Prepared by Venable LLP Attorneys, Walter Calvert and Elizabeth Stieff
The tax and investment communities continue to be abuzz with discussion of the huge tax benefits that Opportunity Zone Funds have the potential to provide. This update is intended to provide guidance on the key topics to enable the reader to move forward with the implementation of Opportunity Zone Funds based on the Proposed Regulations issued by the IRS.
What is the Opportunity Zone program?
The Tax Cuts and Jobs Act, signed into law on December 22, 2017, authorized a new tax incentive program to encourage investment in low-income community businesses.
What are the benefits to investors?
Under the Opportunity Zone program, individual and corporate taxpayers are eligible to defer paying tax on gains from the sale of stock, business assets, or any other property by investing the proceeds into an Opportunity Zone Fund. The Opportunity Zone Fund, in turn, must invest at least 90% of its assets, directly or indirectly, in businesses located in certain low-income communities designated as Qualified Opportunity Zones. Partial elimination of tax on deferred gains from that original, rolled-over investment results from a 10% increase in the basis of an Opportunity Zone Fund investment held for at least five years and a 15% increase in the basis of an Opportunity Zone Fund investment held for at least seven years. All of the deferred gain will be realized at the end of 2026, if not realized by disinvestment sooner. But the big prize is that future appreciation on the new investment in the Qualified Opportunity Zone can be excluded from taxation if the investment in the Opportunity Zone Fund is held for at least 10 years.
What “gains” are eligible for investment under the Opportunity Zone program?
Only capital gains are eligible for investment.
Are capital gains realized by a partnership, corporation, REIT, or other entities eligible?
Yes. Gains recognized by individuals, C corporations, S corporations, RICs, REITs, partnerships, and certain other pass-through entities are all eligible.
Who can/must be the investor in the Opportunity Zone Fund?
Where an individual or C corporation sells property at a gain, then such individual or C corporation must be the person that makes the investment in the Opportunity Zone Fund. See the following Q&A regarding a partnership or S corporation realizing capital gain.
If the capital gain is realized by partnership or similar pass-through entity, is it the entity or the owner that must reinvest the gain to qualify?
The partnership may elect to defer the gain. If the partnership does not elect to defer the gain, then a partner may elect to defer its portion of the partnership’s gain. The partner generally has 180 days from the end of the partnership’s tax year to so elect. Similar rules will apply to other pass-through entities (including S corporations, decedents’ estates, and trusts) and to their shareholders and beneficiaries.
Are capital gains realized from sales to persons related to or affiliated with the seller eligible?
No. Gains that arise from a sale or exchange with a related person are not eligible.
By what date must gain be realized in order to be eligible?
The taxpayer must realize the gain no later than December 31, 2026, in order to obtain any deferral (all deferral ends as of December 31, 2026 in any event) and exclusion benefits from the OZF Program.
Can the investment be in the form of equity?
Yes. The investment must be in the form of an equity investment. The Proposed Regulations clarify that eligible equity interests include preferred stock and partnership interests with special allocations. However, if there is a deemed contribution of money to a Fund under the tax rules regarding partnership debt and its effect of basis, an increase in a partner’s share of partnership liabilities as a result of such deemed contribution would not cause that basis increase to be an ineligible investment in the Opportunity Zone Fund.
Can the investment be in the form of a loan to the Fund?
No. The investment must be an equity investment. However, the taxpayer may use the equity interest in a Fund as collateral for a loan without affecting the status of the equity as an eligible investment.
Where are Opportunity Zones located?
Each state, DC, and certain territories were required to nominate Qualified Opportunity Zones within their jurisdictions for certification by the Treasury Department. That process is complete. A list and maps of Opportunity Zones are available at https://www.cdfifund.gov/Pages/Opportunity-Zones.aspx
What requirements apply to setting up an Opportunity Zone Fund?
A partnership or corporation certifies itself as an Opportunity Zone Fund by filing an election with its tax return for the first year during which the entity desires to be an OZF. The election is made on Form 8996, Qualified Opportunity Fund. The IRS has released a draft of this form and the instructions thereto. The draft form requires an Opportunity Zone Fund to provide the IRS with information regarding the value of the Fund’s assets and qualified opportunity zone property.
