One of the positive developments resulting from the 2017 tax legislation has been offering taxpayers a limited-time opportunity to defer gain on the sale of assets, reduce the gain when finally recognized and even eliminate gain on certain new investments. This is all made possible under the 2017 Tax Act by investing in "Qualified Opportunity Zones," a new provision that allows taxpayers to free up capital gains and reinvest those gains in economically distressed census tracts.
While the legislation is now one year old, the ability to navigate the new rules has been hampered by a lack of regulatory guidance to provide definitional clarity. Fortunately, this fall, the fog began to lift a bit with the promulgation of the first set of proposed regulations addressing Qualified Opportunity Zones. Bear in mind that (a) these regulations have not been finalized, and (b) the proposed regulations were not comprehensive, such that we expect another round of additional proposed regulations early in 2019. Nonetheless, the ability to defer tax and invest pre-tax proceeds can provide a substantially enhanced rate of return for Qualified Opportunity Zone investments, and taxpayers should move forward in planning on how to take advantage of this new program.
For background information on opportunity zones, including definitions of commonly used terms, please read our previously published alert, "There's a Tax-Savings Opportunity in Qualified Opportunity Zones."
Benefits of Qualified Opportunity Funds
By way of background, a taxpayer can sell property anytime through the end of 2026 to an unrelated party at a gain, and this gain will not be currently taxable if the amount of the gain is reinvested in a Qualified Opportunity Fund within 180 days of the sale. The proposed regulations have clarified that only the amounts treated as capital gain, whether long-term or short-term, will be "eligible gain" qualifying for this reinvestment opportunity. A taxpayer is free to invest more than the "eligible gain" amount in a Qualified Opportunity Fund, but only the eligible gain amounts will qualify for the new special treatment; any excess investment will be treated as a separate investment under the normal tax rules.
The Proposed Regulations have provided a special rule for partnerships and their partners. A partnership may make the election to rollover its gain into a Qualified Opportunity Fund within 180 days of sale, but if the partnership elects not to rollover such gain, then the partners may individually elect to rollover their distributable share of gain, with the 180-day period beginning at the end of the partnership's tax year.
Alternatively, where the partnership does not elect to rollover the gain, the partners may choose to rollover their share of gain during the same 180-day period that the partnership was eligible to use (i.e., 180 days from date of actual sale by the partnership). A similar rule applies to other pass-through entities. It should be noted that while Section 1231 gains may be treated as capital gains in many circumstances, the capital gain treatment of Section 1231 gains is determined at the individual partner level, not the partnership level. Therefore, it does not appear that partnerships will themselves be able to defer Section 1231 gains; rather such gains should be passed through to the partners who can then elect whether to rollover their share of the Section 1231 gains.
The gain invested in a Qualified Opportunity Fund that was not currently taxed will be deferred until the date that the Qualified Zone investment is sold, or December 31, 2026, whichever comes first. The deferred gain will retain the character that it had at the time of original sale; for example, short-term capital gain that was deferred will remain short-term capital gain when finally recognized, even years later. Note that even if the property is not sold by the end of 2026, the taxpayer will still be required to recognize the gain that was deferred, and pay the tax, so investors need to consider their cash flow needs. It should also be noted that in the event of the investor's death before the end of 2026, the deferred amount will still have to be recognized by the investor's estate; there is no step-up at death on this deferred amount.
In addition to the deferral benefit, there may also be a partial reduction in the deferred gain amount. If the investment in the Qualified Zone is held for at least five years, then the taxpayer will receive a basis adjustment, such that 10% of the deferred gain will be eliminated. If the investment in the Qualified Zone is held for at least seven years, an additional 5% of the deferred gain will be eliminated, for a total reduction of 15% of the gain. Note that investments made after 2019 cannot be held for seven years before the end of 2026; therefore, such investments will not be eligible for the 15% basis adjustment.
Finally, if deferral and gain reduction were not enough of a benefit, one more enticement is available: if a Qualified Zone investment is held for at least ten years, then the taxpayer may elect to completely eliminate the tax on the gain that relates to appreciation during the time the investment was held in the Qualified Opportunity Fund. Note that to hold a Qualified Zone investment more than ten years will take the investor beyond 2026, meaning that the deferred gain that was rolled into the Qualified Opportunity Fund will be recognized at the end of 2026, but any gain attributable to appreciation of the Qualified Opportunity Fund investments can be eliminated after ten years. The Proposed Regulations have clarified that the ability to take advantage of gain elimination after ten years will expire at the end of 2047. Therefore, to take advantage of this provision, the investment must be disposed of by December 31, 2047; after that date, this benefit is lost. Mark your calendars.
