HIGHLIGHTS:
- The U.S. Department of the Treasury issued a second tranche of proposed regulations to implement and clarify the new Opportunity Zone Tax Incentive.
- These regulations expand previous guidance issued last October related to the operations of a Qualified Opportunity Fund and the conduct of a trade or business in an Opportunity Zone.
- This alert highlights some of the important clarifications that will assist real estate owners and developers in structuring their projects to take advantage of the Opportunity Zone Tax Incentive.
The U.S. Department of the Treasury issued, on April 17, 2019, a second tranche of proposed regulations (the Second Tranche Regulations) implementing and clarifying the rules of the new Opportunity Zone Tax Incentive. The Second Tranche Regulations supplemented and revised the first tranche of implementing regulations released on Oct. 19, 2018 (the First Tranche Regulations). A public hearing on the Second Tranche Regulations has been scheduled for July 9, 2019, and a 60-day comment period commenced on May 1, 2019, when the Second Tranche Regulations were published in the Federal Register. At the same time as the Second Tranche Regulations were issued, the Internal Revenue Service (IRS) updated the FAQ posted on its website.
The Second Tranche Regulations round out and expand guidance provided in the First Tranche Regulations in connection with the operations of a Qualified Opportunity Fund (QOF) and the conduct of a trade or business in an Opportunity Zone. This alert highlights some of the important clarifications provided in the Second Tranche Regulations that will assist real estate owners and developers in structuring their projects to take advantage of the Opportunity Zone Tax Incentive. We address clarifications to the concepts of original use and substantial improvement, significant expansion of rules related to leasing and clarification of the favorable rules regarding working capital reserves.
For general background on the Opportunity Zone Tax Incentive, please refer to Holland & Knight's prior three-part series and our alert on the First Tranche Regulations.1
Qualified Opportunity Zone Business Property
The Second Tranche Regulations addressed a number of questions relating to the concepts of original use and substantial improvement, which are summarized below. The rules are important for determining whether a Qualified Opportunity Zone Business (QOZB) meets the tangible property test, which requires that at least 70 percent of a QOZB's tangible property be qualified opportunity zone business property (the 70 Percent Test). Although most of the rules apply to a QOZB in which a QOF has an ownership interest and to a QOF that directly acquires qualified opportunity zone business property, for ease of reference we refer here primarily to QOZBs.
Readers may recall that in order to qualify as qualified opportunity zone business property, the "original use" of the property must commence with the QOZB or the QOZB must substantially improve the property. Property is considered "substantially improved" if within a 30-month period after the acquisition of the property, the QOZB makes additions to basis with respect to the property that exceed the adjusted basis of the property at the beginning of the 30-month period.
Original Use
The Second Tranche Regulations for the first time provide a definition of the "original use" of tangible property, including both real and personal property. "Original use" is a critical term for determining if property qualifies as qualified opportunity zone business property. Under the Second Tranche Regulations, "original use" commences on the date the property is first placed in service within the opportunity zone for purposes of depreciation or amortization, or the property is first used in a manner that would allow depreciation or amortization if the taxpayer were the owner (in the case of leased property).
By defining "original use" in this way, the Second Tranche Regulations confirm that the QOZB can purchase construction in progress and can be considered the original user of the resulting building as long as the acquisition occurs before the building is completed and placed in service. If the building under construction is an entirely new building, therefore, the purchaser would not need to meet the substantial improvement test with respect to the building.
The application of this rule to the purchaser of a pre-existing building that has been partially renovated by a prior owner is less clear because the substantial improvement test must be met with respect to the building. If the building is purchased after the prior owner has met the substantial improvement test, but before the building has been placed in service for depreciation purposes, can the purchaser step into the shoes of the prior taxpayer as to the satisfaction of the substantial improvement test? What if the substantial improvement test has not been met? Can the purchaser step in the shoes of the prior owner as to work done prior to purchase and then complete the additional work necessary to meet the substantial improvement test? Although there are rules in other areas of the law (e.g., the historic rehabilitation tax credit and the low-income housing tax credit), providing for "step in the shoes" principles and even treating certain qualifying expenditures as a "separate new building," the Second Tranche Regulations do not give any specific answers to these questions.2
Original Use – Vacant Property
If tangible property has been unused or vacant for an uninterrupted period of at least five years, the Second Tranche Regulations provide that original use in the opportunity zone commences on the date after that period when any person first uses or places the property in service in the Opportunity Zone.3 Accordingly, the substantial improvement test would not need to be met by the purchaser of a building that meets the vacancy test.
