Opportunity zone tax credits become even more attractive: Leased Property Qualifies for Opportunity Zone Tax Benefits
Taxpayers considering investing in an opportunity zone will be happy to hear of the recent guidance regarding leased property inside qualified zones. Taxpayers with December gains will want to quickly assess the possibility of an opportunity zone, given opportunity zone investments must be made within 180 days of a capital gain.
The most recent proposed regulations from the IRS regarding opportunity zones provide that leased property can qualify as opportunity zone business property. The regulations also warn taxpayers that they can lose their tax deferral benefits by certain transfers of their interests in a qualified opportunity fund (QO Fund).
Under the general rules, a QO Fund eligible for investor tax deferral must be an entity treated as a partnership or corporation for Federal tax purposes and must be U.S.-based (including U.S. territories). Funds are required to hold at least 90% of their assets in qualified property.
Market Rate Leases
The new guidance permits tangible property acquired after 2017 under a “market rate lease” to qualify as “qualified opportunity zone business property” if during “substantially all” of the holding period, “substantially all” of the use of the property was in a qualified opportunity zone. For this purpose, whether a lease is market rate requires an arms-length analysis. Also, if the lessor and lessee are related, the leased property won’t qualify if a QO Fund or business makes a prepayment to the lessor for a period of use that exceeds 12 months. Another rule requires that the lessee becomes owner of tangible property within a certain amount of time. The IRS also includes an anti-abuse rule to prevent the use of leases to circumvent the substantial improvement requirement for purchases of real property.
Clarification of “substantially all”
For trade or businesses operating in Opportunity Zones, the law requires that “substantially all” property of the business must be qualified property. A key part of the guidance clarifies the holding period and use requirements as follows:
- For use of the property, at least 70% of the property must be used in a qualified opportunity zone.
- For the holding period, tangible property must be qualified opportunity zone business property for at least 90% of the Fund’s or business’s holding period.
- The partnership or corporation must be a qualified opportunity zone business for at least 90% of the QO Fund’s holding period.
Deferred Gains Can Become Taxable
There are a few situations where deferred gains may become taxable if investors transfer their interest in a QO Fund. For example, if the transfer is done by gift, the deferred gain may become taxable. However, inheritance by a surviving spouse is not a taxable transfer, nor is a transfer upon death of an ownership interest in a QO Fund to an estate or a revocable trust that becomes irrevocable upon death. Because of these rules, it is important to plan not only for original investment in opportunity zones but also for dispositions of those interests.
What’s Coming Up Next
The IRS is working to address administrative rules for QO Funds that fail to maintain the required investment standards. The next rules will include information-reporting requirements for eligible taxpayers. The IRS also intends to revise Form 8996 for tax years 2019 and following. A QO Fund must file this form with its Federal income tax return for initial self-certification and for annual reporting of compliance with the 90-Percent Asset Test.
Not sure if a QO Fund makes sense in your personal situation? Reach out to the tax advisors at Frazier & Deeter to learn more.
Opportunity Zone Tax Benefits- The Opportunity Zone provision in the TCJA allows three possible tax benefits:
- Investors can defer capital gains from the sale of any asset by rolling gains over into a Qualified Opportunity Fund (QOF).
- Investors get a step-up in basis on the deferred gain of either 10% or 15% depending on how long they continue their investment in the Fund.
- Investors can get a permanent exclusion from gains on the appreciation of their interest in the Fund if they hold the investment for 10 years.
Click here for an article on the earlier regulations.