IRS Issues the Opportunity Zone Regulations; The Race Is On
Stites & Harbison, PLLC, November 14, 2018
On October 19, 2018, the U.S. Department of Treasury and the Internal Revenue Service released the first set of the proposed regulations (the “Proposed Regulations”), along with Rev. Rul. 2018-29 and an updated Internal Revenue Service (“IRS”) Frequently Asked Questions, which provide guidance on exactly how the Opportunity Zone program is intended to work¹. The Opportunity Zones program, enacted as part of the 2017 Tax Cuts and Jobs Act, incentivizes investors to invest private capital into low income, underserved communities in exchange for three significant tax breaks; (i) the deferral of the tax on the unrealized gains until December 31, 2026, or the date of a sale (whichever is earlier) if such gains are invested in a Qualified Opportunity Zone Fund (QOZF); (ii) a 10% step up in basis in the QOZF investment if held by the taxpayer for five years and an additional 5% step up in basis in such investment if held for seven years, and (iii) 100% exclusion from tax of any appreciation on the taxpayer’s QOZF investment if held for 10 years. With the recently issued guidance clarifying a number of the questions regarding the program’s application, investors, fund managers, developers, business owners and entrepreneurs are now in the position to finalize their investment and/or project models and tap into the projected $6.2 trillion unrealized corporate and individual capital gains available for investment in Opportunity Zones.
Here is what the Proposed Regulations are telling us:
- TAXPAYERS, CAPITAL GAINS, ATTRIBUTES OF CAPITAL GAINS
- Deferral of Capital Gains. Only gains treated as capital gains for Federal income tax purposes invested by an eligible investor are eligible for tax deferral. The statute makes reference to both capital gains and gains from sale and exchanges of any property. The Proposed Regulations make it clear that only capital gains and not ordinary gains qualify. What remains unanswered is whether the phrase “treated as a capital gains” is intended to include Section 1231 gains, which contain an element of ordinary income. A taxpayer can make multiple elections of previously deferred gains from various parts of single sources, which include rollover deferral of previously deferred gains. Special rules apply in the case of certain gains (e.g., gains from "section 1256 contracts" and "offsetting-positions transactions.”
- Preservation of Tax Attributes of Gains. The law requires taxpayers at some point in time in the future to include in income the previously deferred gains. When this tax event occurs and the capital gains are recognized, the gains’ tax attributes, such as those identified in IRC Sections 1(h), 1231 and 1250, for example, are then taken into account when the gain is subject to tax.
- Eligible Taxpayers. The Proposed Regulations confirm that U.S. taxpayers that recognize capital gains for Federal income tax purposes are eligible to elect to defer the tax on capital gains. This includes individuals, corporations, partnerships, C corporations, S corporations, real estate investment trusts and other pass-through entities. While not addressed, it seems to be the consensus of many that foreign entities that have a U.S. tax liability can avail themselves of the deferral. It is also confirmed that a taxpayer must invest the eligible gain directly in eligible equity interests in the QOZF in order to qualify for gain deferral and not through intermediate partnerships.
- Partnerships (and other Pass-through Entities) Capital Gains Investment Period. A taxpayer must invest the capital gains in a QOZF within a 180-day period commencing on the day the sale or exchange which generates the capital gain. The Proposed Regulations provide guidance with respect to the 180-day investment period for partnership and other pass through entities. A special rule is created which provides the partnership the right to elect to defer its capital gains, but if the partnership declines to make the election, each of the partners, individually, may elect to defer their distributive share of the partnership’s capital gains. Each partner will have 180 days from the end of the partnership’s taxable year to invest in an QOZF or commence the investment period on the same date as the partnership’s investment period. Accordingly, capital gains recognized by a partnership early in 2018 (or even very late 2017) may still be eligible for investment in OZ Funds, even if 180 days have passed.
