Company News

Qualified Opportunity Zone (QOZ) and Qualified Opportunity Funds (QOF)

July 9, 2019

Summary:
QOF’s allow for tax advantages that include:
• Deferral on investment of capital gains when invested in a QOF
• Gains receive a step-up by 10% when held for 5 years and 15% when held for 7 years that is calculated at a % of the gain (not a % of the original basis).
• When a QOF is held for 10 years, receive a basis step-up equal to the sales price, i.e. zero capital gain

Other Information:
• QOF is self-certifying with tax return
• QOF must be a Corporation or Partnership
• QOF can only invest in QOZ property, and must meet a 90% QOZ asset test.
• QOF cannot be setup just to invest in other QOF funds to meet qualification, i.e. direct investment in QOF is required.
• Some stipulation in use of property, but generally does not appear to be an issue.
• Property must be “Original Use” (New construction) or “Substantial Improvement” (Remodel cost equal to basis in property, excluding land).

Overall Synopsis:
Along with the implementation of the Tax Cuts and Jobs Act (TCJA) a new Tax Code, 1400Z, was created that allows for taxpayers to take advantage of a new investment called a Qualified Opportunity Fund (QOF) that invests in Qualified Opportunity Zones (QOZ).

A large part of the goal with this implementation was to spur economic growth in otherwise low income areas. While this has been attempted with various other regulations put in place over the years, think Low Income Housing Tax Credits and the New Markets Tax Credit, this new law would appear to have a better marksmanship in an attempt to draw out capital that would otherwise sit on the sidelines than in the past. However, like all things provided by congress, there are stipulations.

A QOZ is established by the Governor of each state submitting possible areas within that state that meet certain qualifications established under the Code for Federal approval. As of the end of June 2018, the final areas were approved. For Kansas, a list of the qualified areas can be found at kansascommerce.gov/1067/Opportunity-Zones with an interactive map available.

Wichita has some available opportunity within the zone, and this area covers much of the downtown area north of Kellogg to Murdock, and West of Washington to the River, with some additional surrounding areas, such as the Delano District.

In order to invest in these areas, they must be done through a QOF. There are various possible tax benefits to investors in a QOF that include:
• Deferral of Capital Gains
• Possible basis adjustment in Capital Gain recognition
• Possible exclusion from gain on appreciation of the QOF.

In order to take advantage of these benefits, there are stipulations that need to be followed.

Deferral of Capital Gains:
A taxpayer can defer the recognition on capital gain currently by investing in a QOF. In order to do this, the capital gains needs to arise from a sale of a capital asset to an unrelated party. The taxpayer then has 180 days from the date of sale to invest the gains into a QOF, and would make an election for the deferral. As of the time of this memo, the IRS has not yet provided a sample election, or method in which this would be done. Additionally, if the taxpayer invests Capital Gains and other funds (mixed funds) in the QOF, the Code stipulates that “such investment shall be treated as 2 separate investments.”

Basis Adjustment in Capital Gain Recognition:
If the taxpayer maintains the investment in the QOF for a period of 5 years prior to disposal, they will receive a “step-up” in basis equal to 10% of the gain that would have been recognized. Additionally, if they maintain the investment for a period of 7 years, they receive an additional 5% basis adjustment for a total of 15%.

As example, Jane sells stock with a total gain of $100,000 on December 31, 2018, and she will have 180 days to invest these funds into a QOF and make an election to defer the gain recognition. If she were to invest these funds into a QOF for 5 years, she would get a 10% reduction on the gain recognition, or $10,000 ($100,000 * 10%) for a total gain of $90,000 ($100,000 – $10,000). If held for 7 years, she would receive a 15% reduction, or $15,000 ($100,000 * 15%) for a total gain of $85,000 ($100,000 – $15,000).

In addition, the Code stipulates that any gain deferred will be recognized either when the QOF is sold, or December 31, 2026, whichever is earlier. This limits the timing of investment opportunity for anyone that wishes to take advantage of the 15% reduction, and would need to have funds with a QOF by the end of 2019 to qualify for the 7 year reduction.

The last benefit is exclusion from capital gain on the appreciation of the QOF if the investment is maintained for 10 years or longer. This is provided with a basis “step-up” equal to the sales price of the QOF at the time of disposition. As an example, if Jane invest $100,000 in a QOF and holds this investment for 10 years, then sells the QOF for $200,000, for a $100,000 gain ($200,000 – $100,000), she would recognize no taxable gain on the $100,000.

Additionally, if you were to combine the examples above, and Jane initially invests $100,000 of gain from her initial sale in the QOF in 2019, gain would not be taxable until 2026, and would be reduced to $85,000. Additionally, if she maintains the QOF investment for 10 years prior to sale, liquidates for $200,000, the additional $100,000 of gain would be tax free. This could provide Jane with a situation where she realizes $200,000 of gain, and her tax liability would be based on only $85,000 of this total.

QOF qualification:
There are rules in order for a QOF to maintain and qualify for status as a QOF. First, 90% of the assets of the QOF must be maintained in QOZ property. There are some stipulations as to working capital, and funds maintained for improvement of QOZ property, however, if the QOF does not meet the 90% rule at the end of the tax year, then penalties apply monthly for the amount in which it does not meet the qualification status. If in a partnership, these penalties are applied to members of the partnership.

Additionally, the QOF is self-certifying that it meets the guidelines to be a QOF by filing Form 8996 annually with the tax return filed with the IRS, which is still in draft form as of October 19, 2018 when the Form was released.

The property in the QOF must also meet the rules of section 144©(6)(B) where the property cannot be for a golf course, country club, massage parlor, hot tub facility, suntan facility, racetrack, used for gambling, or where used for the sale of alcohol for off premise consumption.

The organizing documents of the QOF must also include a statement of the entity’s purpose of investing in QOZ property and a description of the QOZ business. QOZ property must also meet the stipulations that the original use of the property is with the QOF, or there must be “substantial improvement” in the QOZ property, meaning that the cost of improvements in the acquired property must be meet or exceed the cost basis of the property within a 30 month period beginning on the day of acquisition.

While there are various stipulations involved in order to meet qualification as a QOF, the requirements overall are manageable for the majority of investors, and could provide substantial opportunity.