On October 19, 2018, the U.S. Treasury Department and Internal Revenue Service ("IRS") issued long-awaited and much anticipated proposed regulations (the "Proposed Regulations") relating to the Opportunity Zone Fund ("OZ Fund") rules contained in Section 1400Z-2 of the Internal Revenue Code (the "Code"). The Proposed Regulations provide guidance in a number of important areas, including some where the lack of clarity and/or flexibility in the Code provisions had dissuaded many taxpayers from taking advantage of the OZ Fund investment benefits. However, some issues and unanswered questions still remain, some of which the IRS has indicated are intended to be addressed in subsequent regulations expected to be issued in the near future.
Some of the highlights of the Proposed Regulations include (i) the ability for a qualified opportunity zone business to retain cash (and cash items, and certain debt) as reasonable working capital for up to 31 months without causing a failure of the 90% asset test; (ii) allowing a partner in a partnership to defer its distributive share of qualifying capital gains of the partnership by reinvesting such gains into an OZ Fund; (iii) enabling an OZ Fund investor to elect a fair-market value basis step-up for an interest held for at least 10 years until December 31, 2047; (iv) providing guidance on the methods to be used for calculating compliance with the 90% asset test; and (v) clarifying that the requirement that "substantially all" of a qualified opportunity zone business's tangible property consist of qualified opportunity zone business property will be satisfied if 70% of its tangible property so qualifies.
OZ Funds, enacted on December 22, 2017 as part of the Tax Cuts and Jobs Act (the "TCJA"), generally provide for the ability to defer, until December 31, 2026, capital gains recognized upon the sale of any asset, to the extent such gains are reinvested into an OZ Fund within 180 days of being recognized. To the extent the interest in the OZ Fund has been held for at least 5 years, only 90% of the gain will be recognized on December 31, 2026, and to the extent it has been held for at least 7 years, only 85% of such gain will be recognized on December 31, 2026. Additionally, to the extent the interest in the OZ Fund has been held for at least 10 years, no additional gain (resulting from appreciation over the invested gain amount) will be recognized upon a sale or disposition of such interest. This is achieved by making an election to step-up the basis of the interest to its fair-market value on the date the interest is sold or exchanged.
OZ Fund Qualifications
An OZ Fund is defined as any partnership or corporation organized for the purpose of investing in qualified opportunity zone property ("OZ Property"), at least 90% of the assets of which consist of OZ Property (that does not include an interest in another OZ Fund). The 90% test is conducted by averaging the assets of the OZ Fund held on two semi-annual testing dates; the end of six months and the last day of each taxable year of the OZ Fund.
OZ Property is defined to include qualified opportunity zone business property ("OZ Business Property"), and qualified opportunity zone partnership interests or stock (an "OZ Entity Interest").
OZ Business Property is defined as tangible property located in an opportunity zone and used in a trade or business of the OZ Fund, that (i) was purchased from an unrelated party (generally applying a 20% ownership threshold) after 2017; (ii) either the original use of the property in the opportunity zone commences with the OZ Fund, or the OZ Fund "substantially improves" the property (i.e., it more than doubles its basis in the property within any 30-month period); and (iii) during substantially all of the OZ Fund's holding period of the property, substantially all of the property's use is in the opportunity zone.
To qualify as an OZ Entity Interest, (i) the partnership interest or stock must be acquired by the OZ Fund after 2017 for cash, at original issue; and (ii) the issuing entity must be a qualified opportunity zone business ("OZ Business") (or organized for purposes of being an OZ Business); and qualify as such during "substantially all" of the OZ Fund's holding period of the OZ Entity Interest.
To qualify as an OZ Business, (i) substantially all of the business's tangible property (if any) is OZ Business Property (as defined above); (ii) at least 50% of its gross income is derived from the active conduct of a trade or business in the OZ; (iii) a "substantial portion" of its intangible property is used in such trade or business; (iv) less than 5% of its assets are "non-qualified financial property" (generally includes any securities, but not cash or short-term debt instruments held as reasonable working capital); and (v) is not a listed "sin" business (golf course, country club, massage parlor, hot tub facility, suntan facility, racetrack, other gambling facility, or liquor store).
Effective Date. The Proposed Regulations are proposed to be effective as of the date they are published in the Federal Register as final regulations. However, taxpayers may generally rely on the provisions of the Proposed Regulations, provided they are applied in their entirety and in a consistent manner.
