On April 17, 2019, the IRS and the Treasury Department issued new proposed regulations relating to the Opportunity Zone program. The Opportunity Zone program is intended to encourage investments in economically distressed qualified opportunity zones (QOZs) by allowing taxpayers to defer and, in some cases, reduce or eliminate tax on capital gains if they reinvest their gains within 180 days in qualified opportunity funds (QOFs), which, in turn, generally are required to invest at least 90% of their assets in (1) certain business property located in a QOZ (QOZ Business Property), and (2) equity in certain entities that hold QOZ Business Property (QOZ Subsidiaries and, together with QOZ Business Property, QOZ Property).
Rules Applicable to QOZ Subsidiaries
- Amount of investment in a QOZ. The new proposed regulations provide that at least 70% of the use of QOZ Business Property during at least 90% of a QOF's or QOZ Subsidiary’s holding period must be in a QOZ. Because only 70% of a QOZ Subsidiary’s assets are required to consist of QOZ Business Property, a QOF could satisfy its 90% assets test with as little as 40% of the property effectively owned by the QOF being used within a QOZ (90% x 70% x 70% x 90% = 40%).
- Treatment of leased tangible property. The new proposed regulations clarify that leased tangible property generally may be treated as QOZ Business Property if:
- The property is acquired under a lease entered into after December 31, 2017; and
- Substantially all (70%) of the use of the leased property is in a QOZ during substantially all (90%) of the period for which the business leases the property.
This clarification is helpful in light of the requirement in section 1400Z-2(d)(2)(D)(i)(II) of the tax code that QOZ Business Property be acquired by purchase from an unrelated party.
- 50% gross income test safe harbors. A QOZ Subsidiary must derive at least 50% of its total gross income from the active conduct of a trade or business within a QOZ. The new proposed regulations provide three safe harbors for satisfying this requirement:
- Hours safe harbor: At least 50% of the total number of hours spent during a taxable year by the QOZ Subsidiary's employees and independent contractors in performing services is spent within a QOZ.
- Amounts paid safe harbor: At least 50% of the total amount paid by a QOZ Subsidiary for employee and independent contractor services is for services performed within a QOZ.
- Conjunctive test: The tangible property located in a QOZ and the management or operational functions performed in the QOZ are each necessary to generate at least 50% of the QOZ Subsidiary's gross income.
- Intangible property. A “substantial portion” of the intangible property of a QOZ Subsidiary must be used in the active conduct of a trade or business in a QOZ. The new proposed regulations define “substantial portion” in this context as at least 40% by value.
Rules Applicable to Investors in a QOF
- Holding periods and other tacking rules. The tax benefits of an investment in a QOF are, in part, dependent on the QOF investor’s holding period for that investment. The new proposed regulations generally provide that if a QOF investor exchanges property for its investment in a QOF, the holding period in the QOF investment begins on the date of the exchange, not on the date the QOF investor acquired the exchanged property. Similarly, if a QOF investor disposes of its entire investment in QOF 1 and reinvests in QOF 2 within the 180 days required to avoid recognition of deferred gain, the QOF investor’s holding period for its investment in QOF 2 begins on the date of its investment in QOF 2, not QOF 1.
- Effect of disposition of QOZ Property. The new proposed regulations clarify that sales or dispositions of assets by a QOF do not impact an investor’s holding period or trigger the inclusion of any deferred gain.
Rules Applicable to QOFs
- 90% assets test relief.
- Proceeds from the sale of QOZ Property. The new proposed regulations provide that proceeds received by a QOF from the sale or disposition of QOZ Property are treated as QOZ Property, so long as the QOF reinvests the proceeds within 12 months of the sale or disposition and, in the interim, the proceeds are continuously held in cash, cash equivalents, or debt instruments with a term of 18 months or less.
- Relief for newly contributed assets. The new proposed regulations allow a QOF to apply the 90% assets test without taking into account investments received in the preceding six months, so long as the new assets are held in cash, cash equivalents, or debt instruments with terms of 18 months or less. This is to provide relief for an existing QOF that receives new capital from an equity investor shortly before its semi-annual testing date to determine whether 90% of its assets are QOZ Property.
- Working capital safe harbor. The new proposed regulations make two changes to the working capital safe harbor, which allows QOF Subsidiaries to hold reasonable amounts of working capital for up to 31 months and still meet the 70% assets test.
- The written schedule of the planned use of working capital required to qualify for the safe harbor now includes the development of a trade or business in a QOZ in addition to the acquisition, construction, and/or substantial improvement of tangible property.
- Exceeding the 31-month period does not violate the safe harbor if the delay is due to waiting for government action (e.g., a permit or license), and the application for that government action was filed prior to the 31-month deadline.
General Anti-Abuse Rule
The new proposed regulations provide that if a significant purpose of a transaction is to achieve a tax result that is inconsistent with the purposes of section 1400Z-2 (determined based on all facts and circumstances), the IRS can recast a transaction for federal tax purposes as appropriate to achieve tax results consistent with the purposes of section 1400Z-2. For example, the preamble to the proposed regulations states that Treasury would apply this anti-abuse rule to passive ownership of land for speculation purposes.