United States: IRS Proposes Regulations For Opportunity Zone Tax Incentives

The Tax Cuts and Jobs Act (TCJA) includes a provision that Secretary of the Treasury Steven Mnuchin said should lead to $100 billion in capital investments in distressed areas. The provision allows taxpayers to defer tax on capital gains by investing in such Opportunity Zones. The IRS unveiled proposed regulations on October 19, 2018 that should help investors capture this tax incentive.

The tax incentive in a nutshell

The TCJA established Opportunity Zones, which are census tracts within low-income communities. More than 8,700 communities in all 50 states, the District of Columbia and five U.S. territories have been designated as Qualified Opportunity Zones.

Investors can defer capital gains from any investment by reinvesting the proceeds into qualified opportunity funds (a QOF, or for this alert a "Fund"). The Funds are private investment vehicles to develop and redevelop projects in the zones, including investments in new or substantially improved commercial buildings, equipment, multifamily complexes and Qualified Opportunity Zone businesses. The subsequent appreciation of the investment in a Fund can qualify for permanent exclusion of the capital gain.

The details

Congress created the Opportunity Zone program as an economic development tool to incentivize the movement of capital into designated areas in an effort to reduce poverty and increase employment. The tax incentives are:

  1. Temporary deferral of capital gains until the investment is sold, or December 31, 2026 at the latest;
  2. Step up in basis of the Fund of 10% of the deferred gain if the investment is held five years and an additional 5% (for a total of 15%) for investments held seven years; and
  3. Permanent exclusion of the capital gain on the appreciation of the Fund for investments held ten years.

Which gains are eligible?

The tax incentive is available to any individual, partnership, C or S corporation, trust or estate. The proposed regulations make it clear that only capital gains between unrelated parties are eligible for tax deferral, so this includes both short-term and long-term capital gains from any investment. It also includes gains from the sale of real estate known as Section 1231 gains and unrecaptured Section 1250 gains.

A taxpayer has 180 days to reinvest the capital gain amount into a Fund. There is no requirement that these funds need to be segregated during this time period, which differentiates this from the rules of like-kind or 1031 exchanges. Only the reinvested gain is eligible for these tax benefits, additional investment into the Fund does not qualify for the gain exclusion.

For gains realized by pass-through entities, the rules generally allow either the entity or the partners, shareholders or beneficiaries to elect deferral. If gains are not deferred by the entity, the owner's 180-day period generally begins on the last day of the entity's taxable year. If the owner knows both the date of the entity's gain and its decision not to elect deferral, the owner can begin its own period on the same date as the start of the entity's 180-day period.

The proposed regulations also clarify that an investment in a Fund must be an equity interest, including preferred stock or a partnership interest with special allocations. A debt instrument does not qualify, however a taxpayer can use a Fund investment as collateral for a loan.

If an investor disposes of its entire original interest in a Fund, which normally would trigger inclusion of the deferred gain, the investor can continue the deferral by reinvesting the proceeds in another Fund within 180 days. This allows investors to escape bad deals without forfeiting the deferral benefit.

What is a QOF?

A Qualified Opportunity Zone Fund is a private investment vehicle taxed as a corporation or partnership (including LLCs) that is organized for the purpose of investing in Qualified Opportunity Zone (QOZ) property. At least 90% of its assets must be QOZ property. A Fund cannot invest in another Fund. QOZ property includes stock, partnership interests and business property.

QOZ business property is an important definition as a Fund could invest in that property directly or through an equity interest in a partnership or corporation owning such property. QOZ business property is defined as tangible property used in a trade or business if:

  1. The property is acquired by purchase after December 31, 2017;
  2. Either the original use of the property in the zone commences with the Fund or the Fund substantially improves the property (the Fund or Fund-owned business in both cases); and
  3. During substantially all of the holding period for the property, substantially all of the use of the property is in the zone.

Property is treated as substantially improved if the Fund makes capital expenditures in excess of the amount of initial basis of the property during the 30-month period after acquisition (this has been referred to as "doubling down" because basis needs to be doubled).

The proposed regulations address the issue of land and substantial improvement. The regulations exclude land from the determination of whether a purchased building in an Opportunity Zone has been substantially improved. Improvement is measured only by the Fund's additions to the adjusted basis of the building. For example, if a Fund buys a $3 million property, with $2 million for the land and $1 million for the building, it is only required to invest $1 million to improve the building to qualify.

A Fund can own stock or a partnership interest of a QOZ business. The stock or partnership interest must be originally issued to the Fund after December 31, 2017 and as long as substantially all of the business's leased or owned tangible property is QOZ business property. The proposed regulations provide that substantially all means at least 70% of the leased or owned tangible property.

The tax benefits can be further enhanced when combined with other credits, such as the Low Income Housing tax credit and the New Markets tax credit. Additional rules cover self-certification of Funds, valuation for purposes of the 90% asset test, disqualified businesses and other matters.

More guidance to come

The IRS has requested comments on several parts of the proposed regulations and promises more guidance. Nonetheless, taxpayers generally may rely on these rules if they apply them in their entirety and in a consistent manner. Please contact us if you have questions regarding the Opportunity Zone tax incentives.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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