Recently, the IRS issued a much-anticipated second round of proposed regulations better outlining the framework of the Qualified Opportunity Zone program, which was included in the Tax Cuts and Jobs Act of 2017 (TCJA). With these new proposed regulations, operating businesses that have been waiting on the sidelines should now have enough clarity to begin to tap into the program’s benefits.
First, a primer and refresher on Qualified Opportunity Zones (QOZs):
As defined in the TCJA, QOZs are economically distressed communities where new investments may be eligible for preferential tax treatment. The highlights of this preferential tax treatment include:
• Deferral of gain recognition until the earlier of Dec. 31, 2026, or sale of investment
• Exclusion of 10% or 15% of the gain if the investment is held for five or seven years, respectively, through Dec. 31, 2026
• 100% gain exclusion for investments held at least 10 years
The QOZ program not only provides a boost to otherwise struggling communities, it offers significant tax incentives for private-sector investors. Currently, there are 10 census tracts in Fort Wayne that are deemed QOZs, with another six in northeast Indiana – one each in Adams, DeKalb, Huntington, Steuben, Wabash, and Wells counties.
Key takeaways from the new round of proposed regulations:
Active trade or business
The QOZ statute contains a requirement that at least 50% of a QOZ business’ gross income must be derived from the active conduct of a trade or business in the QOZ. The new proposed regulations provide three safe harbors to meet the 50% gross income test:
• At least 50% of the hours worked by employees and independent contractors for the QOZ business are performed in a QOZ.
• At least 50% of the total amount paid for services by the QOZ business is paid for services performed in a QOZ.
• The tangible property of the QOZ business and the management or operational functions performed in a QOZ are each necessary for the generation of at least 50% of the gross income of the QOZ business.
For example: A company develops software applications on a campus located in a QOZ. Because the business’ global consumer base purchases such applications through online downloads, the business’ employees and independent contractors are able to devote the majority of their total number of hours to developing such applications on the business’ QOZ campus. As a result, this business would satisfy the first safe harbor, even though it makes the vast majority of its sales from outside of the QOZ.
Another example: Let’s say this same company also utilizes a service center located outside of the QOZ, and that more employees and independent contractor working hours are performed at the service center than the hours worked at the business’ QOZ campus. While the majority of the total hours spent by employees and independent contractors of the business occur at the service center, the business pays 50% of its total compensation for services performed by employees and independent contractors on the business’ QOZ campus. As a result, the business satisfies the second safe harbor.
Triple net leases
Triple net leases will likely not qualify for the benefits of the QOZ program. Merely entering into a triple net lease with respect to real property is not the active conduct of a trade or business.
Asset sales by a Qualified Opportunity Fund (QOF)
Under the statute, it’s clear that where an investor sells an interest in a Qualified Opportunity Fund — defined as any investment vehicle that is organized as a corporation or a partnership for the purpose of investing in QOZ property — held for more than 10 years, the capital gains from this sale would be excluded from the investor’s income. It was unclear, however, whether the same would apply to assets sold by the QOF. The most recent proposed regulations now state that capital gains from such asset sales, if they satisfy the 10-year holding period applicable to the investors, can be excluded from the investor’s income.
Reinvestment of proceeds from sale of assets by a QOF
If a QOF sells assets before the 10-year holding period has been met, the gain from such sales will not be excludable from the investor’s income.
Carried interest generally will not qualify for these tax benefits. The proposed regulations state that only the portion of an investor’s equity that is attributable to capital is eligible for the exclusion from capital gains after the 10-year holding period is met.
As detailed above, this new round of proposed regulations provides some welcome clarification to the original QOZ statues. At the same time, however, many variables still exist as this program continues to take shape. It’s best to seek out the advice of a tax expert whenever possible if you’re interested in exploring the potential benefits of the QOZ program.
Interested in learning more about QOZs and their potential tax benefits? On June 27, Greater Fort Wayne Inc. and the Northeast Indiana Regional Partnership are hosting an informational event focused on QOZs. The event will include a presentation and panel discussion with QOZ experts from Katz, Sapper & Miller, Barrett McNagny, the Indiana Economic Development Corp., NCT Ventures, and the city of Fort Wayne. The event is free and open to the public. To learn more and to register, click on the Events tab at greaterfortwayneinc.com.