On October 19th, the Treasury and IRS issued proposed regulations and other guidance related to Opportunity Zones. The proposed regulations provide investors, developers, and sponsors with answers to many, but not all, of the questions that have been raised over the past 10 months. Although the regulations are only proposed regulations, Treasury has stated that these regulations can be relied upon. Caveat being, if they are relied upon they must be relied upon in their entirety. No picking and choosing which sections you want to follow.
What we now know – highlights of some of the items that the proposed regulations addressed
Due to some ambiguous wording within the Opportunity Zone provisions there was a question as to which types of gains would qualify. The proposed regulations state that any gain that is treated as a capital gain for tax purposes qualifies. Therefore ordinary gains, including depreciation recapture gains, will not qualify and presumably 1231 gains will qualify.
Staying with qualifying gains, we now know that partners and S-Corporation owners, as well as the partnership or S-Corporation itself, can elect to defer qualifying gains by reinvesting into a qualified opportunity zone fund (“QOF”). This allows the greatest flexibility for taxpayers to invest into Opportunity Zones. Additionally, if a partner or S-Corporation owner is going to elect to defer the gain through reinvestment into an Opportunity Zone, they have the option to either reinvest within 180 days of the capital gain event or within 180 days from the end of the partnership or S-Corporation’s taxable year.
The proposed regulations also remove any doubt around what kind of equity investments qualify for the gain exclusion for investments held for 10-years. To qualify for the beneficial tax treatment for 10-year investments you must invest equity from gains that you elected to defer and ultimately recognize in 2026. Meaning any equity that has already been taxed does not qualify for the 10-year hold incentive.
Of most concern to those who were eager to take advantage of Opportunity Zones was how long did a qualified opportunity zone business have to deploy their cash into qualifying property? We now know that there is a 31 month working capital safe harbor if certain conditions are met. This should provide ample time for a business to raise equity and perform due diligence before acquiring and or developing qualifying assets.
The proposed regulations, along with the newly issued Revenue Ruling 2018-29, address the substantial improvement requirements as it relates to acquisitions of land. When land and building are acquired, only the building must be substantially improved. This is a considerably favorable outcome for taxpayers as it can significantly reduce the development costs required to be incurred to meet the substantially improved definition. As a result, taxpayers can more easily convert a land and building acquisition into qualified property.
The statue states that a QOF must hold 90 percent of its assets in qualified opportunity zone property. This seems simple enough however asset values can be calculated many ways. The regulations provide us with the exact manner in how these values are calculated. If the QOF has “applicable financial statements” (ie – audited financials), it uses the values as reported on those financial statements. If the QOF does not have applicable financial statements, then you use the cost of each asset. However even this may not provide us with all the answers we need since “cost” can have varying definitions.
To qualify as an opportunity zone business, “substantially all” of the partnership or corporation’s tangible property must be qualified opportunity zone business property. With the proposed regulations, Treasury has ruled that substantially all means 70 percent.
What we still don’t know – a few of the open items
Although many questions were answered, not all were. In the preamble to the proposed regulations, Treasury stated that they, along with the IRS, are working on additional proposed regulations “expected to be released in the near future”.
Until then, here are a sampling of questions that can be debated.
What types of transactions may trigger inclusion of gains that were previously deferred through Opportunity Zone investments. What is the “reasonable period” for a QOF to reinvest the proceeds from the sale of qualifying assets without paying a penalty? How is the penalty for failing the 90 percent asset test calculated? How do 1231 loss carryforwards play into the ability to defer 1231 gains? What does “original use” mean?
Finally, do we really know what the term “substantially all” means? This term is used throughout the Opportunity Zone provisions however the proposed regulations only define substantially all for one section, see above. How is “substantially all” defined for the remaining sections of the Opportunity Zone provisions? Will they be consistent and conclude that in all cases substantially all means 70 percent?
We Can Help
Elliott Davis has a team of experienced finance and tax advisors who can assist you with navigating the complexities of Opportunity Zones. If you aren’t sure that an Opportunity Zone investment is the best investment for you, we can calculate and compare after-tax returns between an Opportunity Zone investment and another investment alternative. If you decide you want to benefit from an Opportunity Zone investment, we can assist you with the organizational structuring, designing the working capital safe harbor plans and analyzing possible exit strategies. Additionally, we can assist you with annual compliance including the 90 percent asset test, the 50 percent gross income test, the substantially all requirements, as well as, the related income tax filings.
For more information on how we can help, contact Cory Ouellette.