First round of proposed regulations issued for opportunity zones

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1 First round of proposed regulations issued for opportunity zones A trending aspect of the Tax Cuts and Jobs Act (TCJA) is the creation of a new incentive, Opportunity zones, intended to direct new investments into distressed communities. This incentive allows individuals, partnerships, corporations, trusts, and estates to defer capital gain as well as potentially exclude portions of current and future gains by investing capital gains into qualified opportunity funds (QOFs). Taxpayers that fund contributions to QOFs with capital gains receive the following benefits: Deferral of the capital gain used to fund the investment in the QOF until Dec. 31, 2026, (or until the sale of the QOF, if earlier) Exclusion of 10 or 15 percent of the capital gain used to fund the investment in the QOF if the QOF is held five or seven years when the deferred capital gain is recognized 100 percent exclusion of gain on the appreciation in a QOF investment when such interest is sold after being held for at least 10 years Several of the most significant opportunity zone program requirements include: Capitals gains must be reinvested into a QOF within 180 days. In contrast to Section 1031 Likekind Exchanges, the opportunity zone program does not require the use of an intermediary and only the gain (versus proceeds) is required to be reinvested. Investments in QOFs that exceed the investor s capital gains within 180 days are not eligible for any of the deferral or exclusion benefits. A QOF can be any partnership or corporation that self-certifies as a QOF by completing and attaching a tax form to its timely filed tax return. Such certification is not an application that the IRS is required to approve.

2 The vast majority of the QOF s tangible property must meet the definition of qualified opportunity zone business property, which is tangible property: o Acquired by purchase after Dec. 31, 2017, from an unrelated party o The original use of which commenced with the QOF or the QOF substantially improved the property (by doubling the property s basis within any 30-month period after acquisition) o Substantially all of the use of such property is in an opportunity zone during substantially all of the QOF s holding period If the QOF directly owns the tangible property, then 90 percent of such property must be qualified opportunity zone business property. If the QOF indirectly owns the property through a portfolio company (i.e., a qualified opportunity zone business), then substantially all of such property must be a qualified opportunity zone business property. A qualified opportunity zone business can be either a partnership or a corporation. In addition to being subject to the tangible property test discussed above, such entities are also required to generate 50 percent of their gross income from the active conduct of a trade or business, and they are required to use a substantial portion of their intangible property in such trade or business. QOFs are subject to monthly penalties to the extent that less than 90 percent of their assets are qualified opportunity zone property, which is defined to include qualified opportunity zone business property owned directly by the qof and qualified opportunity zone businesses. As taxpayers and their advisors have sought to understand this new incentive, many interpretational questions have arisen. These range from basic definitional issues to more complex computational and structuring matters. On Oct. 19, 2018, the Treasury Department and IRS provided the first round of authoritative answers in the form of proposed regulations and a revenue ruling. While these regulations do not answer all questions, they are a significant first step in implementing opportunity zones. See below for a summary of key takeaways for both potential investors and potential QOFs. For potential investors These proposed regulations provide guidance for taxpayers considering an opportunity zone investment. In particular, these clarify how to qualify for the potential tax benefits and the treatment of deferred and excluded gains. What types of gains are eligible for deferral? Consistent with the title of the statute, ( Special rules for capital gains invested in opportunity zones ), only gains taxed as capital gains are eligible for deferral. For this purpose, capital gains include gains that actually result from a sale or exchange as well as gains that are deemed to result from a sale or exchange and any other gain that is required to be included in a taxpayer s computation of capital gain, such as capital gains resulting from dividend distributions from real estate investment trusts (REITs) or regulated investment companies (RICs). Eligible capital gains also include those reported under the Section 1256 mark to market rules. The regulations even allow additional deferral of the original deferred gain if the taxpayer sells its interest in the QOF before Dec. 31, 2026, and reinvests such gain in another QOF. The regulations also clarify that a single capital gain can be deferred via multiple separate investments in QOFs. Further, the proposed regulations clarify that when the deferred gain is recognized (at the earlier of Dec. 31, 2

