As a final holiday present, the IRS and Department of Revenue revealed the final regulations for qualified opportunity zones in December. The regulations will go into effect 60 days after they are issued in the federal register. Despite not being formally published in the register yet, they will be materially unchanged.
The regulations are effective for tax years beginning on or after 60 days after publishing. Meaning, you can still rely on proposed regulations for 2019 and 2020.
What are qualified opportunity zones?
Congress enacted qualified opportunity zones as part of the Tax Cuts and Jobs Act to incentivize economic growth in low-income communities. Qualified opportunity zones (QOZ) are regions where businesses stand to gain tax advantages. Simply put, taxpayers are offering financial incentives to businesses that choose to help stimulate and revitalize their community. These new regulations round out the legislation and clean up remaining details.
Here, we’ll go through a brief synopsis of some of the most important additions.
Fund Setup and Investment Incentives
- 1231 capital gains are applying a gross calculation rather than a net calculation. What this means is you do not need to net 1231 gains against your 1231 losses. Additionally, the prior year’s 1231 losses are not required to recharacterize 1231 gains that are currently being deferred. Instead, this loss recapture will take place in the year the deferred gain comes due.
- 1231 capital gains’ 180 days will now begin on the date of sale for the taxpayer. As you no longer need to net with 1231 losses, there is no reason to defer the gain recognition date for purposes of a QOZ investment until year-end.
- Self-dealing is explicitly prohibited, even if it is a non-related party. Therefore you can no longer acquire an investment in a QOF after selling a property to the QOF or underlying business with the sole intent of reinvesting the gain into the fund, even if it is not a related party
- A Pass-through entity can still elect to defer its capital gains at the entity level. Should the entity pass-through the gain to its owners, the owners have 180 days to invest after the original due date of the entity tax return. Therefore if you receive a K-1 from a partnership or S Corp, you have 180 days from March 15th the following year to make an investment.
- Taxpayers are still able to use the entity’s 180 days. The proposed regulations previously said the ‘‘end of the tax year’’ for the entity. This effectively allows a person inside a hedge fund, who will not receive their K-1 until the beginning of September, to potentially reinvest the capital gain. Often, the taxpayer nor tax preparer has insight into what gains or amounts might be flowing off these large, cavernous K-1s.
Future Opportunity Fund Investment Sales
- It is possible to specifically identify which interest in a QOF a taxpayer is selling within certain guidelines. Therefore if you need to sell a portion of the investment in a QOF and you have multiple tax lots, you can pick and choose which lot is sold.
- For operating businesses, inventories may be excluded from the 90% or 70% asset test pending fund fund structure.
- 70% of tangible property use must be within the confines of a QOZ. This is based on the number of days used inside and outside a zone. There are clarifications about property used in a service trade or business that generates income inside and outside a zone. There is also a safe harbor for leasing tangible property, as long as the length of the lease is no more than 30 days (including extension). The car rental business is a perfect example of a leasing business that fits the safe harbor. Long term equipment leases will not qualify if less than 70% of its use is outside the QOZ.
- The final regulations liberalize “sin business” rules, allowing the presence of certain business activities.
- For example, an athletic club could include a tanning bed and massage space as an amenity. As long as it doesn’t occupy a significant portion of the club and doesn’t account for more than a 5% portion of revenue, these would be deemed de minimis and the business would remain qualified. Additionally, a grocery store that sells alcoholic beverages may also still qualify if the square-footage and income meet the 5% test
- For Real Estate businesses, a single triple-net lease will not qualify as an eligible trade or business. However, a portfolio of triple-net leases or a combination of triple-net and non-triple-net leases will likely qualify. This is a “facts and circumstances” test to be evaluated alongside each fund’s particular business dealings.
- The 31-month rule for the working capital safe harbor can now be doubled to 62 months.
- If on the same, or contiguous, QOZ, you can now aggregate assets for the substantial improvement requirement. The example from the regulations explains this rule exceptionally well.
Have More Questions?
I expect other nuggets of information to come out as we wade through the regulations. While not yet comprehensive, these updates signify the final regulatory additions.
If you have a question regarding this synopsis or any other questions, contact your Aldrich Advisor today.
Meet the Author
Senior Tax Manager - Real Estate
Jonathan McGuire, CPA
Aldrich CPAs + Advisors LLP
Jonathan McGuire has over eight years of experience providing strategic tax planning and compliance expertise to private middle-market clients. He has a deep focus as a real estate accountant, working with investors, developers, realtors, property managers, and other professional service providers in real estate. He works with a wide range of property types ranging from…
- Real estate
- Partnership taxation
- Tax planning and compliance
- Certified Public Accountant
- Repair regulations
- Qualified Opportunity Zones
- Qualified Opportunity Funds