The 2017 “Tax Cuts and Jobs Act” created substantial U.S. federal income tax incentives for certain investments in designated lower-income communities known as “Opportunity Zones.” On October 19, 2018, the U.S. Treasury Department and the IRS released its first significant guidance on the Opportunity Zone program in the form of Proposed Regulations (including an extensive Preamble), a Revenue Ruling, a Draft IRS Form (and Instructions) and a press release. While the guidance does not answer every question regarding the Opportunity Zone program, it addresses many of the issues presented by the original legislation and, importantly, indicates that the U.S. Treasury Department and the IRS are committed to providing workable rules for the Opportunity Zone program.
Additional guidance is still needed, however, and is promised in the near future.
BACKGROUND AND FRAMEWORK
The Opportunity Zone program was enacted to encourage taxpayers to realize gains on appreciated assets and invest such gains in lower-income areas to facilitate economic growth therein. The basic parameters of the program are as follows.
A taxpayer that recognizes capital gain from sales to unrelated persons and within 180 days invests an amount that is less than or equal to the capital gain into a qualified investment vehicle (an “Opportunity Fund”) may elect to defer the portion of the original capital gain so invested until December 31, 2026 (or, if earlier, the disposition date of the taxpayer’s Opportunity Fund interest). Up to 15% of the capital gain may be excluded from U.S. federal income taxation entirely (10% if the taxpayer’s holding period is at least 5 years on such date and an additional 5% if the holding period is at least 7 years). In addition, if a taxpayer holds its Opportunity Fund interest for at least ten years, any appreciation in the Opportunity Fund interest is generally exempt from U.S. federal income taxation.
For example, on January 1, 2019, a taxpayer recognizes a capital gain of $100 from the sale of publicly traded stock. On May 1, 2019, the taxpayer invests $100 in an Opportunity Fund. The taxpayer is not required to include the $100 capital gain in its 2019 taxable income. On December 31, 2026, the taxpayer (still holding its entire interest in the Opportunity Fund, and assuming no intervening events), should include $85 of the originally deferred gain in income ($100 × 85%). On June 1, 2029, again assuming no intervening events, the taxpayer sells its interest in the Opportunity Fund for $300, representing a $200 capital gain over its initial investment. The $200 gain generally should be exempt from U.S. federal income taxation.
INVESTORS IN OPPORTUNITY FUNDS
The Proposed Regulations provide helpful guidance on a variety of issues that Opportunity Fund investors are likely to face, including who may invest in an Opportunity Fund and the types of gain that may be deferred.
Most Taxpayers (Including Pass-Through Entities) Can Defer Capital Gain
The Proposed Regulations provide that any person that recognizes capital gain for U.S. federal income tax purposes (including any individual, “C” corporation (including a regulated investment company, commonly known as a mutual fund (“RIC”), or a real estate investment trust (“REIT”)), partnership, “S” corporation, trust or estate) is eligible to defer all or a portion of such gain by investing in an Opportunity Fund.
Special Rules for Partnerships and Partners That Defer Capital Gain
The Proposed Regulations provide special rules for the deferral of capital gain by a partnership and/or its partners. Where a partnership recognizes a capital gain and invests the gain into an Opportunity Fund, the rules provide that the deferred partnership-level gain will not be taxed at the partner level in the year of deferral. When the gain is later recognized (e.g., upon the earlier of the sale of the Opportunity Fund interest or December 31, 2026), the partnership’s partners will be taxed on the recognized gain at such later time.
To the extent that a partnership does not elect to defer its eligible gain, each partner may elect to defer its allocable share of the gain. Two special rules apply in this situation. First, unless the partner elects otherwise (as described below), the 180-day investment period begins on the last day of the partnership’s taxable year, not on the date on which the relevant asset is sold.
For example, if a partnership with a calendar tax year sells stock on February 1, 2019 and does not make a deferral election, a partner in such partnership may invest its share of the gain in an Opportunity Fund during the 180-day period that begins on December 31, 2019.
However, the Proposed Regulations also allow a partner to invest its share of the partnership’s gain within 180 days of the date that the partnership recognized the gain, provided the partnership does not itself elect to invest such gain in an Opportunity Fund. As such, in the above example, the partner could elect to invest its share of the partnership’s gain within 180 days of February 1, 2019.
