Final Opportunity Zone Regulations Are Generally Favorable for Taxpayers
On December 19, 2019, the Treasury Department released final regulations on opportunity zones (OZones). These regulations generally adopt the approach that the Treasury Department had previously proposed, but there are some important changes and clarifications that should be noted.
Some of the significant developments are as follows:
EXIT AFTER 10 YEARS – EASIER TO OBTAIN TAX BENEFITS
The final regulations have made it easier for an investor to avoid recognizing gain after holding an OZone investment for at least 10 years. Under prior guidance, an investor with a 10-year holding period could avoid paying tax on the gain from the sale of its investment in an OZone fund, but the investor might have had to pay tax if the OZone fund or a subsidiary entity sold an asset. Now it will be much easier for an OZone fund or a subsidiary to sell an asset without jeopardizing an investor's tax benefits. Adverse tax consequences may arise, however, if the proceeds are not distributed to the investors, and there is some complexity in the rules regarding whether an investor has received its share of the proceeds.
GIFTS AND INTER-SPOUSAL TRANSFERS – TAX ACCELERATED AND NO BENEFITS FOR RECIPIENT
When an investor has sold an asset (the Old Asset) and invests the gain in an OZone fund, the sale is not taxed until 2026, and the investor may obtain other tax benefits. Under the final regulations, if the investor makes a gift of the OZone investment or transfers the investment to a spouse (including a transfer incident to divorce), the gain from the sale of the Old Asset cannot be deferred until 2026. Instead, the investor must pay tax on the gain from the sale of the Old Asset as if the gain were recognized at the time of the gift or inter-spousal transfer. In addition, the recipient of the OZone investment will not obtain any special OZone tax benefits by holding the investment. For purposes of these rules, what matters is whether the transfer is treated as a gift for income tax purposes, not whether the transfer is treated as a gift for gift tax purposes.
DEATH – STEP-IN-SHOES APPROACH FOR HEIRS
When an investor sells an Old Asset, invests the gain in an OZone fund, and then dies, the heirs or legatees effectively step into the shoes of the investor. For example, the gain from the sale of the Old Asset is not accelerated; instead, the heirs or legatees must treat that gain as taxable income that is recognized in 2026. In addition, although an heir or legatee is generally allowed to step up its basis in property that it inherits from a decedent so that the basis equals the fair market value of the property, that step up is not allowed when the property is an OZone investment.
RENTAL REAL ESTATE – 180-DAY PERIOD BEGINS ON DATE OF SALE AND GROSS GAINS ELIGIBLE FOR TAX BENEFITS
Prior guidance treated rental real estate differently from capital assets. For capital assets (e.g., most stock and art), the 180-day investment period begins on the day that the asset was sold unless the asset was held through a partnership or through an S corporation. However, for rental real estate that has been held in connection with a trade or business for more than one year (a so-called Section 1231 asset), prior guidance provided that the 180-day investment period began on the last day of the tax year in which the asset was sold.
Also, an investor may shelter gain from the sale of a capital asset even if the investor sells other assets at a loss. In contrast, prior guidance provided that for Section 1231 assets, the maximum amount of gain that was eligible for OZone benefits was limited to the amount of net gain recognized in the sale of Section 1231 assets. Therefore, if a taxpayer recognized $1 million of gain from the sale of one Section 1231 asset but recognized a $1 million loss from the sale of another Section 1231 asset, the taxpayer would not be able to reap any tax benefits by investing in an OZone fund.
Under the final regulations, however, Section 1231 assets will be treated like capital assets. Therefore, the 180-day investment period will generally begin on the day that the asset is sold (unless the asset is held through a partnership or through an S corporation), and the maximum amount of gain eligible for OZone benefits will not be reduced by any losses recognized in the sale of other assets.
As a result, taxpayers who sold Section 1231 assets in the first six months of 2019 and who relied on the prior guidance might not have made timely investments in an OZone fund. Under prior guidance, such gain could not be invested in an OZone fund until December 31, 2019, but under the new final regulations, such gain must generally be invested within 180 days of the date of sale (i.e., before December 31, 2019). Taxpayers who recognized gain in 2019 are, however, allowed to apply the prior proposed regulations so long as they apply those regulations in a consistent manner. Therefore, such taxpayers may use the 180-day period that begins on December 31, 2019, but such investments will be limited to the amount of net gain recognized from Section 1231 assets in 2019. In other words, if a taxpayer uses the December 31, 2019, starting date, losses recognized in 2019 will reduce the amount of gain from Section 1231 assets that is eligible for OZone benefits.
Alternatively, if a taxpayer held the Section 1231 asset indirectly (e.g., through a partnership), the taxpayer might be able to take advantage of the December 31, 2019, starting date without having losses reduce the amount of gain that may be deferred. Like prior guidance, the new final regulations provide that when a partnership sells an asset, a partner may defer paying tax on the resulting gain by making an OZone investment in the 180-day period that begins on the last day of the partnership's tax year.
CARRIED INTERESTS / PROMOTES – REDUCED TAINT FOR CAPITAL INVESTMENTS
Under prior guidance, if a sponsor contributed capital to an OZone fund and also received a carried interest or a promote, the carried interest or promote could taint the capital investment and therefore reduce the amount of OZone tax benefits that the sponsor could receive unless the investment was carefully structured. The new final regulations reduce but do not eliminate the taint that might result from a carried interest or a promote. Therefore, careful structuring is still advisable in order to maximize the tax benefits a sponsor may receive in connection with its capital investment.
AGGREGATION – LIMITED AGGREGATION ALLOWED TO SATISFY SUBSTANTIAL IMPROVEMENT TEST
In general, at least 70% of the tangible property held by an OZone fund (either directly or indirectly) must be "original use" property or be "substantially improved." For property to be "substantially improved," the amount spent to improve the property over a 30-month period must exceed the amount paid to acquire the property. Under prior guidance, each asset was evaluated separately, so amounts spent to purchase or improve one asset could not be treated as an amount spent to improve a different asset. The new final regulations, however, allow assets to be aggregated when various criteria are met. Therefore, in calculating the amount spent to improve one asset, an OZone fund may sometimes include amounts spent to improve a different asset or amounts spent to acquire new property for use in the OZone (such as furniture and restaurant equipment).
QUALIFICATION IN START-UP PERIOD – CLEARER AND EXPANDED SAFE HARBORS
For a tangible property to qualify as "substantially improved" or as "original use" property, the property must be used in a trade or business. For real estate development, it may be difficult to satisfy this requirement in the start-up period, for there might not be a trade or business until construction is complete. Prior guidance provided some safe harbors in the start-up period. The new final regulations clarify and expand these safe harbors, which should make it easier for projects to qualify while under development.