IRS guidance answers taxpayers’ questions
One provision of the Tax Cuts and Jobs Act (TCJA) was designed to spur capital investments in low-income areas. This new tax break allows investors to defer — or even eliminate — their capital gains taxes on investments in so-called “Opportunity Zones.” Late in 2018, the IRS issued proposed regulations that answer some questions that real estate investors have asked about these tax incentives.
What’s the benefit for investors?
More than 8,700 communities in all 50 states, the District of Columbia and five U.S. territories have been designated as qualified Opportunity Zones. Investors can form private qualified opportunity funds (QOFs) for development and redevelopment projects in the zones. The funds must maintain at least 90% of their assets in qualified Opportunity Zone property, including investments in new or substantially improved commercial buildings, equipment and multifamily complexes, as well as in qualified businesses.
Investments in the funds can bring some impressive tax benefits. Investors may defer short- or long-term capital gains on a sale disposition if they reinvest the gains in a QOF. The tax will be deferred until the fund investment is sold/exchanged or December 31, 2026, whichever comes first.
After five years, an investor will enjoy a step-up in tax basis for the investment equal to 10% of the original gain. As a result, the investor will pay tax on only 90% of that gain. An additional 5% in basis is added two years later, further trimming the taxable portion of the original gain. When an investment is held in the QOF for at least 10 years, postacquisition appreciation on the QOF investment is completely tax-exempt.
What are the relevant rules?
The IRS proposed regulations that cover several areas:
Qualifying gains. Under the proposed regulations, only capital gains (for example, gains from the sale of stock or a business) qualify for deferral. Investors can defer tax on almost any capital gain up to December 31, 2026. For pass-through entities that have gains, the rules generally allow either the entity or the partners, shareholders or beneficiaries to defer.
180-day timing requirement. To qualify for deferral, taxpayers must invest in a QOF during the 180-day period that begins on the date of the sale that generates the gain. For amounts that are deemed a gain by federal tax rules, the first day of the period generally is the date that the gain would otherwise be recognized for federal income tax purposes.
For partnership gains the entity doesn’t defer, a partner’s 180-day period generally begins on the last day of the partnership’s taxable year, which is the day the partner otherwise would be required to recognize the capital gain. If a partner is aware of both the date of the partnership’s gain and its decision not to elect deferral, the partner can begin its own period on the same date as the start of the entity’s 180-day period. Similar rules apply to other types of pass-through entities.
Expiration of Opportunity Zone designations. The proposed regulations address questions related to the fact that Opportunity Zone designations expire at the end of 2028, when some gain deferral elections may remain in effect. For example, will investors still be allowed to make basis step-up elections after 10 years for QOF investments made in 2019 or later?
The proposed regulations permit the election to be made until December 31, 2047. The latest gain subject to deferral would occur at the end of 2026, so the last day of the 180-day period for that gain would fall in late June 2027. A taxpayer deferring such a gain would satisfy the 10-year holding requirement in late June 2037. The IRS explained that the extra 10 years are provided to avoid situations where a taxpayer would need to dispose of a QOF investment shortly after reaching the 10-year milestone simply to obtain the tax benefit, even though the disposal is disadvantageous from a business perspective.
It’s possible the proposed regulations will undergo some significant amendments before they’re finalized, and IRS guidance on additional related topics is yet to come. Until final regulations are issued, though, taxpayers can rely on the proposed regulations as long as they apply them consistently and in their entirety.
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Spotlight on qualified opportunity funds
The proposed regulations comprise more than just rules for investors in Opportunity Zones. They also tackle several issues related to the qualified opportunity funds (QOFs).
For example, the proposed rules exempt land when determining whether a purchased building in an Opportunity Zone has been “substantially improved” (defined as doubling the building’s basis). Improvement is assessed solely by additions to the adjusted basis of the building. If, for example, a QOF buys a $1 million property, with $750,000 for the land and $250,000 for the building, it must invest only $250,000 to improve the building.
QOFs also are permitted to invest in qualified Opportunity Zone businesses if “substantially all” of the business’s leased or owned tangible property is qualified Opportunity Zone business property. The proposed regs specify that “substantially all” means at least 70% of the leased or owned tangible property.
Among other matters, the proposed rules cover self-certification of QOFs and valuation for purposes of determining whether the QOFs are maintaining 90% of their assets in Opportunity Zone property.