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Final regulations are out (finally!) and it’s mostly good news for OZ investors. We’ll do this in bullet point format as that makes the most sense to me. I’m also going to assume you have at least a passing familiarity with Opportunity Zones, apologies in advance if you’ve been ignoring everything OZ related for the last 2 years. Anyway, here we go starting with the most impactful:
THIS ONE IS BIG – A sale of the assets by an OZ Fund will now escape depreciation recapture. This means for real estate funds that there is no longer a disparity between a sale of the equity and a sale of the underlying assets.
The IRS fixed the Sec. 1231 gain issue, so now gains are viewed on a sale-by-sale basis, not on an aggregate basis. This means that an investor 1) no longer has to wait until the end of the year in order to determine if they have a qualifying gain and 2) can potentially invest more in OZs since losses are not offset against gains. Quick refresh – Sec. 1231 gains are gains from the sale property used in a trade or business instead of “pure” capital assets. Think rental real estate (Sec. 1231) vs. Amazon stock (capital asset).
The IRS provided clarity around what happens when someone dies, and their heirs inherit an OZ investment. It’s a double-edged sword – the investment is still qualified for the 10-year OZ tax benefit, but there is no normal basis step-up at death.
Significant clarity around “Original Use” of assets has been provided. In general, if something has not been placed in service and depreciated, then it may still qualify as the “Original Use” of the asset. This includes new buildings, though the IRS declined to provide a bright-line test to determine placed-in-service, and specifically rejected the Certificate of Occupancy as the test for placed-in-service.
Not everything in the regulations was good, but there is at least some clarity around several items:
Neither contributions of property to an OZ fund nor improvements made to that contributed property can ever be Qualified Opportunity Zone Property. This means that existing land owners cannot contribute their land to an OZ Fund. It must be acquired by the QOF via purchase.
There is a broad anti-abuse provision that allows the IRS to recast abusive transactions as non-OZ qualified. The best advice here is to act within the spirit of the law as well as to conform with the technical requirements.
A Profits Interest or Carried Interest of a fund sponsor is not eligible for the OZ tax benefits. Special care and analysis should be given to situations where the fund sponsor is also a direct investor in the QOF. Otherwise non-taxable distributions may become taxable without proper structuring.
Blogs are short. These regulations are not (544 pages). Let’s chat if you have more questions on OZ investing and the impact of these final regulations. Call me (Brendan) at 425-283-5831.