On April 17th, 2019, the U.S. Treasury Department (the “Treasury”) and the IRS issued a second set of long-awaited proposed regulations relating to Opportunity Zone (“OZ”) tax incentives. The OZ program was established by Congress as a part of the Tax Cuts and Jobs Act of 2017. After a first set of proposed regulations were issued in October of 2018, the Treasury left many unanswered questions for taxpayers interested in investing in OZs.
We provided two client alerts highlighting the first set of proposed regulations here and here . The new proposed regulations issued by the Treasury provide clarification on a number of key issues left open by earlier guidance:
- New “Substantially All” Tests
- The earlier regulations clarified the statutory requirement that “substantially all” of the tangible property owned or leased by an “Qualified Opportunity Zone Business” (“QOZB”) (i.e., a business operated in an OZ in which a Qualified Opportunity Fund (“QOF”) invests) be “Qualified Opportunity Zone Business Property” (“QOZBP”) (i.e, tangible property in the OZ) equated to at least 70% of such QOZBP being in the OZ.
- The statute also provides that in order to qualify as QOZBP in the hands of a QOF or QOZB during “substantially all” of the holding period of the QOZBP, “substantially all” of the use of such property must be in the OZ. The new regulations clarified these requirements as provided below:
i. For the holding period, “substantially all” is defined as 90% .
ii. In the context of use, “substantially all” is defined as 70% .
- Multi-Asset Fund Relief
- In addition to the reinvestment safe harbor (below), one of the greatest concerns for QOF managers and investors alike was the requirement that the statute requires an investor to dispose of its interest in the QOF (as opposed to the disposition of underlying assets by the QOF) in order to receive tax relief after a 10-year holding period. This restriction appeared to impair the feasibility of a QOF with multiple assets to dispose of such assets of the QOF in the future without resulting in tax to the QOF investors.
- The new regulations provide much welcome relief to investors by permitting investors that have held their QOF interests for at least 10 years to make an election to exclude from gross income some or all of the capital gain from the disposition of qualified OZ property reported on their QOF Schedule K-1, provided the disposition occurs after the taxpayer’s QOF interest 10-year holding period.
- Reinvestment Safe Harbor
- One of the primary concerns for taxpayers creating QOFs was how the sale of assets, including QOZBP, qualified OZ stock or qualified OZ partnership interests, would be characterized if sold before investors received their OZ tax benefits. The new regulations clarify that, so long as the QOF reinvests the proceeds from the taxable disposition of such property during the 12-month period following such disposition, and the proceeds are held in cash, cash equivalents or debt instruments with a term of 18 months or less during that period, such proceeds will count as qualified OZ property for purposes of the 90% asset test.
- Unfortunately, the regulations do not clarify that a similar rule would apply if a QOZB sells QOZBP and reinvests such proceeds into additional QOZBP . Presumably, this is due to the more lenient requirements under the “substantially all” tests.
- In any event, the preamble to the regulations indicates that, while the reinvestment of such proceeds will help a QOF satisfy the 90% asset test, any gain realized by a QOF on the sale of such assets would still be taxable and pass through to the QOF investors if the disposition occurs prior to an investor’s 10-year holding period of its interest in the QOF.
- Original Use and Substantial Improvement
- The statute requires that QOZBP must either be substantially improved or have its “original use” in the hands of the QOF or QOZB.
- The new regulations clarify that “original use” commences on the date when a person or a prior person first places property in service in the OZ for purposes of depreciation or amortization (or first uses the property in the OZ in a manner that would allow depreciation or amortization if that person were the property’s owner).
- The Treasury also clarifies that where a building or other structure has been vacant for at least 5 years prior to being purchased by a QOF or a QOZB, the purchased building or structure will satisfy the original use requirement .
- In addition, improvements made by a lessee to leased property satisfy the original use requirement and are considered “purchased” for the amount of the unadjusted cost basis of such improvements.
- The new regulations also clarify that the “substantial improvement” test for tangible property other than land is made on an “asset by asset” basis, rather than in the aggregate. Interestingly, however, the Treasury has asked for comments on whether an aggregate based test makes more sense, so this test could be revisited.
- Refinancing Permitted
- Real estate developers and investors are accustomed to refinancing construction loans with permanent loans at or near the completion of a project and distributing some or all of such proceeds to investors. There was some question whether this would be permitted in OZ investments. The new regulations clarify that such refinancing and distributions will be permitted, but only to the extent that such distributions do no exceed a QOF investor’s basis in their QOF interest.
- It is worth noting that distributions in excess of a QOF investor’s basis will constitute inclusion events—triggering taxation of their invested gains and eliminating further OZ tax benefits for such investor.
- It is also worth noting that a distribution of debt proceeds in a QOF will be subject to the “ disguised sale rules” applicable to debt financing, and will generally require a 90-day hold of the proceeds by a QOF before they can be distributed without triggering an inclusion event.
- Carried Interest Ineligible for OZ Benefits
- There had been speculation that QOF managers receiving a profits interest (i.e., a carried interest) in the QOF could also receive the tax reduction and elimination benefits under the OZ rules. The new regulations clarify that the portion of a QOF interest attributable to the service component in the interest, i.e., the carried interest, is not eligible for OZ benefits .
- Land Must Be Used
- Prior guidance clarified that land, as opposed to other tangible assets in an OZ, need not be substantially improved to meet statutory requirements.
- The new regulations, however, clarify that land must be used in the business of a QOF or QOZB. In other words, it cannot be “landbanked” or held for investment.
- In addition, the regulations clarify that the production of an agricultural crop, whether active or fallow, would not qualify as “use” in a business.
