What is an Opportunity Zone?
The Opportunity Zone tax incentives program was created by Congress with bi-partisan support to encourage investments in economically-distressed communities. These “opportunity zones” were designated by each state and certified by the U.S. Treasury Department.
The new tax incentives program allows taxpayers to defer eligible capital gains by investing into designated Opportunity Zones, typically areas in need of economic investment infusion, through a Qualified Opportunity Fund (QOF). The QOF then uses those gain deferred investment dollars to acquire Qualified Opportunity Zone Business Property (QOZBP) or a Qualified Opportunity Zone Business (QOZB). Generally, 90% of a QOF’s assets must be QOZBP, and 70% of a QOZB’s assets must be QOZBP.
On December 19, 2019, the government released the highly anticipated final regulations covering the Opportunity Zone tax incentives program, which was created by Congress as part of the Tax Cuts and Jobs Act of 2017. The government also released an accompanying frequently asked questions page.
Where are the Opportunity Zones?
There are designated Opportunity Zones in all 50 states, the District of Columbia and five U.S. territories. IRS Notice 2018-48 provides a list of the more than 8,700 census tracts that have been designated as qualified Opportunity Zones.
Looking for additional resources related to Opportunity Zones? The U.S. Treasury Department’s Community Development Financial Institutions Fund webpage has them.
What are the tax benefits of designated opportunity zones?
Provided all the necessary statutory and regulatory requirements are met, the tax benefits of a qualified investment include:
Highlights of the Final Regulations
Below are some of the highlights contained in the final regulations:
Opportunity zones present significant tax benefits.
In-Depth Discussion of the Final Regulations
Eligible Gain: The Opportunity Zone statute refers to “capital gains” as the only type of gains eligible for the incentive. The general rule is that a taxpayer has 180 days from a sale date to invest its eligible capital gains into a QOF. In proposed regulations, the government interpreted this reference to mean that a taxpayer can only invest section 1231 gains (generally, gains from sale of property used in a trade or business, like real estate) if the taxpayer is in a net positive section 1231 position at the end of the taxpayer’s tax year. In effect, this proposed rule required a taxpayer to wait until the end of their tax year before making a qualified investment of its section 1231 gains. However, in the final regulations, the government allows a taxpayer to invest and defer “gross” section 1231 gains (without regard to any netting, but subject to certain limitations) beginning upon the date of sale.
Additionally, the government clarified that capital gains recognized under the installment sale method can be invested into a QOF, even if the original sale that created the installment payments predates the December 22, 2017 effective date of the OZ program. As a result, if a taxpayer sold a capital asset to an unrelated party in 2016 and the sale was structured as an installment sale, any gain recognized in tax years beginning after December 31, 2017 could be eligible for the OZ tax incentives. The 180-day period for eligible capital gains from an installment sale begins, at a taxpayer’s election, either at the date each installment payment is received or on the last day of the tax year.
Partnerships and S Corporations: Proposed regulations contained a special rule for partnerships and S corporations selling capital assets for a gain. First, the partnership or S corporation can elect to defer the gain by investing into a QOF within 180 days of the sale. However, if the entity did not make a deferral election, each partner/shareholder can elect to defer its share of the gain, either within 180 days of the sale date, or 180 days from the tax year end in which the partnership or S corporation reports the gain for tax purposes.
Recognizing that many partners and shareholders may not receive Schedules K-1 (particularly for entity tax returns with extended due dates) within 180 days of year end, the government added a new rule in the final regulations allowing a taxpayer to start the 180 day period from the due date of the entity’s tax return (not including any extensions). Similar rules were provided for beneficiaries of non-grantor trusts and estates.
Exiting an Investment: Provided all requirements are met, a taxpayer can sell its QOF investment after holding it for 10 years and exclude from taxable income any appreciation. Of course, the original deferred gain is recognized in 2026 (after taking into account any basis step ups).
Proposed regulations stated that a taxpayer selling its QOF interest could exclude both the capital gain and any ordinary income (from, for example, depreciation recapture via the “hot asset” rules). However, proposed regulations provided that while any capital gain arising from the sale of assets held by the QOF/QOZB can be excluded (assuming the QOF interest has been held for the requisite 10-year period), any ordinary income is not eligible for the gain exclusion. For a QOF investor, when exiting a qualified investment, this created a bias towards selling a QOF interest rather than selling assets, and there did not appear to be an identifiable policy reason for the bias.
In the final regulations, the government addressed this bias by providing that both capital and ordinary gain can be excluded upon the sale of a QOF interest or the sale of the QOF/QOZB assets, assuming all other requirements are met. However, any gain from the sale of inventory cannot be excluded if a QOF/QOZB sells its assets.