- Eligible Interests in QOZFs. Investors must receive equity interests in QOZF organized. Debt instruments do not qualify as an eligible investment. The Proposed Regulations identify preferred stock or partnership interests with special allocation as permissible equity investments. The recognition of a partnership interest with special allocations opens the discussion as to whether a “carried interest” can be paired with an equity investment for QOZF’s service providers. The Proposed Regulations clarify that “deemed contribution of money” derived from a partner’s share of partnership debt does not constitute an investments in QOZF nor does it create a separate, non-qualifying investment in the QOZF. Only the taxpayer's contribution of deferred gain to a QOZF will qualify for the tax.
- 10-Year Holding Period Rule. The Proposed Regulations provide that, if the QOZF investment is made prior to June 29, 2027, then the 10-year gain exclusion election is available even though the QOZ’s designations expire on December 31, 2028. Taxpayers holding a QOZF investment for at least 10 years are permitted to make an election to adjust the basis in their investment to its fair market value on the date that the investment is sold or exchanged which results in the exclusion from taxation of any gains on the appreciation of a taxpayer's QOZF interest.
- Premature Disposition of QOZF Interest. A QOZF investor who sells all of his or her interest in an QOZF before December 31, 2026, is allowed to retain the original tax deferral on the deferred gain by reinvesting the proceeds from the sale into a new QOZF within 180 days. This provision, as a practical matter, allows an investor to take advantage of a particular situation, whatever it might be, without forfeiting the tax deferral benefits.
- QUALIFIED OPPORTUNITY ZONE FUNDS
- Organization of QOZFs (and QOZBs). A QOZF must be “organized” as a corporation or partnership. The Regulations clarified that so long as a limited liability company (“LLC”) is taxed as a partnership (with at least two members) or a corporation for Federal income tax purposes, it can serve as a QOZF. Qualified Opportunity Zone Funds (“QOZF”) (and Qualified Opportunity Zone Businesses (“QOZB”) must be organized in one of the 50 states, the District of Columbia, or a U.S. possession. The Proposed Regulations clarify that if a QOZF is organized in U.S. possession, then the QOZF must be organized for the purpose of investing trades or businesses operated in a U.S. possession in which it is organized. (This also true for the QOZB which, if organized in a U.S. possession, then QOZB must actively conduct a trade or business in the U.S. possession in which it was organized). Finally, there are no restrictions precluding pre-existing entities from operating as QOZFs (or QOZBs) so long as they satisfy all rules.
- Self-Certification of QOZF. A qualified entity self certifies as a QOZF by filing IRS Form 8996. It must identify the first taxable year and first month in which it intends to conduct business. In the event the QOZF fails to select the first month, it will, by default, become the first month of its taxable year. For a QOZF investment to qualify for the tax deferral on the gains, it must be made on or after the date the entity becomes a QOZF.
- Compliance with the 90% Asset Test. By law, a QOZF must invest 90% of its assets in Qualified Opportunity Zone Property (“QOZP”). Compliance is measured by computing the average of the percentage of QOZP held in the QOZF on the last day of the first six-month period of the taxable year in which it is organized and on the last day of its taxable year (i.e., June 30 and December 31 for a calendar year QOZF) (the “90% Asset Test”). The Proposed Regulations provide guidance regarding the application of this test with respect to the QOZF’s first year. A QOZF must meet the after the "first 6-month period of the fund" that are composed of months within the same tax year. Consequently, if a calendar-year qualified business entity becomes a QOZF in May, the testing dates for the QOZF are the end of November, which is the end of the first six months of the QOZF and the end of December of the same year. If the calendar-year entity chooses a month after June as its first month as a QOZF, the only testing date is December 31, the last day of its tax year.
In calculating compliance for the 90% Asset Test, a QOZF is required to use an applicable financial statement (“AFS”), to determine the fair market value of the asset reported on the AFS for the reporting period. An AFS is defined as a financial statement prepared in accordance with U.S. GAAP and either: filed with a federal agency besides the IRS, such as the SEC; or audited and relied upon to make financial decisions. Where a QOZF does not prepare an AFS, it must use the cost basis of each of its assets for the calculation. The Treasury is seeking comments as to whether adjusted basis or another valuation method is a better measurement than cost.