3 2026, or disposal of the QOF interest), the attributes of the gain at the time of deferral will carry over to the year of inclusion (e.g., short term vs. long term, etc.). A number of different gains are treated as capital gain for federal income tax purposes. The proposed regulations do not provide a specific listing of all types that are eligible for deferral. However, we expect eligible gains to include normal short- and long-term capital gains, net Section 1231 gains that are treated as long-term capital gains, capital gain dividend distributions from REITs and RICs, and Section 1256 gains. Items like unrecaptured Section 1250 gain would also appear to qualify since they are taxed as capital gains on Schedule D, albeit at special rates. The preamble to the proposed regulations suggests that the deferral election will be made on Form 8949, which draws into question how deferrals of capital gains that are not traditional short- and long-term gains will be reported, since only gains and losses from capital assets are reported on Form Although the broad interpretation of capital gain is generally taxpayer favorable, it creates some potential dilemmas. For example, it is possible that a taxpayer that recognizes Section 1231 gain early in the tax year may be required to invest such capital gain in a QOF before they know for sure that such gain will be taxed as capital gain (e.g., after investing in a QOF, the taxpayer could either recognize a Section 1231 loss or receive a Schedule K-1, reflecting a Section 1231 loss thus reducing the amount of Section 1231 gain taxable as capital gain). Although the regulations answer many questions related to the type of gains eligible for deferral, they raise several additional questions, including: Will taxpayers be allowed to pick and choose which gains they would like to defer if they have a variety of capital gains eligible for deferral on the date they invest in a QOF (e.g., if a taxpayer has both short-term and long-term capital gains or if they have both unrecaptured Section 1250 gain and long-term capital gain)? Can a taxpayer defer an amount that exceeds its net capital gains? For example, if a taxpayer has a $100,000 long-term capital gain and a $40,000 short-term capital loss, can they defer the gross capital gain ($100,000), or are they limited to the net capital gain ($60,000)? When a pass-through entity (PTE) has a capital gain, does the entity have to invest in a QOF to defer the gain or can each owner/beneficiary make their own decision to defer gain by investing in a QOF? The proposed regulations provide very favorable guidance that allows either the PTE or its owners/beneficiaries to defer PTE-level gain by making an investment in a QOF. However, an owner/beneficiary of a PTE can only defer gain to the extent that the PTE does not elect to defer the gain. Capital gain deferred by the PTE is not passed through to the owners/beneficiaries, and it does not increase their basis in the entity. Capital gain not deferred by the entity is treated as it always has been i.e., it passes through to the owners/beneficiaries, and it increases their basis in the entity. Each owner/beneficiary s distributive share of such pass-through capital gain is eligible to be deferred to the extent that they make an investment in a QOF within the required time period. The regulations also provide very favorable guidance regarding the period for making such investment. In particular, the owners/beneficiaries of a PTE can make the investment in a QOF as early as the date that the PTE recognizes the gain or as 3

4 late as 180 days after the end of the PTE tax year in which the PTE recognized the gain. However, an owner/beneficiary cannot defer gain if either they or the PTE is related to the buyer. In most cases, it will be better for the owners/beneficiaries of a PTE (rather than the PTE itself) to make the investment in a QOF. Advantages of owner investment include: More flexibility regarding the time when the investment into the QOF must be made Provides each individual owner/beneficiary with the ability to opt out of the deferral Allows individual owners/beneficiaries to invest in different QOFs Avoids potential inequities that could occur if there are changes in either the owners/beneficiaries or their profit-sharing allocations between the date of the sale/exchange and the date the deferred gain becomes taxable Provides each owner/beneficiary with more flexibility regarding the timing of their sale of the investment in the QOF Also, it is not clear how or if a PTE will be allowed to defer a Section 1231 gain because such gains are not per se capital gains, and the tax treatment of Section 1231 gains is determined at the individual level not at the entity level. If a PTE decides not to defer its capital gains, it will be important for them to determine each owner/beneficiary s distributive share of such gain and communicate such information on a timely basis so that each owner/beneficiary knows how much they need to invest in a QOF to defer their share of the gain. Such communication will be particularly important in 2019 and 2021, so that the owners/beneficiaries can maximize their 15 percent and 10 percent gain exclusion by making investments in QOFs before the end of those respective calendar years. Mid-year reporting on significant capital transactions will be very helpful to owners for planning purposes. Finally, the PTE should consider distributing part or all of the proceeds from the sale to the owners/beneficiaries to enable them to make an investment in a QOF on a timely basis. How does debt affect a QOF investment? The proposed regulations clarify that a qualified investment in a QOF must be structured so that it is respected as an equity investment for tax purposes. Preferred equity and a partnership interest with special allocations will generally be respected as equity for purposes of QOF investments. Additionally, the proposed regulations confirm that deemed contributions under Section 752(a) related to allocations of QOF debt in a fund organized as a partnership do not constitute an investment in a QOF, and therefore do not cause an investor to be subject to the mixed fund rules. Mixed fund rules apply where the taxpayer is investing into a QOF with both deferred gains and nondeferred gains (e.g., cash on hand). Finally, the regulations clarify that a taxpayer can pledge its equity interest in a QOF as collateral for a loan, whether as part of a purchase money borrowing or otherwise, without impairing the status of the QOF investment as an eligible interest. 4

