irrevocable can be an inclusion event, but see item 8.
8. The transfer of a qualifying investment to a beneficiary of an estate or trust as an inheritance is not an inclusion event. Remaining reinvested deferred income is potentially income with respect of a decedent. The beneficiary steps into the shoes of the decedent relating to when the income will be taxable.
9. A corporate subsidiary that is a QOF is not eligible to be included in a consolidated income tax return.
10. A corporate parent that is a QOF is eligible to be included in a consolidate income tax return.
11. A taxpayer may invest amounts exceeding capital gains and Section 1231 gains that are eligible for deferral in a QOF. The excess investment will be separately accounted for as a separate interest that is not eligible for QOF tax benefits. (Any gain relating to that share will be taxable.)
12. Distributions by QOFs can be inclusion events. For example, if a QOF partnership or S corporation borrows money and distributes funds exceeding their tax basis to its partners (remember most QOF interests will start with a basis of zero, because there is no tax basis for the deferred gains that are reinvested in the fund), the distributions will be an inclusion event. (Distributions of operating income should be handled carefully. Remember you can have positive cash flow when you don’t have taxable income because of noncash deductions, like depreciation.)
13. Special rules are provided for mergers, recapitalizations and reorganizations. They are beyond the scope of this summary. See your tax advisor.
14. Used property leased tangible property that was previously not used for a depreciable purpose for at least five years can be eligible “original use” QEF property.
15. The proposed regulations include fairly liberal “substantially all” definitions for various limitations. They are beyond the scope of this summary. See your tax advisor.
16. Leases shouldn’t include prepayments for more than a year.
17. The proposed regulations include valuation guidelines for tangible property when applying the test requiring 90% of the property of the QOF to be used in the Qualified Opportunity Zone. The QOF may either use the value for a qualified (audited) financial statement or cost and present value of lease payments as of the inception of the lease. The property doesn’t have to be revalued each year.
18. QOFs are required to annually pass a 50% of gross receipts test. A least 50% of the QOF’s gross income must be earned in a Qualified Opportunity Zone. Under the regulations, the gross receipts aren’t tested based on where the customer is located, but on where the work is done to produce the products or services. That means sales from reselling products produced overseas won’t be qualified income. Just having a post office box located in a Qualified Opportunity Zone doesn’t mean the business is considered to be located there.
19. Unimproved land won’t be considered qualifying property unless plans are in place to substantially improve the land within 30 months.
The IRS says they will be issuing more proposed regulations for QOFs soon.
These proposed regulations are critically important for taxpayers to realize the tax benefits that they are counting on when making investments in QOFs.