The Tax Cuts and Jobs Act (Tax Reform) was passed in record time and contained a multitude of tax changes affecting businesses of all sizes and industries. The magnitude of the changes, coupled with the speed at which they passed, resulted in the anticipation of much needed guidance from the IRS.
The Opportunity Zones program provides a way for an investor to defer current capital gains and invest in economically distressed areas. Warren Averett is committed to keeping you up to date on tax changes that could affect you or your business. You can check out our original Opportunity Zones program fact sheet here.
Details on the Release of the Proposed Regulations
The U.S. Department of Treasury has released the much awaited first round of guidance for the Opportunity Zones program. Along with a revenue ruling and a draft of Form 8996, “Qualified Opportunity Fund,” the Treasury has provided 74 pages of proposed regulations covering a number of topics that will allow investors, fund managers, real estate developers and operating businesses to begin moving forward with Opportunity Zone (OZ) investments in the designated census tracts across the country. Even though the regulations are proposed and subject to comment for 60 days, the regulations provide that taxpayers can rely on this guidance as long as the rules set forth are followed consistently and in their entirety. The Treasury’s release of guidance on October 19 has provided much needed clarity and should open the gates for investors and fund managers to begin taking actionable steps towards starting projects and investing in businesses within the Opportunity Zones.
The regulations released have provided answers to many of the questions commentators had been asking of the program throughout the summer. Some of the key issues are discussed below.
The proposed regulations provide that a gain is eligible for deferral if it is treated as a capital gain for federal income tax purposes. Eligible gains, therefore, generally include capital gain from an actual, or deemed, sale or exchange or any other gain that is required to be included in a taxpayer’s computation of capital gain. It is currently anticipated that taxpayers will make deferral elections on Form 8949, which will be attached to their federal income tax returns for the taxable year in which the gain would have been recognized.
In addition to the deferral election only applying to capital gains, the attributes of the capital gains being deferred will be preserved through the holding period of the investment in the Opportunity Zone Fund. This means that when the deferred gains are eventually recognized, the gains will be taxed in the same manner as they would have been if they had not been deferred. Guidance has not been provided on what tax rates will be applied in the year deferred gains are recognized, but the expectation is that the rates will be those in effect in the year the gains are recognized, rather than the year in which the gains were deferred.
Taxpayers will have a 180-day period in which gains must be invested in a Qualified Opportunity Fund (QOF). Generally, the first day of the 180-day period is the date on which the gain would be recognized for federal income tax purposes.
The guidance confirms that eligible taxpayers are those that recognize capital gain for federal income tax purposes. These taxpayers include the following list:
- C Corporations, including:
- Partnerships and other qualified pass-through entities
- Common Trust Funds described in Section 584
- Qualified Settlement Funds
- Disputed Ownership Funds
- Entities taxable under the regulations of 1.468B
Because of the pass-through nature of gains related to partnerships and other pass-through entities, the Treasury provided regulations specifically covering this topic. A partnership or other pass-through entity may elect to defer part or all of a capital gain at the entity level resulting in the deferred gain not being included in the distributive share of income of the partners. If the partnership or other pass-through entity does not elect to defer the gain, the opportunity to elect gain deferral will be passed through to the partner on his or her respective distributive share of the gain. In the case of the deferral election being passed through to the partner, the 180-day period in which gains must be reinvested can begin either on the last day of the partnership or other pass-through entity’s taxable year, or, alternatively, the partner may choose to begin the 180-day period on the same start date as the partnership or other pass-through entity.
Qualified Opportunity Funds
Along with the first round of regulations, the Treasury has provided a draft of Form 8996, “Qualified Opportunity Fund,” and draft instructions. It is expected that taxpayers will use this Form both for initial self-certification and for yearly information reporting requirements. While the requirement for a QOF to maintain 90% of its assets in Qualified Opportunity Zone property remains unchanged, the regulations did provide some guidance on the valuation of assets and guidance under which situations cash will qualify for the 90% Asset Test.
For the 90% Asset Test, a QOF will be required to use the asset values that are reported on the QOF’s applicable financial statement for the tax year. For QOFs that do not have an applicable financial statement, the cost of the assets will be used for valuation purposes.
The regulations provide for a working capital safe harbor for QOF investments in a QOZ business that acquires, constructs or rehabilitates tangible business property, which includes both real and other tangible property used in a business operating in an OZ. This working capital safe harbor includes cash, cash equivalents and debt instruments with a term of 18 months or less. QOFs will be able to apply this safe harbor for 31 months (one month longer than the 30-month period in which substantial improvements must be made). Requirements to use the safe harbor include: a written plan that identifies the financial property as property held for acquisition, construction or substantial improvement of tangible property; a written schedule consistent with the ordinary business operations of the business that the property will be used within 31 months; and substantial compliance of the business with the schedule.
