IRS Releases Proposed Tax Regulations for Opportunity Zone Investments
The IRS has released proposed regulations to provide guidance on the incentives created by the Tax Cuts and Jobs Act to encourage investment in Qualified Opportunity Zones (QOZ) — geographic areas in designated economically distressed communities in each state.
Re-investment of capital gains in a Qualified Opportunity Zone fund (QOF) allows taxpayers to defer a portion of the appreciation of the investment, and when the investment is held for at least 10 years, exclude the post-acquisition gains from gross income.
Members of the public have 60 days from October 19, 2018, to submit comments to the IRS and Treasury on the proposed regulations. A public hearing is scheduled for January 10, 2019.
The following is a summary of some of relevant sections of the proposed regulations that may assist taxpayers with their QOF investments.
Clarification on what gains are eligible for deferral
Under IRC Section 1400Z-2, capital gains resulting from an actual sale or exchange of assets are eligible for deferral, as is any other gain that must be calculated as a capital gain. Two additional requirements for deferral include:
- Gain that would be recognized no later than December 31, 2026
- The gain must not arise from a sale or exchange from a related person (as defined in IRC Section 267(b) and 707(b)(1))
Types of taxpayers eligible to elect gain deferral
An eligible taxpayer is any “person” that may recognize gain for federal income tax accounting purposes, including C corporations, regulated investment companies (RICs), real estate investment trusts (REITs), partnerships, common trust funds, and certain other pass-through entities, as well as, qualified settlement funds and disputed ownership funds.
Eligible interest in a QOF
An investor’s eligible interest in a QOF includes preferred stock or a partnership interest with special allocations. Debt instruments, such as a bond, debenture notes or certificates, or other evidence of indebtedness, are excluded. However, an investor may use equity interest in a QOF as collateral for a loan used for the purchase of such interest.
180-day rule for deferring gain by investing in a QOF
A taxpayer must generally invest in a QOF during the 180-day period after the sale or exchange of the capital asset that gave rise to the gain. Where the IRC provisions deem an amount to be a gain, but do not specify a date for the deemed sale, the first day of the 180-day period is the date the gain would otherwise be recognized for federal income tax purposes.
Attributes of included income when gain deferral ends
Taxpayers may make separate investments in a QOF that are indistinguishable, made at different times, or are made at the same time with separate gains possessing different attributes (such as different holding periods). If a taxpayer does not dispose of all of its interests in a QOF, the fund interests that are disposed of must be identified using a first-in, first-out (FIFO) method. If the FIFO method does not provide a complete answer, the proposed regulations require that a pro-rata method be used to determine the character and any other attributes of the recognized gain.
Special rules for eligible gains
Gain not already subject to an election
Gains already subject to a deferral election under Section 1400Z-2(a) are not eligible gains for purposes of Opportunity Zone investments.
Section 1256 contracts
The proposed regulations allow a taxpayer to defer the net capital gain from Section 1256 contracts for a taxable year, with the 180-day period for investing the net capital gain in a QOF beginning on the last day of the taxable year. The deferral of gain from a Section 1256 contract is not allowed if one of the taxpayer’s Section 1256 contracts was a part of an offsetting-positions transaction in which any of the other positions was not also a Section 1256 contract.
Offsetting-positions transactions, including straddles
The deferral of gain that results from a straddle transaction, where the taxpayer has the option to buy or sell the same investment asset at the same time, is not eligible for deferral under section 1400Z-2(a).
Gains of partnerships and other pass-through entities
Under IRC Section 702.1.1400Z-2(a), a partnership may make an eligible investment in a QOF and the partnership’s deferred capital gain due to its election need not be included in the distributive shares to partners. Partnership capital gain that is not deferred by an investment in a QOF is included in the distributive shares of its partners. In this case, a partner’s adjusted basis in the partnership interest does not include those gains invested in a QOF. Should the gain pass through to a partner or shareholder, their 180-day window begins on December 31, 2018, unless they elect to use the same date as the pass-through entity.
