The IRS has completed its guidance on implementation of the Opportunity Zones tax incentive. Opportunity Zones offer capital gains tax relief for investments in almost 9,000 economically distressed areas certified by the Treasury Department.
The final rules provide clarity in determining how new investments in Opportunity Zones can qualify for tax benefits. They also provide guidance on the types of gains that qualify for Opportunity Zone investments, as well as gains that may be excluded from tax after a 10-year holding period.
Opportunity Zone Tax Benefits Explained
The Opportunity Zone tax law allows three possible tax benefits:
- Investors can defer capital gains from the sale of an asset by rolling gains over into a Qualified Opportunity Fund within 180 days.
- Investors get a step-up in basis on the deferred gain of either 10% for staying in the fund 5 years or 15% for continuing their investment for 7 years.
- Investors can get a permanent exclusion from gain on the appreciation of their interest in an Opportunity Fund if they hold the investment for 10 years.
The final rules cover many aspects of Opportunity Zone investment. Here are some of the more important changes.
What types of gains may be invested and when?
- General rule — The final regulations amend the proposed rule that only capital gain may be invested in a Qualified Opportunity Fund (QOF) during the 180-day investment period by clarifying that only eligible gain taxable in the U.S. may be invested in a QOF.
- Sales of Sec. 1231 business property —The final rules allow a taxpayer to invest the entire amount of gains from sales of business property, without first netting those gains with losses.
Example: If an investor has $100,000 of Sec. 1231 gain from the sale of business property on March 1 and $40,000 of Sec. 1231 loss on April 1, the entire $100,000 can be invested in a QOF.
The rules also change the beginning of the 180-day investment period from the last day of the investor’s tax year to the date of the sale of each asset. This is a taxpayer-friendly change that eliminates an unnecessary delay in investing.
- Investment Period, Partnership gain — Partners in a partnership, shareholders of an S corporation, and beneficiaries of estates and non-grantor trusts have the option to start the 180-day investment period on the due date of the entity’s tax return, not including any extensions. This change addresses taxpayer concerns about potentially missing investment opportunities due to an owner of a business entity receiving a late Schedule K-1 from the entity.
- Investment of Regulated Investment Company and Real Estate Investment Trust gains — The rules clarify that the 180-day investment period starts at the close of the shareholder’s tax year and provides that gains can, at the shareholder’s option, also be invested based on the 180-day investment period starting when the shareholder receives capital gains dividends from a RIC or REIT.
- Installment sales — The rules clarify that gains from installment sales can be invested when received, even if the initial installment payment was made before 2018.
- Nonresident investment — Nonresident alien individuals and foreign corporations may make Opportunity Zone investments with capital gains that are effectively connected to a U.S. trade or business. This includes capital gains on real estate assets taxed to nonresident alien individuals and foreign corporations under the Foreign Investment in Real Property Tax Act rules.
When may gains be excluded from tax after an investment is held for 10-years?
- Sales of property by a Qualified Opportunity Zone Business (QOZB) — In the proposed regs, an investor could only elect to exclude gains from the sale of qualifying investments or property sold by a QOF operating in partnership or S Corporation form, but not property sold by a subsidiary entity. The final regs provide that capital gains from the sale of property by a QOZB that is held by a subsidiary also may be excluded as long as the investment in the QOF has been held for 10 years. However, the amount of gain from asset sales that an investor in the QOF may elect to exclude each year will reduce the amount of the investor’s interest in the QOF that remains a qualifying investment.
- Applicability to other gains — The final rules clarify that the exclusion is available to other gains, such as distributions by a corporation to shareholders or a partnership to a partner, that are treated as gains from the sale or exchange of property (other than inventory) for Federal income tax purposes.
The 544 pages of regulations cover numerous other topics including the following:
- How large C Corporations can invest in opportunity zones.
- Expansion of the working capital safe harbor.
- Aggregation of property for the substantial improvement test.
- Vacancy period to allow a building to qualify as original use.
- 70% use test for tangible property.
- Leased property.
- Location and use of intangible property.
From a tax professional’s perspective, the final regulations are remarkably detailed and answer many remaining questions for investors in opportunity zones. Overall, the IRS made many pro-taxpayer calls in formulating these rules. In short, the tax benefits of investing in Opportunity Zones can be significant if the many rules and deadlines are followed carefully.