The Tax Cuts and Jobs Act (TCJA) signed into law on December 22, 2017, introduced some of the most sweeping changes to the country’s tax code in over 30 years. One of the biggest changes was the creation of Opportunity Zones.
Now, less than 24 months after the TCJA was enacted, the Final Regulations on Opportunity Zones have been released. (To read all 544 pages of the Regulations, download the PDF from the U.S. Department of Treasury.)
To help you save valuable time, here’s our summary of everything real estate investors need to know about the final Opportunity Zone regulations.
Section 1231 gains have new guidance
Gains from real estate or business property held for one year or more come under Section 1231, allowing investors to claim the lower capital gains tax rate vs. an ordinary income tax rate.
- Invest entire gains irrespective of losses.
- Investment period begins at the date the asset was sold.
- Investors who are outside the 180-day window of a 1031 exchange due to these revisions may seek recourse as described in Section 1.1400Z2(a)-1(g)(2)(ii).
Installment sales gains can be deferred
An installment sale is a strategy used by investors to partially defer capital gains into future taxation years by recognizing revenues at the time of receipt vs. the time of sale.
- Gains may be invested in a QOF (Qualified Opportunity Fund) when they are received, even if the first installment payment was received prior to 2018.
- Or, at the investor’s option, the ‘clock starts ticking’ on the last day of the tax year the installment gain would be recognized in.
- As a result, a taxpayer could have multiple 180-day periods during the same year or alternatively could opt for choosing the last day of the year for all gains.
- This clarification provides investors with additional options for eligible gains and the ability to collect more tax benefits from Opportunity Zone investments.
More choices for real estate investment types
The final Opportunity Zone rules published by the IRS also give investors more and better choices for real estate investment types:
- Assets may be combined and treated as a single asset to satisfy the conditions of the substantial improvement test.
- For example, aggregating multi-building projects as a single property, but generally require the same entity to operate the business elements and operation.
- Buildings sitting vacant for one year or more now qualify as original use vs. substantial improvement.
Aggregation rules make meeting substantial improvement rules easier
Final Opportunity Zone regulations offer more flexible aggregation rules that replace the prior individual asset approach:
- Multiple properties located in the same Qualified Opportunity Zone can be used to meet the substantial improvement requirement if they are used in the same trade or business and the functionality of the non-original use property has been improved.
Options for non-U.S. investors
Deferring capital gains tax using a QOF is only available for gains subject to federal income tax. However:
- Non-U.S. investors who have a taxable gain from a U.S. trade or business may defer tax payment via a Qualified Opportunity Fund investment, unless the gain is already exempt under a tax treaty.
Safe harbor for working capital expanded
Assets can now benefit from two 31-month safe harbor periods, for a total of 62-months:
- Not a straightforward grant of 62 months for project completion, but instead require additional amounts of working capital and plans.
- In-progress assets and gross income generated by working capital safe harbor assets during the safe harbor period are treated as being used in a trade or business.
Timing of gains
Investors with ownership interests in passthrough entities such as partnerships and S corporations may not receive notice of eligible gains until Schedule K-1s are issued.
To provide additional time for investment in Opportunity Zones the IRS now allows:
- Investors the option to elect to begin the 180-day investment window on the due date of the entity’s tax return, excluding any extensions.
Excluding gains after the 10-year holding period
Investing in a Qualified Opportunity Zone Business (QOZB) or QOF partnership is also made more attractive with the new rules:
- Sale of property by a QOZB beyond the 10-year holding period qualifies for the exclusion of capital gains.
- All gains from a sale – not just capital gains – may now be excluded, except gains from the sale of inventory used for ordinary business purposes.
- A QOF partner’s stepped-up basis after the 10-year election is now equal to the net fair market value of the partner’s interest plus the partner’s share of partnership debt related to the interest.
Investing by C Corporations is also more attractive
Significant changes to the final Opportunity Zone rules also offer certain advantages for investment by C Corporations:
- C Corporations QOFs may be members of a consolidated group.
- Investment in a QOF is not limited to the consolidated group member realizing the capital gain.
- In other words, other consolidated group members may make investments on behalf of the member realizing the capital gain.
Leasing activity in a QOZ or QOZBP
The final Opportunity Zone rules also help to make leasing more investor-friendly:
- Requirements for market-rate leases do not apply if the tenant is part of the state or local government or an Indian tribal government.
- Leases between unrelated parties are generally assumed to be at market-rate terms.
- Lessors using personal property outside a QOZ on a short-term lease may still count the property as a Qualified Opportunity Zone Business Property (QOZBP).
Key takeaways of the Final Opportunity Zone regulations
The final OZ regulations provide more investor-friendly options for investing in Opportunity Zones, QOFs and QOZBs.
At the end of the day, investors also realize four significant tax benefits from investing in Qualified Opportunity Funds, provided the investment is held for at least 10 years:
- Taxable capital gains are deferred by investing in a QOF, similar to the way a 1031 exchange is used to defer capital gains taxation.
- Basis of the investment is stepped-up by 10% if a QOF investment is held for at least 5 years, which reduces the original amount of the taxable deferred gain.
- Basis of the investment is stepped up by an additional 5% (for a total increase of 15%) if a QOF investment is held for an additional two years (for a total of 7 years).
- No taxable gain on QOF investments held for at least 10 years, provided the investment is sold before January 1st, 2048.