Land of Tax Opportunity Zones
Treasury Issues Highly Anticipated Guidance for the Implementation of Opportunity Zone Program
On October 19, 2018, the Treasury Department issued highly anticipated guidance on investment in qualified opportunity zones (the “Opportunity Zone Program”). Enacted as part of the 2017 U.S. federal income tax reform, the Opportunity Zone Program is designed to encourage investments of private capital into low-income communities by providing significant federal income tax incentives to investors in such communities.
Senior Treasury officials described the Opportunity Zone Program as an initiative that is expected to foster economic revitalization and promote sustainable economic growth, which was a major goal of the recent U.S. federal income tax reform. They further anticipated that $100 billion in private capital will be dedicated towards creating jobs and economic development in qualified opportunity zones.
The first package of guidance, issued on October 19, 2018, includes proposed treasury regulations (the “Proposed Regulations”), Revenue Ruling 2018-29 (the “Revenue Ruling”), and a Draft IRS Form 8996 (and instructions) providing much needed guidance for the implementation of the rules relating to the Opportunity Zone Program contained in Section 1400Z-2 of the Internal Revenue Code (the “Code”).
While it does not answer all relevant questions, the initial package provides significant guidance and establishes a more complete framework for the implementation of the Opportunity Zone Program. Additional guidance is expected to be issued in the near future.
The Opportunity Zone Program is intended to spur economic development in population census tracts (mostly low-income tracts) nominated by governors and certified by Treasury in exchange for significant U.S. federal income tax benefits.
The program allows taxpayers to defer tax with respect to capital gains from sales to unrelated persons to the extent a portion of the proceeds is reinvested into one or more qualified opportunity funds (“Opportunity Fund”). Under the Opportunity Zone Program, the gain is deferred until the earlier of the disposition of the underlying qualified investment and December 31, 2026. However, if the interest in the Opportunity Fund is held for at least five years, the taxpayer is entitled to permanently exclude 10% of the initial gain and if the interest is held for at least seven years, 15% of the initial gain is permanently excluded. In addition, if the taxpayer holds the interest in the Opportunity Fund for at least ten years, any appreciation in the Opportunity Fund is generally exempt from U.S. federal income tax.
To qualify as such, an Opportunity Fund must, among other things, hold at least 90% of its assets (the “90% Asset Test”) in qualified opportunity zone property (“Opportunity Zone Property”), which includes qualified opportunity zone stock, qualified opportunity zone partnership interest and qualified opportunity zone business property.
Additional Insights Under Recent Guidance
Electing to Defer Gain Under the Opportunity Zone Program
The Proposed Regulations provide that eligible gains include both short-term and long-term gains that are treated as capital gain for federal income tax purposes. These gains generally include capital gain from an actual or deemed sale or exchange, including deferred gain triggered upon the sale of an interest in an Opportunity Fund. Gain that is realized but not recognized for U.S. federal income tax purposes (such as in connection with a section 1031 “like-kind” exchange, or a corporate reorganization) is not eligible. In addition, capital gain recognized in connection with a position that is part of an “offsetting positions transaction” is not eligible for the deferral treatment.
The Opportunity Zone Program generally requires a taxpayer to make an investment into an Opportunity Fund within 180 days following the day the subject matter gain would otherwise be recognized. In the case of a capital gain dividend received from a regulated investment company (“RIC”) or a “real estate investment trust (“REIT”), the recognition date is that date in which such dividend is paid.
The Proposed Regulations clarify that taxpayers for these purposes include individuals, corporations (including RICs and REITs), partnerships, S corporations, and other pass through entities. The Proposed Regulations include important rules with respect to the ability of investors in such pass-through entities to make the deferral election themselves to the extent such election was not done by the respective entity: if a partnership (or another pass-through entity) does not make an election to defer capital gain, a partner (or beneficial owner) in the partnership (or such entity) may elect to defer his/her portion of such capital gain within 180 days following the last day of the tax year of the partnership (or other entity) during which the applicable asset was sold. The partner (or such beneficial owner) may alternatively elect to invest its share of the gain in an Opportunity Fund within 180 days of the date the partnership (or other entity) recognized the subject matter gain. It is expected that investors in partnerships and other pass-through entities may negotiate additional provisions addressing potential participation in the Opportunity Zone Program.
