10 Key Questions — Answered — About Qualified Opportunity Zones – November 20, 2018 by Angel Rice

The first round of proposed regulations on Qualified Opportunity (QO) Zones was released on Friday, October 19, 2018. The regs provide answers to key questions — specifically defining which gains qualify, who is eligible to invest, what is an eligible interest, how to elect the deferral and more.

A second round of proposed regulations is scheduled to release on or before December 31, 2018. But until then, the following guidance will allow interested investors to confidently move forward with forming and investing in Qualified Opportunity Funds (QO Funds).  

1. What is an Eligible Gain Under the QO Zone Program?

A gain is eligible for deferral under the QO Zone program if the gain: 

  • Is treated as a capital gain for federal income tax purposes;
  • Would be recognized for federal income tax purposes, if not for this deferral provision, before January 1, 2027;
  • Does not arise from a sale or exchange with a person who is related to the taxpayer recognizing the gain; and
  • Is not already subject to an election. 

What This Means

  • All types of gain treated as capital gain for federal purposes would qualify for reinvestment into this program
  • Short- and long-term capital gain qualifies
  • Section 1231 gain, subject to the five-year lookback rule on Sec. 1231 losses (which would turn Sec. 1231 gain into ordinary income), would qualify as well as unrecaptured Sec. 1250 gain
  • Gain subject to Sections 1245 and 1250 recapture would not qualify, as these two types of gain are reported as ordinary income
  • Regarding 1256 contracts, gains must be netted with losses and only capital gain net income is eligible for deferral. Gain from offsetting positions transactions, such as straddles or derivatives, are not eligible  

Capital gain deferred under this program retains its tax attributes through the deferral period and must be taken into account in the year the QO Fund interest is sold or on the mandatory gain recognition date of December 31, 2026, whichever comes earlier.
 
For example, short-term capital gain deferred under this program and invested in a QO Fund in 2018 and held through 2026 would be short-term capital gain when the taxpayer is required to recognize the deferred gain on December 31, 2026. 

2. What is an Eligible Taxpayer Under the QO Zone Program?

An eligible taxpayer is one that recognizes capital gain for federal income tax purposes. Eligible taxpayers include: 

  • Individuals
  • C Corporations, including regulated investment companies (RICs) and real estate investment trusts (REITs)
  • Partnerships
  • S Corporations
  • Trusts and estates 

What This Means

Note that having the ability to make the election at the pass-through entity level gives greater flexibility on the timing of the election. (See the “180-day period” section below for further discussion on timing to make the deferral election.) 

3. What is an Eligible Interest Under the QO Zone Program?

An eligible interest in a QO Fund is an equity interest issued by the Fund, including preferred stock or a partnership interest with special allocations. The term “eligible interest” excludes any debt instrument.
 
The interest may be used as collateral, provided 1) the eligible taxpayer is the owner of the equity interest in the QO Fund, and 2) the status as an eligible interest is not impaired by using the interest as collateral for a loan, whether as part of purchase-money borrowing or otherwise.
 
Deemed contributions of money under Section 752(a) do not result in the creation of a separate investment in a QO Fund. 

What This Means

This definition of an eligible interest gives flexibility to QO Funds to issue different types of partnership units or classes of stock to investors. With this flexibility, preferred stock or specially allocated partnership units could be created that may have attributes very similar to debt, so depending on the risk tolerance of the investor, the QO Fund would have the ability to offer different classes of interests with different rates of returns.
 
Note the QO Fund investments made into either a QO Zone partnership interest or corporation also must be an equity interest. In other words, the money invested in the QO Fund must be used to make an equity contribution and cannot simply serve as a loan to the QO Zone business. 

4. When Does the 180-Day Period Begin?

Except when otherwise stated, the 180-day period with respect to any eligible gain begins the day on which the gain would have been recognized for federal income tax purposes had the taxpayer not deferred it under the QO Zone program.
 
The regulations provide some helpful examples:

Type of Gain

Start Date for 180-Day Period

Individual stock sale

On the trade date

RIC or REIT capital gain dividends

On the date the dividend is paid

RIC or REIT undistributed captial gain

Last day of RIC or REIT's taxable year





 







The proposed regulations permit a partnership to elect to defer gain at the partnership level. If the partnership does not, the partner may do so, following these stipulations: 

  • The partner’s 180-day period generally begins on the last day of the partnership’s tax year.
  • Alternatively, if a partnership does not elect to defer all of its eligible gain, the partner may elect to defer the gain. The partner may choose to begin his or her own 180-day period on the same date as the start of the partnership’s 180-day period. 

The rules above for partnerships and partners also apply to other pass-through entities and their shareholders, such as S Corporations, as well as beneficiaries, such as decedents’ estates and trusts.
 
Additionally, an investor may re-elect to defer gain on a complete disposition of his QO Fund interest if he reinvests in another QO Fund within the new 180-day period.
 
If a taxpayer sells less than all of his or her interest(s) in a QO Fund, the regulations discuss a first-in first-out method to calculate what character and tax attributes will be applied to the gain that the taxpayer will be required to include into income. If it is undistinguishable, the pro-rata method can be used. 

5. How Do I Elect Deferral Under the QO Zone Program?

It is anticipated that taxpayers will use Form 8949 to make the deferral election and attach it to their federal income tax returns for the taxable year in which the gain would have been recognized had it not been deferred.
 
