Treasury Provides Additional Clarity on Opportunity Zones by Issuing Second Round of Proposed Regulations
On April 17, 2019, the U.S. Department of the Treasury issued its second set of proposed regulations (the “New Regs”) regarding investments in qualified opportunity zones, a federal tax benefit provided by the Tax Cuts and Jobs Act of 2017. Although the first set of proposed regulations, issued in October of 2018 (“Initial Regs”), addressed several matters that pertain to the initial investment in, and the creation of, a qualified opportunity fund (“QOF”), many questions were left unanswered. Within the 169 pages of guidance, the New Regs clarify several terms, such as what constitutes “substantially all”, the use of qualified opportunity zone business property (including leased property) in a qualified opportunity zone, the “reasonable period” for a QOF to reinvest proceeds from the sale of qualifying assets, and what transactions comprise an inclusion event that would lead to the recognition of deferred gain in gross income. The focus of this Tax Alert is to provide you with some key highlights from the New Regs while briefly restating some of the prior rules in order to enable investors, fund managers, and others who are interested in understanding the rules pertaining to investments in qualified opportunity zones.
Summary of Certain Significant Provisions
Defining “substantially all” in areas not previously covered
Original use flexibility with a five-year vacancy rule
Leased assets versus owned assets
50% gross income test -three safe harbors and a facts and circumstances catchall
Details and clarification on the working capital safe harbor
Investing capital on a more flexible timeline
Assets that straddle Opportunity Zone geography
One-year grace period to sell assets and reinvest the proceeds, thus avoiding penalties intended to prevent funds from sitting on cash
Investors who have at least a 10 year holding period – even if the fund didn’t own the asset for a full decade - qualify for special tax treatment
Investors in opportunity zones are able to inject capital into low-income communities with the hope that these investments will promote long-term economic growth within the community. Investors with taxable capital gains from the sale or exchange of property may reinvest the gain in a QOF within 180 days of the sale or exchange. In doing so, investors may receive significant tax benefits such as: (1) tax deferral for capital gain invested in a QOF, (2) potential elimination of up to 15% of the tax on the capital gain that is invested in the QOF, and (3) potential elimination of tax when exiting a QOF investment. The gain is deferred until the earlier of the date when the investment is sold or exchanged or December 31, 2026.
Operation as a QOF
A QOF is defined in the statute as an investment vehicle organized domestically as a corporation or partnership for the purpose of investing in qualified opportunity zone property (“QOZP”) and that holds at least 90% of its assets in QOZP. A QOF cannot invest in another QOF but it can have an equity investment in corporations or partnerships that operate one or more qualified opportunity zone businesses (“QOZB”) so long as the equity interest was acquired after December 31, 2017 solely in exchange for cash.
The QOF must have tangible property that is used in a trade or business and:
(1) the property is acquired by purchase from an unrelated party (using a 20% related party test instead of 50%) after December 31, 2017;
(2) EITHER (a) the original use of the property in the zone commences with the QOF (or the QOZB) or (b) the QOF (or QOZB) substantially improves the property; and
(3) during substantially all of the holding period for the property, substantially all of the use of the property is in the zone.
Prior to the New Regs, some of the terms above were not defined or were unclear. As indicated in the italics the term “substantially all” is used twice. The Initial Regs only defined the term “substantially all” in the context of use of the property to mean 70%. The term “substantially all” in the context of the holding period of the property was not defined in the statute or in the Initial Regs. The New Regs reaffirm the “substantially all” requirement for the use of the tangible business property to mean that at least 70 % of the property must be used in a qualified opportunity zone. The New Regs define the “substantially all” requirement for holding period requirements to have a different percentage interest by requiring that tangible property must be qualified opportunity zone business property for at least 90% of the QOF’s or QOZB’s holding period. The New Regs indicate that the higher percentage threshold in the holding period context is warranted because taxpayers are more easily able to control and determine their holding period.
