The Opportunity Zone provisions of the Tax Cuts and Jobs Act of 2017 (TCJA) have generated significant interest among taxpayers, particularly those who may have amounts to invest from recent capital transactions. Proposed regulations on the topic have caused further enthusiasm, as they appear to give taxpayer-friendly answers to some of the questions raised by the statutory language.
As we noted in a previous article, the new rules apply when a taxpayer sells a capital asset and reinvests the capital gains into a Qualified Opportunity Fund (QOF) within 180 days. When that happens, tax on the capital gain is deferred until the sale of the QOF or until December 31, 2026, whichever is earlier. The law includes additional incentives for hanging on to the QOF for longer periods. At five years, investors get a 10% basis step-up. At seven years, they get another 5%, for a total of 15%. After 10 years, any post-acquisition appreciation in the QOF is exempt from capital gains tax.
Taxpayer-Friendly IRS Guidance
The IRS recently released the first batch of proposed regulations on the Opportunity Zone program, and the public response has been favorable. The rules include:
- Broad inclusion in the definition of “capital gains.” The rules permit almost any type of capital gains to qualify for deferral if invested into a QOF. Partnerships, S-corporations, estates, and trusts can elect to participate at the entity level or on an individual basis for each owner or beneficiary.
- Qualified Opportunity Zone business property (QOZBP). The rules provide some insight into what constitutes QOZBP. First, it must be acquired by purchase after December 31, 2017. Second, because the law is intended to drive new investment in these zones, the original use of the property must be within the Opportunity Zone. Therefore, purchase of existing property inside a zone will not result in the creation of QOZBP unless the purchaser makes “substantial improvements.” The regulations define “substantial improvements” as an investment of an additional amount equal to or greater than the taxpayer’s basis in the property. In the case of real property, the investment only needs to be equal to or greater than the basis in the building. Basis in the land itself is not part of the calculation.
- Working capital safe harbor. The proposed regulations allow a business operating in an Opportunity Zone to hold working capital funds for up to 31 months. To qualify, the business needs to:
- Identify the assets as held for the acquisition, construction, or substantial improvement of Qualified Opportunity Zone (QOZ) property.
- Prepare a written schedule for how the funds will be used during the 31-month period.
- 70% threshold. A trade or business is deemed to be operating in a QOZ if “substantially all” of the tangible business property that it owns or leases is in the zone. The proposed regulations have set the “substantially all” threshold at a very taxpayer-friendly 70%.
- Self-certification and deferral election. An entity can register as a QOF simply by filing a form with the IRS. No prequalification or approval is needed. Preexisting entities can register as QOFs as long as they meet the requirements of the law. Taxpayers report the deferral of capital gain income as part of their return for the tax year in which the gain would have been recognized but for the Opportunity Zone investment.
Watch for More Guidance to Come
The IRS has received more than 140 comments on these proposed regulations since they were released. After a public hearing, the IRS will issue a final version of these rules. In addition, at least one more set of proposed regulations is expected. That guidance will likely focus more on the operational aspects of running a QOZ business.
If you recently sold or are considering the sale of appreciated assets, please contact your CRI advisor to learn more about how the Opportunity Zone program could help you defer and reduce the impact of federal taxes on the transaction.