5 As opportunity zones benefits only apply to the portion of investments funded with gains deferred under Section 1400Z-2(a), the regulations alleviated concerns that the allocation of liabilities under Section 752(a) could dilute a QOF investor s eligibility for gain exclusion upon sale of the QOF investment after a 10-year holding period. Note that while the proposed rules state that an eligible taxpayer cannot treat a debt instrument as an eligible investment, they do not appear to prohibit an investor from making a loan to a QOF in addition to their equity interest. When must an investor dispose of their QOF interest to obtain the step-up to Fair Market Value? As written, opportunity zone designations expire on Dec. 31, Section 1400Z-2(c) allows a taxpayer who has held their QOF investment for at least 10 years prior to disposal to elect to step-up their basis in the investment to fair market value upon sale, thus eliminating any gain on the sale. The proposed regulations clarify that the benefits under 1400Z-2(c) extend through Dec. 31, 2047, despite the fact that opportunity zone designations expire on Dec. 31, This allows a taxpayer to make an investment into a QOF on the last date that a deferral election can be made and still benefit from the basis step-up election after holding the investment for as long as 20 ½ years. However, the regulations require QOF investors to sell their investment in the QOF by 12/31/47 to benefit from the fair market value basis step-up election. The regulations alleviate any concern that a plain reading of the statute could prevent QOF investors from realizing benefits of the opportunity zones program after the expiration of the opportunity zones designations on Dec. 31, The preamble to the proposed regulations includes a detailed description of the pros and cons of four alternatives that the Treasury Department considered regarding the interaction between the expiration of designated zones and the election to exclude gain for investments held at least 10 years. Although the proposed regulation reflect Treasury s preferred solution (i.e., establishing a clear deadline to elect the post-10-year gain exclusion), they invite comments on other alternatives, including whether or not the regulations should provide for a presumed basis step-up election immediately before the ability to elect a step-up upon disposition expires. For potential qualified opportunity funds The proposed regulations and revenue ruling also cover a variety of topics that provide potential QOFs with additional guidance on how to qualify and how various testing requirements will be measured. What types of entities are eligible to be QOFs or qualified opportunity zone businesses? An entity is eligible to be a QOF or a qualified opportunity zone business if it is treated as either a partnership or corporation for federal tax purposes, and it is created or organized in one of the 50 states, the District of Columbia, or a U.S. possession. The regulations also clarify that pre-existing 5