Note that no approval or action by the IRS or other federal agency is needed for certification. Unless the IRS adds additional requirements when it ultimately provides regulatory guidance on the program, the statutory requirements are limited to the following:
The Opportunity Zone Fund must be organized as a corporation or partnership; and
The Opportunity Zone Fund must be organized for the purpose of investing in “qualified opportunity zone property.”
The requirement that the Opportunity Zone Fund be a corporation or partnership refers to the Fund’s characterization for federal income tax purposes. Thus a state law limited liability company with more than one member (and that has not made an election to be treated as an association taxable as a corporation) would be treated as a partnership and is eligible to self-certify as an Opportunity Zone Fund.
No restrictions apply as to who may organize, own, or manage an Opportunity Zone Fund. Thus, Funds can be single-investor funds in which a single taxpayer with gains to defer forms its own fund and directly controls the timing and selection of its investment in Opportunity Zone Property. Note that in order to have only a single investor/owner, an OZF would need to be classified as a corporation for federal income tax purposes, and corporate income tax status may not be the best way to achieve all of an OZF’s tax objectives (e.g., any losses would not pass through to the investor). At the other end of the spectrum, a sponsor could raise funds from multiple taxpayers who have recognized gains and pool their gain rollovers into a multi-investor Fund, with the sponsor selecting and managing the Fund’s investments.
Are there ongoing compliance filings that a Fund must make each year?
Yes. Form 8996 must be filed annually by the Fund. More importantly, as discussed below, an Opportunity Zone Fund must hold at least 90% of its assets in Opportunity Zone Property. This testing requirement comes with its own, separate monetary penalty for non-compliance. The monetary penalty is calculated, if applicable, on Form 8996.
How quickly must a taxpayer roll over gain into an Opportunity Zone Fund?
The statute provides a 180-day period during which the investment into the Opportunity Zone Fund must be made beginning with (and including) the date of the sale or exchange of the existing investment.
Partnerships have the benefit of a special rule that provides significant flexibility for the timing of the election for capital gain realized at the entity level. If a partnership realizes eligible capital gain, but does not make an OZF deferral election with respect to such gain, the partner may elect to defer his or her share of the gain. In such a situation, the partner has 180 days from the end of the partnership’s taxable year. However, a partner can choose to start the 180-day period earlier. For example, if a partnership sells a capital asset on January 1, 2018 and notifies the partners that it will not make a gain deferral election, then a partner has until June 30, 2019 to elect to roll over its share of that gain into an Opportunity Zone Fund.
If a taxpayer invests in a Fund and later sells or exchanges the Fund interest such that the taxpayer would recognize the deferred gain, then the taxpayer can reinvest the gain from the sale of the Fund interest into another Opportunity Zone Fund and elect again to defer the previously deferred gain. This provision allows a taxpayer to make back-to-back investments. This provision is available only if the taxpayer has disposed of its entire initial investment in the Fund.
What is the process for making the capital gain deferral election?
Taxpayers will make the deferral election on Form 8949, Sales and Other Dispositions of Capital Assets, attached to taxpayers’ income tax returns for the year in which the gain would have been recognized but for the deferral election.
What happens when the deferred gain is recognized?
A taxpayer will recognize the deferred gain on the earlier of (1) the taxpayer’s sale or exchange of the Opportunity Zone Fund investment; or (2) December 31, 2026. As noted above, a taxpayer may be able to avoid recognition of the deferred gain under (1) by reinvesting his or her gain into another Opportunity Zone Fund. However, all deferred gain must be recognized by December 31, 2026, even if the taxpayer has not sold or exchanged his or her investment. Accordingly, taxpayers must be aware that they may have a gain recognition event in 2026 with no associated income or cash.
Note that a taxpayer may make separate investments in an Opportunity Zone Fund at different times. If the investments are indistinguishable (other than the timing of the investment) and the taxpayer sells less than all of his or her interests, the IRS will identify the interests sold using the “first-in, first-out” method. Accordingly, taxpayers making multiple investments in the same Opportunity Zone Fund are encouraged to separately identify these investments in the event of a future sale of less than all of a taxpayer’s interests.
How quickly must an Opportunity Zone Fund invest in Opportunity Zone Property?
