The Qualified Opportunity Zone Proposed Regulations: My Commentary

On October 19, 2018, the IRS published their proposed regulations corresponding to Section 1400Z-2 of the Internal Revenue Code, which set forth the tax benefits of the Qualified Opportunity Zone (QOZ) program. If you don't know what the QOZ program is, you've literally been living under a rock; it's the greatest government-sponsored tax shelter in American history, a game-changer so seismic that it has the potential to affect the flow of trillions of dollars of investment capital. In this rather long post, I'll be explaining what the QOZ program is and how it works, just to educate those of you who have, in fact, been living under a rock or only have a passing familiarity with the concept. The good part for most of you, though, will be my thorough rundown of what the proposed regulations say and their many planning implications.

Okay, I've been living under a rock. What is this QOZ program all about?

The QOZ program was part of the Tax Cuts and Jobs Act of 2017. The program represented the culmination of a years-long effort by a lobbying outfit called the Economic Innovation Group, which boasts Sean Parker as an officer (yes, that Sean Parker -- the Napster guy and the one Justin Timberlake portrayed in the Facebook movie). The idea behind the program was to stimulate investment into high-poverty, low-income areas of the country through tax incentives (as it turns out, really strong tax incentives). This would theoretically stimulate both the left and the right; the victory for the left's constituency is the investment that would flow into areas that make up a core part of their demographic, and the victory for the right's constituency is another big tax incentive to be seized by a core part of their demographic. This is not unlike conservation easements; the left claimed a victory for environmentalism, and the right claimed a victory for tax reduction.

Amid all the hoopla about tax reform in general -- and prominent changes such as the pass-through deduction and the doubling of the estate and gift tax exemption -- QOZs initially received little attention in the weeks after President Trump signed the tax bill into law. But as the advisor community and (eventually) the public slowly woke up to how powerful the QOZ program really was, interest has gradually intensified to a fever pitch.

The basic way the QOZ program works is as follows:

• The Treasury Department tasked the governors of all 50 U.S. States and all U.S. territories (Puerto Rico, American Samoa, Guam, etc.) with designating QOZs. These QOZs had to be high-poverty, low-income areas, or contiguous communities to these types of areas that also met certain requirements (for those of you familiar with the New Markets Tax Credit areas, the QOZ program piggybacked off those criteria). All of the QOZs are "census tracts," or little subdivisions of each county carved out for purposes of conducting the U.S. census every 10 years. Importantly, all the QOZ designations expire on December 31, 2028.
• By mid-summer, every single governor had successfully submitted candidate QOZs to Treasury, and Treasury ended up certifying all of the QOZs. Looking for a map of where these things actually are? You can find it here, on Treasury's website. There are QOZs in every county in America.
• In exchange for taking otherwise "stagnant capital" and redirecting it into a proper QOZ investment, taxpayers will receive what I consider the strongest tax incentives this country has ever seen. I detail the mechanics in the following section.

So what are the tax benefits of investing in a QOZ?

Here's how the tax incentives work:

