With the release of the Opportunity Zone proposed regulations, potential investors, developers, funds and hoards of others eagerly awaiting this guidance began moving into the next phase of a plan to inject capital into, and develop projects in, distressed communities. Department of Treasury Secretary Steven Mnuchin predicted earlier this year that the Opportunity Zone program would unlock $100 billion worth of investment nationwide.
Until recently, however, gating issues hindered even the most ambitious investors interested in the Opportunity Zone program. Many of these gating issues were addressed in regulations proposed last month.
While the regulations will not be finalized until January 2019 at the earliest, Treasury and the Internal Revenue Service permit taxpayers to rely on the regulations for the time being. These rules address many investor and fund concerns. (To read a brief McGuireWoods alert announcing the release of the proposal, see “IRS and Treasury Issue Opportunity Zone Proposed Regulations and Guidance,” available on the firm’s website.)
Below is a description of the proposed provisions relevant to potential investors and qualified opportunity funds.
Eligible Gain. The proposed regulations dispel any notion that ordinary income gains can be deferred under the Opportunity Zone program, and provide guidance on the timing of investing such gains. The regulations make it clear that only capital gains are eligible for deferral. Though many investors anticipated this result (and the legislative history suggested as much), this clarification helped investors identify with greater tax certainty which type of gains to roll over into a qualified opportunity fund (QOF).
To be eligible for deferral, the capital gain must be invested within 180 days of the date of the sale or exchange giving rise to that gain. In most cases, this 180-day period is not difficult to determine; however, some capital gains result as a function of federal tax law (e.g., certain gains from the sale of exchange-traded stock and capital gain dividend distributions). While these amounts are deemed capital gains under tax law, the law doesn’t specify dates, which is relevant for marking the start of the investment window. The regulations clarify that the first day of the 180-day period is the date when such deemed capital gains would have been recognized under tax law. Given the paramount importance of investing capital gains within 180 days to qualify for gain deferral, this provides guideposts for investors who are active in corporate restructurings and partnership dealings, which often give rise to deemed capital gains from a sale or exchange treatment, who also want to explore QOFs.
The rules provide that all of the deferred gain’s tax attributes are preserved during the deferral period; they would be taken into account when the gain is later included in income. Further, the proposed regulations provide guidance when separate investments are made at different times or when the rolled over gain has differing tax attributes. Oftentimes, these circumstances may arise when an investor purchases common stock of a QOF at different times or when an investor has capital gains arising from multiple sources. The rules explain that when taxpayers dispose of less than their full investment interest, a first-in, first-out method would be used, unless a pro rata method is more accurate. Investors exiting their Opportunity Zone investments will want to keep these considerations in mind.
The proposed regulations contain other special rules as well. Included therein, the regulations address special deferral rules applicable to Section 1256 contracts and other offsetting position transactions, including straddles.
Eligible Taxpayer. The proposed rules provide broad flexibility by allowing gain deferral for most types of taxpayers. The regulations clarify that eligible taxpayers include individuals, C corporations (including RICs and REITs), partnerships and certain other pass-through entities. Essentially, a taxpayer that recognizes capital gains for federal income tax purposes is eligible.
The rule provides that capital gains deferral is available at both the partnership level and the partner level. If the partnership is in receipt of capital gains and it defers only a portion of the gain, then the capital gain is included in the partner’s distributive share. The partner may then defer the capital gain included in the partner’s distributive share.
The proposed regulations also provide for how the taxpayer would make the election to defer such gain. Taxpayers will make elections on Form 8949, which is attached to the federal income tax return for the taxable year of when deferral begins.
Eligible Investment Interest. The proposed regulations clarify that only an equity interest qualifies as an investment in a qualified opportunity fund. Examples of eligible interest include preferred stock or a partnership interest with special allocations in a QOF. In fact, the regulations allow such eligible interests to be used as collateral for debt; however, to qualify for gain deferral, the investment interest itself cannot be a debt instrument.
Under the Opportunity Zone program, when the investment is held for at least 10 years, the taxpayer may elect to increase the basis of the investment to the fair market value (which often results in no capital gains recognized). Questions arose, however, for gain that was deferred beyond 2028, the year in which the Opportunity Zone designations expire under the tax law. The IRS and Treasury took a flexible approach here by permitting the basis step-up election until the end of 2047. The 2047 date allows investors to make an investment before the expiration of Opportunity Zones at the end of 2027 and hold the investment for the next 10 years to get the basis step-up election. The rules provide an additional 10-year window so that investors are not compelled to dispose of their QOF investment, which could serve to diminish the efficacy of the Opportunity Zone programs.
Qualified Opportunity Funds
Certification. The statute allows Treasury to prescribe regulations for the certification of QOFs. Prior to the regulations, it was unclear whether certification of a qualified opportunity fund was necessary before eligible gain could be deferred. Had Treasury prescribed rules whereby the IRS and/or Treasury were certifying each individual fund, investments could slow to a snail’s pace. Treasury and the IRS opted to permit funds to self-certify that they qualify. The IRS provided Form 8996 for self-certification, which will be attached to the tax return of the year in which the fund became a QOF. The regulations and form also provide that the QOF may choose the month when it became a QOF.
One of the questions surrounding certifying as a QOF was whether a pre-existing entity could be treated as a QOF. Again, the IRS and Treasury took a broad approach, clarifying that there is no prohibition to using a pre-existing entity. Potential funds may want to keep in mind the statutory requirement that the corporation or partnership be organized solely for the purpose of investing in the Opportunity Zones.
The 90 Percent Asset Test. Under the statute, it is critical that the fund meet the 90 percent asset test, which is conducted semi-annually. In this regard, many funds may run into issues of developing a new business or construction that may take longer than six months. This restriction hamstrings funds, forcing them to identify projects that are more liquid than others — funds wouldn’t want to be caught holding cash when the 90 percent asset test is conducted.
The proposed regulations provide a “working capital” safe harbor allowing funds to hold cash for up to 31 months. The safe harbor applies if there is a written plan that identifies certain Opportunity Zone property, a written schedule indicating that the property will be used within 31 months, and the business substantially complies with that schedule. This allows QOFs to have cash on hand while they are developing their projects, without running afoul of the 90 percent asset test rules. Treasury and the IRS provide broad flexibility (i.e., 31 months to hold cash) under the 90 percent asset test to facilitate investment in the designated Opportunity Zones. There is no restriction on the amount of the working capital safe harbor, and accordingly, all 90 percent of a QOFs assets could potentially be working capital.
Qualified Opportunity Zone Business. As noted above, a QOF must be invested 90 percent in qualified opportunity zone property. Such property must generally fill three requirements: (i) the property must be acquired after 2017; (ii) such acquisition is the original use of the property; and (iii) substantially all of the use of the property must be in the opportunity zone during substantially all of the holding period. If at least 70 percent of the property is used in the opportunity zone, then it meets the “substantially all” requirement. The proposed regulations did leave open the definition of the term “substantially all,” as it appears elsewhere in the statute. As a result of the 90 percent asset test and the “substantially all” requirement, a QOF could invest at a minimum 63 percent of its assets in a qualified opportunity zone business in some cases and still qualify as a fund.
Though this first tranche of guidance did provide enough information to get many investments off the sidelines, some of the finer points remain open. Questions still surround the penalty to QOFs, the definition of qualified opportunity zone business property, and other issues related to the exit of investors from a fund.