The Tax Cuts and Jobs Act has provided a host of new regulations aimed at spurring economic development. One of those provisions that has flown under the radar throughout 2018 is the newly established qualified opportunity zones (O-Zones). The Department of Treasury recently released the long-awaited proposed regulations that help provide a level of clarity to ease investor uncertainties. The O-Zones are census tracts in low-income communities designated by the governor of each state. Qualified Opportunity Funds (O-Funds) are investment vehicles established to invest in O-Zone assets that offer several tax incentives aimed at providing additional returns to investors and attractive financing opportunities for real estate projects and operating businesses. While somewhat similar in concept to a 1031 exchange there are several variances that open up opportunities where a 1031 like-kind exchange would not be possible.
The O-Zones provide three separate tax benefits to taxpayers:
- deferral of gain on the sale of a capital asset
- reduction of the future taxable gain if certain holding periods are met
- tax-free appreciation in the O-Fund investment if a holding period is met.
The new regulations allow investors to defer the recognition of capital gains occurring before December 31, 2026 if the funds are reinvested in an O-Fund within 180 days of the capital transaction. There are no required exchange intermediaries to hold onto the funds during the 180 days and the funds do not need to be reinvested in similar type property as with a 1031 exchange. The timing deferral of paying the tax is a significant benefit that decreases as we get closer to 2026. The regulations allow taxpayers to defer all forms of capital gain except gains arising from transactions with related persons. An owner of a pass-through entity may elect to defer allocated gains if the entity does not take part in its own O-Zone deferral election. For purposes of the 180 day period for pass-through gains, the beginning date is generally the last day of the entity’s taxable year though a taxpayer may elect to treat the 180 day period as beginning on the date the entity incurred the capital gain.
Investors receive another set of benefits based on the holding period of the subsequent investment in the O-Fund. Those who stay invested in the O-Fund for 5 years will receive a 10 percent step-up in the original deferred gain and if invested for 7 years another 5 percent step-up is earned. Investors who meet these holding periods will see up to 15 percent of the original deferred capital gain forgiven.
An income recognition event occurs at the earlier of the date on which the O-Fund investment is sold or December 31, 2026. At that point, taxpayers will have to pay the tax on the remaining deferred capital gain taking into consideration basis step-ups such that an investor could potentially only have to pay tax on 85 percent of the originally deferred gain in 2026. As we move closer to 2026 the ability for an investor to meet the 5 or 7 year holding periods diminishes such that by 2022 investors will not be able to meet the holding period to receive partial forgiveness. Up front planning is necessary if investors plan on holding onto the O-Fund investment past 2026 to make sure they have funds available to cover the taxable income reported in 2026.
Investors who meet a 10-year holding period receive a final benefit upon disposition of the O-Fund. Investors may elect to step-up the basis in the O-Fund to fair market value on the date the investment is sold as long as the disposition occurs before January 1, 2048, thereby eliminating any taxable income attributable to the post-purchase appreciation in the O-Fund. This allows investors at least 20 years to stay invested in the O-Fund and encourages patient capital investment. The step-up to fair market value provides investors with a significant opportunity to take advantage of depreciation deductions and other basis related reductions.
O-Funds are investment vehicles organized as either a corporation or a partnership, including LLCs, for the purpose of investing in O-Zone property. The IRS has announced that the O-Fund will self-certify by attaching the newly established Form 8996 to the entity’s tax return. The O-Fund must hold at least 90 percent of its assets in O-Zone property or be subject to a monthly noncompliance penalty. The 90 percent threshold is measured as the average of the O-Zone property held on the last day of the first 6-month period and the last day of the taxable year. The regulations provide a safe harbor for businesses that acquire, construct or rehabilitate property such that they can treat cash held with the intent of investing in qualified opportunity zone business property as working capital for up to 31 months if there is a written plan for its use. This safe harbor will prevent businesses from failing to meet the 90% asset test when holding cash for the intended purpose of building or improving property.
O-Zone property is qualified opportunity zone stock, qualified opportunity zone partnership interest or qualified opportunity zone business property. Both qualified opportunity zone stock and partnership interest must be issued after December 31, 2017 in exchange for cash and the entity must meet the definitions of an O-Zone business. An O-Zone business must hold at least 70 percent of its assets in O-Zone business property and cannot hold more than 5 percent of its assets in non-qualified financial property with the aforementioned exception for working capital. It is not necessarily a separate entity be established to serve as a holding company for the O-Zone property though many investment managers are packaging together various qualifying investments to offer as a separate O-Zone Fund. Given the discrepancy of an O-Fund needing to maintain 90 percent of its assets in O-Zone property whereas an O-Zone business must only meet a 70 percent threshold the regulations provide a significant advantage to having the O-Fund serve as a holding company of O-Zone businesses rather than investing directly in O-Zone business property.
O-Zone business property is tangible property used in a trade or business that is acquired by purchase from an unrelated party after December 31, 2017, and the original use of such property in the O-Zone commences with the O-Fund or the O-Fund substantially improves the property. Property is substantially improved if during any 30-month period beginning after the date of acquisition additions to basis exceed the original basis of such property. It is not necessary to factor in the land basis when determining if a substantial improvement has occurred. The land is treated as O-Zone business property if additions to the building basis exceed the building’s original basis.
In the case of an investment in an O-Fund where only a portion of the investment consists of a deferred capital gain, the investment shall be treated as two separate investments. Only the portion related to the deferred capital gain is eligible for the O-Zone tax benefits. Thus, investors who do not have a capital gain to defer are not eligible for any of the O-Zone tax benefits.
The mechanics of establishing and maintaining an O-Fund are complex and the Department of Treasury plans to release additional guidance to help investors. Contact PBMares with any questions you have about forming or investing in an O-Fund.
