The Opportunity Zones (“OZ”) provision from the recent Tax Cuts and Jobs Act (“TCJA”) offers a new tax incentive for many taxpayers.
We addressed this topic in earlier tax Insights (please click here for links to these articles). The IRS issued its initial set of regulations last fall, and they recently issued the second round of regulations on OZ. The focus of this article is on what the IRS offered in these latest regulations (please click here to look at these recent OZ proposed regulations).
Background on Opportunity Zones
Congress wanted to provide incentives for taxpayers to invest in certain lower income areas to stimulate economic growth in these areas. These opportunity zones have already been established in every state and in Washington, D.C. Please click here for IRS Notice 2018-48 which lists all 8,761 census tracts in the U.S. that are designated as opportunity zones. To obtain the OZ tax break, taxpayers must invest in a “Qualified Opportunity Fund” (“QOF”), which is an investment vehicle targeted at businesses located in these opportunity zones.
Taxpayers (investors) obtain the following tax breaks:
Any recognized capital gain reinvested in a QOF is deferred until December 31, 2026 (unless disposed of earlier). Generally, the reinvestment must be made within 180 days after the capital gain is recognized.
Basis Boost. A taxpayer receives a 10% bump in the tax basis once the QOF investment is held for five years and another 5% bump after seven years.
Finally, an exclusion of the post-acquisition gain in the QOF investment if this investment is held for 10 years. The taxpayer does this by making an election to adjust the basis of the QOF investment to its fair market value when the investment is sold (after this ten-year period).
Qualified Opportunity Fund. As noted above, the QOF is the vehicle used to accept investments and then redeploy these funds into opportunity zones. The QOF must be classified as a partnership or corporation for federal tax purposes and follow other specified rules. The main requirement for a QOF is that it meet a “90% Assets Test.” This test specifies that 90% of the QOF’s assets are invested in Qualified Opportunity Zone Property (“QOZP”). The QOF self certifies that it meets this 90% test, and this determination is done in the initial year of the QOF and all subsequent years. The QOF must annually file Form 8996 to show its adherence to these rules.
What the Latest Opportunity Zone Proposed Regulations Provide
The second round of proposed regulations on OZ covers various issues and questions related to this new incentive. There is guidance for investors, developers and businesses wanting to create QOFs and start making investments into OZ. Here are several selected developments included in round two of the OZ proposed regulations:
- The “original use” of property (“QOZBP”) in an OZ is a critical determination that must be made, and this is described in these regulations as the first use of the property in the opportunity zone.
- A special rule was added for vacant buildings. If the building has been vacant for five years or more, then this can be treated as new property.
- Land is treated as qualified property and does not need to be substantially improved in the opportunity zone (assuming it is used in a trade or business).
- A key part of these regulations was guidance related to the rules for a Qualified Opportunity Zone Business or QOZB. The following three “safe harbors” were added to determine if more than or equal to 50% of the gross income was generated in the opportunity zone:
- If ≥50% of the total employee hours are worked in the opportunity zone, then the QOZB meets the 50% gross income test.
- If ≥50% of the total wages paid to the employees are worked in the opportunity zone, then the QOZB meets the 50% gross income test.
- If the management or operations performed in the opportunity zone and the tangible property used in the opportunity zone are both necessary to generate 50% of the gross income of the QOZB, then the 50% gross income test is met.
Note – only one of these safe harbors needs to be met for this 50% gross income test. Also, if none of these safe harbors are met, this test could perhaps still be satisfied based on the facts and circumstances of the QOZB.
- A key feature of the opportunity zone incentive is determining the conditions for property to be treated as a qualified opportunity zone business property. The new law states: “during substantially all of the qualified opportunity fund’s holding period for such property, substantially all of the use of such property was in a qualified opportunity zone.” The statute did not define “substantially all” for these purposes, but in the latest set of proposed regulations, the IRS defined what “substantially all” means in both situations:
- First, the regulations defined “substantially all” to be at least 70% of the tangible property of the QOF must be used in an opportunity zone.
- The IRS, however, established a higher 90% threshold as being “substantially all” for the QOF’s holding period.
- Special relief was provided to a QOF that recognizes gain from the sale of QOF property. The QOF is allowed 12 months to reinvest the proceeds into other QOF property, providing the investor does not get cashed out of the QOF interest. Also, the underlying gain of this QOF property must still be recognized by the investors.
- The regulations provide that some debt-financed distributions are allowed for QOF partnership investors.
- The regulations also provide that certain transfer events will cause an investor’s deferred gain in the QOF to be recognized. Investors need to carefully monitor these events (referred to in the regulations as “inclusion events”) to avoid triggering any gain.
- One other item of note, the regulations address whether Section 1231 gains qualify to be reinvested into a QOF. As noted above, taxpayers can only invest capital gains into a QOF and receive the indicated tax benefits. There was some uncertainty after the first set of regulations whether Section 1231 gains could be reinvested into a QOF. The second set of regulations covered this issue and indicated that taxpayers with Section 1231 gains could reinvest these gains into a QOF if for the year the taxpayer’s Section 1231 gain is taxed as a capital gain to the taxpayer (which would be impacted by any Section 1231 losses the taxpayer had for the year). Due to this uncertainty with Section 1231 gains and losses, until the tax year is over, the regulations provide relief by allowing the taxpayer 180 days after the end of the year with any net Section 1231 gains (which are taxed as capital gains) to make the investment into a QOF. Thus, any taxpayer with a net Section 1231 gain incurred in 2018 (which is taxed as a capital gain in 2018) has until June 29, 2019 to make an investment into a QOF. This QOF investment could provide tax savings with the taxpayer’s 2018 tax return, even if the taxpayer has already filed for 2018.
The new opportunity zones create many opportunities for taxpayers and entrepreneurs looking to invest in certain low-income areas. These latest round of proposed regulations provide guidance to assist all parties looking at getting involved with opportunity zones.
Look for more activity and publicity with OZ in the coming months. Please contact your Sikich tax advisor with any questions you have with opportunity zones.