On October 19, 2018, the IRS and the U.S. Treasury released the first of the expected series of clarifying guidance (in the form of proposed regulations, a revenue ruling, updated FAQs, and various tax forms (drafts of Form 8996 & Instructions), collectively, the “Guidance”) related to the implementation of Opportunity Zones, which are designed to incentivize taxpayers to defer capital gains through qualifying Opportunity Zone investments as contemplated under the Section 1400Z-2 of the Internal Revenue Code (the “OZ Statute”).
The combined effect of the Guidance’s (i) elimination of land from the “original use” and “substantial improvement” tests set forth in the OZ Statute, (ii) favorable treatment of project debt, and (iii) somewhat surprising addition of an “in the qualified opportunity zone” requirement for the OZ Statute’s 50% “gross income” test for qualified opportunity businesses (which would create significant compliance risks for many operating businesses as noted in a recent Bloomberg article) makes real estate projects the big winner of the first round of clarifying guidance. The IRS invited commentary on the Guidance (particularly, the proposed regulations) and it is clear that the “in the qualified opportunity zone” addition will be the subject of significant commentary leading up to the December 28, 2018 comment deadline for the proposed regulations.
As a reminder, Opportunity Zones are a place-based incentive, designed to attract investment capital in low-income communities throughout the United States (including, the District of Columbia and U.S. territories).
As we previously explained in our March blog post, Alabama Governor Kay Ivey and other chief executive officers across the United States began nominating eligible population census tracts as “opportunity zones”. As of July 9, 2018, the final list of qualifying Opportunity Zones was published by the IRS in Notice 2018-48. Several resources have been developed to identify qualifying tracts (CDFI, Novogradac, and EIG), and some states and local governments have developed specialized mapping tools and marketing materials to highlight investment opportunities in their Opportunity Zones.
Since our first blog post on this topic, we have been fielding questions from fund managers, real estate investment companies, private equity investors, real estate developers, business owners, economic developers, municipal leaders, and others on a host of gating issues regarding the nascent Opportunity Zones.
The Guidance answered several key open questions, including the following:
- Are gains other than “capital gains” eligible for the deferral under the OZ Statute? What is a “capital gain” for purposes of the OZ Statute? Only capital gains are “eligible gains” under the OZ Statute. A “capital gain” includes any gain resulting from an actual or deemed sale or exchange that is treated as a capital gain for Federal income tax purposes, or any other gain that is required to be included in a taxpayer’s computation of capital gain. Deferral elections for eligible gains will be made on Form 8949 to be filed with the tax return for the year the eligible gain occurred.
- How will the “self-certification” process for qualified opportunity funds work? An entity (including a limited liability company) taxed as a corporation or partnership may “self-certify” to obtain designation as a qualified opportunity fund by filing a Form 8996, on which it selects the month and year for which it seeks to first become a qualified opportunity fund (a “QOF”).
- Can a pre-existing entity self-certify as a QOF? Yes, but any eligible gains invested in the pre-existing entity prior to qualifying as a QOF will not qualify for deferral under the OZ Statute.
- How much time does a QOF have to spend investment proceeds? Generally, a QOF does not have a specific time period in which it must spend investment proceeds. However, a QOF must spend its cash to comply with the “90% test”, which requires at least 90% of the QOF’s assets to be invested in opportunity zone property (direct investments in opportunity zone business property or indirect investments in qualified opportunity zone businesses). The 90% test is measured at the end of the first 6-month period of the taxable year of the QOF and again at the end of the taxable year.
- If a QOF invests in a qualified opportunity zone business, what portion of the tangible property owned or leased by such business must be qualified opportunity zone business property? The proposed regulations clarified that a qualified opportunity zone business must invest and hold at least 70% of its tangible property in qualified opportunity zone business property. If this “70/30 test” is satisfied by a qualified opportunity zone business, then the QOF’s entire interest in the business is considered qualified opportunity zone business property for purposes of the 90% test.
