Some of the highlights of the first round of proposed regulations released on October 19, 2018 in conjunction with Revenue Ruling 2018-29 are as follows:
- Capital Gains: The regulations take the position that only capital gains for federal income tax purposes are eligible to be invested in a Qualified Opportunity Fund (QOF). Thus, gains such as depreciation recapture are not eligible, while certain Section 1231 gains are likely to be eligible.
- Retention of Rate: Capital gains invested in a QOF will retain the rate at which the gains were to be taxed if not for an investment in a QOF. This means that when the deferral of the initial tax on gains ends (earlier of sale out of a QOF or December 31, 2026), the rate of tax on the gains will be the same at deferral, i.e. short-term capital gains invested in a QOF will eventually be subject to the short term capital gain rate when deferral ends.
- QOFs as LLCs: QOFs can be set up as LLCs taxed for federal income tax purposes as a partnership or corporation. This will enhance flexibility within the QOF and not subject the QOF to general partner requirements or liability at the state level.
- Taxpayers Eligible to Invest in a QOF: Taxpayers that recognize capital gains for federal income tax purposes may invest in a QOF. This includes individuals, partnerships, corporations, trusts, Regulated Investment Companies (RICs), etc. Pass-through entities such as partnerships and S corporations also have special timing rules on making investments in a QOF that may allow for more than the 180 day period.
- Construction Projects: Some clarity was provided in the new regulations regarding the eligibility of construction or rehabilitation projects to qualify as Opportunity Zone Business Property. There is now a 31 month safe harbor, provided a written plan is in place and there is substantial compliance with the plan. In Revenue Ruling 2018-29, the value of land is not included when calculating whether the substantial improvement test has been satisfied. Therefore, only the value of the building is taken into account. There is still some uncertainty for large urban construction projects that will legitimately take longer than 31 months. However, the Treasury Department indicated a safe harbor longer than 31 months may not be consistent with the policy goal of economic development.
- Using Debt: The regulations provide that a taxpayer may borrow funds to invest in a QOF, presuming the taxpayer meets all of the other requirements. Additionally, the taxpayer may pledge the interest in a QOF as collateral for a loan. This can help mitigate the tax hit when the deferral period ends.
These proposed regulations are the first round of regulations and the Treasury Department has stated it will be releasing a second round of proposed regulations soon. This first round begins to answer many of the questions confronting QOFs, investors, and developers. Some unanswered issues relate to how interim gains will be treated and what a reasonable amount of time will be to reinvest exits out of QOF investments. More clarity is also expected on the interpretation of “original use.”
Investors, QOFs, developers, and other stakeholders interested in learning more or planning investments related to the Opportunity Zone Fund program can contact Vikram Agarwal at email@example.com.
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