Deferring Tax on Capital Gains by Investing in Opportunity Zones
- Type of Gain: Only “capital gain” for federal income tax purposes is eligible for deferral under the provisions of IRC Sec. 1400Z-2 (the “Qualified Opportunity Zone Statute”). As stated in the preamble to the Proposed Regulations, that is “capital gain 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.” Also, the gain must be gain that would be recognized, absent deferral, not later than December 31, 2026 and must not arise from a sale or exchange with a “related person.”
- Section 1256 Contracts: The only gain arising from “Section 1256 contracts” that is eligible for deferral is “capital gain net income” for a taxable year. However, no deferral of gain from a Section 1256 contract is allowed in a taxable year if, at any time during the taxable year, one of the taxpayer’s Section 1256 contracts was part of an offsetting positions transaction in which any of the other positions was not also a Section 1256 contract.
- Section 1231 Gain and Unrecaptured Section 1250 Gain: Based on a reading of the Proposed Regulations, Section 1231 gain and unrecaptured Section 1250 gain should be eligible for deferral.
- Eligible for Deferral: Taxpayers eligible to elect deferral are those that recognize capital gain for federal income tax purposes. These taxpayers include individuals, C corporations (including regulated investment companies and real estate investment trusts), partnerships, S corporations, trusts and estates.
- Eligible Interest in a Qualified Opportunity Fund: An investment in the qualified opportunity fund must be an equity interest in the qualified opportunity fund, including preferred stock or a partnership with special allocations. A debt instrument is not an eligible interest. Importantly, status as an eligible interest is not impaired by the taxpayer’s use of the interest as a collateral for a loan, whether a purchase-money borrowing or otherwise.
- Treatment of Liabilities: A deemed contribution of money under IRC Sec. 752(a) (increase in partner’s share of liabilities in a partnership) does not result in the creation of an investment in a qualified opportunity fund. Thus, such a deemed contribution does not result in a partner having a separate investment (which is the case when an investor makes an investment in a qualified opportunity fund in excess of the eligible gain from a recent sale or exchange).
- 180-Day Period to Invest: The Proposed Regulations generally provide that the first day of the 180-day period is the date on which the gain would be recognized for federal income tax purposes. Where a taxpayer acquires an original interest in a qualified opportunity fund and a later sale or exchange of that interest triggers an inclusion of the deferral gain, if the taxpayer makes a qualifying new investment in a qualified opportunity fund, the taxpayer is eligible to make an election to defer the inclusion of the previously deferred gain, provided that the entire initial investment has been disposed.
- Deferred Gain Attributes: All of the deferred gain’s tax attributes are preserved through the deferral period and are taken into account when the gain is included in income. So, for example, treatment of a gain as short-term, or as unrecaptured Section 1250 gain, or a Section 1256 contract gain as 60% long-term/40% short-term, is retained.
Deferral of Gains of Partnerships and Other Pass-Through Entities
- The Proposed Regulations permit a partnership to elect deferral and, to the extent that the partnership does not elect deferral, allow a partner to do so. These rules clarify the circumstances under which the partnership and a partner can elect and when the applicable 180-day period begins. The 180-day period for the partnership begins on the date that the partnership would recognize the gain from the sale or exchange. If the partnership does not elect to defer all or a portion of the gain, the partner’s 180-day period generally begins on the last day of the partnership’s taxable year unless the partner elects to use the beginning of the partnership’s 180-day period.
How to Elect Deferral
- It is currently anticipated that taxpayers will make deferral elections on Form 8949, to be attached to their federal income tax returns for the taxable year in which the gain would have been recognized if it had not been deferred. Form instructions to this effect are expected to be released shortly.
Election for Investments Held At Least 10 Years
- Under the qualified opportunity fund Statute, a taxpayer that holds a qualified opportunity fund investment for at least 10 years may elect to increase the basis of the investment to the fair market value of the investment on the date the investment is sold or exchanged. The Proposed Regulations reiterate that a taxpayer may make the election to step up the basis in an investment in the qualified opportunity fund held for 10 years or more only if a proper deferral election has been made for the investment.
- Under the qualified opportunity zone Statute, qualified opportunity zone designations expire on December 31, 2028. The Proposed Regulations extend the ability to make the election to step up the basis of the investment to fair market value until December 31, 2047.
