Guidance on Opportunity ZoneStructuring & Capital Gain Deferral

DECEMBER 12, 2018

New IRC §§1400Z-1 & 2

• The new IRC §§1400Z-1 & -2 establish an entirely novel & completely different regimen for deferring & exonerating capital gains

• New vocabulary & acronyms require definition & explanation

• Unique concepts describe actions, limitations, results & options

• With working knowledge of terms, we can describe how they work to defer any capital gain & free from taxation ultimate values that may be achieved with Opportunity Zone investments

Qualified Opportunity Zones

• Qualified opportunity (QO) Zones: Low-income census tracts identified by states Fund: Corporation or partnership that invests in qualified opportunity

zone (QOZ) property

• Not limited to real estate Businesses with substantially all of tangible property owned or leased

in a QOZ Cannot be golf course, country club, gaming, etc.

Qualified Opportunity Zones, continued

• Qualified Opportunity Zones are specially designated areas that are eligible for specific federal tax benefits for investors

• The first set of QOZs were designated on April 9, 2018. They were nominated by the state governors, generally from low income census tracts

• A QOZ retains its designation for 10 years. There are almost 9,000 of them now identified

• There are numerous QOZs in & around Tulsa & Oklahoma City—many of which are prime areas for current redevelopment or new projects

Oklahoma Opportunity Zones

• There is a map on which all QOZs can be seen: https://www.cims.cdfifund.gov/preparation/?config=config_nmtc.xml

• See IRS Notice 2018-48, 2018–28 Internal Revenue Bulletin 9, July 9, 2018, for the official list of all population census tracts designated as QOZs for purposes of Internal Revenue Code §§ 1400Z-1 & -2

• Differentiating QOZs from similar sounding prior programs (New Markets, Enterprise Zones, etc.): there is no limit on the number of quality opportunity funds (QOF) or individual investments that may be made in QOZs

• There are no dollar limits on the amounts that can be invested; there are no government funds awarded for investment or other purposes

Qualified Opportunity Zones, continued

Qualified Opportunity Zones, continued

• Temporary deferral of gain 180-day reinvestment of gain directly in fund Deferral ends on earlier of date of next sale, or 2026 Percentage of deferred gain recognized depends on holding period

• < 5 years: 100%• > 5 but < 7 years: 90%• > 7 years: 85%

Permanent exclusion of gain on sale of QOF• Appreciation in the investment• 10-year hold requirement

Qualified Opportunity Zones, continued

Gain Deferral

What gains can be deferred?

• Proposed regulations provide that only capital gain is eligible for deferral

Must stem from an actual, or deemed, sale or exchange with unrelated party

Related person threshold is 20%, instead of 50%

Must be realized & included in computation of capital gain by taxpayer

• Need further guidance on §1231 gains (net loss is ordinary while overall gain is capital)

• Section 1256 gains

Gain Deferral, continued

Who can defer a gain?

• Eligible taxpayers

Person that may recognize gains for federal income tax purposes (includes C corps, REITs, RICs)

Pass-through entities, such as partnerships, S corps, decedent's estates & trusts

Owners or beneficiaries are eligible if gain not deferred at pass-through level

• Taxpayers cannot invest in QOZ property directly; must invest through QOFs

Reinvestment Period180-day Reinvestment Period• Gain (or portion of gain) must be reinvested in QOF within 180 days of

sale/deemed sale

• Proposed regulations clarify 180-day period begins on date gain is recognized for federal income tax purposes

• 180-day reinvestment period begins at end of pass-through entity’s taxable year

• Optional: owner may elect to use the day gain was recognized by entity to start the 180-day period (clarification needed for application to S corps & other flow-through entities)

• 180-day window for §1256 capital gains begins on last day of taxable year

Reinvestment Period, continuedExample: Partnership Investments• On January 1, 2019, Partnership P realizes $100K capital gain & decides not to elect to

defer

• Two of five partners want to defer their allocable portions of that gain

• Partner 1 invests $20K in QOF on February 2020

• Investment falls within 180-day window under general rule (window begins on last day of partnership’s year-end)

• Partner 2 invests $20K in QOF on February 2019

• Investment falls within 180-day window under elective rule (partner elects to use date of sale to start 180-day period)