As noted above, investments in a Qualified Opportunity Fund may be made from sources other than
How to be "Qualified"
To receive these benefits, the investment of the deferred gain must be put into a formal entity designated as a Qualified Opportunity Fund. Such a fund must be a corporation, partnership or limited liability company formed for the purpose of investing in Qualified Opportunity Zone Property. However, the Fund cannot be a single-member LLC, which is a disregarded entity for tax purposes. The IRS has indicated the Fund will self-certify on Form 8996; this form will require that the Fund specify the effective date of its election to be a Qualified Opportunity Fund. Note that an investor must rollover gain only after the effective date of the Fund's election in order to receive the benefits.
To be treated as a Qualified Opportunity Fund, the Fund must hold at least 90% of its assets in "Qualified Opportunity Zone Property," (defined below). This will be measured each year as the average of asset balances after the first six month period and the last day of the tax year (e.g., June 30 and December 31 for a full calendar year). For this purpose, assets will be valued based on applicable financial statements of the Fund, or if the Fund does not have an applicable financial statement, the assets will be valued based on the Fund's cost of the assets. There will be a penalty for the failure to consistently meet the 90% threshold. Form 8996 will be used annually by funds to indicate compliance with this requirement.
Qualified Opportunity Zone Property consists either of (1) Qualified Opportunity Zone Business Property, (2) Qualified Opportunity Zone Stock or (3) Qualified Opportunity Zone Partnership Interests.
Qualified Opportunity Zone Business Property is tangible property that was acquired by purchase after 2017 and that is used in a trade or business of the Qualified Opportunity Fund. The original use of the property must either begin with the Qualified Opportunity Fund or the Qualified Opportunity Fund "substantially improves" such property. Property is "substantially improved" only if, during the 30-month period after acquisition, the additions to basis by the Qualified Opportunity Fund exceed the Fund's basis in the property at the beginning of the 30-month period (i.e., you must spend at least as much as the property's pre-improvement basis in order for the improvements to be deemed "substantial"). The Proposed Regulations provide that substantial improvements to real estate will be measured by only taking into account the adjusted basis of the building, not the land. During substantially all of the Qualified Opportunity Fund's holding period, substantially all use of the property must be in in a Qualified Opportunity Zone. Unfortunately, the Proposed Regulations did not define "substantially all" for this purpose.
Qualified Opportunity Zone Stock is stock of a domestic corporation acquired by the Qualified Opportunity Fund after 2017 from the issuing corporation solely for cash. Such corporation must be a Qualified Opportunity Zone Business (defined below) during substantially all of the Qualified Opportunity Fund's holding period of the stock.
Qualified Opportunity Zone Partnership Interest is an interest in a domestic partnership acquired by the Qualified Opportunity Fund after 2017 from the partnership solely for cash. Such partnership must be a Qualified Opportunity Zone Business (defined below) during substantially all of the Qualified Opportunity Fund's holding period of the partnership.
A Qualified Opportunity Zone Business, which is required for either Qualified Opportunity Zone Stock or a Qualified Opportunity Zone Partnership Interest, is a trade or business in which "substantially all" of the tangible property owned or leased by the entity is Qualified Opportunity Zone Business Property (defined above) and which meets several additional requirements:
The Proposed Regulations have clarified several of the requirements for a Qualified Opportunity Zone Business. One the significant clarifications in the regulations
The second major clarification made by the Proposed Regulations concerns the retention of working capital. In the definition of Qualified Opportunity Zone Business property above, no more than 5% of the assets can be in nonqualified financial assets. The Proposed Regulations provide a working capital safe harbor, under which working capital assets will be treated as reasonable if three requirements are met:
1. There is a written plan designating the working capital as being held for acquisition, construction or substantial improvement of tangible property in the Qualified Zone;
2. There is a written schedule consistent with the ordinary start-up of a trade or business for the expenditure of the working capital; under this schedule, the working capital is to be spent within 31 months of receipt of the assets by the business; and
3. The working capital is actually used in a manner substantially consistent with the written plan.
In addition, any tangible property that is being acquired, constructed or substantially improved with working capital under this safe harbor that will qualify as Qualified Opportunity Zone Business Property by the end of the 31-month period will be treated as so qualifying during this 31-month construction period.
Where do we go from here?
It is expected that most Qualified Opportunity Funds will direct their investments into Qualified Opportunity Zone Partnerships as opposed
We can advise you on how to maximize the tax benefits when planning investments in 2019 and to consider whether new Qualified Opportunity Zone tax incentives may enhance anticipated returns, particularly in real estate investments. The tax deferral and tax reduction aspects of Qualified Opportunity Zones offer significant potential for enhanced returns. The statute left many unanswered questions, and the proposed regulations addressed many of these issues. However, many questions remain unresolved, and it is expected that the next round of proposed regulations will provide additional guidance. It is not too soon to consider the structuring issues involved in setting up a new fund.