We learned that the election to invest in a Qualified Opportunity Fund (QOF) may be made by either the pass-through entity that sold the asset generating the gain or by its owners, in the foregoing order of priority. This means that if the entity does not so elect, its owners may each decide for themselves whether to invest their respective shares of the gain. This flexibility notably contrasts with the rigid rules applicable to Section 1031 like-kind exchange transactions, which require that the purchaser of the replacement property be identical to the seller of the relinquished property. The entity’s owners may also decide whether to use the entity’s tax year end date or the date the entity sold the asset as the commencement date for the 180-day period within which the investment in a QOF must occur.
We now know that "gain" means "capital gain." The sales of many businesses and real estate assets generate both capital gain and ordinary gain. The new legislation used the term "gain," giving commentators some hope that ordinary gain from the sale of assets would qualify for investment in a QOF. The proposed regulations dash that hope.
A QOF may hold cash from investors for an extended period of time to allow for development projects without "flunking" the periodic qualification tests that apply to a QOF. Specifically, as long as the QOF jumps through specified hoops, it will have 31 months to deploy the funds for qualified purposes. This was a key issue raised by many organizations. My expectation is that there will be additional questions regarding this aspect of the proposed regulations, but at least we know that immediate deployment is not required.
Entities that are taxed as partnerships may qualify as QOFs. The statute provided that a QOF must be organized as a partnership or corporation, but no mention was made of limited liability companies, the entity of choice for many real estate investors and developers. The new guidance allows limited liability companies to qualify as QOFs, provided they have at least two members.
The guidance is quite favorable for those situations where the QOF acquires land with a building that will be substantially improved. In order to qualify, the statute requires that the cost of the improvements exceed the cost of the property. We now know that the foregoing "substantial improvement" test is measured only by the portion of the purchase price attributable to the building. In addition, the land need not be separately improved for it to qualify as "Zone Business Property." This will increase the importance of allocating the property's purchase price between land and building in a manner that will be respected by the IRS.
The guidance from the IRS anticipates more to follow. Expect a sequel to this post in due course.