October 26, 2018

     On October 19, the Treasury Department issued proposed regulations, ending the wait for much needed clarification regarding Opportunity Zones. Moving forward, both investors and advisors now have greater clarity regarding the nuances of both establishing Qualified Opportunity Funds (“QOFs”), as well as undertaking investment activities through these entities. As a note of caution – although the regulations issued by the Treasury Department are proposed, and can be withdrawn at any time prior to becoming final, the guidance provided through the proposed regulations is welcome nonetheless, as lingering questions can have been answered.

Introduction

To begin, providing a brief bit of background detailing the history and underpinnings of Qualified Opportunity Zones may be helpful. Qualified Opportunity Zones are constructs ushered in by passage of the Tax Cuts and Jobs Act of 2017 (the “TCJA”).[1] Set forth in Section 1400Z-1 et seq. of the Internal Revenue Code (the “Code”),[2] Qualified Opportunity Zones were created to be economic development tools for specified low-income communities[3] in which investors have the availability to invest capital for rehabilitative and developmental purposes. The rationale for inserting this incentive into the Code was to promote development activities in economically distressed areas through the grant of tax benefits for investors. Currently, the Service has afforded Qualified Opportunity Zone status to over 8,700 geographical areas located throughout all 50 states, which is greatly expanded from the initial designation made earlier this year.[4][5]

How Opportunity Zones Function

Qualified Opportunity Zones are structured to permit investors to invest in Qualified Opportunity Zone Property (“QOZ Property”) and receive either (a.) deferral of capital gain income recognition for amounts invested in QOZ Property or (b.) deferral and possible exclusion of any capital gain generated by selling QOZ Property. This is quite of bit of nuanced information contained within one sentence, so a bit of unpacking is in order. First, what is an investor for purposes of investing within a Qualified Opportunity Zone? An investor can be an individual or an entity – be it a corporation, partnership, or limited liability company, otherwise referred to as a “Qualified Opportunity Fund” (“QOF”). Being able to invest in a Qualified Opportunity Zone through an entity can be beneficial for the same reasons as when dealing with non-Qualified Opportunity Zone investments: aggregation of capital and flexibility. If a QOF is utilized, investments are restricted to Qualified Opportunity Zone Property, which must comprise at least 90% of the QOF’s assets.

A “working capital safe harbor” is now provided by the proposed regulations, which benefits qualifying businesses engaged in the acquisition, construction, and rehabilitation of real estate. Under the safe harbor, for purposes of satisfying the 90% asset requirement to be considered a Qualifying Opportunity Fund, cash, cash-equivalents, debt instruments with a maturity not exceeding 18 months, and accounts receivable from the sale of inventory will be includable. For the safe harbor to apply, the foregoing assets can only be applied towards satisfying the 90% threshold for up to 31 months, provided the assets are held pursuant to (1.) a written plan specifying that the assets are held for the acquisition, construction, or substantial improvement of tangible property within a Qualified Opportunity Zone; and (2.) a written schedule consistent with ordinary business operations of the qualifying business setting forth that the assets will be used within the 31-month timeframe. Additionally, the assets must actually be used within the 31-month timeframe.

Next, what exactly is “Qualified Opportunity Zone Property?” It is Qualified Opportunity Zone Stock,[6] a Qualified Opportunity Zone Partnership Interest,[7] or Qualified Opportunity Zone Business Property.[8] Importantly, QOZ Property does not include investments made by the QOF in other QOFs. It is crucial to keep this distinction clear: investments made by a QOF in other QOFs are not permissible for purposes of obtaining the benefits of QOF investments, but an investment by a QOF into a Qualified Opportunity Zone Partnership Interest[9] or Qualified Opportunity Zone Stock[10] is allowed. What does this mean? A QOF may not invest in another QOF, which in turn invests in a partnership qualifying as a Qualified Opportunity Zone Business, or stock of a corporation similarly qualifying as a Qualified Opportunity Zone Business. Instead, the investment must be direct – a QOF must itself invest in a partnership interest or stock, whichever is applicable, of a Qualified Opportunity Business.

