Proposed Tax Regulation for Qualified Opportunity Zones Released
As part of the 2017 tax reform enacted as the Tax Cuts and Jobs Act (“TCJA”), the Internal Revenue Code (the “Code”) was amended to add Sections 1400Z-1 (designating qualified opportunity zones (“QOZs”)) and 1400Z-2 (deferral of certain gains related to investments in a qualified opportunity fund (a “QOF”)). Although the two Sections work in tandem, Section 1400Z-1 was largely used by governments in establishing QOZs. On the other hand, Section 1400Z-2 was intended to be used by taxpayers investing in those QOZs established under Section 1400Z-1. Taxpayers and practitioners have looked to the Department of the Treasury (“Treasury”) and the Internal Revenue Service (the “IRS”) for guidance regarding open questions presented by Section 1400Z-2. On Friday, October 19, 2018, Treasury and the IRS responded with proposed regulations (the “Proposed Regs”) and Revenue Ruling 2018-29 (the “Revenue Ruling”). This article starts with a background discussion before moving to analyses of the Proposed Regs and the Revenue Ruling. Finally, this article concludes with a description of additional guidance Treasury promised in issuing the Proposed Regs.
As noted above, Section 1400Z-2 provides for the deferral of certain gains. That deferral comes in two primary forms. First, taxpayers are permitted to defer inclusion in gross income if corresponding amounts are invested in a QOF. Second, post-acquisition gains on investments in a QOF may be excluded from income to the extent the investment is held for at least ten years. Taxpayers and practitioners alike have identified a number of open issues not resolved by the Code, and have called upon Treasury and the IRS to provide guidance. The Proposed Regs and the Revenue Ruling are a response to that call to action. Treasury has promised additional regulatory guidance in the future. What follows is a summary of the guidance issued on Friday, October 19.
The Proposed Regs
The Proposed Regs address a number of different issues related to QOZs and the taxation of investment in those QOZs:
- Gains Eligible for Deferral. Only capital gains are eligible for deferral under Section 1400Z-2. Moreover, (1) the capital gain must be gain that would be recognized, if deferral under Section 1400Z-2 were not permitted, not later than December 31, 2026; and (2) the gain must not arise from a sale or exchange with a related person. For purposes of the Proposed Regs, a “related person” is based on the definition provided in Code Sections 267(b) and 707(b)(1), but substituting 20% instead of the typical 50% in those Code Sections.
- Taxpayers Eligible to Elect Gain Deferral. The Proposed Regs permit individuals, C corporations, regulated investment companies, real estate investment trusts, partnerships, and certain other pass-through entities to avail themselves of the tax deferral.
- Investments in a QOF. The investment in a QOF must be an equity investment, which is broadly defined to include preferred stock and/or special partnership allocations.
- 180-Day Rule for Deferral of Gain. The first day of the 180-day period is the date on which gain would be recognized for federal income tax purposes. The Proposed Regs include a number of examples intended to identify that date under a variety of factual scenarios.
- Attributes of Included Income When Gain Deferral Ends. When a taxpayer defers gains under Section 1400Z-2, all of the deferred gain’s tax attributes are preserved through the deferral period and later taken into account when gain is included in the taxpayer’s income. To the extent a taxpayer disposes of less than all of the taxpayer’s interests in a QOF, the Proposed Regs provide a “first-in, first-out” methodology for determining gain inclusion.
- Gain Not Already Subject to an Election. Section 1400Z-2 is intended to apply to gain that has not been subject to other elections. Although a fine point, this is intended to make certain that gain only achieves one benefit under Section 1400Z-2 in cases in which a taxpayer initially elects for a portion of the gain to benefit, and then later expands the election.
- Gains of Pass-Through Entities, such as Partnerships. The Proposed Regs permit pass-throughs to make the deferral election; and, to the extent some or all of the entity’s gain is not subject to an election, the Proposed Regs permit the pass-through owner to make an election as to that gain. With respect to the 180-day rule, the general rule for a partnership will be that the 180-day period starts on the last day of the entity’s taxable year.
- How to Elect Deferral. Treasury contemplates using Form 8949 for purposes of reporting the gain deferral.
