The proposed new regulations provide much needed guidance to encourage the future use of the Opportunity Zone tax benefit.
On April 17, 2019, the Department of Treasury released a second set of proposed regulations for the Opportunity Zone legislation (the first set of regulations was released in October 2018), which is intended to encourage economic growth and investment in designated distressed communities, known as Qualified Opportunity Zones, by providing federal income tax benefits to taxpayers who invest new capital in businesses located within these areas through a Qualified Opportunity Fund.
The 169 pages of proposed new regulations provide much needed guidance to encourage the future use of the Opportunity Zone tax benefit and specifically provide guidance for Opportunity Zone businesses. The following are the highlights of the proposed regulations:
Reinvestment of Proceeds from a Sale or Disposition
A Qualified Opportunity Fund has 12 months from the time of the sale or disposition of Qualified Opportunity Zone property or the return of capital from investments in relative stock or 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 percent asset test.
Real Property Straddling an Opportunity Zone and a Non-Opportunity Zone
A business that purchases real property straddling multiple census tracts where not all of the tracts are designated as a Qualified Opportunity Zones may satisfy the relevant business requirements if the unadjusted cost of the real property inside a Qualified Opportunity Zone is greater than the unadjusted cost of real property outside it.
Safe Harbors for the 50 Percent Income Test for Qualified Opportunity Zone Businesses
The proposed regulations provide three safe harbors and 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 percent test.
- The first safe harbor requires that at least 50 percent 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 provides that if at least 50 percent 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 percent gross income test.
- The third safe harbor provides that a trade or business may satisfy the 50 percent 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 percent of the gross income of the trade or business.
- Finally, taxpayers not meeting any of the other safe harbor tests may meet the 50 percent requirement based on a facts-and-circumstances test if, based on all pertinent information, at least 50 percent 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.
Note that the 70 percent tangible property test requires 70 percent of the tangible property of the business located within the Opportunity Zone continues to be operative for that business.
Working Capital Plans—The 31-Month Test
The following two changes were made to the safe harbor for working capital:
- First, the written designation for planned use of working capital now 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, exceeding the 31-month period does not violate the safe harbor if the delay is attributable to waiting for government action, the application for which is completed during the 31-month period.
To help startup businesses, the proposed regulations allow a Qualified Opportunity Fund to satisfy the 90 percent test without taking into account any investments received in the preceding six months―provided those new assets be held in cash, cash equivalents or debt instruments with a term of 18 months or less. This flexibility is intended to alleviate concerns with a Qualified Opportunity Fund receiving additional capital gain funds right before a testing period and not being able to deploy the funds prior to then.
A taxpayer that is the holder of a direct Qualified Opportunity Fund partnership interest or qualifying stock of a Qualified Opportunity Fund 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 taxpayer’s 10-year holding period.
Continued Opportunity Zone Treatment after Death
Neither a transfer of the Qualified Opportunity Fund investment to the deceased owner’s estate nor the distribution by the estate to the decedent’s legatee or heir would result in the loss of the Qualified Opportunity Fund investment benefit.
Where a building or other structure has been vacant for at least five years prior to purchase by a Qualified Opportunity Fund or Opportunity Zone business, the purchased building or structure will satisfy the original use requirement.
Leased Property—Qualified Opportunity Zone Businesses, Original Use, Related Party Permissions and Anti-Abuse Rules
Leased property may be treated as Qualified Opportunity Zone business property if the following two general criteria are satisfied:
- First, leased tangible property must be acquired under a lease entered into after December 31, 2017.
- Second, substantially all 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.
The proposed regulations, however, do not impose an original use requirement with respect to leased tangible property and do not require leased tangible property to be acquired from a lessor that is unrelated. However, the proposed regulations provide one limitation as an alternative to imposing a related person rule or a substantial improvement rule and two further limitations that apply when the lessor and lessee are related.
- First, the proposed regulations require in all cases that the lease under which a Qualified Opportunity Fund or Qualified Opportunity Zone business acquires rights with respect to any leased tangible property must be a “market rate lease.”
- Second, if the lessor and lessee are related, a Qualified Opportunity Fund or Qualified Opportunity Zone business at any time may not make a prepayment to the lessor for a period of use of the leased tangible property that exceeds 12 months.
- Third, the proposed regulations do not permit leased tangible personal property to be treated as Qualified Opportunity Zone business property unless the lessee becomes the owner of tangible property that is Qualified Opportunity Zone business property and that has a value not less than the value of the leased personal property. This acquisition of 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.
- Finally, the proposed regulations include 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 that is leased by a Qualified Opportunity Fund, 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 Qualified Opportunity Fund for an amount of consideration other than the fair market value, this would violate the anti-abuse rule.
It is also worth noting that improvements made by a lessee to leased property satisfy the original use requirement and are considered purchased property. Thus, a tenant in a building can also satisfy the Qualified Opportunity Zone business tests noted under the Opportunity Zone program.
For purposes of determining whether a substantial portion of intangible property of a Qualified Opportunity Zone is used in the active conduct of a trade or business, the term “substantial portion” means at least 40 percent.
Unimproved land that is within a Qualified Opportunity Zone and acquired by purchase is not required to be substantially improved if it is used in a trade or business of the Qualified Opportunity Fund or the Qualified Opportunity Zone business.
Investments Held by Funds
Funds have been provided with additional flexibility to hold more than one investment within a fund if they are structured appropriately.
Inventory in transit to a Qualified Opportunity Zone business within its zone will be treated as tangible property that counts for purposes of the 70 percent test for Qualified Opportunity Zone businesses even if it is not within the Opportunity Zone, so long as it is on the way.
Debt Financed Distributions
Guidance has been provided under the new regulations regarding refinancing and distributions to partners/members which would permit appreciated portions of the property that have been refinanced to be distributed to the partners or members of the Qualified Opportunity Fund on a tax free basis, so long as the distribution is not in excess of the investor’s basis.