By Vikram Agarwal
The IRS issued its first round of proposed regulations on Oct. 19, 2018, which described and clarified the requirements that taxpayers must meet to defer the recognition of gains by investing in a qualified opportunity fund (QOF). The regulations under Section 1400Z-2 of the Internal Revenue Code were added by the Tax Cuts and Jobs Act. These proposed regulations cover some of the questions that have arisen in the course of practitioners trying to understand and structure transactions that qualify for the benefits offered by investments in opportunity zones.
PRACTICAL IMPACTS: INVESTORS
The proposed regulations expressly state that only capital gains are eligible for investment in a QOF. Gains such as depreciation recapture are not eligible, while certain Section 1231 gains are likely to be eligible. It is important to understand that all types of capital gains are eligible for investment in a QOF and the rate corresponding to the type of capital gain will remain throughout the lifecycle of the QOF investment. For example, an investor may invest short-term capital gains into a QOF, and the generally higher rate of the short-term capital gain will apply when the initial deferral period is over.
The proposed regulations also defined who the taxpayers are that may invest in a QOF. Essentially, individuals, C corporations (including regulated investment companies and real estate investment trusts), partnerships, and certain other pass-through entities may invest in a QOF. The proposed regulations provided for special timing rules for when the investment must be made that apply to pass-throughs such as partnerships. Pass-throughs, like a partnership, may have six months from the date of sale of the capital asset to invest in a QOF at the entity level, which would effectively force all partners to invest in a QOF. Alternatively, the partners (or owners) may have six months from the end of the tax year of the entity to invest in a QOF. This is a powerful gift from the IRS which will allow more time to plan the QOF investment by interested investors. It also allows owners of pass-throughs that have disposed of capital assets in 2018, and were not aware of the program, to still take advantage of the program in 2019 with the extended time horizon to invest in a QOF.
Other important clarifications from the proposed regulations that aid investors are that cash is treated as being fungible, such that the exact same funds realized on disposing of a capital asset are not required to make the QOF investment. In fact, even borrowed funds may be used to fund a QOF. Moreover, the interests of a QOF may be pledged as security, which may be useful later in the lifecycle of the QOF investment in 2027 when the tax bill will become due and funds will be needed to pay the tax piper.
PRACTICAL IMPACTS: QOFS
For those forming QOFs, one of the most important clarifications is that QOFs can be set up as LLCs taxed for federal income tax purposes as a partnership or corporation. This clarification will enhance flexibility within the QOF and not subject the QOF to general partner requirements or partnership liability at the state level. One item to be aware of is that QOFs must be formed for the purpose of being a QOF, so states that do not allow for customized formation documents for LLCs may add additional risk to using an LLC as a QOF in such a state.
The proposed regulations also clarify that investors may break up their rollover of capital gains into multiple QOFs. This allows the investors to diversify risk and allocate their capital gain among multiple QOFs, which are most likely to be single asset QOFs. Due to the new rules in the proposed regulations and still existing uncertainties unanswered by the new proposed regulations, many advisors are suggesting single asset QOFs to reduce risk and allow for easier disposition of the interest in QOFs.
Lastly, the proposed regulations provided a 70 percent threshold to interpret the substantially all requirement for an Opportunity Zone Business’s requirement to hold Opportunity Zone Business Property. Effectively, because 90 percent of a QOF’s assets must comprise Qualified Opportunity Zone Property, this means that only 63 percent of the assets of a QOF need to be Qualified Opportunity Zone Property if such QOF assets are held indirectly in partnership or stock interests.
PRACTICAL IMPACTS: SPONSORS
One of the most important clarifications in the proposed regulations concerns the requirements for construction or rehabilitation of real estate to qualify for the program. There is now a 31-month working capital safe harbor, provided a written schedule is in place and there is substantial compliance with the schedule. The schedule must set forth the expected amount of QOF funds appropriated for the acquisition of the subject property, construction expenditures, and necessary ancillary expenditures for the project. If such a plan is in place and substantially complied with, the cash earmarked for its use will fall under the working capital exception in meeting the 90 percent asset test of a QOF. Banks may be able to play an intermediary role here in facilitating escrow accounts that meet the necessary requirements of the proposed regulations.
Another important clarification came in the form of a revenue ruling. In Revenue Ruling 2018-29, the value of land is not included when calculating whether the substantial improvement test has been satisfied. Therefore, only the value of the building is taken into account in meeting the test. This rule significantly assists developers in making projects qualify for the program as the amount invested to substantially improve existing structures should be less, and in some cases, significantly less.
WHAT’S NEXT FOR STAKEHOLDERS?
During the Feb. 14, 2019 Opportunity Zone Fund hearing, the IRS stated it will be releasing a second round of regulations shortly and is working to release final regulations in the spring. The first round begins to answer many of the questions confronting QOFs, investors, and sponsors, and the IRS has been receiving comments since its release. In the hearing, the IRS listened to witnesses in attendance who provided comments and suggestions on a variety of topics including how interim gains in connection with the sale of underlying QOF assets will be treated, how e-commerce business can qualify, clarification on how unimproved land is treated, clarification on the original use test, clarification for how operating businesses can qualify, and requesting that long-term ground leases be treated as Qualified Opportunity Zone Business Property. The next step is for the IRS to release the second round of proposed regulations based on the comments it has received.
Despite the many persisting uncertainties, the first round of regulations provided enough clarity that many opportunity funds have been formed and are beginning to make investments into projects. The market for the program is on an encouraging uptrend as more and more interested parties begin to learn about the program and its exciting opportunities.