Reinvestment Period, continued

REITs & RICs

• 180-day period starts when capital gain dividends are paid

• For undistributed capital gains, 180-day period begins at end of taxable year

10-Year Basis Adjustment Rules

Treatment of Deferral over the Years

• When deferral expires, if held for five years, taxpayers receive basis step-up equal to 10% of deferred gain

• If held for seven years, taxpayers receive additional 5% basis adjustment (reduction of gain)

• Reporting of deferred gain retains character of original gain

• Taxpayers may also elect to permanently exclude gain related to QOF appreciation after a 10-year holding period

10-Year Basis Adjustment Rules, continued

• Expiration of zone designations is December 31, 2028 10-year holding period

• Expiration of zone designations will not impact time frame for making basis adjustment election

Additional 10-year window• Proposed regulations provide taxpayer has until December 31, 2047, to

make election

Fund Entity RequirementsRules for a QOF

• Entity treated as a corporation or partnership for federal income tax purposes eligible to self-certify as using Form 8996 Preferred interest or special allocations Cannot be debt instrument Can be used as collateral for loan Partners’ share of liabilities (§752(a)) is not treated as additional investment

(mixed fund) & does not increase qualified investment

• Pre-existing entities may qualify by satisfying requirements under §1400Z-2(d)

• Note: existing tangible property will not qualify for the 90% test

Fund Entity Requirements, continued

Self-certify as a QOF

• Form 8996 attached to federal income tax return for applicable year(s)

• Any earlier election needed or advised? May be prudent to also file when QOF established as a safeguard until regulations are finalized.

• Entity may choose to identify taxable year & first month of that year to be treated as QOF

• Failure to specify: treated as qualified on first month of entity's tax year

• Initial testing dates

Fund Entity Requirements, continued

Example: Initial Testing Dates

• Corporation formed in February, but elects April first month as QOF

• Investments before April do not qualify for deferral

• Testing periods are end of September & end of December (first 6-month period of taxable year of the period in which it was a QOF & end of year

QOF – Single Asset Structures(Directly or Through 2nd Tier Entity)

Alternative 1 Alternative 2 Alternative 3

Investor Capital Gain Investor Capital Gain Investor Capital Gain

from Unrelated Party from Unrelated Party from Unrelated Party

QOF(Corporation,

partnershipor LLC

QOF(Corporation,partnership

or LLC

QOF(Corporation,partnership

or LLC

Corporation Partnership(or LLC taxedas partnership)

90% of total assetsQOZ

business property

Purchase Purchase

70% of tangible assetsQOZ

business property

70% of tangible assetsQOZ

business property

If 70% test met, 100% of QOZ Business Property Qualifies for the QOF 90% qualified asset test. This allows a QOF to have only 63% of QOZ Business Property overall & still satisfy testing requirements.

Single Member Limited Liability companies could be created in between levels

Development Level (each may have multiple partners or shareholders)

No limit on additional structures

QOF – Multiple Asset StructuringInvestor Capital Gain

from Unrelated Party

QOF(Corporation,

partnershipor LLC

Corporation Partnership(or LLC taxedas partnership)

90% of total assetsQOZ

business property

Purchase Purchase

70% of tangible assetsQOZ

business property

70% of tangible assetsQOZ

business property

If 70% test met, 100% of QOZ Business Property Qualifies for the QOF 90% qualified asset test. This allows a QOF to have only 63% of QOZ Business Property overall & still satisfy testing requirements.

Single member LLCs can be introduced between these levels to further isolate liability between various developments

Development Level (each may have multiple partners or shareholders)

QOF – Structuring for Operating BusinessesAlternative 1 Alternative 2 Alternative 3

Investor Capital Gain Investor Capital Gain Investor Capital Gain

from Unrelated Party from Unrelated Party from Unrelated Party

QOF(Corporation,

partnershipor LLC

QOF(Corporation,partnership

or LLC

QOF(Corporation,partnership

or LLC

Corporation(operatingBusiness) Partnership

(or LLC taxedas partnership)

90% of total assetsQOZ

business property

Purchase Purchase

70% of tangible assetsQOZ

business property

70% of tangible assetsQOZ

business property

Alternative 1:An existing business sets up a QOF & expands its business so that a new segment operates within a qualified opportunity zone & is in the active conduct of a trade or business. The property used within the zone is purchased new & more than 70% of the tangible assets of the business are used within the qualified opportunity zone. This should qualify. Proposed Regs. request comment on used property moved into a zone. Map planned CapXpotentially to Opportunity Zones to limit capital gain recognition by a business group.

