Proposed Regulations Provide Further Clarification About Opportunity Zones
The Opportunity Zone program presents a unique opportunity for a taxpayer to defer the capital gains tax by investing the proceeds of a realized capital gain in a Qualified Opportunity Fund (“Opportunity Fund”) holding certain property in a Qualified Opportunity Zone (“Opportunity Zone”). The goal of the Opportunity Zone program is to encourage economic growth and investment in Opportunity Zones. Sections 1400Z-1 and 1400Z-2 of the Internal Revenue Code discuss Opportunity Zones. On October 19, 2018, the Treasury Department and the Internal Revenue Service (“IRS”) issued proposed regulations under Section 1400Z-2 (the “Proposed Regulations”). Although the Proposed Regulations are not yet finalized, the Proposed Regulations provide guidance for issues that were unresolved in the text of Section 1400Z-2. In addition to these Proposed Regulations, the Treasury Department and the IRS expect to publish additional proposed regulations in the near future.
I. Realized and Recognized Gains
When property is sold or exchanged, a taxpayer can realize a gain or loss. The realized gain or loss from a sale or exchange of property is usually a recognized gain or loss for tax purposes. A recognized gain must be included in gross income. A taxpayer then pays taxes on the recognized gain. However, a taxpayer is not always required to recognize a gain in the same year that the gain is realized. Under the Opportunity Zone program, a taxpayer who realizes a capital gain on the sale or exchange of a capital asset can defer the gain recognition event by investing the proceeds of the realized capital gain in an Opportunity Fund.
II. Review of Opportunity Zone Program and Tax Consequences
As a refresher, an Opportunity Zone is a nominated population census tract that is considered a low-income community. In Florida, then-Governor Rick Scott designated 427 communities as Opportunity Zones, including 26 communities in Palm Beach County. A taxpayer invests in an Opportunity Zone by purchasing an interest in an Opportunity Fund. An Opportunity Fund is a corporation or a partnership that holds at least 90% of its assets in qualified opportunity zone property. Qualified opportunity zone property includes qualified opportunity zone business property, qualified opportunity zone stock, and a qualified opportunity zone partnership interest. For a more detailed discussion of Opportunity Zones and Opportunity Funds, please review our prior post entitled “New Tax Deferral Possibility by Investing in Qualified Opportunity Zone.”
If a taxpayer realizes a capital gain on the sale or exchange of any capital asset to an unrelated person, the taxpayer can defer the gain recognition event by investing the proceeds in an Opportunity Fund. However, the taxpayer must recognize this realized capital gain at the earlier of (i) the date on which the taxpayer sold or exchanged the Opportunity Fund interest, or (ii) December 31, 2026. Except as provided below, the taxpayer’s basis in an Opportunity Fund interest will be zero. A taxpayer can increase their basis by holding the Opportunity Fund interest for at least five years. If a taxpayer holds the Opportunity Fund interest for five years, the taxpayer’s basis in the Opportunity Fund interest increases from zero to 10% of the deferred capital gain invested in the Opportunity Fund. If a taxpayer holds the Opportunity Fund interest for seven years, the taxpayer’s basis in the Opportunity Fund interest increases to 15% of the deferred capital gain invested in the Opportunity Fund. If a taxpayer holds the Opportunity Fund interest for ten years and sells the interest after December 31, 2026, such taxpayer’s basis in the Opportunity Fund interest will equal the fair market value of the Opportunity Fund interest on the date that such interest is sold or exchanged. In such an instance, a taxpayer will only pay taxes on the original deferred capital gain.
III. Eligible Types of Gains for Opportunity Zone Program
The wording of Section 1400Z-2(a)(1) made it unclear whether Congress intended for capital gains and ordinary gains to be eligible for the tax deferral benefit under Section 1400Z-2. The Proposed Regulations clarify that only capital gains are eligible for the tax deferral benefit. Under the Opportunity Zone program, a taxpayer may defer the capital gains tax by rolling over the proceeds of a realized capital gain into an Opportunity Fund. A taxpayer can defer the amount of capital gain eligible for the capital gains tax up to the amount of the capital gain proceeds invested in an Opportunity Fund. Regardless of when a taxpayer recognizes the deferred capital gain, the deferred capital gain retains the same tax attributes in the year of inclusion that it would have had if the tax on the capital gain had not been deferred.
IV. Eligible Taxpayers for Opportunity Zone Program
Section 1400Z-2 did not adequately describe what types of taxpayers were eligible to invest in Opportunity Funds. For instance, it was unclear whether a partner or shareholder in a partnership or S corporation could invest in an Opportunity Fund when the partnership or S corporation was the taxpayer that sold a capital asset and generated a capital gain. The Proposed Regulations clarify that taxpayers eligible to invest in an Opportunity Fund include individuals, C corporations, partnerships, S corporations, trusts, and estates. The Proposed Regulations provide special rules for applying Section 1400Z-2 to a partnership, S corporation, trust, or estate. Under the special rules, either a partnership or its partners can take advantage of the tax benefits afforded by the Opportunity Zone program. If a partnership generates the capital gain, the partnership must have the first opportunity to make an election to defer the capital gain by investing in an Opportunity Fund. If the partnership makes this election, the deferred capital gain is not included in the distributive shares of the partners under Section 702 and is not subject to Section 705(a)(1) until the partnership subsequently includes such capital gain in income. If a partnership declines to invest the capital gain in an Opportunity Fund, the individual partners can defer the capital gains tax by investing the capital gain allocated to such partner in an Opportunity Fund. The aforementioned special rules also apply to an S corporation and its shareholders, a trust and its beneficiaries, or an estate and its beneficiaries.
