On October 19, the Internal Revenue Service (IRS) and US Department of the Treasury released the first set of proposed regulations under Internal Revenue Code Subchapter Z—Opportunity Zones On the same day, the IRS also issued Revenue Ruling 2018-29 relating to the application of the Opportunity Zone tax incentives to improvements of real property.
Investors may receive significant tax benefits, including (1) deferral of tax for capital gains (from an unrelated investment) invested in a Qualified Opportunity Fund (QOF), (2) elimination of up to 15% of the tax on capital gains invested in a Qualified Opportunity Fund (10% if the investment is held for more than five years, 15% if the investment is held for more than seven years), and (3) potential elimination of tax on the appreciation of a Qualified Opportunity Zone investment, if the Qualified Opportunity Fund investment is held for more than 10 years.
What "gains" are eligible for deferral?
An eligible taxpayer may elect to defer recognition of some or all eligible gains to the extent that the taxpayer timely invests in an eligible interest in a Qualified Opportunity Fund. The Proposed Regulations clarify that a "gain" is eligible for a Qualified Opportunity Zone deferral if it is treated as "capital gain for federal income tax purposes." Eligible gains, therefore, include capital gains from an actual, or deemed, sale or exchange, or any other gain that is required to be included in a taxpayer's computation of capital gain. Gains under Section 1231 of the Code would presumably satisfy this requirement. In addition, the Proposed Regulations provide that the gain must not arise from a sale or exchange with a "related person."
The deferred gain's tax attributes are preserved through the deferral period and taken into account when the gain is later reported as taxable income. For example, if the gain originally would have been includible as a short-term capital gain, when the taxpayer later includes the previously deferred gain in income, it will be treated as a short-term capital gain.
Which taxpayers are eligible to invest in a Qualified Opportunity Fund?
"Eligible Taxpayers" include individuals, C corporations, including Regulated Investment Companies (RICs) and Real Estate Investment Trusts (REITs), partnerships, S corporations, trusts and estates. Therefore, entities, as well as individuals, can make investments in eligible interests in a Qualified Opportunity Fund.
Can a Qualified Opportunity Fund be a limited liability company?
In the statute, a Qualified Opportunity Fund is defined as "any investment vehicle organized as a corporation or partnership for the purpose of investment in Qualified Opportunity Zone Property (QOZ Property)." The Proposed Regulations clarify that any entity that is classified as a corporation or a partnership for federal income tax purposes and that is created or organized in the 50 states, the District of Columbia or a US Possession could qualify as a Qualified Opportunity Fund, provided that other requirements are satisfied. If the entity is created or organized in a US Possession, it must be investing in a Qualified Opportunity Zone within that US Possession.
Therefore, an entity that is formed as a limited liability company for state law purposes could qualify as a Qualified Opportunity Fund, as long as the entity has two or more members and is not treated as a disregarded entity for federal income tax purposes.
If a Qualified Opportunity Fund purchases land and an existing building in the Qualified Opportunity Zone, does the land need to be substantially improved to qualify?
Qualified Opportunity Zone Business Property (QOZ Business Property) is tangible property used in a trade or business of the Qualified Opportunity Fund if: (1) the property was acquired by purchase from an unrelated party after December 31, 2017, (2) the original use of such property in the Qualified Opportunity Zone commences with the Qualified Opportunity Fund or the Qualified Opportunity Fund substantially improves the property, and (3) during substantially all of the Qualified Opportunity Fund holding period for such property, substantially all of the use of such property was in a Qualified Opportunity Zone. Section 1400Z-2(d)(2)(D)(ii) considers property substantially improved only if during "any 30-month period beginning after the date of acquisition . . . additions to basis with respect to such property in the hands of the qualified opportunity fund exceed an amount equal to the adjusted basis of such property at the beginning of such 30-month period in the hands of the qualified opportunity fund."
The Proposed Regulations and Revenue Ruling provide that land is treated separately from the improvements thereon for purposes of the substantial improvement test, and provide several important clarifications regarding the treatment of land. The Revenue Ruling provides that land, given its permanence, may never be treated as originally used by a Qualified Opportunity Fund in a Qualified Opportunity Zone. However, the examples in the Revenue Ruling indicate that the land may qualify as Qualified Opportunity Zone Business Property if the improvements qualify, even if the land is not improved. For the purposes of the substantial improvement requirement, a Qualified Opportunity Fund needs only to substantially improve the building on acquired land in order for the entire parcel to qualify for the 90-Percent Asset Test.
What are the other requirements to become a Qualified Opportunity Fund?
To become a Qualified Opportunity Fund, the eligible entity must self-certify as a Qualified Opportunity Fund on IRS Form 8996 and specify the first month in the initial tax year that it wants to be a Qualified Opportunity Fund. Investments made prior to the entity becoming a Qualified Opportunity Fund will not qualify for gain deferral. More generally, a Qualified Opportunity Fund cannot invest in another Qualified Opportunity Fund, and a Qualified Opportunity Fund must hold at least 90 percent of its assets in Qualified Opportunity Zone Property (90-Percent Asset Test).
What does the term "substantially all" mean?
A Qualified Opportunity Fund may own a Qualified Opportunity Zone Business (rather than directly owning Qualified Opportunity Zone Property). However, such business will not qualify as a Qualified Opportunity Zone Business unless "substantially all" of its assets are Qualified Opportunity Zone Business Property. The Proposed Regulations provide that, solely for this purpose, "substantially all" means at least 70%. Accordingly, a Qualified Opportunity Fund that owns a Qualified Opportunity Zone Business may have as little as 63% of its capital invested in Qualified Opportunity Zone Business Property (i.e., 90% in the Qualified Opportunity Zone Business multiplied by 70% of the Qualified Opportunity Zone Business's property). This definition may provide more flexibility as to the timing of capital investments into a Qualified Opportunity Fund and the use of that capital.
The term "substantially all" also is used in a number of other contexts within the Qualified Opportunity Zone rules. The Proposed Regulations do not clarify the meaning of "substantially all" in these other contexts.
Parts of this article were taken from one recently published in The National Law Review (click here for the entire article):
Since the Tax Cuts and Jobs Act became law, Louisiana has nominated, and the U.S. Treasury Department has approved, 150 Qualified Opportunity Zones, including 44 in the New Orleans metropolitan area, 33 in the Baton Rouge metropolitan area, and many more throughout the state of Louisiana.
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