Substantial Improvement – Unimproved Land
The First Tranche Regulations (together with the companion Revenue Ruling 2018-29) provided that if a QOZB acquires a piece of land with a building on it, the substantial improvement test is measured against the basis of the building alone and does not include the basis of land on which it sits. Indeed, the First Tranche Regulations note that the land itself does not have to be substantially improved to be treated as qualified opportunity zone business property.
The Second Tranche Regulations take this concept further by providing that vacant land acquired by a QOZB will satisfy the original use test and therefore does not have to be substantially improved in order to be treated as qualified opportunity zone business property, provided that the unimproved land is used in the QOZB's active trade or business.4
For example, under this new rule, it would appear that walking trails and other site improvements and amenities on land that support the operation of a resort hotel would qualify the land as used in the hotel owner's trade or business, and the land would thus be qualified opportunity zone business property. Use of land with minimal improvement by a parking lot operator should also qualify if it can be demonstrated that operating parking lots is the operator's trade or business. However, the Second Tranche Regulations contain an anti-abuse rule stating that the rule that land does not have to be improved to qualify as qualified opportunity zone business property cannot be relied upon "if the land is unimproved or minimally improved and the QOZB purchases the land with an expectation, an intention, or a view not to improve the land by more than an insubstantial amount within 30 months after the date of purchase." This rule is apparently intended to prevent acquisition of land with the sole goal of holding it for later sale (sometimes referred to as land banking). An example provided in the preamble to the Second Tranche Regulations postulates the acquisition of agricultural land currently used entirely for the production of a particular crop, whether active or fallow at the time of purchase. The preamble notes that, without improvement, the property could qualify if it is used in the taxpayer's trade or business. However, this result may be deemed abusive if a "significant purpose" for acquiring the land was to achieve an inappropriate tax result. In a situation like this, the taxpayer would be wise to take steps to improve the land (although we do not know what qualifies as "by more than an insubstantial amount") and demonstrate a level of economic activity consistent with increasing the economic value of the business.
Substantial Improvement – Asset-by-Asset Test
Prior to the Second Tranche Regulations, commentators had requested that the substantial improvement test be applied to the basis of QOZB assets on an aggregate basis. The request was thought to be particularly necessary for operating businesses. In addition, real estate projects may involve multiple buildings on one site, some of which may need substantial renovation and others of which only need cosmetic attention. If the substantial improvement test could be met on an aggregate basis by spreading the aggregate improvement costs over the aggregate basis of all buildings, it may be possible to qualify all of the buildings where expenditures on a building-by-building basis would result in some buildings not meeting the test. Similarly, improvements that do not add to the building's basis – such as FF&E for a charter school – may still substantially improve the overall project, and it can be argued that, from a policy perspective, they also should be included in the numerator of the substantial improvement test.5 Unfortunately, the Second Tranche Regulations did not adopt an aggregate test for substantial improvements and instead provided for an asset-by-asset approach. This is disappointing because, at 100 percent of the cost basis of an asset subject to the substantial improvement test, the substantial improvement rule represents a very high bar. The rule can present even more difficulties in the context of an operating business, where personal property may be a significant part of the business and may be harder to improve.
Property Straddling an Opportunity Zone
The Second Tranche Regulations contain a new rule for property that straddles an opportunity zone and a contiguous non-opportunity zone census tract. The rule provides that if the portion of a parcel that is located in the opportunity zone is "substantial" in comparison to the portion that is located in a contiguous non-opportunity zone tract (based on "square footage"), then the property will be treated as if it were entirely in the Opportunity Zone. The regulation itself does not define "substantial" for this purpose, but the preamble of the Second Tranche Regulations states that if the unadjusted cost of the portion of the parcel within the Opportunity Zone exceeds the unadjusted cost of the portion of the parcel outside the Opportunity Zone (but in a contiguous tract), then the property will be treated as though it were entirely in the opportunity zone. The relative cost requirement may be intended to prevent a taxpayer from purchasing a contiguous parcel in order to qualify the contiguous parcel as an Opportunity Zone property by combining it with the Opportunity Zone property.
It is unclear why the Treasury Department did not include the definition of "substantial" in the regulation itself, and it is also unclear whether the definition provided in the preamble is intended to be relied upon.
Finally, it should be noted that because the straddling rule is part of the definition of a QOZB, the leeway granted can only be relied on for an indirect investment by a QOF in a QOZB, not where a QOF acquires qualified opportunity zone business property directly.6
Leasing Rules
The Second Tranche Regulations includes a significant suite of very helpful rules for how leases of property in an Opportunity Zone can comply with the Opportunity Zone Law. This is very helpful, because the law itself contains only one reference to leases and there was substantial confusion about how the rules would apply to leased property.
