Judging from all of the clarifications and guidance issued by the IRS in regards to several laws enacted by the TCJA, it is apparent that the new tax law was hastily drafted. Outside of all the proposed and official guidance issued in an attempt to clarify the IRC §199A deduction, the IRS has issued clarifications and guidance in regards to Qualified Opportunity Zone (OZ) Funds.
Investment in OZs is nothing new. When it was first enacted, the goal was the gentrification of areas that were considered to be dilapidated. These areas were determined by the federal government, which deemed these areas Empowerment Zones. The goal was to have businesses invest in these areas and employ the population. The incentives for these companies to invest were tax credits for building as well as credits for hiring the people who lived there.
Before the passage of the TCJA, business owners selling the assets of their company and real estate investors, as well as anyone else involved in an income-producing endeavor, were allowed to defer capital gains taxes upon sale through an IRC §1031 Exchange, referred to as a like-kind exchange. However, the TCJA changed the law and only allowed a 1031 for real estate.
The TCJA allowed a provision for anyone who received a capital gain to not only defer it but also eliminate it, whether it came from selling business assets or securities.
How can these gains be avoided? Well, 180 days after the capital gain occurred, the taxpayer can either start their own OZ or invest in an OZ Fund. They must invest in at least 90 percent of the Qualified Opportunity property.
A whole host of IRS regulations followed; however, in April 2019, temporary regulations by the IRS superseded the prior ones. REG-120186-18 gave further guidance. Before it was issued, it was only clear that an OZ Fund interest that threw off the sought-after tax benefits could be acquired via a contribution of cash to an OZ Fund. Now, the 2019 proposed regulations also allow an investor to acquire OZ Fund interests for a (non-cash) property contribution and by secondary purchase from other persons (e.g., an intermediary or an early stage, seed or bridge-capital investor). For OZ Fund interests acquired by a cash contribution or secondary cash purchase, the 2019 proposed regulations naturally treat the amount of such cash as the amount of the investor’s OZ Fund investment.
For OZ Fund interests acquired by property contributions, the investment amount will depend on whether the interests were acquired in a taxable or non-taxable manner.
For the former, the investment amount is the fair market value of such property (and any gain arising from such a taxable transaction is not eligible for deferral under the OZ regime). For interests acquired in a non-recognition transaction, the investment amount is the lesser of the adjusted basis of the property contributed or the fair market value of the OZ Fund interest received (which often will equal the adjusted basis or fair market value of the property given up in the non-recognition exchange). If the fair market value exceeds the investor’s adjusted basis, such excess is a separate investment in the OZ Fund and is not eligible for the related tax benefits.
Prior to 2019, the proposed regulations allowed a Master Fund. And before the proposed regulations on Qualified Zone Funds (QZFs), each was required to set up a new entity for each investment. However, the 2019 proposed regulations now allow fund managers to form one aggregating vehicle as the OZ Fund to make different OZ qualifying investments without the need to form a separate fund for each investment. It also would allow the fund manager to control dispositions without the need for investor cooperation on the sale.
Finally, the proposed regulations state that if the QZF uses debt to finance the project and the debt is distributed, the proceeds can be taxable.
Craig W. Smalley, MST, EA, has been in practice since 1994. He has been admitted to practice before the IRS as an enrolled agent and has a master's in taxation. He is well-versed in US tax law and US Tax Court cases. He specializes in taxation, entity structuring and restructuring, corporations, partnerships, and individual taxation, as well as...