Treasury’s Opportunity Zones Guidance Answers Many Key Questions
The starting gates opened months ago for opportunity zones (OZs)–as the U.S. Treasury Department designated OZs and determined that qualified opportunity funds would self-certify. The race didn’t fully begin, though, until Oct. 19.
That’s when those involved in OZs–investors, fund managers, real estate developers, operating businesses and others–received the long-awaited first tranche of tax guidance from Treasury. The guidance included proposed regulations, a revenue ruling, an updated Q&A document and a draft of Form 8996 for qualified opportunity funds (QOFs) and instructions for the form.
It was a significant day for an incentive designed to unlock capital gains for investment in low-income communities. This is big: The Economic Innovation Group estimates that there is as much as $6 trillion in gains that could be invested in OZs. More than 8,700 OZs around the nation will benefit.
Importantly, during the period between when the starting gates opened and the guidance was issued wasn’t barren. Investors and fund managers organized funds and identified and underwrote investments, as they prepared to invest in distressed areas. Many investors contributed gains to QOFs. Some QOFs invested in qualified opportunity zone property.
But many waited for Treasury’s guidance.
With guidance out, many gating issues–those that determine whether an investor participates and how businesses qualify–are clarified.
We know the incentive applies to capital gains. We know that taxpayers can benefit from the incentive beyond the current expiration date of the OZ designations. We know what “substantially all” percentage to use in measuring an OZ business’s OZ business property. We know answers to many questions.
Greater amounts of capital should now begin flowing into OZs. While the regulations are proposed and not final, taxpayers and QOFs can rely on the regulations–as long as they apply the rules in their entirety and do so in a consistent manner.
The tax guidance was extensive, though not exhaustive. Following is a high-level look at what Treasury clarified, followed by what wasn’t clarified and potential timelines for future guidance.
Highlights of Guidance
Treasury guidance covered who is eligible for the OZ incentive as well as how deferred gain elections apply to partnership asset sales, how QOFs measure the 90 percent asset test, what constitutes “substantially all” for a qualified OZ business and plenty more.
The guidance included 74 pages of proposed regulations. Some highlights included:
- OZs are for capital gains. The statute says OZs are for “gains,” but now we know it’s more limited.
- Deferred gain retains the same attributes in the year it’s recognized as it had in the year it would be reported if tax wasn’t deferred.
- Those who are eligible for the OZ include individuals, corporations (including RICs and REITs), partnerships, common trust funds (under Section 584), qualified settlement funds, disputed ownership funds and other entities taxable under IRC Section 1.468B.
- Partnerships may defer all or part of a capital gain. If the partnership does so, the elected deferred gain is not included in the distributive shares of its partners.
- When a partnership doesn’t defer gain, a partner may elect its own deferral with respect to their distributive share.
- A partner’s 180-day period begins on the last day of the partnership’s taxable year, or (if the partner chooses) on the same day as the start of the partnership’s 180-day period.
- QOFs must be classified as a corporation or partnership for federal income tax purposes (which means a limited liability company is eligible) and be organized in a state, the District of Columbia or a U.S. possession.
- QOFs can choose their first month in a taxable year for when they officially begin, but if they don’t choose, it will be the first month of that year. Also, the “first six-month period of the taxable year of the fund” means the first such period that includes months within the tax year and in which the entity is a QOF.
- The valuation method for the 90 percent asset test uses asset values on the QOF’s applicable financial statement for the taxable year, or the cost of the assets if the QOF has no applicable financial statement.
- The “substantially all” threshold of an OZ business’s OZ business property is 70 percent. The OZ business should use asset values reported on its applicable financial statement for that year, but if there is no applicable statement, the QOF can generally use the same methodology for determining the OZ business’s compliance with the 70 percent requirement that the QOF uses to determine its compliance with the 90 percent asset requirement, subject to a Five Percent Zone Taxpayer rule.
- The reasonable working capital safe harbor for OZ businesses is 31 months, presuming the intended uses are designated in writing, there is a reasonable written schedule and the working capital is used in a manner substantially consistent with the uses and schedule.
- At least 50 percent of the gross income of a qualified OZ business must be derived from business conduct in the OZ.
- A substantial portion of the intangible property of an OZ business must be used in the active conduct of a trade or business in the OZ.
- The ability to make the 10-year basis step-up election at the sale of the QOF investment is preserved until Dec. 31, 2047. This means taxpayers can benefit from the 10-year hold incentive even after current OZ designations expire.
Still Seeking Guidance
The guidance was comprehensive, but not complete. There are still issues awaiting guidance, topics that will likely be included in a second–or even third–tranche of guidance from Treasury.
Outstanding areas include:
- Federal tax treatment of gains recognized by a QOF, that a QOF reinvests.
- What constitutes a “reasonable period” for a QOF to reinvest proceeds from a sale of qualifying assets.
- The reasonable period for a QOF to invest cash received by a QOF from an investor.
- The definition of “substantially all” in uses other than the OZ business description above.
- How to determine the use in an OZ of an OZ business’s inventory, delivery trucks and other items.
- What conduct could lead to decertification of a QOF.
Revenue Ruling Provides Specific Clarity
In addition to the guidance, Treasury released Revenue Ruling 2018-29 to provide clarity on the “substantial improvement” standard for a building. Treasury said that the original use of the building isn’t considered to have started with the QOF, that standard is not applicable to the land on which a building is located and the substantial improvement to the building is measured by the QOF’s additions to the adjusted basis of the building. The significance of that is the basis doesn’t include the land–which lowers the bar for the “substantially improved” test.
The revenue ruling also included an example that implied that residential rental property is eligible OZ business property, at least if it’s owned by the QOF.
Digest, Suggest, Improve
The guidance provides clarity for participants in the OZ incentive and pages of documents that will require parsing and further examination by all involved. Treasury will accept comments for 60 days from the guidance’s publication in the Federal Register, giving stakeholders an opportunity to weigh in on several issues for which Treasury requested comment.
Many of the rules adopted in the proposed regulations and guidance were consistent with the consensus recommendations of the Opportunity Zones Working Group, made up of industry participants. In the weeks and months ahead, the OZ Working Group will focus its attention on responding to the areas for which Treasury requested comments, comment on the proposed regulations and other guidance as released, and develop recommended practices for implementing portions of the regulations and guidance. If you are interested in being a part of that group, go to www.opportunityzonesresourcecenter.com for more information.
Guidance is here, more is coming and more undoubtedly will be en route in the weeks, months and years ahead. After the Oct. 19 release of the first tranche, participants in the incentive can start making the impact in low-income communities that was expected when the OZ incentive was included in tax reform legislation.
That’s good news.
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