It is unclear how this special rule works in various circumstances, including in situations in which both the partnership and one or more partners attempt to elect to defer the same item of capital gain. Partners and partnerships should consider including appropriate notification and coordination provisions in their partnership agreements to ensure that duplicative deferral elections are not made, and that partners receive prompt notice from partnerships that recognize capital gain that will not be invested by the partnership in an Opportunity Fund (perhaps together with estimated allocations of such capital gain to the partners), so that partners have the ability to promptly identify and invest in Opportunity Funds.
Second, where a partner elects to defer its share of partnership capital gain, for purposes of determining whether the item of gain arises from a sale to a related person, the purchaser must be unrelated to both the partnership and the partner. Thus, it may be advisable for partnership agreements to include information gathering and notice provisions to assist the partnership and its partners in ensuring that a capital gain targeted for investment in an Opportunity Fund investment is not derived from a sale to a related person.
The Proposed Regulations provide analogous rules for other pass-through entities and their owners, such as “S” corporations and their shareholders and trusts and estates and their beneficiaries.
Only Recognized Capital Gain Is Eligible for Deferral
The Proposed Regulations clarify that only capital gain (both long-term and short-term, including any capital gain treated as short-term capital gain under the new “carried interest” tax rules) that would otherwise be recognized before January 1, 2027 is eligible to be deferred.
Examples in the Proposed Regulations make clear that “eligible gain” includes (i) “collectables” gain (e.g., artwork), typically taxed at a 28% rate, (ii) capital gain dividends recognized by shareholders of RICs and REITs and (iii) “unrecaptured Section 1250 gain” on the sale of real estate, typically taxed at a 25% rate. Subject to the discussion below on Section 1256 contracts and offsetting position transactions, it appears that capital gain is eligible for deferral even if the taxpayer has an offsetting capital or ordinary loss. Notably, deferred gain that is triggered upon the sale of an Opportunity Fund interest is eligible for additional deferral if the taxpayer timely makes a new investment in another Opportunity Fund. Based on the statute, it appears that an Opportunity Fund cannot itself defer gain by investing in another Opportunity Fund.
Any gain that is not treated as capital gain is not eligible to be deferred. In addition, any gain that is realized but not recognized for U.S. federal income tax purposes, such as gain in corporate reorganizations, certain partnership transactions and Section 1031 “like-kind” exchanges, is not eligible to be deferred.
The Proposed Regulations allow a taxpayer to “split” the gain derived from a single transaction into multiple Opportunity Fund investments. For example, if a taxpayer realized a $300 capital gain on January 1, 2019 and invested $200 of the gain into an Opportunity Fund on February 1, 2019, the remaining $100 portion of the gain could be invested into an Opportunity Fund prior to the expiration of the 180-day period beginning on January 1, 2019. However, to the extent that the second investment exceeded $100, the excess amount would not qualify for the Opportunity Fund tax benefits.
In the case of “Section 1256 contracts,” (i.e., regulated futures contracts, foreign currency contracts, nonequity options, dealer equity options and dealer securities future contracts), which taxpayers are generally required to mark to market on an annual basis, the gain eligible for deferral is the net gain from all of the taxpayer’s Section 1256 contracts (to the extent not part of an offsetting-positions transaction (as described below)), and not the gross amount of gain realized on any individual Section 1256 contract.
Capital gain arising from a position that is part of an “offsetting-positions transaction,” such as a straddle, is not eligible to be deferred. The Proposed Regulations define an offsetting-positions transaction as a transaction in which a taxpayer has substantially diminished its risk of loss associated with one position in personal property by holding one or more additional positions with respect to personal property (even if the offsetting position or positions are held with property of different kinds). Further guidance to clarify the scope of this exception may be required.
