United States: IRS Issues The Opportunity Zone Regulations; The Race Is On

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
  1. ​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."
  2. 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.   
  3. 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.
  4. 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. 
  5. 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. 
  6. 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.
  7. 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
  1. 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.
  2. 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.
  3. 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
  1. 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).
  2. 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
  3. 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.
  4. 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.

Footnote

1 The 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.

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.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
Similar Articles
Relevancy Powered by MondaqAI
Dickinson Wright PLLC
 
In association with
Related Topics
 
Similar Articles
Relevancy Powered by MondaqAI
Dickinson Wright PLLC
Related Articles
 
Related Video
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Mondaq Free Registration
Gain access to Mondaq global archive of over 375,000 articles covering 200 countries with a personalised News Alert and automatic login on this device.
Mondaq News Alert (some suggested topics and region)
Select Topics
Registration (please scroll down to set your data preferences)

Mondaq Ltd requires you to register and provide information that personally identifies you, including your content preferences, for three primary purposes (full details of Mondaq’s use of your personal data can be found in our Privacy and Cookies Notice):

  • To allow you to personalize the Mondaq websites you are visiting to show content ("Content") relevant to your interests.
  • To enable features such as password reminder, news alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our content providers ("Contributors") who contribute Content for free for your use.

Mondaq hopes that our registered users will support us in maintaining our free to view business model by consenting to our use of your personal data as described below.

Mondaq has a "free to view" business model. Our services are paid for by Contributors in exchange for Mondaq providing them with access to information about who accesses their content. Once personal data is transferred to our Contributors they become a data controller of this personal data. They use it to measure the response that their articles are receiving, as a form of market research. They may also use it to provide Mondaq users with information about their products and services.

Details of each Contributor to which your personal data will be transferred is clearly stated within the Content that you access. For full details of how this Contributor will use your personal data, you should review the Contributor’s own Privacy Notice.

Please indicate your preference below:

Yes, I am happy to support Mondaq in maintaining its free to view business model by agreeing to allow Mondaq to share my personal data with Contributors whose Content I access
No, I do not want Mondaq to share my personal data with Contributors

Also please let us know whether you are happy to receive communications promoting products and services offered by Mondaq:

Yes, I am happy to received promotional communications from Mondaq
No, please do not send me promotional communications from Mondaq
Terms & Conditions

Mondaq.com (the Website) is owned and managed by Mondaq Ltd (Mondaq). Mondaq grants you a non-exclusive, revocable licence to access the Website and associated services, such as the Mondaq News Alerts (Services), subject to and in consideration of your compliance with the following terms and conditions of use (Terms). Your use of the Website and/or Services constitutes your agreement to the Terms. Mondaq may terminate your use of the Website and Services if you are in breach of these Terms or if Mondaq decides to terminate the licence granted hereunder for any reason whatsoever.

Use of www.mondaq.com

To Use Mondaq.com you must be: eighteen (18) years old or over; legally capable of entering into binding contracts; and not in any way prohibited by the applicable law to enter into these Terms in the jurisdiction which you are currently located.

You may use the Website as an unregistered user, however, you are required to register as a user if you wish to read the full text of the Content or to receive the Services.

You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these Terms or with the prior written consent of Mondaq. You may not use electronic or other means to extract details or information from the Content. Nor shall you extract information about users or Contributors in order to offer them any services or products.

In your use of the Website and/or Services you shall: comply with all applicable laws, regulations, directives and legislations which apply to your Use of the Website and/or Services in whatever country you are physically located including without limitation any and all consumer law, export control laws and regulations; provide to us true, correct and accurate information and promptly inform us in the event that any information that you have provided to us changes or becomes inaccurate; notify Mondaq immediately of any circumstances where you have reason to believe that any Intellectual Property Rights or any other rights of any third party may have been infringed; co-operate with reasonable security or other checks or requests for information made by Mondaq from time to time; and at all times be fully liable for the breach of any of these Terms by a third party using your login details to access the Website and/or Services

however, you shall not: do anything likely to impair, interfere with or damage or cause harm or distress to any persons, or the network; do anything that will infringe any Intellectual Property Rights or other rights of Mondaq or any third party; or use the Website, Services and/or Content otherwise than in accordance with these Terms; use any trade marks or service marks of Mondaq or the Contributors, or do anything which may be seen to take unfair advantage of the reputation and goodwill of Mondaq or the Contributors, or the Website, Services and/or Content.

Mondaq reserves the right, in its sole discretion, to take any action that it deems necessary and appropriate in the event it considers that there is a breach or threatened breach of the Terms.

Mondaq’s Rights and Obligations

Unless otherwise expressly set out to the contrary, nothing in these Terms shall serve to transfer from Mondaq to you, any Intellectual Property Rights owned by and/or licensed to Mondaq and all rights, title and interest in and to such Intellectual Property Rights will remain exclusively with Mondaq and/or its licensors.

Mondaq shall use its reasonable endeavours to make the Website and Services available to you at all times, but we cannot guarantee an uninterrupted and fault free service.

Mondaq reserves the right to make changes to the services and/or the Website or part thereof, from time to time, and we may add, remove, modify and/or vary any elements of features and functionalities of the Website or the services.

Mondaq also reserves the right from time to time to monitor your Use of the Website and/or services.

Disclaimer

The Content is general information only. It is not intended to constitute legal advice or seek to be the complete and comprehensive statement of the law, nor is it intended to address your specific requirements or provide advice on which reliance should be placed. Mondaq and/or its Contributors and other suppliers make no representations about the suitability of the information contained in the Content for any purpose. All Content provided "as is" without warranty of any kind. Mondaq and/or its Contributors and other suppliers hereby exclude and disclaim all representations, warranties or guarantees with regard to the Content, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. To the maximum extent permitted by law, Mondaq expressly excludes all representations, warranties, obligations, and liabilities arising out of or in connection with all Content. In no event shall Mondaq and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use of the Content or performance of Mondaq’s Services.

General

Mondaq may alter or amend these Terms by amending them on the Website. By continuing to Use the Services and/or the Website after such amendment, you will be deemed to have accepted any amendment to these Terms.

These Terms shall be governed by and construed in accordance with the laws of England and Wales and you irrevocably submit to the exclusive jurisdiction of the courts of England and Wales to settle any dispute which may arise out of or in connection with these Terms. If you live outside the United Kingdom, English law shall apply only to the extent that English law shall not deprive you of any legal protection accorded in accordance with the law of the place where you are habitually resident ("Local Law"). In the event English law deprives you of any legal protection which is accorded to you under Local Law, then these terms shall be governed by Local Law and any dispute or claim arising out of or in connection with these Terms shall be subject to the non-exclusive jurisdiction of the courts where you are habitually resident.

You may print and keep a copy of these Terms, which form the entire agreement between you and Mondaq and supersede any other communications or advertising in respect of the Service and/or the Website.

No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

By clicking Register you state you have read and agree to our Terms and Conditions