Key Takeaways From the Latest Proposed Opportunity Zones Regulations
Authors: Josh Hight & Joshua Caddel, CPA
The topic of opportunity zones has been building steam for the last nine months and the second round of proposed regulations has only added fuel to the fire. Recently, our own Melissa Wall hosted a webinar condensing the top takeaways from the 169-pages released by the IRS in April 2019. If you missed the webinar, you can view the recorded presentation here.
Section 1400Z created a new way for taxpayers to defer their capital gains tax today, opportunity to reduce tax on the gain when due, and permanently exclude tax on any future growth down the road. All of this can be accomplished by reinvesting capital gain into a Qualified Opportunity Fund (QOF). This new taxpayer-friendly investment option allows for flexibility in the deferral amount as well as the investment strategy to undertake.
So, what has changed since the first round of proposed opportunity zones regulations were released last fall? The quick answer is: a lot. Below are some key takeaways from the newly released guidance.
Original Use Requirement
After the first round of proposed regulations were published, we knew property could only qualify as Qualified Opportunity Zone Business Property (QOZBP) if it was original to the QOF or the QOF met the substantial improvement requirements. The term “original use” was left entirely undefined the first time around. In the most recent proposed regulations, a comprehensive definition was provided, as well as some specific examples as outlined below:
- Original use begins when a QOF places property in service for purposes of depreciation or amortization.
- The purchase of used property can qualify for original use, as long as it wasn’t previously placed in service by any taxpayer within the opportunity zone.
- Vacant property can qualify for original use if it has been sitting vacant for an “uninterrupted” 5-year period.
- Improvements made by a lessee to leased property can also qualify as original use.
90% Asset Test Relief
QOF’s are required to meet a 90% test, bi-annually, where 90% of the assets must be QOZBP. In the April 2019 proposed regulations, the IRS presented three taxpayer-friendly relief provisions related to this test:
- When a QOF receives newly invested funds, there would be a 6-month grace period to reinvest the newly acquired contributions before it’s required to be included in the 90% asset test.
- If a QOF receives money from the sale of QOZBP, the IRS has proposed a 12-month grace period to reinvest the funds into new QOZBP before it must be included in the 90% asset test.
- The working capital safe harbor plan was introduced in the first round of regulations. The safe harbor allows a QOF up to 31 months to purchase, construct or substantially improve QOZBP. The cash or cash equivalent being held for the purposes of the plan can be excluded from the 90% asset test, so long as the plan is designated in writing and the consumption of funds is consistent with the plan laid out. Due to unforeseen circumstances that arise in many development projects, the IRS concluded that a taxpayer would be granted relief from the 31-month timeline when failure to achieve the required benchmark is caused by government delays.
Mixed Fund Investments
When a taxpayer invests amounts into a QOF exceeding the amount of their deferred gain, a separate investment is created and must be tracked. Any investment into a QOF not related to qualifying deferred gain does not qualify for any of the opportunity zone benefits. The IRS clarified how it intends to treat investments attributable to deferred capital gain versus those that are not. Any items of income, loss, debt or distributions will be applied proportionately based on the percentage of each type of investment.
For example, a taxpayer has a $100,000 capital gain to be reported on their 2018 tax return but decides to defer the tax on that gain by reinvesting in a QOF Partnership. In addition to the $100,000, the taxpayer makes an additional cash contribution of $100,000 for a total investment of $200,000. This creates two investments: A and B, each worth 50% of the total investment. A is related to properly deferred capital gain but B is not. In 2019, the taxpayer takes a $20,000 distribution from the QOF. This results in $10,000 reducing investment A* (50%) and $10,000 reducing investment B (50%). After applying the distribution to each investment, the remaining amounts are now $90,000 in investment A and $90,000 in investment B.
*Note: the distribution related to investment A may be considered an inclusion event, which may trigger the recognition of some of the previously deferred gain. See below.
When there is a change in circumstance relating to an opportunity zone investment, an inclusion event may be triggered. This can result in recognizing some, or all, of the gain previously deferred and possibly dilute the original QOF investment. Before the most recent proposed regulations, the only inclusion events we knew for certain were at the earlier of selling the interest in a QOF, or December 31, 2026. We now have more guidance on other circumstances that may result in an inclusion event. Here are a few common scenarios to consider:
- Distributions: so long as they do not exceed the basis in the Qualified Opportunity Fund, they are not considered inclusion events. Debt basis is considered basis for the purposes of distributions.
- Gifting: considered an inclusion event and will eliminate part or all of the qualified interest.
- Charity: considered an inclusion event and will eliminate part or all of the qualified interest.
- Deaths: distributions to the beneficiary as required by law or an estate is generally not considered an inclusion event.
- Grantor Trusts: when a qualified interest is transferred to a grantor trust and the taxpayer is the sole owner of the trust, an inclusion event is not triggered. Any changes thereafter may result in an inclusion event.
A taxpayer who has properly elected to defer their gain by reinvesting in a QOF will have no basis in their initial investment in the QOF. When the taxpayer has achieved one of the required holding periods to qualify for a step-up in basis (i.e., holding for 5 years results in a 10% basis step-up), this increase will take place immediately. When an inclusion event is triggered, and the deferred gain is included in income, basis in the QOF investment will first be increased before any other tax consequences are taken into consideration.
Originally, there was a significant lack of clarity surrounding the process of exiting an investment in a QOF. Before this new guidance was issued, the conservative interpretation of the regulations indicated a taxpayer would have to sell their investment in the QOF to qualify for the exclusion of appreciation on the original investment. This would likely mean selling an entire QOF LLC interest as opposed to having the ability to sell just the underlying assets.
However, this round of proposed regulations provided an alternative option which was more consistent with common transactions in the industry. If a QOF sells some, or all, of its qualified property to an unrelated third party, and the sale generates a gain, then the taxpayer subject to including the gain on its tax return will still have the election to exclude recognition available to them. This would include gains flowing through to taxpayers via Schedule K-1.
Several states have considered disconnecting the Federal opportunity zone program. For Oregon residents, there are currently two proposed bills:
- HB 2144: The gain deferred for purposes of federal tax will be an addback on the Oregon tax return. This would be a complete disconnect from the Federal opportunity zone law.
- HB 2727: Enables the taxpayer a subtraction from taxable income arising from the sale of opportunity zone property when certain requirements are met. This would create an alternative Oregon opportunity zone program, with its own incentives, different requirements and separate reporting standards.
If you have any questions or would like to talk to Delap about Opportunity Zones, please reach out to our team at (503) 697-4118. Melissa Wall leads our Opportunity Zone team. We would love to explore Opportunity Zones with you!