The Treasury Department recently issued proposed regulations pertaining to the Opportunity Zones program, created by the Tax Cuts and Jobs Act (TCJA or the Act). The regulations describe and clarify the procedures and requirements taxpayers must fulfill in order to defer or exclude from income gains reinvested in designated low-income communities. While the regulations are generally effective when published as final, investors and other affected parties may rely on them currently as long as they are applied consistently and in their entirety. Unfortunately, the regulations do not address all of the questions and concerns taxpayers have regarding Opportunity Zones (OZ). Consequently, additional regulations are expected by the end of the year.
- Only capital gains are eligible for deferral,
- The expiration of a Qualified Opportunity Zone (QOZ) designation does not preclude a taxpayer from excluding the gain on the appreciation of Qualified Opportunity Fund (QOF) investment,
- A business qualifies as a QOZ business if 70 percent of its tangible property is QOZ business property,
- A safe harbor is provided to afford a QOF business to hold the working capital required to acquire, construct or improve QOZ property without incurring penalties,
- Leveraging a part or all of a QOF interest does not taint the taxpayer’s eligibility for gain deferral or exclusion.
The OZ provisions were implemented via the TCJA to spur economic growth and investment in low-income communities through tax benefits. Under a nomination process completed earlier this year, delineated areas in nearly 9,000 communities across all 50 states, the District of Columbia and five U.S. territories were selected as OZs. These designations remain in effect for 10 years. (You may find all of the identified QOZ with our interactive mapping tool.)
The OZ provisions contain three important tax breaks:
- Temporary deferral of taxable gains reinvested in an QOF,
- Permanent exclusion of up to 15 percent of the gain from taxable income if the taxpayer holds the investment in the QOF for at least five to seven years, and
- Post-acquisition appreciation with respect to the QOF investment held by the taxpayer for at least 10 years would be permanently excluded from federal taxation.
Any taxpayer that recognizes capital gains for federal income tax purposes is eligible to defer or exclude reinvested gains, including individuals, partnerships, corporations, trusts, estates real estate investment trusts and regulated investment companies.
Eligible capital gain includes gain arising from actual or deemed sales or exchanges, so long as they are not between related parties.
Qualified Opportunity Fund
A QOF is defined as any investment vehicle organized as a corporation or partnership for the purpose of investing in QOZ property (other than another QOF) and holds at least 90 percent of its assets in QOZ property (discussed further below). A QOF self-certifies by annually attaching a form to its tax return. No IRS approval is needed.
The taxpayer must reinvest the gain in a QOF in exchange for an equity interest (to include preferred stock or a partnership interest entitled to special allocations) within 180 days of the triggering sale or exchange, and make an election on its tax return for the period that includes the gain event. There is no tracing requirement; in other words, reinvestment does not need to be made via the same proceeds received in the transaction triggering the gain.
As a QOF interest must be an equity interest, debt instruments do not qualify. However, the regulations clarify that the eligibility of an equity interest is not jeopardized by using it as collateral for a loan, whether purchase-money borrowing or otherwise.
A taxpayer that is a pass-through entity (including partnerships, S corporations, decedents’ estates and trusts) and makes the election to defer gain will not pass any of the gain through to its owners or beneficiaries. If the pass-through taxpayer declines to make the election, and any or all of the owners’ or beneficiaries’ share of the gain is eligible for deferral (including not arising from a sale or exchange with a related party), the owner or beneficiary generally may elect its own deferral period with respect to their share of the gain. The owner or beneficiary generally would have 180 days from the last day of the pass-through entity’s taxable year to reinvest the gain in a QOF. Alternatively, they can elect to have 180 days from the date the sale or exchange occurred at the pass-through entity level. To illustrate:
Five individuals own equal interests in partnership P, a calendar-year partnership. On Jan. 17, 2019, P realizes a capital gain of $1,000 that it does not elect to defer. Two of the partners decide to elect to have 180 days from Jan. 17, 2019, to reinvest their respective $200 shares of the capital gain in a QOF. Absent making such an election, the other three partners will have 180 days from Dec. 31, 2019, (the end of P’s taxable year) to reinvest.
Deferred gain must be included in income in the earlier of (a) the taxable year in which the QOF investment is sold or exchanged, or (b) the taxable year that includes Dec. 31, 2026. If the QOF investment is held for five years by the end of the deferral period on Dec. 31, 2026, 10 percent of the deferred capital gain can be permanently excluded from income; if held for seven years, 15 percent can be permanently excluded. Note that the seven-year holding period requires calendar-year taxpayers to invest by Dec. 31, 2019, to achieve a 15 percent exclusion.
