The IRS has issued proposed regulations and a related revenue ruling addressing the treatment of new investments in Qualified Opportunity Zones (QOZs), a tax incentive program enacted last year as part of the Tax Cuts and Jobs Act (TCJA). The goal of the program is to encourage taxpayers to invest in underfunded communities by providing them with three tax incentives: The ability to defer tax for up to eight years on unrelated capital gains, such as gains from the sale of corporate stock, or gains from the sale of a business or real property interest not located in a Zone, as long as those gains are invested in an Opportunity Zone; the ability to avoid up to 15 percent of that deferred tax, if the new investment is held for specified periods of time; and the ability to completely avoid tax on any gains realized on the new Opportunity Zone investment if it is held for at least 10 years.
- For example, a taxpayer selling stock for $100,000 with a zero basis would ordinarily pay $23,800 of tax on that $100,000 of gain, leaving $76,200 to make a new investment.
- If the new investment were made in an Opportunity Zone, the taxpayer could invest the full $100,000, not just $76,200, since the $23,800 of taxes ordinarily due would be deferred.
- If the original $100,000 investment generated annual unrealized capital gains at a rate of 10% per year, it could grow and be sold for $259,370 with no taxes due on that $159,370 of gain because of the Opportunity Zone provisions. In the eighth year, the taxpayer would have to pay 85 percent of the initially deferred $23,800 of taxes from the non-Opportunity Zone investment, presumably from other sources.
- All in, the taxpayer would have approximately $235,000 after all taxes were paid. Without the Opportunity Zone tax benefits, the taxpayer would have only around $169,000 after all taxes were paid, a benefit of approximately $66,000.
- It is important to note, however, the concept of opportunity cost. For example, if the Opportunity Zone investment only generated unrealized capital gains at the rate of seven percent per year, while the taxpayer’s alternative non-Opportunity Zone investment did so at the rate of 10 percent, the Opportunity Zone tax benefits would just about be offset by the reduced profitability of the Opportunity Zone investment, compared to the taxpayer’s alternatives outside of the Zone.
Aside from the economics, many unanswered tax questions remain. Neverthless, the proposed regulations do address many of the most important technical tax issues presented by the new law. These include the type of gains that may be deferred and invested in Zones, the time frames in which those gains must be invested to obtain the tax benefits, and the rules governing a decision to take advantage of the tax deferral. They also contain rules regarding the QOFs themselves, including rules for self-certification, valuation of QOF assets, and guidance on qualified opportunity zone businesses.
Gain eligible for deferral
Although the statute was arguably ambiguous on this point, the proposed regulations provide that only capital gains, including gains from the sale of property governed by section 1231, are eligible for tax deferral through an investment in a QOF. Thus, gains that would generate ordinary income are ineligible. The IRS made this determination by looking to the legislative history of the statute, as well as its title, but acknowledged that the statutory text refers broadly to gain from the sale or exchange of, “any property.” Some taxpayers may decide to challenge this restrictive interpretation.
Generally, a taxpayer must make a qualified investment in a QOF within 180 days of incurring the gain, in order to qualify for the statutory tax benefits. The proposed regulations explain that this 180-day period generally begins on the date the gain is otherwise recognized for Federal income tax purposes. They also explain that the deferred gain’s tax attributes (such as whether it qualifies as long-term or short-term capital gain) are preserved and taken into account when the gain is recognized at the end of the deferral period.
The proposed rules also provide special rules for applying the deferral election to gain recognized by a partnership. Under the proposed rules, a partnership is eligible to make the QOZ deferral election. In that case, all of the incentives apply at the partnership level, and the original gain is not recognized and taken into account by the partners. However, if the partnership does not make the deferral election, each partner is allocated his or her share of the non-deferred gain, and each partner may then decide to reinvest his or her share in a Zone and thereby qualify for tax benefits at the partner level. In that case, the 180-day investment window generally begins at the close of the taxable year in which the gain is recognized. However, if the partner has actual knowledge of the date the gain was recognized by the partnership, he or she may elect to have the 180-day window begin on that earlier date. Because of the tight time frame, if a partnership issues its Schedules K-1 on extension, the 180-window (e.g., late June 2019 in the case of a calendar year 2018 partnership) might have passed by the time the partners receive their Schedule K-1 informing them of the gain, which might not be issued until as late as September 2019.
