Final opportunity zone regulations: key takeaways

The Department of Treasury recently released finalized opportunity zone (OZ) regulations, combining and revising two sets of proposed rules issued in October 2018 and May 2019 into a single regulatory package. The final regulations are comprehensive and generally taxpayer-favorable. For additional background and details regarding OZ and the proposed regulations.

The most significant takeaways from the final regulations are:

Additional types of gains excluded for investors with a 10-year holding period: The statute and proposed regulations allow taxpayers holding a qualified opportunity fund (QOF) interest for a requisite 10-year period to exclude any gain (1) from the disposition of the QOF interest itself, and (2) any capital gains arising from the QOF selling its qualified opportunity zone (QOZ) property, if the QOF is organized as a partnership or s corporation.

The difficulty presented by these options was that the only way to fully benefit from the income exclusion provision was to dispose of the taxpayer’s entire equity interest in the QOF. If a QOF disposed of its investment in a qualified opportunity zone business (QOZB), the taxpayer could elect only to exclude capital gain flowing through the QOF as a result of the transaction. However, any ordinary income or depreciation recapture would be subject to taxation.

Moreover, if the QOZB disposed of its assets, including qualified opportunity zone business property (QOZBP), the transaction would be fully taxable. This caused frustration among investors, project sponsors and practitioners alike, as the only sure-fire way to realize the full benefit of excluding any gain on exit was to set up multiple single-asset or single-project funds, creating organizational and compliance-related inefficiencies.

The final regulations address these issues by allowing eligible investors to exclude:

• Gains on sales of any property, with the exception of inventory, by the QOF and by any subsidiary QOZB, and
• Any ordinary income associated with such property sales.

Apart from the obvious benefit of allowing investors to exclude nearly all gains after achieving a 10-year hold, this provides critical flexibility in structuring QOZ deals. Specifically, a single QOF can now invest in multiple projects, falling in line with how a typical investment portfolio operates. In other words, the final regulations facilitate the creation of multi-asset QOFs.