The tax and investment communities continue to be abuzz with discussion of the huge tax benefits that Opportunity Zone Funds have the potential to provide. This update is intended to provide guidance on the key topics to enable the reader to move forward with the implementation of Opportunity Zone Funds.
What is the Opportunity Zone program?
The Tax Cuts and Jobs Act, signed into law on December 22, 2017, authorized a new tax incentive program to encourage investment in low-income community businesses.
What are the benefits to investors?
Under the Opportunity Zone program, individual and corporate taxpayers are eligible to defer paying tax on gains from the sale of stock, business assets, or any other property by investing the proceeds into an Opportunity Zone Fund (a "QOF"). The QOF, in turn, must invest at least 90% of its assets, directly or indirectly, in businesses located in certain low-income communities designated as Qualified Opportunity Zones. Partial elimination of tax on deferred gains from that original, rolled-over investment results from a 10% increase in the basis of a QOF investment held for at least five years (such that investment in the QOF must occur by the end of 2019) and a 15% increase in the basis of a QOF investment held for at least seven years (such that investment in the QOF must occur by the end of 2020). All of the deferred gain will be realized at the end of 2026, if not realized by disinvestment sooner, including the occurrence of an "inclusion event" as discussed below. But the big prize is that future appreciation on the new investment in the Qualified Opportunity Zone can be excluded from taxation if the investment in the QOF is held for at least 10 years.
What "gains" are eligible for investment under the Opportunity Zone program?
Only capital gains are eligible for investment. This includes net 1231 capital gains as determined as of the end of the taxpayer's tax year.
Are capital gains realized by a partnership, corporation, REIT, or other entities eligible?
Yes. Gains recognized by individuals, C corporations, S corporations, RICs, REITs, partnerships, and certain other pass-through entities are all eligible.
Who can/must be the investor in the QOF?
Where an individual or C corporation sells property at a gain, then such individual or C corporation must be the person that makes the investment in the QOF. See the following Q&A regarding a partnership or S corporation realizing capital gain.
If the capital gain is realized by partnership or similar pass-through entity, is it the entity or the owner that must reinvest the gain to qualify?
The partnership may elect to defer the gain. If the partnership does not elect to defer the gain, then a partner may elect to defer its portion of the partnership's gain. The partner generally has 180 days from the end of the partnership's tax year to so elect. Similar rules will apply to other pass-through entities (including S corporations, decedents' estates, and trusts) and to their shareholders and beneficiaries.
Are capital gains realized from sales to persons related to or affiliated with the seller eligible?
No. Gains that arise from a sale or exchange with a related person are not eligible. "Related person" is defined for this purpose using a 20% common ownership test.
By what date must gain be realized in order to be eligible?
The taxpayer must realize the gain no later than December 31, 2026, in order to obtain any deferral (all deferral ends as of December 31, 2026 in any event) and exclusion benefits from the Opportunity Zone program.
Can the investment in the QOF be in the form of equity?
Yes. The investment must be in the form of an equity investment. The Proposed Regulations clarify that eligible equity interests include preferred stock and partnership interests with special allocations. However, if there is a deemed contribution of money to a QOF under the tax rules regarding partnership debt and its effect on basis, an increase in a partner's share of partnership liabilities as a result of such deemed contribution would not cause that basis increase to be an ineligible investment in the QOF.
Can the investment be in the form of a loan to the QOF?
No. The investment must be an equity investment. However, the taxpayer may use the equity interest in a QOF as collateral to secure a loan without affecting the status of the equity as an eligible investment.
Can the investment in the QOF be made with property other than cash?
Yes. If a taxpayer transfers property other than cash to a QOF, the taxpayer's QOF investment (i.e., the portion of the taxpayer's investment that is eligible for Opportunity Zone program benefits) is equal to the lesser of (1) the taxpayer's basis in the transferred property or (2) the fair market value of the taxpayer's QOF investment (in the case of a QOF that is a partnership, determined without regard to any liabilities allocated to the taxpayer).
Note that QOF equity interests solely issued in exchange for the taxpayer's services (i.e., a carried interest) would not be qualifying QOF investments eligible for the Opportunity Zone program benefits.
