what we now know about qualified opportunity zones
TRANSCRIPT
What We Now Know About Qualified Opportunity Zones
PRESENTED BY:
› DAVE SOBOCHAN, CPA, PARTNER
› ANGEL RICE, CPA, MACC, MT, SENIOR MANAGER
July 16, 2019
Welcome & Introductions
Angel Rice, CPA, MACC, MTDave Sobochan, CPA
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CPE Credit Guidelines
› To receive CPE you must:- Be logged in for at least 50 minutes- Answer at least 3 of the 4 polling questions
A copy of today’s slides will be available following this presentation
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Questions During the Webinar
› If you have questions during the webinar:- Use the “Questions” feature to “Enter a
question for staff” then click “Send”- We will address during the program if
there is time or will follow up after the program
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Overview
› Highlights of the 2nd set of proposed regulations including:- Treatment of Sec. 1231 gain- Definition of substantially all- Definition of original use- How can leased property qualify as QO Zone Business Property- Inclusion events and the ability to make a debt financed distribution- Importance of exit strategy- And more….
› Walk-through of how the penalty calculation works› Key takeaways
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Terminology
Abbreviation Term
QOZ Qualified Opportunity ZoneQOZB Qualified Opportunity Zone BusinessQOZBP Qualified Opportunity Zone Business PropertyNQFP Non-Qualified Financial PropertyQOF Qualified Opportunity FundQOZP Qualified Opportunity Zone Property
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Background
› Created as part of the Tax Cuts and Jobs Act that was signed into law December 22, 2017- Established 2 new code sections 1400Z-1 and 1400Z-2
› This provision is designed to incentivize long-term investment in low-income and economically distressed communities
› Is available to a wide range of taxpayers — individuals, C Corps (including RICs and REITs), S Corps, partnerships, trusts and estates
› Taxpayers have the ability to defer paying tax on capital gains by investing those capital gains into qualified opportunity funds which in turn invest in qualified opportunity zone property
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Sec. 1231 Gain
› The only gains eligible for deferral include gains treated as capital gains for Federal income tax purposes:
- Short-term capital gain and long-term capital gain would qualify- Unrecaptured 1250 gain would qualify- Gain subject to Section 1245 and 1250 recapture would NOT qualify- Only net Section 1231 gain (subject to end of year netting process and
the 5-year lookback rules for section 1231 losses)- The 180 day period for reinvesting net Sec. 1231 gains does not
begin until the last day of the tax year
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Definition of Substantially All
› The term “substantially all” is used in several places throughout Sec. 1400Z-2(d)
› A QOZB is required to have 70% of its tangible property owned or leased meet the requirements to be considered QOZBP
› In the context of the “use” of the property within a QOZ, the threshold is also set at 70%
› When used in the context of a “holding period,” the threshold is set at 90%
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Definition of Original Use
› Original use commences on the date when any person 1st places the property into service in the QOZ for purposes of depreciation or amortization (or 1st used the property in the QOZ in a manner that would allow depreciation or amortization)
› Used tangible property can satisfy the original use test if never used within that QOZ in a manner that would have allowed it to be depreciated or amortized by any taxpayer
› Vacant property can meet the original use test if it has been unused or vacant for an uninterrupted period of at least 5 years
› Land is not required to meet either the original use or substantial improvement tests in order to be considered QOZBP
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Polling Question # 1
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Leased Property
› Leased tangible property may be treated as QOZBP as long as certain criteria are satisfied:- Must be acquired under a lease entered into after 12/31/17- The terms of the lease must be market rate (as determined) under
Sec. 482- Substantially all (70%) of the use of the leased tangible property must be
in a QOZ during substantially all (90%) of the period for which the business leases the property
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Leased Property (cont.)
