On April 16, 2019, Treasury issued its second set of proposed regulations (“OZ Regs 2”) regarding Section 14002 of the Internal Revenue Code of 1986, as amended (the “Code”). The OZ Regs 2 are very helpful and answer a substantial number of questions left open in the initial set of Opportunity Zone (“OZ”) regulations. First, the bad news: while the new rules are generally taxpayer friendly, they contain one significant disappointment, a negative answer to both the triple net lease question, and a provision that applies the “Substantial Rehabilitation” test to property which is not originally used in an Opportunity Zone on an asset by asset basis as
opposed to an aggregate basis. The disappointment: gain from interim sales will be subject to tax. The OZ Regs 2 require that 100 percent of the proceeds of the sale must be reinvested in a qualified opportunity zone business (“QOZB”) within 12 months. As a result, the federal income tax liability must be funded from other sources, either outside the OZ structure or through debt within the structure. For example, a Qualified Opportunity Zone Partnership “QOZPS” could borrow before the sale, distribute the proceeds (not in excess of the basis of the QOF in the QOZPS), and then sell. The distributed loan proceeds could then be used to pay the tax on the
interim sale. The second disappointment is that it appears as that “mere” triple net leases do not qualify as an “active” Opportunity Zone business. While the OZ state that the leasing of real property constitutes an active business, triple net leasing of assets will not be treated as an active business. We will discuss triple net leasing and the substantial improvement issues in more detail
The OZ Regs 2 modified the initial OZ regulations by providing that cash received by a Qualified Opportunity Fund (“QOF”) will not be included in its assets for compliance purposes for the 6-month period after receipt. Accordingly, while the compliance testing dates are not changed, QOFs will have not less than 6 months to invest capital contributions. This is a substantial improvement to the prior rules.
The OZ Regs 2 have established rules that will facilitate multiple investments by a single QOF. When a QOF sells an asset after the 10-year holding period, the basis step-up to fair market value applies not only to the equity interests held by the QOF investors, but also to the assets held by the QOF. As a result, the QOF can sell its interest in a QOZPS or a QOZ corporation without recognizing gain on the sale. If the QOF sells a portion of its assets, say one of three QOZPS, and distributes the proceeds, the QOF investor can elect to exclude his portion of the gain on the percentage of the total assets held. Accordingly, while a purchaser interested in the QOZB assets would be forced to buy the equity interests of the QOZPS, that is a significant improvement over buying equity interests in two tiers of ownership entities. A possible solution to this issue in many of these transactions could be for the investor member QOF to sell its interest in the OZBPS to the managing member. The managing member would make an election to step-up the basis of the assets in the QOZPS, and following the step-up sell the assets to a third party purchaser.
While the OZ Regs 2 specifically state that the basis step-up is applicable to inventory and receivables, with no reference to depreciation, there is no tax or policy reason to treat depreciation differently than other “hot assets.” In this regard, the OZ Regs 2 specifically provide that FMV will be determined on a “gross basis” by including the outstanding principal of any debt with respect to the assets sold. So property purchased for $1 million, subject to $1 million of debt, worth a net $4 million at a 10-year disposition, would have a basis of $5 million for purposes of the sale. As a result, there would be no gain, and should be no depreciation recapture.
The OZ Regs 2 specifically address the consequences of debt-financed distributions. Such distributions are NOT “inclusion events” that trigger current tax of both the old deferred and new gain and reduce or eliminate the 10-year basis step-up PROVIDED THAT the amount of the distribution does not exceed the basis of the QOF investor AND is not recharacterized as a “disguised sale.” Distributions made with 2 years of the acquisition of an asset are presumed to be “disguised sales” under Treasury Regulations Section 1.707-5. Distributions which occur after the 2-year holding period are presumed to NOT be disguised sales, subject to a facts and circumstances analysis.
This rule would permit the distribution of cash to pay taxes due on the original sale which will become payable on December 31, 2026, provided that the QOZB could support the additional debt necessary to fund the distribution. It also means QOF investors could get a substantial amount of their invested cash back prior to the end of the 10-year holding period, as early as the conversion to permanent debt after a 2 plus year construction and lease up period.
Leased property counts as QOZBP if it is leased after December 31, 2017 and substantially all of its use occurs within the OZ. Leased property is not required to be substantially improved. All leased property must have “market rate” terms and, if leased from a related party, cannot include prepaid rent for terms longer than 12 months and the QOZPS must purchase property with a value equal to or greater than the leased property. If improved property is leased, neither the lessor nor the lessee can force the other to purchase the leased property at other than fair market value.
The OZ Regs 2 provide rules to value leased property. Taxpayers can elect to use the Treasury Regulations Section 1.475-4(h) valuation rules, or in the alternative, taxpayers can value leased property at the present value of the leased property, discounted at the applicable federal rate. The value is calculated at the time that the lease commences, and remains fixed thereafter.
The OZ Regs 2 provide rules to determine if an operating business is actively conducted within an OZ. The OZ Regs 2 provide 3 safe harbor tests, any one of which can be satisfied. The first safe harbor is that 50+% of the total hours of the QOZB employees and independent contractor are performed in the QOZ. It may be difficult to track the locations in which traveling employees will log their hours, to say nothing of the difficulty in obtaining and tracking independent contractor hours. The second safe harbor requires 50% of the “value” of employee and independent contractor hours to be performed within the OZ. The third safe harbor is satisfied when the management of the enterprise is located with am OZ and substantially all the property of the enterprise is local in the OZ. If none of the safe harbors are met, the taxpayer can apply a facts and circumstances to determine if the enterprise meets the income sourcing test. These tests should be able to be met by most operating businesses.
