Real Estate Investors Will Love These IRS Opportunity Zone Clarifications
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Although the Opportunity Zone Program was introduced without much fanfare along with the Tax Cut and Jobs Act, it has sent waves through the world of real estate, municipal development, and financial advisory.
According to AccountingToday.com In the meantime, more than 8,700 qualified opportunity zones and hundreds of qualified opportunity funds have been created to pull in investment dollars for economically challenged areas. Of course, the altruism of investors is rewarded by generous tax deferrals & exemptions on capital gains.
Despite this, billions of dollars have been waiting patiently on the sidelines, until Tranche II (new proposed opportunity zone regulations) are published.
Upon publication, tranche II did not disappoint. It clarified many of the issues investors anticipated.
Capital Contributions, Equity Interest And Disposition
- The new regulations make it clear that investors can make capital contributions other than cash to a Qualified Opportunity Fund. The qualified investment in such a case would be the lesser of the tax basis in the property contributed or the fair market value of the equity interest in the Qualified Opportunity Fund. Liabilities on the asset added will reduce the qualified investment, and the tax basis of the asset contributed.
- Quality Opportunity Fund investors that provide services and receive compensation in equity interest, and investors who receive a Qualified Opportunity Fund interest in exchange for appreciated assets, will create a mixed fund.
- These investors will not be eligible for Opportunity Zone benefits for the full value of the appreciation in the contributed property or Qualified Opportunity Fund value received as remuneration for services rendered.
- Any disposition of an interest in a Qualified Opportunity Fund by a holder of equity will be considered an inclusion event that will immediately trigger tax on unrecognized deferred gains.
- However, distribution of the qualifying investment to a beneficiary by an operation of the law/estate, will not be considered an inclusion event.
- Any donation of an interest in a Qualified Opportunity Fund to a charity will be seen as a termination of the donor’s investment in the Qualified Opportunity Fund.
- This will then trigger tax on the deferred gain to the donor.
- However, when treated as a gift to a grantor trust, it will be deemed not to be a Qualified Opportunity Fund interest termination, and hence, no gain will be triggered.
- Because of the Qualified Opportunity Fund basis step-up, no depreciation recapture will be reportable upon exiting from a Qualified Opportunity Fund, after ten years.
- Were the Qualified Opportunity Fund or Qualified Opportunity Zone business to generate ordinary income by selling depreciated personal property, not the code nor regulations exempt the gain from taxability.
- However, the disposition of a Qualified Opportunity Zone interest held for more than ten years, will exempt the depreciation recapture.
Improvement and Original Use Defined
- The regulations make it clear that raw land does not have to be improved substantially (=100% of original basis within 30 months)
- When it comes to the substantial use requirement for used tangible personal assets (non-real estate), the regulations make it clear that the substantial improvement test must be applied asset-by-asset and not on an aggregate basis.
- Treasury and the IRS concur that if a building has been vacant for more than five consecutive years before a Qualified Opportunity Fund or Qualified Opportunity Zone Business purchased it, the original use requirement will be met without any further substantial improvements.
- Leased assets are treated as original use by the lessee and treated as purchased property. For real and personal property, no substantial improvement is required.
Partnership and Basis Treatment
- Partner or member tax basis in a Qualified Opportunity Fund is zero at the point of initial investment since the gain is being deferred. The basis increases along with the partner’s share of liabilities.
- A transfer in a Section 721 transaction is not an inclusion event.
- Some partnership distributions may be considered inclusion events. Cash-out-refinances for Qualified Opportunity Finds will, as a rule, be allowed.
- The original Qualified opportunity Zone investor can sell his equity interest, and the new investor can step right into his shoes, but the 10-year holding period for the new investor starts fresh.
- Also, the new investor will have to roll a qualifying capital gain into the repurchase before deriving the five-, seven-and 10-year benefits.
- The deferred gain to be recognized in 2026 will be taxed at 2026 rates for capital gains and not the rate of the year the first sale took place.
Qualifying Business Within The OZ
- Fifty percent of the gross receipts of a Qualified Opportunity Zone Business must derive from an active business within the Qualified Opportunity Zone.
- Alternatively, based upon the compensation paid by the Qualified Opportunity Zone Business to employees, at least 50% of the salary must be paid for services performed within the Qualified Opportunity Zone.
- Alternatively, based on the hours worked by the employees, at least 50% of the hours must be accomplished inside the Qualified Opportunity Zone.
- Alternatively, the tangible property located within the Qualified opportunity Zone Business must constitute at least 50% or more of the entire property within the Qualified Opportunity Zone.
- In unique situations, a fallback into a “facts and circumstances provision” is provided.
- The Qualified Opportunity Fund can elect a semi-annual qualification test without considering investments received in the preceding six months. This essentially provides the Qualified Opportunity Fund with 12 months to reinvest in a Qualified Opportunity Fund Business or Property.
“Substantially All” Clarified
- The threshold is 70% for the use in an Opportunity Zone threshold. For intangible use, the test is 40%.
- The threshold is also 70% for the tangible property “owned or leased,” which has to be qualified Opportunity Zone property for a business to be a Qualified Opportunity Zone Business.
- The threshold is 90% when measuring a Qualified Opportunity Fund holding period of tangible property as Qualified Opportunity Zone business property, Qualified Opportunity Zone partnership or corporation.
- The regulations clarify that GAAP valuations or another method may be used for leased asset qualification testing.
- It has been clarified that as long as the Qualified Opportunity Zone follow specific management rules, residential rental activities can qualify as a Qualified Opportunity Zone Business and/or Qualified Opportunity Property, but a Qualified Opportunity Fund that enters into a single triple-net-lease with respect to real or personal property, will not qualify as an active trade or business.
- The original use of tangible property purchased starts on the date the person first placed it in service in the Qualified Opportunity Zone for purposes of depreciation or amortization.
- Documented working capital can be treated as Qualified opportunity Zone property for a term of up to 31-months (in respect of 90% and 70% semi-annual testing).
- Net Section 1231 losses are treated as ordinary losses.
- Net Section 1231 gains are treated as ordinary capital gains.
- The 180-day clock starts “ticking” at the year-end.
- If the Qualified Opportunity Fund sells Qualified Opportunity Zone property shortly before the 90% testing date, it is provided enough time to reinvest the proceeds back into the Qualified Opportunity Zone. Reasonable time/enough time is defined as 12 months, invested in cash or debt instruments with maturities of less than 18 months. The reinvestment has no impact on the reporting of the tax gain triggered on the sale.
What Remains To Be Clarified After Tranche II?
- More robust reporting requirements would improve the evaluation of Opportunity Zone benefits by federal, state, and local government agencies.
- The new regulations contain no reporting requirements to allow the IRS, HUD, and the public to determine taxpayer compliance with the new rules.
- The IRS & Treasury acknowledge that despite the burden brought about by more reporting requirements, to address the concerns, comments are invited for the next set of regulations.
Tranche II answered many questions and will provide taxpayers and investors enough comfort to move forward with Opportunity Zone investment. More questions remain, however. Treasury will continue to issue guidance, so watch this space.
Readers should note that this article is only intended to convey general information on these issues and that FAS CPA & Consultants (FAS) in no way intends for the contents of this article to be construed as accounting, business, financial, investment, legal, tax, or other professional advice or services. This article cannot serve as a substitute for such professional services or advice. Any decision or action that may affect the reader’s business should not rely solely on the contents of this article, but should rather be consulted on with a qualified professional adviser. FAS shall not be responsible for any loss sustained by any person who relies on this presentation. This article is subject to change at any time and for any reason.
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