The New Regs provide clarity on the requirement that tangible property acquired by purchase has its “original use” commencing with QOF or QOZB, or be substantially improved. The New Regs provide that the “original use” of tangible property acquired by purchase by any person commences on the date when that person or a prior person first places the property in service in the qualified opportunity zone for purposes of depreciation or amortization (or first uses the property in the qualified opportunity zone in a manner that would allow depreciation or amortization if that person were the property’s owner). Thus, tangible property located in the qualified opportunity zone that is depreciated or amortized by a taxpayer other than the QOF or QOZB would not satisfy the original use requirement of section. The New Regs further provide that tangible property (other than land) located in the qualified opportunity zone that has not yet been depreciated or amortized by a taxpayer other than the QOF or QOZB would satisfy the original use.
Importantly, the New Regs provide that where a building or other structure has been vacant for at least five years prior to being purchased by a QOF or QOZB, the purchased building or structure will satisfy the original use requirement.
In addition, land is treated as qualified opportunity zone business property if it is used in a trade or business of a QOF or QOZB. However, the New Regs clarify that holding of land for investment itself does not give rise to a trade or business and such land could not be qualified opportunity zone business property.
Treatment of Leased Tangible Property
The New Regs allow leased tangible property that meets certain criteria to count as qualified zone business property for purposes of satisfying the 90-percent asset test and the substantially all requirement. The leased tangible property must be acquired under a lease entered into after December 31, 2017 and substantially all of the use of the leased tangible property must be in a qualified opportunity zone during substantially all of the period for which the business leases the property. Unlike owned tangible property, there is no original use requirement with respect to leased tangible property. Furthermore, unlike tangible property that is purchased by a QOF or QOZB, the New Regs do not require that leased tangible property be acquired from an unrelated party.
The New Regs, however, impose other conditions on leased tangible property. First, the New Regs require in all cases, that the lease under which a QOF or QOZB acquires rights with respect to any leased tangible property must be a “market rate lease,” which is an arms-length market price in that relevant locale Second, if the parties are related, the New Regs do not permit leased tangible property to be treated as QOZBP if, in connection with the lease, a QOF or QOZB at any time makes a prepayment to the lessor relating to a period of use of the leased tangible property that exceeds 12 months. Third, when the lessor and lessee are related, the lessee must become the owner of tangible property that is QOZBP and that has a value not less than the value of the leased personal property. The acquisition of this property must occur during a period that begins on the date that the lessee receives possession of the property under the lease and ends on the earlier of the last day of the lease or the end of the 30-month period beginning on the date that the lessee receives possession of the property under the lease. There must be substantial overlap of zone(s) in which the owner of the property so acquired uses it and the zone(s) in which that person uses the leased property. By way of example, let’s assume that Paul owns tangible property in 2019. Paul uses that property within a qualified opportunity zone. In March of 2021, his brother, John, enters into a lease with Paul to use that same tangible property at the applicable fair market value rate for use in the same opportunity zone as his brother. The New Regs would permit John and Paul to engage in this transaction provided that John buys the property outright from Paul within 30 months of taking possession of the property (i.e. within 30 months of March 2021). However, under the New Regs, John is prohibited from prepaying his lease term for more than 12 months.
The New Regs also provide for an anti-abuse rule to prevent the use of leases to circumvent the substantial improvement requirement for purchases of real property (other than unimproved land). In the case of real property (other than unimproved land) that is leased by a QOF, if, at the time the lease is entered into, there was a plan, intent, or expectation for the real property to be purchased by the QOF for an amount of consideration other than the fair market value of the real property determined at the time of the purchase without regard to any prior lease payments, the leased real property is not qualified opportunity zone business property at any time.
The New Regs added clarity to the requirements for business operations. To qualify as a QOF, it must have a trade or business where at least 50% of the entity's total gross income is derived from the active conduct of that business. The New Regs cite the rules under section 162 for determining the existence of a trade or business. However, the New Regs further provide that the ownership and operation (including leasing) of real property used in a trade or business is treated as the active conduct of a trade or business for opportunity zone purposes.
