ALERT! The article below was written prior to Treasury’s release of the final Opportunity Zone regulations on December 19, 2019 and has not been updated to incorporate any items that may have changed. Stay tuned for more as The Tax Warriors pour through the 544 pages of new guidance, which you can access here. Happy Holidays from the IRS!
At Drucker & Scaccetti, December is always abuzz with tax planning as our clients’ annual tax pictures come into better focus and strategies can be designed and implemented to increase Santa's allocated budget. But in the Opportunity Zone (OZ) context, year-end is even more critical. Below are 3 things you need to know before December 31st if you're managing or investing in OZ Funds.
#1 - Status of Treasury Regulations and IRS Guidance
On Friday, December 6, 2019, Treasury submitted its final regulations to the Office of Management and Budget (OMB) for approval. While drafts of these final regulations have not yet been released, we expect OMB will approve and release these regulations sometime around year-end. While it's unclear how these final regulations may differ from the previously proposed regulations, we expect (hope?) that they will clarify some of the remaining outstanding questions and incorporate other changes commenters previously identified on the proposed regulations. There will likely be taxpayer-friendly and unfriendly provisions; but for those currently operating and investing in OZ Funds, know that the previously proposed regulations can still be relied upon—for the time being.
#2 - December 31st is a Critical Date for OZ Fund Investments for 2 Reasons…
December 31, 2019, is the last day OZ Fund investors can make investments and achieve the additional 5% reduction on their deferred gains. The OZ law requires investors who defer gains into OZ Funds to recognize those gains no later than December 31, 2026. The law also allows a 10% reduction of that deferred gain for OZ Fund investments held at least 5 years, and an additional 5% reduction for investments held at least 7 years. Accordingly, investors deferring gains into an OZ Fund AFTER December 31, 2019, will recognize their deferred gains (on 12/31/2026), before they've held their OZ Fund investment for the 7-year period required to achieve the 5% reduction. In short, OZ Fund investments made after December 31, 2019 will never be eligible for the additional 5% reduction.
December 31, 2019, is also the first day certain types of gains can be invested into OZ Funds. The proposed regulations do not allow IRC Section 1231 gains, which are generally realized on the sale of rental real estate or other property used in a trade or business, to be deferred into an OZ Fund until the last day of the investor's tax year, generally December 31st. Additionally, capital gains from flow-through entities, including partnerships and S-corporations, are also eligible for OZ Fund deferral on the last day of the flow-through entity's tax year (again, generally 12/31).
This makes December 31, 2019, both the first date certain gains incurred in 2019 can be invested into an OZ Fund and also the last date OZ Fund investments can qualify for the 5% deferred gain reduction. Accordingly, we expect A LOT of OZ Fund investments to be made precisely on December 31, 2019. Keep in mind, capital "commitments" do not qualify as investments for OZ purposes - cash must actually be contributed into the OZ Fund. If you're planning to execute a transaction on December 31, 2019, we strongly recommend you let your banker know in advance… and send them something nice to celebrate the new year.
#3 - December 31st is a Critical Date for OZ Fund Testing
Those managing OZ Funds should be aware that the funds are subject to semi-annual testing to ensure at least 90% of the fund's assets are invested in qualified opportunity zone property. All OZ Funds filing their taxes on a calendar year are tested on December 31, 2019. Therefore, fund managers need to critically review their OZ Fund's balance sheet in advance of this deadline to ensure the fund will not be subject to penalties for failing the 90% test.
Notably, cash is NOT a qualifying asset for the purposes of this 90% asset test, so OZ Funds with more than 10% of total assets in cash should be especially concerned. Acknowledging that it takes funds time to deploy capital contributions, the proposed regulations allow cash and other qualifying short-term investments to be excluded from an OZ Fund's asset-testing base if they were contributed to the fund 6 months prior to the testing date. So, OZ Funds funded after June of 2019 may be OK to hold cash on 12/31/2019. But for OZ Funds capitalized before July of 2019, which would include any OZ Funds funded with 2018 capital gains, cash will count as a "bad asset" for purposes of the 12/31/2019 asset test. These OZ Funds should consider contributing their cash to a lower-tier entity (a Qualified Opportunity Zone Business - QOZB) before 12/31/2019, so the QOZB can avail itself of the working capital safe-harbor in order to exclude the cash from its asset-testing. This safe-harbor is only available to lower-tier QOZB entities, NOT to OZ Funds themselves, which is why many OZ Funds have employed "2-tier structures" to assist with cash management.