On December 19, 2019, nearly two years to the day since the enactment of the Opportunity Zones legislation (Pub. L 115-97), the U.S. Treasury Department and Internal Revenue Service issued 544 pages of anticipated final regulations on the Opportunity Zones program. The final regulations make important changes and refinements to the first two tranches of proposed regulations as well as provide guidance to other unanswered tax-related issues.
Opportunity Zones were designed to spur economic development and job creation in urban and rural distressed low-income communities by providing tax incentives for qualified investments in designated Opportunity Zones. Qualified investors who reinvest capital gains in a Qualified Opportunity Fund (QOF) within 180 days of the property's disposition can achieve the following three tax benefits:
- The deferral of gain realized from the disposition of capital gain property to an unrelated person until the earlier of the date on which the subsequent investment is sold or exchanged or Dec. 31, 2026;
- The reduction of up to 15% of the capital gain that has been reinvested in a QOF provided certain holding periods (5 years – 10% or 7 years – 15%) are met; and
- The elimination of all income tax on gains associated with the appreciation in the value of an investor's interest in a QOF, provided that the investor's investment in the QOF is held for at least 10 years.
While an extensive discussion of the final regulations is beyond the scope of this article, the following represent a number of highlights of the final regulations1:
-Capital gain deferral. The final regulations amend the proposed regulations' general rule that only capital gains may be invested in a QOF during the 180-day investment period by clarifying that only eligible gain taxable in the United States may be invested in a QOF.
-Sales of Section 1231 business property. The proposed regulations required an investor to invest the net gain from the sale of business property in a QOF after all gains and losses from the sales of such property are offset, and required the 180-day investment period to begin on the last day of the investor's tax year. The final regulations allow a taxpayer to invest the entire amount of gains from the sales of business property without regard to losses, and change the beginning of the investment period from the end of the year to the date of the sale of each asset.
-Partnership gain. Partners in a partnership, shareholders of an S corporation, and beneficiaries of estates and non-grantor trusts have the option to initiate the 180-day investment period on the due date of the entity's tax return, not including any extensions. This result elevates investors' concerns about missing investment opportunities as a result of receiving a late Schedule K-1 (or other form) from the entity.
-Nonresident & foreign investment. The final regulations provide that nonresident alien individuals and foreign corporations may make Opportunity Zone investments with capital gains that are effectively connected to a U.S. trade or business. This includes capital gains on real estate assets taxed to nonresident alien individuals and foreign corporations under the Foreign Investment in Real Property Tax Act rules.
-The substantial improvement test-aggregation of property. The final regulations permit, in certain situations, the grouping of two or more buildings located on the same parcel(s) of land will be treated as a single property. In these cases, any additions to the basis of the buildings are aggregated to determine satisfaction of the substantial improvement requirement. Consequently, a taxpayer is not required to increase the basis of each building by 100% as long as the total additions to the basis for the group of buildings equals 100% of the initial basis for the group.
-Vacancy period to allow a building to qualify as original use. The final regulations reduce the five-year vacancy requirement in the proposed regulations to a one-year vacancy requirement if the property was vacant for at least one year prior to the formation of the Qualified Opportunity Zone (QOZ) being designated and remains vacant through the date of purchase. For other vacant property, the proposed five-year vacancy requirement is reduced to three years. In addition, property involuntarily transferred to local government control is included in the definition of the term vacant, allowing it to be treated as original use property when purchased by a QOF or QOZB from the local government.
-Working capital safe harbor. The final regulations provide several refinements to the working capital safe harbor. An additional 62-month safe harbor for start-up businesses has been created to ensure that they can comply with the 70% tangible property standard, the 50% gross income requirement, and other requirements to qualify as a Qualified Opportunity Zone Business (QOZB).
-Self-constructed property. The final rules provide that self-constructed property can count for purposes of the QOF's 90% asset test and the QOZB's 70% asset test, and is valued at the purchase price as of the date when physical work of a significant nature begins.
-De minimis exception for "sin businesses". The final regulations provide that a QOZB may have less than 5% of its property leased to a so-called "sin business" described in 26 U.S.C. §144(c)(6)(B). For example, a hotel business of a QOZB could potentially lease space to a spa that provides tanning services.
-QOFs with multiple assets. IRS and Treasury allowed for QOF to be structured like most funds that invest in multiple businesses or properties. The Proposed Regulations required the QOF to be sold in its entirety in order to qualify for the maximum capital gains tax discount. This was a significant deterrent. Under the final regulations a QOF can sell individual properties or businesses rather than being forced to sell the entire QOF. QOFs now have the ability to hold multiple properties and businesses and exit those assets without creating taxable events or losing the Opportunity Zone (OZ) benefits.
Overall, the new rules are intended to provide certainty to investing in QOFs and for QOFs deploying capital in qualified OZ projects and operating businesses. With the certainty comes flexibility and with flexibility comes investments. The final Regulations go a long way to solidifying the tax aspects of the program. It is now up to the remaining interested stakeholders to provide the various other elements to make this program reach its potential.
1The highlights set out herein were taken from the Internal Revenue Service Frequently Asked Questions issued in conjunction with the release of the IRC Section 1400-2 Final Regulations on December 19, 2019.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.