Importantly, if QOF assets are sold during the 10-year holding period (rather than at the conclusion), any gain is not automatically excluded, but the proceeds can be reinvested into other qualified QOF property within 12 months, or deferred under other available means, such as a like-kind exchange.
Qualified Property: Qualified Opportunity Zone Business Property generally must be originally used, or substantially improved, by the QOF/QOZB. Substantial improvement generally means spending $1 to improve property for every $1 that is allocated to the purchase price of the property (excluding land).
For example, a QOF/QOZB purchasing land and a building for $150, with $100 of purchase price allocated to the building and $50 allocated to the land, must invest, at the minimum, an additional $100 into the building in the form of substantial improvements. The statute provides a taxpayer up to 30 months to make “substantial improvements” to acquired property, and the final regulations provide that during those 30 months, the QOF/QOZB will be deemed to hold qualified property, even though there may not be an operating business.
The final regulations also allow “substantial improvement” to be measured on an aggregate basis among multiple assets under certain fact patterns.
Original Use Defined: “Original use” generally means purchasing new or constructing something new. The final regulations clarify that “self-constructed” property is treated as QOZB with original use beginning on the day “physical work of a significant nature” begins.
Property that was previously used in an Opportunity Zone (before the area was designated as an Opportunity Zone) cannot satisfy the original use requirement, even if the property was not previously placed into service for depreciation and amortization purposes. However, real property (including land and buildings) that has been vacant for at least a year prior to the land being designated as in an Opportunity Zone can qualify for original use. Other real property, vacant for an uninterrupted 3-year period after an Opportunity Zone designation, can also qualify for original use. A property is “vacant” if more than 80% of the building or land, measured by square footage, is not being used.
One possible transaction (recognized by the government in an example in the final regulations) arising from these rules involves a QOF/QOZB satisfying the “original use” requirement by purchasing an almost completed development, provided the development has not yet been (and is not yet capable of being) placed into service. For instance, a hotel developer could construct a large hotel complex in an Opportunity Zone, and just before completing the project, a QOF/QOZB could purchase the project from the developer. So long as the project has not yet been placed into service (and is not yet eligible to be placed into service), and assuming all other requirements are met, the QOF/QOZB’s purchase satisfies the “original use” requirement.
Leasing Updates: Although a taxpayer cannot sell property to a QOF/QOZB in which the taxpayer owns more than 20%, there is no explicit related party prohibition for leases, meaning an owner may be able to lease its Opportunity Zone property to a QOF/QOZB even where the owner controls more than 20%.
The final regulations add that leases between unrelated parties are presumed to be market rate. The final regulations also provide more clarity on whether a so called “triple net” lease can be used as part of a qualifying business. Generally, a triple net lease may not always be fatal, but caution should be used when executing a triple net lease as part of a QOZB.
Rules for Consolidated Groups: A new update in the final regulations allows a consolidated group of C corporations to hold an interest in a QOF by treating a lower-tier C corporation as a QOF and member of the consolidated group, so long as the QOF complies with certain other requirements.
Working Capital: Proposed regulations created a 31-month “working capital safe harbor” granting a QOF/QOZB time to raise and deploy capital as part of a business. Under this safe harbor, a QOZB could hold working capital as part of a written plan to deploy the capital, and provided certain requirements, including customary and reasonable business practices, are met, the QOZB would be deemed to hold QOZBP. The final regulations expand on this safe harbor definition by providing that any assets acquired during the 31-month period can be deemed to be QOZBP, even if the assets are being constructed and/or improved. Furthermore, the government created a new working capital safe harbor for certain start-up businesses. A start-up business that meets all the requirements could have up to 62 months to become operational, and during that 62-month window, the business’s assets (including the working capital) would be deemed to be QOZBP.
We recently put together a webinar highlighting the goals of the opportunity zone program and its potential tax incentives.
What Should I Do Next?
The final regulations provide answers and a refined regulatory regime for the Opportunity Zone tax incentive program. The final regulations are generally effective March 13, 2020, although taxpayers can choose to rely upon these final regulations (or earlier proposed regulations) for tax years beginning prior to their effective date.
Taxpayers with eligible capital gains interested in deferring the gain without using the more restrictive rules of a like-kind exchange should consider the benefits afforded from using the Opportunity Zone tax incentive program.
Have questions on opportunity zones? We can help.
The Eide Bailly Opportunity Zone Team consists of professionals with expertise in community development, construction, real estate, finance and tax. They can:
Our recent webinar “Qualified Opportunity Zones: Understanding the Opportunity – Final Regulations” can be found here.