6 entities are eligible to be QOFs and qualified opportunity zone businesses as long as they meet all of the QOF or qualified opportunity zone business requirements outlined in Section 1400Z-2(d). The proposed regulations rely on the tax classification of an entity, either a partnership or corporation, when determining eligibility as a QOF or a qualified opportunity zone business. This indicates that a state law limited liability company (LLC) is eligible as long as it is treated as a partnership or corporation for federal income tax purposes. Based on a literal interpretation of the statute, prior to the release of the regulations, some commentators speculated that a QOF or qualified opportunity zone business would need to be either a state law corporation or partnership. It will be challenging for pre-existing businesses to meet the QOF and qualified opportunity zone business requirements considering that either 90 percent or substantially all of their tangible property must be qualified opportunity zone business property, which excludes any property acquired on or before Dec. 31, With that in mind, the preamble to the regulations invites comments on whether there is a statutory basis for additional flexibilities that might facilitate qualification of a greater number of pre-existing entities across broad categories of industries. As mentioned in the preamble to the proposed regulations, the IRS released a draft version of Form 8996 and its instructions contemporaneous with the release of the regulations. QOFs will be required to attach Form 8996 to a timely filed tax return to self-certify as a QOF, report annual compliance with the 90 percent asset test (discussed below), and calculate any penalty for failure to satisfy the 90 percent test. It is worth noting that Form 8996 includes a requirement that before the end of first QOF year, the QOF s organization documents must include a statement regarding its purpose of investing in qualified opportunity zone property and a description of the qualified opportunity zone business(es) that the QOF expects to engage in either directly or indirectly through a first-tier portfolio company. A single-member LLC treated as a disregarded entity for federal income tax purposes could not itself be a QOF. Does a QOF have any flexibility to determine when its self-certification will become effective? The proposed regulations allow a QOF to choose both the taxable year and first month in that year when its self-certification will become effective. Form 8996 must be filed to identify such dates. The form must be filed with the QOF s tax return for the year that the self-certification will become effective. If the QOF s initial Form 8996 does not identify the first month it will be treated as a QOF, the regulations provide that the QOF election will be effective at the beginning of such tax year. It is important that a QOF choose a start date prior to the first date in which an investor makes a deferral election under 1400Z-2(a), otherwise, any deferral elections made for investments preceding the effective date of the QOF self-certification will be invalid. 6

7 As a result of the latitude granted to QOFs to choose the effective date of their selfcertification, a fund whose initial month falls during the last six months of its initial QOF year will only be required to compute the 90 percent asset test (discussed below) once in its initial QOF year. The end of the taxable year is a required testing date. Consequently, a fund whose first month is late in the year will have its first testing period sooner than six months. The proposed regulations indicate that the penalty for failure to meet the 90 percent test will not apply to any months prior to the first month the entity chooses to be treated as a QOF. Will a QOF be allowed a grace period to deploy cash into qualified opportunity zone property without penalty? The proposed regulations include a safe harbor that applies to qualified opportunity zone businesses and allows such businesses to carry reasonable working capital provided that they: Have a written plan identifying such funds as held for acquisition, construction, or substantial improvement of tangible property in an opportunity zone (including ancillary but necessary expenditures for the project). Have a written schedule showing that the funds will be used within 31 months of the receipt of such funds by the business. Comply with the schedule. A qualified opportunity zone business will enjoy the following benefits to the extent that it complies with the safe harbor during its tax year: Any gross income earned on the reasonable working capital will be counted toward satisfaction of the requirement that 50 percent of the qualified opportunity zone business s gross income is derived from the active conduct of a trade or business in the opportunity zone. The business will be treated as satisfying the requirement that a substantial portion of the business s intangible property is used in the active conduct of a trade or business in the opportunity zone. The business s reasonable working capital will be treated as qualified opportunity zone business property for purposes of determining if substantially all of its tangible property is qualified opportunity zone business property, provided that the tangible property is expected to satisfy the requirements of qualified opportunity zone business property as a result of the planned expenditure of the working capital. The basis of an existing building that the business is planning to improve will not fail the substantial improvement test even if the business s basis in the building has not yet doubled. The business s reasonable working capital will not be nonqualified financial property. The preamble to the proposed regulations acknowledges that Treasury created the safe harbor in response to comments indicating that developing a new business and constructing or rehabilitating real estate may take longer than six months. The preamble suggests that the intention of this safe harbor was to alleviate hesitation that a potential QOF investor may have regarding a QOF s ability to deploy its invested equity soon enough to satisfy the 90 percent test. However, the proposed regulations appear to limit the applicability of this working capital safe harbor to qualified opportunity zone businesses. If so, QOFs can only utilize this safe harbor to the extent that they make investments indirectly through portfolio companies. In the 7

