Authors: Patrick J. O’Sullivan and Louis Tuchman
On October 19, 2018, the Treasury Department issued proposed regulations that address many, but not all, of the open questions surrounding the Opportunity Zone tax incentive adopted as part of the Tax Cut and Jobs Act of 2017. The Treasury Department promises more regulations by the end of this year. In addition, the Internal Revenue Service (“IRS”) issued Revenue Ruling 2018-29, embodying some of the points in the proposed regulations.
The Opportunity Zone tax incentive allows a taxpayer to defer gains that are recognized before 2027 if such gains are re-invested, within 180 days after being recognized, in a Qualified Opportunity Fund (“QOF”). The gain is deferred until the QOF interest is sold, or, if earlier, December 31, 2026. If the taxpayer holds the QOF interest for 10 years, the taxpayer can elect to step-up the basis of the interest to fair market value upon disposition, thus eliminating the gain that accrues with respect to the investment in the QOF interest.
The QOF must invest its funds in a designated Opportunity Zone in accordance with the rules described below. Each state nominated certain census tracts as Opportunity Zones. The Treasury Department later approved those designations, and a complete list of census tracts has been published by the IRS.
Requirements in the statute
An entity can qualify as a QOF if 90 percent of its assets consist of qualified Opportunity Zone property; that is: (i) tangible property purchased 2017 and used in a trade or business located in an Opportunity Zone; or (ii) an interest in a corporation or partnership that is a qualified Opportunity Zone business. A QOF can self-certify by filing Form 8996, a draft of which was released by the IRS. To be a qualified Opportunity Zone business, substantially all of the corporation’s or partnership’s tangible assets must consist of qualified Opportunity Zone property and other conditions must be met. For property to qualify for these purposes, it must be “original use” property or be substantially improved. An asset is substantially improved if, over a 30-month period, the qualified Opportunity Zone business invests as much in improvements to the property as the amount of its acquisition cost. Further, no more than 5 percent of a qualified Opportunity Zone business’s assets can consist of nonqualified financial assets.
Proposed regulations
The proposed regulations provide rules to clarify that:
- The deferral of gain applies to any type of taxpayer – corporation, individual, partnership or trust. If the taxpayer is a pass-through entity, and elects not to reinvest and defer the gain, the individual partners (or the owners of the trust) can make the election individually.
- A QOF or the partnership or corporation in which the QOF invests can be a pre-existing entity provided it meets the statutory and regulatory requirements.
- The deferral of gain is only available for capital gain, not for ordinary income.
- In applying the substantial improvement test to real estate, the qualified Opportunity Zone business can ignore the cost allocated to land and invest an amount at least equal to the cost allocated to the existing improvements to satisfy the test.
- A qualified Opportunity Zone business may hold certain cash and cash equivalent assets as working capital for a 31-month period, without violating the ceiling on nonqualified financial assets, if it has a written plan identifying the assets as held for the acquisition, construction or substantial improvement of tangible property in the Opportunity Zone, with a schedule for use of the assets within 31 months.
- The step-up in basis after holding the QOF interest for more than 10 years is available even after the Opportunity Zone designation expires provided that the interest is sold before 2048.
- A qualified Opportunity Zone business meets the requirement that “substantially all” of its tangible assets consist of qualified Opportunity Zone property if at least 70 percent of its assets qualify.
Effective Dates
The regulations will not become effective until the end of a comment period and final publication by the Treasury Department. In the meantime, the regulations can be relied on by taxpayers who apply them in their entirety and with consistency.
Revenue Ruling
In addition to the proposed regulations, the IRS issued Revenue Ruling 2018-29 on October 19, 2018. The Revenue Ruling embodies the rules, contained in the proposed regulations, governing the applicability of the substantial improvement test to real property. Taxpayers can rely on the Revenue Ruling immediately, without regard to their ability to rely on the proposed regulations.
Related Content
Our August 2018 alert contains an overview of eligibility requirements and tax considerations for Opportunity Zones and Qualified Opportunity Funds, along with a link to maps of the 514 Opportunity Zones in New York State.