Can an interest in a QOF be acquired from a person other than the QOF?
Yes. An investor can invest capital gain in a QOF by buying an interest in the QOF from another person. The purchase can be made using either cash or property. The qualifying investment in the QOF is either (i) the amount of cash paid for the QOF interest or (ii) the fair market value of property other than cash.
If the investor transfers appreciated property and triggers taxable gain on the purchase, that gain is not eligible for deferral via investment in a QOF.
Can the taxpayer invest more than his or her deferred gain in a QOF?
Yes; however, such investment would be treated as a "mixed-funds" investment. A taxpayer has a "mixed-funds" investment if:
- The taxpayer contributes cash or other property to the QOF than is greater than the taxpayer's eligible gain. In this case, the QOF investment would be limited to the taxpayer's eligible gain. Any equity received for the excess amount contributed would not be eligible for the Opportunity Zone program benefits.
- The taxpayer contributes property that has a fair market value in excess of the property's adjusted basis in a nonrecognition transaction. Here, any equity received for the excess amount would not be eligible for the Opportunity Zone program benefits.
- The taxpayer receives part of his or her QOF equity in exchange for services rendered (i.e., a carried interest). Here, the portion of the equity that would not be eligible for the benefits of the Opportunity Zone program is equal to the taxpayer's highest percentage interest in residual profits attributable to the "service" portion of the interest.
If a taxpayer has a mixed-funds investment in a QOF (including a QOF taxed as a partnership), the taxpayer would be treated as having 2 separate interests solely for purposes of the Opportunity Zone program. If the QOF is a flow-through entity, items of income, gain, loss, and deduction would be allocated to the interests based on the taxpayer's relative capital contributions for each "separate" interest.
Where are Opportunity Zones located?
Each state, DC, and certain territories were required to nominate Qualified Opportunity Zones within their jurisdictions for certification by the Treasury Department. That process is complete. A list and maps of Opportunity Zones are available at https://www.cdfifund.gov/Pages/Opportunity-Zones.aspx
What requirements apply to setting up a QOF?
A partnership or corporation certifies itself as a QOF by filing an election with its tax return for the first year during which the entity desires to be a QOF. The election is made on Form 8996, Qualified Opportunity Fund. The IRS has released a draft of this form and the instructions thereto. The draft form requires a QOF to provide the IRS with information regarding the value of the QOF's assets and qualified opportunity zone property. Note that the IRS plans to update Form 8996 for 2019 and subsequent tax years.
Note that no approval or action by the IRS or other federal agency is needed for certification. Unless the IRS adds additional requirements when it ultimately provides regulatory guidance on the program, the statutory requirements are limited to the following:
- The QOF must be organized as a corporation or partnership; and
- The QOF must be organized for the purpose of investing in "qualified opportunity zone property."
The requirement that the QOF be a corporation or partnership refers to the QOF's characterization for federal income tax purposes. Thus a state law limited liability company with more than one member (and that has not made an election to be treated as an association taxable as a corporation) would be treated as a partnership and is eligible to self-certify as a QOF.
No restrictions apply as to who may organize, own, or manage a QOF. Thus, QOFs can be single-investor funds in which a single taxpayer with gains to defer forms its own fund and directly controls the timing and selection of its investment in Opportunity Zone Property. Note that in order to have only a single investor/owner, an QOF would need to be classified as a corporation for federal income tax purposes, and corporate income tax status may not be the best way to achieve all of a QOF's tax objectives (e.g., any losses would not pass through to the investor). At the other end of the spectrum, a sponsor could raise funds from multiple taxpayers who have recognized gains and pool their gain rollovers into a multi-investor QOF, with the sponsor selecting and managing the QOF's investments.
Are there ongoing compliance filings that a QOF must make each year?
Yes. Form 8996 must be filed annually by the QOF. More importantly, as discussed below, a QOF must hold at least 90% of its assets in Opportunity Zone Property. This testing requirement comes with its own, separate monetary penalty for non-compliance. The monetary penalty is calculated, if applicable, on Form 8996.
