Tax considerations for opportunity zone sales prior to year 10

The qualified opportunity zone (QOZ) regime is fast approaching its six-year anniversary. In exchange for investments into qualified opportunity funds (QOFs), taxpayers can generally defer tax on eligible capital gains until Dec. 31, 2026. Additionally, any gain on the sale of the QOF investment is exempt from tax if a taxpayer holds its interest in a QOF for at least 10 years.

This article explores some of the many possibilities for how QOFs and their investors can proceed in the wake of a sale prior to an investor’s 10-year hold period. Most businesses under the QOZ regime have a two-tier structure under which the QOF’s only asset is equity in an entity called a qualified opportunity zone business (QOZB). The QOZB itself operates a trade or business (e.g., the QOZB acquires a parcel of real estate and operates a rental activity). As such, a sale under the QOZ regime may take several formats, such as a sale of: QOZB assets, all or some QOZB equity or QOF equity. Because most QOFs invest in real estate rental activities, this article will have a particular focus on the sale of real property.

As the earliest possible date a QOF interest could have been acquired is Dec. 22, 2017, investors are still a ways off from achieving the 10-year holding period requirement. Consider that a QOZB may get an offer to sell too attractive to decline, or alternatively, may realize its business model has proven unviable. Economic conditions in both cases may cause the QOZB to liquidate. This liquidation on its own would not trigger the investors’ recognition of their initially deferred capital gains, but depending on how the QOF chooses to proceed in the wake of the QOZB’s liquidation, an inclusion event may result. It is important to note that neither interest nor penalties will be assessed on the recognition of the originally deferred capital gains. 

QOF continues to exist

In situations where an asset sale occurs at the QOZB level, taxpayers can still obtain at least some of the tax benefits of the QOZ program. The QOF is not required to liquidate in reaction to the sale of QOZB assets. If a QOZB wishes to continue to operate after an asset sale, the QOZB has at least three options. 

QOZBs and like-kind exchanges

Where a QOZB sells real property, the QOZB can execute a like-kind exchange (LKE) under IRC section 1031 (a detailed discussion of LKEs is beyond the scope of this article). An LKE would defer interim gain on the sale of any real estate held by the QOZB.  It should be noted that the like-kind property would also need to be located in an opportunity zone and meet all the requirements of the QOZ regime. For any personal property, the QOZB will report gain or loss to the QOF, which in turn will be reported to the QOF’s investors. Tax distributions made by the QOZB or QOF are possible to assist the investors with the associated liability on a gain, to the extent the respective operating agreements provide for them. If the QOZB has no personal property and executes a LKE on any real property sold, then all of the QZ benefits are retained. 

It is critical to note that while an LKE is a potentially viable strategy, careful planning is needed to ensure that the transaction satisfies the rules and requirements imposed by both LKE and QOZ regimes (specifically with respect to the latter, any depreciable replacement property would need to satisfy the “substantial improvement” requirement).

QOZBs and a new business venture

If a QOZB cannot accomplish an LKE, then any gain from the asset sale will be reported to the QOF. A QOZB that wishes to start a new venture must follow the myriad rules the QOZ regime imposes. These rules include, but are not limited to, 70% of its tangible property must be “QOZB property,” 40% of its intangible property must be used in a QOZ, and any nonqualified financial property (broadly, debt, stock, partnership interests, etc.) it holds must make up less than 5% of the adjusted basis of its total asset holdings. Regarding this last requirement, an exception is afforded for reasonable amounts of working capital held in cash, cash equivalents and short-term debt instruments.

The Treasury Regulations support that working capital also includes amounts held pursuant to a 31-month development plan (often referred to as the “31-month working capital safe harbor plan”). If a QOZB sells an asset for cash, the QOZB could possibly establish a new 31-month plan and pursue a new development, however, whether the safe harbor applies to sale proceeds, in addition to capital contributions received by a QOZB, is uncertain.

