IRS guidance on Opportunity Zones (OZ) has finally arrived. The proposed regulations are a mix of surprises that address part of the outstanding questions on this new law. We’ll look at key parts of the new proposed regulations and rulings in this article, while additional guidance appears on the horizon before the end of 2018.
Type of Gain
The IRS ruled in the proposed regulations that only capital gain is eligible for deferral using OZs. The regulations state, “A gain is eligible for deferral if it is treated as a capital gain for Federal income tax purposes.” The gain must come from an actual, or deemed, sale or exchange with an unrelated person. The IRS emphasizes the gain must be realized and included in the computation of capital gain by the taxpayer. One key open point is the treatment of Section 1231 gains from the sale of property. This type of gain is ordinary if it’s a loss, but capital if there’s an overall gain. Additional guidance from the IRS will help clarify this outstanding point, as well as the effect of unrecaptured §1231 losses.
The IRS also broadly interpreted the taxpayer definition for electing to defer capital gains and investing in an OZ Fund. The IRS stated that pass-through entities, including partnerships, S corporations, decedents’ estates and trusts, are eligible to invest in OZ Funds if they have an eligible capital gain. Not only are the pass-through entities eligible to own an OZ Fund, but the owners or beneficiaries also are eligible to own an interest in an OZ Fund directly and defer the capital gain distributed by the pass-through. Let’s use a partnership as an example. The partnership can elect to defer capital gain by making an investment in a qualified OZ Fund. If the partnership chooses not to defer the gain, each partner has the option to reinvest the gain into a qualified OZ Fund.
A key component to the OZ legislation is the ability for taxpayers to defer their gain by investing in a qualified OZ Fund. The gain must be reinvested in an OZ Fund within 180 days from sale (or deemed sale) date. The IRS clarified that the 180-day period starts on the date the gain is recognized for federal income tax purposes. For partners who receive a gain from a pass-through entity, the partner or shareholder’s 180-day reinvestment period starts at the end of the pass-through entity’s taxable year. The IRS indicates this is the day the partner/shareholder recognizes the gain from the pass-through entity. The electing taxpayer also may choose to use the day the gain was recognized by the pass-through entity to start the 180-day period. This provides ultimate flexibility for flow-through entities and their owners alike.
The proposed regulations also address the timing for reinvestment when regulated investment companies (RIC) and real estate investment trusts (REIT) distribute capital gain dividends to shareholders. The 180-day period starts when the dividends are paid. For undistributed capital gains, the 180-day period begins at the end of the taxable year of the RIC or REIT.
Substantial Improvement Requirement & Land
One of the surprises in the proposed regulations was the definition of substantial improvement. If an OZ Fund or business were to buy existing property within an OZ, the OZ Fund would have to make “substantial improvements” to the property for it to qualify under the OZ rules as qualified OZ property. The OZ rules define substantial improvement as spending as much on improving the property as was paid to acquire it. Fortunately, the IRS ruled that the acquisition cost of land can be excluded from the overall acquisition cost in determining the amount the OZ Fund must spend to substantially improve the acquired OZ property. This is a big win for taxpayers.
Ten-Year Basis Adjustment
Another major concern was focused on the December 31, 2028, expiration of zone designations and the potential effect on investors’ ability to make the election for basis step-up after such expiration. Once again, the proposed regulations provide favorable guidance by determining that the expiration of zone designations won’t impact the time frame for making this basis adjustment election. The regulations provide that a taxpayer has until December 31, 2047, to make this election. This is 20 and a half years after the latest date an eligible taxpayer may make an investment that is part of a deferral, and it effectively provides an additional 10-year window beyond a 10-year holding period for those investments.
Fund Entity Requirements
An entity treated as a corporation or partnership for federal income tax purposes is eligible to self-certify as an OZ Fund. This means an LLC that’s taxed as a corporation or partnership can qualify. In addition, an electing entity can be a pre-existing entity, provided it otherwise meets the requirements of an OZ Fund. An electing entity can specify the beginning month and year of the election, and a failure to specify a beginning month will default the entity to be treated as qualified on the first month of the entity’s tax year. The 90 percent asset test must be met within six months after the initial period. For example, an entity qualifying as of April will be required to meet the 90 percent test at the end of September. If an existing entity is used, special attention should be given to the ability to qualify for this test. It’s also worth a reminder at this point that the qualifying investment must occur after the OZ Fund is certified, so existing tangible property in existing entities won’t qualify for the 90 percent asset test.
Ninety Percent & Seventy Percent Asset Test
One final benefit may be insignificant to many but could prove to be very significant to a limited set of taxpayers. For purposes of the 90 percent asset test, the OZ Fund may use the asset values that are reported for applicable financial statement purposes, if the OZ Fund issues such applicable financial statements. Applicable financial statements include those filed with a federal agency other than the IRS, such as the SEC, or audited financial statements. If such financial statements aren’t prepared, the OZ Fund is required to use the cost basis of its assets. The OZ Fund isn’t required to use the tax-adjusted basis of assets for this test.
An OZ Fund that invests in tangible assets must meet the 90 percent test. However, if the OZ Fund invests in an OZ business, the qualifying business only is required to meet the “substantially all” test, which requires that only 70 percent of its business assets be qualifying assets. For this purpose, the applicable financial statement rule also applies. This is a favorable position that may encourage OZ Fund investments into operating businesses and not just tangible assets.
There were concerns about the ability of an OZ Fund to invest contributed funds in a sufficient time to meet the first 90 percent asset test, which is six months from the beginning of the creation of the fund. The proposed regulations provide a safe harbor for working capital favorable to OZ Funds that will engage in substantial improvement or require a period longer than six months to make the investments or substantial improvements in qualifying assets. The safe harbor, using a definition of working capital from other existing code sections, provides that property can be held by the OZ Fund for a period up to 31 months to make the qualifying investments and improvements. The safe harbor provision requires that there’s a written plan identifying the financial property to be considered working capital and a written schedule of how and when the property will be used—to which the OZ Fund must comply. These documents must be maintained by the OZ Fund to support the allocation of assets to the working capital safe harbor.
While this first round of guidance answered a lot of questions and serves to provide favorable guidance for potential OZ Fund investors, additional guidance is expected this fall. This article is focused on the changes in the recently released proposed regulations.
Additional information about OZs can be found in our OZ fact sheet, and you also can listen to an archived “Simply Tax” podcast featuring Derek. If you have further questions, contact Derek, Michael or your trusted BKD advisor.