Qualified Opportunity Funds - A New Investment Vehicle from the TCJA

A new Qualified Opportunity Zone (“QOZ”) program to encourage investment in low-income communities (“LICs”) is part of the massive tax law enacted in December 2017 that is often referred to as the Tax Cuts and Jobs Act of 2017 (“TCJA”). This program allows deferral and possible forgiveness of tax on capital gains invested in LICs.

Adoption of this program in a state requires certain actions by the state governor (or the chief executive of U.S. possessions and the District of Columbia) by March 21, 2018. (A governor may request a 30-day extension.) Thus, access to this program for a state is time-sensitive.

New Internal Revenue Code Sections 1400Z-1 and 1400Z-2 provide temporary deferral of inclusion in gross income for capital gains reinvested in a qualified opportunity fund (“QOF”) and the permanent exclusion of capital gains from the sale or exchange of an investment in a QOF, if certain conditions are met. QOFs are formed to invest in businesses or business property in QOZs.

A taxpayer can defer capital gains in an unlimited amount by investing them in a QOF. A taxpayer must invest proceeds from the sale or exchange within 180 days of that sale or exchange in an amount equal to the gain to be deferred. The deferred gains are taxable when the investment in the QOF is sold, or if earlier, December 31, 2026. Depending on the holding period of the investment in the QOF, up to 15% of the invested gains may be excluded from taxation.

In addition, if the investment in the QOF is held by the investor for at least 10 years, the gain on the sale of the QOF interest is tax-free.

Investments in a QOF that are not part of a gain deferral are not eligible for the special QOZ tax benefits.

The TCJA allows the designation of certain LIC population census tracts as QOZs. In general, the number of population census tracts in a state that may be designated QOZs may not exceed 25% of the number of population census tracts in the State that are LICs. Basically, the designation lasts for 10 years. (Certain adjacent non-LIC census tracts may be designated QOZs, but not in excess of 5% of the total census tracts designated QOZs in a state.)

The governor will be responsible for nominating to the U.S. Treasury Secretary population census tracts in the state as QOZs. This nomination must take place by March 21, 2018. (A governor may request a 30-day extension to complete nominations.)

Thus, taking into account the 25% limitation on the percentage of LIC census tracts that can be designated, one would expect the competition to be fairly robust to have qualifying census tracts designated QOZs.

The IRS released Revenue Procedure 2018-16 about 10 days ago. This revenue procedure provides guidance to the governors of states (and other CEOs of U.S. possessions and the District of Columbia) on the procedure for nominating LICs as QOZs.

This has been a brief summary of the new QOZ investment program. Many questions remain with regard to this tax incentive program. Hopefully, the Treasury will issue additional guidance soon. In any case, governors must take action by March 21, or 30 days thereafter upon being granted an extension, in order for LICs designated QOZs in a state to be eligible for this incentive program.

If you have any questions about this new program, please call your HM&M tax advisor.