Last November, we published an alert about the qualified opportunity zone (QOZ) regime enacted as part of the December 2017 federal tax reform law. This exciting new tax law allows for (1) deferral until 2026 of capital gain, (2) elimination of up to 15 percent of the deferred capital gain and (3) no tax on appreciation for the investment of the deferred gain if the taxpayer holds the investment for at least 10 years. Our alert discussed the first round of proposed regulations, which provided enough guidance to start use of this new opportunity (pun intended), as demonstrated by the launch of countless qualified opportunity funds (QOFs). Unfortunately, key questions remained unanswered, and these ambiguities prevented many taxpayers from pulling the trigger. On April 17, the IRS issued its second round of proposed regulations that addressed many of these key issues. As with the prior guidance, these new proposed regulations maximize the ability of taxpayers to benefit from this new regime. (Standard attorney caveat: please keep in mind that this publication is only meant to highlight certain items discussed in the new proposed regulations. The opportunity zone regime is complicated with a lot of moving parts and you should consult your tax advisor to ensure compliance with these rules.)
- The No Tax on Appreciation Benefit Can Apply to Flow-Through Gain The language chosen by Congress indicated that the no tax on appreciation benefit would apply only to a taxpayer’s sale of an interest in the QOF, and not to the flow-through gain from the sale of the QOZ business property. This could have made investment exits difficult because buyers often want to acquire the QOZ business property, and not interests in the QOF. It also created complexity for QOFs with a portfolio of assets. The IRS has provided relief and, provided that the taxpayer satisfies the 10-year holding period at the time of the sale of the QOZ business property, the taxpayer can elect to exclude the gain reported on a Schedule K-1.
- Original Use of Used Property Can Begin With QOZ Business For tangible property to qualify for the regime, its original use must begin with the QOZ business (or the QOZ business must substantially improve the property). The proposed regulations provide that the original use of acquired property or improvements to leased property occurs on the date that a person first uses the property in the QOZ in a manner that allows for depreciation or amortization. Thus, original use of used property acquired from outside the QOZ, even if used in a different QOZ, can commence with the QOZ business.
- No Original Use or Substantial Improvement Requirement for Leased Property The original use and substantial improvement requirements do not apply to leased property. Accordingly, the original use of leased property does not need to begin with the QOZ business and the QOZ business does not need to substantially improve the leased property.
- QOZ Business Can Lease Property From a Related Person The rules for property owned by a QOZ business generally prevent property contributed or sold by a related person (e.g., a taxpayer that owns 20 percent or more of the QOF) from being treated as qualified property. This meant that the value of such property would be part of the 30 percent (or 10 percent for QOZ businesses directly operated by a QOF) of allowed nonqualified property. The proposed regulations provide property leased by a QOZ business from a related person (including a ground lease) can be treated as qualified property, provided that (1) the QOZ business does not prepay the rent and (2) if the original use of the leased property does not begin with the QOZ business, the QOZ business acquires QOZ business property with a value at least equal to the leased property.
- Easy Rules for Valuing Leased Property The proposed regulations resolve ambiguities about how to value leased property. Taxpayers can elect between two methods for determining the value of leased property: (1) the value reported on an applicable financial statement or (2) the sum of the present value, using AFR as the discount rate, of the payments to be made during the term of the lease, generally including extensions.
- Helpful Rules to Implement the 50 Percent Gross Income Requirement At least 50 percent of a QOZ business’s gross income must derive from the active conduct of a trade or business within the QOZ. Although issues for this requirement do not arise for businesses in which the income producing activities and customers are in the QOZ, like renting residential or commercial space or operating a fast food restaurant, there was concern that this would prevent businesses with customers outside the QOZ from qualifying. The proposed regulations provide that taxpayers can use any of three alternative safe harbors (or, if necessary, a facts and circumstances test):
- Time-Based: At least 50 percent of the time spent on business activities by the QOZ business’s employees or independent contractors occur in the QOZ.
- Amount Paid to Service Providers: At least 50 percent of the amount paid by the QOZ business to employees or independent contractors are for services performed in the QOZ. This test provides relief if the QOZ business has low costs activities outside the QOZ that require significant time.
- Tangible Property and Management: The tangible property located in the QOZ and the management or operational functions performed in the QOZ are each necessary to generate 50 percent of the income. This test provides relief for a QOZ business headquartered in a QOZ that has customers outside the QOZ and uses equipment stored in the QOZ.
These rules will make it easier for businesses to use the new commercial space developed because of the QOZ regime.
- Helpful Definition of Active Conduct of a Trade or Business The proposed regulations define trade or business by reference to IRC § 162, which allows the deduction for ordinary and necessary expenses incurred in carrying on a trade or business. A special, favorable rule provides that the ownership and operation of real property, including leasing other than a triple-net lease, constitutes active conduct of a trade or business.
- Taxpayers Can Invest With Cash or Other Property The proposed regulations make clear that a taxpayer can invest in a QOF with cash or a contribution of other property. This means that a taxpayer can defer gain from the sale of property, while keeping all of the cash from the sale (not just the return of basis), by making the QOF investment with other property. However, investing with property other than cash generally will be treated as a “mixed-fund investment” so that the QOF investment is bifurcated between the portion that qualifies for the no tax on appreciation benefit and the portion that does not.
- Original Use of a Vacant Building Commences with the QOZ Business Generally, a QOZ business must substantially improve an existing building in a QOZ for the building to be qualified property. This requires investing an amount at least equal to the purchase price for the building. As we discussed in a different alert, this created a potential problem for brownfield projects. The proposed regulations provide relief for property in a QOZ that has been unused or vacant for at least five years.
- Clarification of the Working Capital Safe Harbor Generally, working capital must be spent in a 31-month period to be treated as QOZ business property. The proposed regulations provide that exceeding the period does not violate the safe harbor if the delay arises from waiting for government action.
- Reinvestments by QOF Proceeds received by QOF on the sale of QOZ property are treated as QOZ property, provided that the QOF reinvests the proceeds within 12 months. In the preamble to the proposed regulations, the IRS discussed whether reinvestment in QOZ property would allow for nonrecognition, like a 1031 exchange. Although the IRS generally interpreted the QOZ statutory provisions in the most taxpayer-friendly manner, this was a bridge too far.
Although the proposed regulations generally provide good news to taxpayers, there are some potential traps for the unwary. For example, it appears that a carried interest will not receive the no tax on appreciation benefit. (The original proposed regulations potentially opened the door for a taxpayer investing a nominal amount of capital gain in a QOF for a carried interest that qualified for the no tax on appreciation benefit. The IRS has shut this door.) Also, although gain invested in a QOF can be deferred until 2026, it is recognized earlier if the taxpayer sells or exchanges the investment in the QOF. The proposed regulations provide detailed rules about such income inclusion events, including that a gift of a QOF interest generally constitutes an income inclusion event, but a transfer upon death does not. Finally, the proposed regulations do not provide any guidance for reconciling the QOZ benefits and the special rules that apply to gains from the sale of a U.S. real property interest by foreigners (FIRPTA). As we noted in another prior alert, although it appears that the no tax on appreciation benefit can apply to a foreigner who invests in a QOF capital gains that the United States would not tax, procedural issues arise with respect to the withholding required for the future sale of the QOF interest or distribution of the flow-through gain. The proposed regulations do not address this.