One of the lesser known provisions in last year’s Tax Cuts and Jobs Act (TCJA) may soon be a popular topic, as the new Opportunity Zones (OZ) offer a tax incentive for many taxpayers. While we addressed this subject in an earlier tax insight article, the IRS recently issued its first batch of regulations on the OZ. This article highlights guidance offered by the IRS in these proposed regulations.
Congress wanted to provide incentives for taxpayers to invest in certain lower income areas to stimulate economic growth in these parts. These opportunity zones have already been established in every state and in Washington, D.C. (please click here for IRS Notice 2018-48, which spells out the listing of 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 an Opportunity Zone Fund (OZ Fund), which is an organized investment intermediary targeted at businesses located in these opportunity zones. Taxpayers (investors) obtain the following tax breaks:
- a deferral (gain deferred until December 31, 2026 unless disposed of earlier) of recognized gains if the eligible gains are reinvested in an OZ Fund within 180 days of gain transaction;
- a 10% bump in the tax basis once the investment in the OZ Fund is held for five years and another 5% after seven years;
- and finally, an exclusion of the eligible gain if the OZ Fund investment is held for ten years. The taxpayer does this by making an election to adjust the basis of the OZ Fund investment to its fair market value when the investment is sold (after this ten-year holding period).
What the OZ Proposed Regulations Provide
The proposed regulations seek to address many issues and questions related to this new program. There is guidance for investors and others wanting to create OZ Funds and to start making investments into opportunity zones. Here are several selected developments included in the proposed regulations:
- Eligible Gains. First, it is important for taxpayers to know what types of gains can be reinvested into an OZ Fund. The proposed regulations indicate eligible gains that can be reinvested in OZ Funds include capital gains (long term or short term); Section 1231 gains; unrecaptured Section 1250 gains; capital gain dividends from RICs (mutual funds); capital gain dividends from REITs; Section 1256 gains; and collectible gains. In addition, “carried interests,” that now have a three-year holding period, qualify for reinvestment in OZ Funds.
Please note that all or a portion of any of these gains can be reinvested into OZ Funds. In addition, the OZ Fund tax incentives only apply for gains that are not recognized in sales with related parties.
- Eligible Taxpayers. The proposed regulations indicate that an eligible taxpayer is a taxpayer “that may recognize gains for purposes of Federal income tax accounting.” Thus, the following taxpayers are eligible taxpayers that can invest in OZ Funds and therefore can defer eligible gains: “individuals; C Corporations, including Regulated Investment Companies (RICs – mutual funds) and Real Estate Investment Trusts (REITs); partnerships; S Corporations; trusts and estates.”
- Reporting Deferring Gains. The proposed regulations indicate the IRS will issue rules on how to defer gains that are reinvested in OZ Funds. Currently, it is anticipated that taxpayers will make deferral elections on Form 8949. Form 8949 summarizes various capital gain and loss sales/transactions and brings these amounts over to Schedule D. The IRS recently issued a draft of the instructions to Form 8949 for 2018, and these instructions address the gain deferral for OZ Funds on pages 1, 10, and 11.
The OZ Fund deferral uses a Code “Z” in “Column f” of Form 8949, and the amount of the deferral would be reported in “Column g” (please click here to see the draft of Form 8949 instructions for 2018). Please note – these are draft instructions, and there could be changes in the final instructions to Form 8949 when they are issued for the 2018 tax return filing season.
- 180-Day Period for Reinvestment in OZ Funds. A critical aspect of the gain deferral for taxpayers is observing the 180-day reinvestment requirement. Unlike a like-exchange, the taxpayer does not need to deposit the proceeds in an escrow account. Rather, the taxpayer has access to the sales proceeds, but needs to reinvest the gain (any or all of the gain) into an OZ Fund within 180 days of the sale transaction. The investment into an OZ Fund must be an equity interest (which could be a preferred interest but cannot be a debt interest) in the OZ Fund.
- Special Rule for this 180-Day Period with Gains Recognized by Partnerships. As noted above, a partnership itself can decide to defer a gain into an OZ Fund. If the partnership opts not to make an OZ Fund gain deferral, then each of the partners in the partnership can decide individually to invest in an OZ Fund for their allocable share of the partnership’s gain. However, the 180-day period begins on the last day of the partnership’s tax year. This provides a longer time for the partner to consider making a reinvestment into an OZ Fund. For example, if a calendar year partnership recognized a capital gain on May 15, 2019 and decided not to reinvest the gain into an OZ Fund, then the gain would be included in the partnership’s 2019 tax return ending on December 31, 2019. The partners would have until June 28, 2020 (180 days after December 31, 2019) to reinvest their share of the gain into an OZ Fund.
The partner could elect to use the same 180-day period available to the partnership for the gain reinvestment rather than wait 180 days after the partnership’s tax year. This would allow the partner to reinvest the gain sooner into the OZ Fund. The partnership would need to provide the details of the gain (date, amounts, etc.) to its partners for them to make this election.
Finally, the proposed regulations indicate that similar rules to these “rules provided for partnerships and partners apply to other pass-through entities (including S Corporations, decedents’ estates, and trusts) and to their shareholders and beneficiaries.”
- OZ Funds. An OZ Fund must be classified as a partnership or corporation for federal tax purposes. The proposed regulations indicate an LLC can be an OZ Fund provided it is treated as a partnership or elects to be treated as a corporation. It cannot be a disregarded entity (thus, an OZ Fund cannot be a Single-Member LLC (SMLLC)).
The main requirement for an OZ Fund is that it meets a 90% Assets Test. This test specifies that 90% of the OZ Fund’s assets are invested in Opportunity Zone property. This determination is done in the initial year of the OZ Fund and all subsequent years. The OZ Fund certifies its compliance with the 90% test by annually filing Form 8996; it does not need to apply to the IRS to be classified as an OZ Fund. (Please click here for a Draft version of Form 8996.) To calculate the 90% test, the OZ Fund looks at the assets on its Applicable Financial Statements (AFS). If it has no AFS, then it looks to its cost basis of its assets. Further, if the OZ Fund fails this 90% assets test, it is assessed a penalty determined by how much it missed the 90% test. It does not necessarily lose its OZ Fund status.
- Opportunity Zone Property. Opportunity Zone Property for an OZ Fund is described as ownership in a partnership or a corporation which is an opportunity zone business. It also includes tangible property used in trades or businesses located in an opportunity zone. The company and this property must be acquired after December 31, 2017. If the acquired property in the OZ Fund was located in the opportunity zone before December 31, 2017, then the property needs to be substantially improved. This improvement looks to the cost of the building, and not to land. The IRS issued Revenue Ruling 2018-29 to assist in analyzing whether a substantial improvement is met. The OZ Fund makes the determination as to whether it satisfies the rules to qualify as an OZ Fund.
- Opportunity Zone Business. An Opportunity Zone Business is a business located in an opportunity zone. The following businesses are not eligible: suntan facilities, golf courses, country clubs, hot tub facilities, racetracks, gambling facilities, liquor state, and massage parlors.
The new opportunity zones create many opportunities for taxpayers and entrepreneurs looking to invest in certain lower income areas. Please contact your Sikich tax advisor with any questions you have regarding opportunity zones and keep an eye out for more activity and guidance on this topic in the coming months.