8 absence of a safe harbor applicable to working capital that a QOF holds directly, QOFs will need to carefully balance their acceptance of deferred gains and the deployment of such capital into qualifying investments. In addition, QOFs should do their best to invest cash received from investors in qualified opportunity zone property before the next applicable semiannual testing date. The preamble requests comments on the adequacy of working capital safe harbor. We anticipate that many comments will be submitted requesting the safe harbor to be extended to working capital held directly by a QOF for acquisition of qualified opportunity zone business property directly by the QOF. We also anticipate comments suggesting to expand the safe harbor beyond the acquisition, construction, or rehabilitation of tangible business property. What valuation method can a QOF use to apply the 90 percent qualified opportunity zone property test? Also, what valuation method can a qualified opportunity zone business use to apply the substantially all requirement related to its tangible property? Section 1400Z-2(d)(1) requires that a QOF hold an average of at least 90 percent of its assets in qualified opportunity zone property to avoid penalties. In calculating this average, the asset values are required to be determined in a manner consistent with the value of the assets as reported on the QOF s applicable financial statements for the relevant reporting period. If the entity does not have applicable financial statements, the cost-basis method is the default. Similar rules apply in determining if substantially all of a qualified opportunity zone business s tangible property is qualified opportunity zone business property. However, if the qualified opportunity zone business does not have an applicable financial statement, the regulations allow the qualified opportunity zone business to use the same valuation method as its upper-tier QOF, unless the qualified opportunity zone business has two or more upper-tier QOFs that own at least 5 percent, in which case the qualified opportunity zone business can use the valuation method that results in the highest percentage of qualified opportunity zone business property as long as such valuation method is consistent with the method used by one of its 5 percent QOF owners. In addition to financial statements required to be filed with the SEC or other federal agencies, the definition of applicable financial statements includes certified audited financial statements prepared in accordance with U.S. GAAP used for lending decisions or by equity holders for evaluating their investments provided that these statements contain values for eligible positions that are used in substantially all of the significant management functions of the business. Since GAAP-basis financial statements reflect tangible assets net of depreciation, there could be dramatic differences applying the 90 percent test based upon GAAP values vs. cost basis, particularly for pre-existing businesses that may have significant assets acquired on or before Dec. 31, To the extent that the valuation method could make a difference in whether or not the QOF passes the test, the QOF should consider taking steps that will enable it to qualify to use the valuation method that is expected to be most favorable. 8

9 The preamble to the regulations requests comments on these valuation methods and whether another method, such as tax-adjusted basis, would be better for purposes of assurance and administration. As discussed above, since Treasury is interested in ways to facilitate qualification of a greater number of pre-existing entities across broad categories of industries, Treasury should reconsider the requirement to use the cost-basis method, which does not reflect depreciation. Do the proposed regulations clarify how to be treated as a qualified opportunity zone business (e.g., how to determine if substantially all tangible property is qualified opportunity zone business property, how to apply the 50 percent gross income and substantial use of intangible assets tests, etc.)? As discussed above, at least 90 percent of a QOF s assets must be qualified opportunity zone property, which includes qualified opportunity zone business property owned directly by the QOF and qualified opportunity zone businesses owned by the QOF. Substantially all of the tangible property owned or leased by a qualified opportunity zone business must be qualified opportunity zone business property. The proposed regulations define substantially all as at least 70 percent. The proposed regulations also clarify that for each taxable year at least 50 percent of the gross income of a qualified opportunity zone business must be derived from the active conduct of a trade or business in the opportunity zone. The regulations also clarify that with respect to any taxable year, a substantial portion of the intangible property of a qualified opportunity zone business must be used in the active conduct of a trade or business in the opportunity zone. The preamble to the proposed regulations acknowledges that substantially all is used multiple times in Section 1400Z-2, but these proposed regulations only attempt to define the one specific occurrence of this term that defines the requirement for tangible assets of a qualified opportunity zones business. It is clear that Treasury adopted a more favorable definition of substantially all to make it easier for operating businesses to benefit from investments by QOFs. The preamble to the proposed regulations acknowledges that the 70 percent threshold will give QOFs an incentive to invest in qualified opportunity zone businesses rather than own qualified opportunity zone business property directly. As discussed above, the working capital safe harbor provisions of the proposed regulations also provides an incentive for QOFs to invest in qualified opportunity zone businesses. In addition, the proposed regulations clarify that the gross income and intangible assets tests must be satisfied solely by activity within the opportunity zone. Such interpretation raises additional questions, including how to identify where gross income is earned and how to determine where a business uses its intangible assets. Unfortunately, Treasury s position on these tests will make it even more difficult to use the opportunity zone program to finance operating businesses. 9