• In order to receive tax incentives, I have to invest deferred gain from the sale of a capital asset. And this really means any capital asset -- investment real estate, closely held business interests, publicly traded securities, artwork and other collectibles, and alternative investments (private equity fund interests or hedge fund interests, for instance). Like a Section 1031 exchange, I have 180 days to reinvest. The regulations provided lots of details about this that I cover later on.
• If you're used to 1031 exchanges, you might be thinking that QOZs work the same way -- you have to reinvest your entire gross sales price of the capital asset in question. And you'd be wrong -- you can actually take back your adjusted basis amount tax-free and only reinvest the portion corresponding to capital gain. You also don't need to put your money in escrow; you can take your cash back and leverage against it, so long as you reinvest the same amount of cash as equity in a QOZ before the 180-day deadline is up.
• I can't just reinvest directly into a QOZ. Instead, I have to reinvest through a Qualified Opportunity Fund (QOF). That sounds complicated, but it really isn't -- a QOF can be any entity organized as a tax corporation or a tax partnership (including LLCs, except for LLCs that have only one member and are taxed as disregarded entities). The QOF has to be organized for the exclusive purpose of investing in QOZs. All QOFs will self-certify by filing a one-page form with the IRS (more on that later).
• QOFs have to invest in any combination of two types of assets. First, they can invest directly in tangible or real property located in a QOZ. Or second, they can invest in "QOZ businesses," which are corporations or partnerships formed for the purpose of conducting an active trade or business in a QOZ. These QOZ businesses have to own or lease most of their property in a QOZ and derive at least half their income from a QOZ, among other smaller requirements.
• But regardless of whether the QOF invests directly in property or invests in a QOZ business, most of the property has to meet certain important criteria. First off, the property has to be owned or leased from an unrelated party after December 31, 2017. So if you already own property within a QOZ, you can take solace in knowing its value probably just went up quite a bit (or you could do special tax planning to qualify, but I will not go over that in this post; contact me directly if you want to discuss this). Second (and this is really important), the property has to be either "originally used" or "substantially improved" within the QOZ. The statute was clear about this much: "original use" means the QOF was the first one to use that particular property within the QOZ (as opposed to being the first to use it at all -- the QOF could relocate property from outside the QOZ into the QOZ). It also said "substantial improvement" meant the QOF needed to spend at least as much money improving the property as it did purchasing the property (there's a 30-month deadline). For instance, if a QOF bought a dilapidated building for $1 million, a QOF would have to spend $1,000,001 or more either gut renovating or developing the property to qualify it for tax benefits. This meant taxpayers couldn't simply buy a rental property and continue operating it as is. Think of it this way: Congress wanted QOFs to bring jobs to the QOZ, not just put money in existing property owners' pockets. But the statute's description of this was limited, and taxpayers clamored for more guidance... which the proposed regulations kinda-sorta gave us. Again, more on that later.
• Now for the real juice: there are three time horizons at which investors in a QOF get the major tax benefits.

1. If a taxpayer invests prior to December 31, 2021, then the taxpayer gets 10% of her deferred capital gain forgiven from all taxes after five years of holding an interest in a QOF.
2. If a taxpayer invests prior to December 31, 2019, then the taxpayer gets an additional 5% (15% total) of her deferred capital gain forgiven from all taxes after seven years of holding an interest in a QOF.
3. And finally, the 800-pound elephant: if a taxpayer invests prior to June 30, 2027, then the taxpayer has all profit on the QOF investment COMPLETELY FORGIVEN FROM ALL INCOME TAXES after ten years of holding an interest in a QOF, as long as the taxpayer sells before December 31, 2047.

Note that if I haven't sold my QOF investment by December 31, 2026, I recognize whatever part of my deferred capital gain hasn't been forgiven beforehand (by virtue of the five- or seven-year holding benchmarks described above). So on April 15, 2027 (when I file my 2026 IRS Form 1040), I'll pay the taxes on whatever part of my deferred capital gain hasn't been forgiven, come hell or high water. If I haven't sold (and I probably won't, because I really want that ten-year holding period incentive), then I have what's known as a "phantom income event," meaning I owe taxes but don't have the corresponding cash. More on this later.

This calls for an example. Let's say I own some stock in Facebook. My adjusted basis is $500,000. The Facebook stock sells for $1,500,000 on July 1, 2018, representing a $1,000,000 capital gain. I take back my $500,000 adjusted basis amount tax-free. I have until December 31, 2018 to reinvest $1,000,000 in a QOF in order to get complete deferral of income taxes on my capital gain. We'll call this $1,000,000 gain the deferred capital gain (DCG) amount.

