As part of the Tax Cuts and Jobs Act (“TCJA”) signed into law on December 22, 2017, new tax incentives were created under Sections 1400Z-2 of the Internal Revenue Code (“IRC”), which allows you to elect to defer certain gains until as late as December 31, 2026, if those gains are reinvested in a Qualified Opportunity Fund (“QOF”) within 180 days. QOFs are required to invest in one or more businesses or property located in a Qualified Opportunity Zone (“QOZ”). To the extent an investment in a QOF is held for at least 5 (or 7) years, a taxpayer can permanently reduce the amount of the original gain to be recognized by 10% (or 15%), respectively. To the extent a QOF investment is held for at least 10 years, a taxpayer can elect to step up the basis of the investment to fair market value, ensuring that no gain will be recognized on the sale of the investment.
On October 19, 2018, the Treasury Department issued proposed regulations explaining the operation of the rules, and provided some much-needed guidance and clarity, along with several definitions of terms used in the law. The IRS also released Revenue Ruling 2018-29 to provide further clarification regarding the treatment of existing buildings and land located in QOZs. It is important to be aware of these new proposed regulations, and to review some of the following key highlights:
Taxpayers and gains eligible for deferral by rolling into a QOF
The proposed regulations clarify that the tax incentives offered under IRC Section 1400Z-2 are available only with respect to capital (not ordinary) gains reinvested in a QOF. The regulations also clarify that taxpayers eligible to elect deferral are those that recognize capital gain for Federal Income tax purposes. Therefore, individuals, C corporations (including RICs and REITs), partnerships and certain other pass-through entities are all eligible. There is also a special rule that allows pass-through owners to elect deferral with respect to their allocable share of a pass-through entity’s capital gain, as long as the pass-through entity does not elect deferral. Finally, taxpayers can roll over gains on sale of QOF investments by reinvesting those gains in other QOFs within 180 days of the transaction date. A taxpayer with a transaction occurring in 2018 may elect to invest in a QOF in 2019 if the investment in 2019 is within the 180-day rule.
Eligibility to make fair market value basis step-up election preserved until December 31, 2047
All Qualified Opportunity Zones (“QOZs”) were designated nationwide during 2018; under the law, the census tracts so designated retain that designation through December 31, 2028. The Proposed Regulations clarify that the ability to make the election to step up the basis of a taxpayer’s investment in a QOF to fair market value that has been held at least 10 years is preserved until December 31, 2047, regardless of whether the designation as a QOZ has expired.
Qualified Opportunity Fund requirements for self-certification
The proposed regulations provide guidance for qualification of entities as QOFs. Any entity taxable as a corporation or partnership (including a limited liability company) is eligible to elect to be a QOF as long as the requirements are met, including pre-existing entities. The election is made by filing the newly released Form 8996, in accordance with the filing instructions.
Original use or substantial improvement requirement for QOZ business property
In order for tangible property to meet the definition of QOZ business property, the original use must commence with the QOF or the QOZ business, or it must be substantially improved by the QOF or the QOZ business. The law provides that at least 100% of the adjusted basis of the property must be spent improving the property within a 30-month period in order to be considered “substantially improved.” The proposed regulations and the related Revenue Ruling 2018-29 clarify that land is not subject to the original use requirement and is not required to be substantially improved in order to be considered QOZ property. Existing buildings must be substantially improved by expenditures at least equal to the basis of the building within a 30 month period in order to be considered QOZ property.
Qualified Opportunity Zone business requirements
Under the law, at least 90% of a QOF’s assets must consist of QOZ property which can be either (1) QOZ stock; (2) QOZ partnership interest or (3) QOZ business property. If a QOF invests in QOZ stock or QOZ partnership interest, those entities are subject to additional requirements. One of those requirements is that the entity must be a QOZ business. Substantially all of the entity’s tangible property must be QOZ business property, and less than 5% of its assets can be nonqualified financial property. The proposed regulations clarify that the term “substantially all” means 70%, and that reasonable working capital will not be treated as “nonqualified financial property” to the extent that it meets a safe harbor test. There is a safe-harbor of up to 31 months for reasonable working capital held by a QOZ business that allows the QOF to treat its investment in such business as QOZ property.
Use of Leverage in Real Estate Transactions
While the use of leverage in real estate transactions will be available for developer/sponsors for a source of funding capital improvements, the general rule will be that the basis associated with the leverage will not have the tax attributes associated with the leverage amounts. However, various structuring opportunities exist to enhance returns on capital. Stay tuned for a separate Cherry Bekaert update on the use of debt in an Opportunity Zone.