How quickly must a taxpayer roll over gain into a QOF?
The statute provides a 180-day period during which the investment into the QOF must be made beginning with (and including) the date of the sale or exchange of the existing investment.
Partnerships have the benefit of a special rule that provides significant flexibility for the timing of the election for capital gain realized at the entity level. If a partnership realizes eligible capital gain, but does not make a QOF deferral election with respect to such gain, the partner may elect to defer his or her share of the gain. In such a situation, the partner has 180 days from the end of the partnership's taxable year. However, a partner can choose to start the 180-day period earlier. For example, if a partnership sells a capital asset on January 1, 2018 and notifies the partners that it will not make a gain deferral election, then a partner has until June 30, 2019 to elect to roll over its share of that gain into a QOF.
If a taxpayer invests in a QOF and later sells or exchanges the QOF interest such that the taxpayer would recognize the deferred gain, then the taxpayer can reinvest the gain from the sale of the original QOF investment into another QOF and elect again to defer the previously deferred gain. This provision allows a taxpayer to make back-to-back investments. This provision is available only if the taxpayer has disposed of its entire initial investment in the QOF. The reinvestment into another QOF would re-start the taxpayer's holding period for his or her QOF investment.
What is the process for making the capital gain deferral election?
Taxpayers will make the deferral election on Form 8949, Sales and Other Dispositions of Capital Assets, attached to taxpayers' income tax returns for the year in which the gain would have been recognized but for the deferral election.
What happens when the deferred gain is recognized?
A taxpayer will recognize the deferred gain on the earlier of (1) the taxpayer's sale or exchange of the QOF investment; or (2) December 31, 2026. As noted above, a taxpayer may be able to avoid recognition of the deferred gain under (1) by reinvesting his or her gain into QOF. However, all deferred gain must be recognized by December 31, 2026, even if the taxpayer has not sold or exchanged his or her investment. Accordingly, taxpayers must be aware that they may have a gain recognition event in 2026 with no associated income or cash.
Note that a taxpayer may make separate investments in a QOF at different times. If the investments are indistinguishable (other than the timing of the investment) and the taxpayer sells less than all of his or her interests, the IRS will identify the interests sold using the "first-in, first-out" method. Accordingly, taxpayers making multiple investments in the same QOF are encouraged to separately identify these investments in the event of a future sale of less than all of a taxpayer's interests.
How quickly must a QOF invest in Opportunity Zone Property?
At least 90% of the assets of a QOF must be invested in Opportunity Zone Property. Opportunity Zone Property includes both (i) direct ownership and operation by the QOF of Qualified Opportunity Zone Business Property and (ii) indirect investment in such business property via investments in equity interests in one or more operating subsidiary entities (which in turn must each be a tax law corporation or partnership) that are Opportunity Zone Businesses. The Proposed Regulations provide that the QOF should use the asset values reported on its applicable financial statement for the taxable year to determine whether the QOF has satisfied this test. If the QOF does not have applicable financial statements, the Proposed Regulations provide that the QOF should use the unadjusted cost of its assets.
The QOF must satisfy the 90% test on both the last day of the first 6-month period of the taxable year of the QOF and the last day of the taxable year of the QOF. The Proposed Regulations allow a QOF to designate the first month it will be treated as a QOF; however, no deferral election can be made for investments to the QOF until the "first month" elected by the QOF. Thus, depending on when funds are contributed into a QOF, the QOF would have six months at the most to invest at least 90% of its assets into Opportunity Zone Property. For example, if the first month for the QOF was October 2018 and the QOF uses the calendar year as its taxable year, then it will have only one testing date for its first year of operation – December 31, 2018. However, if the QOF's first month is February 2018 and the QOF uses the calendar year as its taxable year, it will have two testing dates in its first year of operation – July 31, 2018 and December 31, 2018.
For purposes of the 90% test, a QOF can exclude any investments received in the 6 months preceding the testing date; provided that such investments are cash, cash equivalents or short term (18 months or less) debt instruments.
What happens if a QOF sells property that it holds? Does it get any grace period before the sale proceeds count against it for purposes of the 90% test?
