Investments in qualified opportunity zones offer significant U.S. and potential state tax savings

By Stephen Christiano, Business Tax Associate Director at Frank Hirth

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In August Frank Hirth published a summary of the new tax-incentivized program introduced in the 2017 Tax Cuts and Jobs Act for investment in designated U.S. "qualified opportunity zones" (QOZ's). Click here to read.

On October 19th, 2018, the Treasury Department issued proposed regulations which offer sufficient clarity about the implementation of the QOZ provisions to permit investment advisers to proceed with packaging and marketing "qualified opportunity funds" (QOF's) to make QOZ investments. In addition, Rev. Rul. 2018-29 was issued to provide guidance for taxpayers on the "original use" requirement for land purchased after 2017 in qualified opportunity zones. Lastly, a draft of the self-certification form, Form 8996, has been released.

It now seems clear the incentives-which include both deferral of already realized capital gains and favoured tax treatment of gains from QOZ investments-represent an opportunity as much for non-U.S. persons having capital gains taxable in the U.S. as for U.S. persons. In particular, QOZ investments can offer a means of deferring tax on gains (a) from the disposal by a non-U.S. person of a U.S. real property interest (under the "foreign investors real property tax act" or FIRPTA) or (b) deriving from participation in partnerships engaging in a U.S. trade or business.

The proposed regulations have clarified the following:

• All gains treated as capital gains for federal income tax purposes (other than gains derived in certain transactions with related parties) qualify for deferral. This includes both short- and long-term capital gains, FIRPTA capital gains, new Section 864(c)(8) capital gains, and Section 1231 capital gains. Special rules apply to capital gains from section 1256 contracts. The related party rules have also been clarified.
• There is no restriction on the use of QOF investments as collateral for a loan, whether purchase-money borrowing or otherwise.
• To qualify as a QOF a specified proportion of the fund's assets must be invested in QOZ property, and the application of these tests has been clarified.
• Working capital safe harbor for QOZ business test - allows businesses to maintain working capital in cash, cash equivalents or debt instruments for a period of up to 31 months if the following three requirements are met:
• • There is a written plan that identifies the working capital assets as property held for the acquisition, construction or substantial improvement of tangible property in the opportunity zone;
  • There is a written schedule consistent with the ordinary start-up of a trade or business, that the property will be used within 31 months; and
  • The assets are used in a consistent manner with the schedule.
• There has been a significant relaxation of the test for determining when developed property acquired by a QOF will be considered to have been "substantially improved" by the QOF, as required for tax-favored treatment.
• The proposed regulations provide that gain from an investment in a QOF will be tax-free provided the investment is disposed of on or before December 31st, 2047. This is a huge win for taxpayers as it had initially been expected that such investments would have to be disposed of by the end of 2038.
• Where a partnership realizes a capital gain and does not itself make a QOF investment to defer tax, any partner may make its own QOF investment to defer tax on its allocable share of such capital gains. For this purpose, the partner's 180-day period for reinvestment begins on the last day of the partnership's taxable year, i.e. December 31st for the calendar year partnership filers.
• A roll-over incentive is available for a taxpayer that sells its interest in a QOF prior to December 31, 2026. The taxpayer may invest in another QOF within a 180-day period and further defer gains deferred on the original QOF investment.
• Draft Form 8996, "Qualified Opportunity Fund", has been released for initial self-certification and for annual reporting of compliance with the 90-percent asset test. Guidance from the IRS indicates that taxpayers will make deferral elections on Form 8949 in the year in which the gains would have been recognized if no election was made.

The IRS has requested that any comments on the proposed regulations be submitted by December 18th, 2018, and a further public hearing on the proposed regulations will be held on January 10th, 2019. As further guidance becomes available, we will be updating this article however the proposed regulations have given taxpayers much-needed guidance to feel more comfortable on the tax aspects of the Qualified Opportunity Zone program.

If you have any interest in learning more on the Qualified Opportunity Zone program, please reach out to your Frank Hirth contact as we can assist with the initial structuring and ongoing U.S. tax compliance each year.

Author: Stephen Christiano

Professional Partnerships & Funds Associate Director

To find out more please contact Stephen Christiano. Click here.