Ultimate Guide on Opportunity Zone Tax Incentives!

[Lance Lvovsky]

Last Friday, the Treasury released their Proposed Regulations [REG-115420-18] on Opportunity Zones - possibly the best tax shelter created, ever! At Marcum, we are hard at work putting together insights as we peruse the Proposed Regulations. In addition, at this time, the Treasury has asked for comments from the public, CPAs, and Attorneys as to what needs to be addressed in the Final Regulations.

I have prepared below a summary of the Proposed Regulations. If you rather read the Regs yourself (don't know why you would), here is the link:

https://www.irs.gov/pub/irs-drop/reg-115420-18.pdf

Below are our insights as to what the Regulations say:

Background

The Tax Cuts and Jobs Act enacted Code sections 1400Z-1, which allows for designation of certain areas as Qualified Opportunity Zones, and 1400Z-2, which provides for certain tax benefits for investing in certain Qualified Opportunity Zones. Qualified Opportunity Zones (QO Zones) have been designated in each of the states and includes all of Puerto Rico. The designation lasts for ten years.

A taxpayer who has an “eligible gain” and invests such gain in cash in a QO Fund within 180 days of the sale:

• Can elect to avoid paying tax on the gain currently.
• The tax on the deferred gain is due on the earlier of the date of disposition of the interest in the QO Fund or 12/31/2026. If the interest has been held five years on the date of inclusion, the deferred gain is discounted by 10% (so tax is only paid on 90% of the gain). If the interest has been held for seven year on the date of inclusion the deferred gain is discounted by 15%.
• If the interest in the QO Fund in held for ten years on the date of actual disposition, then any additional post-acquisition gain due to appreciation in the value of the QO Fund interest can be eliminated under an election to treat basis equal to fair market value.

To benefit from the maximum discount (15%), the investment must be made by 12/31/2019. The 10% discount can apply to acquisitions by 12/31/2021. No reduction in the deferred gain applies for investments in QO Funds made after 2021.

A QO Fund is an investment vehicle organized as a corporation or partnership for the purpose of investing in Qualified Opportunity Zone Property (QOZP) and which satisfies an Asset Test. Under the Asset Test, at least 90% of the assets of the QO Fund (calculated as the average of two semiannual testing dates) must be Qualified Opportunity Zone Property. QOZP includes: Qualified Opportunity Zone Stock, Qualified Opportunity Zone Partnership Interest, and Qualified Opportunity Zone Property.

Proposed Regulations. IRS requests comments on many parts of the proposed regulations to determine whether its rules correspond with the primary purpose of the statute – to spur economic development in the low-income communities designated as QO Zones.

Only Capital Gains are eligible for deferral

The statute refers to “gain from the sale to, or exchange with, an unrelated person of any property held by the taxpayer” to the extent invested in a QO Fund during the 180-day period beginning on the date of the sale or exchange. This language created a question as to whether any gain could qualify.

The Proposed Regulation provides that only capital gain from an actual or deemed sale or exchange qualifies. Ordinary income and ordinary gain are not eligible for deferral.

There may be a technical question (since the regulation itself reference capital gain) whether section 1231 gain is covered. The Preamble includes as eligible gain “any other gain that is required to be included in the taxpayer’s computation of capital gain.” This would indicate the inclusion of section 1231 gain treated as long-term capital gain. However, how does one know whether this gain qualifies, since all section 1231 gains and losses must be netted to determine the appropriate treatment? Will this treatment be known within the 180-day acquisition period?

Other Elements of an Eligible Gain

The gain must be of a type that would be recognized as a taxable gain before 1/1/2027 (absent this provision of the law); and

The gain must not be from a sale or exchange with a “related party”. For this purpose, section 267(b) and 707(b) definitions of a related party is used but substituting 20% instead of 50%.

Who are Eligible Taxpayers that can make the election

The statutory language suggests that the taxpayer that sold the property producing the gain being deferred must be taxpayer making the investment in the QO Fund. The proposed regulations defines the taxpayers who can make the election by type, and then expands the group who can make the election for certain pass-through entities.

Eligible Taxpayers include:

Individuals

Corporations (including RICs and REITs)

Partnerships

Certain other Pass-Through Entities (including common trust funds)

Qualified Settlement Funds

Disputed Ownership Funds

Other Entities Taxable under Reg section 1.468B

For QO Fund investment, the proposed regulations do not require that the selling party be the party investing the gain for pass-through entities.

For Partnerships:

The entity can make an election to defer the gain. Where such an election is made, the deferred gain is not allocated to the partners as part of their distributive shares of partner income. Subsequent recognition of the deferred gain is allocated at that time.