In addition to a deferral and partial exclusion of pre-QOZ investment gain, a taxpayer that sells or exchanges a QOF investment held for at least 10 years can elect to step up its basis to fair market value; in essence, excluding from income any gains arising from the investment’s post-acquisition appreciation. This election is available to the taxpayer even if the abovementioned 10-year OZ designation period has expired, but must be made by Dec. 31, 2047. Lastly, this election is only available if the taxpayer previously made an election to defer the recognition of gain initially reinvested in the QOF. For example:
In 2020, a taxpayer sells stock at a $100 gain, invests $100 in a QOF in exchange for an equity interest, and properly makes an election to defer the $100 of gain on the stock sale. At the end of 2028, the OZ designation for the low-income community in which the QOF operates expires. In 2031, the taxpayer sells its investment in the QOF at a gain and elects to increase its basis in the QOF to fair market value. This election is valid as it was made before Dec. 31, 2047, and the taxpayer elected to defer the reinvested gain on the stock sale. The appreciation of the QOF is thus not taxable in the hands of the taxpayer. The expiration of the OZ designation is irrelevant.
Qualified Opportunity Zone property defined
There are three types of QOZ property: (1) qualified opportunity zone stock, (2) qualified opportunity zone partnership interests, and (3) qualified opportunity zone business property.
QOZ stock and partnership interests must relate to so-called “qualified opportunity zone businesses.” A QOZ business generally is an entity that derives at least 50 percent of its gross income from the active conduct of a trade or business, 70 percent of the property it owns or leases is QOZ business property, and less than 5 percent of the average of the aggregate unadjusted basis of its property is attributable to nonqualified financial property (broadly defined as any financial asset other than cash, cash equivalents and certain debt instruments).
Tangible property will qualify as QOZ business property if:
- It is acquired by the QOF via purchase (generally any acquisition of property other than that acquired from a related party, a decedent or via gift),
- Its original use in the QOZ commences with the QOF or the QOF “substantially improves” the property, and
- During “substantially all” of the period during with the QOF held the property, “substantially all” of the property’s use was in a QOZ.
It is important to note the fact that the regulations issued to date have not defined “substantially all” for the purpose of satisfying the requirements set forth by item 3.
In order to meet the “substantially improves” requirement, a QOF must add to the property’s basis in an amount exceeding the purchase price within a 30-month period. With respect to real property, the QOF is not required to make improvements to acquired land to satisfy this rule.
Failure to meet the abovementioned 90 percent asset requirement (as determined on an annual basis) will result in a penalty assessment, although a safe harbor was made available by the regulations for a QOZ business to hold “working capital.”
This was a matter of particular interest among the real estate industry since acquiring, constructing or improving properties to meet these requirements generally requires cash or cash equivalents on hand to fund the project. As these assets are not considered QOZ property, there was a concern that working capital would trigger the penalty for failing the 90 percent asset test. Given the penalty is determined by multiplying the QOF’s total assets by the short-term federal rate for the given month plus three percentage points, the assessment on a real estate project would undoubtedly be substantial.
The 30- and 31-month requirements are illustrated as follows:
In 2019, an individual recognized $1 million of capital gains and invested the entire $1 million in QOF T. T immediately acquired from partnership P a partnership interest in exchange for $1 million in cash. P immediately placed the $1 million in working capital assets, where it remained until used. P had written plans to acquire land and a commercial building in a QOZ, and substantially improve the latter. Of the $1 million, $400,000 was dedicated to land purchase, $200,000 to the building purchase, $200,001 for building improvements and $199,999 for ancillary but necessary project expenditures. The written plans provided the land and building would be purchased within a month of the receipt of cash from T, and the remaining $400,000 would be spent on the building improvements and ancillary expenditures within 30 months. All phases of the plan were executed on schedule. As the cash, which otherwise would not qualify as QOZ business property, was spent within 31 months and since improvements were made to the acquired building equal to the allocated purchase price, the 90 percent asset test is not failed.
Concerns remain in the real estate industry that the 30-month safe harbor is not sufficient due to inherent delays in construction including weather and permitting processes.
It is critical to note that this safe harbor only applies to a QOF that holds equity interests in QOZ businesses and not to QOFs that own QOZ business property directly. It should be anticipated that as a result, QOFs will generally not make any direct property acquisitions.
As noted, additional guidance on the OZ provisions is forthcoming. Issues that remain unclear include:
- Definition of “substantially all” as it applies to whether investments qualify as QOZ property
- Tax consequences to an investor if a QOF disposes of its underlying investments before the investor disposes of its fund interest
- Impact to a partner’s basis if a partnership passes through gains to the partners and whether the gain increases the partner’s basis in the partnership if the partner makes an election to defer the gain
- Adaptation of the QOF rules for state income tax purposes
- Computation of depreciation and other QOF level deductions if QOFs have tax basis in the property they acquire with the deferred gains, since the contributing investor will have a zero basis in their initial investment
The OZ provisions offer taxpayers opportunity both for tax deferral and permanent exclusion of a portion of the deferred gain as well as appreciation related to the OZ investment. However, as with any investment decision, caution should be exercised and related risk of investing in such OZs should be carefully considered.
Analysis of new regulations will be provided as guidance is issued. Meanwhile, please reach out to your Baker Tilly advisor with questions on how you may benefit from the OZ program.
For related insights and in-depth analysis, see our Tax Reform Resource Center.
The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely. The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.