Taxpayers will be able to make the basis step-up election after a QO Zone designation expires in 2028 and preserve the permanent exclusion of post-acquisition gain on the QO Fund interest until December 31, 2047. However, the QO Fund interest must be sold by that point or the permanent exclusion expires. 

6. What Types of Entities Are Eligible to be a QO Fund (How Do I Self-Certify)?

A QO Fund must be an entity that is: 

  • Classified as a corporation or partnership for federal income tax purposes, and
  • Created or organized in one of the 50 states, the District of Columbia or a U.S. possession. 

The regs confirm that a limited liability company being taxed as a corporation or partnership is an eligible entity for a QO Fund.
 
Regarding self-certification, Form 8996 will be used for both the initial self-certification and for annually reporting compliance with the 90% asset test. This form is attached to the taxpayer’s federal income tax return for the relevant years.
 
As a part of the self-certification process, the QO Fund will identify the taxable year in which the entity becomes a QO Fund and may choose the first month in that year it wants to be considered a QO Fund. Identifying the first month of the QO Fund’s existence is important for two reasons: 

  1. Any investment prior to the first month will not qualify under this program, and
  2. The date impacts the calculation of the penalty provision in meeting the 90% asset test. 

If the self-certification fails to specify the first month in the initial taxable year the eligible entity first wants to be a QO Fund, then the first month of the eligible entity’s taxable year as a QO Fund is the first month that the eligible entity is a QO Fund, which would could result in an eligible investor missing the 180-day period.
 
A pre-existing entity can be used as a QO Fund; however, there are additional requirements the pre-existing entity must meet in addition to filing Form 8996 to self-certify. 

7. How Do I Value the Assets of My QO Fund?

For purposes of the 90% asset test, QO Funds that have an applicable financial statement are required to use the asset values reported on that statement. QO Funds that do not have an applicable financial statement will be required to use the cost basis of its assets.
 
An applicable financial statement for this purpose is one that is prepared in accordance with U.S. Generally Accepted Accounting Principles (GAAP) and: 

  • Is filed with the SEC or a federal agency other than the IRS, or
  • Is a certified audited financial statement either 1) given to creditors to help make lending decisions, 2) given to equity holders to help evaluate their investment or 3) provided for other substantial non-tax purposes. 

8. How Does the QO Zone Working Capital Safe Harbor Work?

The proposed regs provide a working capital safe harbor for QO Fund investments in QO Zone businesses that acquire, construct or rehabilitate tangible business property. Tangible business property includes both real property and other tangible property used in a business operating in an opportunity zone.
 
The working capital safe harbor for QO Zone businesses is for a period of up to 31 months if: 

  • It is designated in writing. These amounts are designated in writing for the acquisition, construction and/or substantial improvement of tangible property in a QO Zone.
  • There is a reasonable written schedule. There must be a written schedule consistent with the ordinary start-up of a trade or business for the expenditure of the working capital assets. Under the schedule, the working capital assets must be spent within 31 months of the date the business receives the assets.
  • Property consumption is consistent. The working capital assets must actually be used in a manner substantially consistent with the schedule. 

Note that the working capital safe harbor is applied at the subsidiary operating business level. There doesn’t appear to be an equivalent safe harbor at the fund level for a QO Fund that is directly completing the construction or rehabilitation of QO Zone business property. 

9. What is the Definition of Substantial Improvement for a Building Purchased Within a QO Zone?

Revenue Ruling 2018-29 was issued in conjunction with the proposed regulations to address the substantial improvement requirement with respect to a purchased building located in a QO Zone. The ruling confirms: 

  • The basis attributable to land on which the building sits is not taken into account when determining whether or not the building has been substantially improved.
  • A QO Fund or subsidiary business does not have to separately substantially improve the land upon which the building is located for the building to still qualify as a good asset and eligible for the benefits of the program. 

10. What are the Remaining Issues that Still Need Addressed in Future Guidance?

The preamble to this first wave of proposed regulations acknowledges not all of the outstanding issues on which taxpayers have requested guidance have been addressed. Accordingly, the Treasury intends to address the following issues in a second set of proposed regulations expected to be issued on or before December 31, 2018, including: 

  • The meaning of “substantially all” in each of the various places it appears in the regs;
  • The types of transactions that may trigger inclusion of the gain that has been deferred under the QO Zone election — For example, whether or not the QO Fund distributes money to the investors and avoids triggering the gain that was originally deferred (whether the distributions were the result of a debt-refinancing or were from current operations);
  • The definition of a “reasonable period” for a QO Fund to reinvest proceeds from the sale of qualifying assets without paying a penalty;
  • Administrative rules for when a QO Fund fails to maintain the required 90% investment standard;
  • Information-reporting requirements for QO Funds. 


The first set of proposed regulations on QO Zones has provided an abundance of information to help investors and those interested in creating QO Funds get started. Work closely with your advisory team to follow this guidance and stay tuned for additional developments to come.
 
Please contact a member of your service team, or contact Dave Sobochan at dsobochan@cohencpa.com, Adam Hill at ahill@cohencpa.com or Angel Rice at arice@cohencpa.com   for further discussion. 
 

Cohen & Company is not rendering legal, accounting or other professional advice. Information contained in this post is considered accurate as of the date of publishing. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts, circumstances and current law.