Implementation of the 180-Day Rule
To achieve deferral, eligible gain must be invested in an Opportunity Fund within the 180-day period that begins on the date on which the taxpayer would otherwise be required to recognize that gain (the “Recognition Date”). In the case of a stock sale effected on an exchange, the Recognition Date is the trade date. In the case of a capital gain dividend received from a RIC or REIT, the Recognition Date is the date that the dividend is paid. In the case of a taxpayer that is a partner (or “S” corporation shareholder or beneficiary) seeking to defer its share of gain realized by the partnership (or “S” corporation or trust or estate), the Recognition Date is the last day of the entity’s tax year, except (as noted above) the taxpayer may elect to treat the entity’s Recognition Date as its own Recognition Date in the event that the taxpayer knows (i) the entity’s Recognition Date and (ii) that the entity will not itself invest the gain in an Opportunity Fund. In the case of a Section 1256 contract, the Recognition Date is the last day of the taxpayer’s tax year.
Recognition of Deferred Gain
As noted above, any gain deferred by a taxpayer in connection with an investment into an Opportunity Fund will be recognized upon the earlier of the taxpayer’s disposition of its Opportunity Fund interest or December 31, 2026.
In the case of a disposition of an Opportunity Fund interest, the recognition of deferred gain would be in addition to any gain recognized as a result of appreciation of the Opportunity Fund since the date(s) of the taxpayer’s investment in the Opportunity Fund. The statutory language suggests that a taxpayer’s deferred gain may be triggered by any disposition of its Opportunity Fund interest before December 31, 2026, even if the relevant transaction is not itself a recognition event (e.g., a contribution of the Opportunity Fund interest to a partnership, a gift or a transfer incident to a divorce).
For example, suppose that a taxpayer recognized a $100 capital gain from the sale of publicly traded stock and invested an amount equal to such gain in an Opportunity Fund on May 1, 2019. If the taxpayer sold its Opportunity Fund interest within 5 years, it would recognize (and be subject to tax on) all of its originally deferred gain plus any additional gain recognized on such sale. If the taxpayer sold its Opportunity Fund interest after 5 years, but within 7 years, it could exclude $10 of the gain deferred upon the initial investment from its taxable income, and this exclusion would increase to $15 if the taxpayer instead sold its Opportunity Fund interest after 7 years. However, unless the taxpayer holds its Opportunity Fund investment for more than 10 years, the taxpayer would be subject to U.S. federal income tax on the amount realized on the sale in excess of $100. If, however, the Opportunity Fund is sold for less than $100 or is worth less than $100 on December 31, 2026, the gain recognized is capped at such lower amount.
The Proposed Regulations provide that the subsequently recognized gain will have the same attributes as the deferred gain would have had in the year it was originally realized, had it not been so deferred. For example, if a taxpayer defers $100 of short-term capital gain in 2019, the deferred gain (determined taking into account any available basis adjustments), when triggered in a subsequent year, would be treated as short-term capital gain in that year. Further guidance on certain aspects of these rules may be required.
Where a taxpayer makes investments in an Opportunity Fund on more than one date and/or has invested gains from more than one underlying transaction on the same date, the Proposed Regulations generally provide for a “first in first out” (“FIFO”) ordering rule to determine the Opportunity Fund interests that are disposed of (and, therefore, the amount of deferred gain that is recognized and the amount of gain that is eligible for exclusion under the 10%, 15% or 10-year rules discussed above). Although the operation of the FIFO rule is relatively clear in the case of an Opportunity Fund classified as a corporation (for which shares can be identified), it is less clear in the case of an Opportunity Fund classified as a partnership (as a taxpayer typically has a single tax basis for an investment in a partnership). This issue will likely require additional guidance.
OPPORTUNITY FUNDS; OPPORTUNITY ZONE PROPERTY
While questions remain, the Proposed Regulations provide helpful guidance on a variety of issues that Opportunity Funds and their sponsors are likely to face, including in respect of valuation and the treatment of certain assets.
90% Asset Test: Valuation and Working Capital Safe Harbor
For an entity to qualify as an Opportunity Fund, at least 90% its assets must consist of “qualified opportunity zone property” (“Opportunity Zone Property”), which requirement generally is tested annually (the “90% Asset Test). For this purpose, the Opportunity Fund is required to use the “book” value of its assets as shown in its financial statements filed with the U.S. Securities and Exchange Commission (or another U.S. federal agency), or the value of its assets as prepared in accordance with U.S. GAAP. If the Opportunity Fund does not have applicable financial statements, it must use the cost of its assets.