Furthermore, the requirement that at least 50% of income be derived from the active conduct of a trade or business is clarified by providing three safe harbors in addition to a facts and circumstances test for determining whether sufficient income is derived from a trade or business in a qualified opportunity zone for purposes of the 50% test. The first safe harbor in the proposed regulations requires that at least 50% of the services performed (based on hours) for such business by its employees and independent contractors (and employees of independent contractors) are performed within the qualified opportunity zone. The second safe harbor is based upon amounts paid by the trade or business for services performed in the qualified opportunity zone by employees and independent contractors (and employees of independent contractors). Under this test, if at least 50% of the services performed for the business by its employees and independent contractors (and employees of independent contractors) are performed in the qualified opportunity zone, based on amounts paid for the services performed, the business meets the 50% gross income test. The third safe harbor is a conjunctive test concerning tangible property and management or operational functions performed in a qualified opportunity zone, permitting a trade or business to use the totality of its situation. The proposed regulations provide that a trade or business may satisfy the 50% gross income requirement if (1) the tangible property of the business that is in a qualified opportunity zone and (2) the management or operational functions performed for the business in the qualified opportunity zone are each necessary to generate 50% of the gross income of the trade or business. Finally, taxpayers not meeting any of the other safe harbor tests may meet the 50% requirement based on a facts and circumstances test if, based on all the facts and circumstances, at least 50 % of the gross income of a trade or business is derived from the active conduct of a trade or business in the qualified opportunity zone.
Working Capital Safe Harbor
As mentioned above to operate as a QOF, at least 90% its assets must consist of QOZP. The Initial Regs provide for a working capital safe harbor to count towards the 90% asset test. The working capital safe harbor applies to cash and certain cash equivalents held by a QOZB, provided that the following conditions are met: (i) the QOZB designates the use of such working capital assets for the acquisition, construction, and/or substantial improvement of tangible property in a Qualified Opportunity Zone; (ii) there is a written schedule consistent with the ordinary start-up of a trade or business for the expenditure of the working capital asset that shows that the working capital assets will be spent within 31 months of the receipt by the business of the asset; and (iii) the working capital assets are actually used in a manner consistent with the written records described in clauses (i) and (ii).
The New Regs make two changes to the safe harbor for working capital. First, the written designation for planned use of working capital includes the development of a trade or business in the qualified opportunity zone as well as acquisition, construction, and/or substantial improvement of tangible property. Second, the New Regs provide an exception to the 31-month period if the delay is attributable to waiting for government action the application for which is completed during the 31-month period.
Relief with Respect to the 90% Asset Test for Newly Contributed Assets
The New Regs provide relief for new QOF’s seeking assets. Failure to satisfy the 90% asset test on a testing date does not by itself cause an entity to fail to be a QOF. The New Regs allow a QOF to apply the test without taking into account any investments received in the preceding 6 months. The QOF’s ability to do this, however, is dependent on those new assets being held in cash, cash equivalents, or debt instruments with term 18 months or less.
Concerns were raised regarding location of property over several tracts, some of which were within an opportunity zone, and some which were not. The New Regs address this concern by looking to the Empowerzone statutes for guidance which provide that if the amount of real property based on square footage located within the qualified opportunity zone is substantial as compared to the amount of real property based on square footage outside of the zone, and the real property outside of the zone is contiguous to part or all of the real property located inside the zone, then all of the property would be deemed to be located within a qualified zone. The New Regs use this approach by stating that real property located within the qualified opportunity zone should be considered substantial if the unadjusted cost of the real property inside a qualified opportunity zone is greater than the unadjusted cost of real property outside of the qualified opportunity zone.
The New Regs define the length for a reasonable period of time to reinvest the return of capital from investments in qualified opportunity zone stock and qualified opportunity zone partnership interests, and to reinvest proceeds received from the sale or disposition of qualified opportunity zone property. The New Regs provide that a QOF has 12 months from the time of the sale or disposition of qualified opportunity zone property or the return of capital from investments in qualified opportunity zone stock or qualified opportunity zone partnership interests to reinvest the proceeds in other qualified opportunity zone property before the proceeds would not be considered qualified opportunity zone property with regards to the 90% asset test. A QOF may reinvest proceeds from the sale of an investment into another type of qualifying investment.
