Opportunities beckon in new qualified opportunity zones.

• Author: Nitti, Tony

As part of the legislation known as the Tax Cuts and Jobs Act, (1) Congress enacted two companion provisions designed to encourage investment and economic growth in certain low-income communities. First, Sec. 1400Z-1 paved the way for more than 8,700 such low-income communities and qualifying contiguous census tracts to be designated as "qualified opportunity zones" (QOZs). In turn, Sec. 1400Z-2 offers three federal income tax incentives to a taxpayer who invests in a business located within one of these zones: (1) the temporary deferral of capital gains, to the extent the gains are reinvested into a "qualified opportunity fund" (QOF); (2) the partial exclusion of previously deferred gains when certain holding period requirements in a QOF are met; and (3) the permanent exclusion of post-acquisition gains from the sale of an investment in a QOF held longer than 10 years.

While Sec. 1400Z-2 teases a tantalizing menu of tax breaks, the statutory language contains little practical guidance. As a result, taxpayers were initially uncertain of how to meet the various investment requirements to achieve the promised tax benefits. This was particularly problematic because Sees. 1400Z-1 and 1400Z-2 are temporary. QOZs will disappear at the end of 2028, and, as soon as 2020, a portion of the potential tax benefits will be gone forever.

On Oct. 19, 2018, however, the IRS published proposed regulations providing much of the direction taxpayers had been seeking. (2) Guidance on investing in opportunity zones is far from a finished product, however. The IRS has promised additional rounds of proposed regulations, and as this article reveals, the previously published proposed regulations have generated no shortage of additional questions. (3)

This article discusses the October proposed regulations in detail and reviews issues that remain unresolved, which, until addressed, will curb the desired flow of private-sector investment into low-income communities.

Summary: The QOZ life cycle and resulting tax benefits

Sec. 1400Z-2 entails a specific process, complete with critical definitions, deadlines, and quantitative tests that must be satisfied before the promised tax benefits become a reality. The life cycle of an opportunity zone investment can be represented at a high level as follows:

A taxpayer realizes an eligible gain. The taxpayer reinvests the gain within 180 days into a QOF and defers the gain for the year of sale. The QOF conducts business, either directly by holding QOZ business property (QOZBP) or indirectly by holding QOZ stock or a QOZ partnership interest. The taxpayer recognizes the deferred gain on the earlier of Dec. 31, 2026, or the date the taxpayer sells or exchanges the QOF interest.

After holding the interest in the QOF for five years, the taxpayer excludes 10% of the original deferred gain. After an additional two years, another 5% of the original deferred gain is excluded. After an additional three years (a total of 10 years), the taxpayer may sell the investment in the QOF at any time before 2048 and exclude the gain resulting from the sale. A detailed look at this life cycle follows.

Qualified opportunity zones

Sec. 1400Z-1 allowed for the designation of certain low-income community population tracts (4) as QOZs. In addition, a limited number of other, contiguous, census tracts could be designated as QOZs. (5) These designations were made in 2018 and will remain in effect until Dec. 31, 2028. A listing of these zones can be found in Notice 2018-48.

Eligible gain

The immediate benefit provided by Sec. 1400Z-2 is the deferral of "eligible gain" that is reinvested into a QOF within 180 days of the sale or exchange that gives rise to the gain. Eligible gain is gain that: (6)

* Is "treated as capital" for federal income tax purposes; (7)

* Would be recognized for federal income tax purposes before Jan. 1, 2027; (8) and

* Does not arise from a sale or exchange with a related party.

For these purposes, persons are related to each other if they are described in Sec. 267(b) or Sec. 707(b), determined by substituting 20% for 50% wherever it appears in those sections. (9)

The use of the term "treated as capital gain" is important. It allows for gain arising from the sale of a Sec. 1231 asset--which by definition is not a capital asset but the net gain from which is taxed as capital gain--to qualify as eligible gain. (10) Any depreciation recapture taxed as ordinary income under Sees. 1245 and 1250, however, is not eligible gain.

Eligible gain includes gain arising from an actual or deemed sale or exchange, or any other gain that is required to be included in a taxpayer's computation of capital gain. (11)

Eligible taxpayers

Any taxpayer that realizes eligible gain for federal tax purposes may elect to defer that gain if all of the requirements of Sec. 1400Z-2 are met. These taxpayers include individuals, C corporations (including regulated investment companies and real estate investment trusts), partnerships, S corporations, and trusts and estates. (12)

If a partnership realizes eligible gain, it has a choice: It may elect to defer that gain at the partnership level, or it may pass the gain through to its partners, who are then free to make their own decision on deferral.

