CohnReznick Opportunity Zones Alert: Guidance has Arrived!
As a potentially powerful tool to encourage economic development in designated distressed communities all over the country, Opportunity Zone legislation has created excitement and anticipation for investors, fund managers, investees, and local community development stakeholders for almost 10 months. And now we have guidance (as proposed) that provides clarity on some very important issues, as outlined below. The proposed regulations should create additional momentum for activity in the Zones, and bring more investors off the sidelines.
The guidance is very helpful regarding how investors should mitigate risks, as they explore the most effective way to “do well by doing good.” What is contained in the proposed regulations is very helpful, but it is important to note that comments to the most-recent clarifications are requested and therefore the ultimate outcome is subject to change. We should also note that there are more regulations – and possibly additional forms of clarification – pending. The expectation is that the impediments to optimizing, if not maximizing investment in Opportunity Zones, will be addressed, and we will all see the power unleashed by this progressive tax provision.
The guidance deals with two very basic issues that were largely expected, but nonetheless of import to interested observers. The first is that only capital gains will be eligible for deferral based on any sale or exchange or other gain included in a taxpayer’s computation. The second is the ability to use an LLC as the Qualified Opportunity Fund (QOF) vehicle, in addition to a partnership or corporation.
The guidance released on October 19 is lengthy, so we have distilled the content into some of the more impactful aspects, in the discussion below. It is important not to infer too much from the guidance, especially with another round of clarifications (and comments to this guidance) pending. Application of the proposed regulations is always best dealt with in the context of the facts and circumstances of specific situations. Similarly, there may be ways to interpret guidance depending on how certain asset classes will characteristically benefit, or require some creative and thoughtful approaches to their business models.
The IRS Revenue Ruling 2018-29, issued contemporaneously with the proposed regulations, clarifies the substantial improvement requirement, which is applicable to a purchased building located in a QOF. This applies only to the investor’s basis of the building and improvements. The basis of the land is not considered for purposes of determining whether the building has been “substantially improved.” For example, if an eligible investor plans to defer $10 million of capital gains by purchasing an existing building (deemed to have an “original use”) and land located in a Qualified Opportunity Zone (QOZ). The investor determines that the land is allocated a basis equal to $6 million, and the building is allocated a basis of $4 million. The investor must spend an additional $4 million (or more) improving the building to meet the substantial improvement requirement for the land and building to be Qualified Opportunity Zone Property.
Qualified Opportunity Zone businesses are required to have “substantially all” of their tangible property owned or leased by the business in an Opportunity Zone. The proposed regulations show that this standard is met if 70-percent of the tangible property is in the Opportunity Zone. The proposed regulations also show that for each taxable year, at least 50% of the gross income of a Qualified Opportunity Zone Business is derived from the active conduct of a trade or business in the QOZ.
The proposed regulations also provide a “working capital safe harbor” for investments in Qualified Opportunity Zone Businesses that acquire, construct, or rehabilitate tangible business property,” including real property. The safe harbor extends to working capital held for up to 31 months, if there is a written plan in place, a written schedule that the capital will be used within 31 months, and the business substantially complies with the schedule. Note that the working capital safe harbor applies solely to investment in Qualified Opportunity Zone Businesses, not at the QOF level.
The designation of existing QOZs will expire on December 31, 2028.The proposed regulations permit taxpayers to make a basis step-up (associated with a 10-year holding period) after the QOZ designation expires. An additional 10-year period also is provided to provide flexibility as to timing of dispositions for acquisitions made at the end of the current statutory deferral period - 2026. Specifically, the eligible holding period is extended until December 31, 2047, 20½ years after the latest date that an eligible taxpayer may properly make a qualifying investment.
Clarifications related to the treatment of debt in certain contexts are also noteworthy in the proposed regulations. A taxpayer electing to defer capital gain by investing in a QOF must make an investment in an equity interest issued by the QOF. In this regard, an equity interest issued by a QOF is specifically defined in the proposed regulations as an “eligible interest.” Conversely, a debt instrument issued by a QOF is specifically excluded from the definition of an eligible interest. Interestingly, an eligible interest is not impaired if it is pledged as collateral for a loan by the owner of the equity interest; including a “purchase-money borrowing.” Last, but certainly not least, the proposed regulations clearly indicate that deemed contributions of cash related to an increase a partner’s share of partnership liabilities (under Section 752(a)) do not result in a separate QOF investment. Thus, a partner’s increase in outside basis in the partnership is not considered in determining what portion of the partner’s interest is or is not subject to deferral.