At least 90% of the assets of an Opportunity Zone Fund must be invested in Opportunity Zone Property. Opportunity Zone Property includes both (i) direct ownership and operation by the Fund of qualified opportunity zone business property and (ii) indirect investment in such business property via investments in equity interests in one or more operating subsidiary entities (which in turn must each be a tax law corporation or partnership) that are Opportunity Zone Businesses. The Proposed Regulations provide that the Opportunity Zone Fund should use the asset values reported on its applicable financial statement for the taxable year to determine whether the Fund has satisfied this test. If the Fund does not have applicable financial statements, the Proposed Regulations provide that the Fund should use the cost of its assets. However, the IRS has requested comments on both of these valuation methods.
The Opportunity Zone Fund must satisfy the 90% test on both the last day of the first 6-month period of the taxable year of the Fund and the last day of the taxable year of the Fund. The Proposed Regulations allow an Opportunity Zone Fund to designate the first month it will be treated as an Opportunity Zone Fund; however, no deferral election can be made for investments to the Fund until the “first month” elected by the Fund. Thus, depending on when funds are contributed into an Opportunity Zone Fund, the Fund would have six months at the most to invest at least 90% of its assets into Opportunity Zone Property.For example, if the first month for the Fund was October 2018 and the Fund uses the calendar year as its taxable year, then it will have only one testing date for its first year of operation – December 31, 2018. However, if the Fund’s first month is February 2018 and the Fund uses the calendar year as its taxable year, it will have two testing dates in its first year of operation – July 31, 2018 and December 31, 2018.
When does the reinvestment period begin to run?
The statute provides that an Opportunity Zone Fund will have a “reasonable period of time” to reinvest proceeds from qualified opportunity zone stock, qualified opportunity zone partnership interests, and qualified opportunity zone business property. The IRS plans to issue more guidance on what is a “reasonable period of time,” as well as the tax treatment of any reinvested gains.
If an Opportunity Zone Fund invests in a corporation or partnership in an Opportunity Zone, how quickly must that entity invest in Opportunity Zone Property?
As noted above, an Opportunity Zone Fund can invest in qualifying projects directly (including through a single-member limited liability company) or indirectly through a corporation or partnership. The time for an Opportunity Zone Fund to make its investment directly or into the stock or partnership interest of a subsidiary is discussed in the context of the 90% test and its related penalty. The topic here is the time for a subsidiary corporation or subsidiary partnership of an Opportunity Zone Fund to invest funds received from its parent Opportunity Zone Fund.
A Fund’s interests in a corporation or partnership qualify for the 90% asset test if the corporation or partnership qualified as an Opportunity Zone Business. The corporation or partnership must be a qualified opportunity zone business both at the time the Fund acquires its interests in the subsidiary and during substantially all of the Fund’s holding period for its interests in the subsidiary.
Among the requirements for the subsidiary to qualify as an Opportunity Zone Business are that:
Substantially all (i.e., at least 70%) of the tangible property owned or leased by the subsidiary is qualified opportunity zone business property, as determined by the following criteria:
The property is acquired by the subsidiary by purchase after December 31, 2017;
The original use of the property commences with the subsidiary or the subsidiary substantially improves the property (these requirements are discussed below); and
During substantially all of the subsidiary’s holding period for the property, substantially all of the use of the property was in a Qualified Opportunity Zone.
The subsidiary derives at least 50% of its gross income from the active conduct of a trade or business;
The subsidiary has less than 5% of the average of the aggregate unadjusted basis of its property attributable to “nonqualified financial property,” and
The subsidiary uses a substantial portion of any intangible property in an active business.
These rules come by cross-reference to other tax programs, which require that such tests be satisfied on a taxable-year basis. Accordingly, investing cash so as to satisfy these tests by the end of the first taxable year (which could be a short year) could be difficult or impossible for many Opportunity Zone Businesses.
“Nonqualified financial property” is defined elsewhere in the Internal Revenue Code as debt, stock, partnership interests, options, futures contracts, forward contracts, warrants, notional principal contracts, annuities, and other, similar property specified in regulations, but does not include (1) reasonable amounts of working capital held in cash, cash equivalents, or debt instruments with a term of 18 months or less, or (2) certain debt instruments. Such term would include bank accounts, checking accounts, and other time and demand deposits.