› There is no restriction against related party leases – however two additional requirements must be met:- The lessee cannot at any time make a prepayment of rent related to a
period of use that exceeds 12 months- If the original use of the leased tangible personal property does not
begin with the lessee, the lessee must become the owner of an equal amount of tangible property that is QOZBP within the relevant testing period and there must be substantial overlap in the zones in which the lessee uses the leased and acquired property
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50% Gross Income Safe Harbors
› At least 50% of the services performed by employees and independent contractors are performed within the QO Zone (based on hours), OR
› At least 50% of the services performed by employees and independent contractors are performed in the QO Zone (based upon amounts paid for the services), OR
› The tangible property of the business located in a QO Zone and the management or operational functions performed for the business in the QO Zone are each necessary to generate 50% of the gross income of the trade or business
› The proposed regulations also include a facts and circumstances test that allows a business to qualify even if any of the three safe harbors above are not met
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Preferred Structuring
› 90% of assets must be QOZ business property (QOZBP) or a QOZ business (Stock/Partnership Interest)QOF
QOZBusiness(Project LLC)
› 5% NQFP (Working Capital Safe Harbor allows cash not to be considered NQFP)
› 70% of its assets in QOZBP
Assets of Business
Characteristics of Business
› No sin business› 50% sales/payroll/property› ≥40% of intangible property used in the business
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Working Capital Safe Harbor Expansion
› Working Capital Safe Harbor (For NQFP Rule)
- Available for qualified opportunity zone businesses that acquire, construct or rehabilitate tangible business property, which includes both real property and other tangible property, used in a business operating in an opportunity zone
- Also available for the development of a trade or business within an opportunity zone
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Working Capital Safe Harbor Expansion (cont.)
› Working Capital Safe Harbor (cont.)- Will provide for a period of up to 31 months before the cash being held
by the qualified opportunity zone business will be considered NQFP if the following are true:- There is a written plan designating the amounts for the acquisition,
construction and/or substantial improvement of property within the zone
- The written plan is reasonable- The working capital assets are actually used in a manner consistent
with the schedule
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Polling Question # 2
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Preferred Structuring and Exit Strategy
› The largest tax benefit for a taxpayer participating in QOZ program is the ability to permanently exclude gain attributable on the appreciation of his or her QOF interest if held for at least 10 years
› Working capital safe harbor only applies to indirect structure› The proposed regulations provide for differing treatment of the gain
on sale depending upon if the taxpayer sells his or her QOF interest vs. the QOF selling qualified opportunity zone property
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Preferred Structuring and Exit Strategy (cont.)
› Sale of a QOF partnership interest- The basis of all assets of the QOF are deemed to be stepped up to FMV
similar to a Sec. 743(b) adjustment under a valid Sec. 754 election- A consequence of the deemed step-up is that no amounts of the gain on
sale will be re-characterized as ordinary income under the Sec. 751 rules related to “hot assets”- Hot assets include unrealized receivables, inventory items and
depreciation recapture- Ultimately this results in all gain (both ordinary and capital) escaping
taxation
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Preferred Structuring and Exit Strategy (cont.)
› Sale of assets- The taxpayer can make an election to exclude from gross income some or all of
the capital gain arising from the disposition of QOZP reported on the Schedule K-1 he or she receives from the QOF
- The taxpayer must have held a qualifying investment in a QOF partnership or QOF S Corporation for at least 10 years
- The QOF partnership or QOF S Corporation must dispose of the QOZP after such 10-year holding period
- The election only applies to capital gain from QOZP- Therefore a taxpayer will be required to recognize into income any ordinary
income that results under the Sec. 751 rules- Taxpayers cannot rely on this rule at this time
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QOF Reinvestment Rule
› A QOF can “churn” through assets but it comes at a cost› The QOF will have 12 months to reinvest proceeds received from
either the return of capital or dispositions of QOZP into other QOZP› During this 12-month period, the proceeds will be treated as “good”
property for purposes of the 90% asset test as long as the QOF holds the proceeds in cash, cash equivalents or debt instruments with terms of 18 months or less
› Interim gains generated from the sales or dispositions of QOZP will not be able to be excluded from income
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Polling Question # 3
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Carried Interests
› Mixed Fund Investments- Only investments made with eligible gain proceeds into the QOF will
qualify for the tax incentives under the program- A taxpayer may make additional investments without gain proceeds
into a QOF, but these investments will not be eligible for the benefits of the program and are required to be tracked separately (otherwise known as a mixed fund investment)
- A partnership interest received in exchange for services is also treated as a mixed-funds investment
- Ex. a carried interest
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Inclusion Events
