The Opportunity Zone program was created under the Tax Cuts and Jobs Act and went into effect on January 1, 2018. The proposed regulations, released on October 19, 2018, provide additional guidance for potential investors under new US Code section 1400Z-2, clarifying several key issues which were not addressed in the Tax Cuts and Jobs Act. In this article, we discuss the most consequential elements of the guidance that was released and how it will impact both Opportunity Zone investors and potential Opportunity Zone investments.
Types of Capital Gains that Qualify for Investment
The initial legislation broadly stated that capital gains qualify for the tax incentives offered under the Opportunity Zone program. The proposed regulations specify that in order to be eligible for tax deferral, the gain must be treated as capital gain for federal income tax purposes. For investors, this means that short-term and long-term capital gains, as well as section 1231 gains are eligible for tax deferral. However, section 1245 or section 1250 gains are not eligible because they are not capital in nature. It’s worth noting that even though short-term capital gains are considered to be eligible for investment in an Opportunity Fund, they still maintain their ordinary income character, and therefore will be taxed at ordinary income rates when ultimately recognized.
In addition to the criteria above, the proposed regulations also exclude capital gains arising between related parties as eligible for deferral.
Tax Forms Required for Individual Investors
Initial legislation stated that eligible capital gains must be invested into a Qualified Opportunity Fund (QOF) within 180 days of recognition of the gain. The proposed regulations provided only slight clarification on investor reporting requirements, stating that it is anticipated that investors will report their investment in a QOF to the Internal Revenue Service (IRS) using Tax Form 8949 – a form used for reporting sales and other dispositions of capital assets. To accommodate the introduction of the Opportunity Fund tax incentives, an updated form and instructions are expected to be released imminently. We believe that the updated form will likely include fields for QOF investors to indicate the amount of their realized gain rolled into a QOF, the date in which the investment was placed into the QOF, and the name of the QOF.
Which Taxpayers Can Make an Investment and When
For capital gains that arise in the context of a partnership (or any other pass-through entity), the proposed regulations allow for the investment of gains into a QOF to be made either at the individual partner level or at the partnership level. For gain tax deferral made at the partnership level, the 180-day period begins on the date in which the gain was recognized. In the event that a deferral election is not made at the partnership level but rather by the individual partner, the partner may elect to begin the 180-day period either on the date in which the gain was recognized by the partnership or on the last day of the partnership’s taxable year. This flexibility is crucial for partners, because their ability to make a deferral election no longer hinges on immediate communication from the partnership in which they are invested.
Definitions of Reasonable Working Capital
Section 1400Z-2(d)(1) requires a Qualified Opportunity Fund to hold at least 90% of its assets in Qualified Opportunity Zone property (QOZ property). This 90% test calculation is determined by the average of the percentage of QOZ property held in the fund as measured (A) on the last day of the first six-month period of the taxable year of the fund, and (B) on the last day of the taxable year of the fund. The proposed regulations allow for working capital to be included as QOZ property for the purposes of the 90% test, but, the amounts must be designated for the acquisition, construction, or substantial improvement of tangible property in an opportunity zone. The QOF must have a written plan detailing what the working capital is earmarked for, and it also must spend the working capital funds within 31 months of receipt. The working capital safe-harbor is a critical clarification, as it provides a clear path for QOFs to substantially improve properties without failing the 90% test.
Land Exclusion for Substantial Improvement Test
In order to be considered QOZ property, the original use of such property must commence with the QOF, or the QOF must substantially improve the property. “Substantial improvement” requires that improvements to the property must exceed an amount equal to the adjusted basis of the property during the 30-month period beginning after the date of acquisition. The proposed regulations narrow the scope to encompass only the adjusted basis of buildings preexisting on the property. They also state that the QOF is not required to separately substantially improve the land upon which a building is located.
This clarification is crucial for any real estate renovations in major cities, such as Los Angeles and New York City, where land is an expensive and large share of the cost of development.
Opportunity Fund Certification and Reporting
A QOF is required to provide self-certification to the IRS stating that they meet the statutory requirements for the beneficial tax treatment; no prior approval or actions by the IRS is required. This certification will be made on the new IRS Form 8996, which will be attached to the QOF’s annual tax return. The form requires a QOF to indicate that they are organized for the purpose of investing in QOZ property, and includes the information necessary to calculate the 90% test and any penalty for non-compliance.
Tax-free Gain on Opportunity Zone Investments
One of the fundamentals of the Opportunity Zone program is that if an investor holds their Opportunity Fund investment at least ten years, they are exempt from taxes on any appreciation from their original Opportunity Fund investment. The original statute provided for the expiration of Opportunity Zones 2028, which left many wondering if appreciation on their investment may only grow tax-free for ten years. The IRS clarified in these proposed regulations that appreciation on an Opportunity Zone investment may grow tax-free until December 31, 2047.
The Department of the Treasury (Treasury Department) and IRS have requested the submission of comments on the proposed regulations, and will hold a public hearing on January 10, 2019, after which the IRS may proceed to finalize the regulations. In the meantime, until regulations are finalized, the IRS has stated that much the proposed guidance can be relied upon in draft form.
The Treasury Department and IRS are also working on providing additional guidance, including the release of more proposed regulations, which are expected to be published in the near future. These additional proposed regulations are expected to address topics not covered in the current proposed regulations, including further definitions of “substantially all” and delineation the “original use” requirement.
While some unanswered questions still remain, these proposed regulations provide much-needed and long-awaited guidance for investors and Qualified Opportunity Funds on the most critical topics. The new proposed regulations allow many investors that previously felt sidelined by uncertainty to begin seriously analyzing the tax benefits of Opportunity Zones.