On October 19, 2018, the United States Department of Treasury (“Treasury”) released long-awaited pieces of guidance on the Opportunity Zones (“OZ”) program. The OZ program, which aims to incentivize investment in designated low-income census tracts, was introduced as part of the Tax Cuts and Jobs Act of 2017 as newly created Sections 1400Z-1 and 1400Z-2 of the Internal Revenue Code (“Code”). Despite widespread excitement about the potential of the program, investors and developers alike have been hesitant to take advantage of the program due to numerous technical questions about how the program would be implemented. The release of the October 19 guidance should help bring some potential participants off the sidelines. Items released by the Treasury include:
- A draft of proposed regulations for implementation of the OZ program (the “Proposed Regulations”). The draft will be open for public comment for 60 days and discussed at a public hearing scheduled for January 10, 2019. Final regulations are expected to be published after the public hearing.
- IRS Revenue Ruling 2018-29 (the “Revenue Ruling”), which answers questions from the real estate community regarding the eligibility of land and building acquisitions as qualified opportunity zone property.
- A draft of the IRS’ new Form 8996 and accompanying Instructions, which will allow partnerships and corporations to self-certify as a qualified opportunity fund (“QOF”). It is expected that QOFs will also be required to file a Form 8996 annually for compliance reporting. As with the Proposed Regulations, the draft of Form 8996 will be open for public comment before a final version is published.
Below are a few highlights from the Proposed Regulations and Revenue Ruling that will be of interest to potential participants in the OZ program:
- How does an investor elect to defer capital gains that have been reinvested in a QOF? Although this topic was not covered in the Proposed Regulations themselves, the Treasury noted in the Preamble to the Proposed Regulations that it expects any taxpayer that reinvests capital gains in a QOF to make a deferral election on Form 8949 to be attached to the taxpayer’s federal income tax return.
- When does an entity begin to be treated as a QOF? The Proposed Regulations provide that a corporation or partnership, or an entity treated as a partnership for federal tax purposes, may self-certify as a QOF. The Preamble indicates that an entity must specify in its Form 8996 the year and month in which it will be first treated as a QOF. The Form 8996 must be filed annually with along with its tax return. Any capital gain that is reinvested in an entity before the entity’s first month as a QOF will not be considered a valid investment in a QOF.
- 90% of a QOF’s assets must be invested in qualified opportunity zone property. How are assets valued when determining if this requirement has been satisfied? For purposes of determining if this “90% test” has been met every tax year, the Proposed Regulations require that if a QOF has an “applicable financial statement” (as defined in §1.475(a)-4(h)(1) of the Income Tax Regulations), it must use the asset values from its applicable financial statement. If the QOF does not have an applicable financial statement, its asset values must be measured using the cost of each asset.
- What types of gains are eligible for deferral? The Proposed Regulations provide that a gain is eligible for deferral if it is a gain that (i) constitutes a “capital gain for federal income tax purposes,” (ii) would be recognized before January 1, 2027 had Code Section 1400Z-2 not applied to it, and (iii) does not arise from a sale or exchange with a related person.
- How do the “original use” and “substantial improvement” tests apply to acquisitions of land? A common question from the real estate community is whether a QOF could ever be an original user of land that it has acquired. As background, Code Section 1400Z-2 provides that to be considered “qualified opportunity zone property,” property must be acquired by a QOF that either (i) is the original user of the property, or (ii) “substantially improves” the property (Code Section 1400Z-2 defines a substantial improvement as additions to the property’s tax basis equal to or greater than its purchase price). The Revenue Ruling holds that because of the “permanence of land”, a QOF could never be considered an original user of it. However, any building located on acquired land could be considered qualified opportunity zone property if substantially improved in accordance with Code Section 1400Z-2.
- What happens if an investor contributes capital to a real estate project that cannot be spent right away? To account for the possibility of long-term construction and rehabilitation schedules, the Proposed Regulations provide for a working capital safe harbor. Any investments not immediately used can be held as working capital for up to 31 months provided that the amounts to be held as working capital are designated in writing and are spent within 31 months in a manner consistent with a written schedule.
Topics for Future Regulations
In the preamble to the Proposed Regulations, Treasury advised that additional regulations are forthcoming, which are expected to cover the following topics:
- When defining each type of qualified opportunity zone property, Code Section 1400Z-2 includes a caveat that during “substantially all” of the period during which such property is held by a QOF, the property must satisfy the requirements of a qualified opportunity zone business. The Preamble to the Proposed Regulations notes that future guidance will define what “substantially all” means in this context.
- Events that could result in the inclusion in a taxpayer’s income of capital gain that has been deferred due to reinvestment in a QOF.
- The amount of time a QOF will have to reinvest the proceeds of a sale of qualifying assets without incurring a penalty.
- Administrative procedures for dealing with a QOF that fails to satisfy the 90% investment requirement.
- Information reporting requirements for QOFs.
As mentioned above, this Quick Study discusses only a few highlights of the Proposed Regulations and Revenue Ruling. We encourage those who are interested to contact a member of our Opportunity Zones Working Group with any questions.