On October 19, 2018 the Internal Revenue Service (“IRS”) unveiled its long-awaited guidance on the Opportunity Zone program. The IRS released proposed regulations which have a 60-day notice and comment period before being finalized. Although the regulations may not be finalized, they can be relied on by investors and Fund managers. The IRS also released additional guidance in the form of Revenue Ruling 2018-29, which addresses the “substantial improvement” requirement as applied to real property.
The proposed regulations provide helpful guidance on a range of topics and questions that have been discussed since the passage of the Tax Cuts and Jobs Act, including the following:
- Gains Eligible for Investment and Deferral – The proposed regulations clarify that only gain treated as capital gain for U.S. federal income tax purposes is eligible for the tax deferral and reductions for investing in a Qualified Opportunity Fund (“QOF”). This would include gains under Internal Revenue Code sections 1221 and 1231, including long or short-term capital gains. However, depreciation recapture will not be eligible for investment. Additionally, a carried interest gain could also potentially be eligible for investment in a QOF.
- Eligible QOF Investors – The proposed regulations provide that any taxpayer can make an investment into a QOF and receive the tax benefits associated with the Opportunity Zone program. Any taxpayer includes: an individual, a C or S corporation, a regulated investment company, a real estate investment trust, a partnership, a trust or estate, and a common trust fund described in IRC 584. Furthermore, in the case of a partnership, the deferral election and investment can be made at the partnership level (to be applicable to all partners) or at the partner level and only applicable to electing and investing partners based on their allocated share of the gain. If an individual partner is making the election, it would have 180 days from the end of the taxable year of the sale or exchange to invest in a QOF. The rules also allow an eligible partner to make such an investment within 180 days of the transaction provided no election was made by the partnership.
- Step-Up in Basis to Fair Market Value after 10 Years – The most significant benefit associated with this program is the step-up in basis of an investment in a QOF upon a sale or exchange if the taxpayer holds the QOF interest for 10 years or more. However, in light of the wording of the statute, there was a question as to how the step-up in basis would apply if an investment is made after 2018 and the zones expire in 2028. The proposed rule provides that an investor can receive the basis step-up if it sells or exchanges its QOF interest by December 31, 2047.
- Rollover or Recycling of QOF Interests – Another important issue clarified by the proposed regulations is the circumstance of a taxpayer selling or disposing of its QOF interest and investing in a different QOF during the required holding period. The regulations make clear that a taxpayer can rollover a QOF interest into a different QOF within 180 days of selling or disposing of the previous QOF interest. The regulations also make clear that a taxpayer seeking to do so must dispose of its entire previous QOF interest. Despite the clear guidance provided to investors for rollovers, the regulations do not likewise address a QOF’s recycling of assets by selling Qualified Opportunity Zone Property (defined below) and replacing that property within a reasonable period of time with other Qualified Opportunity Zone Property. It is expected that this arrangement will be permitted, but we must await future guidance for additional details in terms of the tax treatment of such a transaction, as well as with respect to how much time a QOF would have to reinvest in other Qualified Opportunity Zone Property.
- Certification and Asset Testing – Another major question surrounding the Opportunity Zone statutory provisions concerns how funds would certify and begin reporting whether they are in compliance with the 90 percent asset test. To maintain QOF status, a QOF must hold at least 90 percent of its assets in Qualified Opportunity Zone Property. The regulations provide that a QOF will certify and report using IRS Form 8996. The regulations allow a QOF to identify the taxable year it chooses as well as the month for when its QOF status becomes effective. A deferral election for making an investment in a QOF can only be made if the investment is made in a qualifying entity. Accordingly, a QOF must certify as such an entity by the time it begins taking investments.
- Qualified Opportunity Zone Businesses – A QOF is permitted to acquire property directly or make an investment into a Qualified Opportunity Zone Business which will acquire Qualified Opportunity Zone Property. The statute provides that a Qualified Opportunity Zone Business is one with substantially all of its property being Qualified Opportunity Zone Property. The statute is silent as to what “substantially all” means. The proposed regulations provide that 70 percent of the business’s property must be Qualified Opportunity Zone Property—meaning the property was acquired in 2018 or after and its first use is in the opportunity zone or it is substantially improved.
- Substantial Improvement – The regulations and Revenue Ruling 2018-29 provide specific guidance pertaining to the substantial improvement requirement for real property. When a QOF or Qualified Opportunity Zone Business is looking to calculate the capital improvements necessary to increase the basis, the value of the land is excluded from the basis. The guidance also clarifies that land can never be originally used in a zone; hence the need for the above rule in determining whether a substantial improvement has been made. The IRS has invited comments on how the original use test should apply to vacant land as this is another issue that requires further clarification in guidance.
- Working Capital Safe Harbor – When a QOF invests in a Qualified Opportunity Zone Business, that business cannot hold 5 percent or more of its assets in nonqualified financial property with an exception for working capital for a project or business. The regulations provide a 31-month period for working capital to be expended if done pursuant to a written plan and other documentation requirements. This provides QOF subsidiaries or investee businesses with a 31-month period to spend funds on acquisition and development of property without failing the nonqualified financial property provision. However, there is an outstanding question as to whether this safe harbor is applicable for allowing a Qualified Opportunity Zone Business to satisfy the “substantially all” test, requiring 70 percent of its assets be Qualified Opportunity Zone Property. The regulations and introductory comments suggest this was the likely intent of the safe harbor, but the actual language of the regulation is not as clear. The IRS has invited additional comments and suggestions on this issue.
- Mixed Funds – A QOF is permitted to take capital gain investments as well as any other capital from investors. However, all of the tax benefits, including the 10-year step-up in basis to fair market value, are only applicable to capital gain invested in a QOF. Furthermore, when a QOF takes on debt, the debt allocated to partners will not be treated as a separate investment in a QOF.
- Valuation of Assets – A QOF and a Qualified Opportunity Zone Business should generally look to their financial statements for valuing assets. However, in the event that the entity does not have a financial statement, the cost basis should be used for valuation purposes.
This guidance is a great first step by Treasury, but additional clarification and policies must be considered for the program to reach its full potential. The IRS also released Form 8996, which is used for certification and asset reporting by a QOF. The Instructions for the Form 8996 provide useful guidance as well and can be accessed here.
We will continue to keep you apprised on any program or regulatory developments pertaining to the Opportunity Zone program.