The Proposed Regulations adopt a working capital safe harbor that applies to cash as well as other “financial property” (including stock, bonds and other debt, partnership interests, options and certain derivatives). Under this safe harbor, such cash and financial property counts toward the 90% Asset Test, if:
(i) the Opportunity Fund keeps contemporaneous written records that designate the use of the financial property for the acquisition, construction or substantial improvement of Opportunity Zone Business Property and provide a reasonable schedule for the expenditure of the financial property within 31 months of acquisition; and
(ii) the Opportunity Fund actually uses its working capital consistent with its written records.
While the Proposed Regulations indicate that the working capital safe harbor applies to property that has not yet been acquired, not all aspects of the safe harbor are clear. Hopefully, further guidance will clarify these issues.
Opportunity Zone Property (for purposes of the 90% Asset Test) includes certain business assets located in an Opportunity Zone (“Opportunity Zone Business Property”) and equity in certain entities, classified as partnerships or corporations for U.S. federal income tax purposes, that hold Opportunity Zone Business Property (“Opportunity Zone Businesses”). As such, an Opportunity Fund may be structured to invest directly in Opportunity Zone Business Property, or indirectly through a subsidiary or joint venture entity that qualifies as an Opportunity Zone Business, as further discussed below.
Opportunity Zone Business: “Substantially All” Requirement and 70% Safe Harbor
In order for an entity to be treated as an Opportunity Zone Business (and therefore count towards an Opportunity Fund’s 90% Asset Test), among other requirements, “substantially all” of the tangible property owned or leased by the entity must be Opportunity Zone Business Property. The Proposed Regulations provide a bright-line rule that, if at least 70% of the entity’s tangible property is Opportunity Zone Business Property, the entity satisfies this “substantially all” test (the “70% Safe Harbor”).
Although the phrase “substantially all” is used in many other places in the statute, the 70% Safe Harbor applies only in the situation described above. Furthermore, the 70% Safe Harbor is applied with respect to an entity’s tangible property. The Proposed Regulations do not provide any guidance as to whether Opportunity Zone Business Property must constitute a minimum percentage of the entity’s total property (including intangible property).
Given that the Opportunity Fund must meet the 90% Asset Test, and an Opportunity Zone Business need only meet the 70% Safe Harbor, we anticipate that many Opportunity Funds may structure investments through lower-tier Opportunity Zone Businesses, as it appears that, in combination, the Opportunity Fund and the Opportunity Zone Business may need to hold only 63% of their assets in Opportunity Zone Business Property. Such a structure, when combined with the working capital safe harbor described above, may provide additional flexibility for capital-intensive Opportunity Zone projects, including real estate acquisition and development.
If an Opportunity Fund (or Opportunity Zone Business) sells an investment, the Opportunity Fund (or Opportunity Zone Business) may have more cash than is permitted under the 90% Asset Test and may also recognize taxable gain. In the Preamble, the IRS promised future guidance addressing the timing requirement for reinvesting the proceeds into a new qualifying investment without causing the Opportunity Fund to fail the 90% Asset Test. The IRS also promised future guidance on the U.S. federal income tax treatment of any gain attributable to the reinvested proceeds. However, the Preamble does not provide guidance on the potential treatment of such gain, such as whether reinvested gain may be further deferred under the Opportunity Zone Program. Furthermore, the Proposed Regulations do not provide guidance as to the eligibility of an Opportunity Fund (or Opportunity Zone Business) to defer taxable gain under other tax regimes, such as a like-kind exchange under Section 1031.
“Substantial Improvement” of Land with Existing Buildings; Unimproved Land
Property qualifies as Opportunity Zone Business Property only if, among other things, the original use of the property commences with the Opportunity Fund or the Opportunity Fund “substantially improves” the property. Substantial improvement generally means capital expenditures that exceed the initial tax basis of such asset that are made within 30 months after acquisition of the property.
The Guidance provides that with respect to an acquisition of land with an existing building, located entirely within an Opportunity Zone, 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 no separate requirement to improve the land, so long as the existing building itself is substantially improved.
For example, if an Opportunity Fund purchases land with an existing building located entirely within an Opportunity Zone for $100 and allocates $40 to the building and $60 to the land, the land and the building would be treated as Opportunity Zone Business Property if, within 30 months of the purchase, the Opportunity Fund incurs more than $40 in capital improvements to the building.
