In December 2019, the U.S. Treasury Department and the Internal Revenue Service (IRS) released final regulations regarding investments in opportunity zones. The final regulations offer clarity around a host of important issues for investors and businesses interested in taking advantage of the incentive.
With the final regulations in place, now is the time to take a deep dive into the Qualified Opportunity Zone (QOZ) program and the potential tax benefits that may await.
Refresh: What are Qualified Opportunity Zones?
With the signing of the Tax Cuts and Jobs Act (TCJA) in December 2017, Qualified Opportunity Zones emerged as a new, viable federal incentive.
The leading principle behind the program is a desire to spur investments in undercapitalized communities. Per the guidelines, any corporation or individual with capital gains can qualify for the program and, in return for the community investment, receive significant tax benefits.
As specified by the program, Governors of the 50 states and four U.S. territories, as well as the mayor of Washington DC, nominate zones for consideration. The Treasury Department then officially designates which tracts receive status as a Qualified Opportunity Zone.
Research from the Urban Institute revealed that the 8,762 selected tracts (accounting for 12% of U.S. census tracts), often have lower incomes, higher poverty rates, and higher unemployment rates than non-designated tracts.
Upon identifying a QOZ, investors can finance a broad variety of activities and projects in the area. For instance, funds can finance commercial and industrial real estate, housing, infrastructure, and existing or start-up businesses. For real estate projects to qualify, the investment must result in “substantial improvement” to the properties.
Also, there are some “sin” businesses that do not qualify for the program or tax benefits. More specifically, investors cannot use their Qualified Opportunity Fund (QOF) to provide (including the provision of land) any private or commercial golf course, country club, massage parlor, hot tub facility, suntan facility, racetrack or other facility used for gambling, or any store or business of which sells alcoholic beverages for consumption off of the premises.
Refresh: What are the tax benefits of financing a project in a Qualified Opportunity Zone?
The federal program provides three notable tax benefits for investing your unrealized capital gains in a QOZ:
- Temporary deferral of taxes on previously earned capital gains;
- Basis step-up of previously earned capital gains invested; and
- Permanent exclusion of taxable income on new gains.
For more information on the technical details of these tax benefits, please check out our other QOZ resource: “Qualified Opportunity Zones: Revitalizing Communities and Deferring Capital Gains Taxes”.
What are the Qualified Opportunity Zone final regulations?
With the release of the final regulations (TD 9889), the IRS provides guidance for eligible taxpayers to invest in federally recognized QOZs. The regulations include provisions from both the 2018 and 2019 proposed regulations, thereby retaining the basic approach and structure while implementing some revisions. In conjunction with the final regulations, the Treasury Department also issued an FAQ to provide additional guidance. Some highlights of the final regulations include:
Treatment of Sec. 1231 Gains
One of the more drastic changes from the proposed regulations is in regards to the treatment of Sec. 1231 gains.
Sec. 1231 assets include depreciable property and non-depreciable real estate used in a trade or business for longer than one year. When you dispose of these assets, there is a necessary netting process. At the end, net Sec. 1231 gain for the year is taxed as capital gain, while net Sec. 1231 loss is deducted as an ordinary loss. The proposed regulations required you to wait until the last day of the tax year – when the netting process would be complete – before contributing any Sec. 1231 gain into a QOF.
However, the final regulations change these rules. Now they allow you to immediately contribute a Sec. 1231 gain to a QOF, even though you could have other Sec. 1231 losses during the year that reduce the net Sec. 1231 gain. More simply, each Sec. 1231 gain stands on its own and may be immediately invested into a QOF without regard to other Sec. 1231 losses that may occur before or after recognition of the gain.
This change is significant for taxpayers as it increases the amount of gain you may invest and defer and starts the investment window immediately. Furthermore, a Sec. 1231 gain may be immediately invested into a QOF and deferred, while any Sec. 1231 loss for the year now adds to the net Sec. 1231 loss, giving rise to an ordinary deduction.
