The Opportunity Zone program created by the Tax Cuts and Jobs Act of 2017 (the “TCJA”) allows taxpayers that realize certain gains to elect to defer the federal income tax on such gains by reinvesting them into Qualified Opportunity Funds (“QOFs”). QOFs must invest in businesses located in low-income, distressed areas designated as “opportunity zones,” of which approximately 8,700 communities across the United States have been so designated.
On Friday, October 19, 2018 the Internal Revenue Service released proposed regulations (the “Proposed Regulations”) that provide guidance on a wide range of issues that potential investors in the newly-created Opportunity Zone program have been wrestling with since the program was added to the Internal Revenue Code by the TJCA. The Proposed Regulations do not answer all questions, and the IRS acknowledges that additional issues require clarification or further guidance and has indicated that further guidance will be forthcoming in 2018.
Tax Benefits of Investing in Qualified Opportunity Funds
Investing in QOFs can provide three tax benefits:
Basic Requirements for Claiming Tax Benefits
To qualify for the tax benefits of the Opportunity Zone program:
- A taxpayer must generally invest in a QOF during the 180-day period beginning on the date of the sale or exchange event which gave rise to the gain.
- At least 90 percent of a QOF’s assets must be invested in qualified opportunity zone property, which generally includes qualified opportunity zone business property (“QOZBP”), or stock or certain equity interests in operating businesses in which substantially all the of the tangible property is QOZBP.
- The definition of QOZBP requires property to be used in a qualified opportunity zone (“QOZ”), and also requires new capital to be employed in a QOZ. An eligible business must be a corporation or partnership created or organized in, or under the laws of, one of the 50 states, the District of Columbia, or a U.S. possession. QOZBP is tangible property used in a trade or business, only if:
- 1) the property was purchased after December 31, 2017,
- 2) the original use of the property in the QOZ commences with the QOF, or the QOF substantially improves the property, and
- 3) during substantially all of the QOF’s holding period for the property, substantially all of the use of the property was in a QOZ.
An eligible trade or business does not include any golf course, country club, massage parlor, hot tub, suntan, racetrack or gambling facility, or any store that sells alcoholic beverages for consumption off premises as its principle business.
Clarifications on Eligible Gains
The Proposed Regulations clarify that only capital gains are eligible for tax benefits. Confusion had arisen because the statute’s header uses the term “capital gains,” but the actual statutory language uses only the word “gains.” The Proposed Regulations also clarify that only capital gains realized before December 31, 2026 are eligible, and that the gains must not arise from a sale of property to a “related party”. There is a modified definition of “related party” that applies for purposes of this rule, which changes the 50 percent threshold for prohibited common ownership to 20 percent.
A taxpayer that holds a QOF investment for at least 10 years may generally elect to increase the basis of its investment to the fair market value of the investment on the date that the investment is sold or exchanged (thereby excluding any such gain from federal income taxation). If a taxpayer invests in a QOF in part with deferred gains, and in part with other funds, the investments must be treated as two separate investments which receive different treatment for federal income tax purposes. The Proposed Regulations reiterate that a taxpayer may make the election to step-up basis in an investment in a QOF that was held for 10 years or more only if a proper deferral election was made for the investment.
The Proposed Regulations address the 180-day rule for deferring gain by investing in a QOF, which generally requires that a taxpayer invest in a QOF during the 180-day period beginning on the date of sale or exchange giving rise to the gain. One issue that arises from this rule is determining when to begin the 180-day period where a capital gain is deemed to be recognized under Federal tax rules but lacks a specific realization date. This issue is addressed in the Proposed Regulations by providing that generally, the first day of the 180-day period is the date on which the gain would be recognized for Federal income tax purposes.
