On April 17, the Treasury released additional guidance (the “Proposed Regulations”) addressing several areas of uncertainty concerning the operation of the qualified opportunity fund (“QO Fund”) provisions introduced by the Tax Cuts and Jobs Act of 2017. These QO Fund provisions provide tax incentives to encourage taxpayers to invest in low-income communities through QO Funds that invest in or conduct business in certain designated low-income areas (a “QO Zone”). As discussed in a prior client alert, the Treasury released a first set of proposed regulations in 2018 that provided helpful guidance to taxpayers, but many significant issues remained unresolved. The Proposed Regulations provide significant additional clarity as to the application of the QO Fund rules. Many of the new guidelines set forth in the Proposed Regulations provide greater flexibility for the formation and operation of QO Funds and are likely to increase taxpayers’ interest in these funds. The discussion below focuses on some of the key provisions included in the Proposed Regulations, as well as certain issues that remain unresolved in the guidance provided to date.
At a high level, the QO Fund provisions provide three primary tax incentives for investors to invest in QO Funds.
- Deferral. A taxpayer is able to temporarily defer recognition of capital gains from the sale or exchange of assets by reinvesting such gains in a QO Fund within 180 days of the date of the sale or exchange. The deferral ends on the earlier of (a) the date on which the taxpayer disposes of its investment in the QO Fund and (b) December 31, 2026 (the “Recognition Date”). On the Recognition Date, the taxpayer will recognize gain equal to the difference between the amount of gain deferred (subject to the discussion of excluded gain below) and the taxpayer’s basis in the QO Fund investment.
- The QO Fund provisions also gradually convert a portion of this deferral benefit into a permanent exclusion. While the taxpayer’s basis in the QO Fund is initially zero, the taxpayer’s basis increases by 10% of the deferred gain after five years, and by an additional 5% after seven years. The taxpayer will recognize the deferred gains exceeding its basis in its QO Fund interest on the Recognition Date, and the amount recognized will also be added to the taxpayer’s basis in its QO Fund interest.
- If the taxpayer holds its investment in a QO Fund for at least 10 years, the taxpayer may increase the basis of its investment to its then fair market value, “permanently” eliminating any federal income tax on any appreciation in its interest in the QO Fund above the amount of gain originally deferred.
In order to be treated as a QO Fund, an investment vehicle must hold at least 90% of its assets in “qualified opportunity zone property” (“QO Property”), which consists of:
- “QO Business Property” - a direct investment in (a) original use or substantially improved property, (b) property acquired by purchase after December 31, 2017, and (c) property substantially all of the use of which is within a QO Zone during substantially all of the time held by the QO Fund or a “qualified opportunity business” (a “QO Business”); or
- Equity investments in a QO Business - an entity substantially all of the tangible property of which is QO Business Property.
II. The Proposed Regulations
Although the QO Zone rules were well received, a lack of technical guidance on their interpretation has prevented most taxpayers from moving forward on QO Fund investments. The Proposed Regulations make significant progress and provide guidance on a broad spectrum of issues concerning investments in QO Funds, many of which should provide greater certainty to potential investors in such funds and expand the ability of QO Funds to conduct qualifying businesses. However, uncertainties as to the application of the QO Fund provisions remain. Below is a discussion of certain significant rules introduced by the Proposed Regulations and various issues that require further guidance.
A. QO Business Property
1. Defining “Substantially All”
For property to be treated as QO Business Property, “substantially all” of the property must be used in a QO Zone for “substantially all” of the QO Fund’s holding period for such property, although these terms were not defined in the statute or prior guidance. The Proposed Regulations provide that, for purposes of the use test, “substantially all” means 70% and for purposes of the holding period test, “substantially all” means 90%.
2. Treatment of Land
In order to determine whether tangible property qualifies as QO Business Property, the QO Fund provisions require either that (a) the original use of tangible property commence with the QO Fund, or that (b) the QO Fund substantially improve the property.
The Proposed Regulations provide that the original use and substantial improvement tests do not apply to land. Instead, the Proposed Regulations require that land must be used in a trade or business to be treated as QO Business Property and merely holding land for investment will not give rise to a trade or business.
B. Treatment of Leased Property
The Proposed Regulations allow certain leased tangible property to be treated as QO Business Property even though the original use or substantial improvement tests are not satisfied. Leased tangible property will be treated as QO Business Property if:
- it is acquired under a lease entered into after December 31, 2017; and
- substantially all of the use of the leased tangible property is in a QO Zone during substantially all of the period for which the business leases the property.
In addition, the Proposed Regulations provide that improvements to leased property satisfy the original use requirements and are considered purchased property in an amount equal to the unadjusted cost basis of such improvements.
