Treasury Issues Highly Anticipated Guidance Clarifying the Deferral of Gains Invested in Qualified Opportunity Zone Funds
On October 19, 2018, the Internal Revenue Service (“IRS”) issued highly anticipated guidance regarding the Qualified Opportunity Zone Program (the “QOZ Program”). The guidance consists of proposed treasury regulations under Code Section 1400Z-2 of the Internal Revenue Code, as amended (the “Code”), Revenue Ruling 2018-29, an updated Q&A document, which can be found here, and a draft IRS Form 8996, Qualified Opportunity Fund, and instructions thereto. The newly issued guidance answers a number of questions regarding qualifying for the tax breaks associated with the QOZ Program, and is likely to spur significant activity from investors and funds that have thus far put their decisions regarding investments in Qualified Opportunity Zones (“QOZs”) on hold. The Treasury Department anticipates issuing additional guidance later this year.
The QOZ Program, enacted as part of The Tax Cuts and Jobs Act, is designed to promote and drive investment in low-income communities by allowing taxpayers to defer, and potentially reduce, the recognition of capital gain if the taxpayer invests capital gain proceeds in a QOF within 180 days of the underlying sale and prior to December 31, 2026. Further, if the taxpayer holds the investment in the QOF for at least 10 years, the taxpayer will be allowed to exclude the entire gain on all appreciation of the QOF during the investment period. For more information regarding The Tax Cuts and Jobs Act, please review our previous client alert by clicking here.
A variety of questions regarding how to structure investments that would qualify for the tax incentives offered by the QOZ Program and how QOFs would work emerged, leaving potential investors pondering on whether or not to take advantage of the program. The recently issued guidance is a good first step toward providing answers to such questions.
The Proposed Regulations
Below is a summary of the major issues addressed by the Proposed Regulations.
Capital Gains Only
The Proposed Regulations clarify that only capital gains are eligible for deferral. Specifically, gains are eligible for deferral only if: (1) the gains are treated as capital gains for Federal income tax purposes; (2) the gains would be recognized, if deferral under Code Section 1400-2(a)(1) were not permitted, no later than December 31, 2026, and (3) the gains do not arise from a sale or exchange with a related person. Deemed contributions of money to a partnership pursuant to Code Section 752(a) do not result in a QOF eligible investment for purposes of the QOZ Program.
Under the Proposed Regulations, an “eligible interest” in a QOF is an equity interest issued by the QOF, including preferred stock or a partnership interest with special allocations. Debt instruments are not considered eligible interests. The Proposed Regulations permit an eligible interest to be used as collateral, provided that the taxpayer is treated as the owner of the equity interest for Federal income tax purposes.
The Proposed Regulations clarify that eligible taxpayers include: (1) individuals; (2) corporations; (3) partnerships; (4) common trust funds under Code Section 584; (5) qualified settlement funds; (6) disputed ownership funds; and (7) other entities taxable under Treas. Reg. Section 1.468B.
The Proposed Regulations provide rules regarding a corporation’s or partnership’s ability to self-certify as a QOF. To qualify, the certification: (i) must identify the first taxable year that the eligible entity elects to be a QOF, and (ii) may identify the first month (in that initial taxable year) in which the eligible entity elects to be a QOF. If the self-certification does not specify the month, then the first month of the eligible entity’s initial taxable year as a QOF will be the first month that the eligible entity is a QOF. Critically, a deferral election may only be made for investments in a QOF. Therefore, if an investment in eligible interests of an eligible entity occurs prior to the eligible entity’s first month as a QOF, the deferral election will be invalid.
Pre-existing entities may qualify for self-certification, but only if all of the requirements of Code Section 1400Z-2 and the regulations thereunder are satisfied, including the requirements regarding QOZ property being acquired after December 31, 2017.
As part of the guidance, the IRS issued a draft of Form 8996, Qualified Opportunity Fund. Form 8996 must be filed both for initial self-certification and for annual reporting of compliance with the 90 percent asset test. The Form 8996 can be found here.
180-Day Rule for Deferring Gain
A taxpayer must invest eligible capital gains into a QOF during a 180-day period beginning on the date of the sale or exchange giving rise to the gains. The Proposed Regulations clarify that, except as specifically provided in the regulations, the first day of the 180-day period is the date on which the gains would be recognized for Federal income tax purposes, without regard to the deferral under the QOZ Program. The clarification addresses the uncertainly which arises in situations where the statute providing capital gain treatment of an asset does not provide a specific date for the deemed sale or exchange.
