Treasury Releases Final Opportunity Zones Regulations
On December 19th, 2019, the Treasury finalized guidance (the “Final Regulations”) for the Opportunity Zone (“OZ”) program which updates the previous regulations (collectively, the “Proposed Regulations”) that were laid out in October 2018 and April 2019. Surveying the commentary from leading Opportunity Zone law firms, a common refrain is that the Treasury’s general tenor remained constructive and taxpayer-friendly, an outcome that mirrors previous rounds of guidance.
Each round of additional guidance from the Treasury has been correlated with increased capital flows into Qualified Opportunity Funds (“QOFs”).1 We expect that the clarity provided by the Final Regulations should perpetuate and perhaps accelerate that trend in early 2020. As highlighted by the law firm King & Spalding, “although they contain many nuances and subtleties, the Final Regulations provide clarity and relative certainty on a number of issues crucial to both investors and businesses seeking the tax benefits of the QOZ program.”2 According to the Treasury’s Preamble, “the Treasury Department and the IRS anticipate that this clarity generally will encourage taxpayers to invest in QOFs and will increase the amount of investment located in QOZs.”3
In assessing the implications of the Final Regulations, these four key points stood out to us:
1. Exit structuring
A key area of uncertainty from the Proposed Regulations had centered on the required exit structure of QOFs. Based on previous guidance, most experts believed a sale of interests in a QOF was the form of exit that was certain to preserve the statute’s tax benefits, but interest sales can give rise to added to transactional costs and complicated fund structures.
The Final Regulations finally eliminate this lingering uncertainty and confirm the 10-year tax benefit will be available on any gain allocated to investors from the sale of underlying property owned by the QOF. This clarification will simplify previously complex exit provisions required for entity sales and also increase the feasibility of multi-asset fund structures.
2. Depreciation recapture
When the Treasury released the new Opportunity Zones guidance in April 2019, we wrote that investors would very likely benefit from eliminating depreciation recapture on Opportunity Zones investments:
“As it stands, the current regulations seem to allow investors the ability to avoid depreciation recapture within Qualified Opportunity Funds. This benefit could meaningfully increase the tax-equivalent IRR earned by investors. Cadre’s partnerships will be set up to benefit from this potentially favorable outcome.”
The Final Regulations clarify that all gains (excluding sale of inventory) by a QOF partnership or by a QOZ Business partnership are eligible for the capital gains exclusion. This means that ordinary gains, including depreciation recapture, are covered by the Final Regulations.
This is a very advantageous final result for investors that we will seek to capitalize on during our holding periods.
3. Partnership / K-1 gains flexibility
Investors generating capital gains through a partnership have multiple options when it comes to defining the 180-day period in which they can reinvest capital gains proceeds. The 180-day period either begins at the time of capital gain realization, or on the last day of the partnership’s taxable year.
Consider the below hypothetical example:
Christine is invested in a private equity fund that sold a portfolio company and made a large distribution at the end of January 2019. That distribution is now classified as a capital gain on Christine’s Schedule K-1 from the private equity fund. Applying the standard 180-day rule, Christine’s 180-day window would have expired in July 2019. However, given the gain was generated through a partnership, she can choose to start her 180-day clock at the end of the partnership’s taxable year. This election would give Christine until June 28th, 2020 to re-invest her capital gain.
The Final Regulations have added a third choice for the 180-day period, the 180-day period beginning on the date the partnership’s tax return is due, without extensions (generally March 15th).
As highlighted by Duval and Stachenfeld, “This last option was newly added in the Final Regulations, and it addresses the (very common) concern that most partners do not receive their K-1s for a taxable year until spring, or even summer, of the following year. So the new 180-day window aligns nicely with the full amount of time that other QOF investors have to decide whether to invest in a QOF.”4
4. 1231 gains flexibility
Similar to the K-1 gains outcome, Treasury also provided additional flexibility for investors seeking to re-invest Section 1231 capital gains (typically gains from the sale of property). April’s Proposed Regulations suggested that only the net 1231 gain for a given taxable year could be re-invested, which generally prevented re-investment until December 31st of a given year. Treasury consequently received many comments suggesting this was a draconian outcome for investors.
The Final Regulations deviate from the Proposed Regulations and provide that Section 1231 gains will be calculated on a gross basis, allowing for reinvestment at time of sale for an asset generating 1231 gains.
Taken together, the Final Regulations do not call for any material deviations from the strategy we’ve employed since the inception of our Opportunity Zones program, but should provide added flexibility for investors looking to participate.
Our team will continue to monitor updates to nuances within the Final Regulations that may arise as Opportunity Zone fund managers put these guidelines into practice, but we look forward to now focusing our attention on managing and sourcing qualifying investments on behalf of our investors.
As we look to 2020, we expect to remain active in pursuing new Opportunity Zone offerings, but as highlighted in previous updates, we will ensure the discipline and rigor associated with any new investment holds firm as potentially more firms compete for attractive projects.
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- Novogradac, December, 2019
- King and Spalding, December, 2019
- Department of the Treasury, December, 2019
- Duval and Stachenfeld, December, 2019