The Tax Cut and Jobs Act of 2017 (TCJA) created a new economic development tool designed to assist low-income communities which are designated as Qualified Opportunity Zones (QOZs). The incentive operates to make QOZs attractive targets for investment by the lure of deferring the recognition of taxable gains. As a result, QOZs have become the topic du jour in the investment and economic development world.
The TCJA created two main tax incentives to encourage investment in QOZs. First, it allows for the deferral of recognizing certain tax gains to the extent a corresponding amount is reinvested in a Qualified Opportunity Fund (QOF). Second, the TCJA offers a gross income exclusion for the post-acquisition gains on investments in QOFs that are held for at least 10 years.
The first Opportunity Zone incentive allows taxpayers to postpone until 2026 paying tax on all or a portion of gains which are reinvested in QOFs. QOFs are equity funds that make investments in "Qualified Opportunity Zone Property" which is located in QOZs. QOFs are required to meet an asset test. The asset test requests QOFs to hold at least 90 percent of their assets in QOZs. While QOFs can invest capital in businesses located in QOZs, the investor interest has mostly focused on real estate development/redevelopment projects. A portion of the taxable gains which remain invested in a QOF for certain time periods are eligible for partial permanent non-recognition treatment. If the funds remain invested for at least 5 years, only 90 percent of the original gain is subject to tax. If the investment is held for 7 years, only 85 percent of the original gain is taxed. However, because the first QOZ incentive only allows taxpayers with eligible investments to defer taxes on their gains until the end of 2026, taxpayers must make eligible investments by the end of 2021 in order to qualify for the five-year incentive to reduce the required 2026 tax payment. The second QOZ incentive allows increase in value of an investment in a QOF to avoid taxation. The appreciation in value of an investment in a QOF which is held for 10 years escapes tax entirely by allowing the taxpayer to step-up the adjusted basis to fair market value.
See Dickinson Wright's Client Alert: " Treasury and IRS announce designation of Opportunity Zones for 18 States" dated April 11, 2018 which sets forth a more detailed description of the Opportunity Zone tax incentive.
Each state was allowed to designate up to 25% of its low-income, high poverty census tracts as a QOZ. The designation process concluded in July 2018. For a list of the more than 8,700 QOZs created nationally and a mapping tool for locating QOZ's, see the Opportunity Zones Resources Page maintained by the Community Development Financial Institutions Fund here: https://www.cdfifund.gov/Pages/Opportunity-Zones.aspx
The TCJA statutory language establishing QOZs left several unanswered questions. What types of tax gains can be deferred? How are the rules applied to partnerships? When can a step-up election be made? How to certify a QOF? While there has been significant interest in the new Opportunity Zone tax incentive, potential investors and fund sponsors have eagerly been waiting for additional guidance on the multitude of unanswered questions from U.S. Department of the Treasury (Treasury). On October 19, 2018, Treasury finally issued long-awaited Opportunity Zone guidance in the form of proposed regulations. The Proposed Regulations clarify the character of gains that - in Treasury's view - qualify for tax deferral, which taxpayers and investments are eligible, the parameters for QOFs, and other guidance. Treasury also announced plans to issue additional guidance before the end of 2018. The Proposed Regulations can be found here: https://www.irs.gov/pub/irs-drop/reg-115420-18.pdf
Contemporaneous with the issuance of the Proposed Regulations, the IRS released Rev. Rul. 2018-29 addressing the application to real property of the "original use" and "substantial improvement" requirements as they relate to QOZ investments. Proposed Regulations
Below is a summary of the guidance provided by Treasury for the Proposed Regulations and Rev. Rul. 2018-29.
Gains Eligible for Deferral Only capital gains are eligible for deferral under Section 1400Z-2(a)(1) of the Internal Revenue Code of 1986, as amended (Code). Gains characterized as "ordinary income" are not eligible for deferral. The Proposed Regulations address two additional gain deferral requirements. First, the gain to be deferred must be gain that would otherwise be recognized, if deferral under Section 1400Z-2(a)(1) were not permitted, not later than December 31, 2026. For example, gains deferred under the like-kind exchange rules of Section 1031 of the Code - which is mandatory and not elective - would call off the availability of deferral under Section 1400Z-2(a)(1).1 Second, the gain must not arise from a sale or exchange with a related person. For Section 1400Z-2 purposes, a related party is more broadly defined, which will require greater scrutiny of continuing ownership interests in QOFs.
Types of Taxpayers Eligible to Elect Gain Deferral Taxpayers must affirmatively elect gain deferral under Section 1400Z-2. Taxpayers eligible to elect deferral under Section 1400Z-2 are those that recognize capital gain for Federal income tax purposes. Taxpayers eligible to make an election include individuals, C corporations, partnerships, and certain other...