Although not specifically listed, the term “nonqualified financial property” also would include cash on hand. However, the IRS provided a working capital safe harbor in the Proposed Regulations that protects against a violation of the test for cash or other investments held in compliance with safe harbor requirements. The safe harbor is available for businesses that acquire, construct, or rehabilitate tangible business property (including real property). Such businesses can hold cash in excess of the 5% standard for a period of up to 31 months if (1) there is a written plan that identifies the cash as held for the acquisition, construction, or substantial improvement of opportunity zone property; (2) there is a written schedule showing that the cash will be used within 31 months; and (3) the business substantially complies with the written schedule.
Although the safe harbor is helpful for certain businesses, it is hoped that the IRS will provide further guidance that enables relief on these timing issues by giving a subsidiary more time to satisfy the Opportunity Zone Business tests, and allowing it to hold cash in connection with businesses other than the acquisition, construction, or rehabilitation of tangible property.
How quickly must rehabilitation of acquired existing Opportunity Zone Property occur?
Here again is one of numerous instances in which uncertainty exists in implementing the OZF Program: Either an Opportunity Zone Fund or its subsidiary must substantially improve the property it acquires, unless the “original use” (as discussed below) of the property in the Opportunity Zone commenced with the Opportunity Zone Fund or subsidiary. To “substantially improve” a property, during a 30-month period an Opportunity Zone Fund (or its subsidiary) must make additions to its basis with respect to the property in the hands of the Opportunity Zone Fund (or subsidiary) that exceed its basis in the property at the beginning of the 30-month period. The rehabilitation must occur “during any 30-month period beginning after the date of acquisition of such property.”
Although the statute appears to provide flexibility regarding when the 30-month period can be considered to begin, until the IRS provides guidance on the timing of commencement requirement, taxpayers may want to take a conservative approach and plan to complete required improvements of their property during the 30-month period beginning on the date of acquisition.
What does it mean that the “original use” of Opportunity Zone Property must be by the Opportunity Zone Fund?
For all projects, the “original use” of the property in the Opportunity Zone must commence with the Opportunity Zone Fund, or the Opportunity Zone Fund must substantially improve the property. The substantial improvement requirement is discussed in the Q&A immediately above. The original use standard has been used in other programs similar to the Opportunity Zone program (including the Gulf Opportunity Zone program and the DC Enterprise Zone program), which indicates that the standard’s application to tangible personal property should be clear: new tangible personal property purchased by the Opportunity Zone Fund or a subsidiary that constitutes an Opportunity Zone Business and first used in an Opportunity Zone should qualify. And used tangible personal property previously used outside the Opportunity Zone, but purchased from a third party and relocated to the Opportunity Zone, should also qualify.
The rules with respect to real property are less clear. An existing building located in an Opportunity Zone could not satisfy the original use test when purchased by an Opportunity Zone Fund, and thus would have to be substantially improved. Vacant land located in an Opportunity Zone also appears to fail the original use test, and therefore would have to be substantially improved. But it is hoped that the IRS will provide more guidance on the application of the “original use” and substantial improvement requirements to situations involving the acquisition of land in an Opportunity Zone.
What types of projects/property are permissible investments?
All types of projects and property qualify as permissible investments for an Opportunity Zone Fund, with the exception of the limited types of prohibited businesses if the investment is made through a subsidiary as follows: a private or commercial golf course, country club, massage parlor, hot tub facility, suntan facility, racetrack or other facility used for gambling, or any store, the principal business of which is the sale of alcoholic beverages for consumption off premises. While the statute does not impose these restrictions if an Opportunity Zone Fund invests directly in an Opportunity Zone Property, guidance may well subject all investments to these restrictions, as the difference in treatments seems unlikely to have been intentional.
One of the requirements for qualifying as an Opportunity Zone Business (applicable if an Opportunity Zone Fund invests through a corporate or partnership subsidiary, but not if it invests directly in projects) is that at least 50% of its total gross income be derived from the “active conduct” of a trade or business. The trade or business standard raises a question regarding whether certain types of projects, particularly rental real estate, are eligible for investments held by the Fund via a subsidiary. A similar requirement applied with respect to certain benefits available for projects in the Gulf Opportunity Zone. In that context, the IRS provided guidance stating that “the determination of whether a trade or business is actively conducted by the taxpayer is to be made based on all of the facts and circumstances. A taxpayer generally is considered to actively conduct a trade or business if the taxpayer meaningfully participates in the management or operations of the trade or business.”