A subset of the new leasing rules relates to when a QOZB whose business activity involves leasing property to one or more tenants is conducting an active trade or business (in this case, the QOZB is the landlord). Another subset relates to QOZBs that acquire their qualified opportunity zone business property pursuant to a lease (in this case, the QOZB is the tenant). Both sets of rules are described below.
Leases for QOZB Landlords
The Second Tranche Regulations provide that Code Section 162 is the starting point for determining if any entity is conducting a trade or business. The Opportunity Zone law further requires that a QOZB must be conducting an active trade or business. The Second Tranche Regulations clarify that the ownership and operation (including leasing) of real property does constitute the active conduct of a trade or business. Accordingly, the development and leasing of an apartment complex, an office building or a mixed-use project should constitute an active trade or business, presumably even if management of the property is delegated to a property management agent. However, the Treasury Department clarified that "merely" entering into a triple net lease with respect to property owned by the taxpayer is NOT the active conduct of a trade or business. This rule may be directed at a long-term triple net lease of an entire building to a single credit-worthy tenant entered into based primarily on the credit of the tenant, where the entire risk and reward of the business operation effectively resides in the tenant. However, it does appear that there is room to shift some of the operating responsibility and risk to the landlord in order to distinguish a single tenant lease from a classic triple net lease arrangement. In addition, if a project involves multiple short-term leases on a triple net basis in a multi-tenant building, it should be possible to satisfy the active business requirement by demonstrating that the landlord has active property management and leasing/releasing functions that can be distinguished from a classic triple net lease of a single building.
Leases for QOZB Tenants
The Second Tranche Regulations expansively (and favorably) address the terms on which a QOZB may acquire qualified opportunity zone business property and conduct its trade or business under a lease instead of an ownership structure.
Under the new rules, a QOZB may lease property, even from a related party, provided that the lease is 1) entered into after Dec. 31, 2017 and 2) is on arm's length, market terms in the locality that includes the Opportunity Zone. For a determination of market terms, the rules refer to Code Section 482, which contains extensive rules on arrangements, including leases, between related or controlled parties. In the case of a related party lease, it is sensible to assume that a market study or valuation will be needed to substantiate that the lease is on arms-length terms. On the other hand, if the lease is between unrelated parties, a separate market rate analysis may seem superfluous, but should not be difficult to obtain.
The leasing rules also contain an anti-abuse rule providing that if there is "plan, intent, or expectation" at the time a lease is entered into for the real property to be purchased at less than the fair market value of the property determined at the time of purchase, without regard to any prior lease payments, the leased property does not qualify as qualified opportunity zone business property, regardless of whether the lease is between related parties.
Under the new rules, there are two limitations on a lease from a related party: 1) there can be no repayment of rent for a period exceeding 12 months, and 2) if the original use of leased tangible personal property does not commence with the lessee, the lessee must, within 30 months, become the owner of tangible property that is qualified opportunity zone business property having a value not less than the value of the leased tangible personal property. In the latter case, there must be substantial overlap between the zone in which the property so acquired is used and the zone which the taxpayer uses the leased property.
The original use of leased property in an opportunity zone commences on the date the property is first placed in service for depreciation purposes (or first used in a manner that would allow depreciation or amortization if the person were the property's owner). Unlike in the case of tangible property owned in fee, there is no requirement that leased property be substantially improved if it has been previously placed in service by a prior owner.
Notably, the rules provide that improvements to leased property satisfy the original use requirement and are treated as purchased for the amount of the adjusted cost basis of such improvements. The new vacant property rule applies to leased property as well, so original use of a vacant building that is leased by the QOZB commences on the date it would have been placed in service if it was owned by the tenant.
Lease Valuation Rules
There are special rules for valuing leased property for purposes of the 70 Percent Test. Leased property may be valued 1) based on the value of the leased property set forth on an applicable financial statement [within the meaning of Code Section 1.475(a)-4(h)] for the relevant reporting period, or 2) based on a calculation of the present value of the leased property. For purposes of this rule, the present value of the lease property is equal to the aggregate of the present values of all future lease payments measured using a discount rate equal to the applicable federal rate. The Second Tranche Regulations provide that a QOZB using the present value calculation method to value leased property must calculate the present value of such leased property at the time the lease is entered into and, once measured, such present value is used as the value of the leased property for all applicable testing dates.
