Qualified Opportunity Zones – Treasury Issues Proposed Regulations

The Treasury Department issued proposed regulations related to qualified opportunity zones on October 19, 2018. Congress created the qualified opportunity zone regime as part of the Tax Cuts and Jobs Act, which was enacted at the end of 2017, to encourage investment in certain low-income areas. Under the statute, a taxpayer may defer recognition of gain on the sale of property to an unrelated person if that gain is invested in a qualified opportunity fund (QOF) within 180 days of the sale. Deferred gain is recognized, however, on the earlier of the date on which a taxpayer sells its interest in the QOF or December 31, 2026. If a taxpayer holds an interest in a QOF for five years, the taxpayer’s basis in the investment increases by 10% of the gain that was deferred. If a taxpayer holds an interest in a QOF for seven years, the taxpayer’s basis increases by an additional 5%. If a taxpayer holds an interest in a QOF for 10 years, the taxpayer may be able to permanently avoid recognizing additional gain attributable to the appreciation of the investment over the holding period by increasing the basis at the time of sale to the fair market value of the interest. The statute is vague and ambiguous in a number of respects and have raised many questions among practitioners and taxpayers seeking to take advantage of the gain deferral.

The proposed regulations clarify many of the ambiguities presented by the opportunity zone statutes. Following are summaries of some of the more significant provisions of the proposed regulations.

• Only capital gains are eligible for deferral. The proposed regulations make clear that only capital gains are eligible for deferral under the opportunity zone rules. Gains that are treated as ordinary income cannot be deferred under opportunity zone statute.
• Deferred gains retain their tax character. Generally, gain that is deferred under the opportunity zone rules will have the same character that it would have had if the gain had not been deferred. For example, if a taxpayer sold property that would have resulted in short-term capital gain and then deferred such gain by investing in a QOF, the gain will continue to be treated as short-term capital gain when ultimately recognized (i.e., when the taxpayer either sells an interest in a QOF or when gain is triggered on December 31, 2026), even if the taxpayer held the investment in the QOF for more than one year.
• Individuals, corporations, partnerships, and other pass-through entities may invest in QOFs. The proposed regulations provide that any person that realizes gains may defer recognition by investing in a QOF. Special rules apply to partnerships and other pass-through entities and their owners depending on whether the partnership or pass-through entity elects to defer gain.
• 10-year basis step-up will be available after the expiration of qualified opportunity zone designations. The qualified opportunity zones that were designated by the chief executives of each state generally will all expire on December 31, 2028. The proposed regulations provide that QOF interests that continue to be held after that date generally will continue to be eligible for the 10-year basis step up, despite the expiration of the opportunity zone designations.
• An LLC can be a QOF. The opportunity zone statute provides that any entity that is “organized” as a partnership or corporation may qualify as a QOF. As many practitioners expected, the proposed regulations interpret this to include any entity that is classified as a partnership or corporation for federal income tax purposes. Thus, under the proposed regulations an LLC that is classified as a corporation or a partnership for federal income tax purposes can qualify as a QOF if it meets all other requirements.
• QOFs may self-certify. The IRS will allow entities to self-certify as QOFs. To do so, an entity that meets all the applicable requirements must submit Form 8996 with its federal income tax return for the first year in which it will be treated as a QOF. The Form 8996 is required to be submitted each year to ensure that the QOF continues to qualify, including by satisfying the requirement that 90% of the value of its assets be qualified opportunity zone property.
• Special rules for real property. For property to constitute qualified opportunity zone business property, such property must, among other requirements, have been either originally placed in service or substantially improved by the owner entity. Property is considered substantially improved if, over a 30-month period, the entity makes additions to the property in an amount equal to the original basis of the property at the beginning of the 30-month period. The proposed regulations provide that for purposes of this test, in the case of real property, the original basis of the property does not include the value of the land. Instead, only the value of any existing improvements are taken into account. This allows for the substantial improvement requirement to be more easily satisfied in the case of investments that include improvements to real property.
• “Substantially all” means 70%. For a business to qualify as a qualified opportunity zone business, among other requirements, “substantially all” of its tangible property must be qualified opportunity zone business property. The proposed regulations interpret “substantially all” to mean 70% of an entity’s assets. The phrase “substantially all,” however, appears in many different sections of the opportunity zone rules and the Treasury Department made clear that the 70% definition of “substantially all” does not apply to those other references (relating to certain requirements for the holding period and usage of property in the business).
• Working capital safe harbor. Generally, only five percent of a qualified opportunity zone business’s assets may be “nonqualified financial property.” The proposed regulations create a safe harbor with respect to this requirement for working capital that (i) is designated in writing for the acquisition, construction, or substantial improvement of property in a qualified opportunity zone, (ii) is subject to a written schedule under which the working capital assets will spent within 31 months of the receipt by the business, and (iii) is actually used in a manner consistent with the written designation and schedule. In addition, any income derived from working capital assets is counted toward satisfaction of another requirement that 50 percent of the business’s gross income be attributable to the active conduct of a trade or business. This safe harbor does not appear to give a QOF additional time to satisfy the requirement that 90% of its assets be invested in qualified opportunity zone business property.

The proposed regulations answer a number of pressing questions regarding the interpretation of the QOF statutes, but leave open a number of unanswered questions. The Treasury Department recognized that significant questions remain to be answered and has indicated it expects to issue another set of proposed regulations by the end of this year, so interested parties should watch closely for additional guidance.

If you have questions about the new proposed regulations or opportunity zones in general, please contact one of the lawyers listed in this alert.