As investors sell their real estate or other assets, they are searching for tax-efficient strategies to redeploy their capital. On Oct. 19, proposed regulations and other guidance were released concerning the tax incentive for investing in “Opportunity Zones,” which could be an advantageous approach for many taxpayers.

Background

Internal Revenue Code Section 1400Z-2, which was enacted as part of the 2017 tax legislation, provides certain incentives for capital gains invested in Opportunity Zones, designated economically-distressed communities. First, capital gains invested in a Qualified Opportunity Fund (QOF) that invest in qualified opportunity zone property are deferred until the earlier of Dec. 31, 2026, or the date the investment is sold or exchanged. In addition, the basis of any investment is increased by 10 percent of the amount of gain deferred if the investment is held for five years and an additional 5 percent for any investments held for seven years.

If an investment is held for 10 years, any post-investment capital gains realized from the investment in the QOF are tax exempt (the Ten Year Incentive). An entity will only qualify as a QOF if at least 90 percent of its assets are held in qualified opportunity zone property, such as qualified opportunity zone business property or stock or partnership interests in a qualified opportunity zone business.

After Section 1400Z-2 was enacted, potential investors had many questions concerning the mechanics and implementation of its various provisions.  In order to provide further clarity, the U.S. Department of the Treasury and the Internal Revenue Service released proposed regulations and other guidance.

Eligible Investors in QOFs

In general, eligible taxpayers who can invest in QOFs include individuals, C corporations, partnerships, S corporations, trusts, and estates. The proposed regulations also provide that if a partnership does not elect to invest in a QOF, then a partner may elect on its own to be an investor in a QOF.  This provision also applies for other pass-through entities, such as S corporations, estates, and trusts.

How to Elect Deferral

In general, taxpayers have 180 days from the date a capital gain would be recognized to make an investment in a QOF. Under certain circumstances, a partner has 180 days from the end of a partnership's taxable year to invest in a QOF. The released guidance provides that such deferral election will be made on Form 8949, “Sales and Other Dispositions of Capital Assets.”

Qualification Period for the Ten Year Incentive

Prior to the issuance of the proposed regulations, it was unclear if a taxpayer would qualify for the Ten Year Incentive after the Opportunity Zone designation expires on Dec. 31, 2028. The proposed regulations provide that a taxpayer may qualify for the Ten Year Incentive provided that the taxpayer disposes of the interest in a QOF by Dec. 31, 2047, which is 20.5 years after the latest date that an eligible taxpayer may make a qualifying investment in a QOF. This should provide potential investors with comfort that they have flexibility to qualify for the Ten Year Incentive in the future.

Working Capital of a Qualified Opportunity Zone Business

The proposed regulations provide a safe harbor for working capital (e.g., cash, cash equivalents, or certain debt instruments) held by a qualified opportunity zone business to qualify as qualified opportunity zone property so long as the working capital is held for no more than 31 months and the qualified opportunity zone business complies with certain documentation and usage requirements. In essence, the safe harbor for working capital allows a qualified opportunity zone business to hold cash for 31 months prior to the acquisition, construction, or substantial improvement of property provided that the documentation and usage requirements prescribed by the proposed regulations are satisfied.

Land and the Substantial Improvement of Property

Tangible property qualifies as qualified opportunity zone business property only if the original use of such property commences with the QOF or the QOF substantially improves the property. Property is treated as substantially improved only if additions to the basis of such property during any 30-month period beginning after the acquisition of the property exceed an amount equal to the adjusted basis of such property. For purposes of this substantial improvement requirement, the proposed regulations and Revenue Ruling 2018-29 provide that the basis attributable to land is not included in the calculation. In other words, a QOF must only improve a building and not the underlying land.