Insights: Article

Proposed Regulations Released on Qualified Opportunity Zone Incentives

October 29, 2018

As part of the new tax reform law, taxpayers may defer—and, in some cases, partially exclude from taxable income—capital gains if the gains are reinvested in a Qualified Opportunity Fund (QOF). Any taxpayer recognizing eligible capital gains can generally qualify for the deferral. Recently issued proposed regulations answer some of the questions that had, so far in 2018, held up investments in QOFs.

Congress designed the new law to provide tax benefits that will encourage investment in certain distressed communities. A nomination process completed earlier this year resulted in over 8,700 communities in all 50 states, the District of Columbia and five US territories being designated as qualified opportunity zones. A qualified opportunity zone (QOZ) is a population census tract that is a low-income community that the chief executive officer of a state nominated by notifying the IRS within a designated 90-day determination period. Investments made within the QOZ have the ability to gain tax benefits.

How it Works
A QOF is an investment vehicle organized as a corporation or partnership to invest in QOZ property. The QOF must hold at least 90 percent of its assets in QOZ property, or it will be subject to penalties.

As a taxpayer with a capital gain transaction, you can elect to defer gain from the sale or exchange of capital assets to the extent of the amount re-invested in a QOF. The QOF investment must be made within 180 days of the date of the sale or exchange and may provide an alternative to a section 1031 tax deferred exchange. Recognition of the capital gain is deferred until the earlier of:

  • The sale or exchange of the QOF investment, or
  • December 31, 2026.

Note: as a result, any deferred gain will be reported no later than 2026, even if the QOF investment made to create the deferral is still owned after 2026.

Other benefits are available if you hold the QOF investment for specified time periods:

  • If the QOF investment is held at least 5 years, you can reduce the original gain amount by 10 percent,
  • If the QOF investment is held at least 7 years, you can reduce the original gain amount by 15 percent, and
  • If the QOF investment is held 10 years, any gain from the sale of the QOF investment can be excluded from taxable income.

In 2018, you sell for $70,000 publicly traded stock that you originally purchased for $50,000. Your capital gain amount is $20,000, but within 180 days of the trade date, you reinvest the $20,000 gain amount in a QOF in 2018. The results vary depending on how long you hold the QOF investment:

  • If the QOF is held for 5 years and sold in 2023 for $30,000, you include in 2023 taxable income:
    • $18,000 of the original $20,000 of capital gain from the 2018 sale, and
    • $10,000 of gain from the sale of the QOF investment.
  • If the QOF is held for 7 years and sold in 2025 for $36,000, you include in 2025 taxable income:
    • $17,000 of the original $20,000 of capital gain from the 2018 sale, and
    • $16,000 of gain from the sale of the QOF investment.
  • If the QOF is held for 10 years and sold in 2028 for $50,000 you would have already included $17,000 of the original $20,000 capital gain in your 2026 taxable income:
    • No gain is reported upon sale of the QOF investment in 2028.

Proposed Regulations
On October 19, 2018, the U.S. Treasury Department and IRS released proposed regulations clarifying some of the issues that had prevented many taxpayers from forming and reinvesting capital gain amounts in QOFs. Issues the proposed regulations address include:

  • The type of gains that may be deferred by investors.
  • The time by which gain amounts must be invested in QOFs.
  • The manner for investors to elect to defer gains.
  • The process for QOFs to self-certify, value assets and determine qualified opportunity zone businesses.

A few of the noteworthy issues clarified by the proposed regulations follow:

  • Only capital gains (whether short-term or long-term) are eligible for deferral. The gain to be deferred must be gain that would be recognized, absent the QOF deferral, not later than December 31, 2026. In addition, the gain cannot arise from the sale or exchange of property with a related person (as defined in the proposed regulations).
  • Any taxpayer recognizing capital gain for federal income tax purposes is eligible to elect deferral. This includes individuals, C corporations, partnerships, S corporations, trusts, estates and other specified entities. For partnerships, either the partnership or its partners can elect deferral of eligible capital gains. Other pass-through entities (S corporations and their shareholders and trusts and estates and their beneficiaries) receive similar treatment.
  • QOF owners are permitted to pledge their respective interests in a QOF as collateral for a loan. This may help investors with liquidity needs during the holding period of the QOF.
  • A new, yet-to-be-issued IRS form—numbered 8949—will be used for taxpayers to elect deferral of eligible capital gains.
  • A “working capital safe harbor” provides a process for treating cash as qualified opportunity zone property for a period of 31 months, if specific requirements are met, to assist a QOF with the 90 percent qualification test.

In addition to the proposed regulations, a revenue ruling and a draft version of a new IRS form for use by QOFs (along with related instructions) were released. Rev. Rul. 2018-29 provides additional guidance on the treatment of land in a QOF. Form 8996, when finalized, will be used to self-certify as a QOF and comply with the QOF annual investment standard test (and calculate any penalty amount due).

The Treasury Department and IRS will hold a public hearing on January 10, 2019, to consider comments from taxpayers and their representatives related to the proposed regulations.

More Information
Investing in a QOF that supports distressed economic areas and promotes economic growth and job creation can result in tax benefits. Visit the Treasury Department’s website dedicated to Qualified Opportunity Zones here for more information, including FAQs and lists of the state-by-state designated opportunity zones. 

Contact your Eide Bailly professional to learn more about QOZs or QOFs and for additional information on making comments related to the proposed regulations to the IRS.

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