Treasury Department Releases Investor-Friendly Proposed Opportunity Zones Regulations
On October 19, 2018, the Treasury Department issued highly-anticipated proposed regulations related to the U.S. Tax Cut and Jobs Act of 2017's Opportunity Zones Program (the "Proposed Regulations"). Taxpayers and investors have been anxiously awaiting guidance from the Treasury Department before funneling millions of dollars into the previously designated Opportunity Zones. The Proposed Regulations clarify certain fundamental aspects of the Opportunity Zone Program and address specific complex issues.
Ultimately, the Proposed Regulations confirm many of the theories and opinions that Sullivan & Worcester’s Opportunity Zones Practice Group previously advanced and provide several investor-friendly provisions that should dramatically accelerate the creation of Qualified Opportunity Funds ("QOFs") and the deployment of capital into Opportunity Zones. Although the Proposed Regulations are not final, and remain subject to a public comment period and further review by the Treasury Department, taxpayers and investors should feel confident relying on the Proposed Regulations.
The Proposed Regulations confirm the following threshold issues:
1. Identity of the Taxpayer.
As written, the Opportunity Zones legislation did not satisfactorily specify which taxpayers were eligible to take advantage of the Opportunity Zones Program. Significantly, it was not clear if, in the case of a partnership that sells a capital asset and generates a capital gain, the partnership could be the "taxpayer" that invests in a QOF or if the individual partners can invest the capital gain portion of any of their distributions in a QOF.
The Proposed Regulations establish that either a partnership or a partner can be the "taxpayer" for purposes of investing in a QOF, and this principle can be extended to other types of pass-through entities and their owners (e.g., S-corporations and their shareholders).
Notably, the mechanics of the Proposed Regulations require that the partnership (or other pass-through entity) must first make an election with respect to making a qualified Opportunity Zones investment, and only if the partnership declines to make a qualified Opportunity Zones investment can individual partners use gain attributed to them to make a qualified Opportunity Zones investment. The Proposed Regulations provide some timing relief for individual partners: a partner’s 180-day period to invest gain begins on the last day of the partnership’s tax year, unless the partner knows (i) that the partnership has elected to not make a qualified Opportunity Zones investment and (ii) when the partnership realized its capital gain. Interestingly, this timing relief could create tension among partners who have differing investment strategies and staggered Opportunity Zones investment opportunities.
2. Gains Eligible for Deferral
The Opportunity Zones legislation is silent as to whether Congress intended both ordinary gains and capital gains are eligible for deferral. Unsurprisingly, the Proposed Regulations confirm that only capital gains are eligible for deferral under the Opportunity Zones legislation.
3. Entities Eligible to be QOFs
The Proposed Regulations clarify that a QOF must be an entity classified as a corporation or partnership for Federal income tax purposes, and the entity must be created or organized in one of the 50 states, the District of Columbia, or a U.S. possession. This clarification confirms that QOFs may be structured as multi-member limited liability companies.
4. Certification of QOFs
As drafted, the Opportunity Zones legislation created the possibility of self-certification for QOFs but deferred the mechanics of how QOFs would self-certify and allowed the Treasury Department to create the self-certification process. The Proposed Regulations confirm that QOFs can self-certify compliance with the Opportunity Zones statute, and the Internal Revenue Service has promulgated a draft form (Form 8896) to be filed with each QOF’s tax return for the purposes of self-certifying compliance.
5. Initial Compliance with the 90% Asset Test
One of the key limiting factors that has depressed QOF activity is the requirement that any QOF have at least 90% of its assets deployed on the December 31 and June 30 testing dates. Investors and practitioners wondered if a QOF that accepted capital contributions on November 1 would actually be required to deploy 90% of its capital only two months later. Although the Proposed Regulations provide some timing relief for entities formed in the first six months of a calendar year, regardless of when an entity becomes a QOF, the last day of the taxable year is a testing date. Therefore, for the purposes of 2018, QOFs that have been created and funded after July 1, 2018 must deploy 90% of their assets by December 31, 2018.
6. The Definition of “Substantially All”
The Opportunity Zones legislation requires that, in order to be a qualified opportunity zone business, a business must own or lease "substantially all" of its qualified opportunity zone business property. As drafted, however, it was not clear what "substantially all" means.
The Proposed Regulations clarify that "substantially all" as applied to qualified opportunity zone business property owned or leased by a trade or business means at least 70%. In other words, a trade or business can own or lease no more than 30% of its total tangible property that is not used in an Opportunity Zone.
In addition to certain necessary clarifying guidance, the Proposed Regulations provide certain investor-friendly guidance that is largely a reaction to comments and suggestions received by the Treasury Department, including the following four provisions:
1. Special Allocations
The Proposed Regulations clarify that an investment in a QOF must be in the form of an equity interest in the QOF, including preferred stock or a partnership interest with special allocations. Importantly, the "special allocations" language suggests that QOFs can mimic traditional fund structures and provide for the distribution of profits and losses in ways that do not necessarily correspond to the partners' actual percentage of ownership interests in the QOF. This is a potentially enormous advantage to fund sponsors and could loosen the logjam that has hindered experienced investment professionals from moving ahead with the structuring and raising of QOFs.