A QOF is allowed 12 months from the date of the distribution, sale or disposition of qualified opportunity zone stock, qualified opportunity zone partnership interests, or Qualified Opportunity Zone Business Property to reinvest proceeds from such transaction in other qualifying property. During such 12 month period, any proceeds must be held in cash, cash equivalents or short term (18 months or less) debt instruments.
No similar reinvestment grace period is available for asset dispositions by a QOZB. Thus, following a disposition any cash held by the QOZB likely will have adverse effects under the several tests that apply for determining QOZB status. The IRS has requested comments on whether a rule similar to the grace period now provided to QOF dispositions should be available for asset dispositions by QOZBs (i.e., whether a QOZB can reinvest proceeds from a sale of its assets).
Note, however, that if a QOF (or a QOZB, if the IRS expands the reinvestment rule to such entities) disposes of its assets, the QOF likely would recognize gain. If the QOF is a pass-through entity, this gain would flow-through (i.e., be taxable to) its owners (except to the extent that the owners have satisfied the 10 year holding period requirement and the flow-through gain is all capital gain). At this time, the IRS has declined to exempt QOFs and investors from the income tax consequences of such dispositions, although the IRS has requested further comments on this issue. The result is that, for sales within the 10 year holding period, the investors will have flow-through gain even if the QOF reinvestments 100% of the proceeds from any sale into qualifying property.
If a taxpayer holds an equity interest in a QOF for at least 10 years, the taxpayer can elect to exclude from its gross income any capital gain recognized by the QOF as a result of the disposition of the QOF's Qualified Opportunity Zone Business Property. But this election to exclude gain realized by the QOF after the end of the 10 year holding period applies only to capital gain – any other gain (such as gain from hot assets or depreciation recapture) will be taxable to the pass-through entity owner. A special rule is available for REITs in such a situation. No such exclusion rule is available for a QOF that is a "c corporation."
If a QOF invests in a corporation or partnership in an Opportunity Zone, how quickly must that entity invest in Qualified Opportunity Zone Property?
As noted above, a QOF can invest in qualifying projects directly (including through a single-member, disregarded limited liability company) or indirectly through a corporation or partnership. The time for a QOF to make its investment directly or into the stock or partnership interest of a subsidiary is discussed in the context of the 90% test and its related penalty. The topic here is the time for a subsidiary corporation or subsidiary partnership of a QOF to invest funds received from its parent QOF.
A QOF's interests in a corporation or partnership qualify for the 90% asset test if the corporation or partnership qualifies as a QOZB. The corporation or partnership must be a QOZB both at the time the QOF acquires its interests in the subsidiary and during substantially all (i.e., 90%) of the QOF's holding period for its interests in the subsidiary.
Among the requirements for the subsidiary to qualify as a Qualified Opportunity Zone Business ("QOZB") are that:
- Substantially all (i.e., at least 70%) of the tangible property owned or leased by the subsidiary is Qualified Opportunity Zone Business Property ("QOZBP"), as determined by the following criteria:
- The property is acquired by the subsidiary by purchase after December 31, 2017;
- The original use of the property commences with the subsidiary or the subsidiary substantially improves the property (these requirements are discussed below); and
- During substantially all (i.e., at least 90%) of the subsidiary's holding period for the property, substantially all of the use of the property was in an Opportunity Zone.
- The subsidiary derives at least 50% of its gross income from the active conduct of a trade or business;
- The subsidiary has less than 5% of the average of the aggregate unadjusted basis of its property attributable to "Nonqualified Financial Property," and
- The subsidiary uses a substantial portion (i.e., 40%) of any intangible property in an active business.
These rules come by cross-reference to other tax programs, which require that such tests be satisfied on a taxable-year basis. Accordingly, investing cash so as to satisfy these tests by the end of the first taxable year (which could be a short year) could be difficult or impossible for many QOZBs.
"Nonqualified Financial Property" is defined elsewhere in the Internal Revenue Code as debt, stock, partnership interests, options, futures contracts, forward contracts, warrants, notional principal contracts, annuities, and other, similar property specified in regulations, but does not include (1) reasonable amounts of working capital held in cash, cash equivalents, or debt instruments with a term of 18 months or less, or (2) certain debt instruments. Such term would include bank accounts, checking accounts, and other time and demand deposits.
