Only capital gains can be deferred under the new Opportunity Zone program designed to improve economically distressed communities.
Proposed regulations (REG-115420-18) released October 19 allow taxpayers seeking to wipe out capital gains realized upon investment in a qualified fund to take advantage of the program even after designations expire at the end of 2028. That means taxpayers won’t have to rush to make investments this year to receive the benefit. Instead, the proposed rules allow taxpayers in some cases to invest capital gains into qualified funds and receive a full basis step-up on gains accrued in the fund if invested by June 2027 and held in that fund for at least 10 years, as long as the disposition of the investment occurs by the end of 2047.
The Tax Cuts and Jobs Act (P.L. 115-97) added the Opportunity Zone program to the code to spur investment in lower-income communities. The program allows taxpayers to defer capital gains by rolling over amounts into qualified funds, and allows a 10 percent basis step-up if the investment is held for at least five years and a 15 percent step-up if it’s held for at least seven years.
If the investor holds the investment for 10 years, it can elect to exclude gains realized and effectively eliminate any capital gains tax on the gains accrued in the fund. The communities subject to the program were designated by state and U.S. territory governors in the spring.
Because of the strict timing rules that must be followed under the program, taxpayers were anxiously awaiting guidance. While more guidance is on the way, the government addressed some of the outstanding issues first. “The proposed regulations released today clarify what gains qualify for deferral, which taxpayers and investments are eligible, the parameters for Opportunity Funds, and other guidance,” according to a Treasury release.
Treasury officials at an October 19 briefing said the Office of Information and Regulatory Affairs review process for the regs took longer than some expected in part because the process is still new, but also because the Opportunity Zone program is a brand-new regime that could have a substantial economic impact.
Legislative History Relied On
Over the summer, practitioners wondered which types of gains would qualify for deferral under the program. For example, some suggested that Treasury and the IRS allow all gains from the sale of property — other than property for sale to customers in the ordinary course of business — to qualify for the benefit, like gains from depreciation recapture or the sale of specific debt instruments.
The government in the proposed regulations said the legislative history and text of the TCJA indicate the deferral was intended only for capital gains. The proposed rules clarify that the capital gains to be deferred must be gains that would be recognized by December 31, 2026, the final date for the deferral of gain under the program, and that gains can’t be from a sale or exchange to a related person.
Substantially Clearer
The guidance provides clarity on how a trade or business can be treated as a qualified Opportunity Zone business. To qualify, it “must (among other requirements) be one in which substantially all of the tangible property owned or leased by the taxpayer is qualified opportunity zone business property,” the proposed regs say.
The “substantially all” requirement means at least 70 percent of the tangible property, according to the regs. Michael Bernier of EY said that is a relief because some speculated that the threshold would be 90 or even 95 percent.
Michael J. Novogradac of Novogradac & Co. LLP said the 70 percent rule was one of the more substantial clarifications. He said that threshold, which was recommended by the Novogradac Opportunity Zones Working Group, provides necessary flexibility even if there are still definitional issues that require clarification. However, the phrase “substantially all” is used several times throughout the statute, and the IRS and Treasury want input on their proposed use of the term, as well as how it should apply in other areas of the statute.
Some taxpayers were concerned that a qualified fund could violate the requirement that investments in qualifying assets occur within six months because developing a business or constructing real estate may take longer. In response, the proposed regulations provide a safe harbor that allows qualified businesses to apply the definition of working capital provided in section 1397C(e)(1) to property held by the business for up to 31 months, as long as it meets some requirements.
Those requirements include a “written plan that identifies the financial property as property held for the acquisition, construction, or substantial improvement of tangible property in the Opportunity Zone,” and a “written schedule consistent with the ordinary business operations of the business that the property will be used within 31 months.” Diana M. Lopo of Skadden, Arps, Slate, Meagher & Flom LLP said that every project in an Opportunity Zone will have some sort of start-up or development aspect to it, so allowing 31 months in some instances before the money must be spent is helpful.
Debt and Collateral Treatment
The proposed regulations allow partnerships to elect to defer capital gains at the entity level, and none of the gain need be included in the partners’ distributive shares. If the partnership decides not to defer gain and invest in an eligible fund, partners can make the elections on their portions of the distributive shares, if other requirements are met, the proposed regs say.
Under section 1400Z-2(e)(1), if a taxpayer makes an investment in which some amounts are subject to deferral and others aren’t, those amounts should be treated as separate investments.
The proposed rules clarify that deemed contributions under section 752(a) don’t constitute an investment in a qualified opportunity fund and therefore don’t result in the partner’s having a separate investment. Under section 752(a), any increase in a partner’s share of liabilities, or assumption of liabilities, is considered a contribution from the partner to the partnership.
The statute refers to investment vehicles that qualify for the program as those organized as a corporation or a partnership, so some practitioners wondered whether that meant limited liability companies taxed as corporations or partnerships would technically be ineligible. In the proposed regulations, the government clarifies that a fund “must be an entity classified as a corporation or partnership for federal income tax purposes.”
Bernier said it’s interesting that the proposed regs allow funds to be used as collateral. He used the example of a taxpayer who invests in real estate and after six years wants to refinance the property and take cash out.
“Under an Opportunity Zone structure, if you refinance the property and took cash out of the Opportunity Zone fund, that would be a disposition and trigger the gain and reduce the amount of investment that is eligible for the 10-year deferral,” Bernier said. “But if you can use [the fund] as collateral, instead of refinancing the property and pulling the cash, you can borrow against the Opportunity Zone fund.” There are a few extra hurdles to using that strategy, but it’s valuable in the real estate world and would be the rough equivalent of a cash-out refinancing, Bernier said.
Other Guidance
Also released October 19 was Rev. Rul. 2018-29, 2018-45 IRB 1, which clarifies the treatment of a qualified fund purchasing an existing building, and whether substantial improvements to the building mean additions to adjusted tax basis in the building, or to the building and the land.
For example, it clarifies that if a fund purchases a building wholly within an Opportunity Zone, a substantial improvement to the building is measured by the fund’s additions to the adjusted basis of the building. Measuring that doesn’t require the fund to separately improve the land on which the building is situated, according to the revenue ruling.
Nickolas Gianou, also of Skadden, said that before the proposed regulations were issued, it was unclear whether improvements needed to be made on both the land and the building. “For zones in which land value is significant and meaningful, this is going to make projects a lot more feasible because it’s just the value attributable to the building that you have to reinvest in,” Gianou said.
Stephanie Cumings contributed to this article.