How COVID-19 Could Impact Your Qualified Opportunity Fund Investment
By Jacob Ouradnik, CPA, MAcc
Much has been said about the opportunity zone tax break since the Tax Cuts and Jobs Act (TCJA) went into effect two years ago. In fact, we’ve published two articles on Qualified Opportunity Funds (QOFs) and have discussed the topic at length on numerous occasions. Since then, the IRS has issued final regulations to clarify the rules surrounding QOFs and, more recently, guidance for QOFs and their investors in response to the COVID-19 pandemic.
If you’ve considered investing in a QOF or are already invested in one, it’s important to understand how the final regulations and COVID-19 updates could impact you.
First, a quick refresher: What is a QOF?
A Qualified Opportunity Fund, or QOF, is an investment vehicle structured as a partnership, LLC (excluding single-member LLCs), or corporation to invest in eligible property within the bounds of a Qualified Opportunity Zone (QOZ).
A QOZ is a state-designated geographical area where new investments, under certain conditions, may be eligible for preferential tax treatment. Simply put, QOZs are an economic development tool—that is, they are designed to spur development and create jobs within economically distressed communities.
For more on QOFs and the tax benefits of investing in one, read up on our previously published article “Qualified Opportunity Funds: A Tax Perk You Don’t Want to Miss.”
Here are the most significant changes and items of note included in the COVID-19 guidance and final regulations:
180-day Investment Window
If a taxpayer is the owner of a pass-through entity, such as an S corp or a partnership, that recognizes a gain during the year, the taxpayer may choose to start the 180-day window at any of the following:
- Tax year end of pass-through entity (default option)
- Date of sale event (i.e., same 180-day period as the pass-through entity)
- Due date of the pass-through entity’s tax return (i.e., March 15 for a calendar-year entity)
Final regulations introduced the third window (due date of tax return), which should serve as a great benefit to investors who own pass-through entities that historically file extensions and may not receive Schedule K-1s until August or September.
If a taxpayer’s 180th day to invest in a QOF would have fallen on or after April 1, 2020, and prior to December 31, 2020, the taxpayer now has until December 31, 2020, to invest this gain into a QOF.
Investors Can Exclude Gain After 10 Years
The most significant benefit of a QOF investment is the potential to exclude gain when that investment is sold after 10 years. A looming gray area for investors was the question of whether depreciation and other deductions claimed throughout those 10-plus years of QOF investment would qualify for the exclusion.
Final regulations allow both a Qualified Opportunity Zone Business (QOZB) and QOF to exclude gain generated from a sale structured as either as “asset sale” or a “stock sale.”
Final regulations clarified that income from the sale of inventory would be the only item of income/gain not eligible for exclusion. Other forms of ordinary income, such as depreciation recapture, would be eligible for the exclusion.
The clarification on these two items will give investors a higher degree of flexibility when they are looking to liquidate their investment. It also has the potential to dramatically expand the benefits of the QOF investment.
New Ways of Treating Section 1231 Gains
Section 1231 gains are gains from the sale of property used in a trade or business and held for more than one year. Under the final regulations, investors are no longer required to offset these gains with the same type of losses. Instead, each Section 1231 gain or loss stands on its own. The 180-day investment window starts on the day of the sale (and, per COVID-19 guidance, can now be extended to December 31, 2020), if the assets were personally sold by the investor.
Here’s an example of how this new treatment could benefit investors:
Say a taxpayer were to incur a $100,000 Section 1231 gain on March 1 and a $25,000 Section 1231 loss on July 31. Under previous guidance, the taxpayer would have to wait until the end of the tax year to determine that the amount of gain eligible to invest into a QOF was equal to only their net gain of $75,000.
Under the final regulations, however, this taxpayer could now invest the $100,000 into a QOF and defer the full gain. Because net Section 1231 losses generate ordinary income treatment, this would mean the taxpayer would have $25,000 loss to offset other forms of ordinary income.
Gain from an installment sale is taxable as a taxpayer receives payments towards the installment balance. In the case of eligible gain generated from an installment sale, final regulations clarified that each and every installment payment that generates gain will be eligible for QOF investment.
This is true even if the initial sale occurred prior to 2018. The 180-day window in this case may either begin on the date the payment is received or on the last day of the tax year in which the installment sale gain will be recognized. The second option may be beneficial if multiple payments were received throughout the tax year.
Character of Gain When Recognized
Any gain maintains the same character as if it had not been deferred. However, it is subject to whatever tax rate exists at the time of recognition of the gain, which would take place with an inclusion event or on December 31, 2026—whichever comes earlier.
QOF 90% test
A QOF must hold at least 90% of its assets in QOZ property. Per the final regulations, if a QOF fails to meet this percentage on any semi-annual testing date, it would be subject to a penalty for each month it fails. It’s unclear if a QOF would incur additional penalties if it were to repeatedly fail the semi-annual tests.
If a QOF fails the 90% test on any testing dates between April 1, 2020, and December 31, 2020, the QOF will not be liable for the penalty.
To qualify as a QOZ property, a property must be owned by the first individual who placed it into service. In other words, the property must be newly built or newly improved (per a strict set of improvement requirements)—this is called the “original use requirement.” Previous QOF rules, however, didn’t have much to say about vacant property. The final regulations explained how a QOF could claim the original use requirement on vacant property:
- Property becomes vacant AFTER being designated within a QOZ
- Property must be vacant for three years before it can become eligible to be claimed as original use when placed in service.
- Property was vacant for one year PRIOR to being designated within a QOZ.
- Property will be eligible to be claimed as original use when placed in service
Vacancy is defined as “less than 80% of useable space being in use.” The last set of QOZ tracts were designated on June 14, 2018.
Additional COVID-19 Updates:
In addition to the 180-day investment window and 90% test, the COVID-19 guidance loosens other time-sensitive QOF requirements. These include the 31-month working capital safe harbor and 30-month substantial improvement period requirements.
What should you do now?
The IRS may have clarified the rules, but, as you can see, they certainly didn’t simplify them. And while the COVID-19 guidance is beneficial, it isn’t without ambiguity. Needless to say, there’s much to think about when it comes to investing in a QOF, and it’s possible the rules could continue to change.
If you’re considering a QOF or are currently invested in one, be sure you’re getting the right information. We’re here to help if you have questions about the tax ramifications of QOFs or would like to plan out your next steps. We can even provide you with an attorney referral for establishing a QOF if needed. As you may have heard, the opportunity zone tax break won’t be available forever. The longer you wait to explore it, the less advantageous its perk may be.
Contact us today to get started.
Jacob Ouradnik, CPA, MAcc, is a manager in the firm’s Mankato office and enjoys working closely with pass-through businesses and their owners. Jake has a passion for businesses structured as LLCs/partnerships, and enjoys working through the complexities and the inherent opportunities that come with them.
You can reach Jacob at (507) 304-6808 or click here to contact him via email.
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