The IRS released the first batch of guidance implementing the new tax incentives for opportunity zone investments on Oct. 19, providing helpful flexibility in some areas but leaving several key questions for the next round of proposed regulations.
Opportunity zones were created by the Tax Cuts and Jobs Act to encourage investment in specific geographic areas. Taxpayers investing in qualified opportunity funds (QOFs) can defer and even exclude capital gain if they meet certain requirements. The IRS guidance package includes proposed regulations
, a revenue ruling
and a draft form
for self-certifying as a QOF. The guidance provides initial clarity on many key issues, including the following:
- Only gains from capital assets may be deferred for investments made in QOFs.
- Either a pass-through entity or its owners may make an election to defer gain.
- A pre-existing entity may designate a specific month to begin being treated as a QOF and subject to the requirements.
- Cash can be a qualifying asset for a QOF’s 90% asset test for up to 31 months if certain conditions are met under a safe harbor provision.
- Land does not need to be substantially improved to qualify as opportunity zone business property and the value of land is not included when assessing if a building has been substantially improved.
- The threshold for “substantially all” of qualified opportunity zone business’s tangible property to be qualified opportunity zone business property is 70%.
Taxpayers may rely on many of the rules in the proposed regulations before the regulations are finalized if applied consistently, but many key issues remain outstanding. The IRS pledged to soon release another round of proposed regulations that would address remaining issues, including the following:
- The standard for the phrase “substantially all” in other places in the statute where it is used
- The definition of the term “reasonable period” for a QOF to reinvest proceeds from the sale of qualifying assets
- Whether the requirement that qualifying property be put to “original use” in an opportunity zone can apply to property that was previously placed in service but is vacant, underutilized, or abandoned
- Administrative rules when a QOF fails to meet the 90% asset test
- Transactions triggering a gain inclusion
There are more than 8,700 census tracts designated as opportunity zones across all 50 states, the District of Columbia and Puerto Rico, and there are multiple qualifying areas in nearly every major city. The opportunity zone program offers a potentially valuable tax incentive for investors looking to defer gains, real estate and operating businesses active within opportunity zones, and investment funds looking to match investors with qualifying projects. The new guidance is discussed in more detail below.
Incentives for investing in QOF
New Section 1400Z-2 provides up to three tax benefits for taxpayers investing in QOFs.
- Taxpayers can elect to defer the recognition of gain from any capital asset up to the amount invested in QOFs. The taxpayer’s basis in the QOF investment is set at zero, so the deferred gain is essentially recognized when either the investment is sold or at the mandatory recognition date of Dec. 31, 2026.
- Taxpayers who hold the QOF investment for five years receive a basis increase of 10% so that only 90% of the original deferred gain is recognized. If the investment is held for seven years, the basis is increased another 5%, so the taxpayer recognizes only 85% of the original deferred gain.
- If the investment is held 10 years, the taxpayer will recognize only the 85% of the deferred gain on Dec. 31, 2026, and receive a basis step-up upon disposition, so no other gain is recognized.
The proposed regulations provide that only gain from the sale or exchange of a capital asset to an unrelated party may be deferred by investing in a QOF. Ordinary gains are not eligible. The investment must be an equity interest in the QOF and cannot be a debt interest, though taxpayers can borrow against their equity interest. The investment must be made within 180 days after the sale or exchange that created the gain. If the gain is triggered by a deemed sale or exchange, then the 180-day period begins on the date the gain would be recognized for federal income tax purposes. The proposed regulations provide that gain from Section 1256 contracts must be aggregated and netted so the 180-day period begins on the last day of taxable year. Gain on a Section 1256 contract may not be deferred if the contract is subject to an offsetting position such as a straddle.
Grant Thornton Insight: It should be noted that the investment in a QOF must be made after the gain is recognized. The 180-day period does not include the 180 days before the sale. It begins on the date of the sale or exchange (or deemed recognition event). In addition, any amounts invested in the entity before the month designated as when the treatment as a QOF begins are not qualifying investments.
