On Wednesday, April 17, 2019, the Internal Revenue Service (IRS) released the eagerly awaited second batch of proposed regulations (REG-120186-18) relating to the Opportunity Zone program that was enacted as part of the tax reform efforts undertaken in December 2017. While the first round of proposed regulations issued in October 2018 were mainly helpful for real estate investors, the second tranche of regulations provide useful guidance for operating businesses while also addressing questions left unanswered by the first batch. Below are some of the key takeaways from this second round of proposed regulations.

Operating Businesses

  • 50% Gross Income of a QOZB. One of the requirements that must be met in order for the subsidiary of a qualified opportunity fund (QOF) to be an eligible investment by the QOF is that the subsidiary must meet the definition of a “qualified opportunity zone business” (QOZB), which requires in part that 50% of the subsidiary’s gross income be derived from the active conduct of a trade or business in a qualified opportunity zone (QOZ). Under prior guidance, it was unclear how this rule applied to operating businesses (as opposed to real estate investments) looking to afford themselves of the benefits of the Opportunity Zone program. Fortunately, the recent proposed regulations relax this rule by providing three safe harbors and a facts and circumstances test for determining whether sufficient income is derived from a trade or business in a QOZ:
    • The first safe harbor focuses on the total hours worked by employees and independent contractors, and can be satisfied if at least 50% of the company’s total hours are worked within a QOZ. 
      • The preamble to the proposed regulations provides an example of a software development startup with worldwide internet sales. The example concludes that, because a majority of the time spent by the startup’s employees and independent contractors is spent developing the software on the company’s campus within a QOZ, the safe harbor is satisfied even though the vast majority of the company’s sales are located outside of the QOZ.
    • The second safe harbor can be satisfied if at least 50% of the services paid for by the trade or business to employees and independent contractors are for services performed within a QOZ. 
      • The preamble to the proposed regulations contains an example based on similar facts as above, but in this example the startup also utilizes a service center located outside of a QOZ (for example, India). In the example, more hours are expended at the service center outside the QOZ than are worked at the startup’s campus within the QOZ. Nevertheless, because more than 50% of the startup’s total compensation for software development services is paid to employees and independent contractors working at the QOZ campus, the second safe harbor is satisfied. 
    • The third safe harbor focuses on both the tangible property located in a QOZ, and the management or operational functions performed in a QOZ. Under this safe harbor, the 50% gross income test is satisfied if (1) the tangible property of the trade or business located in a QOZ and (2) the management or operational functions performed in the QOZ “are each necessary for the generation of at least 50 percent of the gross income of the trade or business.” The new proposed regulations provide two examples for this safe harbor. 
      • The first example involves a landscaping business with headquarters in a QOZ whose officers and employees manage the daily operations of the business (which takes places within and outside the QOZ) from the headquarters, and all of the business’s equipment and supplies are stored at the headquarters at the end of each day. The example concludes that the activities occurring and the equipment storage taking place in the QOZ, taken together, are a “material factor in the generation of the income of the business.” Therefore this safe harbor is satisfied.
      • On the other hand, the second example provides that a trade or business with only a PO Box within a QOZ is insufficient to satisfy the safe harbor.
    • Finally, if none of the above safe harbors can be met, then taxpayers can potentially meet the 50% gross income test through a facts and circumstances test. The test is satisfied if, based on all facts and circumstances, at least 50% of the gross income of a trade or business is derived from the active conduct of a trade or business in a QOZ.
  • Safe Harbor for Inventory in Transit. One of the statutory requirements necessary for satisfying the definition of “qualified opportunity zone business property” (“QOZ Business Property”) is that, during substantially all of the QOF’s holding period for tangible property, substantially all of the use of such property was in a QOZ. Under prior guidance, it was unclear how the “substantially all” requirements were met in the case of inventory or other raw materials whose legal title passed to a QOF outside of a QOZ. Prop. Treas. Reg. § 1.1400Z-2(d)-1(c)(4)(iii) clarifies that inventory (including raw materials) of a trade or business does not fail to be used in a QOZ solely because the inventory is in transit from a vendor to a facility of the trade or business that is in a QOZ, or from a facility of the trade or business that is in a QOZ to customers of the trade or business that are not located in a QOZ.
  • Leased Property. Another area of importance for operating businesses left unaddressed by the first batch of proposed regulations was the treatment of leased property. Fortunately, the newly issued proposed regulations thoroughly cover leased property, and some of the general issues addressed include providing for two different valuation methods with respect to leased property, the treatment of leased property if the lessee and lessor are related, and the treatment of leased property for purposes of the “substantially all” tests of § 1400Z-2(d)(2).
  • Working Capital Safe Harbor. While the first batch of proposed regulations contained a working capital safe harbor largely geared towards real estate investments, the second batch of proposed regulations expanded the safe harbor to cover operating businesses. Under the new proposed regulations, the working capital safe harbor can now be used to include the development of a trade or business (e.g., identifying locations for the business, leasing property, outfitting the property with necessary equipment and furniture, and hiring and training employees) in addition to the acquisition, construction, and/or substantial improvement of tangible property in a QOZ.