Working Capital Reserves – Delay Due to Governmental Inaction Tolls 31-Month Period
A QOZB is not allowed to have cash reserves in excess of five percent of its assets unless the reserves represent reasonable working capital. To address concerns that this standard would be unduly burdensome on real estate development projects and start-up businesses and to relieve the pressure on QOFs that need to quickly invest their cash into QOZBs early in their development process, the First Tranche Regulations provided a "working capital reserve safe harbor" that was broadened by the Second Tranche Regulations. Compliance with the working capital safe harbor ensures that reserves will be treated as reasonable working capital.
The safe harbor is contingent on the QOZB: 1) designating the working capital assets in writing for the development of a trade or business in a qualified opportunity zone, including (when appropriate) the acquisition, construction and/or substantial improvement of tangible property in an Opportunity Zone, 2) maintaining a written schedule that projects the proposed use of the reasonable working capital reserves in developing the respective project or business over a period not to exceed 31 months, and 3) actually using the reasonable working capital reserves in a manner that is substantially consistent with the designation of and plan for working capital reserve and written schedule for the proposed use of the working capital reserve.
Compliance with the safe harbor results in three additional safe harbors: 1) any income earned by the QOZB during the 31-month working capital period is deemed to be generated for a QOZB's active trade or business, 2) the use of intangible property requirement is deemed satisfied during the working capital period and 3) amounts in the reserve are treated as qualified opportunity zone business property during the working capital period even though they have not yet been "consumed" into the working capital assets they are expected to become. The Second Tranche Regulations clarified that if consumption of the working capital reserves is delayed by waiting for governmental action the application for which is complete, such delay should not cause the failure of the requirement to use the working capital reserves within 31 months. This change is particularly useful for real estate developers concerned that the 31-month time period for the consumption of the reasonable working capital reserves would not be sufficient to secure all required permits for their respective project. The Second Tranche Regulations also confirmed that a single QOZB may have multiple sequential or overlapping working capital reserves, as long as each complies with the safe harbor requirements independently.
Notes
1 Holland & Knight previously published a three-part series describing the powerful new tax incentive contained in the Tax Cuts and Jobs Act for investments in low-income communities designated as "Opportunity Zones."
In Part 1 of that series, we discussed the new tax incentive generally and explained the process for designation of Opportunity Zones for the 10-year period. In Part 2, we discussed the requirements for formation and certification of a Qualified Opportunity Fund and the rules governing its operations. Finally, in Part 3, we discussed the benefits for investing taxpayers, namely the deferral or partial exclusion of gain from the sale or exchange of an asset by a taxpayer who invests in a Qualified Opportunity Fund, as well as the potential exclusion of gain from disposition of an investment in a Qualified Opportunity Fund. In a fourth alert, we highlighted the clarifications provided by the U.S. Department of the Treasury and the IRS on Oct. 19, 2018, through issuance of the First Tranche Regulations and related materials.
2 The leasing rules in the Second Tranche Regulations do provide that improvements to leased property satisfy the original use requirement and are treated as purchases for the adjusted cost basis of the improvements. Thus, in the case of leased property, it appears that the concept of treating improvements to an existing building as a separate asset is acknowledged.
3 Also, note that under the new "original use" rules, used tangible property satisfies the original use requirement if it has not previously been used or placed in service in the Opportunity Zone. Accordingly, used business assets can be moved into an Opportunity Zone and treated as originally used in the zone. However, if the transferred assets have been previously used or placed in service in the Opportunity Zone before they are acquired by purchase, they must be substantially improved.
4 The Second Tranche Regulations also clarified that the term "trade or business" is used in accordance with its meaning under Section 162 of the Internal Revenue Code.
5 Indeed, as many commentators have pointed out, the substantial improvement test requires additions "with respect to" the building, which seems broader than merely adjustments to the building basis.
6 The rule on straddling is framed as a clarification of the requirements of Section 1400Z-(2)(d)(5), which incorporates three concepts from Code Section 1397C into Section 1400Z-2: 1) 50 percent of a QOZB's gross income must be generated with the Opportunity Zone, 2) substantially all of the QOZB's intangible property must be located in the Opportunity Zone and 3) the prohibition on non-qualified financial property that exceeds 5 percent of the aggregated unadjusted basis of the QOZB's assets. Although the straddling rule refers to the location of tangible property as a key part of the straddling analysis, the tangible property rule is not one of the Section 1397C rules pressed into service under Section 1400Z-2(d)(5). Although common sense supports a rule that is based on location of a tangible property owned by a QOZB, the rule as written does not fit well into the statutory framework.
