Proposed Regulations Provide Important Guidance on the Tax Incentives for Capital Gain Invested in Opportunity Zones

I. Background

As part of the Tax Act, Congress established a powerful new tax incentive for investments in certain low income communities and adjacent areas designated as “opportunity zones” by each state. Under this new incentive, taxpayers that recognize capital gain from any source are entitled to tax benefits if they invest that gain in certain funds (qualified opportunity funds) that, in turn, invest the cash in opportunity zones. The incentives include:

(i) Deferral of taxable gain until December 31, 2026 (or earlier, upon the sale or exchange by the taxpayer of its investment in the qualified opportunity fund);

(ii) Reduction of the deferred gain by up to 15%, as long as the taxpayer holds its investment in the qualified opportunity fund for at least 7 years before the end of 2026 (10% if held for only 5 years before the end of 2026); and

(iii) Exclusion from taxable income of the appreciation in the value of the qualified opportunity fund upon the sale of the equity interests in the fund provided the taxpayer holds its interests in the qualified opportunity fund for at least 10 years (10-Year Benefit).

This new program is available to any individual, corporation, S corporation, partnership, trust, estate and other taxpayers that recognize taxable gain and is the subject of considerable interest by big banks, fund managers, family offices, high net worth individuals and other taxpayers wishing to benefit from these new tax incentives or manage qualified opportunity funds.

Example. On July 10, 2018, private equity fund Smart Choice LP, whose general partner is Joe Smith, sold one of its investments in a target company, Unicorn Inc., recognizing $300 million of taxable gain, with Mr. Smith personally recognizing $40 million of taxable gain. Shortly afterwards, Mr. Smith invests $40 million in a qualified opportunity fund, OZ LP, that invests its capital in a mixed use development located in an opportunity zone. Mr. Smith will not be required to pay the tax on the sale of Unicorn Inc. until 2026 (or earlier if he sells his interests in OZ LP before then). At the end of 2026, Mr. Smith will only be required to include $34 million ($40 million x 85%) in his taxable income on his $40 million gain from the sale of Unicorn Inc. (completely excluding from tax the other $6 million of gain). In addition to benefiting from the deferral and $6 million reduction of taxable gain, if Mr. Smith continues to hold his interests in OZ LP and, after the end of 2028 sells his interests in OZ LP for $70 million, Mr. Smith will not be required to pay tax on the $30 million appreciation in the value of his investment in OZ fund.

Practice Tips: As demonstrated by the example, in order to benefit from the 10-Year Benefits, Mr. Smith is required to continue to hold his interests in OZ LP until July 2028, but will nevertheless be required to pay tax on the $34 million gain recognized in 2026. Investors should therefore consider whether they have sufficient other resources from which to pay such deferred tax in 2026. Qualified opportunity funds may also offer ways to mitigate such phantom income.

II. Reliance on New Guidance

On Friday, October 19, 2018, the Treasury and the IRS released proposed regulations (Regulations) and Revenue Ruling 2018-29 (Ruling) providing important guidance on the new incentives. Even though the Regulations are still in proposed form, taxpayers are permitted to rely on the Regulations provided they apply them in their entirety, and not cherry pick only the favorable provisions.

III. Guidance for Investors

The Regulations include important guidance for investors wishing to invest in qualified opportunity funds.

Types of Gain that Qualify for Deferral. The Regulations clarify that only capital gain (and not ordinary gain) from transactions with unrelated persons is eligible for deferral. Importantly, persons are considered related for this purpose using a very low 20% common ownership threshold. Capital gain dividends from REITs and RICs and capital gain net income from 1256 contracts are eligible for deferral. Capital gain from the sale of property that was part of an offsetting position, where the taxpayer was both long and short on the property, is not eligible.

Period for Investing and Investments through Partnerships. To benefit from the tax incentive, the taxpayer must invest in a qualified opportunity fund an amount up to the gain the taxpayer recognized within 180 days of recognizing such gain. If a partnership (such as a fund) recognized gain, such gain can be deferred either by having the partnership invest the gain directly in an opportunity zone within 180 days of recognizing it, or by having the partners invest the gain in a qualified opportunity fund within 180 days of the last day of the partnership’s taxable year during which the gain was incurred.

Practice Tips: if a private equity fund recognized gain on January 1, 2018, and decided not to invest the cash in a qualified opportunity fund, the partners have from the end of the taxable year until June 2019 (180-days beginning on December 31, 2018) to invest the gain in a qualified opportunity fund to be eligible for the tax incentives. While not entirely clear under the Regulations, in this example, investments made by the partners after June 29, 2018 (when the first 180-day period ends) and before December 31, 2018 (when the second 180-day period begins) appear not to be eligible for the tax benefits because they were not made during any 180-day period eligible for investments – this issue may be clarified in future regulations.