Alternative 2: A new business operates in the qualified opportunity zone in partnership form; the business contracts manufacturing in China using intangibles developed within the opportunity zone. This likely qualifies for Opportunity Zone tax benefits provided the intangible assets are used in the active conduct of a trade or business.

Alternative 3: Technically a QOF itself could be an operating business but with cash being a nonqualified asset, typically not advised.

Comparison of Investment in Single Asset vs. 1031 Like-Kind Exchange

Opportunity Zone 1031 ExchangeRecognition of Deferred Gain Earlier of sale of QOF interest or

12/31/2026Upon sale or replacement of property unless deferred to new like-kind exchange (potentially indefinitely)

Use of New Property Does not need to be like-kind Must be like-kind

Nature of New Property Real or personal property Must be real property

Reinvestment identified No limit 45 days

Proceeds to reinvest Only gain on sale Entire proceeds

Closing on reinvestment 180 days 180 days

Tax Basis Step-Up 10% if QOF held for 5 years, 15% if 7 years (in each case before 2026)

None

Failed 1031 Exchange QOF possible fix No fix

22

Under Current Regulations

• Clearest case Real estate development in a single asset QOF (especially those that do not

benefit from the indefinite deferral available through §1031 like-kind exchanges)

• Challenging cases Without further clarity from tax regulations Commingled Funds – exits & reinvestment of proceeds Operating Businesses

• Difficult to establish original use or significant tangible property to improve

• Difficult to deploy money per required time frames

• May be difficult to leave IP in OZ

Asset Tests

90% asset test

• Initial test (6 months) & annually at year-end

• Must be used when QOF invests in tangible assets

• The QOF may use asset values that are reported for applicable financial statement (AFS) purposes AFS includes those filed with federal agency other than IRS, e.g., SEC

or audited financial statements

• If financial statements are not prepared, QOF required to use unadjusted cost basis of its assets

Asset Tests, continued

• Opportunity zone businesses “Substantially all” of the businesses assets must be OZ business

property “Substantially all” defined for this purpose under the proposed

regulations as 70% 50% of OZ business total gross income must be from “active conduct”

of trade or business Applicable financial statement rule also applies here as well 5% zone taxpayer rules

Substantial Improvement Requirement & Land• Substantial improvement requirement with respect to purchased

building located in OZ Additions to basis of property acquired by the QOF must exceed an

amount equal to the adjusted basis of property at beginning of 30-month period When measuring substantial improvement for an acquired building,

cost of land ignored

Substantial Improvement Requirement & Land, continuedExample: Substantial Improvement Requirement

• Z Partnership acquires building & land for $1M. Cost allocated to land is $200K & building is $800K

• Required minimum improvements to meet substantial improvement requirement is $800K

Working Capital Safe Harbor

Invest contributed funds in sufficient time

• 90% test must be met six months from beginning of creation of QOF

• Safe harbor provided by proposed regulations states property can be held by QOF as working capital for period up to 31 months Must be a written plan identifying financial property to be considered

working capital Must be written schedule of how & when property will be used QOF must comply with written plans & schedule

Example: working capital safe harbor Taxpayer realized $10M gain & reinvested in QOF within 180-day

period QOF immediately purchased OZ land with intent to construct building QOF had written plans to acquire land & construct building $1M of the $10M reinvested was dedicated to purchase of land Plans provided for construction within 30 months QOF had no other gross income during 31-month period

Working Capital Safe Harbor, continued

• Additional guidance What happens if a QOF fails 90% test What could cause “decertification” Clarification of §1231 gain issues Rules regarding reinvestment of OZ property by OZ Fund

What Questions Remain

Opportunity Zones & QOFs – Pair with other tax benefits?• How do QOZ/QOF tax benefits compare with other U.S. tax

incentives? Rev Proc. 2018-16, “Investments in a qualified opportunity fund may

also be eligible for other tax benefits” Other tax incentives that may be utilized with Opportunity Zone benefits

• Historic tax credits

• Low-income housing credit

• NMTC

• ITC

• IRC §1031 Like-kind exchanges31

Questions?

Thank You!

• Matthew Campbell, Shareholder, Hall Estill | mcampbell@hallestill.com

• Shawn Loader, CPA, Director, BKD | sloader@bkd.com