The IRS issued additional guidance on Opportunity Zone (OZ) investments that clarifies many open items for investors and developers. 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.
Previously, advisors were concerned with an Opportunity Zone Fund (OZF) owning more than one investment. The new rules indicate that investors can own multiple investments through an OZF and still receive tax-free appreciation after holding the OZF for 10 years. This is a welcome clarification, as it simplifies OZF structuring and reduces uncertainty for investors. The new rules also clarify that the holding period for an OZF starts when the first investment is made.
The OZ rules require taxpayers to reinvest capital gains to enjoy the OZ benefits. Capital gains from the sale of stocks or bonds were clearly eligible, but there was some uncertainty around the sale of certain business property. 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 a hotel, multifamily rental property and land or other buildings used in a trade or business.
The OZF must invest in qualified OZ business through a partnership or corporation, or the OZF can operate a trade or business with qualified OZ property. Substantially all of the property must be held and used within an OZ to qualify as OZ property. The new regulation provides that “substantially all” means the property must be held by the OZF within an OZ at least 90 percent of the time. The new rules also state that qualified OZ property must be used by the OZF within an OZ at least 70 percent of the time. The IRS believes taxpayers can control how and when property is held by the OZF. The use standard needs to have more flexibility because of equipment downtime for events such as maintenance and seasonal business trends. The IRS also clarified that leased property qualifies but is subject to these same rules that apply to property owned by the OZF.
The new rules 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 receive 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.
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.
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