Types of Eligible Investments in a Qualified Opportunity Fund. To be eligible for the benefits, a taxpayer that wishes to benefit from the tax incentives must invest cash in a qualified opportunity fund in return for an equity interest in the fund. This can include preferred equity interests as well as partnership interests with special allocations, but does not include debt. A taxpayer is generally permitted to pledge its interest in the qualified opportunity fund to secure financing (e.g., to pay the tax in 2026).

Tax Benefits Following the 10th Anniversary of the Investment. The Regulations clarify that only deferred capital gains are eligible for the 10-Year Benefit. Cash invested in a qualified opportunity fund from other sources is not eligible. Additionally, notwithstanding that the current designation of the opportunity zones are set to expire in 2028, taxpayers who sell their interests in a qualified opportunity fund after 2028 and before 2048 will still be eligible for the 10-Year Benefit.

Character of Gain Recognized In 2026. According to the Regulations, when the deferred capital gain is recognized on December 31, 2026 (or earlier, upon the sale or exchange of the taxpayer’s investment in the qualified opportunity fund), the gain has the same attributes as it would have had if the gain had not been deferred.

Practice Tips. The deferral does not change the holding period for the deferred capital gain, and gain that was short term capital gain when originally realized will continue to be treated as short term capital gain when eventually recognized in 2026. Additionally, while not entirely clear, it appears that the tax rates that will apply to the deferred gain in 2026 will be the tax rates in effect in 2026 rather than the tax rates that apply when the gain was originally realized. If taxpayers expect tax rates to increase, they should take this risk into account in their decision to participate in the opportunity zone program.

IV. Guidance for Qualified Opportunity Fund Managers

The regulations also include important guidance for qualified opportunity fund managers.

General Requirements. To qualify as a qualified opportunity fund, an entity:

(i) must be classified as a domestic (and in certain circumstances U.S. possessions) partnership or corporation for federal income tax purposes (including LLCs);

(ii) must certify that by the end of the year, the entity’s organizing documents include a statement of the entity’s purpose of investing in qualified opportunity zone property and the description of the qualified opportunity zone business; and

(iii) each year, the entity must certify that at least 90% of its assets consist of qualified opportunity zone property (90% Asset Test). The 90% Asset Test is determined by the average of the properties on two testing dates: the first at the end of the first 6-months of the taxable year and the second at the end of the taxable year of the qualified opportunity fund. The 90% Asset Test is generally determined by using the taxpayer’s certified audited financial statements if available, or its costs basis in its properties. Funds that fail to meet the 90% Asset Test are subject to penalties.

“Qualified opportunity zone property” includes tangible property used in a trade or business of the qualified opportunity fund provided that such property:

(i) was acquired in a taxable transaction from an unrelated party (using a 20% common ownership threshold) after December 31, 2017;

(ii) the original use of such property in the qualified opportunity zone commences with the qualified opportunity fund (Original Use Test), or such property is substantially improved by the qualified opportunity fund (Substantial Improvement Test); and

(iii) during substantially all of the fund’s holding period of such property, substantially all of its use was in a qualified opportunity zone (Qualified Tangible Property).¹

In addition to Qualified Tangible Property, qualified opportunity zone property also includes interests in partnerships and corporations (each a Lower Tier Entity)² that were issued to the qualified opportunity fund by the Lower Tier Entity solely for cash after December 31, 2017, provided that:

(i) “substantially all” of the Lower Tier Entity’s tangible property is Qualified Tangible Property;

(ii) less than 5% of the Lower Tier Entity’s assets are cash and other financial assets (excluding reasonable amounts of working capital); and

(iii) certain other requirements are met.

Substantial Improvement Test. If property is not originally used in the opportunity zone by the qualified opportunity fund, such property must be substantially improved by the qualified opportunity fund or the Lower Tier Entity to qualify as Qualified Tangible Property. The Tax Act defines “substantial improvement” as additions to tax basis (generally, investments in that property) during any 30-month period that exceed the original tax basis in the property at the beginning of the 30-month period (generally, the cost of such property). The Regulations and Ruling provide much sought relief by providing that when a building is acquired and renovated, the qualified opportunity fund only needs to invest an amount that exceeds the cost of the acquired building (excluding the value of the land) to qualify. This facilitates the rehabilitation and repurposing of buildings in areas where the value of the land is high.

Vacant Land. The Regulations and Ruling are not clear with respect to the treatment of vacant land. The Ruling provides that land can never meet the Original Use Test and that the requirement to substantially improve property does not apply to land when acquired together with a building. The Preamble to the Regulations also provides that the absence of a requirement to increase the basis of land “would address many of the comments that taxpayers have regarding the need to facilitate repurposing vacant or otherwise unutilized land.” This statement suggests that vacant land can be Qualified Tangible Property even if not substantially improved. On the other hand, the Regulations and Rulings only appear to address situations where the land is acquired with a building built on it, leaving open the question if the same is true where vacant land is separately acquired. We expect this matter to be further clarified in future regulations.