Although not specifically listed, the term "Nonqualified Financial Property" also would include cash on hand. However as discussed below, the IRS provided a "Working Capital Safe Harbor" in the Proposed Regulations that protects against a violation of the test for cash or other investments held in compliance with safe harbor requirements.
What are the requirements for the Working Capital Safe Harbor? And what tests does it protect against failing?
The safe harbor is available for businesses that acquire, construct, or rehabilitate tangible business property (including real property) and any entities that are developing a trade or business in the Opportunity Zone. Such businesses can hold cash for a period of up to 31 months if:
- there is a written plan that identifies the cash as held for the acquisition, construction, or substantial improvement of opportunity zone property or the development of a trade or business in an Opportunity Zone;
- there is a written schedule showing that the cash will be used within 31 months; and
- the business substantially complies with the written schedule.
Further, if a business is unable to complete its plan within 31 months because it is waiting for government action, this failure to comply would not be considered a violation of the safe harbor.
Satisfaction of the Working Capital Safe Harbor provides the following benefits to a QOZB:
- Such amounts need not be taken into account for purposes of the limitation that no more than 5% of the assets can be Nonqualified Financial Property.
- Earnings on such amounts count favorably for purposes of the 50% gross income test.
- Such amounts are treated favorably for purposes of the 40% use of intangible property with the QOZ test.
- Such amounts are not treated as causing a failure of the requirement that, if a QOZB holds tangible personal property, 70% of such tangible personal property be acquired, constructed or substantially improved in the QOZ.
Note that under the Proposed Regulations the Working Capital Safe Harbor does not apply at the QOF level. Thus, the timing rules for expenditure of funds by the QOF are generally dictated by the desire to avoid imposition of the penalty applicable to failure to comply with the 90% expenditure test.
How quickly must rehabilitation of acquired existing Opportunity Zone Property occur?
Here again is one of numerous instances in which uncertainty exists in implementing the Opportunity Zone Program: Either a QOF or its subsidiary must substantially improve the property it acquires, unless the "original use" (as discussed below) of the property in the Opportunity Zone commenced with the QOF or subsidiary. To "substantially improve" a property, during a 30-month period a QOF (or its subsidiary) must make additions to its basis with respect to the property in the hands of the QOF (or subsidiary) that exceed its basis in the property at the beginning of the 30-month period. The rehabilitation must occur "during any 30-month period beginning after the date of acquisition of such property." Whether the substantial improvement test is satisfied is determined on an asset by asset basis.
Although the statute appears to provide flexibility regarding when the 30-month period can be considered to begin, until the IRS provides guidance on the timing of commencement requirement, taxpayers may want to take a conservative approach and plan to complete required improvements of their property during the 30-month period beginning on the date of acquisition.
What does it mean that the "original use" of Opportunity Zone Property must be by the QOF?
For all projects, the "original use" of the property in the Opportunity Zone must commence with the QOF, or the QOF must substantially improve the property. The substantial improvement requirement is discussed in the Q&A immediately above. The original use standard has been used in other programs similar to the Opportunity Zone program (including the Gulf Opportunity Zone program and the DC Enterprise Zone program), which indicates that the standard's application to tangible personal property should be clear: new tangible personal property purchased by the QOF or a subsidiary that constitutes an Qualified Opportunity Zone Business and first used in an Opportunity Zone should qualify. Property that has been depreciated or amortized by a taxpayer other than the QQF or the Qualified Opportunity Zone Business would not satisfy the original use requirement.
The rules with respect to real property are less clear. An existing building located in an Opportunity Zone could not satisfy the original use test when purchased by a QOF, and thus would have to be substantially improved. However, an existing building can satisfy the original use requirement of the building (i) has been vacant for at least 5 years before purchase and (ii) the QOF or the Qualified Opportunity Zone Business acquires the building by purchase.
Can vacant land be Qualified Opportunity Zone Business Property?