OZ Fund Self-Certification Procedure
The Proposed Regulations provide that an entity, including a pre-existing entity, may self-certify as an OZ Fund, by filing a form (expected to be IRS Form 8966, issued by the IRS in draft form, attached to the return for the taxable year of the OZ Fund for which the certification is being made) indicating the first month and year it wishes to qualify as an OZ Fund. Any investment made prior to such month will not be eligible for the OZ Fund tax deferral and exclusion benefits.
90% Asset Test
Initial OZ Fund Year. If the first month selected for initial OZ Fund qualification is not the first month of the OZ Fund's taxable year, the first 90% testing date will be six months from such month, and if such month is after the sixth month of the OZ Fund's taxable year, there will be only one testing date for such taxable year – on the last day of the year.
Basis for Tests. The Proposed Regulations provide that the 90% test must be calculated based on the value of the OZ Funds assets as reported in its "applicable financial statement" (within the meaning of Treas. Regs. Section 1.475(a)-4(h)). If an OZ Fund does not have an applicable financial statement, it must use the cost of its assets for purposes of the 90% test.
OZ Fund Investment Deferral Election
The Preamble to the Proposed Regulations state that it is anticipated that taxpayers will be required to make the election to defer capital gains reinvested in OZ Funds by attaching IRS Form 8949 to their Federal income tax returns for the taxable year for which the gains would have been recognized but for the deferral election.
Gains Qualifying for Deferral
Capital Gains. The Proposed Regulations clarify that, as indicated in the legislative history, only capital gains are eligible for OZ Fund tax deferral, despite the fact that the Code provision refers simply to "gains."
Gains Not Subject to Election. If a deferral election has been made with respect to only a portion of eligible capital gain, subsequent elections may be made with respect to the remainder of such gains. The Preamble to the Proposed Regulations clarifies that the restriction in the Code prohibiting an election with respect to a sale or exchange for which an election is already in effect applies only with respect to making another election with respect to the same gain, but not to other gains resulting from the same sale exchange for which no election was in effect.
Partnership Gains. A partnership (or other pass-through entity) may elect to defer capital gains by reinvesting such gains in an OZ Fund. To the extent a partnership does not so elect, the partners may elect deferral with respect to their allocable shares of such gains (provided the gains otherwise qualifies).
Additional Requirements. The Proposed Regulations also provide that capital gains are eligible for deferral only if they (i) would have been recognized prior to December 31, 2026, but for the OZ Fund deferral rules, and (ii) do not arise from a sale or exchange with a related person (incorporating the 20% ownership threshold of the other related-party OZ Fund rules).
Section 1256 Contracts. The Proposed Regulations provide that only capital gain net income from section 1256 contracts for a taxable year can be deferred through investment in an OZ Fund, and only applies to section 1256 contracts not part of an "offsetting position transaction" (generally where the taxpayer has substantially diminished its risk of loss from one position with respect to personal property by holding another position with respect to personal property).
General. The Proposed Regulations provide that the 180-day period (during which capital gains must be reinvested in an OZ Fund) begins on the date that the capital gain re-invested would have been recognized for Federal income tax purposes, but for the OZ Fund deferral.
REIT/RIC Capital Gain Dividends. The 180-day period begins on the date the capital gain dividend is paid by the REIT or RIC to the shareholder.
Partnership Gain Allocations. A partner's 180-day period with respect to eligible capital gain allocations made by a partnership (for which the partnership itself did not make a deferral election), begins on the last day of the partnership's taxable year in which the partner takes into account such gain. However, if a partner knows the date that the partnership realized the capital gain, and knows that the partnership itself will not elect to defer such gains, the partner may choose to begin its 180-day period on the date of the gain realization.
Section 1256 Contracts. The 180-day period for reinvesting capital gain net income from section 1256 contracts for any taxable year begins on the last day of such taxable year, when the amount of such gain becomes determinable.
Qualifying OZ Fund Investment
Equity Interest. The investment in the OZ Fund must be made in return for an equity interest, and not a debt interest, in the OZ Fund.
Deemed Partnership Contributions. Deemed contributions by a partner, pursuant to Section 752(a) of the Code (as the result of an increase in the partner's share of partnership liabilities), are not treated as an investment into an OZ Fund entitled to tax deferral.
Reinvestment of Proceeds from Sale of OZ Fund Interest. If a taxpayer disposes of its entire interest in an OZ Fund, the investment that enabled a prior deferral election, and reinvest the proceeds into another OZ Fund within 180 days, the taxpayer may make another deferral election with respect to such reinvestment.
Recognition of Deferred Gain
Character of Gain. The Proposed Regulations provide that when any deferred capital gains are recognized they will retain all of the same tax attributes they would have had had they not been deferred (including characterization as long or short-term capital gains).