If a QOF holds Qualified Opportunity Zone Stock or a Qualified Opportunity Zone Partnership Interest, the underlying corporation or partnership (including limited liability companies treated as partnerships for tax purposes) must itself be a Qualified Opportunity Zone Business. The newly issued proposed regulations help clarify what exactly constitutes a “Qualified Opportunity Zone Business.” Originally, the Code provided that a Qualified Opportunity Zone Business refers to “a trade or business in which substantially all of the tangible property owned or leased by the taxpayer is qualified opportunity zone business property,” subject to certain limitations. Unfortunately, ambiguity was introduced by the term “substantially all” within the definition. However, the proposed regulations provide that if 70% or more of all tangible property owned or leased by a trade or business constitutes Qualified Opportunity Zone Business Property, the “substantially all” requirement is met.

Now, let’s assume an investment in a Qualified Opportunity Zone is made using a QOF, in accordance with the rules set forth above. What are the potential benefits? First, further assume an individual has gain for the current tax year which he or she will be required to recognize for tax purposes. If the gain is characterized as capital in nature for Federal income tax purposes, instead of paying tax on it this year, it can be invested into QOZ Property and receive deferral treatment for up to any amount which is invested. This means tax will not be owed on any amount in the current year. In fact, tax will not be owed on the gain so long as it remains invested in QOZ Property. However, deferral is not for an unlimited duration. Unlike capital gain which is generated through an investment in QOZ Property as discussed below, the maximum length of time in which gain may be deferred is until December 31, 2026.[11]

The second benefit offered through investment in a Qualified Opportunity Zone is through deferral of capital gain income generated currently. If an investment in QOZ Property generates capital gain income which otherwise would be required to be recognized by an investor, such gain will be excludable from tax for the duration of time in which the capital gain income remains invested in QOZ Property.[12] And what if the gain amount is never withdrawn?[13] If the generated capital gain remains invested in QOZ Property for at least 10 years, then at the time such QOZ Property is sold or exchanged, no gain will be recognized by the investor. This affords the potential for tax on the capital gain to be permanently erased. If the QOZ Property is held by the investor, or a QOF in which the investor is an owner, for at least 5 years, 10% of the original capital gain will be permanently excluded from recognition by the investor; if held for more than 7 years, this amount increases to 15%.[14]

Looking Ahead

With issuance of the proposed regulations regarding Qualified Opportunity Zones, greater clarity has been provided by the Service for investors in contemplating initial or additional investments within these areas. However, as always, issues unique for every deal must be taken into account, such as choice of entity, investment deal structuring and negotiations, tax considerations, and exit strategies, to name but a few. At such times, having an advisor with which to discuss these issues may be beneficial to ensure all economic and legal considerations are identified and addressed.

Information provided herein does not, and is not intended to, constitute legal advice.  The content of this Insight is provided for informational purposes only.  Readers of this website should contact legal counsel to obtain advice with respect to any particular legal matter.

[1] Tax Cuts and Jobs Act, Pub. L. No. 115-97, 131 Stat. 2054, 2184 (2017).

[2] I.R.C. § 1400Z-1 et seq.

[3] I.R.C. 1400Z-1(b)(1).

[4] Initially, areas located within only 18 states were designed as Qualified Opportunity Zones. Since the first round of initial designations in April 2018, Opportunity Zones are now located throughout all 50 states as well as some U.S. territories. See I.R.S. Notice 2018-48.

[5] The methodology used to determine which areas qualify for Qualified Opportunity Zone status included use of economic data spanning between 2011-2015.   

[6] I.R.C. § 1400Z-2(d)(2)(A)(i).

[7] I.R.C. § 1400Z-2(d)(2)(A)(ii).

[8] I.R.C. § 1400Z-2(d)(2)(A)(iii).

[9] I.R.C. § 1400Z-2(d)(2)(C).

[10] I.R.C. § 1400Z-2(d)(2)(B).

[11] I.R.C. § 1400Z-2(a)(2)(b).

[12] If Qualified Opportunity Zone Property in which the capital gain is invested is sold or exchanged, an investor will have 180 days from the date of the sale or exchange to re-invest the capital gain in other Qualified Opportunity Zone Property.

[13] Receipt by an investor of the original invested capital gain is permitted so long as any amounts received, from the sale or exchange of property, is re-invested in other Qualified Opportunity Zone Property within 180 days of the sale or exchange.

[14] The mechanism by which the exclusion occurs is by permittance of a taxpayer to increase the basis of the Qualified Opportunity Zone Property held at the time of sale in an amount equal to the applicable exclusionary percentage.