For taxpayers who have been considering making an investment in a Qualified Opportunity Fund (Fund) to take advantage of the tax benefits provided by the Opportunity Zone rules that became effective on January 1, 2018, but did not make the investment before the end of 2019, there is good news and bad news.
Bad news first. One of the benefits of the Opportunity Zone rules is not only the ability to defer the recognition of capital gain that is realized today until December 31, 2026, but to also permanently avoid a portion of such gain. If the amount of realized capital gain is invested into a Fund within 180 days after the sale generating such gain, and the investment in the Fund is held for at least five years prior to December 31, 2026, then 10% of the realized gain is permanently excluded.
If the investment in the Fund is held for at least seven years prior to December 31, 2026, then an additional 5% of the realized gain is permanently excluded. But, of course, to be able to hold an investment in a Fund for at least seven years prior to December 31, 2026, the investment would have had to have been made by December 31, 2019. Thus, the bad news for a taxpayer who did not invest realized capital gain into a Fund prior to 2020 is that the “window” for permanently excluding the additional 5% of gain has closed. Going forward, the maximum amount of gain that may be permanently excluded will be 10%, and that benefit will be possible if an investment in a Fund is made before December 31, 2021, the date on which the second window will close.
Now, to the good news. When the Opportunity Zone statute was enacted effective as of January 1, 2018, and before the issuance of any regulations from the Internal Revenue Service (IRS), it appeared that the benefits of the Opportunity Zone rules were intended only for real estate projects, and not for investment in an operating business. Thus, prior to the issuance of final regulations in December 2019 (Final Regulations), taxpayers and their advisors were unsure how to take advantage of the Opportunity Zone benefits for an operating business.
The Final Regulations, however, address many questions regarding how an operating business could fit within the Opportunity Zone rules. Thus, the good news for taxpayers considering an investment into a Fund in 2020, and thereafter, is that we now have official guidance from the IRS regarding a Fund that will own an operating company, as opposed to a Fund that will engage only in real estate development.
For example, the Opportunity Zone statute requires that at least 50% of the gross income of a qualified Opportunity Zone business must be derived from the active conduct of a business within a geographic Opportunity Zone. So, prior to the issuance of the Final Regulations, a common question was how to satisfy the statutory requirement for a business that is physically headquartered within an Opportunity Zone, yet has customers and employees across the country or the world.
More good news is that the Final Regulations provide specific criteria to measure whether the 50% requirement is satisfied. To illustrate, the Final Regulations provide that if at least 50% of the services performed for the business, based on hours or amounts paid for the services, are performed within the geographic Opportunity Zone, then the 50% requirement is satisfied, regardless of where the customers of the business are located or where the sales actually take place.
And finally, the IRS recently issued relief with respect to several of the Opportunity Zone rules. For example, all qualified Opportunity Zone businesses holding working capital assets intending to be covered by the working capital safe harbor before December 31, 2020, will receive an additional 24 months to expend such working capital assets. As another example, if a taxpayer’s 180-day investment period deadline would fall between April 1, 2020, and December 31, 2020, such deadline is automatically extended to December 31, 2020.
In summary, although an investment in a Fund during 2020 will not capture all of the tax benefits as compared with an investment made prior to 2020, taxpayers should view 2020 as a year to consider employing the Opportunity Zone rules for real estate investment and operating companies as a result of the Final Regulations.