10 How is land handled in applying the definition of qualified opportunity zone business property to determine if the original use of tangible property commenced with the QOF and in applying the substantial improvement test? Both the proposed regulations and Revenue Ruling provide additional clarity around the treatment of land that is wholly within an opportunity zone for purposes of the original use and substantial improvement tests. The Law and Analysis section of this revenue ruling acknowledges that land can never have its original use in an opportunity zone commence with a QOF due to its permanence. Despite such statement, the ruling provides that if a QOF purchases an existing building located on land that is wholly within an opportunity zone, the original use of the building in the opportunity zone is not considered to have commenced with the QOF, and the original use test is not applicable to the land on which a building is located. Since the original use of the building in the opportunity zone is not considered to have commenced with the QOF, the building will only be considered qualified opportunity zone business property if it is substantially improved. The ruling and regulations also provide that: (1) a substantial improvement to the building is measured by the QOF s additions to the adjusted basis of the building (excluding the basis allocable to land); and (2) measuring a substantial improvement to the building by additions to the QOF s adjusted basis of the building does not require the QOF to separately substantially improve the land upon which the building is located. Rev. Rul and the proposed regulations provide that the purchase price allocated to the land is not taken into consideration when determining the amount of required substantial improvement to an existing structure. Whenever building improvements are less than the total purchase price (including land), it will be important to support the purchase price allocation between land and the existing structures. While helpful, the revenue ruling and the related provisions regarding land in the proposed regulations raise additional questions, including: Since the guidance stops short of saying that land can be qualified opportunity zone business property, is it appropriate to assume that land can be treated as qualified opportunity zone business property regardless of the fact that its original use can never commence with a QOF? Note that the revenue ruling holds that the original use requirement is not applicable to the land on which the building is located. If so, does an existing building need to be substantially improved, or does a new building need to be constructed before the underlying land can be considered qualified opportunity zone business property? Also noteworthy within this revenue ruling are two other references. First, the purchase of a building that has been vacant for a period of time and conversion to a new use will not qualify as original use of an existing structure. Additionally, the example in the ruling refers to a conversion of a factory to a residential rental property. While not explicitly stated in the revenue ruling or the proposed regulations, such reference provides additional confidence that residential rental real estate can qualify as a trade or business for purposes of Section 1400Z

11 What s next? Finally, it appears that provisions in the proposed regulations regarding special rules for land and improvement on land held by qualified opportunity zone businesses inadvertently refer to the owner as the QOF instead of the qualified opportunity zone business, which could raise questions about the applicability of such rules to qualified opportunity zone businesses until/if the references are corrected in the final regulations. A comment period on the proposed regulations is now underway, and a public hearing has also been scheduled for Jan. 10, As noted many times throughout the preamble to the proposed regulations, the Treasury Department and IRS are actively seeking input on these rules. Accordingly, the regulations will likely change in some respects based on comments that are submitted. Until that time, taxpayers are permitted to rely on the proposed regulations. Overall, these regulations provide a good degree of clarity and allow investors, businesses, and fund managers to proceed with more certainty. However, there are still many unanswered questions. At least one additional set of proposed regulations is expected prior to year end. Visit plantemoran.com/opportunityzones for the latest guidance and analysis. If you have any questions, please contact your tax advisor or: Valerie Grunduski valerie.grunduski@plantemoran.com Gordon Goldie gordon.goldie@plantemoran.com Greg Harris greg.harris@plantemoran.com The information provided in this alert is only a general summary and is being distributed with the understanding that Plante & Moran, PLLC, is not rendering legal, tax, accounting, or other professional advice, position, or opinions on specific facts or matters and, accordingly, assumes no liability whatsoever in connection with its use. 11