Summit’s Auyon Rahman breaks down the dense regulations recently published by the IRS regarding the Opportunity Zone tax benefit.
As part of the Tax Cuts and Jobs Act passed in December of 2017, Congress created the new Opportunity Zone tax benefit, established to encourage long-term investment in distressed communities throughout the United States. As a result of the legislation, investors receive a tax benefit to invest realized capital gains into Qualified Opportunity Funds (QOFs), which are vehicles for investing into Opportunity Zones. See Summit’s previous blog post for a general overview of Opportunity Zones.
After months of anticipation and debate about next steps for Opportunity Zones within the community development and investment industries, the IRS issued proposed regulations and published guidance for the Opportunity Zone tax benefit on October 19, 2018. While outstanding questions remain about implementation, the regulations do provide clarity on timing requirements (180-day and 90-day periods) for the program, how taxpayers can invest in QOFs, the 90-percent asset test, and the “substantially all” business assets test. In addition, the guidance provides additional guidance for the “original use” requirement.
The proposed regulations, REG-115420-18, provide guidance under new section 1400Z-2 of the Internal Revenue Code relating to gains that may be deferred as a result of a taxpayer’s investment in a qualified opportunity fund (QOF). While this new section provides procedural rules for designating qualified opportunity zones and related definitions, it allows a taxpayer to elect to defer certain gains to the extent that corresponding amounts are timely invested in a QOF. The proposed regulations include explanations of several provisions.
Deferring Tax on Capital Gains by Investing in Opportunity Zones
The proposed regulations clarify that almost all capital gains qualify for deferral, and to qualify for deferral, the amount of a capital gain to be deferred must be invested in a QOF. The QOF must be an entity treated as a partnership or corporation for Federal tax purposes and organized in any of the 50 states, D.C., or five U.S. territories for the purpose of investing in qualified opportunity zone property. Additionally, the 180-Day Rule states that a taxpayer must invest in a QOF within 180 days of the realized gain.
The proposed regulations clarify that in the case of a taxpayer who has made an election with respect to some but not all of an eligible gain, the term ‘eligible gain’ includes the portion of that eligible gain as to which no election has been made. For example, the taxpayer who earned a gain of $100,000 may choose to invest $50,000 in one QOF, and $25,000 each in two separate QOFs, at different times within the next 180 days. The purpose of this rule is to clarify that taxpayers are allowed to make multiple elections within 180 days for various parts of the gain from a single sale or exchange of property held by the taxpayer. With regards to gains from regulated futures contracts, foreign currency contracts and non-equity options – taxpayers generally ‘mark to market’ each investment at the termination or transfer of the taxpayer’s position in the contract or on the last business day of the taxable year if the taxpayer is still holding the contract at the time.
Gains of Partnerships and Other Pass-Through Entities
In the case of a capital gain experienced by a partnership, the rules allow either a partnership or its partners to elect deferral, while similar rules apply to other pass through-entities such as S corporations and their shareholders, and estates and trusts and their beneficiaries.
How to Elect Deferral
It is currently anticipated that taxpayers will make deferral elections on Form 8949, which will be attached to their Federal Income Tax returns for the taxable year in which the gain would have been recognized if it had not been deferred. Form 8949 and the accompanying instructions are expected to be published very shortly after the proposed regulations are published.
Section 1400z-2(c) Election for Investments Held At Least 10 Years
Although the qualified opportunity zone designations expire at the end of 2028, taxpayers may continue to hold QOF interests in those qualified opportunity zones and may still step up the basis of their QOF investments to fair market value if they hold the investment for ten years. The proposed regulations further clarify that investments made as late as June 30, 2027, and sold as late as the end of 2047 would still qualify for a full basis step-up (within the ten-year period ending 2037).
Rules for a Qualified Opportunity Fund
The proposed regulations generally permit any tax payer that is a corporation or partnership for tax purposes to self-certify as a QOF. Additionally, QOFs will be permitted to select the first month in which they will be treated as a QOF. Subsequently, “the first six-month period of the taxable year of the fund” means the first six-month period that falls entirely within the QOF’s taxable year, and that the QOF will always be tested for the 90-percent test on the last day of its taxable year. The proposed regulations clarify that there is no prohibition against using a preexisting entity as a QOF or as a subsidiary entity operating a qualified opportunity business, provided that the preexisting entity satisfies certain requirements.
Section 1400Z-2(e) Investments from Mixed Funds
If only a portion a taxpayer’s investment in a QOF is subject to the deferral election, the regulations require the investment to be treated as two separate investments, which receive different treatment for Federal income tax purposes.
Additionally, the Special Analyses section provides an economic analysis of the anticipated benefits of the proposed regulations. This includes the “substantially all” definition, which specifies that if at least 70 percent of the tangible business property is qualified opportunity zone business property, the requirement that “substantially all” business property can be satisfied if other requirements are met. The 70 percent requirement for a trade of business is intended to provide QOFs with an incentive to invest in a qualified opportunity zone business rather than owning qualified opportunity business property, since the latter arrangement would require the QOF to hold at least 90 percent of its assets in the qualified opportunity zone property.
Finally, The Treasury and IRS issued a revised rule, titled Rev. Rul. 2018-29, to aid taxpayers in participating in the qualified opportunity zone incentive. The revised rule provides guidance to taxpayers on the “original use” requirement for land purchased after 2017 in qualified opportunity zones. Specifically, the document provides guidance to the following issues/questions:
- If a qualified QOF purchases an existing building located on land that is wholly within a qualified opportunity zone, can the original use or land in the QOZ be considered to have commenced with the QOF?
Guidance: The revised ruling clarifies that since land is permanent in nature, it can never have its original use in a qualified opportunity zone commencing with a QOF.
- If a QOF purchases an existing building in a qualified opportunity zone and the land upon which the building is located in a qualified opportunity zone, is a substantial improvement to the building measured by additions to the adjusted basis in the building or is it measured by additions to the adjusted basis in the building and the land?
Guidance: The revised ruling clarifies that a substantial improvement to the building is measured by additions to the adjusted basis in the building only.
- If a substantial improvement to the building is measured by additions to the qualified opportunity zone’s adjusted basis in the building, does section 1400Z-2(d) require the qualified opportunity zone to separately substantially improve the land?
Guidance: The revised ruling clarifies that the taxpayer is not required to separately substantially improve the land, since the cost of the land within the qualified opportunity zone (upon which the building is located) is not included in the taxpayer’s adjusted basis in the building.
Do you have questions about Opportunity Zone regulations? Please contact Auyon.Rahman@summitllc.us.
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