The Guidance does not provide rules for acquisitions of unimproved (i.e., raw) land located in an Opportunity Zone. Hopefully the IRS provides additional guidance on this issue.
Partnership Opportunity Funds That Incur Debt
Under normal U.S. federal income tax principles, when an entity classified as a partnership for U.S. federal income tax purposes borrows money, the liability is allocated to its partners, each of whom is deemed to make a cash contribution to the partnership in the amount of the allocated liability. When an Opportunity Fund that is classified as a partnership for U.S. federal income tax purposes (a “Partnership Opportunity Fund”) incurs indebtedness, it was unclear whether the deemed contributions would be treated as separate investments for purposes of the Opportunity Fund rules, and whether the deemed contributions would affect the amount of gain that the investor is able to defer, as well as the operation of the 10-year gain exclusion rule.
The Proposed Regulations provide that any deemed contribution resulting from an allocation of a partnership liability is ignored for purposes of determining the percentage of an investment in an Opportunity Fund that is subject to the deferral election. For example, if an investor recognized $100 of capital gain that was contributed to a Partnership Opportunity Fund, the Partnership Opportunity Fund borrowed an additional $200 that was allocated to the investor, and used the $300 of cash to acquire and substantially improve Opportunity Zone Business Property, then the deemed $200 contribution is not treated as a separate investment in the Partnership Opportunity Fund. As such, the investor’s entire capital gain is eligible for deferral.
The Proposed Regulations do not provide specific guidance on the operation of the 10-year gain exclusion rule in the case of an investment in a Partnership Opportunity Fund that incurs leverage.
Opportunity Fund Structure: Organizational Form, Capital Structure and Subsidiaries
The Proposed Regulations provide that any entity classified as a domestic corporation or a domestic partnership for U.S. federal income tax purposes, which should presumably include a limited liability company (LLC) or business trust, is eligible to be an Opportunity Fund. Opportunity Funds may be organized as REITs and “S” corporations. Disregarded entities, entities treated as trusts (including a grantor trust) for U.S. federal income tax purposes and “qualified joint ventures” between spouses do not appear to be eligible to be Opportunity Funds.
The Proposed Regulations clarify that an eligible interest in an Opportunity Fund includes preferred stock and a partnership interest with special allocations. An Opportunity Fund interest treated as debt for U.S. federal income tax purposes is not an eligible interest.
The Draft IRS Form suggests that an Opportunity Fund must hold Opportunity Zone Business Property directly or through (at most) one tier of regarded entities; however, the Proposed Regulations do not address the issue of tiered structures directly. Further guidance on this point would be helpful.
Self-Certification of Opportunity Funds
The Proposed Regulations state that entities self-certify as Opportunity Funds by filing IRS Form 8996 with their U.S. federal income tax returns and permit existing entities to be treated as Opportunity Funds, including by permitting an entity to elect Opportunity Fund status as of a particular month in the year (and the Opportunity Fund requirements would not be applied to earlier months in the year).
The Draft IRS Form appears to permit an entity to self-certify as an Opportunity Fund, even if it fails the 90% Asset Test in its first year (and thus owes a penalty), so long as the entity’s organizational documents include a statement of its purpose of investing in Opportunity Zone Property by the end of its first tax year and a description of the Opportunity Zone activity that the entity expects to engage in; however, the Proposed Regulations do not directly address the issue of failure to satisfy the 90% Asset Test in the Opportunity Fund’s first year.
If an Opportunity Fund fails to satisfy the 90% Asset Test for any month, the Opportunity Fund must pay a penalty equal to the shortfall in its 90% Asset Test multiplied by the IRS underpayment rate. The Draft IRS Form clarifies that the penalty calculation uses the per annum IRS underpayment rate divided by 12 (rather than applying the full per annum rate to a monthly calculation); however, the Proposed Regulations do not address this calculation. The Preamble states that the IRS intends to publish additional guidance addressing the penalty and conduct that may lead to decertification of an Opportunity Fund.
The October 19 Guidance has provided welcome assistance to Opportunity Fund sponsors and investors. As the IRS has noted, the Guidance represents the first step of a broader regulatory project that hopefully will provide greater certainty with regard to various aspects of the Opportunity Fund program.