On October 19, 2018, the IRS issued Proposed Regulations addressing new Sections 1400Z-1 and 1400Z-2 relating to Qualified Opportunity Zones. Among other things, the Proposed Regulations confirmed that only capital gains (short-term or long-term) can be deferred under Section 1400Z-2.
Section 1400Z-2 permits a taxpayer to defer recognition of a capital gain if an amount equal to such gain is invested in a qualified opportunity fund (“QOF”) within 180 days of the date that the tax would have been recognized by the taxpayer. For example, if the taxpayer sells stock that he has held for over a year, assuming the gain on the sale of the stock is $100,000 characterized as long-term capital gain, the gain may be deferred by reinvesting the amount of the gain in a QOF within the 180-day period.
The Proposed Regulations allow partnerships, S corporations and other pass-through entities, such as trusts and estates, to defer capital gains at the entity level, or if the partnership or S corporation (or other pass-through entity) decides not to defer gain and invest in a QOF, the partners or shareholders (or beneficiaries) can make the elections on their portion of their distributive share of such income. In the case where the partner, shareholder or beneficiary elects to defer the gain, the 180-day deferral period begins on the last day of the taxable year of the partnership, S corporation or other pass-through entity in which such partner’s, shareholder’s or beneficiary’s allocable share of such gain was taken into account.
The gain is deferred until the earlier of the disposition of the taxpayer’s interest in the QOF, or December 31, 2026. If the equity interest in the QOF is held by the taxpayer for at least five years, the taxpayer will receive an adjusted basis equal to 10% of the gain, and if held for seven years, such basis will be increased by another 5% of the gain. This effectively results in any taxpayer holding an equity interest in a QOF for at least seven years paying a tax on only 85% of the deferred capital gain on December 31, 2026 (assuming the taxpayer’s equity interest in the QOF is not disposed of prior to December 31, 2026). For example, a taxpayer would only pay capital gain on $85,000 of the original $100,000 deferred gain if the taxpayer has held his or her equity interest for at least seven years as of the earlier of the disposition of the interest in the QOF or December 31, 2026.
If the taxpayer holds his or her equity interest in a QOF for at least ten years, the taxpayer is permitted to step up his or her basis in the QOF to the fair market value of such interest. This allows the taxpayer to exclude any post-acquisition appreciation in the value of the equity interest in the QOF when the taxpayer sells the equity interest in the QOF.
The Proposed Regulations also allow taxpayers seeking to eliminate capital gains upon investment in a QOF to take advantage of this section even after the designations of Qualified Opportunity Zones expire at the end of 2028. The Proposed Regulations basically permit taxpayers to invest capital gains in a QOF and receive the full basis step-up on gains accrued in the fund if invested by June 2027 (approximately 180 days after December 31, 2026) and held for at least ten years, as long as the disposition of the investment occurs by the end of 2047.
The Proposed Regulations set forth the requirements for a fund to qualify as a QOF. A QOF means any investment vehicle which is organized as a corporation or a partnership for the purpose of investing in Qualified Opportunity Zone Property that holds at least 90% of its assets in Qualified Opportunity Zone Property determined by the average of the percentage of Qualified Opportunity Zone Property held in the fund measured on the last day of the first six-month period of the taxable year of the fund, and on the last day of the taxable year of the fund.
Qualified Opportunity Zone Property means: (1) Qualified Opportunity Zone Stock; (2) Qualified Opportunity Zone Partnership Interest; or (3) Qualified Opportunity Zone Business Property. The Proposed Regulations elaborate on the definitions of each of these terms.
As stated above, a QOF must hold at least 90% of its assets in Qualified Opportunity Zone Property, either directly or through a Qualified Opportunity Zone Stock or Qualified Opportunity Zone Partnership Interest. The Proposed Regulations provide taxpayer-friendly provisions which allow the value of the QOF’s entire interest in an entity to count for the QOF’s satisfaction of the 90% asset test, and which provide that stock or a partnership interest will be treated as Qualified Opportunity Zone Stock and Qualified Opportunity Zone Partnership Interest if at least 70% of such entity’s assets are in Qualified Opportunity Zone Business Property.
Additionally, the Proposed Regulations provide a safe harbor that allows qualified businesses to apply the definition of working capital provided in Section 1397C(e)(1) to property held by the business for up to 31 months, provided certain requirements are met. Those requirements include a written plan that identifies the financial property as property held for the acquisition, construction or substantial improvement of tangible property in the opportunity zone and a written schedule consistent with the ordinary business operations of the business that the property will be used within 31 months.
The Proposed Regulations also allow QOFs to be used as collateral without having any adverse tax effects on the taxpayer.
The Proposed Regulations issued on October 19th are the first of a number of regulations the IRS intends to issue regarding Qualified Opportunity Zones, and provide that taxpayers may rely on the Proposed Regulations.
The Proposed Regulations failed to address whether relief to make the election to defer gain under Section 14002-2 will be available for taxpayers who recognized gain in the early part of 2018. Commentators have suggested that the 180-day election for 2018 gains should not be triggered until the Proposed Regulations are finalized. Consequently, this remains an open issue until addressed by the IRS.