In December 2018 and June 2019, we shared with you qualified opportunity zone (QOZ) talking points for holiday parties and Fourth of July BBQs. Since June, Treasury has released final QOZ regulations, which were published in January of this year. Here, we present to you updated (non-season–specific) QOZ talking points reflecting these final regulations, which were generally taxpayer favorable.

Investment in QOZs, Generally

In order to make a qualifying investment in a QOZ, an investor generally must "reinvest" capital gain into a special investment vehicle (called a qualified opportunity fund or QOF) within a certain 180-day period. An investor who makes a qualifying investment into a QOF receives up to three benefits: (i) deferral of paying tax on the reinvested gain until as late as December 31, 2026; (ii) after five years, effective reduction of the deferred gain by 10 percent; and (iii) after 10 years, effective permanent exclusion from tax of any additional gain on the sale of the investor's interest in the QOF. (Formerly, there was a fourth benefit: After seven years, effective reduction of the deferred gain by an additional 5 percent. However, this benefit effectively expired on January 1, 2020, as after that date there was less than seven years until December 31, 2026.)

Generally, a QOF is a business entity, organized for the purpose of investing in property located in a QOZ (generally, a designated low-income census tract). At least 90 percent of the assets of a QOF must be (i) QOZ business property (certain tangible property), or (ii) interests in special subsidiaries called QOZ businesses (which hold QOZ business property). Due to certain more favorable rules, almost all QOZ investments use a two-tier structure, with a QOF holding its property through an interest in a QOZ business entity.

New Timing Rules

In general, an investor has 179 days from the date of sale of property giving rise to capital gain to reinvest that gain into a QOF. The investor may also invest the gain on the date of sale, giving the investor a total period of 180 days.

Partnerships (including LLCs classified as partnerships for tax purposes) are eligible to reinvest capital gain. Additionally, under the proposed regulations, generally, investors who are partners in partnerships could reinvest their share of gain that a partnership did not reinvest. Partners could invest during one of two alternative 180-day periods: (i) the same period as the partnership, or (ii) the 180 days beginning on and inclusive of the last day of the partnership's taxable year (generally Dec. 31). The final regulations retained the rules of the proposed regulations and added one additional period for a partner to invest: (iii) the 180 days beginning on and inclusive of the unextended filing deadline for the partnership's tax return (generally March 15). (Analogous rules apply to S corporation shareholders and the beneficiaries of certain non-grantor trusts.)

Example: Adam is a 50% partner in partnership AB (a calendar-year taxpayer). On January 1, 2019, AB sells property and recognizes $100 in gain. As late as September 10, 2020 (the 179th day after AB's return deadline of March 15, 2020), Adam may make a qualifying investment of his $50 share of AB's gain (50% of $100) into a QOF.

In addition to the partnership changes, the final regulations now treat gains from the sale of property used in a trade or business (section 1231 gains) in the same manner as capital gains for timing (and all other) purposes.

The final regulations also clarified or liberalized the timing of reinvestment of gain from an installment sale (each payment begins its own 180-day period), and from the receipt of a capital gains dividend from a REIT or a mutual fund (shareholders may begin the 180-day period on the date of payment or on the last day of the shareholder's taxable year).

Sale of Real Property (Rather Than Entity Interests)

Under the proposed regulations, the 10-year benefit (effective exclusion from tax of all gain from appreciation in the investment) applied only to an investor's sale of its interests in a QOF, or the QOF's sale of property that it held directly. As most QOFs hold property through subsidiary QOZ business entities, this meant that most investors could get the 10-year benefit through a sale of entity interests (either of the QOF or the QOZ business) only.

The final regulations also permit the sale of property by an underlying QOZ business entity to qualify for these purposes. This liberalization will ease the structuring of multi-asset QOFs. However, the final regulations imposed an additional limitation: If the net proceeds from the sale of underlying property are not distributed, a portion of any subsequent sales of property by the QOF or its subsidiary QOZ business entity will not be eligible for the 10-year benefit. This rule was likely put into place to prevent QOFs from locking in capital in order to become vehicles for permanent tax deferral. However, as a practical matter, the net effect of the new rules will generally be helpful for QOFs.

QOF Disqualification Seemingly Limited to Abusive Cases

Under the statute and proposed regulations, it was unclear whether a QOF's failure of the 90% test would merely cause it to incur a penalty (subject to an exception for reasonable cause), or would cause a QOF from qualifying altogether (which would disqualify its investors' tax benefits).

Although they stop short of expressly stating it, the final regulations seem to indicate that non-abusive failures of the 90% test cause only the application of the penalty. This means that, even in its initial year of qualification, a QOF will generally not fail to qualify due to a good faith failure of the 90% test. This is particularly important because, as mentioned above, most QOFs have only one asset: an interest in a QOZ business entity. If the QOZ business fails to qualify, that means that the QOF will have 0% qualifying assets for purposes of the 90% test. However, absent abuse, this means a QOF will only be subject to a penalty, and not disqualification (even if it has 0% qualifying assets).

Conclusion

Continuing the trend of the proposed regulations, the final regulations provide practical interpretations of the law that will facilitate investment into QOZs. These regulations should largely give taxpayers the certainty necessary to proceed with their QOZ investments.

Ezra Dyckman is a partner at Roberts & Holland. Aaron S. Gaynor is an associate at the firm.