As part of the Tax Cuts and Jobs Act of 2017, Congress enacted sections 1400Z-1 and 1400Z-2 of the Internal Revenue Code, which were intended to promote investments in low-income communities designated as “Opportunity Zones.” Opportunity Zones have been designated across the United States and its territories, including in major cities. For businesses and investors that plan to dispose of appreciated property to unrelated parties, these rules offer significant opportunities to (1) defer, and potentially reduce, gains from such property, and (2) potentially realize tax-free gain on Opportunity Zone investments.
On October 19, 2018, the US Treasury (Treasury) and the Internal Revenue Service (IRS) released highly anticipated proposed regulations (the Proposed Regulations) that provide businesses and investors with some clarity on these rules. Treasury and the IRS simultaneously issued Revenue Ruling 2018-29 as well as a drafts of IRS Forms 8996 and 8949 and their respective Instructions. Treasury indicated that another set of proposed regulations would be forthcoming.
A taxpayer can elect to defer capital gain from a sale or exchange of property to an unrelated party if, within 180 days, the taxpayer reinvests the amount of such gain (Reinvested Gain) in an equity interest in a Qualified Opportunity Fund (QOF) — generally, a US corporation or partnership that invests in Qualified Opportunity Zone Property (described below). The following benefits are available under these rules:
- Deferral of tax on the Reinvested Gain until the sale of the interest in the QOF or December 2026, whichever comes first;
- If the investment in the QOF is held for at least five years, the taxpayer’s basis in the QOF, which is zero when the investment is made, is increased by an amount equal to 10% of the Reinvested Gain, which may effectively exclude such amount from income;
- If the investment is held for at least seven years, the taxpayer’s basis in the QOF is increased by an additional amount equal to 5% of the Reinvested Gain (or 15% total), which may effectively exclude such amount from income; and
- Subject to certain limitations described below, if the investment is held for at least 10 years, the taxpayer can elect to increase its basis in the QOF to the fair market value of the QOF at the time of disposition, effectively excluding post-acquisition gain from income (the Post 10-Year Gain Exclusion).
Which Taxpayers Are Eligible?
The Proposed Regulations provide that any person that recognizes gains for US federal income tax purposes is eligible, including individuals, C corporations (including regulated investment companies and real estate investment companies), partnerships, S corporations, trusts, and estates.
Eversheds Sutherland Observation: Limited liability companies that are treated as corporations or partnerships for US federal income tax purposes should be eligible. Foreign persons subject to US federal income tax (generally, as a result of the effectively connected income rules, including the Foreign Investment in Real Property Act) should also be eligible.
Which Gains Are Eligible?
The Proposed Regulations provide that for a gain to be eligible it must (i) be treated as a capital gain for US federal income tax purposes; (ii) be recognized (subject to deferral under these rules) prior to January 1, 2027; and (iii) not arise from a sale or exchange with a related party. The Proposed Regulations include special rules for section 1256 contracts and capital gain arising from a position that is part of an “offsetting-positions transaction.”
Eversheds Sutherland Observation: Gains that are not treated as capital gains are not eligible. The treatment of section 1231 gains remains unclear. Such gains generally will be treated as long-term capital gains, but only if section 1231 gains exceed section 1231 losses for that year. Does the eligibility for deferral really depend on the results of this “hotchpot” calculation? Treasury should provide additional guidance to clarify this issue.
How Do You Elect to Defer?
As noted above, an eligible taxpayer may elect to defer an eligible gain if it reinvests that gain in a QOF within 180 days. A taxpayer makes the election by filing new IRS Form 8949 with its tax return for the taxable year in which the gain would have been recognized if not deferred.
The Proposed Regulations clarify that a partnership may make the election; if the partnership does not, the individual partners may elect to defer their distributive share of the partnership’s eligible gains. Similar rules apply to other pass-through entities (including S corporations, trusts, and estates) and to their shareholders and beneficiaries.
Eversheds Sutherland Observation: Partners should consider including appropriate provisions in partnership agreements regarding QOFs, including provisions to avoid duplicative deferral elections and to provide notice to allow partners to identify and invest in QOFs when the partnership declines to do so.
How Long Can You Hold a QOF and Still Elect the Post 10-Year Gain Exclusion?
The designations of Opportunity Zones expire on December 31, 2028. This raised the issue of whether taxpayers that did not meet the 10-year holding period until after that date, by virtue of making a QOF investment after December 31, 2018, would be able to elect the Post 10-Year Gain Exclusion. The Proposed Regulations address this point by providing that the election may be made until 2047 (i.e., 20 ½ years after December 31, 2026, which is the last date a taxpayer can make an investment as part of the deferral program).
What Is a QOF?
A QOF is a US corporation or partnership organized for the purpose of investing in Qualified Opportunity Zone Property (QOZ Property). The Proposed Regulations permit entities to self-certify QOF status by filing new IRS Form 8996.
For an entity to qualify as a QOF, at least 90% of its assets must consist of QOZ Property (the 90% Asset Test). QOZ Property includes certain tangible business property located in an Opportunity Zone (OZ Business Property) or interests in certain corporations or partnerships “substantially all” of the tangible property of which is QOZ Property (OZ Businesses). Accordingly, a QOF can choose to invest directly in OZ Business Property or indirectly through OZ Businesses.
Generally, for property to qualify as OZ Business Property, the “original use” of the property must commence with the QOF or the QOF must “substantially improve” the property. Property is treated as substantially improved if the QOF makes capital expenditures with respect to the property that exceed the property’s initial tax basis within 30 months of the property’s acquisition.
The Proposed Regulations provide a bright-line rule that if at least 70% of an entity’s tangible property is OZ Business Property, the entity satisfies the requirement that “substantially all” of its tangible property must be OZ Business Property.
Eversheds Sutherland Observation: As a result of this bright-line rule, where a QOF invests through an OZ Business, it appears that in combination the QOF and OZ Business need only hold 63% of their assets in OZ Business Property for the QOF to satisfy the 90% Asset Test.
Working Capital Safe Harbor
The Proposed Regulations establish a “working capital safe harbor” that allows an OZ Business to hold cash and other financial property for up to 31 months so long as such property is being held as part of a written plan to acquire, construct or rehabilitate tangible property in an Opportunity Zone.
Investments in Real Estate
As noted above, for property to qualify as OZ Business Property, the “original use” of the property must commence with the QOF or the QOF must “substantially improve” the property. Revenue Ruling 2018-29 addresses an acquisition by a QOF of an existing building on land in an Opportunity Zone. The Ruling states that the “original use” requirement is not satisfied with respect to the building and is not applicable to the land. The Ruling goes on to clarify that the tax basis attributable to the land is not taken into account in determining whether the building has been substantially improved and that there is not a separate requirement to improve the land.
Open Questions and Further Guidance
Treasury has indicated that further proposed regulations will be forthcoming and has requested comments both on the Proposed Regulations and the open issues to be addressed in the forthcoming proposed regulations. Some open questions include: the meaning of “substantially all” in a number of contexts; transactions that may trigger the inclusion of deferred gain; the “reasonable period” for a QOF to reinvest proceeds from the sale of qualifying assets; administrative rules applicable when a QOF fails to meet the 90% Asset Test; and information-reporting requirements.