By now you have probably seen that the Internal Revenue Service (the “IRS”) and the Treasury Department issued proposed regulations and Revenue Ruling 2018-29 on October 19, 2018, clarifying some of the big questions looming over lawyers, investors and communities eager to begin investing in Opportunity Zones (“OZ”) and deferring capital gains in 2018.  We’ve previously written about the creation of Opportunity Zones under the tax law signed in December 2017 (better known as the “TCJA”).  This practice update highlights not only the important regulatory clarifications, but also how to take those and put them into action.

Qualification of QOFs

Many investors have been concerned about the working capital on-ramp needed for cash reserves prior to satisfying the test for holding 90% of its assets in “qualified opportunity zone property.”  Under the statutory description of qualifying OZ property, cash reserves do not qualify, creating a substantial limitation for qualified opportunity funds (“QOFs”).  Many practitioners wondered how QOFs could effectuate projects absent debt financing.  Fortunately, the Treasury Department provided a working capital safe harbor for QOF investments in subsidiaries that meet certain requirements and spend the working capital within 31 months of the business’s receipt of the assets.  It is not clear at this time whether the safe harbor will be extended to QOF investments directly in OZ business property.

From an entity selection perspective, the TCJA required QOFs to be “organized as a corporation or partnership.”  The Treasury Department has clarified, as expected, that they read this provision to apply to QOFs treated for tax purposes as either of the foregoing, supporting the use of limited liability companies and S corporations.

Certification of QOFs

As expected, taxpayers may self-certify as QOFs; such certification will be made on Form 8996, an early draft of which has been released (although it cannot be relied upon at this time). The certification generally requires taxpayers to identify the first taxable year and month for qualification. Taxpayers are welcome to use pre-existing entities that meet all applicable requirements for a QOF (including that all qualified OZ property be acquired after December 31, 2017).

Eligible Gains

The TCJA was unclear as to whether both capital gains and ordinary gains could qualify for deferral if invested in a QOF.  The newly-proposed regulations clarify that only capital gains qualify for deferral.  This applies to both short-term and long-term capital gains, as well as Section 1231 gain and unrecaptured Section 1250 gain.  Upon recognition, the deferred gain retains its original character as short- or long-term and is taxed accordingly.  Further, the proposed regulations include strict prohibitions on gains arising from a sale or exchange with a related party, which includes entities sharing at least 20% common ownership.

Eligible Investors

The proposed regulations made it clear that individuals, C corporations (including REITs and RICs), partnerships, trusts and estates are allowed to defer any realized capital gain by investing in QOFs.  In addition, if a pass-through entity (e.g., partnerships, LLCs, S corporations, certain trusts) does not elect to defer any gain at the entity level, the owners of the entity (i.e., partners, members, shareholders, beneficiaries) would be permitted to make their own independent election based on their distributive share of the eligible gain.

Treatment of Debt

The TCJA set forth rules for “mixed funds” comprised of eligible gain invested and other amounts that do not qualify for deferral. We were previously concerned that debt allocated to an QOF investor would be deemed a cash investment by the investor and thus not eligible for OZ benefits. The proposed regulations make clear that debt allocated to investors is not treated as a separate investment by the investor.  We expect further clarification in future guidance on the use of debt allocations among investors.

Timing

The TCJA was clear in its mandate that taxpayers must invest gains within a QOF within 180 days of the relevant sale/exchange — but the date on which the clock starts ticking was left undefined.  The proposed regulations clarified that the first day triggering the 180-day period is the date on which the gain would be recognized for federal income tax purposes, with additional rules applicable to partnerships. For stock, this 180 day period begins on the trade date. For RIC/REIT undistributed capital gain, the period begins on the last day of the REIT’s taxable year. For RIC/REIT capital gain dividends, the period begins when the dividend is paid.

Further, property held by a QOF for at least 10 years can exclude gain from taxation by making an “exclusion election” after expiration of the OZ designation (December 31, 2028) but prior to December 31, 2047.

Ability to Rollover QOF Gain

The proposed regulations affirmed that a taxpayer who sells its entire investment in a QOF before December 31, 2026 can rollover that gain into another QOF (or even the same QOF) during the 180 day period, and make a new deferral election.

Treatment of Land

A combination of the proposed regulations and a new revenue rulings clarity how “substantial improvements” are calculated for both land and a building purchased by a QOF. The regulations clarified that only the adjusted basis of a building is taken into account, disregarding the adjusted basis of the land, meaning that the QOF is not required to separately substantially improve land for it to qualify.

Open Issues

• We expect comments to be forthcoming and further clarification to be issued on the seeming differentiation between direct and indirect investments made by QOFs, and the “reasonable period” a QOF has to reinvest proceeds from the sale of qualifying assets.
• The Treasury Department is not clear on how raw and unimproved land is treated prior to the construction of buildings and improvements.
• As the Treasury Department noted in the proposed regulations, additional guidance is needed to define the “original use” requirement, for both real property and other tangible property, specifically where such property has been abandoned or underused.
• The proposed regulations do not address the treatment of gains recognized by QOFs on interim sales of QOZ property.  If a QOF sells QOZ property, the sale may trigger a taxable gain to the QOF or its investors absent any additional guidance from Treasury.
• Further regulations are needed to elucidate the penalties and conduct that can result in QOFs being decertified.

Conclusion

Taxpayers may rely on the proposed regulations until final regulations are approved if applied consistently and in their entirety. We are suggesting to our clients who are eager to commence operations to craft flexibility in QOF operating agreements to deal with future guidance from the IRS.  With the draft regulations in hand, investors may confidently proceed with OZ investments.

We do expect further revisions to be suggested during the 60-day comment period, and we have been in close contact with those submitting comments.

Use this map to search properties by address to determine if they are included in an OZ in your community.