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.