- 90% Asset Test Relief
- In response to concerns by taxpayers about inventory in transit on the last day of the taxable year (a testing date for a QOF to meet the 90% asset test), the regulations clarify that QOF does not fail the 90% asset test (i.e., that 90% of a QOF’s assets are in an OZ on a testing date) if inventory is in transit from a vendor to a facility of the trade or business that is in an OZ or from a facility of the QOF that is in an OZ to customers outside the OZ.
- The new regulations also allow a QOF to apply the 90% asset test without taking into account any investments received in the preceding 6 months , so long as those assets are being held in cash, cash equivalents, or debt instruments with a term of 18 months or less.
- Government Action Delays OK
- For both the 31-month working capital safe harbor applicable to QOZBs and the 12-month safe harbor for reinvestment, exceeding those periods does not violate the safe harbor if the delay is attributable to waiting for government action the application for which is completed during the applicable period.
- Leased Property
- The Treasury determined that leased tangible property meeting certain criteria may be treated a QOZBP for purposes of satisfying the 90% asset test.
i. Leased tangible property must be acquired under a lease entered into after December 31, 2017 .
ii. Substantially all of the use of such property (70%) must be in an OZ during substantially all of the period for which the business leases the property (90%).
iii. In addition, there is no “original use” or “substantial improvement” requirement .
- For a lease from a related party, there are several additional rules:
i. The lease must be at market rate.
ii. The lessee may not make a prepayment to the lessor (or a person related to the lessor) that exceeds 12 months.
- Valuation method can be elected by QOF or QOZB
i. Financial statement method—only if the applicable financial statement is prepared according to GAAP.
ii. Alternative valuation method—determined based on the present value of the leased property—equal to the sum of the present values of the payments to be made under the lease using the AFR as the discount rate.
- 50% of Gross Income Safe Harbors
- The earlier regulations required that 50% of the gross income of a QOF or QOZB must come from the OZ—which raised many questions about how to determine what income is “from” the OZ.
- The new regulations created three safe harbors for this purpose:
i. Hours—at least 50% of the services performed (based on hours) for such business by its employees and independent contractors are performed within the OZ.
ii. Amounts Paid—at least 50% of the services performed for the business by its employees and independent contractors are performed in the OZ based on the amounts paid for the services performed.
iii. Tangible Property and Management-if the tangible property of the business that is in the OZ and the management and operational functions performed for the business in the OZ are each necessary to generate 50% of the gross income of the trade or business.
- The regulations also provide that a QOF or QOZB that does not meet one of the safe harbors can still meet the 50% gross income requirement based on the facts and circumstances of each case.
- Inclusion Events
- The new regulations go into detail on what types of dispositions of an interest in a QOF would constitute an “inclusion event” —i.e., an event that would result in the inclusion of gains deferred in a qualifying investment. Many dispositions that would otherwise be considered tax free (e.g., a gift or contribution to charity) would constitute inclusion events and require investors in a QOF to recognize their invested gains, while others (most transfers by death, contributions to a disregarded entity or a grantor trust, or contributions to a partnership) were deemed not to require gain recognition. Any exchange or disposition of a QOF interest will require an analysis of these new regulations to determine if it will trigger gain recognition.
- The earlier regulations required that a “substantial portion” of the QOF or QOZB intangible assets must be used in the active conduct of a trade or business. The new regulations clarify that a “substantial portion” equals 40%.
- Active Conduct for Real Estate
- The new regulations 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 purposes of the OZ rules.
- However, “ merely entering into a triple-net-lease with respect to real property owned by a taxpayer is not the active conduct of a trade or business by such taxpayer.” The new regulations are, unfortunately, not clear on how much management or commercial activity by a landlord is needed to not be a triple-net-lease.
- 1231 Gains
- Section 1231 is the section of the Internal Revenue Code that deals with the tax treatment of gains and losses on the sale or exchange of real or depreciable property used in a trade or business and held over one year. Net gains or losses from the sale or other taxable disposition of such assets is calculated at the end of each year—but a net gain is taxed at capital gains rates, subject to a recapture rule, and a net loss is counted as an ordinary loss (i.e., the best of both worlds for tax purposes).
- The new regulations clarify that only the net 1231 gains (and not gains calculated on an asset-by-asset basis) are treated as eligible gains for purposes of the OZ program .
- The new regulations also clarify that, because the net 1231 gain determination is made at the end of each tax year, the 180-day period for investing such net 1231 gains begins on the last day of the taxable year .
- Working Capital Safe Harbor Can Be Used Multiple Times
- There was some question about whether the working capital safe harbor available to QOZBs could only be used one time. The new regulations clarify that a business may benefit from multiple overlapping or sequential applications of the working capital safe harbor , provided that each application independently satisfies the other requirements of the safe harbor (i.e., a written working capital plan and timeline is put together, and substantially complied with throughout the period).
- S Corporation Investor Rule
- Of interest to S corporation investors in QOFs, the new regulations clarify that its investment would be treated as disposed (i.e., no longer eligible for further OZ tax benefits) of if there is a greater than 25% (in the aggregate) change in the ownership of the S corporation from the date of the original investment.
This is not intended to be a comprehensive analysis of the new regulations, but rather highlights the most impactful rules set forth in those regulations. The new regulations are subject to a 60 day notice and public comment period. Right now, the Treasury does not anticipate issuing any further regulations with respect to the OZ program. We will continue to follow the guidance on OZs to best inform our clients about this exciting new economic development program. Please contact our experienced Opportunity Zone Team if you are interested in learning more.