Internal Revenue Code (the “Code”) Section 1400Z, the Opportunity Zone statute, enacted by the Tax Cuts and Jobs Act of 2017, provides potential for the deferral, and permanent exclusion, of taxable gain from the sale of property if the amount of gain is reinvested in an Opportunity Zone Fund (a “Fund”) within 180 days after the sale. A Fund is defined as a corporation or partnership that invests in certain businesses located in specified low-income communities.
Opportunity Funds, like tax-free exchanges under Code Section 1031, provide a vehicle to avoid the immediate recognition of gain on the sale of property. However, Section 1031 is only available upon the sale of real property, while Section 1400Z may be used when any property is sold.
If the Fund investment is held for five years, then 10 percent of the deferred gain is permanently excluded. If the Fund investment is held for seven years, then an additional 5 percent of the deferred gain is excluded (for a total of 15 percent permanent exclusion). The deferral ends upon the earlier of (i) the disposition of the Fund investment, or (ii) December 31, 2026, at which time the deferred gain, reduced by any of the permanent exclusions above, must be recognized. Finally, if the Fund investment is held for at least 10 years, a taxpayer can make an election to increase the basis of the Fund investment to equal the fair market value of such investment on the date that the Fund investment is sold or exchanged.
Although the Opportunity Zone statute became effective as of January 1, 2018, the Internal Revenue Service (the “IRS”) did not provide any guidance on the statute until October 19, 2018, when it issued the much-needed Proposed Regulations. Below are a few of the issues that the Proposed Regulations have addressed.
- Only capital gain is eligible for the Opportunity Zone benefits. Thus, if the sale of property produces ordinary income (such as depreciation recapture), the recognition of such income may not be deferred. There is no requirement, however, that eligible capital gain must be long-term, meaning that short-term capital gain is eligible for deferral.
- The tax attributes of any deferred gain will be preserved when the gain is ultimately recognized. For example, the maximum capital gain rate for collectibles is 28 percent. Thus, if a taxpayer defers the recognition of income from the sale of a collectible asset (such as a painting) in 2018, then such gain will be taxed at a maximum rate of 28 percent when the taxpayer must recognize the gain upon the earliest of the disposition of the Fund investment, or December 31, 2026.
- The Opportunity Zone benefits are not limited to individual taxpayers, as the benefits apply to any taxpayer that may recognize capital gains for federal income tax purposes. Thus, Opportunity Zone benefits are available to individuals, partnerships, and corporations.
- Although the Opportunity Zone statute provides for a 180 day rule, the Proposed Regulations provide a taxpayer-friendly rule for partnerships that realize capital gains. A partnership may elect to defer eligible gain, in which case such gain is not included on the partners’ Schedule K-1. But, if a partnership does not make such an election, the gain is included on the partners’ Schedule K-1, in which case the partner may elect to defer eligible gain reported on the Schedule K-1. In the second scenario, the 180 day period begins on the last day of the partnership’s taxable year, as opposed to when the partnership sold the property.
For example, assume on March 1, 2018 a partnership sold an asset that produced capital gain. If the partnership wants to defer recognition of the gain, it must invest an amount equal to the realized gain into a Fund by August 28, 2018. If the partnership does not defer such gain, a partner has until June 28, 2019 to reinvest the amount of eligible gain shown on the partner’s Schedule K-1.
- The Proposed Regulations address what may be called the “un-deployed” working capital issue. This issue concerns the requirement under the statute that 90 percent of a Fund’s assets must consist of “qualified opportunity zone property,” which is defined as either (i) stock in a corporation that operates a qualified opportunity zone business, (ii) an interest in a partnership that operates a qualified opportunity zone business, or (iii) tangible property acquired after December 31, 2017 for which the business’s original use is in a specified opportunity zone or which the business has substantially improved. In other words, a Fund can either make an indirect investment in a qualified opportunity zone business by owning stock in a corporation or interests in a partnership that operates a qualified opportunity zone business (see clauses (i) and (ii) above), or a Fund can directly operate a qualified opportunity zone business ((iii) above). In either case, 90 percent of a Fund’s assets must consist of assets described in clauses (i), (ii), or (iii) above.
Suppose a Fund receives a large amount of cash from taxpayers electing to defer the recognition of eligible gain and the Fund wants to construct a building to operate a business in an opportunity zone. Suppose further that it will take approximately one year to construct the building for use in the business. Until the Fund’s cash is deployed to construct the building, the majority of the Fund’s assets will consist of “un-deployed” cash. The problem, under a literal reading of the statute, is that such cash does not meet the definition of (i), (ii) or (iii) above and, therefore, such a Fund would fail to satisfy the requirement that 90 percent of a Fund’s assets must consist of qualified opportunity zone property.
To address this issue, the Proposed Regulations provide for a working capital safe harbor. Under the safe harbor, cash held by a Fund will not cause the Fund to fail the 90 percent test if (a) such amounts are designated in writing for the acquisition, construction, and/or substantial improvement of tangible property, (b) there is a written schedule consistent with the ordinary start-up of a business for the expenditure of the working capital assets, which requires the funds to be spent within 31 months, and (c) the working capital assets are actually used in a manner consistent with the requirements above.
While the working capital safe harbor addressed a practical issue identified by many tax practitioners, it is important to note that the Proposed Regulations seem to indicate that the safe harbor applies only if a Fund makes an indirect investment in a qualified opportunity zone business by owning stock in a corporation or interests in a partnership that operates a qualified opportunity zone business, and does not apply if a Fund directly operates a qualified opportunity zone business.
The Proposed Regulations helped to answer many questions raised by the Opportunity Zone statute, but there are questions that are still unanswered. In the preamble to the Proposed Regulations, the IRS stated that it is working on additional proposed regulations which are expected to be published in the near future.
For questions, contact Doug Coats, (410) 576-4002.