Extension of time for electing basis step-up
Under the statute, all opportunity zone designations are scheduled to expire ten years after designation as a QOZ. Some were concerned that this would complicate the process of making the elections necessary to obtain gain exclusion. To allow ample time for taxpayers to dispose of their QOF interests, taking into account all necessary business considerations, the proposed regulations state that the election to exclude gain will be available until Dec. 31, 2047.
Substantially all tests defined for QOF-owned entities
A QOF is allowed to operate a trade or business through one or more entities, and in such a case must take into account the value of all qualified entities in applying the 90 percent asset test. For an entity to qualify as a QOZ business and therefore count favorably towards the QOF’s 90 percent asset test, substantially all of the entity’s tangible property must be considered QOZ business property—which, amongst other qualifications, requires the property to be physically located in the opportunity zone. In this regard, the proposed regulations define “substantially all” as at least 70 percent of the tangible property owned or leased by the business. This appears to be quite lenient. In many other cases the tax law defines “substantially all” as 80 percent or even higher.
Special rules for capital gains
In Revenue Ruling 2018-29, the IRS discussed the applicability of the QOZ rules related to, “original use,” and, “substantial improvement." Generally, to be considered QOZ business property, the original use of tangible property must commence with a QOF or a QOZ business. Thus, a newly constructed building will qualify, but a building previously built and used by another taxpayer outside of the QOZ rules would not qualify. There is an exception, however, if the property is substantially improved.
The Revenue Ruling establishes that 1) unimproved land can never have its original use in a QOZ; and 2) if land with an existing building on it were purchased by a QOF, the original use would also not commence with the purchase by the QOF. Thus, in either case, the QOF must substantially improve the property.
Substantial improvement of tangible property occurs if, during the 30-month period beginning with its acquisition, a QOF’s basis increases in the building by an amount exceeding the taxpayer’s adjusted basis at the time of acquisition. For example, a building costing $100,000 must have improvements worth at least another $100,000. In the case of a purchase of land with an existing building on it, the value of the land is not considered part of the value of the building for the purpose of the substantial improvement test. Further, the land need not be improved separately from the existing building for it to qualify as QOZ business property.
In addition to the items highlighted above, the proposed regulations also give guidance on the following items:
- A safe harbor for Qualified Opportunity Zone Businesses to hold working capital to improve tangible property in an Opportunity Zone
- Rules, unfortunately still incomplete, covering investments in QOF from both deferred gain and other sources of money or property, including a rule that an increase in a partner’s share of liabilities from a QOF is not an additional investment
- Rules concerning the timing of gain deferral with respect to certain special types of gain (including gain from section 1256 contracts), and an absolute bar to deferring gain from so-called “offsetting-position” transactions
- The form and process for making the initial deferral election
- The process by which a QOF will self-certify its qualifying status
- How assets will be valued for purposes of the 90 percent test (financial statement value for most taxpayers with a financial audit)
- A provision that the investment must be an equity interest in the QOF. However, the taxpayer may use its investment in the QOF as collateral for a loan
- Clarification that QOFs and related entities generally must be US based, with special rules for US possessions
Despite all this guidance, there remain very significant open questions, some of which go beyond mere compliance formalities and could affect the economics of the incentives. Notably, the proposed regulations do not touch at all on the mechanical interactions of the special basis rules of the QOZ regime with the existing basis rules for corporations and partnerships (i.e., “inside” and “outside” basis). We believe additional guidance in this area is essential for taxpayers to make informed choices about whether or not to pursue QOZ incentives.