Who is an Eligible Taxpayer
The statute addressed deferral of gains realized by “the taxpayer.” This left some uncertainty about how gains realized by pass-through entities could be deferred. The Proposed Regulations clarify which taxpayers are eligible to defer to recognition of capital gain through investing in a QOF and describe how different types of taxpayers may satisfy the requirements for electing to defer capital gain. Specifically, in order to incentivize partners and partnerships to invest, the Proposed Regulations describe rules for how partnerships and partners in a partnership may invest in a QOF and elect to defer recognition of capital gains. Under the Proposed Regulations, virtually all types of taxpayers can take advantage of the opportunity zone incentive – individuals, C corporations (including regulated investment companies and real estate investment trusts), trusts, LLCs and partnerships, and most other pass-through entities. In the case of pass-through entities such as partnerships, the election to defer tax on capital gains can be made at either the partnership or partner level.1 It is most likely for this reason that the Opportunity Zone program has been getting so much attention in the mainstream press, because past tax benefit programs that focused on incentivizing investments in economically distressed communities did not have the same broad eligibility as the Opportunity Zone program, and specifically have excluded non-corporate taxpayers from utilizing these tax benefits.
Opportunity Zone Designations and Eligible Investments
An investment in a QOF can continue to be eligible for the deferral benefits even if the community in which the investment is made subsequently ceases to be designated as an opportunity zone. Furthermore, only equity investments – including preferred stock or a partnership interest with special allocations – can give rise to the tax benefits. Debt investments are ineligible.
Qualified Opportunity Funds can be formed as Limited Liability Companies
The Proposed Regulations clarify that the statutory language requiring a QOF to be an entity “which is organized as a corporation or a partnership” extends to an entity that is not in form a state law partnership, such as a limited liability company, so long as the entity is classified as a partnership for federal tax purposes. It is also now clear that an entity must be a domestic corporation or partnership (or, in limited circumstances, an entity created under the laws of a U.S. possession).
Self-Certification Details Unveiled
One of the most attractive features of the Opportunity Zone program is that the funds can self-certify their status, rather than go through an approval process or await any governmental agency action. The Proposed Regulations provide a series of rules pursuant to which an entity that intends to self-certify can determine the time period at which it wishes to be considered a QOF. Since a deferral election may only be made for investments in a QOF, a proper deferral election may not be made for an otherwise qualifying investment that is made before an eligible entity is a QOF.
Opportunity Zone Business Issues
A major issue relating to whether a business is eligible to be a QOF investment is the fact that it may have more than a de minimis amount of “nonqualified financial property,” such as cash. Working capital is allowed, and reasonable amounts of working capital held in cash, cash equivalents, or debt instruments with a term of 18 months or less (working capital assets) are excluded from the definition of nonqualified financial property. The Proposed Regulations establish a working capital safe harbor under which a qualified opportunity zone business may hold cash or cash equivalents for a period generally not longer than 31 months. The Treasury Department and the IRS have left open the question of whether future regulations will address extensions of the safe harbor period due to unforeseeable circumstances, such as when there are natural disasters, or delays caused by federal or state agencies.
The Proposed Regulations address the substantial improvement requirement with respect to a purchased building located in a QOZ by providing that the basis attributable to land on which such a building sits is not taken into account in determining whether the building has been substantially improved. The purpose of this is to facilitate repurposing vacant buildings in QOZs. The Treasury Department and the IRS are working on additional published guidance regarding possible approaches to defining the “substantial improvement” requirement, and the “original use” requirement for both real property and other tangible property.
Although the Proposed Regulations provide fairly extensive and important guidance on many issues, there remain some important points:
- Real Estate is expected to be a major source of opportunity zone projects and certain rules especially important for real estate – notably “original use” and “substantial improvement” – still need comprehensive definitions.
- Many provisions in the statute and Proposed Regulations use the term “substantially all;” a comprehensive definition of that term has been expressly left to future regulations.
- Future regulations are authorized to be issued to ensure that a QOF has “a reasonable period of time to reinvest the return of capital from investments in qualified opportunity zone stock and qualified opportunity zone partnership interests, and to reinvest proceeds received from the sale or disposition of qualified opportunity zone business property” - future regulations are expected to provide guidance on reinvestments.
The Proposed Regulations are intended to provide more certainty to taxpayers, which should in turn incentivize them to invest more into QOZBP. The greater purpose behind this is to bring investments into businesses located in low-income, distressed areas. Due to the 180-day rule, it is important to move quickly in order for taxpayers to be eligible to defer tax on related gains.