In order to elect to defer the capital gains tax, Section 1400Z-2(a)(1)(A) provides that a taxpayer must invest the capital gain proceeds in an Opportunity Fund within 180 days from the date of the sale or exchange of the capital asset. The Proposed Regulations relax this requirement when a partnership generates the capital gain, elects not to invest in an Opportunity Fund, and then distributes the capital gain to its partners. If, following the distribution of the capital gain proceeds to the partners, a partner elects to invest any portion of the capital gain proceeds in an Opportunity Fund, the Proposed Regulations provide that such individual partner’s 180 day period to invest the capital gain proceeds begins on the last day of the partnership’s tax year.
V. Structure of Opportunity Funds
The Proposed Regulations describe the form in which an Opportunity Fund can be structured. An Opportunity Fund can be any entity classified as a corporation or partnership for federal income tax purposes. Thus, an Opportunity Fund can be structured as a limited liability company. A pre-existing entity may become an Opportunity Fund, but such entity must satisfy all of the requirements of Section 1400Z-2 and the Proposed Regulations. For example, a pre-existing entity must acquire a sufficient percentage of qualified opportunity zone property after December 31, 2017. The Proposed Regulations provide rules describing how an entity can self-certify as an Opportunity Fund without IRS approval. To self-certify as an Opportunity Fund, the corporation or partnership must complete a form and attach it to a timely filed federal income tax return. Simultaneously with the release of the Proposed Regulations, the IRS promulgated Form 8996, which is an early release draft of the self-certification form.
The Proposed Regulations discuss the interests that can be issued by an Opportunity Fund. For purposes of Section 1400Z-2, an eligible interest in an Opportunity Fund includes any equity interest issued by the Opportunity Fund. An equity interest includes preferred stock or a partnership interest with special allocations. However, an eligible interest does not include any debt instrument within the meaning of Section 1275(a)(1) and Treas. Reg. Section 1.1275-1(d). Interestingly, the Proposed Regulations provide that a taxpayer who owns an Opportunity Fund interest can use such interest as collateral for a loan, as long as such taxpayer is the owner of the equity interest for federal income tax purposes.
VI. 90% Asset and Substantial Improvement Requirements
Under Section 1400Z-2(d)(1), an Opportunity Fund must hold at least 90% of its assets in qualified opportunity zone property (“QOZ Property”) located in an Opportunity Zone. This 90% asset test is determined by averaging the percentage of QOZ Property held in the Opportunity Fund as measured on the last day of the first 6-month period of the taxable year of the Opportunity Fund, and on the last day of the taxable year of the Opportunity Fund. If the Opportunity Fund does not meet the 90% threshold at those times, the Opportunity Fund must pay a penalty for each month it fails to meet the 90% threshold. The Proposed Regulations provide some timing relief for eligible entities formed in the first six months of a calendar year. However, the last day of the taxable year will always be a testing date for purposes of the 90% asset test. For example, an Opportunity Fund formed on October 1, 2018 must hold at least 90% of its assets in QOZ Property located in an Opportunity Zone by December 31, 2018. Since December 31 is always a testing date for the 90% test, a taxpayer interested in forming an Opportunity Fund will likely wait until 2019 to form the Opportunity Fund.
Since developing, constructing, and rehabilitating real estate may take longer than six months, real estate commenters believed that Opportunity Funds investing in real estate projects should be afforded additional time to comply with the 90% asset test. Those commenters also recommended that cash should be considered QOZ Property for purposes of the 90% asset test if the cash was held with the intent of investing in QOZ Property. Although the Proposed Regulations do not provide any time extensions for purposes of satisfying the 90% asset test, the Proposed Regulations include a working capital safe harbor for Opportunity Fund investments in a qualified opportunity zone business (“QOZ Business”) that acquires, constructs, or rehabilitates tangible business property, including real property and other tangible property used in a business operating in an Opportunity Zone. If certain requirements are met, a QOZ Business can treat cash held by such business as working capital for up to 30 months.
An Opportunity Fund must invest in QOZ Property. Under Section 1400Z-2(d)(2), QOZ Property includes qualified opportunity zone business property (“QOZ Business Property”), qualified opportunity zone stock, and a qualified opportunity zone partnership interest. Section 1400Z-2(d)(2)(D) discusses the requirements of QOZ Business Property. To be considered QOZ Business Property, the original use of QOZ Business Property must commence with the Opportunity Fund (or QOZ Business) or the Opportunity Fund (or QOZ Business) must substantially improve the property. Under Section 1400Z-2(d)(2)(D)(ii), property is substantially improved only if “during any 30-month period beginning after the date of acquisition of such property, additions to basis with respect to such property in the hands of the [Opportunity Fund] exceed an amount equal to the adjusted basis of such property at the beginning of such 30-month period in the hands of the [Opportunity Fund].” The Proposed Regulations address the substantial improvement requirement with respect to a purchased building located in an Opportunity Zone. Since land can never have its original use commence with an Opportunity Fund, the Proposed Regulations and Revenue Ruling 2018-29 clarify that the basis attributable to the land on which the purchased building sits will not be taken into account in determining whether the building has been substantially improved. In order to satisfy the substantial improvement requirement, an Opportunity Fund only needs to invest an amount exceeding the adjusted basis of the building at the beginning of the 30 month period. An Opportunity Fund is not required to separately substantially improve the land.
The goal of the Opportunity Zone program is to encourage economic growth and investment in Opportunity Zones. The Proposed Regulations clarified numerous issues that were unresolved by the text of Section 1400Z-2. Beginning in 2019, it is anticipated that an Opportunity Fund will become a viable investment opportunity for taxpayers looking to defer the incurrence of the capital gains tax.