I end up making a $1,000,000 investment into a QOF on November 1, 2018. Because my capital gain is deferred, I do not have any basis in my QOF investment. On October 31, 2023, as long as I haven't had a recognition event earlier, my basis gets adjusted to $100,000 (which is 10% of my DCG). On October 31, 2025, if I still hold my QOF investment and I haven't had a recognition event, my basis gets adjusted to $150,000 (which is 15% of my DCG). On December 31, 2026, the long-term capital gain that hasn't been forgiven -- or $850,000 (which is $1,000,000 minus my $150,000 step-up in basis) -- becomes due and reportable on my 2026 IRS Form 1040. My basis in my QOF investment becomes $1,000,000. And finally, on or after October 31, 2028, I can sell my QOF investment for however much I want before December 31, 2047, and I DO NOT PAY INCOME TAXES ON MY PROFIT. EVER.

• I can combine these tax benefits with any other tax benefit available under the Code. Tax-free profit and the New Markets Tax Credit, or the Low-Income Housing Tax Credit, or the Historic Rehabilitation Tax Credit? No problem. Tax-free profit and Section 1202 Qualified Small Business Stock? Nothing in the statute or regulations says that you can't have both (there are some clashes with the two statutes, but we can make that work). Tax-free profit and state/local subsidies or tax incentives? Have at it. Tax-free profit and bonus depreciation? Sure, as long as your QOF investment has sufficient outside basis (which you can get from debt shares) and you meet the other requirements under the Code.

I'm a sponsor looking to start a QOF, or I want to just start a QOF for my own investment and not accept any outside capital. What do I need to know?

• The QOF files Form 8996 with the IRS to self-certify. Check out a draft form at this here link and draft instructions for filling out the form right over here.
• The QOF needs to invest at least 90% of its assets in qualifying property. I went over that above -- a lot of this revolves around the "original use" and "substantial improvement" requirements. What does that basically mean? You can't just buy existing real estate or an existing business already within a QOZ, then just sit on the investment. You need to either gut renovate the real estate or develop new real estate from the ground up. For businesses, you need to start a new one or relocate an existing one from outside the QOZ into the QOZ.
• The QOF will have this 90% requirement tested twice a year: for calendar year funds (that'll be almost all of them), the testing dates are June 30 and December 31. If the QOF doesn't have at least 90% of its assets in qualifying property, there's a penalty that nobody wants to incur. If you're out of compliance long enough, the IRS can decertify the QOF. The proposed regulations cleared up almost all the mystery behind the 90% test.

The Long-Awaited Proposed Regulations

Since the statute was part of a tax reform bill that was literally drafted over the course of a few weeks, it was frustratingly ambiguous (read: poorly drafted) and punted much of the sorely needed clarification to the IRS. The IRS wisely chose to take the regulations in stages -- this is the first of what will be several rounds of proposed regulations on QOZs. We got some great guidance on certain aspects of the statute, and we'll have to wait for clarification on some other ones. Time to get super technical...

• Only Capital Gains are Eligible: The proposed regulations clarified that only capital gains are eligible for deferral, not ordinary gain. So no "flipped" property, and no sales of sponsor units in a condo. What's frustrating about this is that there's no guidance on how ordinary income recapture or Section 751 income will be treated, and there's no equivalent of "boot netting" or "debt replacement," like there is in a Section 1031 exchange. However, capital gains with higher tax rates are available for deferral into a QOZ, including collectibles gain (hello classic cars and artwork, which ohbytheway just became ineligible for Section 1031) and unrecaptured Section 1250 gain (you probably know this as "25% gain" if you're in real estate).
• There's No Restriction on the QOF Capital Stack: While debt investments in a QOF aren't eligible for tax benefits, any equity investment is OK. Carried interest? Check. Preferred equity? Check. Waterfall or mezzanine equity structures? Check. Throw a party if you're in private equity... this is a big victory.
• The 90% Test Gets Fleshed Out:

1. Turns out the first 90% test will be applied either six months after the fund is formed or December 31 of the same year, whichever is sooner. For instance, if I form a fund on April 1, my first testing date is October 1. If I form a fund on October 15, though, then my first testing date is December 31. In every subsequent year, I conduct the 90% test on June 30 and December 31.
2. The 90% test will either use the financial statement value of property (for companies required to prepare them every year) or initial cost of the assets. This leaves for some interesting loopholes -- since 10% of a QOF's property can be non-qualified, you might be able to sneak in QOZ tax benefits for equity in a startup company, intangibles, or other property not really meant for these benefits. (Note this is a nice candidate for the IRS to change it up prior to finalizing the regulations, so be careful)

