Qualified Opportunity Zones
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In October 2018, the Internal Revenue Service and the U.S. Department of Treasury issued IRS Revenue Ruling 2018-29 and the first set of proposed regulations for Opportunity Zones that created an attractive set of tax incentives intended to encourage investments in economically-distressed communities.
Background of Opportunity Zones
In December 2017, Congress enacted an extremely attractive tax incentive program to promote long-term investments in economically distressed communities designated as opportunity zones (“Opportunity Zones”). Designated Opportunity Zones exist in every state and represent over 10% of the land mass in the United States, including all of Puerto Rico. There are roughly 8,700 low-income communities designated Opportunity Zones.
A taxpayer can realize the tax benefits of the Opportunity Zone program by investing the amount of any eligible capital gain in a “qualified opportunity fund” (“QOF”) during the 180-day period that begins on the date the taxpayer would have been required to recognize the capital gain. The QOF then invests capital directly or indirectly in property or a business located in an Opportunity Zone.
IRS Code Section 1400Z-2 of the Internal Revenue Code (“Code”) provides the following three major tax incentives for investing in a QOF:
- Initial Gain Deferral. Taxpayers may elect to defer the recognition of capital gain to the extent such gain amount is invested in a QOF within the 180-day period that begins on the date the taxpayer would have been required to recognize the capital gain. The gain is deferred until the earlier of: (i) when the taxpayer sells or exchanges the QOF interest or (ii) December 31, 2026. The IRS currently anticipates that the deferral election will be made on Form 8949, which will be attached to the taxpayer’s federal income tax return for the taxable year in which the gain would otherwise have been recognized. Further guidance with respect to this election and the relevant Form Instructions are expected to be released shortly.
- Partial Reduction in Deferred Gain. For an investment in a QOF held at least five years, the taxpayer may permanently exclude 10% of the deferred gain from the taxpayer’s income. For an investment in a QOF held at least seven years, the taxpayer may permanently exclude an additional 5% of the deferred gain from the taxpayer’s income. In order to realize the full 15% tax savings, a taxpayer must invest in a QOF no later than December 31, 2019.
- Exclusion of QOF Gain. If a taxpayer holds an investment in a QOF for at least 10 years, the taxpayer may generally elect to exclude from income any post-acquisition gain realized from its investment in the QOF. This effectively means that after 10 years of ownership in the QOF, any appreciation the taxpayer recognizes in the QOF is tax-free
If a calendar-year taxpayer realizes a $200,000 capital gain from the sale of property to an unrelated person on August 1, 2018, and invests that gain in a QOF on December 1, 2018, the taxpayer will not pay any tax on the $200,000 gain realized in 2018. If the taxpayer holds its investment in the QOF until December 31, 2026, 15% of the $200,000 deferred gain will be permanently excluded from the taxpayer’s income because the taxpayer will have held its investment in the QOF for more than seven years, and the remaining $170,000 of deferred gain will be included in the taxpayer’s income for the 2026 calendar year.
If the taxpayer sells its interest in the QOF on April 1, 2023 (less than five years from the date of investment in the QOF), then the taxpayer will pay tax on the entire $200,000 of deferred capital gain in 2023. Alternatively, if the taxpayer sells or exchanges its interest in the QOF on April 1, 2024 (more than five years, but less than seven years from the date of the investment in the QOF), the taxpayer will pay tax on $180,000 of the deferred capital gain in 2024.
Revenue Ruling and Proposed Regulations
The Revenue Ruling and Proposed Regulations answer many questions and provide clarity regarding the provisions in IRS Code Section 1400Z-2 and the requirements for a QOF.
Highlights from the recent guidance include the following:
Eligible Capital Gains. The Proposed Regulations provided clarity that that only capital gains are eligible for deferral. Eligible capital gains may be short-term or long-term capital gains, and include amounts treated as capital gains (such as mutual fund capital gain dividends, IRS Code Section 1231 gains, and unrecaptured IRS Code Section 1250 gains). Capital gains that are not eligible for deferral include IRS Code Sections 1245 and 1250 depreciation recapture (taxed as ordinary income) and capital gains from a sale with a related party.
Eligible Taxpayers. The Proposed Regulations make clear that eligible taxpayers include individuals, C corporations (including regulated investment companies and real estate investment trusts), partnerships, subchapter S corporations, trusts and estates. Additionally, under the Proposed Regulations, only equity (including preferred stock and partnership interests with special allocations) in a QOF entitles the taxpayer to the Opportunity Zone tax benefits described above. A taxpayer that invests in a debt instrument issued by a QOF will not qualify for the deferral.
