The IRS issued final QOZ regulations at the end of 2019, almost two years after Qualified Opportunity Zones (“QOZs”) were introduced to investors in the 2017 Tax Cuts and Jobs Act. For a more detailed explanation of Qualified Opportunity Zones please click here. These regulations finalized the proposed regulations. While the final regulations largely follow the proposed regulations that were issued in October 2018 and May 2019, some important revisions were made. Some of these notable changes are highlighted below.
1. QOF Reinvestments
Under the proposed regulations, a Qualified Opportunity Fund (“QOF”) was permitted to reinvest proceeds from a sale of its qualified property only if the QOF sold all of its qualified property and reinvested the gain in other qualified property within 12 months of the sale. The final regulations allow a QOF to reinvest proceeds even if the QOF disposes of only part of its qualified property.
2. Section 1231 Gain
Property (including real property) used in a trade or business for more than one year is not a “capital asset,” but is instead “Section 1231 property.” If Section 1231 property is disposed of, a complicated netting process is used to determine the amount and character of the gain or loss for the year. Net Section 1231 gain is treated as capital gain, but net Section 1231 loss is deducted as ordinary loss.
Due to this netting process, a taxpayer with Section 1231 property gain was not allowed under the proposed regulation to contribute the Section 1231 gain to a QOF until the last day of the tax year. The final regulations allow a taxpayer to determine Section 1231 gain on a rolling basis. As a result, a taxpayer may contribute Section 1231 gain to a QOF as of the date of the disposition, even though the taxpayer may generate more Section 1231 gains and losses throughout the year.
3. Disposition of Property by Pass-Through Entities
Under the proposed regulations, a pass-through entity (e.g., LLC, partnership, or S corporation) that realized eligible gain could elect not to defer that gain by contributing it to a QOF, and instead pass such gain through to its owners. If an owner invested his or her share of such gain in a QOF, the owner could elect to start the 180-day investment period either on the date the gain was generated or the last day of the entity’s tax year. The final regulations retain these two options for when the 180-day investment period begins, and add a third option – the due date of the pass-through entity’s tax return for the year.
4. Substantial Improvement Requirement
Tangible property cannot qualify as Qualified Opportunity Zone Business Property (“QOZ Business Property”) unless it satisfies either the original use requirement or the substantial improvement requirement. The original use requirement is satisfied if the property is placed in service and depreciated for the first time in the QOZ. Property is substantially improved if new investments in the property double the property’s adjusted basis within 30 months of acquisition. The final regulations clarify that it is the adjusted tax basis of the property that must be doubled, and not the property’s original cost.
The final regulations also provide more flexibility in meeting the substantial improvement requirement. Taxpayers may purchase other original-use property to help satisfy the substantial improvement requirement so long as the original-use property improves the functionality of the non-original-use property and is used in the same trade or business. Certain expenses which are chargeable to the tax basis of land (such as environmental remediation or utility upgrades) may be added to the basis of the building on that land to help satisfy the substantial improvement requirement.
The final regulations allow a group of two or more buildings located on the same parcel or adjoining parcels of land to be treated as a single property, so that any additions to the basis of the buildings in the group can be aggregated to satisfy the substantial improvement requirement.
5. Original Use Requirement – Vacancy
Under the proposed regulations, the original use requirement would be satisfied if property were placed back in service after having sat vacant for at least five years. The final regulations reduce this vacancy period from five to three years if the property became vacant after the property was designated as a QOZ. If the property was vacant on the date the property was designated as a QOZ, the minimum vacancy period is only one year.
6. New 62-Month Working Capital Safe Harbor for Start-Up Businesses
The final regulations adopt the 31-month working capital safe harbor that was included in the proposed regulations, but provide some refinements. The final regulations create an additional 62-month safe harbor for start-up businesses.
7. Expiration of QOZ Designations
All QOZ designations expire on December 31, 2028. The final regulations clarify that if part of a taxpayer’s 10-year holding period occurs after that date, the expiration of the QOZ designation alone will not disqualify the taxpayer’s QOF investment from qualifying for the QOZ tax benefits.
8. Exclusion of Gain from Sale of Property by QOZ Business
Under the proposed regulations, gain would be excluded from income if QOZ property were sold by a QOF, but not if qualified property were sold by the QOF’s subsidiary. The final regulations provide that gains from the sale of qualified property by a QOZ business owned by a QOF may also be excluded from income.