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Opportunity Zones: reading the first-round regs

REG-115420-18 filled in enough of §1400Z-2 to raise real money, and left enough blank that the second round cannot come fast enough

The Editors
Staff, Incorporator.org
10 min read Updated
Contents 8 sections
  1. What the statute actually does
  2. The 180-day window and who gets in
  3. What a Qualified Opportunity Fund is, mechanically
  4. The land-versus-building problem, and Rev. Rul. 2018-29
  5. The parts that are still blank
  6. Second-order effects the industry is already pricing
  7. What to watch next
  8. Sources

he first round of Opportunity Zone proposed regulations landed on October 19, 2018, and for the first time the §1400Z-2 program looks like something a fund manager can actually price. REG-115420-18 answers the first wave of questions, Rev. Rul. 2018-29 answers the land-versus- building question that was holding up every real-estate deal, and Form 8996 gives a Qualified Opportunity Fund a way to self-certify without waiting on Treasury.

What the regs do not yet answer is the part that matters for operating businesses, and that is the part the market is now waiting on.

What the statute actually does

The Tax Cuts and Jobs Act added two new Code sections at the end of 2017: §1400Z-1, which designates the zones, and §1400Z-2, which supplies the tax benefit. The mechanics sit in §1400Z-2(a)(1). An investor who has realized a capital gain may elect to defer that gain by rolling the gain amount (not the full sale proceeds, just the gain) into a Qualified Opportunity Fund within 180 days of the sale. The gain then sits on the investor's books, deferred, until the earlier of the date the QOF interest is sold or December 31, 2026.

Two separate benefits attach to holding the QOF interest. Under §1400Z-2(b)(2)(B)(iii) and (iv), a five-year hold gets a 10% basis step-up on the deferred gain; a seven-year hold gets another 5%, for 15% total. Both of those numbers are computed against the 2026 recognition deadline, which means the seven-year step-up is only available to investors who are in by the end of 2019. The clock is already short.

The third benefit, under §1400Z-2(c), is the one doing the heavy lifting in fund marketing: a ten-year hold lets the investor elect to treat the basis of the QOF interest as equal to fair market value on the date of sale, which zeroes out the appreciation inside the fund for federal tax purposes. Deferred gain still recognizes in 2026; new gain from the QOF itself, over ten years, is the part that can be fully excluded.

If you followed our walk-through of the zone designations that finished in June 2018, this is the other half of the puzzle. The map was Treasury's answer to §1400Z-1. The regs are Treasury's answer to §1400Z-2.

The 180-day window and who gets in

Proposed §1.1400Z-2(a)-1(b) locks down the investment timing in sharper terms than the statute alone provided. For a sale producing capital gain, the 180-day clock starts on the date of the sale or exchange that would, absent the election, have triggered recognition. For a partner's distributive share of partnership gain, the regs give the partner two choices: start the clock on the last day of the partnership's taxable year (a safe harbor that lines up with how the K-1 actually shows up in the investor's hands), or, if the partner prefers, start on the date the partnership realized the gain. The partnership itself can also make the election at the entity level, within its own 180 days from realization.

That second rule is quietly important. Without it, a limited partner in a private-equity fund who learned about a portfolio sale months after it closed would have been out of time before they knew there was an election to make. The regs give that LP until 180 days after their own year-end K-1 is finalized. It is a practical fix that tells you Treasury read the comments from the investment-management bar.

The regs also answer, affirmatively, the question of what kind of gain qualifies. Short-term and long-term capital gain both work. §1231 gain, which nets to capital at year-end, qualifies for the portion that nets to capital. Ordinary income does not qualify, and neither does depreciation recapture taxed at ordinary rates. The election is gain-by-gain, not wholesale, so an investor can roll one sale and not another.

What a Qualified Opportunity Fund is, mechanically

A QOF is a corporation or partnership (an LLC taxed as either works) organized for the purpose of investing in Qualified Opportunity Zone Property, per §1400Z-2(d)(1). The entity self-certifies by filing Form 8996 with its federal tax return. There is no pre-approval, no waiting line at Treasury, and no application fee. Sponsors who have spent a decade on New Markets Tax Credit allocation auctions are still checking that sentence twice.

The certification form asks for three things: the entity's EIN, the taxable year in which it is electing to be treated as a QOF, and a month-by-month worksheet for the 90% asset test. §1400Z-2(d)(1) requires that, measured on the last day of the first six-month period of the taxable year and on the last day of the taxable year, at least 90% of the fund's assets be Qualified Opportunity Zone Property. Miss the test and you owe a penalty computed monthly under §1400Z-2(f), at the underpayment rate of §6621(a)(2).

Proposed §1.1400Z-2(d)-1(a)(3) gave sponsors a small kindness here: the fund can choose the first month of its first taxable year as a QOF (pick your own start month), which lets a sponsor who organized in, say, June hold cash into December without failing the first six-month test, because the first test falls six months after the chosen start month. A fund organized in June that picks a November start does not face a test until April of the following year. For sponsors still raising capital, that is six extra months of runway.

The land-versus-building problem, and Rev. Rul. 2018-29

The statute requires that QOZ business property either have its "original use" with the QOF, or that the QOF "substantially improve" the property. §1400Z-2(d)(2)(D)(i)(II). Substantial improvement, per (d)(2)(D)(ii), means that within 30 months of acquisition the QOF doubles its basis in the property.

