As discussed in the Oct. 2, 2018 column, the Tax Cuts and Jobs Act, P.L. 115-97 (Dec. 22, 2017) (Tax Act), created a new economic development vehicle with tax deferral and tax abatement (qualified opportunity zones or QOZ). QOZ provides a deferral mechanism for short- and long-term capital gains for current investments in nearly all asset classes. A QOZ provides (1) the ability to invest only the gain rather than the principal of a current investment; (2) a broad range of investments eligible for the deferral; (3) a potential basis step-up of 15 percent or substantially more of the initial deferred amount of investment; and (4) an opportunity to eliminate taxation on capital gains post-investment.

The QOZ program is designed to encourage investment in distressed communities designated as qualified opportunity zones, by providing tax incentives to invest in QOZs that, in turn, invest directly or indirectly in the opportunity zones. The enacted statutory language left many uncertainties regarding the operation of the opportunity zone program. The Proposed Regulations answer some of the most important questions, mostly with taxpayer-friendly answers. See REG-115420-18; 83 Fed. Reg. 54,279 (Oct. 29, 2018). However, important questions remain unanswered and additional proposed regulations are expected to be issued in the near future.

Summary of the Proposed Regulations

Working Capital Safe Harbor. An opportunity fund is permitted by the statute to invest directly in an opportunity zone or indirectly through a partnership (a zone partnership) or a corporation (a zone corporation and collectively, zone entities). However, an opportunity fund that invests directly in property must be engaged in a trade or business and no more than 10 percent of its assets may consist of cash. A zone entity in which an opportunity fund invests must also be engaged in a trade or business and less than 5 percent of the unadjusted basis in its assets may be attributable to financial property, other than a reasonable amount of working capital. One of the concerns raised by these limitations is that they do not allow a sufficient period of time for opportunity funds or the zone entities in which they invest to receive capital and develop new businesses or construct or rehabilitate real estate and other tangible property. The Proposed Regulations partially address this concern by providing that a zone entity that acquires, constructs, and/or substantially rehabilitates tangible business property may treat cash, cash equivalents and debt instruments with a term of 18 months of less as a reasonable amount of working capital for a period of up to 31 months if certain conditions are satisfied. In addition, under the safe harbor, tangible property that is being acquired, constructed and/or substantially improved with the working capital and that is expected to qualify as zone property after the expenditure of the working capital will be treated as being used in the active conduct of a trade or business during the construction and improvement period. Thus, if a zone entity raises cash that satisfies the working capital safe harbor and uses that cash to construct a building that is expected to qualify as zone property, the partially completed building qualifies as zone property during the construction phase. This safe harbor does not apply to an opportunity fund that directly holds working capital or constructs property.

The 70 Percent Rule for Zone Businesses. The statute provides that 90 percent of the assets of an opportunity fund must consist of “qualified opportunity zone stock” (zone stock), “qualified opportunity zone partnership interests” (zone partnership interests) or “qualified opportunity zone business property” (zone business property) (collectively zone property). Under the statute, a trade or business operated by a zone entity qualifies as a “qualified opportunity zone business” (zone business) if substantially all of the tangible property owned or leased by the zone entity is zone business property. The Proposed Regulations provides that the substantially all requirement is satisfied if at least 70 percent of the tangible property owned or leased by the zone entity is zone business property. If a zone entity satisfies this test, then the entire value of the opportunity fund's zone stock or zone partnership interest is treated as zone property for purposes of the requirement that at least 90 percent of an opportunity fund's assets consist of zone property (the 90 percent test). This means that an opportunity fund could hold as little as 63 percent of its assets within an opportunity zone (i.e., 70 percent of 90 percent) and provide the tax benefits to investors.

Special Rules for Land and Improvements on Land. In order for property to qualify as zone business property, the “original use” of the property in an opportunity zone must begin with an opportunity fund or a zone entity or, if property that existed in the zone is purchased, an amount equal to the purchase price of the property must be used to improve the property. There were concerns that land might not qualify as zone business property because the original use of land can never begin with an opportunity fund or zone entity and, technically, land is never improved. However, Revenue Ruling 2018-29, issued along with the Proposed Regulations, provides a favorable rule, to the effect that, if an opportunity fund or zone entity purchases an existing building located on land that is wholly within an opportunity zone, the “original use” and “substantial improvement” requirements do not apply to the land and a substantial improvement to the building is measured by the additions to basis of the building (and the basis attributable to the land on which the building sits is not taken into account). Thus, if an opportunity fund purchases a property wholly within an opportunity zone for $800,000, consisting of land worth $480,000 and a building worth $320,000, and the opportunity fund invests at least $320,000 to improve the building, then the original $800,000 purchase price plus the $320,000 of improvements to the building qualify as zone business property.