The Proposed Regulations also provide that a taxpayer may reinvest gain, previously invested in a QOF, in another QOF if the taxpayer does so within 180 days of the date of the inclusion-triggering disposition. [It is not clear whether this subsequent deferral of gains permits the deferral of gains earned from the investment of the original gains].
The Proposed Regulations describe rules for how partnerships and partners in a partnership may invest in a QOF and elect to defer recognition of capital gains. Under the Proposed Regulations, both the partnerships and their partners are eligible to defer all or a portion of capital gains.
If a partnership makes the election, the deferred gain with respect to which the election is made will not be included in the partner’s distributive share of the partnership’s capital gains. If the partnership does not make the election, a partner may elect its own deferral with respect to the partner’s distributive share of capital gains from the partnership, subject to certain requirements.
The partner’s 180-day period to make the required election will begin on the last day of the partnership’s taxable year, but the partner in some instances may be able to elect the date of the partnership’s gain (i.e., the date of sale) to commence its 180-day period.
Valuation of QOF Assets for Purposes of the 90% Asset Test
A QOF must hold 90% of its assets in QOZ property, such as stock or a partnership interest in a QOZ business. The Proposed Regulations contain a reasonable working capital safe harbor for QOZ businesses that acquire, construct and/or improve tangible business property used in a business located in a QOZ. Specifically, the Proposed Regulations allow QOZ businesses to treat working capital as an asset for the 90% test, if: (1) there is a written plan that identifies the property as property held for acquisition, construction, or substantial improvement of tangible property in a QOZ; (2) there is a written schedule consistent with the ordinary business operations of the entity that the property will be used within this 31-month period, and; (3) the business substantially complies with the schedule.
For purposes of calculating the 90% asset test, the Proposed Regulations permit the QOF to use the asset values as reported on its applicable financial statements for the taxable year, as defined in Treas. Reg. Code Section 1.475(a)-4(h). If a QOF does not have an applicable financial statement, then the QOF must use the cost of its assets.
The Proposed Regulations further clarify the application of the 90% asset test with respect to the fund’s first year as a QOF, if the fund’s first month as a QOF is a month other than the first month of its first taxable year. Specifically, the Proposed Regulations provides that the phrase “first 6-month period of the taxable year of the fund” shall mean the first 6 months composed entirely of months which are within the taxable year and during which the entity is a QOF. By way of example, if a calendar-year entity that was created in February chooses April as its first month as a QOF, then the testing dates for the 90% asset test are the end of September and the end of December. If a calendar-year fund chooses a month after June as its first month as a QOF, then the only testing date for the taxable year will be the last day of the QOF’s taxable year.
Qualified Opportunity Zone Business
To qualify as a QOZ business, “substantially all” of the business’s tangible property must be QOZ business property. The Proposed Regulations specify that a trade or business will be treated as satisfying the “substantially all” requirement if at least 70% of the tangible property owned or leased by it is QOZ zone business property. For purposes of determining whether a trade or business satisfies this test, the entity should look at the value of its assets as reported on the entity’s’ financial statements for the relevant reporting period. If the entity does not have the applicable financial statements, it should make the calculation using the cost of its assets.
Qualified Opportunity Zone Business Property
Tangible property used in a trade or business of a QOF will be treated as QOZ business property if, among others, the original use of the tangible property in the QOZ commenced with the QOF, or the QOF substantially improves the property, and if, during substantially all of the QOFs holding period of the tangible property, substantially all of the use of the property was in a QOZ.
The Proposed Regulations provide guidance on satisfying the “substantial improvement” test. The Proposed Regulations include a special rule for land and improvements on land. The Proposed Regulations provide that, if a QOF purchases a building located on land wholly within a QOZ, substantial improvement will be measured by the QOF’s additions to the basis of the building, and not the land. This special rule is illustrated in Revenue Ruling 2018-29 issued as part of the guidance (see discussion below).
First-In, First-Out (FIFO) Method for Disposals of Interests in QOFs
The Proposed Regulations clarify that, if a taxpayer holds investment interests with identical rights (e.g., a certain class of shares of stock in a corporation) in a QOF that were acquired on different dates, and the taxpayer disposes of less than all of such interests in a single transaction, the first-in-first-out (“FIFO”) method should be used to identify which interests were disposed of by the taxpayer. This identification will help determine whether the investment was one to which a gain deferral election applied, the attributes of the gain at the time such gain is included in income, all of which will generally be preserved, and any increase in the basis of an investment interest being disposed of, to the extent applicable.