Can an Opportunity Zone Fund hold cash pending investment in Opportunity Zone Property?
It depends – as discussed above, the Proposed Regulations include a working capital safe harbor that is available to a subsidiary partnership or subsidiary corporation in which an OZF invests. But that safe harbor is not available to the Opportunity Zone Fund itself. Rather, under the Proposed Regulations, the holding of cash by the OZF is restricted by the twice-annual application of the 90% test for investment by the Fund (and the resulting annual penalty for shortfalls in meeting the 90% tests) as discussed above.
Can borrowed funds (leverage) be used in the Opportunity Zone program?
Yes, leverage can be used at several different levels. Because there is no required connection between the capital gain that a taxpayer desires to defer and cash proceeds used to fund an investment in an Opportunity Zone Fund, a taxpayer could borrow such amounts. In addition, there is no prohibition on an Opportunity Zone Fund borrowing to partially fund (together with the taxpayer’s equity investment in the Opportunity Zone Fund) the purchase of Opportunity Zone Property.
Similarly, a partnership or corporate subsidiary of an Opportunity Zone Fund could borrow to help fund a project. Borrowing at the subsidiary level could potentially be tailored to comply with the timing requirements and cash limitations discussed above – for example, a taxpayer’s equity could be used to acquire an existing property, and then borrowed funds could be drawn down as needed to improve the property.
But if a Fund investor invests amounts in an Opportunity Zone Fund in addition to its capital gain eligible to be rolled into the Fund, then such excess investments will not be eligible for any of the benefits of the OZF Program, regardless of the source of the investor’s fund for excess investment. Thus, an investor cannot take advantage of the exclusion benefit with respect to investments that it makes in a Fund in addition to its capital gain rollover.
If a Fund acquires a building located on land in a Zone, how does the “original use” apply to them?
The original use of the building is not considered to have commenced with the Fund. The original use requirement is not applicable to the land.
If land and a building are to be improved, how does the substantial improvement requirement apply to them?
The Fund must substantially improve the building by spending an amount on improvements to the building at least equal to the Fund’s cost basis in the building. The separate cost basis of the land does not affect the substantial improvement calculation for the building, and the land does not need to be improved in order for the substantial improvement requirement to be satisfied with respect to the overall project.
What happens if a taxpayer holds his or her Fund investment for at least 10 years?
If a taxpayer holds an equity interest in a Fund for at least 10 years, the taxpayer can increase the basis of his or her equity interest to the fair market value of that equity interest on the date the interest is sold or exchanged. As a result, all of the gain attributable to appreciation in the Fund’s value would be tax-free. The basis step-up is available only to the extent that the taxpayer elected to defer the recognition of capital gain. Accordingly, if a taxpayer invests cash (for which no deferral election has been made) and proceeds from a capital transaction (for which a deferral election has been made), the investment will need to be bifurcated, and the appreciation with respect to the cash portion will be subject to tax on the eventual sale or exchange of the Fund interest.
To what extent can these Proposed Regulations of October 2018 be relied on?
Taxpayers can rely on the Proposed Regulations with respect to any gains recognized after October 19, 2018.
What further guidance can be expected from the IRS?
The IRS plans to issue additional published guidance, which will address, among other things, (1) the meaning of “substantially all” throughout Section 1400Z-2; (2) whether certain transactions will trigger the inclusion of the deferred gain; (3) the length of the “reasonable period” for the QOF to reinvest proceeds from the sale of a qualifying asset; (4) further guidance regarding the impact of failing to satisfy the 90% investment standard; and (5) other information-reporting requirements. In addition, the IRS is soliciting comments on (1) the Proposed Regulations of October 2018; (2) the definition of “original use” for real and other tangible property, including the appropriate metrics for determining whether tangible property is used in an opportunity zone and whether prior lack of use should affect the property’s ability to satisfy the original use test; and (3) whether taxpayers need additional guidance regarding the “substantial improvement” requirement.
When can such additional guidance be expected from the IRS?
Additional regulatory guidance is expected at any time. Revisions to the existing proposed regulations can be expected only after the IRS has had time to review the many comments submitted suggesting alterations and additions to them.