On December 22, 2017, as part of the enactment of the 2017 Tax Act, Congress added Internal Revenue Code Sections 1400Z–1 and 1400Z–2, which designated certain low-income communities as “qualified opportunity zones.” This new law allows taxpayers a temporary deferral of realized gains if the taxpayers timely reinvest the gains in eligible property (referred to as “opportunity zone properties”) that is located in an opportunity zone.
Taxpayers may organize either a partnership or a corporation (a “qualified opportunity fund”) for the purpose of investing in opportunity zone properties. In other words, such partnership or corporation is organized as a “qualified opportunity zone business.” A qualified opportunity zone business can generally be any active trade or business in which substantially all of the tangible property owned or leased by the trade or business is through the opportunity fund and treated as qualified opportunity zone business property.
The one caveat is that the Code section provides a list of certain businesses that will not be treated as qualified opportunity zone businesses. Specifically, businesses that are considered a “sin business” will not qualify as an opportunity zone business, and include:
• Golf courses
• Country clubs
• Massage parlors
• Hot tub facilities
• Suntan facilities
• Racetracks or other facilities used for gambling
• Any store where its principal business is the sale of alcoholic beverages for consumption off premises.
Compliance Requirements and the Qualified Opportunity Fund Asset Test
For compliance purposes, the IRS has confirmed that taxpayers can self-certify and become a qualified opportunity fund by completing a form and by attaching that form to the taxpayer’s federal income tax return for that taxable year. The form itself is not yet available but it is expected that the IRS will soon issue a sample of this form, to be released later this year.
In addition to the initial self-certification to become a qualified opportunity fund, the taxpayer must also meet an asset test on a semi-annual basis. If a qualified opportunity fund fails to meet this test, that fund may be subject to a penalty for each month that it fails to meet the stated percentage requirement. The penalty is the differential between the percentage of assets invested in a qualified opportunity zone property and the 90 percent of assets amount, multiplied by the underpayment interest rate.
Temporary Deferral of Gains
In order to qualify for the temporary deferral of realized gains, the taxpayer must (1) reinvest their gains from the sale to, or exchange with, an unrelated person of any property held by the taxpayer in a qualified opportunity fund, and (2) the taxpayer must do so within 180 days from the date of the sale or exchange.
In the year that the taxpayer later sells or exchanges the investment, the taxpayer must include the amount of gain in the gross income for that year, and in any case, if the taxpayer has not sold or exchanged the investment by December 31, 2026, the taxpayer must include the amount of gain in the gross income for 2026.
Investments Held for 5, 7, or 10 Years
Any investment held by the taxpayer for at least 5 years will receive an increase in the basis of such investment by 10 percent of the gain that was deferred. Any investment held by the taxpayer for at least 7 years will receive an increase in the basis of such investment by an additional 5 percent of the gain that was deferred.
Any investment held by the taxpayer for at least 10 years will receive a step up in the basis of such property to the fair market value of the investment on the date that the investment is sold or exchanged. Because the 10-year mark will not be reached until after the temporary deferral period has already ended in 2026, taxpayers who are still holding their investments in an opportunity fund on December 31, 2026 are required to recognize and pay taxes on any deferred gain at that time (subject to any basis adjustments that have been made). After 2026, if the taxpayer holds the investment for the full 10 years (or longer), any potential increase in the fair market value of the investment will receive a step up in its basis upon its sale or exchange.
In order to take advantage of this special 10-year rule, the taxpayer must make an election under IRS Code Section 1400Z-2(c). More guidance is expected on how the taxpayer can make this election.
Key Considerations Pending Treasury Regulations
While the IRS has issued an IRS Notice, IRS Bulletin, and a list of Frequently Asked Questions, there are still many more unanswered questions relating to compliance matters, including:
· Can investors obtain the benefits of deferral if they sell the underlying property or investment, rather than the sale of their interest in the opportunity fund itself?
· How long can a qualified opportunity fund hold cash after the disposition of an asset before the cash needs to be reinvested?
· If the opportunity fund is organized as a partnership, can the partnership realize gains on behalf of its investors and reinvest the gains in a new partnership, while achieving the benefits of deferral?
· Will land be treated as qualified opportunity zone property?
In order for property to be treated as opportunity zone property, the property must be an “original use” property by the opportunity fund, or the property must be “substantially improved” by the fund. However, the terms original use and substantial improvement have not been clearly defined.
The Treasury Department is expected to issue specific regulations and guidance later this year, which will hopefully help to clear up many of the outstanding questions and uncertainties.