IRS Delivers Final Opportunity Zone Regulations
On Dec. 19, 2019, the IRS released a long-awaited gift to the tax and investment communities: A robust 544-page dissertation in the form of final Qualified Opportunity Zone regulations. The proposed guidance issued prior to the release of these final regulations left many unanswered questions and produced more than a few perplexing outcomes.
The final regulations should relieve much anxiety related to Qualified Opportunity Zone (QOZ) investing as many of the resolutions are favorable to the QOZ investor.
Key updates from the final regulations include:
- Multi-Asset Funds Are Now More Tax Efficient
Prior to the release of the final regulations, there were a host of tax-related issues with a Qualified Opportunity Fund (QOF) holding multiple assets. Now:
- Lower-tier QOZ Business (QOZB) pass-throughs can make an election to sell assets and exclude gain. Prior to the new guidance it appeared that they could not.
- If the aforementioned election is made, all gain in the investment is excluded (with the exception of inventory). Prior to the new guidance, only capital gain was excluded via this special election.
- §1231 Gain: A Much-Needed Fix
Prior to the final regulations, investors who wanted to invest §1231 gains were required to:
- Net all §1231 losses with all §1231 gains from the year and only the net §1231 gain was eligible as a qualifying investment in an QOZ.
- Wait until the last day of the tax year (usually Dec. 31) to make an eligible investment in a QOZ. This was particularly frustrating to investors, as it created a dead period (from the sale to the last day of the tax year) within which qualifying QOZ investments could not be made with respect to that gain.
In a welcome reversal, the final regulations modify the above rules by:
- Allowing taxpayers to invest gross §1231 gains without regard to any §1231 losses or non-recaptured §1231 losses from the previous five years.
- Allowing the 180-day period for investing eligible gross §1231 gains to begin on the date of the sale.
- Pass-Through Gain: Investment Window is Increased
Ordinarily, investors have 180 days from a realization event to get eligible capital gains invested in a QOZ. However, the 180-day rule for partners in partnerships states that:
- A partner’s 180-day clock begins on the last day of the partnership’s taxable year; or
- If the partnership does not elect to defer all its eligible gain, the partner may take on the same 180-day period as the partnership (date of sale).
The final regulations add an additional option of flexibility without eliminating the general rules stated above. The final regulations add that a partner can elect to start the 180-day clock on the due date of the entity’s tax return, not including extensions.
- Substantial Improvement Gets Critical Modification
Generally, used property must be substantially improved in order to qualify as QOZ Business Property (QOZBP). Substantial improvement is measured as improvements that double the cost of the property. The proposed regulations indicated that this had to be done on an asset-by-asset basis opposed to allowing for an aggregate approach. This was an absolute calamity. How do you double the basis of the office desk you just purchased?
The final regulations allow for a limited ability to aggregate.
First, QOFs and QOZBs can utilize new assets to improve used assets where they are used in the same trade or business in the QOZ for which a non-original use asset is used, and they improve the functionality of the non-original use assets in the same QOZ. (Think of a hotel that adds gym equipment, new mattresses, etc.)
Second, a group of two or more buildings located on the same parcel of land can be treated as a single property. Additionally, in limited circumstances, buildings that sit on more than one parcel may be aggregated for purposes of determining substantial improvement. Thus, a taxpayer need only double the basis of the combined group of buildings opposed to having to double the basis of each individual building.
- QOZB Working Capital Safe Harbor Extension
There will be more to come on this issue, but in certain circumstances a working capital safe harbor can be extended from 31 months to 62 months.
These predominantly taxpayer-friendly regulations help clarify many unanswered questions, and, in doing so, will likely serve to encourage additional investment in Qualified Opportunity Zones.
Please reach out to your KSM advisor to determine how this may be relevant for your situation.
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