Last week the Department of Treasury released highly-anticipated proposed regulations on investment in qualified opportunity zone funds (QOFs), a creature of the new Section 1400Z-2 of the Internal Revenue Code, enacted as part of 2017’s Tax Cut and Jobs Act. Investment into QOFs are to provide taxpayers with potentially significant tax incentives, which makes compliance guidance from Treasury so important to the myriad of constituencies that stand ready to direct a significant flow of capital into qualified opportunity zones (QOZs)—distressed communities around the U.S. that are eligible to benefit from the program.
The IRS and Treasury are seeking comments and will hold a public hearing regarding the proposed regulations in January 2019. Even though the regulations are merely proposed at this point, they reflect Treasury’s current approaches to many items that the Section 1400Z-2 leaves open to interpretation or further rulemaking, and currently, they represent the best indications of where final requirements will be fixed.
Previously on this blog, we surveyed the tax benefits of QOF investment. In this post, we’ll touch on some of the most significant QOF investment-related questions that we believe are answered by the proposed regulations.
What gains are eligible to be deferred through investment in a QOF?
The proposed regulations clarify that only capital gains (and not also ordinary gains) are eligible for deferral. Section 1400Z-2 itself imposes additional requirements for the gain: (1) the gain must have been otherwise recognized by the taxpayer by December 31, 2026, and (2) the gain must have occurred through sale or exchange with an unrelated person (as defined by statute).
Are preferred equity or debt investments in QOFs eligible for favorable tax treatment?
The proposed regulations clarify that only equity investments in a QOF is eligible for deferral, including preferred stock or partnership interests with special allocations. Debt investments however, are not eligible for deferral.
Can a taxpayer continue to defer previously deferred capital gains if they dispose of the QOF investment?
If a taxpayer defers capital gains through an investment in a QOF, but then sells that QOF interest, which would otherwise trigger inclusion of the taxpayers deferred gain in their taxable income, then the taxpayer may continue to defer the previously deferred gain if it makes a qualifying new investment in a QOF within 180 days of the disposition. This would allow an investor to dispose of a QOF investment and continue to defer the initial gains through new QOF investments up until those gains would need to be recognized by December 31, 2026
What kind of entities can qualify as a QOF?
Section 1400Z-2 provided that a QOF can be organized a corporation or partnership. We wondered whether organized referred to the entity’s existence under state law, or whether the consideration related to how the entity was classified for tax purposes. The regulations clarify that the statue refers to federal tax classification, meaning that an entity organized as an LLC under state law can still qualify as a QOF if it elects to be taxed as a corporation or partnership.
How long can an investor hold an interest in a QOF and defer gains of the investment? Does the expiration of a qualified opportunity zone designation have any effect?
Potentially the most powerful tax benefit to be derived from QOF investment is the elimination of post-acquisition taxable gains from the QOF interest, through a stepped-up basis to fair market value at time of disposition, once that QOF investment has been held for at least 10 years. Many commentators observed that QOZ designations expire in 2028 and questioned whether taxpayers would be able to exclude post-acquisition gains on investments held for more than 10 years if the QOF designation expired before the taxpayer disposed of the investment. Thankfully, the proposed regulations would permit taxpayers make the stepped-up basis election after the QOZ designations expire, provided that disposition of the QOF investment occurs prior to January 1, 2048.
How are assets valued for the 90% asset test?
Under Section 1400Z-2, a QOF must hold at least 90% of its assets in QOZ property, as measured by the average percentage held during semi-annual periods. For purposes of the 90% asset calculation, the proposed regulations require the QOF use the asset values that are: (i) reported in its applicable financial statements or (ii) the cost of the assets in instances where the QOF does not have financial statements that meet certain statutory criteria.
How can existing real estate be “substantially improved” for purposes of meeting the requirements of qualified opportunity zone business property?
Rehabilitation of real estate figures to be a major play within QOFs. In order for its investors to be eligible for the tax benefits, a QOF with such a real estate strategy must (among other things) either commence the original use of the property or substantially improve the property. The statute defines substantial improvement to require that additions to the basis within 30 months of acquisition must exceed the QOF’s basis at acquisition.
But what if a QOF acquires a property with existing improvements, intending to convert the buildings to another use? Is the value of the land taken into account in determining the amount of basis that must be more than doubled within 30 months? Must the land be improved separately?
Revenue Ruling 2018-29, which Treasury released in conjunction the proposed regulations, holds that in the real estate context, substantial improvement will be measured by additions to the adjusted basis of the existing improvements only, and the land doesn’t need to be improved to satisfy the statutory test. Thus, the regulatory interpretation on this point will make it easier for QOFs to satisfy the substantial improvement requirement for real estate than it would have been if land factored into the test.
What if an entity holds cash (raised from investors) to deploy over a long development period? Could that defeat its qualification as a QOF under asset tests?
Commentators had asked Treasury to regard QOF-held cash that is to be later invested as QOZ property for qualification purposes, because often investments in new businesses or development of real estate may take longer than 6 months. The proposed regulations would provide a working capital safe harbor for QOZ businesses that acquire construct or rehabilitate real property and other tangible property. It appears that the safe harbor would allow QOZ businesses to characterize working capital as QOZ property for up to 31 months (a “start-up” period), provided:
- There is a written plan that earmarks the working capital for acquisition, construction, or substantial improvement of the property
- There is a written schedule consistent with the ordinary start-up of a trade or business for the expenditure of the working capital, which under the schedule would be expended within 31 months of their receipt, and
- The working capital is actually used in a manner that is substantially consistent with that schedule.
Treasury is requesting further comments on whether the safe harbor for working capital provides an adequate start up period.
What critical questions remain?
Treasury stated in its commentary to the regulations that it is working on additional proposals regarding the following items, which may be published in the near future:
- The meaning of “substantially all” as written within certain contexts of Section 1400Z-2
- What transactions may trigger the inclusion of gain that has been deferred
- The reasonable period for a qualified opportunity fund to reinvest sales proceeds into new QOZ property without paying a penalty
- Administrative rules related to a QOF’s failure to maintain 90% asset test compliance
- Taxpayer reporting requirements
We’re busy designing due diligence requirements for reviews of QOFs, which will undoubtedly draw from much of the substance outlined in Treasury’s proposed and future regulations.