Opportunity Zone Update: New IRS Language Clarifies Lingering Issues

Posted on May 2nd, 2019

The IRS recently cleared significant hurdles for investors interested in Opportunity Zone Funds with the release of its second set of Treasury regulations regarding Opportunity Zone investments.

Beacon Hill will focus on Qualified Opportunity Zone Funds (“QOZF”) that invest primarily in real estate, and this summary will address that space. The potential tax advantages for an investor who has a capital gain on another (original) asset and structures the investment appropriately include the following benefits:

1.            Defer the original capital gain tax for a decade

2.            Reduce the original capital gain tax by 15%, and, most importantly

3.            Eliminate the capital gain tax on the appreciation in the QOZF

With these benefits, an investment of $1,000,000 over 10 years at a 5% growth rate, a QOZF investment would grow by more than $250,000 more than a comparable investment without the QOZ tax benefits!

In the initial language proposed by the IRS in October of 2018, there were significant hurdles to QOZFs to be able to satisfy our investors’ needs.  The IRS largely overcame these issues with this new language. 

Key Issues Resolved

1. QOZF timing of deploying funds

QOZF’s must invest 90% of their assets in Qualified Opportunity Zone Property (“Qualified Property”), and the IRS has promulgated tests to ensure compliance with this.  Previously, it would have been possible to fail those tests the very day after receiving an investor’s money.  The new regulations allow the QOZF to disregard new investments received in the last 6 months in the testing they conduct [1].

2. Interim Gains

QOZFs may now liquidate Qualified Property throughout the life of the QOZF and, while the investor will need to pay the capital gains tax on gains realized, it will not [2]

  • Trigger the inclusion of their original gains or
  • Stop the clock on the 10-year holding period.

3. Valuation and Testing

QOZFs have several tests in order to ensure that they are, in fact, investing into Qualified Opportunity Zones.  One such test requires 90% of the assets to be invested in Qualified Property, either through operating a Qualified Opportunity Zone Business itself or investing in a subsidiary that operates a qualified business, which has its own set of tests.  The new language allows the testing to be conducted using, among other methods, unadjusted cost basis as the valuation metric, which will significantly ease this requirement.

4. Working Capital Safe Harbor

Pertinent to the testing discussed above, if a business shows plans to put the capital to work, it may have up to 31 months to do so.  Many developments run into delays beyond their control (i.e. permitting issues, municipal approvals, etc.) and the new regulations address this by adding a safe harbor if it can be shown that a violation of the 31 months occurred due to government actions.

5. Vacant Property & Land

Qualified Property must either have an “original use” in the QOZF or it requires “significant improvement”[3] once acquired by the QOZF.  For vacant land purchases, it does not require either, but is required to be used in the “Active Trade or Business” as defined by IRS section 162, which eliminates “land banking” that perhaps would have otherwise occurred. 

6. Distributions, Exiting & Winding down QOZF

  • Distributions: Subject to various limitations, a distribution of cash to a QOZF investor is only taxable to the extent the distribution exceeds their basis, including allocable debt.  As the rule is currently written, however, it will limit the ability of a partnership to timely distribute refinance proceeds to investors.
  • Secondary Market: The new regulations provide that if a taxpayer acquires a direct investment in a QOZF from a direct owner of the QOZF, the taxpayer is treated as though they made the investment on the date of purchase, rather than the seller’s initial purchase date.  This will likely give rise to a secondary market for these QOZFs.
  • Winding down a QOZF: QOZFs will need a reasonable time to sell off their Qualified Property in order to fund investor redemptions, which could generate gains.  The proposed regulations allow a QOZF investor that has held the QOZF investment for 10 years to exclude the capital gain from the disposition of Qualified Property as reported on the Schedule K-1.  Unlike the majority of the proposed regulations, it is specifically stated that the proposed rules on this topic cannot be relied upon until the regulations are finalized, as it questions its authority in this area. 

Other Issues

1. 1231 Gains

In order to get the benefits of the Opportunity Zone tax treatment, investors must invest capital gains as delineated under IRS Section 1231, which covers tax treatment of the gains and losses on the sale/exchange of real or depreciable property used in a trade or business.  The proposed regulations clarify that as those gains must be netted against losses to determine the amount of net gains, it can only be done at the end of the year.  Therefore, the 180-day window to invest 1231 gains in the QOZF can only occur at the end of a year.  This is different than previous language where it appeared that

  • Partnership’s 180-day window would start either
    • on the date of the sale that generated a capital gain or 1231 gain, or,
    • that it would give the underlying investor another chance when it would be passed through to them at the end of the year. 
  • Individual’s 180 day window would occur on the date of the sale that generated the capital gain.

The IRS has signaled to expect further clarifications and requirements as to the ongoing reporting required, penalties for violating various tests and changes to the form 8996 that all QOZFs will be required to submit.

[1] As long as the investment is held in cash (cash, cash equivalents, or debt instruments with a term of less than 18 months)

[2] Must be held in same “cash” investments as above.  Must reinvest proceeds into Qualified Property within 12 months

[3] Significant improvement requires a doubling of the cost basis of the improvements (not land)