If the partnership does not make an election, the gains are allocated as distributive income to the partners. Each partner can elect to defer some or all of its share of the eligible gain. To be “eligible gain” for the partner, the gain must be an “eligible gain” determined at the partnership level. In addition, the gain cannot arise from a sale or exchange with a related person to the partner.

This will require reanalysis of the eligibility of the gain to determine related party statuts.

Similar rules apply for S corporations and their shareholders; trusts and estate and their beneficiaries.

Shareholders of RICs and REITs can make an election of eligible gain passed through the entity.

180-Day Investment Rule (and special rule for owners of pass-through entities)

The basic rule is that the taxpayer must invest in a QO Fund during the 180-day period beginning on the date of the sale or exchange. This begins on the day on which the gain would be recognized for federal income tax purposes if an election to defer gain under this provision of the law was not elected.

However, special rules apply for owners of pass-through entities. The proposed regulations recognize that some capital gains are the result of federal tax rules deeming an amount to be a gain where there is no specific date for the deemed sale. The regulations consequently provide alternate 180-day periods in certain situations.

Capital Gain dividends received by RIC and REIT shareholders – the 180-day period begins on the day on which the dividend was paid (not from the date of the sale by the entity).

Undistributed Capital Gains taxed to RIC or REIT shareholders – the 180-day period begins on the last day of the REIT or RIC tax year

Partner/S Corporation shareholder – the 180-day period begins: (a) on the last day of the entity’s tax year; or (b) at the election of the partner or S shareholder on the day of sale by the entity.

Can the Section 1400Z-2 Election be Made if Investment is Disposed of Before 12/31/2026

The proposed regulations provide there where a taxpayer elects deferral and later disposes of the QO Fund investment which would trigger the deferred gain prior to the mandatory gain inclusion date (12/31/2026), a new 180-day period is created for to acquire a new QO Fund investment and to defer the original gain. However, there must be a disposition of the entire initial investment (since the Code expressly prohibits the making of a deferral election if an election previously made with respect to the same sale or exchange remains in effect)

Making the Election

IRS expects the election to be made of Form 8949 attached to the federal income tax return for the tax year in which the gain would have been recognized. IRS is to prescribe the specifics in future guidance.

NOTE: This raises a question of whether partners, S corporation shareholders, trust and estate beneficiaries, RIC or REIT shareholders should be put on extension.

Preservation of Tax Attributes

The tax attributes of the deferred gain are preserved throughout the deferral period and characterize the gain included in income on a trigger event. For example, the portion of the gain which is short-term gain remains short-term on ultimate gain recognition.

Where there is a disposition of less than the entire interest of the QO Fund, the proposed regulation provides for a FIFO approach to characterizing the gain. If this does not give a complete solution, then a pro rata method is to be used. For example, where gains from the sale of multiple assets with different attributes are invested in QO Fund interests at the same time, a pro rata approach will have to be used.

Deferral Applies Only to QO Fund Investment made with Deferred Gain

The benefits of section 1400Z-2, including the elimination of future appreciation for investments held for 10 years, only applies to QO Fund interests acquired with cash which is no greater than the deferred gain. It does not apply to interests in a QO Fund acquired with other assets. These will be treated as separate qualifying and non-qualifying interests.

The Preamble to the regulations make it clear that the election to step-up the basis to fair market value is only allowed for the portion of the investment made up to the amount of prior gain AND where a proper deferral election has been made.

Since QO Zone Designations are only good until 2028, how does this impact the elimination of gain which occurs upon holding the investment for 10 years.

There is no statutory language, as a condition to making the basis step-up election, that he QO Zone continue to have such designation at the time of sale. IRS and Treasury consider the continued qualification of the investment to be integral to the primary purpose of the law. The proposed regulations conclude that the election can be made even in QOZ status expires after 2028 for the particular area.

However, where there is an expiration of QOZ status, the proposed regulations limits the benefit of the rule to elections related to dispositions occurring by 12/31/2047 (which is 20.5 years after the last day of being able to make a QOZ investment – 6/30/2027).

As currently written, the last day that a sale producing deferred gain which can be invested in a QOF is 12/31/2026 (after that date, there is no election allowed) and designations will terminate after 2028, it is likely that all QO Funds should be viewed as not being indefinite in their term but will need to be sold or exchanged in a taxable transaction by 12/31/2047.

***NOTE: THE ABOVE IS NOT TAX OR LEGAL ADVICE. THOSE SEEKING ADVICE SHOULD CONSULT WITH THEIR TAX ADVISOR***

[Lance Lvovsky]

@Michael Plaks That was the best I can do given how long the Regs are!

The purpose of this was for the other tax advisors on here (as a learning tool), and for the rest of the real estate community to be aware of the Opportunity Zones, and that they should be asking their advisors if they are interested in this strategy.