Qualified Opportunity Zones –
Where Are We?
By Jackie Matsumura and Greg Dresdow
Since Qualified Opportunity Zones (QOZs) were first
introduced in 2017, we have received two sets of proposed
regulations dealing with QOZs and there have been two
formal Treasury Department hearings regarding these
rules, as well as a couple of additional published guidance
items issued.
While many questions have been answered, there still
exist further questions and uncertainty. However, with the
guidance we now have, Qualified Opportunity Zone Funds
(QOZFs) are being formed and “the train has left the station.”
We have previously published two standalone releases on
QOZs. The purpose of this article is to look at some of the
remaining issues/uncertainties. The last Treasury hearing on
QOZs was July 9. There will likely be no further hearings, and
it is expected that final regulations will be issued, hopefully in
the near future, although it is unclear whether there may be
additional proposed regulations.
Here is some discussion around some, not all, of the
remaining issues.
Section 1231 Gains
The existing regulations provide an investor must invest
capital gains into a QOZF to achieve the desired tax benefits.
The sale of trade or business assets (e.g., sale of rental real
estate) is classified as Section 1231 gain. Section 1231 gain
is treated as capital gain and the amount that can be invested
in a QOZF is the net Section 1231 gain (after offsetting the
gain by any Section 1231 losses for the year). Since the
amount eligible for investment in a QOZF is the net Section
1231 gain, the investor has to wait until the end of the year
to see what his / her net Section 1231 gain is. It appears the
recapture of prior year Section 1231 losses would not impact
the calculation of the net Section 1231 gain for the current
year and thus the amount eligible for investment.
Further, the latest round of regulations indicates the 180 day
investment period for such gain starts on the last day of the
tax year. So, if you sold your rental apartment in February
and generated $5 million of Section 1231 gain, your 180 day
investment period does not start until December 31 of your
tax year. Taxpayers who invested Section 1231 gains prior to
the release of the second set of proposed regulations may
find the investment does not qualify for QOZ benefits unless
some relief is forthcoming.
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BPM Real Estate Insights
The fact that a portion of the Section 1231 gain may be treated
as Section 1250 unrecaptured depreciation gain should not
change this favorable treatment. Section 1250 unrecaptured
gain is still treated as capital gain but merely taxed at a higher
tax rate (25%).
It is hoped that in the regulatory guidance to come, taxpayers
would be given a choice to use either the 180 day period
beginning on the realization date or the 180 day period
beginning on the last day of the tax year.
Substantial Improvement Test
In order for a property to qualify as a Qualified Opportunity
Zone Business Property (QOZBP), the original use of that
property has to commence with the QOF or the QOF has
to “substantially improve” the property. The question arises
in the context of purchased property and whether the QOF
can meet the substantial improvement test on an asset by
asset basis or can the fund aggregate assets to meet the
test. The preamble to the regulations indicates the test
is on an asset by asset basis. So, if you purchased a 10
building apartment complex, on one land parcel, you would
have to meet the substantial improvement test on each of
the 10 separate buildings rather than meeting the test in
the aggregate. If you made no improvements to three of the
buildings, but spent sufficient amounts on the remaining
buildings to meet the test on each of those buildings, you
would only have seven of the 10 buildings that would be
QOZBP. If you were allowed to aggregate all 10 buildings,
then the entire project would qualify.
It is hoped that in the guidance to come some reasonable
aggregation would be allowed. For example, in the real estate
context, aggregation should be allowed if the property (the 10
building apartment complex above) operates as an integrated
unit (as evidenced by management, financing, and general
operations, etc.).
Valuing a Carried Interest
A partnership interest received for services (a carried interest
or a profits interest) is not a qualifying interest in a QOZF.
If a partner has a mixed investment (e.g., a capital interest
and a carried/profits interest), the allocation percentages are
calculated, for the profits interest, based on the highest share
of the residual profits the partner would receive with respect
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