Recognizing Gain: Inclusion Events
The New Regs provide a nonexclusive list of inclusion events resulting in recognition of the deferred gain because the event would reduce or terminate the QOF investor’s qualifying investment for Federal income tax purposes or in the case of distributions would constitute a “cashing out” of the QOF investor’s qualifying investment. As a result, the QOF investor would recognize all, or a corresponding portion, of its deferred gain. Some of the inclusion events lists are as follows:
A taxable disposition (for example, a sale) of all or a part of a qualifying investment (qualifying QOF partnership interest) in a QOF partnership or of a qualifying investment (qualifying QOF stock) in a QOF corporation;
A taxable disposition (for example, a sale) of interests in an S corporation which itself is the direct investor in a QOF corporation or QOF partnership if, immediately after the disposition, the aggregate percentage of the S corporation interests owned by the S corporation shareholders at the time of its deferral election has changed by more than 25 percent. When the threshold is exceeded, any deferred gains recognized would be reported;
In certain cases, a transfer by a partner of an interest in a partnership that itself directly or indirectly holds a qualifying investment;
A transfer by gift of a qualifying investment;
The distribution to a partner of a QOF partnership of property that has a value in excess of basis of the partner’s qualifying QOF partnership interest;
A redemption of qualifying QOF stock that is treated as an exchange of property for the redeemed qualifying QOF stock under section 302; and
Certain liquidations of a QOF corporation.
Although transfers by reason of death will terminate the owner’s qualifying investment, the Treasury Department and the IRS have concluded that the distribution of the qualifying investment to the beneficiary by the estate or by operation of law is not deemed an inclusion event.
Special Election for Direct Investors in QOF Partnerships and QOF S Corporations and REITs
For investments held for at least 10 years, an investor that is the holder of a direct qualifying QOF partnership interest or qualifying QOF stock of a QOF S corporation may make an election to exclude from gross income some or all of the capital gain from the disposition of qualified opportunity zone property reported on Schedule K-1 of such entity, provided the disposition occurs after the investor’s 10 year holding period. To the extent that such Schedule K-1 separately states capital gains arising from the sale or exchange of any particular capital asset, the investor may make an election with respect to such separately stated item. To be valid, the investor must make such election for the taxable year in which the capital gain from the sale or exchange of QOF property recognized by the QOF partnership or QOF S corporation would be included in the investor’s gross income, in accordance with applicable forms and instructions. If an investor makes this election with respect to some or all of the capital gain reported on such Schedule K-1, the amount of such capital gain that the investor elects to exclude from gross income is excluded from income for purposes of the Internal Revenue Code and the regulations thereunder.
Even with this election, an investor in a QOF may want to consider selling interests in the QOF rather than relying upon this election as this election by its terms only applies to capital gains and not gains from the sale that are taxed as ordinary income.
A similar rule permits QOFs that are REITs to designate capital gain dividends attributable to long-term gains from the sale of qualified opportunity zone property and to allow qualifying shareholders who have held the stock in the REIT for the applicable ten-year period to exclude the gain from income.
Under the New Regs, the government reserves the right to disqualify the transaction (or series of transactions) from receiving the tax benefits for the opportunity zone investment if a significant purpose of the transaction (or series of transactions) is to achieve a tax result that is inconsistent with the statutory purposes of QOFs. Any such determination by the IRS will be made on the basis of all the facts and circumstances of a given transaction. This type of anti-abuse provision is consistent with the traditional anti-abuse provisions used by the IRS in other tax areas.
Although not discussed in any detail above, the New Regs provide guidance on many other areas including issues pertaining to consolidated groups, the length of holding periods in a qualifying investment, the safe harbor for testing use of inventory in transit for purposes of determining whether substantially all of the tangible property is used in the qualified opportunity zone, valuation of leased tangible property, qualification of transferring property other than cash to a QOF in a carryover basis transaction, timing of basis adjustments, partnership mixed-funds investments, and applicability of rules to S corporations.
The New Regs are a welcomed step in the right direction to providing clarity on investments and operations in opportunity zones. Nevertheless, additional items continue to remain unresolved. The issue of interim gains at the fund level is still unknown. In addition, there are no reporting requirements that would allow the IRS to assess penalties on those who violate the rule. Treasury is expected to continue to issue guidance and hopefully many of these items will likely be included and resolved.