• There's a "Working Capital Safe Harbor" that Applies for QOZ Businesses and Might Apply for the 90% Test Also: This answers the general question, "What do I do about the 90% test when there's a 30-month period to substantially improve QOZ property?" If the QOF invests through a QOZ business (typically an LP or LLC held by a QOF), then as long as the QOZ business has a written plan and concrete schedule to deploy its capital in compliant fashion -- and it actually ends up sticking to the plan and schedule -- then working capital won't count when conducting the 90% test. This is a huge development for real estate QOFs. But here's the thing -- I don't think this allows for $500 million mega-funds like the ones announced by Goldman Sachs, RXR, and other big industry players. By my count, I think everyone still has to stick to single-asset real estate funds to achieve compliance. With huge funds, it'll be too hard to fulfill this compliance requirement.
• THE DEFERRAL RULES FOR ENTITIES ARE HUGELY TAXPAYER-FAVORABLE: For any pass-through entity -- a partnership, a multi-member LLC, an S-Corp, or even estates and trusts -- QOZ deferral could be elected by either the entity itself or by its individual equity holders. In my opinion, this is the biggest bombshell in the proposed regulations. To illustrate, let's say I have a six-member real estate holding LLC taxed as a partnership. The LLC then sells its real estate on November 1, 2018. The proposed regulations present a nice choice: either the LLC itself could elect QOZ deferral, or each of its six members could separately elect to pay taxes or defer into a QOF. Unlike a Section 1031 exchange, I don't need to "drop-and-swap" the property in my pass-through entity. THIS ALSO MEANS YOU CAN BREAK UP A REAL ESTATE S-CORP WITHOUT A TAXABLE EVENT. Remember all those problems when different shareholders of an S-Corp wanted to go their separate ways, and you couldn't swing it because Section 311(b) made liquidating the S-Corp a taxable event? Forget that now -- individual shareholders can either cash out or elect QOZ deferral without any effect on the other shareholders. FOR REAL ESTATE INVESTORS STUCK IN AN S-CORP, THIS IS A ONCE-IN-A-LIFETIME OPPORTUNITY TO GET OUT OF YOUR S-CORP THAT YOU CANNOT MISS.
• THE RULES AROUND THE 180-DAY CLOCK ARE ALSO HUGELY TAXPAYER-FAVORABLE:

1. Here's the way everyone thought this would work: even if you were an equity holder in an LLC or corporation, you'd need to find out when the entity recognized capital gain, and the 180-day clock would start upon that date.
2. Not so - the 180-day clock can either start on (1) the actual date the entity recognized gain, or (2) the end of the taxable year (December 31), at the taxpayer's election. THIS IS AMAZING.
3. Example 1: I'm a member in a real estate holding LLC taxed as a partnership. The LLC sells its real estate on June 15, 2019. I get distributed my cash on September 15, 2019. I reinvest my capital gain into a QOF on April 15, 2020. I'm good to go -- I can elect to have my 180-day clock start on December 31, 2019, so I'm within my 180-day window.
4. Example 2: I'm a member in a real estate holding LLC taxed as a partnership. The LLC sells its real estate on June 15, 2019. I get distributed my cash on September 15, 2019. I reinvest my capital gain into a QOF on November 15, 2019. I'm still good to go -- I now elect to have the 180-day clock start on June 15, 2019, leaving me until December 15, 2019 to reinvest. If I elected the clock to start on December 31, 2019, note that I wouldn't get QOZ tax benefits in this case -- I'm deemed to recognize capital gain after I made my QOF investment, which is no good.
5. Example 3: I'm an LP investor in a hedge fund. I have no idea what kind of buying and selling activity occurs during the 2019 taxable year. I get my K-1 for 2019 on February 1, 2020. No problem -- I have until June 30, 2020 to reinvest any capital gain incurred inside the hedge fund in all of 2019.
6. So yes, this means that as long as you're an equity holder in a pass-through entity, you could potentially have as long as 18 months to reinvest into a QOF (e.g., you might have until June 30, 2020 to reinvest gain incurred on January 1, 2019).
7. Keep in mind this election only applies to pass-through interest holders. So if you're an individual taxpayer or a C-Corp incurring capital gain directly, your 180-day clock starts on the day you recognize your capital gain, period.

