IRS Regulations Give Green Light for Real Estate Investments in Opportunity Zones
Qualified Opportunity Zone Alert
Date: November 26, 2018
On October 19, 2018, the IRS released long-awaited regulations and a Revenue Ruling addressing investments in Opportunity Zones (OZs). After much review and discussion, the general consensus is that those interested in pursuing real estate investments in OZs now have enough information to move forward in considering projects.
OZs have generated interest since the Tax Cuts and Jobs Act of 2017 was released in December 2017, with the hope that this program would bring new investments into areas that need them most. The legislation indicates that potential benefits for capital gains invested as equity in a Qualified Opportunity Zone Fund (QOF) for certain OZ projects include deferral of capital gains until the 2026 tax year, reduction of capital gains tax by 10–15 percent and the ability to exclude future gains on QOF interests held for at least 10 years.
Before the regulations were released many were unsure when or if they should deploy their capital gains using this program. An individual or corporate investor or pass-through entity (partnership, LLC or S corporation) whose sale results in a capital gain has 180 days to place the capital gain into a QOF, with a further 180-day window for a respective equity owner in the pass-through entity to place the capital into a QOF if the entity does not do so. With many individuals seeking investment opportunities as they eye turmoil in the stock market and hear talk of a “bubble” in real estate, these regulations may be what’s needed to drive capital to the 8,700 OZs across the United States, Puerto Rico and the U.S. Virgin Islands.
In addition to the proposed regulations addressing many (but not all) issues, the IRS released a draft Form 8996 and instructions for self-certification and annual reporting as to compliance with certain tests for QOFs.
Regulations and Revenue Ruling Highlights
Along with the regulations, the IRS released a Revenue Ruling that answers many questions. The Revenue Ruling uses a residential rental property as an example, seemingly addressing the question that some tax professionals raised as to whether residential rental property is considered a permissible “active trade or business” for OZs. On a technical level, it is interesting that the Revenue Ruling addresses the situation in which the QOF owns residential rental property, but not the more common situation in which an operating company owned substantially by a QOF owns the residential rental property, but we find the example helpful for both situations. The Revenue Ruling goes on to discuss the substantial improvement test for real estate, saying that improvement costs added to basis in a 30-month period must be at least equal to the tax basis of the building only; land value is not counted and need not be increased.
In more good news for real estate investments, although the legislation suggests that capital must be deployed within six months after investment, the IRS regulations allow a safe harbor provision for real estate. If a QOF places funds in a separate partnership, LLC or corporation that engages in a QOZ Business by acquiring, constructing or rehabilitating real property in an OZ, the QOZ Business has a working capital safe harbor of up to 31 months for deploying the funds, provided it has a reasonable schedule for deployment and acts substantially consistently with the schedule. This is a recognition of the practical hurdles that would be imposed with a six-month deadline, due to the time necessary for real estate projects to be planned and completed. Note, however, that we read this safe harbor as available through a second-tier entity; the QOF itself still has a very short period to deploy the cash, but it can satisfy this requirement by investing in a second-tier entity.
The IRS has also indicated that, even after the sale of a QOF interest, the favorable gain treatment may be retained as long as the sale proceeds are deposited into another QOF within a new 180-day period. As an additional point, if a QOF sells an interest in qualifying assets or a qualifying interest in another entity, future IRS guidance should address the “reasonable period” for the QOF to reinvest such proceeds in substitute qualifying assets.
As to the benefit of the 100 percent capital gains exemption for post-investment appreciation in a QOF interest held for at least 10 years, the regulations provide that, although this benefit is available for an investment in a QOF through December 31, 2026, a taxpayer may delay sale of the asset until December 31, 2047 and have the exemption from taxation apply to any post-investment appreciation. The IRS is considering whether this step up in basis will occur at the end of 2047 without the necessity of a sale.
There are many other details that were released for specific circumstances. More information, including a more detailed summary of the proposed regulations, can be found on the Qualified Opportunity Zones page on our website.
A few issues concerning real estate deals are still outstanding, including:
- Clarification regarding the interest rate for penalties if 90 percent of QOZ funds have not deployed into eligible QOZ businesses.
- What constitutes “reasonable cause” for not meeting the 90 percent test?
- What is a “reasonable period” for the reinvestment from a sale or other disposition?
- What are the tax consequences with respect to gains that a QOF reinvests?
- Whether a vacant or underoccupied building can qualify for original use in an OZ without satisfying the “substantial improvement” requirement.
- Confirmation that a shell or mere foundation of a building without a certificate of occupancy can qualify as original use in an OZ.
- Confirmation that a ground lease or land contribution by a related person does not taint a building constructed on such land.
- The application of active conduct of a business in real estate operations.
The IRS has promised more regulations before year end.
Given the December 31, 2019 deadline for making an investment that could receive the full 15 percent reduction in deferred capital gains tax (after holding for seven years) and the increased interest in the development of QOZ properties, many investors are actively seeking to take gains and identify potential real estate projects or QOFs now.
Thompson Hine’s Qualified Opportunity Zones team is actively tracking IRS guidance and regulations. Our fund formation, tax and real estate attorneys are available to provide guidance on optimal fund structures or investments to take full advantage of investments in OZs. Our fund formation team is also monitoring announcements by sponsors of any plans to form QOFs and any publicly available data related to such QOFs. Our Project Management Consultants finance professionals and our attorneys who advise on finance and incentives can address the potential for coordinating OZ benefits with various other incentives for OZ real estate projects across the country. Our tax attorneys have submitted specific comments to the IRS regarding the application of these provisions in the context of startup tech businesses and to Representative Kirk Schuring regarding an Ohio proposal to provide a state income tax credit.
FOR MORE INFORMATION
For more information, including a list of our Qualified Opportunity Zones team members, please visit the Qualified Opportunity Zones page on our website.
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