If a partnership elects to defer the eligible gain, the deferred gain is not included in the distributive share of the partners and does not increase the partners' basis in the partnership. (13) When some or all of the deferred gain is subsequently recognized by the partnership under the rules of Sec. 1400Z-2, the gain is included in the distributive share of the partners and increases the partners' basis at that time. (14)

Example 1: Individuals A, B, and C each own a one-third interest in PRS, a partnership. In 2019, PRS realizes eligible gain of $90,000. If PRS elects to defer the gain, no amount of the $90,000 gain is allocated to A, B, or C, and the basis of A, B, and C in PRS is not increased. If the partnership does not elect to defer the eligible gain, the gain is included in the distributive share of the partners and immediately increases each partner's basis in the partnership. (15) Each partner, in turn, may then elect to defer some or all of the eligible gain allocated from the partnership, but only if the sale by the partnership giving rise to the gain was to a taxpayer unrelated to the partner. (16)

Example 2: Assume the same facts as Example 1, only partnership PRS does not elect to defer the eligible gain realized in 2019. As a result, each of A, B, and C is allocated $30,000 of gain, and each partner increases his or her basis in PRS at that time. Any or all of A, B, or C may then elect to defer the gain at the individual level, provided all the requirements of Sec. 1400Z-2 are met. The rules allowing a partnership to either defer gain at the entity level or choose instead to pass the gain on to its owners also apply to S corporations, trusts, and estates. (17)

The ability of a partnership to allocate eligible gain to partners, who in turn are free to make their own deferral elections, provides a partnership flexibility that is not available with a traditional Sec. 1031 like-kind exchange. To illustrate, assume a partnership with four partners holds an appreciated building. Two of the partners want to defer all of the appreciation in the building by exchanging it for another building in a Sec. 1031 transaction, but the other two partners would prefer that the partnership sell the building so they can cash out their portion of the investment. Absent proactive tax planning, it is very difficult to satisfy the goals of all four partners using a Sec. 1031 exchange, because the consequences are determined at the partnership level--the partnership must both transfer the relinquished property and hold the replacement property. Under Sec. 1400Z-2, however, the partnership can simply sell the building for cash, allocate the gain and distribute the proceeds among the partners, and allow each partner to make his or her own decision whether to report the gain and keep the cash or defer the gain by reinvesting the gain amount into a QOF.

Required timing of reinvestment of eligible gain

As stated earlier, a taxpayer that wishes to defer eligible gain must reinvest the gain into a QOF within 180 days from the date of the sale or exchange that gives rise to the gain. The 180-day period generally begins on the day on which the gain would be recognized for federal income tax purposes if the taxpayer did not elect under Sec. 1400Z-2 to defer recognition of the gain. (18)

Example 3: Stock is sold at a gain in a regular-way trade on an exchange on Feb. 2, 2019. The 180-day period with respect to the gain on the stock begins on Feb. 2, 2019. The effective date of Sec. 1400Z-2 is Dec. 22, 2017. On the IRS webpage titled "Opportunity Zones Frequently Asked Questions," however, the Service indicates that eligible gain may arise from a sale prior to Dec. 22, 2017. (19) Thus, it would appear that eligible gain may occur prior to the effective date of Sec. 1400Z-2, provided the reinvestment of that gain takes place after Dec. 22, 2017. The webpage also states that a taxpayer who reinvested eligible gain between Dec. 22 and Dec. 31, 2017, may elect to defer that gain on an amended return.

In the case of a partnership that realizes eligible gain but does not elect to defer that gain, choosing instead to allocate the gain to its partners, the 180-day period with respect to the partners' eligible gains generally does not begin on the date of sale. Instead, it begins on the last day of the partnership's tax year in which the partners' allocable share of the partnership's eligible gain is taken into account under Sec. 706. (20)

Example 4: A is a one-third partner in partnership PRS, a calendar-year partnership. On Jan. 8, 2018, PRS realizes $90,000 of eligible gain. PRS elects not to defer the gain and includes $30,000 in A's distributive share. A...