FIFO Method. If less than all of a taxpayer's fungible interests in an OZ Fund are sold, the sold interests must be identified utilizing the first-in-first-out ("FIFO") method.
Pro Rata Method. If the FIFO method is inapplicable (such as where the interests sold are not fungible), a pro rata method must be utilized to determine the nature, character, and other attributes of the interests sold.
FMV Basis Step-Up after 10 Years
The Proposed Regulations clarify that a taxpayer has until December 31, 2047 to make an election to step-up the basis in an OZ Fund interest held for at least 10 years to its fair-market value as of the date the interest is sold, despite the fact that the designations of opportunity zones, themselves, expire on December 31, 2028.
OZ Business Property
Substantial Improvement. For purposes of the requirement that the basis of property whose original use did not commence with the OZ Fund (or OZ Business) be more than doubled within 30 months, the Proposed Regulations exclude the basis of land that a building is located.
Substantially All Requirement. The Proposed Regulations provide that if at least 70% of an OZ Business's tangible property is OZ Business Property, it will be deemed to satisfy the requirement that "substantially all" of its tangible property, if any, is OZ Business Property.
Working Capital Exception. The Proposed Regulations allow an OZ Business to exclude from "non-qualified financial property" (limited to 5% of an OZ Business's assets) reasonable amounts of working capital held in cash, cash equivalents, or debt instruments with a term of 18 months or less. For this purpose, working capital will be deemed reasonable in amount if the following requirements are satisfied: (i) the amounts are designated in writing for the acquisition, construction, and/or substantial improvement of tangible property in an opportunity zone; (ii) there is a written schedule, consistent with the ordinary start-up of a trade or business for the expenditure of the working capital, pursuant to which the working capital will be spent within 31 months of receipt by the OZ Business; and (iii) the working capital is actually used in a manner substantially consistent with (i) and (ii), above. Additionally, if these requirements are satisfied, the tangible property of the OZ Business will not fail to qualify as OZ Business Property solely because the expenditure of the working capital for its intended purpose is not yet complete.
NOTE: This working capital exception would not apply to an OZ Fund itself, which would remain limited by the 90% test to cash or cash items of 10% or less of its total assets.
FUTURE PROPOSED REGULATIONS
The Preamble to the Proposed Regulations indicates that it is expected that additional proposed regulations will be issued in the "near future" containing guidance on the following points:
"Substantially All". Clarifying what this term means in the various contexts it is used in the OZ Fund provisions on the Code (other than when referring to the portion of OZ Business Property required for an OZ Entity to qualify as an OZ Business, that the Proposed Regulations provide for a 70% threshold, as described above).
"Reasonable Period" for Reinvestment by Oz Fund. Defining what would constitute a reasonable period for an OZ Fund to reinvest the proceeds from the sale of qualifying assets without being subjected to the penalties imposed for failing the 90% asset test.
Administrative Rules. Relating to when an OZ Fund fails the 90% asset test, as well as information reporting requirements relating to the various OZ Fund requirements.
Original Use Requirement. The IRS has also requested comments on possible approaches to interpret the requirement that the "original use" of property must commence with the OZ Fund (in the absence of it satisfying the alternative "substantially improves" requirement).
REMAINING QUESTIONS AND ISSUES
OZ Fund Cash/Cash Items Limitations. Although the Proposed Regulations provide much needed flexibility for OZ Businesses to retain working capital for up to 31 months, there is no such corresponding provision for OZ Funds themselves, that invest directly in OZ Business Property. Therefore, in order to take advantage of this flexibility, it would be necessary for an OZ Fund to invest in OZ Entity Interests, through which OZ Businesses are conducted, as opposed to investing directly in OZ Business Property.
Sale of OZ Fund Interests Required. A technical reading of the Code provisions appear to require that in order to obtain the benefit of a fair-market value step-up after 10 years, the OZ Fund interest must be sold; the OZ Fund itself could not sell its OZ Business Property or OZ Equity Interests. As a result, it would generally be necessary to set up separate OZ Funds for each asset, or group of assets, expected to be disposed of in a single sale.
Single Member LLCs. Since an OZ Fund must be either a corporation or partnership, it would not appear that a single member limited-liability company that is disregarded for Federal income tax purposes, would be able to qualify. As a result, if a single owner wants to form an OZ Fund, it would need to either form it as a corporation or, if formed as a partnership, the owner would also need to form a corporation to own an interest in the partnership in order for the OZ Fund to be respected as a partnership for Federal income tax purposes.