The regulations also highlight various scenarios and rules relevant to Sec. 1231 gain. This includes a rule that limits qualified Sec. 1231 gain to the extent that it exceeds any amount with respect to the Sec. 1231(b) property treated as ordinary income under Sec. 1245 or Sec. 1250.
Timing of Eligible Gains
Originally, the proposed regulations required the 180-day investment period to begin the last day of the year. However, this is no longer the case. Per the final regulations, the 180-day investment window commences on the date of the sale or exchange which results in the Sec. 1231 gain.
The final regulations offer timing flexibility for the 180-day investment period. For example, in order to make a qualified investment into a QOF, owners of flow-through entities that recognize the gain have 180 days from 1) the gain recognition event, 2) the end of the flow-through entity’s tax year, or 3) the original due date of the flow-through entity tax return.
Working Capital Safe Harbor
Initially, the proposed regulations allowed you to essentially treat working capital assets held by a business as reasonable in amount and as qualified property for up to 31 months, barring the satisfaction of certain conditions. However, with the final regulations, the government expands this safe harbor protection and generally allows greater flexibility for working capital within a QOZ business with the following additions:
- A working capital safe harbor for start-ups allows 62 months instead of 31 months.
- The safe harbor adds an additional 24 months if the QOZ is in a federal disaster area.
- After a maximum of 62 months, any funds remaining in the safe harbor cannot receive consideration as good assets for the 70% tangible property standard.
- Tangible property, such as equipment and buildings under improvement, qualify as in use in the QOZ business’ trade or business.
As announced in the final regulations, you may aggregate multiple assets into a single property.
More specifically, you can aggregate buildings located entirely within a parcel of land into a single property. Further, you can treat multiple buildings located within adjoining parcels as a single property if:
- The QOF or the QOZ business exclusively operate the buildings;
- The buildings share facilities or significant centralized business elements; and
- The buildings coordinate or rely upon one or more trades or businesses.
In addition, the regulations allow tangible property purchased, leased, or improved by a trade or business that is undergoing the substantial improvement process (but has not yet been placed in service) to qualify as a QOZ business property for the 30-month substantial improvement period as long as the entity reasonably expects that the property will be substantially improved and used in the trade or business in the QOZ by the end of the 30-month period.
Basis Adjustments for Investments Held at Least Ten Years
One of the three primary benefits of the opportunity zone program is the ability to effectively exclude gains on the QOZ investment itself, if held for at least 10 years.
The final regulations provide that all asset sale gains, except the sale of inventory in the ordinary course of business, are eligible for the basis step-up (and, therefore, the gain exclusion) for investments held at least 10 years, regardless of their characterization (as ordinary or capital).
In addition, the final regulations provide additional guidance for calculating the basis step-up for sales of partnership interests, including the use of a corresponding adjustment to the assets of the partnership which would also serve to eliminate potential ordinary gain under Sec. 751(a).
Original Use and Vacancy
Under the final regulations, you can consider real property original use if it has been vacant for at least three years prior to acquisition by the QOF/QOZ business, and also if the property has never been placed in service in an opportunity zone before.
This means redevelopments that started prior to the implementation of QOZ rules can be sold to a QOF as long as the property has not been placed into service.
In addition, property that has been vacant for one year before the tract in which it sits receives QOZ designation is also eligible. The final regulations generally define vacant as less than 80% of useable space being in use.
How can Squar Milner help?
The Qualified Opportunity Zone final regulations are out and now is the time to get in touch with your CPA to make sure you are making the most of the new federal incentive. Our Real Estate and Construction & Engineering practices have the experience and background to help you take advantage of Qualified Opportunity Zones as part of your tax strategy.
We are dedicated to helping you develop a viable plan that benefits you, both professionally and personally. Don’t miss out on this new tax incentive!
Disclaimer: This material has been prepared for informational purposes only, and is not intended to substitute for obtaining accounting, tax, or financial advice from a professional tax planner or financial planner. All information is provided “as is,” with no guarantee of completeness, accuracy, timeliness or of the results obtained from the use of this information.