On October 19, 2018, the IRS released eagerly awaited regulations, a revenue ruling, and a tax form that provide guidance needed to implement the Opportunity Zone Fund program, which was enacted as part of the 2017 tax reform legislation. The Opportunity Zone Fund program offers substantial tax benefits to taxpayers that reinvest capital gains from the sale of existing investments into a Qualified Opportunity Fund (QOF). A QOF must invest in property or businesses in certain low-income communities, identified as Qualified Opportunity Zones. Timely investment in a QOF makes taxpayers eligible for deferral of tax on and a partial basis stepup with respect to the rolled-over old gain and an exclusion of 100 percent of gain attributable to the taxpayer's new investment in the QOF. Our earlier guidance, Opportunity Zone Funds – What We Know at July 2018, will be updated in detail.
The regulations clarified a number of open issues regarding investments in Qualified Opportunity Funds, including the following key points:
Eligibility for investment in a QOF:
- Only capital gains, and no other types of gain or income (such as depreciation recapture), are eligible for investment in a QOF.
- The deferral election should be made on IRS Form 8949, Sales and other Dispositions of Capital Assets, which is to be attached to the taxpayer's tax return for the year in which the gain would have been recognized.
- Individuals, C corporations, regulated investment companies, real estate investment trusts, partnerships, and S corporations are all eligible to make the deferral election.
- Pass-through entities, such as partnerships, provide significant flexibility in electing deferral under the program. The election can be made at the partnership level with respect to all or part of the gain; if the partnership does not make the election or only makes the election with respect to some of the gain, the partners each have an opportunity to make a deferral election with respect to their specific share of the flow-through gain (to the extent the partnership did not make a deferral election with respect to such gain). If the partner is making the election, the partner has 180 days from the last day of the partnership's taxable year to make the election. Analogous rules will apply to other pass-through entities.
Becoming a Qualified Opportunity Fund:
- Taxpayers that are classified as corporations or partnerships under federal income tax rules can be QOFs. Accordingly, entities formed under state law as a LLC but having "partnership" status for income tax purposes can be QOFs.
- Taxpayers will use a new form, Form 8996, Qualified Opportunity Fund, for the initial self-certification of the taxpayer as a QOF, and as the means for annual reporting of compliance with program requirements.
- Taxpayers can specify the taxable year in which the taxpayer becomes a QOF and the month such designation should begin. This is critical, as taxpayers must comply with certain tests (specifically the 90 percent asset test, pursuant to which 90 percent of the fund's assets must be invested in Qualified Opportunity Zone Property), applied at 6-month intervals, to self-certify.
- A QOF will have a reasonable period of time to reinvest gain in other Qualified Opportunity Zone property in order to satisfy the 90 percent asset test. Additional guidance on this topic is forthcoming.
- For purposes of the 90 percent asset tests, funds should use the asset values reported on their applicable financial statements.
- A pre-existing entity can become a QOF.
- Because the QOF must satisfy the 90 percent asset test, commentators were concerned regarding a lack of assets during the start-up phase of a business. The regulations provide a working capital safe harbor for a period of up to 31 months if certain requirements are satisfied.
Qualified Opportunity Zone Businesses:
- A QOF must invest in Qualified Opportunity Zone Property, which includes direct investment in Qualified Opportunity Zone Business Property as well as indirect investment via equity interests in entities that qualify as Qualified Opportunity Zone Businesses.
- Qualified Opportunity Zone Business Property is tangible property used in a trade or business of a QOF, if: (1) the property was acquired by purchase after 12/31/2017; (2) the original use of the property commenced with the QOF or the QOF substantially improves the property; and (3) during substantially all of the QOF's holding period, substantially all of the use of the property was in a Qualified Opportunity Zone.
- To qualify as a Qualified Opportunity Zone Business, substantially all of the tangible property owned or leased by the business must be Qualified Opportunity Zone Business property. "Substantially all" generally means 70 percent.
- In addition, at least 50 percent of the income of the entity must be derived from the active conduct of a trade or business in the qualified opportunity zone.
- For businesses with intangible property, a substantial portion of the property must be used in the active conduct of a trade or business in the qualified opportunity zone. Note that the regulations clarify that the 70 percent standard applies solely for purposes of the tangible property test.
- For equity interests to qualify as Qualified Opportunity Zone Business Property, the entity conducting the business must be a Qualified Opportunity Zone Business both when the QOF acquires its interest in the business and during substantially all of the QOF's holding period of the interest.
- If an entity is a Qualified Opportunity Zone Business, the value of the QOF's interest in the entity qualifies for purposes of the 90 percent asset test.
Significant issues as to the various qualification requirements for investments in and by QOFs remain unanswered after publication of this guidance. The IRS asks for comments on many of those open questions and promises to issue additional guidance. Despite the need for further guidance, this first round of guidance addresses many of the gating issues for QOFs such that in many instances investors, sponsors, and developers should feel comfortable with moving forward with the establishment and funding of QOFs.