Reasonable Working Capital for Lower Tier Entities. In order to meet the 90% Asset Test, the amount of cash that a qualified opportunity fund is permitted to hold is generally limited to 10% of its assets. The Regulations provide a new safe harbor for Lower Tier Entities that permits them to hold a significant amount of cash. For the safe harbor to apply, (i) the cash must be designated in writing for the acquisition, construction or substantial improvement of tangible property in the opportunity zone, (ii) there needs to be a written schedule showing how the cash is reasonably expected to be deployed within 31 months, and (iii) the actual deployment of the cash needs to be substantially consistent with the schedule.

Practice Tips. Funds that expect to raise significant amounts of capital upfront from their investors should consider using a two-tier structure. This will allow them to “park” the cash in a lower tier structure as working capital until it is needed for construction without violating the 90% Asset Test at the fund level or the 70% Asset Test (as defined below) at the Lower Tier Entity level. However, the Regulations appear to require a high level of specificity with respect to the use of the funds, which may not be met if the Lower Tier Entity does not yet know which property it will acquire at the time of the investment.

70% Asset Test for Lower Tier Entities: As set forth above, at least 90% of the assets of a qualified opportunity fund need to be invested in qualified opportunity zone property. On the other hand, the Regulations provide that only 70% of the Lower Tier Entity’s tangible assets need to be Qualified Tangible Property (70% Asset Test).

Practice Tips. If the qualified opportunity fund invests directly in Qualified Tangible Property, at least 90% of its assets will need to consist of Qualified Tangible Property, while if the fund invests the cash in a Lower Tier Entity which then acquires the Qualified Tangible Property, only 63% of the fund’s indirect assets will need to be Qualified Tangible Property (90% x 70%).

Existing Entities. The Regulations clarify that existing entities may also qualify as qualified opportunity funds, but they still need to meet the 90% Asset Test like any other qualified opportunity fund. Meeting this test by existing entities will be more difficult given that qualified opportunity zone properties only include assets acquired from an unrelated party after December 31, 2017.

Leverage Does Not Dilute Tax Incentives. One of the most important provisions in the Regulations clarifies the treatment of loans taken by the qualified opportunity fund or a Lower Tier Entity. If a taxpayer invests both deferred gain and other cash in a qualified opportunity fund, the qualified opportunity fund is treated as a “mixed fund” with only the interests issued in return for the deferred gain eligible for the opportunity zone tax benefits, with the other investment ineligible for the tax benefits. When a qualified opportunity fund treated as a partnership borrows money, the partners are generally treated as contributing cash to the fund resulting in a mixed fund. The Regulations, however, clarify that for purposes of the opportunity zone mixed fund rules, debt taken by the qualified opportunity fund or Lower Tier Entity is not considered an investment of cash in the qualified opportunity fund and therefore such debt does not result in a mixed fund and does not dilute the investor’s tax benefits. This provided much sought after relief as real estate development projects are typically debt financed.

V. Further Guidance Needed

While the issuance of the Regulations is an important first step and is extremely helpful, there are still many aspects of the new opportunity zone program that remain unclear, including the following:

• How vacant land will be treated.

• Whether the rules will provide a practical approach for creating funds with multiple different assets.

• Whether the IRS and Treasury will require investors to recognize gain when the fund sells assets and reinvests the proceeds in other property.

• Whether the IRS and Treasury have not provided any grace period for qualifying opportunity funds to meet the 90% Asset Test – this is important in cases where the fund raises significant capital and intends to directly (and not through a Lower Tier Entity) acquire and substantially improve Qualified Tangible Property, avoiding the need for the two-tier structure described above.

Hopefully, these issues and others will be addressed in future regulations, with the next set of proposed regulations scheduled to be released later this year.

VI. How Sidley Can Help Investors and Fund Managers

The new statute includes intricate conditions—some of which remain subject to further interpretation by the Treasury—that must be met in order to claim the tax benefits. Because of this, significant challenges are presented when structuring a new fund. Sidley’s multidisciplinary team of lawyers is available to guide investors and fund managers through the evolving legal and business issues related to the Opportunity Zone program, through our integrated experience in tax, fund formation and commercial real estate finance. 

¹ The term “Qualified Tangible Property” is used for simplicity. The term used in the Regulations and statute for such property is “qualified opportunity zone business property”.

² The term “Lower Tier Entity” is used for simplicity. The term used in the Regulations and statute is “qualified opportunity zone business”.