IRS Proposed Regulations for Opportunity Zones
On April 17th, 2019, the IRS published proposed regulations for Opportunity Zones. These latest regulations are an extension, rather than a replacement, of the regulations proposed in October of 2018. A third set of regulations is still expected within the coming months. Opportunity Zones is a provision from the Tax Cuts and Jobs Act that creates an attractive set of tax incentives intended to encourage investments in economically-distressed communities. Under this provision, investors that wish to defer capital gains recognized upon a sale or exchange of an asset to an unrelated party (and to derive other tax benefits) can invest that gain in a Qualified Opportunity Fund, which in turn invests in so-called “Qualified Opportunity Zone Property.”
First Round of Proposed Regulations (October 2018)
In October 2018, the IRS released its first set of guidance on the Opportunity Zone program. These regulations, outlined below, spoke to the business aspects of the program but did not address concerns that pertain to the communities the program will serve.
The proposed regulations generally permit any taxpayer that is a corporation or partnership for tax purposes to self-certify as a Qualified Opportunity Fund, provided that the entity self-certifying is statutorily eligible to do so.
The proposed regulations provide that for a gain to be eligible it must:
(a) be treated as a capital gain for income tax purposes;
(b) be recognized (subject to deferral under these rules) prior to January 1, 2027; and
(c) not arise from a sale or exchange with a related party.
The proposed regulations include special rules for section 1256 contracts and capital gain arising from a position that is part of an “offsetting-positions transaction.”
180-Day Investment Period
An investment of eligible gains into a Qualified Opportunity Fund must be made within a 180-day period beginning on the date of the transaction(s) giving rise to the gain.
Investment of Amounts in Excess of Eligible Gain
If an investor makes an investment in a Qualified Opportunity Fund that is in excess of its eligible gains, its investment in the Qualified Opportunity Fund is treated as two separate investments: one investment relating to its recent sales or exchanges, which may qualify for the Qualified Opportunity Zone tax benefits; and a separate investment, consisting of the excess amount, which will not qualify for those tax benefits.
Special Rule for Offsetting-Position Transactions
Any capital gain from a position that is or has been part of an “offsetting-positions transaction” is not eligible to receive Qualified Opportunity Zone tax benefits upon investment in a Qualified Opportunity Fund. For the purposes of Qualified Opportunity Zones, an “offsetting-positions transaction” means any straddle and/or any other transaction in which a taxpayer has substantially diminished its risk of loss from holding one position with respect to personal property by holding one or more other positions with respect to personal property (whether or not of the same kind), regardless of whether either of the positions is with respect to actively traded personal property.
Electing Qualified Opportunity Zone Gain Deferral
A taxpayer can self-elect the Qualified Opportunity Zone gain-deferral on Form 8949 (Sales and Other Dispositions of Capital Assets) to be attached to its federal income tax return for the taxable year in which the gain would have been recognized if it had not been deferred.
Second Round of Proposed Regulations (April 2019)
The Treasury released the second set of program guidelines, and businesses and groups that had lobbied for flexibility in claiming the tax breaks should be satisfied with the released regulations. Some of the key regulations are highlighted below and are subject to change prior to posting in the Federal Registrar.
Deferral of Gains
The new regulations permit the deferral of all or part of a gain invested in a Qualified Opportunity Fund that would otherwise be includable in income. The gain is deferred until the investment is sold or exchanged or Dec. 31, 2026, whichever date comes first.
Property Disposition and Interim Gains
The proposed regulations provide that proceeds received by the Qualified Opportunity Fund from the sale or disposition of Qualified Opportunity Zone Business Property are treated as Qualified Opportunity Zone Property for purposes of the 90-percent asset test, so long as the Qualified Opportunity Fund reinvests the proceeds within 12 months. These sale proceeds must be held in cash, cash equivalents, and debt instruments with a term of 18 months or less in order to qualify. The rules clarify that sales of assets by Qualified Opportunity Funds do not impact an investor’s holding period in the Qualified Opportunity Fund.
10-Year Hold Period
If the investment is held for at least 10 years, investors may be able to permanently exclude the gain from the sale or exchange of an investment in a Qualified Opportunity Fund.
Working Capital Safe Harbor
For a Qualified Opportunity Zone Business to meet the requirements for the 31-month working capital safe harbor, it must designate in writing the planned use of working capital, including, when appropriate, the acquisition, construction, and/or substantial improvement of tangible property in a Qualified Opportunity Zone. The proposed regulations expanded the safe harbor to include the development of a trade or business in the Qualified Opportunity Zone. Serial and overlapping 31-month working capital safe harbor periods are now expressly permitted.
Substantial Improvement Test
To facilitate investments into existing businesses as intended, Qualified Opportunity Zone Businesses should be allowed to elect to treat all of the tangible property of a trade or business as a single property for purposes of the substantial improvement test. The substantial improvement requirement is applied on an asset-by-asset basis, which could be cumbersome and complex for operating businesses. However, the Treasury is considering applying an aggregate standard for the substantial improvement requirement and requests comments on the advantages and disadvantages of such an approach. Stay tuned for additional developments regarding the substantial improvement test.
The regulations provide that leased tangible property can be treated as Qualified Opportunity Zone Business Property for the 90-percent asset test and 70-percent substantially all requirement. The regulations provide an anti-abuse rule to prevent the use of leases to circumvent the substantial improvement requirement for real property other than unimproved land. If there was a plan to purchase the property for an amount other than fair market value at the time of purchase, the leased property is not Qualified Opportunity Zone Business Property.
The proposed regulations state that a partner who receives a debt-financed distribution from a partnership would only recognize taxable income or gain to the extent that the distribution exceeds that partner’s basis in their partnership interest.
More to Come
Comments will be accepted for the 60 days following when the regulations post to the Federal Register. The Treasury and the IRS intend to hold a public hearing on July 9, 2019. We anticipate a third and final round of regulations later this year that will focus on anti-abuse policies and reporting requirements.
Our Tax Team has extensive knowledge on this topic and is positioned to assist in structuring opportunity zone funds and to help with making investments within the designated zones. For more information, please connect with us.
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