Revenue Ruling 2018-29
The revenue ruling released along with the regulations provides clarity on the substantial improvements required when purchasing a building within an OZ that is not beginning its original use with the QOF. The ruling provides that tangible property is treated as substantially improved by the QOF only if during any 30-month period beginning after the date of acquisition of the property, additions to basis with respect to such property in the hands of the QOF exceed an amount equal to the adjusted basis of such property at the beginning of such 30-month period in the hands of the QOF. Most importantly, land is excluded when calculating the adjusted basis of the property. For example:
A QOF purchases a building and the piece of land the building sits on within an OZ for $500,000 with the intent to improve the building. Sixty percent of the purchase price is allocated to the land ($300,000), and forty percent of the purchase price is allocated to the building ($200,000). Under this revenue ruling, the amount allocated to the land is excluded from the basis of the property. The QOF is required to make at least $200,000 in improvements to the building within 30 months of the acquisition in order to satisfy the substantial improvement rule.
Investments in a QOF must be an equity interest in a QOF. This includes preferred stock and partnership interests with special allocations. Thus, an interest cannot be a debt instrument or result from a deemed contribution of money under section 752(a).
QOFs will choose the first month of the taxable year in which they are treated as a QOF. If a QOF fails to choose a first month, then the first month will be deemed to be the first month of the taxable year. The first six-month period at the end of which the QOF is first tested for the 90% Asset Test is the first six-month period composed entirely of months within an entity’s taxable year and during which the entity is a QOF. Only investments made when the entity is a QOF qualify for the OZ program.
Among other items, to qualify as an OZ business, “substantially all” of an entity’s tangible property owned or leased must be qualified Opportunity Zone business property. While the term “substantially all” is found throughout the Opportunity Zones code section, the Treasury has defined it only for this instance as 70%.
The regulations provide that preexisting entities can qualify as QOFs or OZ businesses, providing that they satisfy the necessary requirements. These requirements include the 90% Asset Test for a QOF and the 70% Substantially All Test for an OZ business. The requirements for QOZ business property include:
- The property was acquired by or purchased after December 31, 2017;
- The original use of the property in the QOZ commences with the QOF or the QOF substantially improves the property; and
- During substantially all of the QOF’s holding period for the property, substantially all of the use of property was in in the QOZ.
Because of the requirement that property should be acquired after December 31, 2017, a number of businesses already within the OZ would not qualify for the program. The Treasury and the IRS are requesting comments on whether there is a statutory basis for additional flexibilities that might facilitate qualification of a greater number of pre-existing entities.
Topics Still to be Covered in the Next Round of Regulations
The Treasury and the IRS laid out some topics that will be covered in forthcoming regulations. These topics include:
- The meaning of “substantially all” throughout the provision;
- Transactions that would trigger the inclusion of deferred gain in income;
- The “reasonable period” in which QOFs will have to reinvest proceeds from the sale of qualifying assets and the treatment of any gains realized by these sales;
- Administrative rules for when a fund fails the 90% Asset Test;
- Conduct leading to decertification; and
- Information reporting requirements.
The proposed regulations provided clarity on a few key issues.
- To be eligible to participate in the program, the gain must be a capital gain for federal income tax purposes.
- Gains must be reinvested within a 180-day window beginning with the date on which the gain would be recognized for federal income tax purposes.
- The proposed regulations provided guidance on the type of taxpayers that can participate in the program and how pass-through entities and their owners can participate.
- All investments must be equity investments in Opportunity Zone Funds.
- Taxpayers who purchase a building can exclude the amount applicable to the land when measuring the amount needed to substantially improve the property.
- Taxpayers have 30 months to substantially improve property located in the Opportunity Zone.
- To qualify as an Opportunity Zone business, 70% of a partnership or corporation’s tangible property owned or leased must be qualified Opportunity Zone business property.
On October 18, prior to the new regulations, Warren Averett hosted a webinar to discuss the new Opportunity Zones Program and the five most overlooked business tax credits. The webinar addressed the audience’s questions regarding the Opportunity Zones program and gave insight into the benefits of investing in the program, in addition to highlighting overlooked tax credits, deductions and incentives. To view the webinar and gain some background information on the Opportunity Zones Program, click here.
For more information on Opportunity Zones, please contact your Warren Averett advisor.