Vacant land located in an Opportunity Zone does not need to satisfy the original use test or the substantial improvement test. However, vacant land can be Qualified Opportunity Zone Business Property if it is used in a trade or business of a QOF or a QOZB. A trade or business does not include holding land for investment.
Can real property satisfy the Qualified Opportunity Zone Business Property rules when it straddles an Opportunity Zone census tract? If yes, what test applies?
Yes. If the amount of real property based on square footage located within the qualified opportunity zone is substantial as compared to the amount of real property based on square footage outside of the zone, and the real property outside of the zone is contiguous to part or all of the real property located inside the zone, then all of the property would be deemed to be located within a qualified zone. Real property located within the qualified opportunity zone should be considered substantial if the unadjusted cost of the real property inside a qualified opportunity zone is greater than the unadjusted cost of real property outside of the qualified opportunity zone.
Can existing property that is leased by a QOF or by a QOZB qualify as Qualified Opportunity Zone Business Property?
Yes, provided that (i) the lease is entered into after December 31, 2017 and (ii) substantially all of the use of the leased tangible property occurs in the Opportunity Zone during substantially all of the period for which the QOZB leases the property, and (iii) the lease must be a "market rate lease." The evaluation of whether a lease is at market rate takes into account whether the terms of the lease reflect common, arms-length market practice in the locale that includes the Opportunity Zone.
Must leased property satisfy the requirements applicable to purchased tangible property that its "original use" be in the Opportunity Zone and that it be "substantially improved"?
No. Unlike tangible property that is acquired by purchase, leased tangible property is not subject to either the original use requirement or the substantial improvement requirement. But see the discussion below regarding tangible personal property leased from a related person.
Can existing property be leased from a related person (lessor and lessee are related to one another under the numerous related person rules) and still qualify as Qualified Opportunity Zone Business Property?
Yes. Unlike tangible property that is acquired by purchase, leased tangible property can be leased from a lessor by a QOF or a QOZB as lessee that is a related person to the lessor provided that the following requirements are met (in addition to the general requirements discussed above that are applicable to all leased property):
First, a QOF or a QOZB must not prepay rents on the lease for more than 12 months.
Second, if the lease includes tangible personal property, then the lessee must become the owner of tangible Qualified Opportunity Zone Business Property that has a value not less than the value of the leased personal property. Acquisition of this 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. Note that this rule applies only to tangible personal property such as furniture and equipment and not to real property.
Lastly, an anti-abuse rule requires that for leased real property (other than unimproved land), no plan, intent or expectation can exist that the real property will be purchased by the QOF or the QOZB at less than fair market value to be determined at the time of purchase and without taking regard to prior lease payments.
How is Qualified Opportunity Zone Business Property acquired by lease valued for purposes of the 90% and 70% tests?
Valuation of the leased property is determined annually based on either (i) the reporting of the lease's value on the lessee's financial statements if those statements are prepared according to U.S. generally accepted accounting principles (GAAP) and require recognition of the lease of the tangible property or (ii) a present value calculation.
The IRS commentary notes that, beginning in 2019, generally accepted accounting principles (GAAP) require public companies to calculate the present value of lease payments in order to recognize the value of leased assets on the balance sheet.
The present value of the lease property is equal to the sum of the present values of the payments to be made under the lease for such tangible property using the "applicable Federal rate" set by Section 1274(d)(1) as the discount rate. The present value valuation is done at the time the lease for such property is entered into. Once calculated, such calculated value is used as the value for such asset for all testing dates. The drawback to the discounted present value method (in contrast to the use of reporting on financial statements) is that it does not account for depreciation and thus will no adjust for changes in assets values over time.
What types of projects/property are permissible investments?
All types of projects and property qualify as permissible investments for a QOF, with the exception of the limited types of prohibited businesses if the investment is made through a subsidiary as follows: a private or commercial golf course, country club, massage parlor, hot tub facility, suntan facility, racetrack or other facility used for gambling, or any store, the principal business of which is the sale of alcoholic beverages for consumption off premises. While the statute does not impose these restrictions if a QOF invests directly in Qualified Opportunity Zone Business Property, guidance may well subject all investments to these restrictions, as the difference in treatments seems unlikely to have been intentional.