The preamble to the Proposed Regulations implies that vacant real property purchased by an opportunity fund or zone entity does not qualify as zone business property. Nevertheless, the IRS has requested comments as to whether vacant real property that is productively utilized after some period of abandonment could qualify as zone business property.

Capital Gain as Eligible Gain for Deferral. The statute permits taxpayers that realize gain from the sale or exchange of property to defer the tax on that gain and receive up to a 15 percent basis step-up with respect to the gain by investing the gain in an opportunity fund. The Proposed Regulations clarify that only gain that would be capital gain (short-term or long-term) is eligible for deferral and a basis step-up. Capital gain from a position that is or has been part of an “offsetting-positions transaction” (i.e., a straddle or other transaction that substantially diminished the taxpayer's risk of loss) is not eligible for deferral.

Additional Deferral of Previously Deferred Gains. The Proposed Regulations provide that a taxpayer that sells its entire interest in an opportunity fund and invests the proceeds in a new opportunity fund within 180 days of the date on which the prior gain would be includible in income (but not later than Dec. 31, 2026) can continue to defer tax on the gain with respect to the original property. A taxpayer that sells only a portion of its investment in an opportunity fund cannot continue to defer gain. The availability of certain tax benefits of investing in an opportunity fund depends upon the taxpayer's holding period. The Proposed Regulations do not indicate whether a taxpayer is permitted to tack its prior holding period on to its holding period for its new opportunity fund investment in order to enjoy these benefits. Accordingly, it is unclear whether an investor can continue, or must restart, its holding period for purposes of determining the investor's eligibility for the statutory 5-, 7- and 10-year basis-step ups.

Types of Taxpayers Eligible to Elect Gain Deferral. Under the Proposed Regulations, individuals, C corporations (including regulated investment companies and real estate investment trusts, partnerships, common trust funds, qualified settlement funds, and disputed ownership funds are eligible for deferral. If a partnership does not elect deferral, partners in that partnership may elect deferral under special rules for pass-through entities. Analogous rules apply to S corporations, estates and trusts. The IRS has requested comments regarding whether the special rules for partnerships and other flow-through entities are sufficient.

Only Equity Investments Can Qualify. Under the Proposed Regulations, only equity (including preferred stock and partnership interests with special allocations) in an opportunity fund entitles the taxpayer to deferral of tax on gain with respect to the original property. A taxpayer that invests in a debt instrument issued by an opportunity fund does not qualify for deferral. The equity interest in an opportunity fund can be used as a collateral for a loan without jeopardizing the taxpayer's deferral.

Attributes of Deferred Gains Are Preserved. By statute, the deferred gain is included in income no later than Dec. 31, 2026. The Proposed Regulations provide that all of the deferred gain's tax attributes are preserved. The Proposed Regulations provide a first-in first-out (FIFO) method for recognizing gain if a taxpayer sells less than all of its interest in an opportunity fund prior to Dec. 31, 2026 and does not reinvest the proceeds in another opportunity fund.

Availability of Exclusion After Opportunity Zones Expire. The statute permits a taxpayer that holds an interest in an opportunity fund for 10 years or more to elect to step up its basis in its interest in the fund and avoid all tax with respect to appreciation on its interest in the fund. However, the designation of opportunity zones expires no later than Dec. 31, 2028. The Proposed Regulations provide that the ability to make the 10-year basis step up election is available until Dec. 31, 2047. Accordingly, it appears that the only consequence of the expiration of the opportunity zone designation is that new investments made after Dec. 31, 2028 will not be considered zone business property. The IRS has requested comments on this rule.

Opportunity Funds Can Be Organized as LLCs. Under the Proposed Regulations, any entity classified as a partnership or corporation for federal tax purposes, including a limited liability company (LLC), is eligible to be an opportunity fund. A list of frequently asked questions published by the IRS clarifies that an LLC that is treated either as a partnership or corporation for federal tax purposes can organize as an opportunity fund.

Self-Certifications for Opportunity Funds. The Proposed Regulations permit zone corporations and zone partnerships (zone entities) to self-certify that they meet the requirements to be treated as opportunity funds. The IRS released draft Form 8996 concomitantly with the Proposed Regulations Zone entities that desire to be treated as opportunity funds must include this form with their regular tax returns. See Instructions for Form 8996 (Rev. December 2018).

Effective Date of Proposed Regulations. The Proposed Regulations generally are proposed to be effective on or after the date of publication of final regulations. Nevertheless, taxpayers and opportunity funds may rely on a number of the rules in the Proposed Regulations, so long as the taxpayer and/or the opportunity fund applies the Proposed Regulations in their entirety and in a consistent manner.

Peter M. Fass is a partner at Proskauer Rose.