› An inclusion event is an event that causes inclusion of the gain that was originally deferred into taxable income
› Generally speaking, an inclusion event will result when either the taxpayer reduces his or her direct equity investment in the QOF or the taxpayer effectively “cashes out” of her or her investment in the QOF by receiving a distribution of property with a FMV exceeding the taxpayer’s basis in the QOF
› The proposed regulations provide an expansive list of what are considered inclusion events
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Examples of Inclusion Events
› The following ARE considered inclusion events:- A transfer by gift of a QOF interest - A charitable contribution, as defined in Sec. 170(c), of a QOF interest
› The following are NOT considered inclusion events:- Most transfers of a QOF interest by reason of death- A transfer of a QOF interest to an entity that is disregarded as separate
from the taxpayer (including a grantor trust)- A change in the entity’s status as disregarded will cause an inclusion
event at that time- A transfer of a QOF interest in exchange for a partnership interest under
Sec. 721
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Debt Financed Distributions
› The general rule is that a QOF can make a distribution and have it not be considered an inclusion event to the extent of the taxpayer’s basis in the QOF- A taxpayer’s initial basis in his or her QOF interest is zero- The normal partnership debt basis rules apply
› If there is deemed to be a disguised sale, the taxpayer’s original qualifying investment will be recast as a non-qualifying investment in the QOF and no longer eligible for the benefits of the program
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Polling Question # 4
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QOZ Penalty Calculation
› Assumptions: $100M Gain
› Federal Tax Liability: $23.8M› State Tax Liability: $5M (Used blended rate of 5%)
› Total Tax Liability: $28.8M
Projected Federal tax savings if the QOZ is held for 7 years: $3,570,000 ($23.8M – ($100M x 15% x 23.8%))
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QOZ Penalty Calculation
› Penalty is calculated on the gain amount, not the tax effect of the gain §1400Z-2(f). The penalty rate is the underpayment rate under §6621(a)(2).
› Penalty begins to be assessed if the QOF fails to meet the 90% test on the first testing date and is assessed for each month the fund fails to meet the test. Failure to comply with the first testing date results in a penalty that is applied retroactively back to the date the fund was formed. (Proposed Regs provided an exemption from penalty for the first testing date if held in cash/cash equivalents)
› The penalty rate is currently 6% but is adjusted on a quarterly basis. There is risk that the rate could increase.
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Relief from the 90% Asset Test
› The QOF will be allowed to apply the penalty calculation without taking into account any investments received in the preceding 6 months- The QOF must hold the investments in cash, cash equivalents or debt
instruments with terms of 18 months or less- The QOF will however have to deploy the contributions by the second
testing date in order to avoid a 1-month penalty
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QOZ Penalty Calculation (cont.)
› Facts: A QOF is formed in June 2019 and its first testing date for the penalty calculation is November 30, 2019. The QOF receives an equity contribution of $500K on June 25, 2019. Does the QOF have to deploy all $500K before November 30, 2019 in order to avoid a penalty?
- No, the QOF will have until the 2nd testing date of December 31, 2019 to deploy the $500K of equity contributions into QOZP
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QOZ Penalty Calculation (cont.)
› Facts: $100M Gain. The QOF would have the ability to exclude the equity contributions made to it in June for purposes of the November 2019 testing date. Assume the QOF fails the December 31, 2019 testing date.- 2019 Penalty Amount: $450,000 ($100M x 90% x .06 x 1/12)- 2020 Penalty Amount at 1st testing date of 6/30/20: $2.7M - 2020 Penalty Amount assuming that both testing dates are not met in 2020:
$5.4M› Failure to meet the 90% by 6/30/20 would eliminate most of the Federal
tax savings by investing in a QOF and holding the interest for 7 years. Failure to meet the 90% by the end of 2020 would eliminate all of the 7-year holding period benefit.
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Key Takeaways
› Recommended structure for funds:- Indirect investment in QOZP (tiered structure)- Single asset funds
› The only way to exclude both ordinary and capital gain upon exiting the QOF is to sell the membership interest in the QOF
› QOFs can make debt financed distributions (DFD) to the extent of the taxpayer’s basis in the QOF including debt- DFDs made within the first 2 years of contribution to the QOF will most likely
disqualify the initial contribution as a qualifying investment› The penalty is calculated on the gain amount deferred into the QOF and
not the tax effect of the gain- Not meeting the 90% threshold for two or more testing dates erodes any
benefit to be received from the 5- and 7-year holding periods
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Questions for our Presenters?
Dave [email protected]
Angel Rice216.774.1140 [email protected]
A copy of today’s slides will be available following this presentation
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Upcoming Events
SAVE THE DATE:
Cleveland CPE Conference Wednesday, November 20, 2019
Learn more at www.cohencpa.com/events
Thank you.
July 16, 2019
Information presented is not meant to constitute legal, accounting or other professional advice. Any action based on information in this presentation should be taken only after a detailed
review of the specific facts and circumstances. Information is current as of the date presented.
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