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One of the many new provisions to emerge from the 2017 Tax Cuts and Jobs Act (TCJA) was the creation of Opportunity Zones. Opportunity Zones are designed to incentivize investors to invest in economically distressed communities by allowing deferral, and in some cases reduction or exclusion, of capital gains. For a location to be selected as a Qualified Opportunity Zone, it must be nominated for designation by the state, and then certified by the U.S. Department of the Treasury. You can find a list of Qualified Opportunity Zones on the U.S. Department of the Treasury’s website.
Secretary of the Treasury Steven Mnuchin says Opportunity Zones should lead to $100 billion in capital investments in distressed areas. Now the IRS has released proposed regulations for this tax incentive.
Overview of the tax incentive
The TCJA creates a new section of the Internal Revenue Code, Section 1400Z, that establishes Opportunity Zones 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. They’ll retain that designation until December 31, 2028.
Investors can form private investment vehicles, known as qualified opportunity funds (QOFs), for funding development and redevelopment projects in the zones. QOFs must maintain at least 90% of their assets in qualified Opportunity Zone property, including investments in new or substantially improved commercial buildings, equipment and multifamily complexes, as well as in qualified Opportunity Zone businesses. The QOF must be taxed as a corporation or partnership.
QOF investors are eligible to make certain tax friendly elections. The first election allows an investor to defer the capital gain on the sale of property, such as real estate or stock, to an unrelated party if the gain is reinvested in a QOF within 180 days. The tax on the gain is deferred until the investment in the QOF is sold or until December 31, 2026, whichever comes first. If the investor holds the investment for at least five years, the basis in the investment is increased by 10% of the deferred gain. If the investor holds the investment for at least seven years, the basis in the investment is increased by an additional 5% of the deferred gain, reducing the taxable portion of the original gain to 85%.
The second election allows an investor that holds the QOF for at least 10 years to set the basis of the investment equal to its fair market value on the date the QOF is sold. In this scenario, the investor would pay no taxes on post-acquisition capital gains.
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.
Rules for investors
The proposed regs make clear that only capital gains — such as those from the sale of stock or a business — qualify for tax deferral. But investors have until December 31, 2026 for the transaction to qualify for the subsequent QOF investment for the basis adjustment. For gains experienced by pass-through entities, the rules generally allow either the entity or the partners, shareholders or beneficiaries to elect deferral.
Also, the proposed regs clarify that an investment in a QOF must be an equity interest, including preferred stock or a partnership interest with special allocations. A debt instrument doesn’t qualify. A taxpayer can, however, use a QOF investment as collateral for a loan.
As previously mentioned, to qualify for deferral, investors must invest in a QOF during the 180-day period beginning on the date of the sale that generates the gain. For amounts deemed a gain by federal tax rules, the first day of the period generally is the date that the gain would otherwise be recognized for federal income tax purposes.
For partnership gains not deferred by the entity, a partner’s 180-day period generally begins on the last day of the partnership’s taxable year, which is the day the partner otherwise would be required to recognize the gain. If a partner knows both the date of the partnership’s gain and its decision not to elect deferral, the partner can begin its own period on the same date as the start of the entity’s 180-day period. Analogous rules apply to other pass-through entities.
The IRS noted that the expiration of Opportunity Zone designations at the end of 2028 raises questions about QOF investments that are still held at that time. For example, can investors still make basis step-up elections after 10 years for QOF investments made in 2019 or later?
The proposed regs preserve the ability to make the election until December 31, 2047. Because the latest gain subject to deferral would be at the end of 2026, the last day of the 180-day period for that gain would be late June 2027. A taxpayer deferring such a gain would reach the 10-year holding requirement only in late June 2037. The extra 10 years is provided to preempt situations where a taxpayer would need to dispose of a QOF investment shortly after completion of the 10 years to obtain the tax benefit, even though the disposal otherwise would be disadvantageous from a business perspective.
If an investor disposes of its entire original interest in a QOF, which normally would trigger inclusion of the deferred gain, the investor can continue the deferral by reinvesting the proceeds in a QOF within 180 days. This allows investors to escape bad deals without forfeiting the deferral benefit.
Rules for QOFs
The proposed regs address several issues related to QOFs. For example, the regs exclude land from the determination of whether a purchased building in an Opportunity Zone has been “substantially improved” (defined as doubling the basis, or investing an amount at least equal to the purchase price). Improvement is measured only by the QOF’s additions to the adjusted basis of the building. So, for example, if a QOF buys a $3 million property, with $2 million for the land and $1 million for the building, it’s required to invest only $1 million to improve the building.
Sec. 1400Z also allows QOFs to invest in qualified Opportunity Zone businesses, rather than directly owning property, as long as “substantially all” of the business’s leased or owned tangible property is qualified Opportunity Zone business property. The proposed regs provide that “substantially all” means at least 70% of the leased or owned tangible property.
Additional rules cover self-certification of QOFs, valuation for purposes of the 90% asset test and other matters. For example, the proposed regs clarify that there is no prohibition to using a pre-existing entity as a QOF, provided such entity satisfies the requirements.
More guidance to come
The IRS has requested comments on several parts of the proposed regs, suggesting they’re subject to significant revision, and promises more guidance. Nonetheless, taxpayers generally may rely on these rules if they apply them in their entirety and in a consistent manner.
For more information about this or any other tax reform related topics, please contact a member of your DGC client service team or Joel Rothenberg, CPA, JD, LLM at 781-937-5135 / firstname.lastname@example.org or Matt Mulroney, CPA, MST at 781-937-5372 / email@example.com.
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