Regular readers of this blog may remember that I have posted here occasionally about the Opportunity Zone program since it was enacted into law as a part of the Tax Cuts and Jobs Act in December of 2017. As the government has published proposed regulations implementing this legislation since then, I have been reporting on that guidance. Given the complexity of this method of tax deferral as it may affect commercial real estate investment, there has been a great deal of interest in understanding its workings, as reflected in the inquiries I have gotten and the educational courses I have participated in.
In late December 2019, the Treasury Department and the IRS issued final regulations for Opportunity Zones, meant to give taxpayers who invest their capital gains in a qualified opportunity fund (a “QOF”) additional direction in (1) deferring the recognition of that gain (until the disposition of the fund or December 31, 2026, whichever occurs first) and (2) reducing the gain taxed on disposition based on how long the investment is held (10% if held at least 5 years, 15% if held at least 7 years, and in full if held at least 10 years). These final regulations identify “inclusion events” (activities that trigger recognition of gain), help determine the amount of gain that must be recognized, and specify the standards to be met in order to qualify as a QOF and a qualified opportunity zone business (“QOZB”). These new standards also change some of the prior proposed rules in an effort to better explain how to qualify as a QOF or a QOZB, keeping their general approach but more particularly illuminating what constitutes QOZB property.
This week’s article does not discuss these final regulations in depth, which would be a massive task given that they are more than 500 (!) pages long. Instead, I will simply highlight a few of the more interesting developments contained in those rules, as follows:
- The final regulations include a broad anti-abuse provision intended to deny deferral of gain to any investment that doesn’t follow the spirit of the law—improving the lives of residents of a Qualified Opportunity Zone (“QOZ”). This is illustrated in the final rules by an example, where a taxpayer invests its gains in the operation of a business in a QOZ—a parking lot. In that illustration, the spirit of the law wasn’t met, because the investor was looking only to cash in on land speculation, with the result being the recognition of gain. A useful rule of thumb for investors is this: If it doesn’t sound like the investment will improve the lives of the residents of the QOZ, think twice before investing in a QOZ business.
- From an investor perspective, the final rules give taxpayers several advantages over the proposed regulations. One of these is taxpayers’ increased ability to roll over gains from QOF inclusion events. Under the proposed regulations, such gains could be reinvested as qualifying investments only if the taxpayer disposed of its entire initial interest in the QOF. In the final rules, any amount of gain from an inclusion event may be eligible for deferral if invested in a QOF within 180 days. Another divergence from the proposed rules is the final regulations’ treatment of gains under Section 1231 (gains from sales of business property held more than one year); the new rules generally adopt a gross gain approach, i.e., these gains need not be netted out against section 1231 losses. Due to this gross gain treatment, the 180-day time limit in which to invest eligible section 1231 gains generally starts on the date of the sale or exchange giving rise to the gain. Finally, the final rules allow taxpayers more time to invest their capital gains from partnerships, S corporations and non-grantor trusts; taxpayers will now be able to elect to start the 180-day time limit in which to invest those gains on the due date of the entity’s tax return, without regard for extensions. This final regulation acknowledges the fact that many holders of interests in passthrough entities may not get notice of their eligible gains until those entities issue Schedule K-1s.
- From a business and project perspective, the final regulations allow QOZBs additional practical flexibility. While QOZBs are not allowed to hold more than 5% of their assets in “nonqualified financial property,” such as cash, the proposed regulations gave QOZBs the ability to keep large amounts of working capital as long as they maintained a “safe harbor” written plan of up to 31 months to spend the money and develop a property or QOZB, and the final rules now allow a QOZB to adopt an additional 31-month working capital “safe harbor” written plan, for a “safe harbor” total of up to 62 months, as long as each 31-month period itself meets the qualifications and is part of an integrated plan. The final regulations also include several aggregation rules, replacing the prior asset-by-asset methods used, to determine whether the “sufficient improvement” requirement has been met with regard to a property or group of properties; in general, property may be included in order to satisfy this test with respect to non-original use property if it is located in the same QOZ, used in the same trade or business, and improves the function of, that property.
It should be clear that, in order for commercial real estate investors to take full advantage of the tax benefits of Opportunity Zones in connection with their holdings, they will need to obtain coordinated professional assistance from their investment advisors, attorneys and accountants. Ultimately, as long as a property or business in an Opportunity Zone otherwise meets one’s needs, the tax deferral aspect of these investments can be an attractive option. The text of the final regulations may be found here.