- Basis Step-up for Investments Held at Least 10 Years. To the extent a taxpayer holds a QOF investment at least 10 years, the taxpayer may elect to increase the basis to the investment’s fair market value at the time of sale, which effectively eliminates tax on the increase in value. The Proposed Regs seek to separate out additional amounts invested in a QOF to ensure that this permanent gain exclusion applies only to the QOF investment related to the gain deferral election (that is to say, taxpayers cannot obtain gain deferral to additional funds invested with gain deferral funds).
- QOF Investments and the 10-Year Zone Designation Period. The Proposed Regs aim to clear up confusion about how to handle the 10-year period described immediately above given the law expires on December 31, 2028. The Proposed Regs essentially permit the gain exclusion to apply until December 31, 2047, which is 10 years after the 10-year period for gains realized before the expiration of the provision in 2028.
- Certification as a QOF. The Proposed Regs contemplate the use of Form 8996 for entities to self-certify as a QOF.
- Designating When a QOF Begins. A QOF is permitted to identify the taxable year and month when it becomes such an entity. This will be an important designation because only investments in QOFs will qualify for deferral under Section 1400Z-2. To the extent the entity elects to be a QOF other than the first month of its taxable year, the Proposed Regs provide a methodology for determining whether the QOF meets the “90% Asset Test.” In short, the 90% Asset Test is derived from Section 1400Z-2(d)(1) and essentially provides that a QOF must invest 90% of its assets in certain investments.
- Preexisting Entities May Qualify as QOFs. The Proposed Regs make it clear that existing entities—especially those predating the TCJA—may qualify as QOFs.
- Certain Otherwise Nonqualified Financial Property May Qualify. The Proposed Regs permit a QOF to hold cash and other nonqualified property if the QOF has a written plan that identifies the property as held for acquisition, construction, or substantial improvement of tangible property in the QOZ, a written schedule exists evidencing the use of the property, and the QOF substantially complies with the schedule.
- Qualified Opportunity Zone Business. The Proposed Regs provide that a corporation or partnership may qualify as a QOF. The entity must satisfy the 90% Asset Test. In determining whether the QOF satisfies the 90% Asset Test, the Code and Proposed Regs look to whether “substantially all” of assets are used. What constitutes “substantially all” for these purposes remains the subject of future guidance.
The Proposed Regs included other specific issues likely to be less prevalent:
- Treatment of Section 1256 Contracts.
- Treatment of offsetting-position transactions, including straddles.
- Valuation method for applying the 90% Asset Test.
In summary, the Proposed Regs have addressed many of the open issues discussed since the enactment of the TCJA.
The Revenue Ruling
The IRS targeted a narrower set of issues in the Revenue Ruling, focusing on three primary issues:
- A QOF cannot qualify as “original use” for the acquisition of an existing building on land that is wholly within a QOZ.
- If a QOF acquires a building wholly within a QOZ, a “substantial improvement” under Section 1400Z-2 is measured by reference to additions to the adjusted basis of the building.
- That being said, the QOF need not also substantially improve the land upon which the building is located.
In summary, the Revenue Ruling is looking at situations in which the taxpayer acquires an existing building and land, with an eye toward achieving tax benefits under Section 1400Z-2. In such situations, the taxpayer should apportion the acquisition price between the building and the land, and then seek to improve the building during the next 30 months by an amount that exceeds at least the adjusted basis of the building.
Additional Forthcoming Guidance
The Proposed Regs contain a list of issues Treasury promises will be the subject of future regulatory activity. That list includes:
- The meaning of “substantially all” for purposes of Section 1400Z-2.
- The Section 1400Z-2(a) election and transactions that may trigger gain that has been deferred under that Section.
- Defining the “reasonable period” during which a QOF is required to reinvest proceeds from the sale of qualifying assets without incurring a penalty.
- Consequences for QOFs that fail to maintain the required 90% investment standard.
- Section 1400Z-2 information-reporting requirements.
Of those issues, what constitutes “substantially all” for purposes of Section 1400Z-2 is likely to be the most eagerly awaited guidance.
Opportunity zones are widely regarded as the next “big thing” in the real estate and construction industry. We will be monitoring regulatory activity and the issuance of other agency guidance over the upcoming weeks and months. If you have questions about opportunity zones and their application, please contact your Schwabe attorney, Dan Eller, Jeff Patterson, or Charmin Shiely.
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