The federal Opportunity Zone (OZ) program, created in December 2017, has been a major topic of discussion for investors, businesses, and project developers alike. It seems, however, that the utilization of the OZ program has been relatively slow despite the program’s tremendous potential.
One reason for the relatively slow pace has been a lack of guidance on many of the outstanding questions about how the program will operate. In late October 2018, the IRS proposed regulations as well as other guidance, which answer a number of these questions, but leave others still unanswered.
As discussed in earlier Alerts (States Designate Opportunity Zones, Opportunity Zones: Economic Development and Tax Deferral), the OZ program is intended to spur investment in economically distressed areas by offering investors tax benefits for investing in qualified opportunity funds (QOFs) that in turn invest in qualified OZ property. The proposed rules and guidance begin to address specific taxpayer questions to encourage participation in the program. Although the rules are proposed and not final, taxpayers are generally permitted to rely on them as long as the rules are applied in their entirety and in a consistent manner. Below are a few of the key items addressed by IRS guidance, as well as some important items that were left for another day.
180-Day Election Period. The election to defer gain must be made within 180 days of the transaction resulting in the gain. The proposed regulations include an important liberalization of the rule in the case of partnerships, S corporations, and other pass-through entities. For these entities, there are effectively two chances to defer the gain. First, the entity itself can elect to defer the gain within 180 days of the transaction generating the gain. Second, if the entity does not make such an election, the partner/shareholder has 180 days from the end of the entity’s taxable year to elect to defer the gain at the partner/shareholder level.
Multiple Deferrals Allowed. Generally, a taxpayer must include the deferred gain in income when it sells its interest in a QOF. The proposed rules confirm that a taxpayer that sells or exchanges its original QOF investment can make a new investment in a new QOF and again elect to defer recognition of the previously deferred capital gain, but only until December 31, 2026.
Exclusion of Gain after Ten Years. Another OZ tax benefit allows a taxpayer to exclude its gain from the disposition of a QOF investment held for at least ten years, i.e., the investment made to defer the initial capital gain. However, all OZ designations are set to expire December 31, 2028. A significant question arose as to whether investors investing in 2019 and after would be eligible to exclude the gain after the OZ designations expired. In response, the proposed rules make clear that, so long as the disposition of the investment occurs before January 1, 2048, a taxpayer may exclude the gain, even if the OZ designation has expired.
90% Asset Test. A QOF must hold at least 90% of its assets in qualified opportunity zone property (the Asset Test). The proposed regulations address several potential compliance traps, including a working capital safe harbor for construction and rehabilitation projects. The rules also provide a taxpayer-friendly clarification of the rule that the original use of the property must begin after December 31, 2017: property that is substantially improved (meaning the cost of improvements exceed the cost of the unimproved property) meets the original use test. Importantly, the cost of land is not included in this calculation.
When the underlying qualified OZ property is itself an interest in a corporation or partnership, substantially all of the assets of the subsidiary entity must be qualified for purposes of meeting the Asset Test. A key question was, thus, what “substantially all” meant in this context. The proposed regulations clarify that “substantially all” means at least 70%. That is, the QOF must invest at least 90% of its assets in an underlying corporation or partnership, at least 70% of whose assets are qualified OZ property. This rule is quite taxpayer-friendly, providing certainty and a relatively low threshold to satisfy.
Although the guidance answers a number of questions, some questions remain unanswered. For example, to be qualified, an entity must be in the active conduct of a trade or business. Does “active” include a triple net lease? A QOF is entitled to a reasonable period to reinvest proceeds from the sale of qualifying assets. How long is “reasonable”? Will there be a safe harbor for a QOF to invest the proceeds of the investments it receives?
Perhaps the most important question is whether the guidance we have to date is sufficient to get the many investors who have been sitting on the sidelines, off the sidelines.