- For new construction or “substantial improvement” projects, is there an exception to the timing requirements for QOFs or qualified opportunity zone businesses to spend investment proceeds? Yes. Under certain conditions, a qualified opportunity zone business may hold investment proceeds for up to 31 months to construct or substantially improve property (referred to as the “working capital exception”). In order to take advantage of the 31-month extended period, the qualified opportunity zone business must (1) designate the proceeds for the project in writing, (2) have a written schedule that calls for the investment proceeds to be spent within 31 months and is consistent with an ordinary expense plan for such type of project, and (3) the investment proceeds must be actually spent in a manner consistent with the written schedule and the document designating the proceeds for the project. While the proposed regulations do not make the 31-month working capital exception directly applicable to QOFs with respect to the 90% test, the preamble to the proposed regulations and other Guidance suggests that the working capital exception may apply to QOFs (hopefully to be resolved in the final regulations or future guidance).
- What constitutes a “substantial improvement” for purposes of the OZ Statute? Tangible property will be considered substantially improved if, during any 30-month period after acquisition of the existing property, more than 50% of the tax basis of the qualified opportunity zone business (or QOF, if applicable) is attributable to improvements made to the property. For real estate projects, the value of the land is not included in the substantial improvement calculations, and is not separately required to be substantially improved. For example, if a qualified opportunity zone business purchased a parcel of real estate with a vacant building for $1,000,000, with $400,000 attributable to the land and $600,000 attributable to the building, then the business must spend more than $600,000 for the building to be considered substantially improved. Note that the satisfaction of the “substantial improvement” test does not negate the other requirements for QOFs and qualified opportunity zone businesses.
- If a taxpayer acquires an interest in a QOF and the investment in that QOF subsequently generates a gain, can the taxpayer reinvest proceeds from that gain in a manner that preserves Opportunity Zone benefits? Yes, under the “complete disposition rule” provided that the taxpayer has disposed of the entire initial QOF investment. However, observers believe that the date of investment for purposes of the 10-year hold period is reset upon the reinvestment (this issue may be clarified by future guidance).
- For a partnership (including limited liability companies taxed as partnerships) and its partners, when does the 180-day clock start for electing to make a gain deferral under the OZ Statute and making an investment in a QOF? If the partnership has an eligible gain that it invests in a QOF, the 180-day clock starts immediately upon the occurrence of the event giving rise to the partnership gain if the partnership makes a deferral election under the OZ Statute. However, if the partnership passes the eligible gains through to its partners, the 180-day clock will begin on December 31 of the year of the occurrence of the event giving rise to the eligible gain (assuming the partnership has a calendar tax year), but each partner may individually elect to use the partnership’s 180-day period to start his or her 180-day clock.
- When do Opportunity Zone benefits expire? An event giving rise to an eligible gain must occur on or before December 31, 2026, and a corresponding investment of such gain in a QOF must be made on or before June 28, 2027 (that is, 180 days after December 31, 2026 if the eligible gain occurs on such date). A QOF interest must be disposed by a taxpayer on or before December 31, 2047, the expiration date of the Opportunity Zone benefits, in order to utilize the 10-year basis step-up election. Note that the U.S. Treasury has requested comments on this topic, meaning the expiration date may be subject to change.
- Can a QOF or qualified opportunity zone business fund its investments in qualified opportunity zone property with debt? Yes. The incurrence of debt by a QOF or qualified opportunity zone business will not reduce the portion of an investor’s eligible interest in a QOF that is eligible for tax deferral and basis benefits under the OZ Statute.
While helpful, the Guidance didn’t answer every question, as a few important items, including recycling of interim gains, active conduct of a trade or business rules (especially as related to leases and leasing activities), and decertification rules for QOFs, remain unresolved. We will stay tuned to additional updates as they come along.
In the interim, over the course of the next few months, we will be providing additional blog posts with our thoughts on the following topics:
- Policy Implications Arising Out of the “70/30” Test
- Planning New Construction Projects in Opportunity Zones
- Pre-Existing Property Puzzle: Thoughts on “Original Use” and “Abandonment”
- Maximizing Opportunity Zone Benefits using Debt
- Challenges and Advantages for Partnerships in Opportunity Zone Investments
- Timing Considerations in Forming and Investing in Qualified Opportunity Funds
- Lingering Questions Remain for Operating Businesses in Opportunity Zones
For more information on the Opportunity Zone program, or for help in assessing whether a particular project, property or investment would be eligible for the program, please reach out to one of our experienced professionals in our Real Estate, Public Finance or Fund Formation practice groups.