- QUALFIED OPPORTUNITY ZONE BUSINESS
- The “Substantially All” Test Applicable to QOZBs. To qualify as a Qualified Opportunity Zone Business (“QOZB”), 70% of all the tangible property owned or leased by the QOZB must be Qualified Opportunity Zone Business Property (“QOZBP”). The Proposed Regulations define, for this purpose only, “substantially all” as 70% of the QOZB’s tangible assets. What this means in practice is that a QOZF that owns a QOZB can have as little as 63% of its capital invested in QOZBP (i.e., 90% in the QOZB per the 90% Asset Test multiplied by 70% of the QOZBP). The Proposed Regulations provide alternative methods for determining compliance with the “substantially all” test, based either on the values in a QOZB’s AFS, or, if the business does not prepare an AFS, applying the same methodology used by its QOZF for determining their compliance with the 90% asset test (subject to the 5% investor rule).
- The Conduct of the Active Trade/Business Tests. The Proposed Regulations clarify that (i) at least 50% of the gross income of a QOZB must be derived from the active conduct of a trade or business in a QOZ; and (ii) a substantial portion of the intangible property of a QOZB must be used in the active conduct of a trade or business in a QOZ
- Safe Harbor for Reasonable Working Capital. The Proposed Regulations provide a working capital safe harbor for investments in a QOZB that acquire, construct, or rehabilitate tangible business property. A QOZB can accumulate working capital for a period of up to 31 months so long as (i) there is a written plan identifying the intended use of such capital (i.e., used for the acquisition, construction or substantial improvement of tangible property in a QOZ), (ii) there is a reasonable written schedule of expenditures and (iii) the working capital is actually used in a manner consistent with the plan and schedule. Gross income earned on the working capital during the reasonable working capital period is counted as gross income for purposes of the 50% active trade/business test.
- Original Use of QOZP -Treatment of Real Estate and Improvements. Qualified Opportunity Zone Property (“QOZP”) is tangible property used in a trade or business of the QOZF. Rev. Rul. 2018-29 was issued on October 19th, simultaneously with the release of the Proposed Regulations. The Regulations specifically address the original use requirement as it applies to land and improvements and concludes that: (i) land, given its permanence, can never have an original use and is excluded from the original use requirement; (ii) the original use of a building in the QOZ is not considered to have commenced with the QOZF, and (iii) if the QOZF purchases an existing building and the underlying land, it is only required to substantially improve (“double the basis”) the building and is not required to separately substantially improve the land.
Over the past eight months, stakeholders have labored to understand the nuances of the program in order to match the objectives of the investors with the economic and social impacts intended for the Opportunity Zones. While the release of the Proposed Regulations and Rev. Rul. 2018-29 prove very helpful in addressing and clarifying key issues, a number of important questions still remain which have yet to be answered, including but not limited to; (i) what is the income tax treatment of any capital gains a QOZF reinvests from the sale or exchange of QOZP?; (ii) what constitutes a “reasonable period” for a QOZF to reinvest proceeds from the sale or exchange of QOZP?; and (iii) whether the IRS/Treasury will provide a safe harbor rule on the amount of time a QOZF has to invest the cash it receives from an eligible investor in QOZP? The U.S. Treasury has stated that it will address these issues along with others in a second and possibly third round of proposed regulations which hopefully will be released by year end.
The Opportunity Zone legislation has the potential to be a powerful driver of investment activity in communities that have suffered in the past from the lack of economic development. With many of the uncertainties removed by the Proposed Regulations, it is now up to the stakeholders to fulfill the respective roles to make the Opportunity Zone program a success. The race is on.
¹The Opportunity Zone Program must go through the formal rule-making process before the program can be finalized. The U.S. Treasury Department (the “Treasury”) must first propose a structure for implementing the new rule, after which the agency will issue a notice of proposed rule-making and will request public comments on the proposal. The comment period typically lasts from 30 to 60 days. Upon reviewing the comments and making any necessary changes to the rule, the Treasury will issue a final rule that formally sets up the Opportunity Zone Program.