Hinckley Allen published A Practical Guide to the Qualified Opportunity Zone Program, which details a promising new program contained in the 2017 Tax Cuts and Jobs Act that provides significant tax incentives for real estate investors in Qualified Opportunity Zones (“QOZ”). Although the QOZ program was received enthusiastically, significant questions arose about how potential investors could implement it. As a result, the U.S. Department of the Treasury (“Treasury”) and the Internal Revenue Service (“IRS”) issued guidance on October 19, 2018 in the form of proposed regulations, Revenue Ruling 2018-29, and draft IRS Form 8996.
Here are some of the key insights from the new guidance:
- Only capital gains are eligible for deferral. The proposed regulations clarify that only gains from the sale or exchange of capital assets are eligible under the QOZ program.
- Any taxpayer that recognizes capital gain for federal income tax purposes is eligible to elect deferral. Eligible taxpayers include, but are not limited to, C corporations, including regulated investment companies (RICs) and real estate investment trusts (REITs); partnerships; and S corporations. Limited liability companies (LLCs) that, for federal tax purposes, choose to be treated either as a partnership or as a corporation are also eligible.
- An investment in a Qualified Opportunity Fund (QOF) must be an equity interest. This interest is issued by the QOF and can include preferred stock or a partnership interest with special allocations, but it cannot be a debt instrument. However, if the eligible taxpayer is the owner of the equity interest for federal income tax purposes, status as an eligible interest is not jeopardized if the taxpayer uses the interest as collateral for a loan.
- The first day of the 180-day investment period is the date on which the gain would be recognized for federal income tax purposes without regard to whether deferral is available. To defer gain, a taxpayer must invest in a QOF within 180 days of selling any assets that give rise to capital gains. The proposed regulations clarify when the 180-day investment period begins in a variety of situations with specific and helpful examples. For example, partners in partnerships that do not elect to make a QOF investment at the partnership level can elect to start the 180-day investment period at the partner level on either the last day of the partnership’s taxable year in which the partner’s allocable share of the qualified gain amount is taken into account or the date the partnership sold the asset.
- If a taxpayer acquires its QOF interest after 2018, it is still eligible for QOZ tax exemption if it sells the QOF interest after 2028. A taxpayer can elect to increase the basis in its investment in a QOF if the investment is held for at least ten years from the date of the original investment in the QOF, but current opportunity zone designations are set to expire on December 31, 2028. The proposed regulations clarify that a taxpayer will be eligible for QOZ tax exemption even if it sells its fund interest after 2028 (when the area will no longer be designated as an opportunity zone) as long as the disposition of the QOF interest occurs before December 31, 2047. This means that a taxpayer can invest in a QOF in 2026, hold its investment for the required 10 year period, and then hold its investment for an additional 10 years.
- There are special rules for pass-through entities such as partnerships. A partnership can elect to defer some or all of its gain, and that deferred gain is not included in the distributive shares of the partners. If the partnership does not elect to defer gain, the gains are included in the partner’s distributive shares.
- The cost of the land is not included in a QOF’s adjusted basis if there is a pre-existing building on the land. After an initial investment, the taxpayer must “substantially improve” the QOZ property by investing an amount equal to at least 100% of the original price to increase the tax basis of the property within the first 30 months of ownership. Revenue Ruling 2018-29 clarifies that if an investor purchases QOZ property with a pre-existing building on it, the cost of the land is not included in the basis. Instead, substantial improvement is measured by the QOF’s additions to the adjusted basis of the building.
The Treasury and the IRS are working on releasing additional proposed regulations to be released in the near future. These regulations are expected to clarify matters such as questions about leased property, certain transactions that may trigger the inclusion of gain that has been deferred, the “reasonable period” for a QOF to reinvest proceeds from the sale of qualifying assets without paying a penalty, and administrative rules for when a QOF fails to maintain the required 90 percent investment standard.
Until final rules are promulgated, an eligible taxpayer may rely on the proposed regulations, provided that the eligible taxpayer applies the proposed regulations in their entirety and in a consistent manner.
If you have any questions about the QOZ program, including about the proposed regulations, please contact the authors of this communication, the Hinckley Allen attorney with whom you regularly work, or one of our Tax and Real Estate attorneys.