United States

Opportunity zone regulations bring real estate industry clarity

INSIGHT ARTICLE  | 

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The passage of the Tax Cuts and Jobs Act, signed into law on Dec. 22, 2017, was the most significant change to the Internal Revenue Code in over 30 years. This legislation overhauled several cornerstones of the code and introduced new tax law, including this article’s focus: section 1400Z-1 and section 1400Z-2 which address qualified opportunity zones (QOZs). The business community, specifically real estate investors, has viewed the QOZ as a possible turbocharged vehicle to stimulate economic development in low-income communities throughout the United States. However, the impact of the new code sections has been hampered by key questions on how to apply the provisions. Treasury has responded by releasing proposed regulations to provide guidance for much-needed economic development in distressed areas. At a high level, section 1400Z-2 allows a taxpayer who realizes a capital gain from the sale of certain assets to make an election within 180 days from the date of the transaction to invest in a qualified opportunity zone fund (QOF). A taxpayer’s initial benefit is the deferral of tax on the cash equal to the amount of gain invested in a QOF.

After making an investment in a QOF, the taxpayer is deemed to have zero basis in the QOF investment to reflect the fact that the taxpayer is permitted to defer the tax with respect to the investment in the QOF. If a taxpayer holds the investment for at least five years then the basis in the QOF increases by 10 percent of the amount of the original deferred gain. This means 10 percent of the deferred gain invested will not be subject to tax. If the taxpayer holds the property for seven years or more, the basis is increased an additional 5 percent. In this case, 15 percent of the taxpayer’s deferred gain is never subject to tax. The excess of the original deferred gain over its basis in the QOF will be recognized and tax will be due on the earlier of the disposal of the investment in the QOF or Dec. 31, 2026 (by the end of 2026, the most the basis could be increased is by 15 percent of the original cash invested).  If the taxpayer holds a QOF investment for at least 10 years, the taxpayer can make an election on the date of disposition to increase the basis to fair market value of the investment, thus providing a tax-free return on the appreciation of the QOF investment. This potential permanent tax benefit is heralded as the crown jewel of the provision.

Eligible taxpayers can only defer tax on capital gains invested through a QOF. The preamble of the proposed regulations considered whether to allow deferral of ordinary income. However, Treasury concluded that the deferral of ordinary income was not the intent of Congress. The capital gains eligible for deferral only include actual or deemed sales and exchanges, including disguised sales from partners and partnerships.

As illustrated in our white paper, the proposed regulations issued by Treasury are taxpayer friendly and offer a pragmatic approach to implement the provisions. We discuss the investment, disposition and mechanics of the proposed regulations, and detail some open issues which still need to be addressed.

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