Real Estate

  • Original Use Test. In order to qualify for the tax benefits afforded by the Qualified Opportunity Zone program, one of the requirements that must be satisfied is the definition of QOZ Business Property, which partly requires the tangible property used in a trade or business of a QOF to satisfy one of two tests: either the original use of the property in the QOZ commences with the QOF, or the QOF must substantially improve the property (see § 1400Z-2(d)(2)(D)(i)(II)). While the substantial improvement test was addressed in prior guidance, application of the original use test largely remained unclear. The second batch of proposed regulations clarifies several ways in which the original use test can be met:
    • In general, the original use of tangible property acquired by purchase commences on the date when any person first places the property in service in the QOZ for purposes of depreciation or amortization. See Prop. Treas. Reg. § 1.1400Z-2(d)-1(c)(7)(i).
    • Used tangible property satisfies the original use requirement if the property has not been previously used within the QOZ in question in a manner that would have allowed it to be depreciated or amortized by any taxpayer. If the tangible property has been so placed in service before being acquired by the QOF, it must be substantially improved in order to satisfy the requirements of § 1400Z-2(d)(2)(D)(i)(II).
    • One big question practitioners had with respect to the original use requirement is the treatment of vacant property. Specifically, the main issue was how to treat a vacant building located in a QOZ that was acquired by a QOF after 2017. Fortunately, the Treasury Department and the IRS adopted a taxpayer-favorable rule, and the proposed regulations provide that the prior use of a building is disregarded after being vacant for 5 years. In other words, if a building or other structure in a QOZ has been vacant for at least 5 years prior to being purchased by a QOF (either directly or indirectly), the purchased building is deemed to satisfy the original use requirement. See Prop. Treas. Reg. § 1.1400Z-2(d)-1(c)(7)(i). 
    • Leasehold improvements satisfy the original use test and are considered purchased property for the amount of the unadjusted cost basis of such improvements as determined in accordance with § 1012. See Prop. Treas. Reg. § 1.1400Z-2(d)-1(c)(7)(ii).
  • Active Trade or Business. One question that was raised after the initial guidance was released was whether the rental of real property would be considered an active trade or business. The new proposed regulations provide that, for purposes of the definition of QOZB found in § 1400Z-2(d)(3)(A), ownership and operation (including leasing) of real property is deemed to be the active conduct of a trade or business. On the other hand, the proposed regulations specifically provide that merely entering into a triple-net-lease with respect to real property is not the active conduct of a trade or business.
  • Real Property Straddling a QOZ. One issue raised during the comment period following the initial proposed regulations was how to treat real property that straddles multiple census tracts, with one tract being a QOZ while the other is not. Referencing the rules for Empowerment Zones found in § 1397C(f), the newly proposed regulations provide that, if the amount of real property based on square footage located within the QOZ is substantial as compared to the amount of square footage outside the QOZ, and the two tracts are contiguous, then all of the property will be deemed to be within the QOZ.

Qualified Opportunity Funds

  • Cycling of Fund Investments. The newly proposed regulations make it clear that a QOF that sells or disposes of an investment will be deemed to satisfy the 90% asset test of § 1400Z-2(d)(1) so long as it reinvests the proceeds from the sale or disposition within 12 months. Thus, if an investment is not meeting expectations, investors are free to cause the QOF to dispose of the original investment without fear of losing the tax benefits of the Opportunity Zone program so long as the QOF reinvests the proceeds in another qualifying investment within 12 months. In explaining the rationale of this rule, the preamble to the newly proposed regulations points to how Congress tied the tax incentives to the longevity of the investor’s stake in the QOF, and not to a QOF’s stake in any specific portfolio investment. 
  • Definition of Substantially All. QOZ Business Property is the common denominator among the three types of QOZ Property that a QOF can hold, and a question left unanswered by the first batch of proposed regulations was the two meanings of “substantially all” as used in § 1400Z-2(d)(2)(D)(i)(III)’s requirement that, “during substantially all of the qualified opportunity fund’s holding period for [tangible property used in a trade or business of the QOF], substantially all of the use of such property was in a qualified opportunity zone.” As used here, “substantially all” thus applies to both (1) a holding period requirement, and (2) a use requirement. As for the holding period requirement, the newly proposed regulations provide that “substantially all” means 90%, and for the use requirement it means 70%. Consequently, § 1400Z-2(d)(2)(D)(i)(III) can be read as requiring that, in order for tangible property to be considered QOZ Business Property, during at least 90% of the time the QOF holds the property, at least 70% of the tangible property’s use must be within a QOZ.