Rules for a Qualified Opportunity Fund
- Fund Requirements
- There is no prohibition to using a pre-existing entity as a qualified opportunity fund or as a subsidiary entity operating a qualified opportunity zone business, provided that the pre-existing entity satisfies the various requirements for a qualified opportunity fund.
- Valuation of Assets for 90% Test: One of the requirements for a qualified opportunity fund is that 90% of its assets must be qualified opportunity zone property. The Proposed Regulations require the qualified opportunity fund to use the asset values that are reported on the qualified opportunity fund’s “applicable financial statement” for the taxable year; if the qualified opportunity fund does not have an applicable financial statement, the qualified opportunity fund must use the cost of its assets.
- Entity Classification: A qualified opportunity fund must be an entity classified as a corporation or partnership “for Federal income tax purposes” and must be created or organized in one of the 50 U.S. states, the District of Columbia or a U.S. possession. Therefore, a limited liability company (LLC) should be eligible to be a qualified opportunity fund so long as it is taxed as a partnership or corporation.
- Treatment of Working Capital: One of the big unknown questions has been the extent to which cash can be an appropriate qualified opportunity fund property for purposes of the 90% asset test, where the cash is held with the intent of investing in qualified opportunity zone property. The Proposed Regulations provide a working capital safe harbor for qualified opportunity fund investments in qualified opportunity zone businesses that acquire, construct, or rehabilitate tangible business property – which includes both real property and other tangible property used in a business operating in a qualified opportunity zone. This safe harbor allows qualified opportunity zone businesses to maintain reasonable amounts of working capital in cash, cash equivalents or debt instruments with a term of 18 months or less for a period of up to 31 months, if (i) there is a written plan that identifies the financial property as property held for the acquisition, construction, or substantial improvement of tangible property in the opportunity zone, (ii) there is a written schedule consistent with the ordinary business operations of the business that the property will be used within 31 months, and (iii) the business substantially complies with the schedule. Taxpayers would be required to retain any written plan in their records.
- “Substantially All” Requirement: For a trade or business to qualify as a qualified opportunity zone business, amongst other requirements, it must be one in which “substantially all” of the tangible property owned or leased by the taxpayer is qualified opportunity zone business property. The Proposed Regulations set this threshold as “at least 70%.”
- The regulations are proposed to be effective on or after the date of publication in the Federal Register of a Treasury decision adopting these proposed rules as final regulations. However, taxpayers may generally rely on the Proposed Regulations so long as the taxpayer or qualified opportunity fund, as the case may be, applies the rules in their entirety and in a consistent manner.
- As with the release of proposed regulations typically, a public hearing on the Proposed Regulations is scheduled for January 10, 2019. The Treasury and IRS are soliciting comments on the Proposed Regulations and other guidance necessary to implement the qualified opportunity zone Statute.
As part of the October 19 release, the IRS issued Revenue Ruling 2018-29, which addresses a number of open questions relating to the purchase of an existing building located on land wholly within a qualified opportunity zone. One of the statutory requirements is that qualified opportunity zone property be tangible property used in the trade or business of the qualified opportunity fund if (i) such tangible property is purchased by the qualified opportunity fund after December 31, 2017, (ii) the original use of the tangible property commences with the qualified opportunity fund or the qualified opportunity fund “substantially improves” the tangible property and (iii) during substantially all of the qualified opportunity fund’s holding period for such tangible property, substantially all of the use of such tangible property is in a qualified opportunity zone. Substantial improvement requires the doubling of the investment in the tangible property. The revenue ruling holds:
- The original use of an existing building purchased in the qualified opportunity zone is not considered to have commenced with the qualified opportunity fund, and the requirement that the original use of tangible property in the qualified opportunity zone commence with a qualified opportunity zone is not applicable to the land on which the building is located. As noted in the ruling, given the permanence of land, land can never have its original use in a qualified opportunity zone commencing with a qualified opportunity fund.
- A substantial improvement to the building is measured by the qualified opportunity fund’s additions to the adjusted basis of the building only (i.e., the allocated basis of the land is not taken into account in determining whether the building has been substantially improved, a determination that can materially reduce the amount required to satisfy the substantial improvement test).
- Measuring a substantial improvement to the building by additions to the qualified opportunity fund’s adjusted basis of the building does not require the qualified opportunity fund to separately substantially improve the land upon which the building is located.
Please Click Link Below For an Interactive Map of the Zones: