On Friday, October 19, 2018, the IRS and Treasury released their first set of proposed regulations providing guidance regarding the application and implementation of the Qualified Opportunity Zone tax rules set forth in Sections 1400Z-1 and 1400Z-2 of the Internal Revenue Code of 1986, as amended by the Tax Cuts and Jobs Act of 2017.
The Qualified Opportunity Zone rules are designed to encourage investment in specified lower-income communities by allowing taxpayers to defer capital gains by rolling the amount of capital gain recognized into a qualified fund. In general, the gain that is rolled into the fund is deferred until December 31, 2026 (or earlier sale). However, a ten percent basis step-up in the original gain is allowed if the investment in the qualified fund is held for at least five years, and a fifteen percent basis step-up is allowed if the investment is held for at least seven years, thereby reducing the amount of the original gain ultimately recognized. In addition, if the taxpayer holds the investment for ten years, it can elect to exclude gain on any appreciation of the assets in the fund.
The proposed regulations address a number of significant issues which has prevented the implementation of qualified opportunity fund investments, including to clarify that:
- Only gains treated as capital gain (i.e., excluding any ordinary gains) are eligible for deferral and only to the extent the corresponding amounts are timely reinvested in a Qualified Opportunity Fund. (Note that eligible gain can include gain on e.g., real estate, stock investments, and artwork.)
- The investment in a Qualified Opportunity Fund must be an equity investment (including preferred stock or a partnership interest with special allocations) (i.e., an eligible interest cannot be a debt instrument).
- The investment generally must be made during the 180-day period beginning on the date of the sale or exchange giving rise to the gain.
- In situations where the capital gain is recognized by a partnership, the election to defer gain may be made either by the partnership, or (if the partnership does not make the election) by the partners as to their distributive shares. If the election is made by a partner, the 180-day period generally begins on the last day of the partnership’s taxable year. Similar rules apply to other pass-through entities.
- A taxpayer that holds a Qualified Opportunity Fund investment for at least ten years may elect to increase the basis of the investment on the date that the investment is sold or exchanged and such election may be made even if the qualified opportunity zone designation has expired (e.g., due to a statutory sunset date).
- Any taxpayer that is a corporation or a partnership for tax purposes will self-certify its status as a Qualified Opportunity Fund. (Form 8996 will be issued.)
- A Qualified Opportunity Fund must undergo semi-annual tests to determine whether its assets consist on the average of at least 90 percent qualified opportunity zone property (with a “working capital” safe harbor).
- A trade or business will satisfy the requirement that “ substantially all” is invested “qualified opportunity zone business property” if 70 percent or more of the tangible property owned or leased by a trade or business is qualified opportunity zone business property.
- Rev. Rul. 2018-29, issued at the same time as the proposed regulations, provides in the context of purchasing an existing building in a qualified opportunity zone, that the required “substantial improvement” for original use means additions equaling or exceeding the adjusted basis of the building, and not the combined adjusted basis of the building and the underlying land.
The proposed regulations contain other guidance, and additional guidance, including guidance on the meaning of the term “substantially all” as used in various provisions, is expected before the end of 2018.