Taxpayers will be making an election to defer capital gains under the Opportunity Zone Program by attaching IRS Form 8949 to their federal income tax return for the taxable year for which the gains would have otherwise been recognized.
Disposition of Interest in an Opportunity Fund; Recognition of Deferred Gain
When deferred gain is subsequently triggered (upon the disposition of an interest in an Opportunity Fund or the December 31, 2026 outside date), the gain will have the same attributes as the underlying deferred gain would have had when originally recognized. Therefore, if a taxpayer elects to defer a short-term capital gain, the subsequent gain recognized will retain the short-term treatment notwithstanding that the investment in the Opportunity Fund may have been held for much longer than a year.
The Proposed Regulations clarify that if a taxpayer sells an interest in an Opportunity Fund with respect to which a gain deferral election was made, the taxpayer can make a new qualifying investment and elect to defer the inclusion of the previously deferred gain. To do so, the taxpayer must make a complete disposition of the entire initial investment in the Opportunity Fund and the second investment must be made within 180 days from the date of the sale or exchange.
The designation of opportunity zones is set to expire on December 31, 2028. Prior to the issuance of the initial guidance, practitioners wondered whether an investment in any year after 2018 could satisfy the 10-year holding period (which allows for any subsequent gain on the investment in the Opportunity Fund to be completely excluded). The Proposed Regulations clarify that if the investment is made prior to June 29, 2027, then the 10-year gain exclusion is allowed as long as the disposition of the investment occurs before January 1, 2048.
The Proposed Regulations apply a “first in first out” methodology when a taxpayer makes multiple investments into an Opportunity Fund. The application of that methodology, in the context of an Opportunity Fund treated as a partnership for U.S. federal income tax purposes, may require additional guidance.
Qualifying as an Opportunity Fund
For purposes of the Opportunity Zone Program, an Opportunity Fund generally means any investment vehicle organized as a corporation or a partnership for the purpose of investing in qualified opportunity zone property that holds at least 90% of its assets in Opportunity Zone Property. As briefly mentioned above, Opportunity Zone Property includes stock in a corporation or an interest in a partnership where the corporation or partnership qualify as a “qualified opportunity zone business” (“Opportunity Zone Business”).
An Opportunity Zone Business is defined by Section 1400Z-2 of the Code as, among other things, a trade or business in which “substantially all” of the tangible property owned or leased by the taxpayer is “qualified opportunity zone business property” (“Opportunity Zone Business Property”). Pursuant to the Proposed Regulations, a trade or business of an entity is treated as satisfying such “substantially all” requirement if at least 70% of the entity’s tangible property is comprised of Opportunity Zone Property. Certain trades and businesses are ineligible to qualify as an Opportunity Zone Business, including, among others, golf courses, country clubs, racetracks and other facilities used for gambling and stores the principal business of which is the sale of alcoholic beverages for consumption off premises.
To qualify as Opportunity Zone Business Property, among other things, the original use of the subject property must generally commence with the Opportunity Fund or such property must be “substantially improved” by the Opportunity Fund (generally requires capital expenditures that exceed the initial tax basis of such property made within 30 months from the acquisition thereof). The Revenue Ruling clarifies that where the building is acquired together with the land on which the building is located, , the tax basis attributable to land is not taken into account in calculating whether the “substantial improvement” test is met with respect to the building (and no separate requirement exists to “substantially improve” such land).
The Proposed Regulations clarify that the 90% Asset Test is calculated based on the book value of the Opportunity Fund’s assets as reported in its “applicable financial statement” and in the absence of such applicable financial statement, based on the cost of the Opportunity Fund’s assets. For purposes of satisfying the 90% Asset Test, the Proposed Regulations establish a safe harbor for reasonable amounts of working capital spent within a 31-month period in a manner substantially consistent with a written schedule, provided that such amounts are designated in writing for the acquisition, construction and/or substantial improvement of tangible property in a qualified opportunity zone. An Opportunity Fund that fails to satisfy the 90% Asset Test may be subject to penalties. According to the preamble to the Proposed Regulations, the IRS intends to publish additional guidance addressing penalties and possible decertification of an Opportunity Fund.