C. QO Business
1. Property Straddling Opportunity Zones
The Proposed Regulations provide clarity on how real property that is not wholly within a QO Zone is treated. Specifically, the Proposed Regulations clarify that if the amount of real property (based on square footage) located within the QO Zone is substantial relative to the amount of real property outside of the QO Zone, then all of the property will be treated as located within a QO Zone. The preamble to the Proposed Regulations notes that the amount of real property within the QO Zone should be deemed “substantial” if the relative unadjusted cost of the real property located within the QO Zone is greater than that of the real property outside the QO Zone.
2. Gross Income Safe Harbors
Under the QO Fund provisions and prior guidance, a QO Business must derive at least 50% of its gross income from the active conduct of a trade or business within a QO Zone. The 50% requirement has raised concerns on how sales to customers outside the QO Zone or income from more amorphous sources, such as licensing, will be treated for purposes of qualifying as a trade or business within a QO Zone. The Proposed Regulations provide significant relief by offering three safe harbors to satisfy the 50% gross income requirement:
- 50% of the services performed by employees and independent contractors (based on hours performed) are performed in the QO Zone;
- 50% of the amounts paid for services performed by employees and independent contractors are for services performed in the QO Zone; or
- the tangible property of the QO Business located in the QO Zone and the management or operational functions performed for the QO Business in the QO Zone are each necessary to generate 50% of the gross income of the QO Business.
3. Intangible Assets
The QO Fund provisions require that a substantial portion of intangible property of a qualified business entity must be used in the active trade or business within the QO Zone in order to qualify as a trade or business within a QO Zone. The Proposed Regulations define 40% as a “substantial portion” for this purpose. Unfortunately, the Proposed Regulations did not provide any guidance as to how taxpayers are to determine whether intangible property, such as licenses, trademarks and other intellectual property, is “used” within a QO Zone. Given the nature of such assets, further guidance on this point would provide important clarity to taxpayers.
4. Active Conduct of a Trade or Business
As discussed above, a QO Business must derive at least 50% of its gross income from the active conduct of a trade or business within a QO Zone. The Proposed 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 that purpose.
D. Relief from 90% Test
1. Relief for Newly Contributed Assets
As discussed above, for purposes of determining whether property qualifies as QO Business Property, the QO Fund provisions require that property must be held during “substantially all” (90%) of the QO Fund’s holding period for such property.
For purposes of determining compliance with the 90% tests, the Proposed Regulations allow a QO Fund to choose to exclude from the numerator and denominator the amounts received in exchange for interest in the QO Fund if the exchange occurs within six months of the applicable testing date and such amounts were held in short term investments such as cash, cash equivalents, or debt instruments with a term of 18 months or less.
2. Reinvestment Rule
The QO Fund statutory provisions authorize the Treasury to issue regulations that will ensure that a QO Fund has sufficient time to reinvest the return of capital or proceeds from its QO Property investments within the QO Zone. The Proposed Regulations provide that if (a) the QO Fund reinvests the proceeds received from the distribution, sale, or disposition of QO Property within a year, and (b) the proceeds are continuously held in cash, cash equivalents, or debt instruments with a term of 18 months or less, proceeds from the sale or disposition of QO Property are treated as QO Property for purposes of the 90% test. Additionally, QO Funds may reinvest proceeds from one type of QO Property into another type of QO Property (e.g., reinvest proceeds from the sale of QO Business Property into equity interests in a QO Business).
E. Certain Adjustments to Basis Upon Transfers of QO Fund Interests
The Proposed Regulations provide that if a taxpayer disposes of an interest in a QO Fund that is treated as a partnership for federal income tax purposes, the partnership’s bases in partnership assets are also adjusted (including inventory and unrealized receivables). As noted in the preamble to the Proposed Regulations, this has the effect of avoiding the potential creation of capital losses and ordinary income from the sale.
A related issue that was not addressed in the Proposed Regulations is whether a taxpayer’s basis in a QO Fund treated as a partnership would be affected by allocations of income or gain from the QO Fund. Under general partnership rules, a partner increases its basis in a partnership interest to the extent the partner is allocated income or gain from the operation of the partnership or the sale of partnership assets. The statutory language underlying the QO Fund provisions could be read such that these allocations do not increase a taxpayer’s basis in its QO Fund interest. This remains a significant area of uncertainty that is unaddressed in the guidance thus far provided to taxpayers.
The Proposed Regulations provide helpful guidance to taxpayers with respect to the operation of the QO Fund provisions and provide taxpayers with greater certainty regarding investments in QO Funds. However, as noted above, additional guidance with respect to certain provisions would provide taxpayers with greater clarity in a number of areas. As the Proposed Regulations solicit comments from taxpayers, taxpayers are hopeful that the Treasury will issue additional guidance that will provide such clarity.