QOZB ceases to be a QOZB

Finally, an entity may cease to meet the criteria to be a QOZB prior to year 10. For example, it may sell to an unrelated party and thus no longer be conducting a trade or business, but due to various contractual reasons still holds the liquidation proceeds. It should be noted that this does not automatically disqualify the QOF from being eligible as such. Rather, the QOF is subject to a statutory penalty for holding an equity interest in an entity that fails to qualify as a QOZB. In the event a business sells a portion of assets prior to year 10 or for any other reason ceases to be a QOZB, the QOF could simply pay the statutory penalty and wait until the 10-year hold period is met. The tax savings from the gain exemption could exceed the statutory penalty imposed upon the QOF. However, the taxpayer’s facts and circumstances should indicate that the QOZB’s loss of status was the result of valid business or economic reasons, and not for an extended period given the broad anti-abuse rules under the Treasury Regulations. These rules give the IRS the authority to assert that a QOF investment may not qualify as such if a transaction violates the spirit of the QOZ program (i.e., to invest capital in low-income community businesses).

QOZB terminates, but QOF does not liquidate

If the QOZB ceases all operations and distributes proceeds to the QOF, then the QOF investors will realize gain or loss on the QOZB sale. Again, this alone does not trigger an inclusion event to the extent the QOF investors’ capital says in the fund. QOF’s management can decide to pursue a new investment, and while the fund’s operating agreement will ultimately govern how the investors can proceed, presumably investors would have the option to liquate or hold their QOF equity. Departing investors or those who wish to remain but at a reduced equity share would have a full or partial inclusion event, respectively. Investors would effect their departure either by requesting a redeeming distribution from the QOF, or selling their interest in the QOF to another (new or pre-existing) investor. In either instance, the QOF, and the transferor and transferee investors would need to make certain disclosures to the IRS in connection with the transaction.

Similar to those governing QOZBs, rules are in place that require 90% of a QOF’s assets be QOZ property (QOZP), the definition of which excludes cash and cash equivalents. Failure to adhere to this requirement can result in onerous penalties at the fund level. Proceeds from a QOZB liquidation event or a return of QOZB capital are excluded from this analysis, so long as those proceeds are reinvested in QOZP within a year of their receipt and continuously held in cash, cash equivalents or short-term debt instruments in the interim. In other words, the QOF is given one year to reinvest cash received from the QOZB as a result of the sale. During this time, cash will not cause the QOF to fail the 90% test. Any resulting gains are taxable to the QOF owners; however, these gains to the extent they are capital gains are eligible for purposes of another OZ investment.

QOF liquidates

If the fund and its investors agree to liquidate following the QOZB sale, in addition to recognizing their distributive share of the gain or loss on the underlying business, the investors would realize inclusion events with respect to their originally deferred gains. Again, neither interest nor penalties would be assessed in connection with the inclusion event. Furthermore, investors can defer all or a portion of the inclusion event gain to the extent the transaction occurred prior to Dec. 31, 2026, though a new 10-year holding period would apply.

It should be noted that depending on the ownership structure (i.e., depending on how closely held the QOZB is), the QOF may also receive the “offer it can’t refuse” or realize that its QOZB investment isn’t economically feasible and sell to a third party itself rather than the QOZB doing so.  This too results in inclusion events for the original investors, though the reporting requirements may differ. To the extent that the transaction is treated as the purchase of QOF interests from the buyer’s perspective, the buyer can elect to defer any eligible gains they may have incurred in connection with the QOF interest acquisition, with a new 10-year holding period. In other words, QOF equity does not need to be acquired at original issuance.

In addition to the associated tax liabilities a QOF and its investors must be concerned with, the regulations require funds to “self-decertify” as a QOF upon liquidation, a process the IRS has yet to provide any direction for completing. Outside of including footnote disclosures with its final tax return, it is unclear what more a fund can do to meet this requirement.

Conclusion

While the tax benefits associated with holding a QOF investment for the requisite 10-year period are quite compelling, economic realities may prevent them from being realized. There are a number of options for how a QOF, its investors and its underlying QOZB investment can proceed in light of an early disposal, with varying tax consequences. The rules of the QOZ regime in general are quite complex, and critical to follow, particularly in light of an event so consequential as a sale.

For more information on these important topics, or to learn how a Baker Tilly specialist can help, contact our team.

The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely. The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.