On Friday, October 19, 2018, the U.S. Treasury Department issued long-awaited proposed regulations and other guidance with respect to opportunity zone incentives under Internal Revenue Code (I.R.C.) § 1400Z-2. This guidance, though not finalized, answers a number of critical questions for taxpayers seeking to defer gain and qualified opportunity funds (QOFs) investing in geographic areas designated as Opportunity Zones (OZs).
Eligibility and Deferral Requirements
Taxpayers Eligible for Deferral. The proposed regulations clarify that the following taxpayers are eligible to defer recognition of certain gains by reinvesting corresponding amounts in QOFs:
- Corporations, including REITs and RICs
- Common trusts under I.R.C. §584
- Certain funds and other entities
Under the proposed regulations, a partnership may elect to defer all or part of the gain at the partnership level, or, if the partnership does not so elect, a partner may elect to defer the distributive share of the partner's gain.
Type of Gain. The proposed regulations further clarify that only capital gains meeting the following requirements may be deferred:
- The gain would be recognized prior to December 31, 2026; and
- The gain arises from a sale or exchange with an unrelated person.
QOF Qualification and Structure
The timely acquisition of equity interests in a QOF constitutes a qualifying deferral reinvestment. The QOF as an investment vehicle will hold either qualified OZ stock, qualified OZ partnership interests, or qualified OZ business (OZ Business) property. Qualified OZ stock or partnership interests are equity in a corporation or partnership for which the only trade or business is an OZ Business. The proposed regulations clarify that QOFs or OZ Businesses may be preexisting entities if the entities otherwise satisfy the requirements for either.
An OZ Business must hold substantially all of its tangible property, whether owned or leased, in qualified OZ Business property. The proposed regulations clarify that "substantially all" in this context means seventy percent (70%).
A QOF must be (i) created or organized in the United States and (ii) treated for federal income tax purposes as a corporation or a partnership (including a limited liability company taxed as either). The proposed regulations allow for entities to self-certify as QOFs by using Form 8996, which was issued with the guidance, and choosing the first month the QOF designation is effective.
90 Percent Test and Safe Harbor
Having self-certified and chosen its effective date as a QOF, a QOF may then establish the first 6-month period of the taxable year of the fund. During this period, the QOF must meet the 90-percent asset test (90% of the value of the assets of the QOF must be held in qualified OZ property as averaged over the 6-month period) or be subject to penalties. The proposed regulations establish the asset valuation method for the 90 percent test and use the asset value on the QOF's financial statements under the Treasury Regulations for I.R.C. § 475, or if the QOF lacks an applicable financial statement, cost value is used.
Prior to the issuance of the proposed regulations, there was also concern as to how working capital would be treated with respect to this test. The proposed regulations provide a safe harbor for working capital to be held for up to 31 months if (i) there is a written plan that identifies the financial property as held for the acquisition, construction, or substantial improvement of tangible property in the OZ; (ii) there is a written schedule of how the property will be used; and (iii) the business substantially complies with the schedule.
Zone Designation Period and Basis Step-Up
Previously there was concern as to limitation on the gain deferral available based on the expiration of the designations of all qualified OZ on December 28, 2028. Without further guidance, there was no mechanism for investors to make basis step-up elections for QOF investments from 2019 and later. The proposed regulations remedy this issue by allowing taxpayers to make a basis step-up election after initial designation expires on December 28, 2028. The election is preserved until December 31, 2047, providing the ability to invest at the end of the qualified OZ period and hold the investment for the entire initial 10-year holding period, plus up to an additional 10 years. This proposed rule alleviates the rush to invest before the end of this year for investors planning to make the eventual basis step-up after the initial 10-year holding period.
Revenue Ruling 2018-29 - Original Use of Land and Building
The Internal Revenue Service also issued Revenue Ruling 2018-29 simultaneously with the proposed regulations, and this ruling addresses that (i) land is not required to have original use commence with a QOF and (ii) substantial improvements to buildings will be measured by the QOF's additions to the adjusted basis of the building without including the basis in the land for purposes of qualifying as OZ Business property. Further, the ruling establishes that there is no requirement to substantially improve the land.