The IRS recently issued additional guidance on Opportunity Zone (OZ) investments that clarifies many open items for investors. Given the location of many OZs throughout the U.S., OZs present opportunities for transportation and logistics companies looking to expand their footprint. Many of the outstanding questions tempering investment in OZs were answered favorably. The new regulations can be found on the IRS website. With this new guidance, investors that were on the sidelines are now moving forward with OZ investments.
Type of Gain
The IRS regulations indicate that only capital gain is eligible for deferral using an Opportunity Zone Fund (OZF). 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.
Capital gains from the sale of stocks or bonds are clearly eligible. Previously there was some uncertainty around the sale of certain business property. This type of gain is ordinary if it’s a loss but capital if there’s an overall gain. The new rules state that sales of Section 1231 assets also qualify for investment in OZFs if the net of all §1231 asset sales for the year results in an overall gain. Examples of §1231 gains include sale of rental property and land or other buildings used in a trade or business. The OZ rules require taxpayers to reinvest capital gains to enjoy the OZ benefits.
The IRS also broadly interpreted the taxpayer definition for electing to defer capital gains and investing in an OZF. The IRS stated that pass-through entities, including partnerships, S corporations, decedents’ estates and trusts, are eligible to invest in OZFs if they have an eligible capital gain. Not only are pass-through entities eligible to own an OZF, but the owners or beneficiaries also are eligible to own an interest in an OZF directly and defer the capital gain distributed by the pass-through entity. Let’s use a partnership as an example. The partnership can elect to defer capital gain by making an investment in a qualified OZF. If the partnership chooses to not defer the gain, each partner has the option to reinvest the gain into a qualified OZF.
A key component to the OZ legislation is the ability for taxpayers to defer their gain by investing in a qualified OZF. The gain must be reinvested in an OZF within 180 days from the 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’s 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 new rules also provide clarity regarding when the OZF sells an investment or business. The regulations state that an OZF has one year from the date of sale to reinvest the proceeds in another OZ business or additional OZ property. The proceeds must be continuously held by the OZF in cash, cash equivalents or debt instruments with a term of 18 months or less. It’s important to note the holding period restarts for the 10-year holding requirement to receive tax-free appreciation. If there are multiple investments with different holding periods, the restarted holding periods can lead to some administrative headaches for the OZF.
Investors also received clarification on the 50 percent of gross receipts test for an OZF by providing safe harbors. For example, the test is met if 50 percent of the employee time worked is within an OZ or 50 percent of the employee compensation is within an OZ.
Substantial Improvement Requirement & Land
One surprise in the regulations was the definition of substantial improvement. If an OZF or business were to buy existing property within an OZ, the 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 OZF 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, 2018, 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 regulations provide favorable guidance by determining that the expiration of zone designations won’t affect 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’s 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 OZF. In addition, an electing entity can be a pre-existing entity, provided it otherwise meets the requirements of an OZF. 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 OZF is certified, so existing tangible property in existing entities won’t qualify for the 90 percent asset test.
There were concerns about the ability of an OZF 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 OZF. The regulations provide a safe harbor for working capital favorable to OZFs 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 OZF 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 OZF must comply. These documents must be maintained by the OZF to support the allocation of assets to the working capital safe harbor.
Overall, the new OZ regulations provide welcome clarifications for investors and developers. Additional investments are already moving forward as a result of these new rules. For more information about OZs, view our OZ fact sheet or listen to our archived “Simply Tax” podcast episode. If you have further questions, reach out to your BKD trusted advisor or use the Contact Us form below.