The deferred gain retains its character when eventually recognized. For example, deferred short-term capital gain is still recognized as short-term gain when the interest in the QOF is eventually sold or the gain is recognized on Dec. 31, 2026. If a taxpayer only partially disposes of QOF interests that were purchased in conjunction with different gain deferral transactions, the taxpayer is considered to dispose of its QOF investments on a first-in, first-out basis. If different types of gain were deferred in a single indistinguishable QOF investment, taxpayers determine the type of gain recognized on a pro rata
The regulations provide that pass-through entities such as partnerships, S corporations, estates and trusts can invest in a QOF and make an entity-level election to defer gain recognized at the entity level. If an entity does not elect to defer gain, the owner can make a qualifying investment and an election after the gain is recognized as the owner level. These owners can choose to begin their 180-period on either the last day of the entity’s year (when the owner would be required to recognize the gain) or when the entity itself would begin the 180-day period (the date the entity actually makes the sale or exchange). The IRS announced that the deferral elections will be made on a Form 8949, but a draft version has not yet been released.
Grant Thornton Insight: The unique nature of the Dec. 31, 2026, mandatory gain recognition date requires taxpayers to make investments in a QOF by Dec. 31, 2019, in order to receive the 5% basis increase for holding the asset for seven years before the deferred gain is recognized.
The IRS acknowledged that the statute providing for the designation of opportunity zones is scheduled to expire at the end of 2026 before any taxpayers could possibly hold an investment in a QOF for the 10 years needed for the full basis step-up. In order to fulfill the intent of the provision and to avoid forcing taxpayers to sell an investment solely for tax reasons at an economic detriment, the proposed regulations permit taxpayers to elect the full basis step-up on sales made by Dec. 31, 2047, which is 20.5 years after the last date a taxpayer could make an investment in a QOF.
Grant Thornton Insight: The proposed regulations preclude a taxpayer from making the election to exclude gain for assets held at least 10 years unless the original election was made to defer gain when the investment in the QOF was made. So taxpayers without gain to defer will essentially receive no tax benefit from investing in a QOF.
A QOF is generally defined under Section 1400Z-2 as a partnership or corporation that holds at least 90% of its assets in qualified opportunity zone property. The proposed regulations provide that this definition includes any entity treated as a partnership or a corporation for federal tax purposes, meaning an S corporation would qualify, as would a limited liability company treated as partnership. A QOF self-certifies by filing new Form 8996 with its annual income tax return. The form allows the QOF to identify both the taxable year and the month in which the entity becomes a QOF and is subject to the requirements.
Grant Thornton Insight: The IRS made clear that a pre-existing entity can become a QOF. However, any investments made in the entity before the time it designates as its conversion into a QOF are not qualifying investments. The investments must be made after the entity is designated a QOF. The QOF must be prepared to comply with the 90% asset test over the first six months it becomes a QOF. The preamble also acknowledges that qualified opportunity zone stock and partnership interests can also come from pre-existing entities. However, the rules (discussed in more detail in the next section) will generally require substantial new investment. The qualified opportunity zone stock or partnership interest cannot be purchased from another owner. It must be original issue. Plus, substantially all of the business’s assets have to be acquired after Dec. 31, 2017.
The proposed regulations require taxpayers with applicable financial statements under Treas. Reg. Sec. 1.475(a)-4(h) to use the financial statement asset values for the 90% asset test. Taxpayers without an applicable financial statement must use the cost of the assets for the valuation test.
The proposed regulations also provide a safe harbor under which working capital held in cash, cash equivalents, and debt with a term of 18 months or less can be considered a qualified asset for up to 31 months. To qualify for the safe harbor, the QOF must have a written plan that earmarks the financial property for the acquisition, construction or substantial improvement of tangible property in the opportunity zone, and the QOF must comply with a written schedule that is consistent with the ordinary business operations of the business. The statute also instructs the IRS to allow QOFs a reasonable period to reinvest the proceeds from selling qualified investments. The IRS said this issue would be addressed in the next round of “soon-to-be-released” proposed regulations.