The Proposed Regulations provide that the pro-rata method applies if a taxpayer acquired investment interests with different characteristics on the same day, and is subsequently treated as having disposed of less than all of such interests.
Exclusion of Gain for Investments Held at Least 10 Years
The Proposed Regulations reiterate that a taxpayer may make the aforesaid basis step-up election with respect to an investment in a QOF that was held for 10 years or more only if a proper deferral election was made for the investment. To the extent that the taxpayer invested in a QOF in part with funds with respect to which the deferral election was not made or was not available, such investment will be treated as a separate investment for which the basis step-up, and potential exclusion, will not be available.
Post-10 Year Gain Exclusion
The Proposed Regulations clarify that the ability to make a deferral election to exclude gains from investments held for at least 10 years will not be impaired by the statutory expiration of the designation of a QOZ (set to expire on December 31, 2028), as long as the taxpayer disposes of the investment prior to January 1, 2048. For example, even if a QOZ designation expires for a particular location in which a QOF primarily conducts its trade or business, the taxpayer that invested in such a fund will continue to qualify for the basis step-up election with respect to the investment until December 31, 2047.
Rev. Rul. 2018-29
Contemporaneous with the issuance of the Proposed Regulations, the IRS issued Revenue Ruling 2018-29, addressing the application to real property of the “original use” and the “substantial improvement” requirements of the QOZ Program.
The Revenue Ruling clarifies that, if a QOF purchases an existing building in a QOZ, the original use of the building will not be considered to have commenced with the QOF and the requirement that the original use of tangible property in a QOZ commence with a QOF does not apply to the land on which the building stands. In addition, QOFs don’t have to include the value of the land when calculating how much the statute requires them to spend to improve property. Specifically, for purposes of the “substantial improvement” test, substantial improvement will be measured by QOF’s additions to the adjusted basis of the building, excluding the portion of the adjusted basis attributable to the land. The QOF is not required to separately improve the land.
QOF purchases property A for $1.8 million located within a QOZ, consisting of an existing warehouse building and land. $1 million of the purchase price is allocated to the warehouse building, and $800,000 is allocated to the land. Within 28 months of the purchase, the QOF converts the warehouse to rental apartments at a cost of $1.2 million. The QOF will be treated as having substantially improved property A because during the 30-month period beginning after the day of its acquisition of the property, the QOF’s additions to the basis of the warehouse building exceed an amount equal to the QOF’s adjusted basis in the building at the beginning of the 30-month period ($1 million).
The Revenue Ruling is very significant in that, by excluding the basis attributed to the land, it lowers the threshold that QOFs must meet to satisfy the “substantial improvement” requirement when purchasing and improving land. This aspect of the guidance will be very important to many real estate investors, particularly in areas where land can be a significant portion of a project’s cost.
Comments and Unanswered Questions
There is a 60 day period to provide the IRS with comments to the Proposed Regulations. The IRS is seeking comments on the proposed regulations, including, among others, on all aspects of the definition of “original use” and “substantial improvement.”
The IRS is also working on additional guidance with respect to issues that are not addressed in this guidance, including the treatment of any gains earned within and reinvested by a QOF, what transactions may trigger the inclusion of gain that has been previously deferred, what constitutes a “reasonable period” for a QOF to reinvest proceeds from the sale of qualifying assets without paying a penalty, what is a permissible time period for QOF to invest cash received from an investor, what happens when a QOF fails to maintain the required 90% asset use test, what types of other conduct by a QOF may lead to the fund’s decertification, and any applicable information reporting requirements.
The benefits of the QOZ Program remain clear: (i) significant tax deferral and potential tax savings, (ii) potential wealth transfer opportunities, and (iii) promotion of investment in Qualified Opportunity Zones, each of which creates opportunities for investors, real estate developers and business owners.
The newly issued IRS guidance provides answers to a number of questions raised regarding the QOZ Program thus far. A number of questions remain unanswered. We will be awaiting further guidance from the IRS. In the meantime, CSG stands ready to assist you with your investments in QOFs.
For more information concerning how the Qualified Opportunity Zone Program may benefit you as either an investor, developer or business owner, please contact one of the members of CSG’s Qualified Opportunity Zones Group or the authors listed below.
Bozena M. Diaz | Counsel | firstname.lastname@example.org | (973) 530-2161