Special Rule for Pass-Through Entities. A pass-through entity, such as a partnership, Subchapter S corporation, trust or estate, may elect to defer all or part of the capital gain at the entity level if it makes an eligible investment in a QOF within the 180-day period. Under the Proposed Regulations, if a pass through entity does not make the entity level election to defer all or some of the capital gain, then each pass-through owner can decide to make its own election to defer the pass-through owner’s distributive share of the eligible capital gain. The pass-through owner’s 180-day period with respect to its share of the entity level capital gain generally begins on the last day of the pass-through entity’s taxable year when the pass-through entity realized the capital gain.
QOF Requirements. A QOF must be an entity classified as a corporation or partnership for federal tax purposes and organized for the purpose of investing in “qualified opportunity zone property”, other than another QOF. The Proposed Regulations allow the QOF to self-certify as a “qualified opportunity fund” on IRS Form 8996.
90% Test for QOF. At least 90% of the assets of a QOF must consist of “qualified opportunity zone property” (“Qualified Zone Property”), which includes: (i) “qualified opportunity zone stock”; (ii) “qualified opportunity zone partnership interests”; or (iii) “qualified opportunity zone business property”.
Qualified Zone Business. A qualified zone business is a trade or business (i) in which “substantially all” of the tangible property owned or leased by the qualified zone business is qualified opportunity zone business property; (ii) which satisfies certain tests as described below; and (iii) which is not engaged in a prohibited business. The Proposed Regulations clarify that “substantially all” means 70%.
Substantial Improvements to Existing Properties. The “original use” of the property in the Opportunity Zone begins with either the QOF or the applicable qualified opportunity zone stock or qualified opportunity zone partnership interests qualify. If the original use of the property does not commence with the QOF or the applicable qualified opportunity zone stock or qualified opportunity zone partnership interests qualify (such as an existing office building), then the QOF or applicable qualified opportunity zone stock or qualified opportunity zone partnership interests qualify, as the case may be, must substantially improve the property. An existing property will be treated as substantially improved only if, during any 30-month period beginning after the acquisition date of such property, the QOF or the applicable qualified opportunity zone stock or qualified opportunity zone partnership interests qualify at least doubles the basis of the property relative to the QOF’s adjusted basis of the property at the beginning of the 30-month period.
Revenue Ruling 2018-29 provides that the “original use” and “substantial improvement” requirements under the Code do not apply to the underly land. In addition, whether a substantial improvement is made to the building is measured by the additions to the basis of the building (i.e., the basis attributable to the land on which the building sits is not taken into account). Thus, if a QOF purchases a property wholly within an Opportunity Zone for $500,000, consisting of land worth $100,000 and a building worth $400,000, and the QOF invests at least $400,000 to improve the building, then the original $500,000 purchase price plus the $400,000 of improvements to the building may all qualify as Zone Business Property.
In summary, here are the major benefits of investing in a QOF:
- Gain deferral – All capital gains invested in the QOF may be deferred in the year the temporary deferral election is made.
- Permanent tax exclusion of 10% taxable gain for investments held five years – Investments held in the QOF for at least five years will receive a basis increase equal to 10%.
- Permanent tax exclusion of 15% taxable gain for investments held seven years – Investment held in the QOF for at least seven years will receive an additional basis increase of 5%, for a total increase of 15%.
- Permanent tax exclusion of 100% of taxable gain – A permanent exclusion from taxable income of capital gains from the sale or exchange of an investment in a qualified opportunity zone fund, if the investment is held for at least 10 years. This exclusion applies to the capital gains accrued from an investment in a QOF, and not the original gains invested into QOF.
On February 14, 2019, the IRS held its first public hearing to solicit questions about the Opportunity Zone program. While not answers came from this public hearing, the biggest questions centered around:
- Could an Opportunity Zone fund sell an asset after a period of time (less than the 10 year hold) and then reinvest the money into another Opportunity Zone project for the balance of the 10 year hold?
- Would the 10 year hold period still qualify for the Opportunity Zone program?
- How much capital can an Opportunity Zone fund take out of a project when refinancing an Opportunity Zone project?
- How will the refinancing proceeds be distributed to investors?
Stay tuned on these questions and more as the IRS is expected to release its second round of rules within the next two months.
About the Author
Jason Powell is a seasoned attorney, real estate investor, author, speaker and educator. Jason is a partner at the law firm of Cara Stone, LLP. Jason’s legal practice focuses on real estate and securities law. Jason counsels new, emerging and established managers throughout the United States on forming and operating real estate syndications, real estate funds, mortgage pools and performing and non-performing note pools. Jason also advises clients on all aspects of real estate including acquisition and disposition, property development, joint ventures, title review and comment, equity and debt financing, leases. Jason has prepared offering documents for $125M in opportunity zone funds. Jason is passionate about his role as a deal-maker – creating solutions to join together great people, projects and capital.
Disclaimer: This post discusses general legal issues, but it does not constitute legal advice in any respect. This post is not a substitute for legal