It appears the IRS has a clear mandate from Congress to write flexible, taxpayer-friendly regulations on the new provisions of the 2017 tax reform law, as evidenced by the new Opportunity Zone regulations.
The proposed rules expand tax planning opportunities rather than restrict access to tax benefits, as regulations sometimes do. The IRS’s generous reading of the law extends the timetable for reaping benefits from the program, allows almost any gains to qualify for deferral and permits lower investment thresholds for claiming tax benefits.
The IRS also made clear that investors can hold onto their investments in Qualified Opportunity Funds through 2047 without losing tax benefits, even though the program technically sunsets after 2026.
Tax Benefits: The Opportunity Zone law allows three possible tax benefits, as detailed in an earlier Insight article:
- Investors can defer capital gains from the sale of any asset by rolling gains over into a Qualified Opportunity Fund (QOF).
- Investors get a step-up in basis on the deferred gain of either 10% or 15% depending on how long they continue their investment in the Fund.
- Investors can get a permanent exclusion from gain on the appreciation of their interest in the Fund if they hold the investment for 10 years.
How Qualified Opportunity Funds Work
Taxpayers can either invest directly in a Qualified Opportunity Fund (QOF) or reinvest capital gains from other investments in a Fund.
To be able to defer gain, a taxpayer must invest in a QOF within 180 days after the sale or exchange giving rise to the gain. A QOF must be an entity treated as a partnership or corporation for Federal tax purposes and must be U.S.-based (including U.S. territories).
Funds are required to hold at least 90% of their assets in qualified property. Qualified opportunity zone property includes:
- Any qualified opportunity zone stock;
- Any qualified opportunity zone partnership interest; and
- Any qualified opportunity zone business property, which is tangible property used in a trade or business.
Passthrough Gains Qualify
A welcome clarification under the new regulations is that almost all capital gains qualify for deferral. For gains of a partnership, the rules allow either a partnership or its partners to elect deferral. Similar rules apply to other passthrough entities, such as S-corporations and their shareholders, and estates and trusts and their beneficiaries.
The proposed rules also clarify that an investment in the QOF must be an equity interest, including preferred stock or a partnership interest with special allocations, but cannot be a debt instrument.
The proposed regulations include a working capital safe harbor for QOF investments, which allows a business operating in an Opportunity Zone to consider funds held in the business as qualified business property for up to 31 months.
There must be a written plan that identifies the financial property as property held for the acquisition, construction, or substantial improvement of tangible property in the Opportunity Zone. In addition, the business must have a written schedule for how the funds will be used during the 31-month period.
Trade or Business Property
For trade or businesses operating in Opportunity Zones, the law requires that “substantially all” property of the business must be qualified property, interpreted to mean at least 70% of the tangible business property owned or leased by a trade or business should be qualified property.
If the tangible property is a building, the proposed regulations say that “substantial improvement” is measured only with regard to the basis of the building, not the basis of the underlying land.
The Opportunity Zone law requires investors to spend at least as much to improve the property as they paid for it. The proposed regulation only applies this requirement to buildings and not to underlying land value, which expands opportunities for real estate investors.
Rev. Rul. 2018-29 explains how the new law applies these rules to the investment in land. The new law states that the “original use” of the property must begin with the qualified opportunity fund or the qualified opportunity fund must substantially improve the property.
In the Revenue Ruling, the IRS recognizes that an original use requirement is difficult to apply to land that has had many uses over the years. Thus, the IRS concludes that a taxpayer is not required to separately improve land for it to qualify. Instead, substantial improvement to a building on the land is required.
This is measured by the Fund’s additions to the adjusted basis of the building during the 30-month period beginning after the date of acquisition of the building. Those additions must exceed the adjusted basis of the building at the beginning of the 30-month period.
For example, if the building’s basis was $320,000 at the beginning and $400,000 worth of additions to basis were made, the building improvement would be considered substantial and would qualify.
Self-Certifying, How to Elect Deferral
An eligible partnership or corporation can self-certify as a qualified opportunity fund on Form 8996 and attach this form to its tax return. In this way, a Fund does not have to wait for the IRS to prequalify it. The proposed rules also clarify that there is no prohibition to using a pre-existing entity as a Qualified Opportunity Fund as long as the entity meets all of the requirements of the Opportunity Zone law.
Taxpayers make deferral elections on Form 8949, the regular capital gains reporting form. This form should be attached to their Federal income tax returns for the tax year in which the gain would have been recognized if it had not been invested in an Opportunity Zone.
List of Qualified Zones, Projections
Click here for complete list of Opportunity Zones.
What level of investment is contemplated for Opportunity Zones? The Treasury Secretary weighed in when the regulations were released.
“We anticipate that $100 billion in private capital will be dedicated to creating jobs and economic development in Opportunity Zones,” predicted Secretary Steven T. Mnuchin.