Qualifying opportunity zone property
Qualifying assets of a QOF include qualified opportunity zone business property, qualified opportunity zone stock or a qualified opportunity zone partnership interest. Qualified opportunity zone stock and qualified opportunity zone partnership interests are original interests in partnerships or corporations issued after Dec. 31, 2017, solely in exchange for cash that are qualified opportunity zone businesses for “substantially all” of the time the QOF holds the interest. A qualified opportunity zone business is a trade or business in an opportunity zone in which:
- “Substantially all” of the tangible property owned or leased by the business is qualified opportunity zone business property
- At least 50% of gross income is derived from the active conduct of the business in the opportunity zone
- A “substantial portion” of the intangible property is used in the active conduct of the business
- Less than 5% of the average of the aggregate unadjusted bases of the property of such entity is attributable to nonqualified financial property
- The business is not a golf course, country club, massage parlor, hot tub facility, suntan facility, racetrack casino or liquor store
Qualified opportunity zone property must fulfill three requirements:
- The property must be acquired by the QOF or qualified opportunity zone business after Dec. 31, 2017.
- The original use of the property in the opportunity zone must commence with the QOF or qualified opportunity zone business.
- Substantially all of the use of the property must be in the opportunity zone during substantially all of the QOF’s or opportunity zone business’s holding period.
The proposed regulations provide that the threshold for “substantially all” of a qualified opportunity zone business’s tangible property to be qualified opportunity zone business property is 70%. The IRS declined to provide any similar guidance on the requirement that qualified opportunity zone stock and partnership interests be qualified opportunity zone businesses for “substantially all” of the QOF’s holding period, or for the requirements that “substantially all” of the use of opportunity zone business property be in the opportunity zone for “substantially all” of the QOF’s holding period. These definitions of substantially all will be addressed in future guidance.
Grant Thornton Insight: The IRS acknowledged in its analysis of the impact of the regulations that the 70% threshold provides a lower hurdle for property held through an opportunity zone business than for property held directly by a QOF. If a QOF simply holds property directly, 90% must be qualified opportunity zone business property. If a QOF instead holds qualified opportunity zone stock or partnership interest that in turn holds qualified opportunity zone business property, then those lower-tier entities only need to hold 70% of their assets in qualified opportunity zone business property. A QOF could effectively invest as little as 63% of its assets in qualified opportunity zone business property if 90% of its assets are qualified partnership or stock interests and only 70% of the assets of those entities is qualified property. In addition, depending on how the IRS defines the other definitions of “substantially all,” this property could be used outside the opportunity zone for some periods.
Substantial improvement is defined as doubling the basis of property over a 30-month period. The IRS’s revenue ruling provides that land does not need to meet the “original use” or “substantial improvement” tests to qualify as opportunity zone business property. In addition, the basis of any land is not included in the basis of a building for the substantial improvement test. The IRS declined to offer guidance on “original use,” instead asking for comments on issues such as whether original use in an opportunity zone should depend solely on physical presence, and if original use can include pre-existing property in an opportunity zone that has been abandoned.
Grant Thornton Insight: The IRS’s discussion in the preamble and request for comments seem to indicate a willingness to provide flexibility under the original use requirement for property that is underutilized, vacant, or abandoned. However, it will be difficult for taxpayers to know how permissive these rules will be until further proposed regulations are actually issued.
Next steps The regulations are not proposed to be effective until finalized, but the IRS provided that taxpayers can
rely on many of the rules if applied in their entirety and in a consistent manner. The guidance provides helpful clarity in many areas and should allow some taxpayers to begin structuring their funds and investments. However, the IRS has not yet provided any guidance on many of the most pressing questions, and it asked for comments on a significant number of areas both covered by the proposed regulations and reserved for future guidance. Opportunity zones offer powerful tax incentives, but the rules are complex and evolving, so investments should be considered carefully to ensure qualification.
For more information, contact:
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Grant Thornton LLP
+1 202 861 4144
Washington National Tax Office
Grant Thornton LLP
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