The OZ Regs 2 provide that the deferral of original gain to 2026 is terminated if the Taxpayer experiences an “inclusion event.” Inclusion events include disposition of the Taxpayer’s QOF interest, including gifts of QOF interests. Receipt of each distribution in excess basis is also an inclusion event.
A number of non-taxable transfers were excluded from the definition of an inclusion event. The contribution of a QOF interest to a partnership, and transfers of QOF interests pursuant to a corporate reorganization are not inclusion events. A transfer of an interest at death is NOT an inclusion event, including the transfer by the decedent to his estate and a transfer by a decedent’s estate to a beneficiary. Sales by the estate or by a beneficiary will not qualify for exclusion of gain even if the beneficiary holds the QOF interest for more than 10 years. A transfer of an interest to a disregarded LLC or to a granter trust does not constitute an inclusion event, but if the LLC becomes a regarded entity, or the grantor trust loses its grantor status, it triggers an inclusion event. Inclusion events may be partial, such as a transfer of 50% of the tax payer interest in a QOF, or may be a total transfer. Inclusion events that occur prior to 2026 not only accelerate the taxation of the portion of the QOF interest affected by the transaction but also terminate the possibility of the 10-year step-up in basis to FMV with respect to the affected portion.
There are several miscellaneous provisions in the OZ 2 Regs that are worth discussing. First, a building that is vacant for five years will be treated as originally used by its purchaser. Tangible property that was used outside the OZ and is brought into the OZ treated as “originally” used in the OZ. The definition of “substantially all” is 90% in the case of use of property within an OZ for “substantially all” of the time. With respect to intangible property, “substantial portion” means 40% of the use of such property must be in the OZ.
The OZ 2 Regs apply the “substantial improvement” test under an asset-by-asset method, not on an aggregate method. This approach makes compliance substantially more difficult. For example, if a QOZPS purchases a parcel of land containing 3 buildings, then the purchase price must be allocated among the three buildings and the rehabilitation of each of the three buildings must be substantial. We cannot discern a policy reason that supports the “asset-by-asset” approach. If the buildings function as a whole, but one building is in good condition and does not require a substantial rehabilitation to meet the requirement on an aggregate basis, the OZ economy and its residents would be benefitted by the project. The regulations should adopt an aggregate approach to the “substantial improvement” issue, and we recommend that a comment letter be prepared to advocate for that approach.
The initial OZ regulation established a 31-month period to expend the OZ proceeds in establishing an OZ property. The OZ 2 Regs extend the 31-month period where completion is delayed because of a delay in the issuance of a government permit. While an extension for cases in which the government is the cause of the delay is welcome, many other events beyond the control of the OZ business can cause delays that would also merit an extension.
The OZ 2 Regs provide that property may be transferred to a QOF in exchange for a QOF interest. While in some transactions a property transfer could be helpful, the transfer of property as opposed to cash from a QOF to a QOZPS does not qualify as QOZBP. Accordingly, it is not clear what can be done with any property contributed to a QOF.
Dan Kowalowsky, the Treasury person responsible for the OZ Program, spoke at the Denver, Novogradac OZ Conference and summarized the major provisions of the OZ Regs 2. His remarks clarified Treasury’s view of several issues, generally in a restrictive manner. First, he made clear that the receipt of QOF interests for services rendered does NOT qualify for OZ benefits. He specifically included “promotes” in his remarks and took a hard line on this issue. IRS and Treasury are not likely to adapt a narrow, technical approach to promotes, and will not permit strategies that would avoid taxation under Code Section 83 rules to be effective under the OZ Regulations.
Mr. Kowalowsky also stated that triple net leases do not constitute an active trade or business. Taxpayers will need to retain certain items of expense at the QOZB level, provide for percentage rent, or lease some reasonable portion of the property pursuant to on a non-triple net lease to establish an active business. The word “merely” is important here. Taxpayers must do something beyond execute a “mere” triple net lease” and collect rental payments. While the magnitude of “something” is not clear, we do not believe that the scope of “something” is not large.
In discussing post year 10 exits, Mr. Kowalowsky emphasized that the basis step-up for QOF assets did not extend to a lower tier QOZPS. As a result, QOFs will be forced to liquidate QOZPS or sell the QOZPS interests to the managing member of an LLC to avoid an asset sale at the entity level. Such a liquidation or interest, any could have the effect of triggering transfer taxes, recording fees and other transactional expenses. The conclusion that the post 10-year basis step-up does not extend to the assets of a QOZPS will impose a toll charge on the benefits of the OZ statute, and should be included in any comments provided to IRS and Treasury.
Finally, Mr. Kowalowsky ended speculation that a QOF could sell its entire interest in a QOZPS which would be sold after an additional 10 years, and be able to do a second step-up. Mr. Kowalowsky stated firmly that Treasury compiled the OZ statute to permit a single step-up to fair market value, a “one and done” approach.
In conclusion, the OZ 2 Regs were very helpful and should provide a solid foundation for closing OZ transactions. The scope of “unknowns” and “uncertainties” has been substantially reduced. While Treasury requested additional comments on almost 20 separate issues, it is not clear if any guidance beyond the finalization of both sets of proposed regulations will be forthcoming.
Opinions and conclusions in this post are solely those of the author unless otherwise indicated. The information contained in this blog is general in nature and is not offered and cannot be considered as legal advice for any particular situation. Any federal tax advice provided in this communication is not intended or written by the author to be used, and cannot be used by the recipient, for the purpose of avoiding penalties which may be imposed on the recipient by the IRS. Please contact the author if you would like to receive written advice in a format which complies with IRS rules and may be relied upon to avoid penalties.