That rule is easy to apply to a piece of equipment. It is agonizing to apply to a building you bought for its land. If a sponsor buys a vacant lot with a derelict warehouse for $5 million, with $4 million of the purchase price allocated to land and $1 million to the building, does "doubling" mean spending another $5 million, or another $1 million? And what is the "original use" of a lot that has been sitting fallow for thirty years?

Rev. Rul. 2018-29, issued the same week as the proposed regs, answered the expensive half of that question. For a building situated on land within a zone, the substantial-improvement measurement is made against the basis of the building only, not the land. Doubling the $1 million, not the $5 million, clears the bar. The ruling also clarified that the original-use requirement does not apply to the land itself, meaning a QOF can buy previously-used land and still satisfy the property tests as long as it substantially improves (or originally uses) the improvements sitting on that land.

Every urban-infill real-estate deal in the pipeline runs through that ruling. Without it, the program was functionally a ground-up-construction program on empty dirt; with it, adaptive-reuse projects on high-land- value parcels are back on the table. That is most of the interesting deal flow in most of the zones.

The parts that are still blank

Two large gaps in the first-round regs are slowing operating-business deals. The first is the meaning of "substantially all" in §1400Z-2(d)(3), which defines a Qualified Opportunity Zone Business. A QOZ Business must hold "substantially all" of its tangible property as QOZ Business Property. The statute uses the phrase; the statute does not define it. The proposed regs took a first pass at 70% for this test, meaning a subsidiary operating business can be a QOZ Business if 70% of its tangible property by value sits inside a zone and otherwise qualifies. That 70% is paired with the fund-level 90% test, so the effective through-fund floor is 63%, which is where the deal lawyers are currently modeling.

Whether 70% survives to the final regs is genuinely open. Treasury asked for comments on it. Sponsors want it lower; zone advocates want it higher. The proposed reg is enough to underwrite against for funds that plan to use the two-tier structure (QOF holding a QOZ Business subsidiary), but not enough for anyone who would prefer to hold property directly in the fund without a subsidiary, because those funds still face the 90% asset test with no equivalent flexibility.

The second blank is the working-capital safe harbor. An operating business does not buy all of its assets on day one. It raises money, holds the money as cash, and deploys the cash over a year or two of hiring, leasing, building out. Cash is not QOZ Business Property. Without a safe harbor, the 70% test is unworkable for a new business.

Proposed §1.1400Z-2(d)-1(d)(5)(iv) sketched a 31-month safe harbor: cash held pursuant to a written plan for the acquisition, construction, or substantial improvement of tangible property in a zone, and deployed in substantial compliance with that plan within 31 months, counts as QOZ Business Property for the tests. The outline is there. What is not yet clear is how the safe harbor handles serial deployments, refinancings, or operating-business cash (as distinct from capex cash). Sponsors are writing plans that cover all three; whether Treasury will bless that breadth is the open question the next round of regs needs to answer.

Second-order effects the industry is already pricing

Two patterns are visible in the deals closing in the fourth quarter of 2018 and the first weeks of 2019. The first is that funds are organizing as partnerships rather than corporations almost universally. The reason is §1400Z-2(c)'s ten-year basis step-up, which applies to the sale of a QOF interest. A corporate QOF would pay corporate tax on an asset sale before the investor ever saw proceeds, which defeats the exclusion at the entity level. Partnership QOFs push the sale up to the investor, who then elects the basis step-up at the sale of the fund interest. Corporate QOFs still have a narrow use case for operating businesses that plan to IPO, where exit by stock sale is the base case.

The second is that single-asset funds are the dominant structure. Multi-asset funds trigger the question of what happens when one asset is sold in year eight. The investor's QOF interest has not been sold, so the ten-year hold has not matured, and the gain on the sold asset would ordinarily flow through to the partner. Without further guidance, no one is quite sure whether the basis step-up election can be made at the asset level or only at the fund-interest level. Single-asset funds route around the problem by aligning the asset sale with a fund dissolution, at which point the investor is selling (or being redeemed out of) their fund interest. This is legal architecture in response to a gap in the regs, and it is the kind of thing a second round could simplify.

One more thing worth flagging: the deferral election under §1400Z-2(a)(1) is made on Form 8949, attached to the investor's return for the year of the original gain. That means an investor who made a qualifying investment in late 2018 makes the election on the 2018 return, filed in April 2019. For investors with late-2018 gains who have not yet invested, the 180-day window may still be open well into 2019, and they have until their return is filed to make the election on the 2018 gain. The filing-year mechanics are not symmetric with the investment-year mechanics, which is tripping up early preparers.

What to watch next

Treasury has signaled a second round of proposed regs is in the pipeline. The working-capital safe harbor, the 70% "substantially all" threshold, the treatment of sales of QOZ Business Property held through a subsidiary, and the interaction with §1231 netting for partnership investors are all on the docket. None of those are fatal gaps for single-asset real-estate funds, which is why you are reading about a wave of those closing right now. All of them are material for operating-business funds, which is why those funds are largely still in the gate.

For an investor with a capital gain realized in the second half of 2018, the planning window is now. The 180-day clock is ticking, the seven-year basis step-up requires an investment before December 31, 2019, and the ten-year exclusion requires a hold through at least 2029. The regs are not everything the market would like. They are enough to write the first wave of checks against, and the people who wait for the final regs to clear will find that the seven-year step-up has lapsed by the time they do.

Sources

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