Opportunity Zone Q&As

The Tax Cuts and Jobs Act of 2017 created a new tax incentive for investments in qualified opportunity zones (QOZs). The incentive is designed to reward investors for making long-term reinvestments in economically underdeveloped zones. If a taxpayer elects to reinvest capital gains in a qualified opportunity fund (QOF), the benefits include tax deferral and, if holding periods are met, the exclusion of a significant portion of the gain.

On Oct. 19, 2018, the U.S. Department of the Treasury issued proposed regulations and Revenue Ruling 2018-29, which provide guidance on phrases such as “original use,” “substantial improvement,” and “substantially all.” The proposed regulations also clarify who can elect to defer gains, when the 180-day reinvestment period begins, and how to initially and continually certify the QOF.

The following questions and answers clarify the basics of the proposed regulations:

• Which gains qualify for deferral?

Gains from a sale or exchange with an unrelated person that are treated as capital gains for federal income tax purposes and recognized prior to Jan. 1, 2027, are eligible for rollover into a QOF. This presumably includes Section 1231 gains and short-term capital gains.

Questions remain as the proposed regulations do not include provisions about potential netting of capital gains with losses or Section 1231 gains with unrecaptured Section 1231 losses.

Gains from the sale or exchange of an entire interest in a QOF that subsequently are invested in another QOF also are eligible for deferral.

• Who is eligible to make the election?

Any individual, C corporation, regulated investment company (RIC), real estate investment trust (REIT), partnership, S corporation, trust, or estate is eligible to make the election, which will be included on Form 8949, “Sales and Other Dispositions of Capital Assets.” Additionally, Treasury favorably interprets the statute to allow either a pass-through itself or the owner or partner of the pass-through receiving the Schedule K-1, “Partner’s Share of Income, Deductions, Credits, Etc.,” to make an election to defer eligible gains.

• Which QOF investments qualify?

The proposed regulations specify that only equity investments, including preferred stock and partnership interests with special allocations, qualify. Investments in debt instruments issued by a QOF are not eligible for deferral. Additionally, deemed contributions to partnerships pursuant to IRC 752 do not constitute equity investments.

• How does the 180-day reinvestment period work?

The 180-day period begins on the day on which the gain would be recognized for federal income tax purposes. The proposed regulations provide four examples for specific recognition transactions:

1. Sale of stock: The period begins on the trade date.
2. Capital gain dividends of an RIC or REIT: The period begins on the dividend payment date.
3. Undistributed capital gains from an RIC or REIT: The period begins on the last day of the RIC or REIT’s taxable year.
4. Gains from pass-through entities, estates, and trusts: Generally, the period begins on the last day of the pass-through entity’s taxable year. Owners and beneficiaries can make an election to use the trade date of the pass-through entity, estate, or trust. For pass-through entities, the partners, shareholders, and beneficiaries might need to elect deferral for unelected pass-through items before the pass-through entity or the individual files its respective tax return.

• When and how is the QOF certified and tested?

According to the statutory language, the QOF’s 90 percent asset threshold is tested for qualifying assets six months after the QOF’s taxable year begins and on the last day of its taxable year. However, existing entities that become QOFs after the beginning of their taxable year are tested six months after their self-certification date instead of six months after the taxable year begins. Any investments made prior to initial certification would not qualify as eligible reinvestments.

Initial and annual certifications are made on IRS Form 8996, “Qualified Opportunity Fund,” and will be based on the values reported on the QOF’s applicable financial statements or based on cost when applicable financial statements are not available.

Treasury also provides a working capital safe harbor in the 90 percent test for long-running projects with undistributed cash. The safe harbor requires a written plan identifying the financial property as held for the acquisition, construction, or substantial improvement in the ordinary course of business operations of the taxpayer as well as a written schedule that shows the property will be used within 31 months.

• What is the “substantially all” requirement for QOZ business?

QOFs are required to maintain 90 percent of their assets in QOZ property, which can be in the form of investments in QOZ stock, QOZ partnership interest, or QOZ business property. QOZ stock and QOZ partnership interests also must qualify as a QOZ business during substantially all the QOF’s ownership. QOZ business property also must meet a substantially all test for use of such property inside a QOZ. The proposed regulations have defined substantially all for each of these tests as 70 percent.

• What do “original use” and “substantial improvement” really mean?

In conjunction with the proposed regulations, Treasury issued Revenue Ruling 2018-29, which provides that if a QOF purchases an existing building located on land within an opportunity zone, the original use is not considered to commence with the QOF. Therefore, it is presumed that regardless of the building’s previous use (such as an investment), a change to its business purpose (such as a rental) also would not qualify.
The ruling also provides that the measurement of substantial improvement is done with respect to only the basis of the building and not the associated land.

• Other guidance

• Ineligible other funds (nongain deferral funds or new money) invested in a QOF must be treated as a separate investment.
• Eligible deferred gains do not change characteristic when finally recognized; for example, short-term capital gains (STCG) deferred do not become long-term capital gains (LTCG) because of the deferral. Additionally, Section 1256 contracts maintain their 40-60 split between STCG and LTCG.
• When disposing of partial interests in QOFs that were acquired on different days, the first-in, first-out method for identifying which interest was disposed is required.
• Changes to or expirations of previously designated zones do not disqualify previous qualifying elective deferrals.

While the regulations have provided some much-needed guidance on the broad statute provided by Congress, additional guidance or judicial interpretation likely will be needed in a relatively short time frame due to the ever-expiring nature of the significant benefits provided by this statute.