The Opportunity Zone program was created under the Tax Cuts and Jobs Act and went into effect on January 1, 2018. Because the legislation left many unanswered questions, the Internal Revenue Service (IRS) intends to release guidance intermittently (perhaps over many years) to address these issues. On September 12, 2018, the IRS submitted initial regulatory guidance regarding capital gains invested in Opportunity Zones to the Office of Information and Regulatory Affairs (OIRA) for review.
Department of Treasury regulations, such as these, that are identified as “significant” regulations are subject to review by OIRA. These much-awaited proposed rules are expected to clarify several key issues for potential Opportunity Zone investors. Although many areas are likely to be touched upon in the proposed rules, these are the major issues that we anticipate to be addressed in this upcoming release of guidance.
The following discussion is comprised of speculation of what the IRS guidelines may look like when issued, and may ultimately be incorrect. Accordingly, the following is for informational purposes only.
Types of Capital Gains that Qualify for Investment
First and foremost, we expect the IRS to clarify which types of capital gains quality for the tax incentives offered under the Opportunity Zone program. Based on the goals of the program and the general wide access offered under the program, we believe that both short term and long term capital gains should qualify. We also anticipate the new rules to specify that US Code section 1231 gains qualify because they receive capital gain treatment. Conversely, because section 1245 gains and section 1250 gains are not considered capital gains and are characterized as ordinary income, we don’t anticipate that they will qualify.
Tax Forms Required for Individual Investors
We anticipate investors to be able to report their investment in a Qualified Opportunity Fund (QOF) to the IRS using Tax Form 8949 – the form used for reporting the sales and other dispositions of capital assets. To accommodate the introduction of the Opportunity Fund tax incentives, we anticipate that the IRS will release an updated Form 8949 before the end of 2018. We believe that the updated form would likely include fields for Opportunity Fund investors to report the amount of their realized gain, which had been rolled into a qualifying Opportunity Fund, the date in which the investment was placed into the Opportunity Fund, and the name of the Opportunity Fund.
Which Taxpayers can Make an Investment and When
For capital gains that arise in the context of a partnership (or any other consolidated group), we expect the IRS to permit the decision to invest gains in a QOF to be made at the individual partner level or at the partnership/consolidated group level.
Some speculate that an election to invest at the partnership level could be made on a modified version of Form 4797.
The IRS should permit individual taxpayers to use any reasonable method to determine the start of the 180-day period in situations where the taxpayer has not yet received a Schedule K-1 at the time of the investment. For instance, if a taxpayer is sent a notice from a partnership he/she is invested in regarding a gain on the disposition of a capital asset, the date of notification should be able to serve as the start date of the 180-day period, since a partner may not have actual knowledge of the date of sale until after the 180-day period has expired. This may also require that the IRS allow the taxpayer to rely on a reasonable method to determine the gain it will allocate, as actual amounts may not be communicated to the taxpayer until tax forms are formally issued.
Opportunity Fund Certification and Reporting
One critical question that remains unanswered concerns how an Opportunity Fund will report any required information to the IRS and certify that it has complied with applicable regulations and therefore is a QOF. The IRS intends to release a new form on which the fund will likely provide information on its Opportunity Zone and non-Opportunity Zone assets. Through an FAQ page, the IRS has already confirmed that this will be a self-certification process, meaning that no approval from or action by the IRS is required. The form is required to be attached to the fund’s tax return and filed timely. We believe that the IRS will collect material but minimal data on the fund’s assets for the purpose of preventing abuse of the tax incentive by funds, but without creating a burdensome reporting requirement.
Definitions of Ramp-Up Period and Reasonable Working Capital
Proposed regulations should provide for a ramp-up period for Opportunity Funds in order to facilitate beginning of its operations. 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.
A ramp-up period would be needed in a practical sense to give an Opportunity Fund reasonable time to invest or reinvest proceeds prudently into QOZ property. We believe that it is appropriate for the Department of Treasury to provide guidance specifying that for one year after receipt of any cash proceeds, such cash be deemed QOZ property. We also suggest that a QOF receive a start-up grace period of at least 18 months (three testing periods) from the time the QOF is formed before it must participate in its first semi-annual testing date.
We also anticipate the allowance of a reasonable amount of working capital that be held by QOZ businesses or properties. We believe that this is necessary in order prevent hindrance of their operations or the progress of substantial improvements made to them. We anticipate this reasonable working capital to be excluded from the 10% threshold of non-QOZ property that an Opportunity Fund is permitted to hold.
OIRA is expected to release a Notice of Proposed Rulemaking after the mandated review period, which last for at least ten days. After this review period, a 60-day public comment period is expected to follow. Upon the conclusion of the public comment period (and after consideration and analysis of comments received), the IRS may proceed to finalize rules. These rules will be subject to OIRA review again. In general, when a government agency publishes a final rule, the rule is typically effective no less than 30 days after the date of publication in the Federal Register. However, it’s common practice to rely on draft guidance in the absence of applicable final regulations. Due to this, we expect the upcoming release of this proposed guidance from the IRS to provide much-awaited information, which could be a catalyst for many to invest in Opportunity Zones.