Pass-through entities other than partnerships
An S corporation, trust, or decedent estate that recognizes an eligible gain is not required to include the gain in the proportional interest of its shareholders or beneficiaries when the gain is deferred under the QOZ program.
Use of Form 8996 for self-certification
A taxpayer that is a corporation or partnership for tax purposes can self-certify as a QOF, provided the entity self-certifying is statutorily eligible to do so. Taxpayers will use Form 8996 for self-certification.
Use of Form 8949 to elect capital gain deferral
Taxpayers will use Form 8949 to make an election to defer capital gains in an investment in a QOF. The Form 8996 self-certification would be attached to the taxpayer’s federal income tax return for the relevant tax years. The IRS has not yet released the form but draft forms are available for public comment.
Election for investments held for at least 10 years
Taxpayers that hold a QOF investment for 10 years may choose a basis step-up election to increase the basis of the investment on the date the investment is sold or exchanged. The basis step-election is available for qualifying investments held for at least 10 years. A taxpayer may have funds that qualify for the deferral election and funds that do not qualify for the deferral election. The non-qualified funds (funds that are not capital gains) are treated as a separate investment that receives different tax treatment from the qualified funds.
Taxpayers will be allowed to make the basis step-up election even after a QOZ expires. The election is preserved until December 31, 2047.
A pre-existing entity as a QOF
A pre-existing entity may be a QOF as long as it satisfies the semi-annual test to determine whether its assets consist, on average, of at least 90 percent QOZ property. For purposes of these semi-annual tests, a tangible asset can be QOZ business property by an entity that has self-certified as a QOF or an operating subsidiary entity only if it purchased the asset after 2017.
Valuation method for applying the 90 percent asset test
A QOF’s assets must consist of an average of at least 90 percent qualified Opportunity Zone property using the asset values that are reported on the fund’s financial statement for the taxable year. If the fund does not have a financial statement, it must use the cost of its assets.
Nonqualified financial property
Cash can constitute an appropriate QOF property for purposes of the 90 percent asset test. The proposed regulations create a working capital safe harbor for QOF investments in QOZ businesses. Under the safe harbor, working capital is defined as property held by the business for a period of 31 months, if there is a written plan that identifies the property as being held for the acquisition, construction, or substantial improvement of tangible property in the Opportunity Zone.
A QOZ business
An entity operating a trade or business is a QOZ business if at least 70 percent of the tangible property it owns or leases is QOZ business property as defined by Section 1400Z-2(d)(3)(A)(i)). Property may be either stock, a partnership interest, or business property.
QOZ business property
QOZ business property is tangible property used in a trade or business of the QOF under the following requirements:
- The tangible property is purchased in the QOF after December 31, 2017;
- Original use of the tangible property commences with the QOF, or the fund substantially improves the tangible property; and
- During the QOF’s holding period for the tangible property, substantially all of the use of the tangible property is in a QOZ.
Tangible property is treated as substantially improved by the QOF only if, during any 30-month period beginning after the date of acquisition, additions to basis when the property is held by the fund exceed the adjusted basis at the beginning of the 30-month period.
Eligible interest in a QOF
Eligible interest in a QOF is the equity interest issued by the fund, including preferred stock or a partnership interest with special allocations. Debt instruments are not eligible interest. However, an eligible taxpayer may use its equity interest in a QOF as collateral for a loan used for the purchase of such interest.
Frequently Asked Questions
No, the eligible interest must be an equity interest.
A taxpayer makes an election to defer capital gains in an investment in a QOF by filing a Form 8949. The IRS has not yet released the form but draft forms will be available soon for public comment.
Yes, an investor may make an investment as late as June 2027 and get a 10-year step-up in basis treatment.
Yes, the proposed regulations provide a working capital safe harbor.
How we can help
Our business tax planning professionals and wealth advisors are immersed in the real estate field, the investment market, tax reform, and the industries our clients operate businesses in. We can help you make clear decisions and realize the full benefits of the Opportunity Zone program before the initial December 31, 2019, deadline.