United States: Opportunity Zones And Opportunity Funds: Treasury Issues Eagerly Anticipated Proposed Regulations And Other IRS Guidance On New Tax Incentive

On Friday, Oct. 19, the Treasury Department released some much needed guidance concerning qualified opportunity zones (QOZs) under Section 1400Z of the Internal Revenue Code, which was added as part of last year's Tax Cuts and Jobs Act. Treasury simultaneously released an initial set of proposed regulations under Section 1400Z and a related revenue ruling, both of which address many significant aspects of the new law. The guidance provides important and helpful clarifications that should assist taxpayers with execution of and compliance with this new incentive program. The guidance is not entirely comprehensive, however, and some open questions remain.

Background: Opportunity Funds and Opportunity Zones – Summary of Key Statutory Provisions

As enacted, Section 1400Z permits taxpayers to defer recognition of gains if the gains are reinvested within 180 days into a qualified opportunity fund (QOF).

  • The taxpayer must recognize the deferred gain on the earlier of (i) the date the investment in the QOF is sold and (ii) Dec. 31, 2026.
  • However, if the taxpayer holds its investment in a QOF for 5 or 7 years, it may permanently exclude 10 or 15%, respectively, of the deferred gain.
  • If the taxpayer holds its investment in a QOF for 10 years, the taxpayer can elect to step up the qualifying basis of such investment to fair market value, which means that any appreciation in the value of that investment is permanently excluded from the taxpayer's gross income.
    • But as currently drafted, Section 1400Z would require such a taxpayer to recognize any initially deferred gain as of Dec. 31, 2026, thus causing a taxable event at such time and a corresponding step-up in basis with respect to the "old" gains, but at the cost of paying the capital gains tax thereon at that time.
  • The statute defines a QOF as a corporation or partnership organized for the purpose of investing in qualified opportunity zone property (QOZP) that holds at least 90% of its assets in QOZP, measured as of (i) the last day of the first 6-month period of the taxable year of the QOF and (ii) the last day of the taxable year of the QOF.

QOZP includes "qualified opportunity zone stock," "qualified opportunity zone partnership interests," and "qualified opportunity zone business property."

  • Qualified opportunity zone business property is tangible property used in a trade or business of a QOF that is (i) acquired by purchase after Dec. 31, 2017, (ii) the original use or substantial improvement of which begins with a QOF, and (iii) substantially all of the use of which is in a QOZ. Qualified opportunity zone stock or partnership interests include stock or partnership interests acquired after Dec. 31, 2017, for cash in a corporation or partnership that is a "qualified opportunity zone business" (QOZB) at the time the QOF acquires the stock or partnership interest and throughout substantially all of the QOF's holding period thereafter.
  • A QOZB is a trade or business (A) substantially all of the tangible property of which is qualified opportunity zone business property (substituting such business for QOF in the definition above), (B) at least 50% of the income from which is derived from the active conduct of such trade or business, (C) a substantial portion of the intangible property of which is used in such trade or business, (D) less than 5% of whose assets (by aggregate basis) are attributable to nonqualified financial property, and (E) that does not operate a prohibited "sin business."

New Proposed Regulations and Other Guidance – Summary of Key Provisions

While it created a promising incentive, Section 1400Z as initially drafted left many open questions that prevented significant investment in QOFs. Treasury provided some answers to important questions about Section 1400Z in an initial set of proposed regulations issued last week, including the following:

