QOZs were created under the Tax Cuts and Jobs Act of 2017 and are generally defined as low-income areas where the median income does not exceed 80% of the statewide or metropolitan area median family income.
Each state has been allowed to nominate up to 25% of its low-income communities to be QOZs. There are currently 8,764 low-income communities in all 50 states, the District of Columbia and five U.S. territories that are designated as Qualified Opportunity Zones (QOZ). A map of current QOZ’s can be found here: https://opportunityzones.hud.gov/resources/map.
- Opportunity Zones offer tax benefits to investors who can elect to temporarily defer tax on capital gains if they timely invest gain amounts in a Qualified Opportunity Fund (QOF). Investors can defer tax on the invested gain amounts until the date they sell or exchange the QOF investment, or Dec. 31, 2026, whichever is earlier. The length of time the taxpayer holds the QOF investment determines the tax benefits they receive.
- If the investor holds the QOF investment for at least five years, the basis of the QOF investment increases by 10% of the deferred gain.
- If the investor holds the QOF investment for at least seven years, the basis of the QOF investment increases by 15% of the deferred gain.
- If the investor holds the investment in the QOF for at least ten years, the investor is eligible to elect to adjust the basis of the QOF investment to its fair market value on the date that the QOF investment is sold or exchanged.
- For additional information, see: https://www.irs.gov/newsroom/opportunity-zones
Gains that may be deferred ("eligible gains") include both capital gains and qualified 1231 gains but are only those that would be recognized for federal income tax purposes before Jan. 1, 2027, and that are not derived from related party transactions. To obtain this deferral, the amount of the eligible gain must be invested in a QOF in exchange for an equity interest in the QOF (qualifying investment).
- Once this is done, taxpayers can claim the deferral on their federal income tax return for the taxable year in which the gain would have been recognized.
- Taxpayers may make an election to defer the gain, in whole or in part.
- For additional information, see How To Report an Election To Defer Tax on Eligible Gain Invested in a QOF in the Form 8949 Instructions.
Qualified Opportunity Fund (QOF)
Any investment in a QOF must be an equity investment such as in the shares of a corporation or in the interests of a partnership, It cannot be a debt instrument or deemed contribution of money (see I.R.C. 752(a)).
- A real estate-only QOF must further be organized for the purpose of investing in QOZ Property, be formed in a U.S. state or U.S. possession if investing only in that possession, be taxed as a corporation or partnership, and hold at least 90% of its assets in QOZ Property (the 90% test).
The 90% Test
A QOF must hold 90% of its assets in QOZ Property as measured by the average percentage of QOZ
holdings on the last date of both: 1) the first six-month period of the taxable year of the fund; and 2) the taxable year of the fund.
- The valuation of the assets is determined by referencing either the QOF’s financial statement for that year or the QOF’s cost basis for the owned assets and values of lease payments for leased assets.
- The QOF then annually self certifies that it is an investment vehicle, that has elected to annually file Form 8996 with the IRS while investing 90% or more of its assets in a QOZ. This annual designation allows the fund to gain preferential tax treatment for investments held for five years or more.
- For additional information, see Form 8996 Instructions.
QOZ Property includes:
- QOZ stock: shares in a domestic entity that is classified as a corporation for federal income tax purposes qualify if:
- The stock is acquired by a QOF after December 31, 2017;
- The corporation has been organized for the purpose of being a QOZ Business (see below); and
- The corporation remains a QOZ Business for at least 90% of the QOF’s holding period for the stock.
- QOZ partnership interests: interests in a domestic entity that is classified as a partnership for federal income tax purposes qualify if:
- The interest is acquired by a QOF after December 31, 2017;
- The partnership has been organized for the purpose of being a QOZ Business; and
- The partnership remains a QOZ Business for at least 90% of the QOF’s holding period for the interests.
- QOZ business property: tangible property used in a trade or business of a QOF or QOZ Business qualifies as QOZ Property if:
- The property was acquired by purchase or lease from an unrelated party after December 31, 2017;
- For purchased property:
- The original use of the property commences with the QOF or QOZ Business or the QOF; or
- The QOZ Business substantially improves the tangible property. Tangible property is “substantially improved” by the QOF only if, during any 30-month period beginning after the acquisition date of the property the QOF adds to the basis of the property an amount equal to more than the adjusted basis of the property at the beginning of the 30-month period.
- For leased property:
- The lease is market rate; and if the lessor and lessee are related parties:
- There is no prepayment of rent exceeding 12 months; and
- By the last day of the lease or 30-months (whichever comes first), the lessee must become the owner of the property whose value is at least equal to the value of the lease and there must be a substantial overlap of time using both the leased and acquired property.
Qualified Opportunity Zone Business (QOZ Business)
An entity that issues stock or partnership interests to a QOF must qualify as a QOF Business for investors
to receive the intended QOZ tax benefits. A QOZ Business has the following requirements:
- 70% of the tangible property owned or leased must be QOZ Property;
- At least 50% of its gross income is derived from the active conduct of a trade or business in the QOZ. There are three distinct tests (safe harbors) for a business to meet this 50% threshold:
- The total hours worked by employees and independent contractors (staff) inside of a QOZ must be at least 50% of the total hours worked by all employees;
- The total dollars paid to the staff within a QOZ must be at least 50% of the total dollars paid; or
- The management, staff, and the QOZ property in the QOZ must generate 50% of the business’ gross income.
- A QOZ business can exclude reasonable amounts of working capital from the value of property that is treated as nonqualified financial property (“working capital safe harbor”). To qualify, a reasonable amount of working capital must satisfy each of the following tests:
- The working capital is designated in writing for the development of a trade or business in a QOZ.
- There is a reasonable written schedule for the consumption of the working capital to achieve the goal set out above.
- The working capital is to be consumed within 31 months of the QOZ business’s receipt of the assets. Any additional applications of this working capital safe harbor must meet the requirements of Regulations section 1.1400Z2(d)-1(d)(3)(v) and must be for a total period of no more than 62 months.
- If the consumption of the working capital assets is delayed by waiting for government action on a completed application, the delay will not jeopardize the safe harbor.
- If the QOZ business is in a QOZ that is in a federally declared disaster area, the QOZ business may receive up to an additional 24 months to consume its working capital assets, provided it meets the requirements of Regulations section 1.1400Z2(d)-1(d)(3)(v).
State QOZ Tax Code Conformity
The set of QOZ rules adopted by each state are important factors investors should also consider. Certain states have adopted federal QOZ rules while others have mandated their own rules regarding QOZs. Investors in states that do conform with the federal provisions may receive state tax incentives similar to those available at the federal level. Conversely, investors residing in nonconforming states may be unable to defer and reduce state taxation on the initial gains invested in opportunity zones. Investors in these nonconforming states may also be required to recognize gain for state tax purposes on their eventual sale of the opportunity fund investment. For additional information, see State Tax Code Conformity.
Ultimately, QOZ’s are a complex area of tax law. Investment decisions should be made in conjunction with a qualified tax professional. Some additional resources include: