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Guide to the Surprises Lurking in the QOZ Proposed Regulations

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April 25, 2019 | Legal Alert
David S. Neufeld
Cherry Hill, NJ

While mid-April is typically associated by most with Tax Day, this year, April 2019, also became the month the highly awaited second round of Qualified Opportunity Zone Proposed Regulations were issued.

With the enactment of the tax law in December 2017, we were introduced to this new concept and, with the first set of Proposed Regulations released in October 2018, several, but not all, questions were answered. Now, six months later, many remaining questions have been answered. This article presents some of the practical impacts of the Proposed Regulations. Subsequent articles will include those that specify the contractual representations and warranties that real estate developers and investors might wish to use to ensure the tax benefits are achieved and the projects are built.

By now, a lot of ink has been spilled across the country on Opportunity Zones and the base line tax benefits. Undoubtedly, contemporaneous with this article will be others synthesizing the rules. While we will leave that to others, a brief framework is in order.

Fundamental QOZ Framework

An individual or entity with capital gains realized after 2017 and before 2027 from any source (e.g. the sale of stock, not just from real estate) can defer paying tax on that capital gain to the extent the gain amount is invested within 180 days of realization in a Qualified Opportunity Fund (“QOF”). That gain can be deferred until as late as the end of 2026 as long as the funds remain invested in the QOF. Depending on the length of that investment period, 10% (for a five-year investment) or 15% (for a seven year investment) of the deferred gain can, in fact, be abated completely (under current law, to achieve the 15% abatement the investment must be made by December 31, 2019, and to achieve the 10% abatement the investment must be made by December 31, 2021). In addition, any tax on the gain from the new investment in the QOF can be entirely abated if the new investment in the QOF is held at least ten years. To be a QOF, the fund must itself be invested in tangible property (real or personal) or businesses located within certain specified zones, called Qualified Opportunity Zones (“QOZ”), located in economically disadvantaged census tracts designated by the governors of each state, and with some limitations, in contiguous census tracts. The Internal Revenue Code and Proposed Regulations, including the second set, delineate the quantum of time and criteria governing the investment necessary to satisfy the opportunity zone rules. Suffice it to say, for purposes of this article, if the QOF touches all bases, the investors should realize the tax benefits appropriate to their situation.

Surprises in the Proposed Regulations

Here are a few of the most interesting and surprising results of the two sets of regulations that may not have been obvious until now:

1. Qualified Opportunity Zone Business Property and Original Use

2. Leased Qualified Opportunity Zone Business Property

3. Qualified Opportunity Zone Business

  1. By the proportion of the number of hours during the year performed by employees, independent contractors, and employees of independent contractors in the QOZ to the total number of hours these persons perform overall in that time frame.

    While it does not say so, the only way for this to work properly is to use an overall number in the denominator that such persons perform for that QOF. Otherwise, the hours a true independent contractor works on other jobs having nothing to do with the QOF or with the QOZ will skew the results.
  2. By the proportion of the amount paid during the year to employees, independent contractors, and employees of independent contractors for work in the QOZ to the total amount paid to these persons overall in that time frame.
  3. “The tangible property of the trade or business located in a [QOZ] and the management or operational functions performed in the [QOZ] are each necessary for the generation of at least 50 percent of the gross income of the trade or business.”
  4. A facts and circumstances test.

4. Notable Rules Governing the Investment

5. Inclusion Events—events that will accelerate the inclusion of gain

Summary

QOZs represent a sweeping program that can have massive tax benefits to investors and economic revitalization to areas that have long been on the losing end of the economy. As we enter this new Emerald City we have to be cautious that the government’s munificence is not met by foolhardy financial deals chasing tax benefits at the expense of true economic worth.

David S. Neufeld is a shareholder at Flaster Greenberg and is licensed to practice in New Jersey, Florida, Pennsylvania and New York. You can reach him at (856) 382-2257 or david.neufeld@flastergreenberg.com.

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