  • Gains Eligible for Deferral. Only capital gains will be eligible for deferral under Section 1400Z. While the statute was silent as to whether ordinary or capital gains would be eligible for deferral, Treasury relied on legislative history to conclude that only capital gains may be deferred under Section 1400Z-2(a)(1).
  • QOF Eligible Entities. In order to be a QOF, an entity must be a corporation or partnership for federal income tax purposes and must be organized in one of the 50 states, Washington, D.C., or a U.S. possession. Thus, LLCs taxable as partnerships or that elect to be taxable as a corporation are eligible to become QOFs.
  • QOF Designations and Compliance. Eligible entities will self-certify as a QOF by filing Form 8996 (released in draft form simultaneously with the proposed regulations) along with their income tax return for the relevant year. An eligible entity can both designate the taxable year in which it becomes a QOF and the first month in that year for the designation to apply. If no month is specified, the first month of the taxable year is treated as the first month that the eligible entity is a QOF.
    • The month designation is significant for purposes of the 90% test for QOFs outlined above. For example, if a calendar-year entity formed in February designates April as its first month as a QOF, the 90% testing dates would be the end of September (6 months after the designation) and the end of December (the end of the taxable year). If the same taxpayer selected a month after June as its first month as a QOF, then the end of its taxable year in December would be the only testing date.
    • With respect to calculating the 90% test, the value of a QOF's assets is as reported on the QOF's financial statements that are (i) filed with the SEC or (ii) (A) certified and audited in accordance with GAAP or (B) filed with another federal agency (other than the IRS) and significantly used in the management of the QOF's business. If no such financial statements are available, the QOF must use the cost of its assets for the 90% test.
  • QOZB Definition of "Substantially All". For purposes of the statutory QOZB test requiring that "substantially all of the tangible business property owned or leased by the trade or business is qualified opportunity zone business property," "substantially all" will mean 70%. Treasury requests comments on how "substantially all" should be interpreted in the other places where it appears in Section 1400Z-2.
  • Working Capital Safe Harbor. The statutory QOZB test precludes a QOZB from having 5% or more of the bases of its assets attributable to nonqualified financial property. The proposed regulations clarify that by reference to Section 1397C, Section 1400Z-2 provides a safe harbor for reasonable amounts of working capital held in cash, cash equivalents, or debt instruments with a term of 18 months or less.
    • Furthermore, the proposed regulations furnish a safe harbor permitting QOZBs that acquire, construct, or rehabilitate tangible real or personal property to treat cash, cash equivalents, or debt instruments with a term of 18 months or less as reasonable working capital for up to 31 months if (i) there is a written plan that identifies such assets as property held for the acquisition, construction, or substantial improvement of tangible property in a QOZ, (ii) there is a written schedule consistent with the ordinary business operations of the QOZB showing that the assets will be used within 31 months, and (iii) the QOZB substantially complies with such schedule.
  • Partnership and Other Pass-Through Gains. The proposed regulations permit a partnership to elect to defer all or part of a capital gain to the extent the partnership makes an eligible investment in a QOF.
    • If the partnership makes such an election, no part of the deferred capital gain is included in the distributive shares of its partners.
    • If the partnership does not elect to defer a gain, then a partner in the partnership may elect to defer its distributive share of such gain to the extent it makes an eligible investment in a QOF, provided the gain otherwise qualifies for deferral in the hands of the partner.
    • Generally, the 180-day window for a partner to defer its distributive share of gain begins on the last day of the partnership's taxable year in which the gain is realized. However, if a partner knows the date on which a partnership realized a capital gain and knows that the partnership will not elect to defer such gain under Section 1400Z, the partner may choose to treat the 180-day window as starting at the same time such window begins for the partnership (i.e., the day the partnership realizes the gain, which is generally the date it sells the relevant asset). Analogous rules apply to other pass-through entities such as S corporations, estates, and trusts.
  • Reliance on Regulations. Taxpayers may generally rely on the proposed regulations before the date of applicability of final regulations if they apply the proposed regulations in their entirety in a consistent manner.
  • Revenue Ruling 2018-29 – Application of "Substantial Improvement" and "Original Use" Requirements. Simultaneously with the issuance of the proposed regulations, the IRS released Revenue Ruling 2018-29. The ruling provides some clarity on what it means to "substantially improve" a building for purposes of the definition of "qualified opportunity zone business property" outlined above.
    • The ruling holds that if a QOF purchases an existing building in a QOZ, (i) the original use of the building cannot be considered to start with the QOF, (ii) in order for the QOF to substantially improve the building, it must incur costs added to the basis of such building over a 30-month period in excess of the adjusted basis of the building (excluding any basis attributable to the land thereunder) as of the beginning of such 30-month period, and (iii) a QOF that substantially improves a building as described above need not separately substantially improve the land on which the building is located.
  • Form 8996 – Qualified Opportunity Fund. As mentioned earlier in this alert, the IRS also issued a draft of Form 8996 – Qualified Opportunity Fund, together with draft instructions, which is to be used by taxpayers to self-certify as a QOF and designate the initial taxable year and month to be treated as a QOF. Taxpayers must also file the form in subsequent years to demonstrate their satisfaction of the 90% test (or to compute the penalty for failure to do so).
  • Updated IRS "Opportunity Zones Frequently Asked Questions". The IRS also released an updated version of its prior informal Q&A guidance on the QOZ program.

Some Open Items and Next Steps

While the regulations and revenue ruling provide some helpful and favorable guidance to taxpayers exploring gain deferral and potential exclusion under Section 1400Z, several open questions remain. The treatment of gains a QOF recognizes throughout a taxpayer's holding period of an interest in such QOF and the required timeline for the QOF's reinvestment of such gains remain unclear. Also unclear is what "substantially all" will mean outside the definition of QOZB as noted in the regulations. There also are further questions about some of the timing requirements and how they apply in certain cases. The regulations "reserve" on the "active conduct of a trade or business" requirement, so this too must await the issuance of further guidance. It is worth noting, however, that Rev. Rul. 2018-29 posits a fact pattern involving the purchase of an existing building located on land that is wholly within a QOZ that is intended to be converted into a "residential rental property," thus implying that such residential rental property could meet the "active conduct of a trade or business" standard. Treasury is accepting comments to the proposed regulations for 60 days from the date of their issuance, so stakeholders have an opportunity to provide input on and seek further clarification of some of these issues.

BakerHostetler's Tax Credit Finance and Economic Development Incentives team is available to answer your questions and provide further updates as more guidance becomes available.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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