New regulatory guidance provides clarity for opportunity zone funds

The Treasury Department and Internal Revenue Service have released additional regulatory guidance regarding investment in Qualified Opportunity Zones, which were established as part of the Tax Cuts and Jobs Act of 2017.

The updated IRS guidance is “providing a lot of clarity,” says Derek Uldricks, head of capital formation for the Virtua Opportunity Zone Fund, sponsored by Virtua Partners. The fund, which launched in June, is among the first opportunity zone funds.

The new guidance clarifies that gains must be a capital gain to be eligible for tax deferral, explains Uldricks, and “depreciation recapture is not eligible.”

Partnership structures will be able to take advantage of the program. A statement from the Treasury Department and IRS notes: “In the case of a capital gain experienced by a partnership, the rules allow either a partnership or its partners to elect deferral. Similar rules apply to other pass-through entities, such as S corporations and their shareholders, and estates and trusts and their beneficiaries.”

In addition, it will be possible to reinvest capital and maintain the tax eligibility. This means a property will not have to be held for 10 years, but could be sold and the proceeds invested into another asset in a qualified opportunity zone.

“This changes the dynamic quite a bit,” says Uldricks.

Uldricks believes the regulations may give private equity fund vehicles “a leg up” compared with syndicated deals, as fund structures are likely to find it easier to manage the reinvestment of proceeds.

In addition, partners in pass-through entities may reinvest their share of an entity’s gains from asset sales, notes a commentary from law firm Stroock & Stroock & Lavan LLP: “The Proposed Regulations include special provisions by which gain recognized by a partnership may (except to the extent the partnership elects to rollover the gain itself) flow through to the partners and be reinvested by such partners into qualified opportunity funds.”

Another key provision will allow investors to hold assets for longer than 10 years — up to 20.5 years — and still maintain the tax eligibility. By pushing the “basis step-up” further into the future, investors will have a longer tax-deferred period.

The regulations also provide for a working capital safe harbor. Uldricks suggests this will “bring more capital to development deals,” as cash can meet the 90 percent test — the requirement that 90 percent of investments must be in qualified opportunity zone assets — for a safe harbor period of 31 months. Unlike acquisitions, development requires investment over a longer period of time, and this provision will make such investments easier.

An additional benefit of the regulatory guidance is that the clarity being provided will allow investors to grow more comfortable about the investment prospects. Although additional regulatory guidance may be forthcoming, “you can rely on what they’ve given now,” says Uldricks.

The new guidance has answered many of the questions investors had about investment in qualified opportunity zones, allowing them to make a more informed decision about the program’s potential.