The “Opportunity” in Opportunity Zone

Rödl & Partner Tax Matters Vol 2018 – 12, published in December 2018

The Tax Cuts and Jobs Act created a new Opportunity Zone program that may provide tax benefits for taxpayers investing in “qualified opportunity funds.” The IRS recently issued proposed regulations and a draft Form 8996 that answer many, but not all, questions surrounding this potentially very significant tax benefit.

THE GAIN DEFERRAL OPPORTUNITY

Under the program, taxpayers may defer capital gains by investing in a “qualified opportunity fund.” Tax basis is increased by 10% if the fund is held for five years and by 15% if the holding period is at least seven years. Tax on the investment is deferred until the earlier of:

When the investment fund is sold, or
The year 2026

If the investment is held for at least 10 years, any additional gain (in excess of the originally deferred gain) can be realized tax-free. The proposed regulations provide rules clarifying procedures for deferral of gains realized by pass-through entities and specific election procedures.

Example:

A taxpayer realizing a $500,000 gain on a stock portfolio can defer tax on the gain by investing the $500,000 in a qualified opportunity zone fund within 180 days. The deferred gain will be taxable only at the earlier of when the investment in the fund is sold or in 2026, and is reduced if the five or seven year holding periods have been met. Gain in excess of the deferred gain can be excluded from taxable income entirely if the investment is held for at least ten years.

QUALIFIED OPPORTUNITY FUNDS

A qualified opportunity zone fund is an entity characterized as a corporation or partnership and organized to invest in “qualified opportunity zone property.” The fund must hold at least 90% of its assets in qualified opportunity zone property, and must file IRS Form 8996 annually to self-certify that it so qualifies.

Qualified opportunity zone property includes direct investment in “qualified opportunity zone business property,” or in a second tier investment in qualified opportunity zone stock or in a qualified opportunity zone partnership interest. Qualified opportunity zone business property is generally tangible property acquired after 2017 used in a trade or business in a qualified opportunity zone. Thousands of opportunity zones have been designated throughout the U.S. (See IRS Notice 2018-48, 2018-28 IRB 9).
With respect to qualified opportunity zone stock or partnership interests, the lower tier entity must also be a “qualified opportunity zone business.”

A qualified opportunity zone business” is a trade or business if substantially all of its owned or leased tangible property is qualified opportunity zone property. In addition, the business must:

Generate at least 50% of its gross income from the active conduct of a trade or business,
Use a substantial part of its intangible property in the conduct of such business,
Have non-qualified financial property of less than 5%, and
Not be a prohibited business (specified recreational activities or the sale of alcoholic beverages for consumption off premises).

Significantly, the proposed regulations provide a safe harbor for the substantially all test. Under the safe harbor, if at least 70% of tangible property is qualified opportunity zone property, then the substantially all test is deemed satisfied for purposes of characterizing a second tier entity as a “qualified opportunity zone business.”

As a result, a qualified opportunity fund can determine its compliance with the 90% test for qualified opportunity zone property by including 100% of its investment in qualified opportunity stock or qualified opportunity partnership interests, as long as the relevant second tier entity meets a 70% test for its investment in qualified opportunity zone business property.

Applicability to Rental Real Estate

While the requirement that 50% of gross income be derived from the active conduct of a trade or business is applicable to second tier qualified opportunity zone stock and partnership interests, it does not apply to direct investments by a qualified opportunity fund. However, direct investments by a fund in qualified opportunity zone business property must nevertheless be tangible property used in a trade or business of the qualified opportunity fund. Commentators have asked for clarification regarding how the trade or business requirement should be applied to rental real estate. Unfortunately, the proposed regulations “reserve” with respect to the definition of “trade or business” for this purpose. On the other hand, Revenue Ruling 2018-29, which was released on the same day as the proposed regulations, discusses a scenario in which a qualified opportunity fund invests in residential rental real estate. Thus, while it is apparent that Congress intended for real estate investments by qualified opportunity funds to be included in the opportunity zone program, we anticipate more clarification from the IRS.

The proposed regulations provide a significant amount of information related to the new opportunity zone program including various definitions, calculations, treatment of working capital, improvements, additional investments, related party restrictions, penalties, and more.

The above discussion is a high-level summary only. For detailed analysis and application to specific situations, please consult your Rödl & Partner representative.

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