The proposed regulations also make clear that a taxpayer who completely disposes of an interest in a QOF is permitted to make a subsequent investment in another QOF, and make a corresponding election to continue the deferral of the previously deferred gain. The general 180-day reinvestment period applies to the reinvestment, the first day of the 180-day reinvestment period is the date that the originally deferred gain would be included in income, if not subsequently re-invested.
For purposes of meeting the 90-percent test required for a corporation or partnership electing to be a QOF, fund management may choose the first month of its initial six-month testing period, so long as the first six-month period falls entirely within the fund’s taxable year. Regardless of the choice of the initial six-month testing period, the last day of the fund’s taxable year is a required test date for purposes of satisfying the 90-percent test. Accordingly, a calendar year QOF that chooses an initial month after June will only have one testing-period ending on December 31. If the eligible entity does not specify an initial month, then the initial month defaults to beginning of the eligible entities taxable year.
Next up are gains resulting from “deemed” sale or exchanges of capital assets that may lack a specific transaction/recognition date because of ambiguity in the respective federal statutory language. In general, the 180-day re-investment period begins on the day that the eligible gain would be recognized for federal income tax purposes. The proposed regulations provide guidance by way of specific examples for items including, but not limited to, capital gain dividends (and undistributed capital gains) from RICs and REITs, and additional deferrals of previously deferred eligible gains (invested and re-invested in QOFs).
Partnerships are clarified by the proposed regulations to be eligible taxpayers, and can elect to defer capital gain (on behalf of its partners) by investing into a QOF. Similarly, partners that are eligible taxpayers can separately elect to defer eligible gains allocated by a non-electing partnership, by investing into a QOF. Partners individually electing to defer capital gain can elect to use the partnerships date of recognition of the eligible gain, or by default the last day of the partnerships tax year as the beginning date of the 180-day reinvestment period.
Any taxpayer that is a corporation or partnership may self-certify as a QOF by using IRS Form 8996 both for initial self-certification and annual reporting of compliance with the 90-percent asset test. Also, capital gain deferral elections will be made by eligible taxpayers on , and attached to the federal income tax return for the year in which the eligible gain would have been recognized.
There are many areas where the IRS is requesting comments and queries as to whether additional guidance is required. Industry groups will be synthesizing comments, so weighing in is encouraged. Also with the issuance of the proposed regulations, the IRS issued Revenue Ruling 2018-29, updated its Opportunity Zone Q&A page online, and Form 8996 Qualified Opportunity Fund and instructions.
The Opportunity Zone legislation has established an incredible foundation for a surge of economic development activity in almost 8,800 census tracts all over the country. The proposed regulations provide clarity that is thoughtful, and will enhance the momentum that is building. CohnReznick professionals could not be more excited to support the variety of activity that will transform such a critical segment of the economy.
The CohnReznick Opportunity Zone team includes national tax experts that analyze the details of legislative policy, transaction advisory experts that strategically analyze and model the practical effect of such policy, as well as experts that handle fund formation, accounting and compliance. Additionally, our industry experts aligned with the Opportunity Zone business sectors (investees) such as real estate, renewable energy, hospitality, technology, life sciences, and manufacturing will help us to ensure that this tax provision has maximum effect for the distressed communities impacted by this provision.
Partner, Affordable Housing Industry Lead
David Kessler, CPA
Chief Executive Officer
Any advice contained in this communication, including attachments and enclosures, is not intended as a thorough, in-depth analysis of specific issues. Nor is it sufficient to avoid tax-related penalties. This has been prepared for information purposes and general guidance only and does not constitute professional advice. You should not act upon the information contained in this publication without obtaining specific professional advice specific to, among other things, your individual facts, circumstances and jurisdiction. No representation or warranty (express or implied) is made as to the accuracy or completeness of the information contained in this publication, and CohnReznick LLP, its partners, employees and agents accept no liability, and disclaim all responsibility, for the consequences of you or anyone else acting, or refraining to act, in reliance on the information contained in this publication or for any decision based on it.
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