Biggest Winners from Second Round of QOZ Regulations: Private Equity

Who’s the biggest winner from the second round of Qualified Opportunity Zone (QOZ) proposed regulations? One might say real estate investors got a big win from the clarification of debt financed distributions. Others may say startups took home the biggest win given the significant flexibility when it comes to sales outside of a QOZ. Both of these are important in the grand scheme of Sec. 1400Z-2’s success or failure but the biggest win from the IRS’s issuance of REG-120186-18 had to be given to private equity.

After the first round of proposed regulations it didn’t seem like the QOZ program was flexible enough to sway taxpayer’s willingness to take a risk in investing in low income and economically distressed communities. Specifically, the ten year holding period was a non-starter for most investors who were leery of holding an investment past the point where it became economically disadvantageous.

However, with the new updates from the second round of proposed regulations, investors might want to think again before writing off QOZs altogether.

Congress Designed The Program For Private Equity

When congress was drafting Sec. 1400Z-2 it appeared they were focusing its attention on private equity and high-net worth individuals to lead the charge with investing in some of the most underserved communities in the U.S. For starters, to qualify for the tax incentives a taxpayer will have to realize a capital gain and subsequently re-invest that gain into a Qualified Opportunity Fund (QOF).

Most taxpayers don’t have any significant unrealized gains so the focus of this program was to entice private equity and high net-worth individuals by offering deferral and total exclusion of capital gains.

Qualified Opportunity Funds Work Best as a Fund

Based on the first and second round of proposed regulations a QOF works best when its designed as a fund. Investors hold interest within a fund which itself holds interest in partnerships and C Corporations. Those partnerships and C Corporations can be startups or even hold real property within a QOZ.

Using this tiered structure a QOF can benefit from all of the tax incentives while effectively holding as little as 40% to 63% of its assets within a QOZ. This flexibility allows for diversification for investors and better overall economic outcomes.

Churn Within a Fund Won’t Impact an Investor’s Holding Period

One of the biggest concerns for investors was the arbitrary ten year holding period to cash out on the total exclusion of capital gains. With the second round of prosed regulations the IRS clarifies that the ten year holding period refers to the interest in the fund and not the actual assets inside the fund.

Therefore, a QOF can buy, sell and exchange investments within that ten year period without impacting the investor’s holding period. During the ten year holding period any capital gains would flow through to the partners or be taxed at the corporate level but after the ten year period those gains would be tax free.

Even better yet, an investor with a ten year holding period can make an election to exclude from income any capital gains from the QOF instead of disposing of the interest altogether.

The QOZ Program Will Only Be Successful if Private Equity Buys In

The second round of proposed regulations makes it more enticing than ever for private equity to throw its money at QOZs. It appears as if the IRS is following Congress’ legislative intent by making its regulations business friendly and extremely flexible.

The way the rules are written, it should be on the radar of those in private equity to at least consider establishing a fund to cash out on some of these lucrative tax benefits. Of course there is risk with investing in these low income communities however Congress is willing to trade investor’s high risk for tax free rewards.

This material has been provided for general informational purposes only and does not constitute either tax or legal advice. Although we go to great lengths to make sure our information is accurate and useful, we recommend you consult a tax preparer, professional tax advisor, or lawyer.