• Substantial Improvement Threshold Won't Include Land: Remember that "substantial improvement" requirement from earlier, which required a QOF to spend at least as much on renovation/development of QOZ property as it did on acquisition within 30 months of purchase? Well, the amount the QOF needs to spend only needs to exceed the purchase price of the BUILDING, not the LAND. Example: if I purchase property for $100, but $40 is attributable to the land and $60 is attributable to the building, then I need only spend $61 or more renovating the building to qualify it as QOZ property. Where there's some ambiguity is how the land will figure into the 90% test, considering the IRS said in the proposed regulations that land cannot ever be "originally used" in a QOZ and need not be "substantially improved." My thought is that land won't count for purposes of the 90% test, but we'll need further clarification.
• You Can "Roll Over" Your QOF Investment: If you invest in a QOF and sell your interest prior to your ten-year holding deadline, you can take the gain from the sale of the QOF interest and roll it over into a different QOF within 180 days without incurring tax.
• "Mixed Investments" Are Bifurcated: Only deferred capital gain will be eligible for the QOZ tax incentives, but if a taxpayer invests out-of-pocket money into a QOF, the latter portion will be taxed like a regular investment. If a taxpayer does make one of these "mixed investments," it'll be an accounting nightmare, but at least a taxpayer can "seed" a QOF with out-of-pocket money if absolutely necessary.
• Puerto Rican QOFs Are Eligible for Tax Benefits: Many of you may already know about the pre-existing tax benefits associated with being a domiciliary of Puerto Rico (and if you don't, you should), and almost the entire island got designated as a QOZ. So if you relocate your existing business to Puerto Rico, you stand to extract multiple layers of tax benefits. I always say tax shouldn't control your life, but the combination of the locally conferred benefits and the QOZ program may make Puerto Rico incredibly compelling for certain high net worth and ultra-high net worth taxpayers.

What Will Future Regulations Comment On?

• "Original use" and "substantial improvement," which only got addressed in this little Revenue Ruling released simultaneously with the proposed regulations. Many, many details still need to be fleshed out in future proposed regulations.
• Anti-abuse transactions, such as certain cash-out refinances of QOZ property or anti-churning transactions meant to help taxpayers qualify property that they owned in a QOZ prior to 01/01/2018 for tax benefits.
• QOZ interactions with other sections of the Code, such as 1031, 1202, the international tax regime, and various tax credit programs.

The release of the first round of proposed regulations reminds me very much of the scene in Die Hard: With a Vengeance when the street kid yells to John McClane, "It's Christmas! You could steal City Hall!" (warning: NSFW language) For the next eight-plus years, taxpayers have an avenue through which they don't really have to pay capital gains taxes. If you're either a taxpayer or an advisor, you'll have to watch out for the inevitable fraud and plain old bad investments that will be peddled by various industry actors. But if you're linked up with a reputable player (and I could link you with several of my clients who fit this description) or you have the savvy to take advantage of this program with your own QOF, you'd best get going on this exciting new program to maximize the available benefits.

I can be reached by private message on LinkedIn or by e-mail at [email protected]. Please do not choose the phone as your method of reaching out unless we already know each other; the inquiries will overload my switchboard. E-mail will do just fine.

There are lots of details about the QOZ program I didn't include in this behemoth of a post. You should become intimately familiar with the statute and proposed regulations if you plan on going about this yourself.

Note that the above does not constitute tax or legal advice. Please consult your own legal or tax advisor about your specific facts and circumstances. This article may be considered Attorney Advertising under the New York Rules of Professional Conduct.