The Tax Cuts and Jobs Act, enacted December 22, 2017, brought about significant changes intended to promote investment and stimulate the economy. Among the changes was the creation of a new investment vehicle called “qualified opportunity funds,” which provide tax incentives for investments in economically distressed communities designated qualified opportunity zones. More specifically, there are three main tax benefits offered by the qualified opportunity funds (“QO Funds”):
- Capital Gain Deferral. Any gain from the sale of appreciated property to an unrelated person that is reinvested in a qualified opportunity fund within 180 days of the date of sale, may be deferred by a taxpayer until the earlier of the disposition of the qualified opportunity fund or December 31, 2026.
- Basis Boost. Upon contribution of the gain into a QO Fund, the taxpayer takes a basis of zero in their fund investment, but if the fund investment is held for 5 years, the taxpayer will receive a basis increase of 10% of the deferred gain. The taxpayer will receive an additional 5% basis increase if the investment is held for 7 years. Thus, it’s possible for a taxpayer to increase his basis in the deferred gain by as much as 15%, thereby eliminating 15% of their future taxable gain.
- Permanent Capital Gain Exclusion. If a taxpayer holds his investment in the fund for at least 10 years, all the gain attributed to the appreciation in the value of his QO Fund investment is permanently excluded from the taxpayer’s gross income.
These tax benefits are offered as incentives for investments in qualified opportunity zones (“QO Zones”). QO Zones are low-income communities that are designated by the Treasury Department. When the Tax Cuts and Jobs Act passed, the Treasury asked governors of each state to nominate up to 25% of their state’s low-income communities for designation as QO Zones. Arkansas has 85 QO Zones that were approved on May 18, 2018. The QO Zones located in Arkansas can be viewed on the website linked here. The QO Zones selected by Governor Asa Hutchinson include areas located in most of Arkansas largest cities. Accordingly, most if not all Arkansas real estate investments in 2018 and beyond should be analyzed to determine whether the investment can qualify as a QO Fund.
To qualify, a QO Fund must be organized for the purpose of investing in qualified opportunity zone property, which is defined to include qualified opportunity zone stock, qualified opportunity zone partnership interest, or qualified opportunity zone business property (“QOZ Property”). A QO Fund may be organized as a corporation, LLC, or partnership so long as it maintains at least 90% of its capital in QOZ Property. To become a QO Fund, an eligible entity self-certifies. Thus, no approval or action by the IRS is required. To self-certify, an entity will complete a form (which according to the IRS will be released in 2018) and attaches that form to the entity’s federal income tax return for the taxable year.
- QOZ stock is stock in a U.S. corporation that is a QOZ business (defined below). The stock must be acquired solely for cash by the QO Fund after 2017, at its original issue (directly or through an underwriter). Also, at the time the stock was issued, the corporation must have been a QOZ business, or for a new corporation, it was organized to be a QOZ business. Further, the corporation must be a QOZ business for substantially all of the fund’s holding period for the stock.
- QOZ partnership interests is capital or profits interest in a U.S. partnership that was acquired by the QO Fund from the partnership after 2017 solely in exchange for cash. Also, at the time the partnership interest was acquired, the partnership must have been a QOZ business or, for a new partnership, it must have been organized for purposes of being a QOZ business. Further, the partnership must be a QOZ business during substantially all of the of the QO Fund’s holding period for the interest.
- QOZ business property is tangible property used in a trade or business of a QO Fund that was purchased after 2017 from an unrelated party. Also, the original use of the property in the QO Zone must begin with the QO Fund, or the QO Fund must substantially improve existing property within the QO Zone. Further, substantially all the use of the property must be in the QO Zone during substantially all of the QO Fund’s holding period for the property. Property is substantially improved if capital expenditures on the property in the 30 months after the QO Fund acquires it exceed the property’s adjusted basis on the date of acquisition by the QO Fund.
The stock or partnership interest that a QO Fund owns must be in a U.S. corporation that is a QOZ business. A QOZ business is any trade or business that meets the following principal requirements:
- Substantially all of the tangible property owned or leased by the business must be purchased by it after 2017;
- The QOZ business must be the first person to use the property in the QO Zone, or it must substantially improve the property;
- The property must be used in the QO Zone during substantially all of the QOZ business’s holding period;
- The property must not be acquired from a related person or a member of a 20-percent-controlled group of which the taxpayer is a member;
- At least 50 percent of the total gross income of the entity is derived from the active conduce of business in the QO Zone; and
- A substantial portion of the business’s intangible property is used in the active conduct of business in the QO Zone.
The law specifically prohibits a qualifying business from being a country club, massage parlor, hot tub facility, racetrack, health club, or liquor store.
Additional information regarding QO Funds can be found on the IRS website linked here.
While we are still awaiting further guidance from the IRS regarding these new investment incentives, it’s clear that the QO fund provides an attractive investment opportunity for Arkansas real estate investors. If you are interested in qualified opportunity funds and investments in Arkansas, please contact any one of our attorneys to schedule a consultation.