The final regulations for Qualified Opportunity Zone (QOZ) investments were published in December, and though they generally follow the proposed regulations of October 2018 and May 2019 they do clarify some of the ambiguities noted in the proposed regs. QOZ investments are a powerful—but due to politics, an uncertain—tax-planning tool, and are a strategy that any individual taxpayer who will realize large amounts of capital gains should consider.
QOZs date back to the Clinton Administration and are based on the prior census tracts, are nominated by state governors and are approved by the U.S. Treasury Department. These are locations where very little new private equity is invested in either businesses or properties. To encourage individual taxpayers to make new private equity investments in these depressed areas, the 2017 Tax Act added two income tax benefits for long-term equity investments of new money in either property or businesses located in a QOZ.
The first income tax benefit is that the capital gains tax due on realized capital gains invested either in a Qualified Opportunity Zone Fund (QOF) or directly into a Qualified Opportunity Zone Business or Property (QOB) is deferred until December 31, 2026. The cash must be invested not more than 180 days after the transaction and the investment cannot be sold or exchanged during that time. If the gains remain in the QOF or QOB for five years, the taxpayer gets a stepped-up basis of 10%. If the gains remain in for the full seven years, there’s a stepped-up basis of an additional 5% for a total stepped-up basis of 15%.
The second income tax benefit for the individual taxpayer who invests realized capital gains in the QOF or QOB is if they leave the funds in the investment for 10 or more years they can sell or exchange that investment without incurring any capital gains tax on the appreciation on the cash invested in the QOF or QOB from the date of the investment.
Both of these benefits depend on the taxpayer making the proper elections and the annual filing of disclosures with their federal income tax returns.
The proposed regs define the type of taxpayers and type of gains eligible for this program, when the investments must take place, how to elect a deferral, the valuation of a Qualified Opportunity Zone Business, what a Qualified Opportunity Zone Fund or Business is, and what the effect of transfer of QOF or QOB interests other than by sale or exchange will be.
The final regulations follow the proposed regulations generally, but do make some specific changes:
• The date that an S. Corporation, partners of a partnership or beneficiaries of a trust must invest the gains in a QOF or QOB is not 180 days after the date of the transaction, but rather 180 days after the date that the S. Corp., partnership or trust must file its income tax return, excluding any extensions.
• Transfer on death of an interest in a QOF or QOB is not considered to be a sale or exchange, and so does not trigger the inclusion of the gains in the estate’s tax return (though the deferred gains do not get an additional stepped-up basis as would ordinary equity investments in the estate).
• Grantor type trusts are eligible for deferral, so long as the grantor would have been eligible if the grantor had owned the interest directly.