The Internal Revenue Service recently issued more proposed regulations (REG-120186-18) on Sec. 1400Z-2, which outline the new tax incentives for investing in economically distressed communities.
For a quick overview, the tax incentives within Sec. 1400Z-2 allow taxpayers to defer a realized capital gain for as long as 7 years if they subsequently invest the capital gain into a Qualified Opportunity Fund (QOF) within 180 days.
If the taxpayers hold that qualified interest in said fund for 5 years, they will be allowed to take a 10% discount off of the original capital gain. If the taxpayers hold the qualified interest for an additional 2 years, they will be given an additional 5% discount on their original capital gain. Fast forward to December 31, 2026 and the taxpayers will only have to pay tax on 85% of their original capital gain that was realized 7 years earlier.
The holy grail of this code section, however, is the permanent exclusion of the post-acquisition gain from the sale of the interest in the QOF if it is held for more than 10 years.
Although the first round of regulations was comprehensive in its explanation on the tax incentives, it left many unanswered questions for real estate investors, specifically:
One of the biggest hesitations for investors was the unanswered question regarding the treatment of debt in calculating an investor’s basis in a QOF. Specifically, real estate investors were afraid of debt financed distributions being classified as an inclusion event, which would prematurely trigger a taxable gain.
Taxpayers who defer a capital gain by reinvesting in a QOF will initially have zero basis in the fund without consideration of debt basis. If debt basis didn’t count towards an investor’s QOF basis, then presumably any distribution would trigger a partial inclusion of deferred gain. Luckily, the IRS will follow the tax basis rules under Subchapter K of the Internal Revenue Code. However, distributions from a corporate QOF that are not considered a dividend (from earnings and profits) will be treated as an inclusion event taxable to the stockholders.
Under the new proposed regulations, QOFs are now more attractive than ever for private equity funds. The sale of qualified partnership interest, qualified corporate stock, or qualified opportunity zone business property by a QOF will not impact the holding period for investors.
For example, a taxpayer’s interest in a QOF will qualify for the exclusion of gain under the 10- year holding period even if the QOF buys, sells, and exchanges qualified opportunity zone property within those 10 years.
Although a sale of QOZ property within a QOF won’t impact an investor’s holding period, the QOF itself is still required to meet the 90 percent test. In the latest proposed regulations, the IRS gives additional leeway to investors by allowing QOFs as long as 12 months to reinvest the proceeds from the disposition of QOZ property as long as the proceeds are held as cash, cash equivalents, or debt instruments with a term of 18 months or less.
As for the recognition of any capital gain, if the investor has not held the QOF interest for 10 years, then any realized gain will be taxed at the corporate level or passed through to the partners in the QOF.
One of the most interesting revelations to come out of the newest proposed regulations is the option to either exclude the gain from the sale of the QOF interest after the 10-year holding period or exclude gains from property sold that was held by the QOF after the 10-year holding period.
For example, say an investor holds qualified interest in a QOF that is taxed as a partnership for federal income tax purposes. After 10 years, the partner sells his or her partnership interest and elects to adjust the basis to the fair market value on the date of disposition (realizing no gain on the sale of the partnership interest). The basis of the QOF partnership assets are also adjusted and such adjustment is calculated in a manner similar to a section 743(b) adjustment.
Assume a similar circumstance as described above but the partner wishes to remain in the QOF. If the QOF were to sell qualified opportunity zone business property and flow the income to the partners, then the partners with the 10-year holding period within the QOF may elect to exclude the allocable gains from their taxable income. This election is advantageous to larger funds that can gradually sell off QOZ property without impacting the real underlying economic value of these investments. This would presumably alleviate the issue of forcing partners to sell all of their partnership interest at once to benefit from the exclusion of taxable gain.
Many investors looking to cash in on these opportunity zone tax incentives without putting substantial capital at risk contemplated speculative land purchases. This type of economic decision-making was contrary to the initial purpose and intent of the legislation, so the IRS proposed additional anti-abuse rules in regard to land purchases.
Under the new proposed regulations, land can be treated as qualified opportunity zone business property for purposes of section 1400Z-2 only if it is used in a trade or business of a QOF or qualified opportunity zone business. This will prevent investors from simply purchasing land and holding onto the property for 10 years.
With the initial round of regulations, the IRS proposed an “original-use” test to prevent investors from buying and holding property without making substantial investments into these economically distressed communities. Under these rules, real estate investors would have to double their investment by making improvements in excess of the original purchase price of the property without regard to land.
For example, if a real estate investor purchases an existing building located in an opportunity zone for $600,000 (of which $100,000 is allocable to land), the investor is required to invest more than $500,000 to substantially improve the property.
Under the second round of regulations, the IRS clarifies the “original-use” rule as property that has not been depreciated by another taxpayer other than the QOF within the opportunity zone. Therefore, a development project that is never completed or put into service may qualify as original-use property.
For example, assume the same facts as the example above, but the property is never put into service by the original seller. Since the property was never depreciated by another taxpayer, the QOF is not subject to the substantial improvement requirement.
What about property that is put into service but subsequently abandoned? Can a QOF side-step the substantial improvement requirement by purchasing abandoned property? Under the new proposed regulations, the IRS allows QOFs to meet the original-use test and circumvent the substantial requirement test only if the property is abandoned for 5 or more years.
Although the second round of regulations has made investing in a QOF more attractive, there are still several unknowns and complexities surrounding the law. Another public hearing is scheduled for July 9, 2019, but investors will need to act quickly to cash in on all of the tax incentives. Investors only have until December 31, 2019 to defer a capital gain and reinvest the proceeds into a QOF to benefit from the total 15% exclusion.
The tax incentives within Sec. 1400Z-2 are lucrative and similar incentives come along infrequently. To get the most out the new law, it’s important to partner with trusted professionals within the QOZ space to avoid any headaches or unintended consequences over the decade to come.