2. Working Capital Safe Harbor
Investors and practitioners submitted numerous recommendations urging the Treasury Department to provide relief for QOFs that desire to qualify cash as appropriate QOF property for purpose of the 90% Asset Test. Commenters noted that traditional real estate projects require staged capital outlays, and QOFs could not reasonably be expected to push 90% of their cash out at the initial phase of their significant real estate development projects, which, arguably, are a critical target of the Opportunity Zones legislation. As applied to real estate project development, the 90% Asset Test, as originally drafted, would pose serious complications for the traditional real estate project development model.
In response, the Proposed Regulations provide a working capital safe harbor for QOF investments in qualified opportunity zone businesses that acquire, construct, or rehabilitate tangible business property, including real property. The safe harbor allows qualified opportunity zone businesses to hold cash as working capital for up to 31 months if certain requirements are satisfied.
Although the Proposed Regulations did not provide the 90% Asset Test testing date relief that many commenters hoped, if a QOF has identified a project, this safe harbor is a valuable tool to satisfy the 90% Asset Test and will give QOFs substantial flexibility to (i) raise capital upfront from taxpayers who want to benefit from the five- and seven-year capital gain deferral holding periods and (ii) complete projects on a timeline and process widely accepted in the real estate development industry.
3. The Definition of "Substantial Improvement"
The Proposed Regulations clarify that, with respect to the substantial improvement test in connection with a building acquired in an Opportunity Zone, the basis attributable to land on which such a building sits is not taken into account in determining whether the building has been substantially improved. Effectively, this allows a QOF to allocate the purchase price to the land and the building separately and permits a QOF to satisfy the "substantial improvement" requirement by making a minimum investment in the building that is equal only to the amount of the purchase price allocated to the building.
4. The Favorable Uses of Debt
The Proposed Regulations suggest that taxpayers are permitted to collateralize a loan with their QOF investments. Effectively, the Proposed Regulations provide a mechanism for taxpayers to monetize capital gains that they elect to defer by borrowing against their QOFs.
Also, the Proposed Regulations clarify that borrowings at the QOF level will not be treated as additional investments in the QOF. As a result, QOF investors can add debt at the QOF level without diluting the amount of the gain initially invested in the QOF; regardless of debt levels, an investor's entire gain will receive tax-free treatment if the investor holds the QOF interest for a minimum of 10 years.
The Proposed Regulations, and, in particular, the guidance provided with respect to special allocations, the working capital safe harbor, the definition of "substantial improvement," and the treatment of debt, should provide investors and fund sponsors with ample confidence to begin in earnest the formation and funding of QOFs.
There are several issues, however, that the Proposed Regulations did not address, and the preamble of the Proposed Regulations states that additional proposed regulations are expected to be published in the near future. It remains unclear if the Proposed Regulations, on their face, will provide enough comfort for fund sponsors to launch largescale opportunity funds or if investors will want guidance on the following open items:
- Disposition Following the 10-Year Holding Period: must the investors in a QOF sell their interests in the QOF or can the QOF sell its underlying assets and distribute the proceeds?
- 90% Asset Test Penalties: what are the penalties for failure to satisfy the 90% Asset Test and how are those penalties calculated?
- "Churning" Investments: how much time after the sale of qualified opportunity zone assets does a QOF have to redeploy its proceeds into another QOF in order to secure the benefit of the legislation for a properly structured QOF investment? The examples provided in the Proposed Regulations seem to allow a taxpayer reinvestment within 180 days after the taxpayer realizes gain from an asset sale by its QOF.
- Anti-Abuse Rules: the Opportunity Zones legislation requires the issuance of anti-abuse regulations, but the Proposed Regulations do not address this.
Sullivan & Worcester will be issuing analysis about the Proposed Regulations on a regular basis, including the exploring the effect of the Proposed Regulations on structuring transactions and identifying what the Proposed Regulations did not adequately address; please visit our website to review all of our analysis of the published guidance.
At Sullivan & Worcester, we are developing innovative structures and approaches to allow our clients to take full advantage of the Opportunity Zones legislation. We collaborate with and advise a nationwide network of taxpayers with gain to deploy, experienced fund sponsors launching Opportunity Zones ventures, seasoned real estate developers pushing into Opportunity Zones, and businesses seeking to locate their operations in Opportunity Zones. We are confident that we can help you maximize the potential of the Opportunity Zones legislation.
If you have any Opportunity Zones projects you'd like to discuss further with us, please let us know. Our multi-disciplinary Opportunity Zones team is ready to help.