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Proposed Guidance: Qualified Opportunity Funds

In October 2018, The Internal Revenue Service (“IRS”) issued proposed regulations and a Revenue Ruling providing guidance for the new Opportunity Zone tax incentive.

The proposed regulations provide guidance on the requirements for deferring gain by investing in a Qualified Opportunity Fund (QOF) under new section 1400Z-2 of the Internal Revenue Code (the “Code”). The proposed regulations address the types of gains that may be deferred by investors, the timing to invest such gains in a QOF, and the manner of electing deferral of such gains. Further, the proposed regulations provide guidance on how the new Form 8996 (QOF) is used for both initial self-certification and annual reporting of compliance with the 90% asset test, how QOF assets will be valued, and certain requirements for Qualified Opportunity Zone (QOZ) businesses.

The preferential tax treatment associated with the Qualified Opportunity Zone Funds include:

  • Deferral of tax on all capital gains invested in a QOF until December 31, 2026, 
  • Potential elimination of tax – 10 percent (if the investment in a QOF held for 5 years) or 15 percent (if the investment in a QOF held for 7 years) of the deferred capital gain is permanently excluded from taxation 
  • If the Investment in a QOF is held for at least 10 years – elimination of tax on all gains earned above the original amount invested in a QOF

The Proposed Regulations 
Below is a summary of the major issues addressed by the Proposed Regulations and Revenue Ruling: 

Gains Eligible for Deferral 
The proposed regulations clarify that only capital gains are eligible for deferral. Gains eligible for deferral generally include capital gain from an actual, or deemed, sale or exchange, or any other gain that is required to be included in a taxpayer’s computation of capital gain.  

Taxpayers Eligible to Elect Deferral 
The proposed regulations clarify that any taxpayer who recognizes gain for Federal income tax purposes is eligible to defer that gain.  This includes individuals, corporations (including regulated investment companies (RICs) and real estate investment trusts (REITs)), and partnerships.  

Eligible Interest in a Qualified Opportunity Fund (“QOF”)  
The proposed regulations confirm that the investment in the QOF must be an actual equity interest, including preferred stock or a partnership interest with special allocations. Thus, an eligible interest cannot be a debt instrument. 

Implementation of the 180-Day Rule 
To achieve deferral, taxpayer must generally invest in a QOF during the 180-day period beginning on the date of the sale or exchange giving rise to the gain. 

Pass-Through Entities  
Under the Proposed Regulations, both partnerships and their partners are eligible to defer all or a portion of capital gains.
If a partnership makes a deferral election, the deferred gain with respect to which the election is made will not be included in calculating the distributive share of the partnership’s capital gains. If the partnership does not make the election, the proposed regulations provide an opportunity for a partner that receives a distributive share of the gain to make a deferral election, subject to certain requirements. The partner’s 180-day reinvestment period begins on the last day of the partnership tax year.   

The proposed regulations state that rules analogous to the rules provided for partnerships and partners also apply to other pass-through entities (including S corporations, decedents’ estates, and trusts) and to their shareholders and beneficiaries. 

Rev. Rul. 2018-29 
The Revenue Ruling 2018-29 addresses the treatment of land when a QOF acquires a building located on land within an Opportunity Zone. The IRS concluded that substantial improvement will be measured by QOF’s additions to the adjusted basis of the building, not the adjusted basis of both the building and the land. Thus, the QOF is not required to separately improve the land.  

Substantial Improvement of QOZ Property and Timing  
The proposed regulations provide guidance for the basis to be used in determining whether a taxpayer has substantially improved QOZ business property. The taxpayer must double their adjusted basis in the property after purchase, and the substantial improvement must be completed within any 30-month period beginning after the date of the acquisition of the QOZ property.  Land is excluded from the adjusted basis calculations. 

The “Substantially All” Requirements  
A QOF may own a QOZ Business (rather than directly owning QOZ Property). To qualify as a QOZ Business, “substantially all” of the tangible property owned or leased by a QOZ Subsidiary must constitute QOZ Business Property.  The proposed regulations state that “substantially all” requirement is satisfied if 70% of the tangible property owned or leased by a trade or business is QOZ business property. 

Self-Certification of Opportunity Funds 
In order to certify as a QOF, an eligible entity will need to file Form 8996 for initial self-certification and annual reporting of compliance with the required 90% asset test.  Further, the IRS confirms that it is permissible to use a pre-existing entity as a QOF.  As far as valuation of assets, for entities with an applicable financial statement (“AFS”), the asset value is the value reported on the AFS.  For an entity without an AFS, asset value is based on cost. 

The proposed regulations provide guidance with respect to many aspects of the QOZ Program. However, a number of questions remain unanswered that the Treasury is expected to address by additional regulations later this year.

Author: Chandrakant Patel, CPA, MST, Tax Senior Manager  | cpatel@withum.com

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