One of the requirements for qualifying as a QOZB (applicable if a QOF invests through a corporate or partnership subsidiary, but not if it invests directly in projects) is that at least 50% of its total gross income be derived from the "active conduct" of a trade or business. The IRS has issued guidance providing that a trade or business has the same meaning for purposes of the Opportunity Zone program as under Section 162. However, solely for purposes of the Opportunity Zone program, the ownership and operation (including leasing) of real property used in a trade or business constitutes the active conduct of a trade or business.
How does a QOZB determine if at least 50% of its total gross income "from the active conduct of such business"?
Three safe harbors and a facts and circumstances test are provided for determining whether sufficient income is derived from a trade or business in a qualified opportunity zone for purposes of the 50% test. Businesses only need to meet one of these safe harbors to satisfy that 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. This test is intended to address businesses located in a qualified opportunity zone that primarily provide services. The percentage is based on a fraction, the numerator of which is the total number of hours spent by employees and independent contractors (and employees of independent contractors) performing services in a qualified opportunity zone during the taxable year, and the denominator of which is the total number of hours spent by employees and independent contractors (and employees of independent contractors) in performing services during the taxable year.
The second safe harbor is based upon amounts paid by the trade or business for services performed in the qualified opportunity zone by employees and independent contractors (and employees of independent contractors). Under this test, 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 found in section 1397C(b)(2). This test is determined by a fraction, the numerator of which is the total amount paid by the entity for employee and independent contractor (and employees of independent contractors) services performed in a qualified opportunity zone during the taxable year, and the denominator of which is the total amount paid by the entity for employee and independent contractor (and employees of independent contractors) services performed during the taxable year.
The third safe harbor is a conjunctive test concerning tangible property and management or operational functions performed in a qualified opportunity zone, permitting a trade or business to use the totality of its situation to evaluate compliance with test. Thus, 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 these three safe harbor tests may meet the 50-percent requirement based on a facts and circumstances test if, based on all the facts and circumstances, 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.
Can a QOF hold cash pending investment in Opportunity Zone Property?
It depends – as discussed above, the Proposed Regulations include a working capital safe harbor that is available to a subsidiary partnership or subsidiary corporation in which a QOF invests. But that safe harbor is not available to the QOF itself. Rather, under the Proposed Regulations, the holding of cash by the QOF is restricted by the twice-annual application of the 90% test for investment by the QOF (and the resulting annual penalty for shortfalls in meeting the 90% tests) as discussed above.
Putting all of the timing rules together, how long might funds invested into a QOF and by the QOF into a lower tier QOZB entity be held as cash?
Stringing all the rules together can provide a period as long as 43 months for deployment of capital following investment of capital gain into a QOF under the following rules:
- A QOF is subjected to the 90% test every six months but gets an exception for funds invested in the QOF with the prior six months. Thus, an investment early in a calendar tax year doesn't trigger a penalty until the December 31 testing date and thus permits almost 12 months before the QOF is compelled to invest in a lower tier QOZB entity without penalty.
- A lower tier QOZB can make use of the 31 month Working Capital Safe Harbor to assist with its qualification as a QOZB while not having deployed the capital invested in it by the QOF.
- Thus, on particular facts, the combination of the timing rules for application of the QOF 90% testing rules and the Working Capital Safe Harbor may provide nearly 43 months before all invested capital must be deployed.
Can borrowed funds (leverage) be used in the Opportunity Zone program?
Yes, leverage can be used at several different levels. Because there is no required connection between the capital gain that a taxpayer desires to defer and cash proceeds used to fund an investment in a QOF, a taxpayer could borrow such amounts. In addition, there is no prohibition on a QOF borrowing to partially fund (together with the taxpayer's equity investment in the QOF) the purchase of Opportunity Zone Property.
Similarly, a partnership or corporate subsidiary of a QOF could borrow to help fund a project. Borrowing at the subsidiary level could potentially be tailored to comply with the timing requirements and cash limitations discussed above – for example, a taxpayer's equity could be used to acquire an existing property, and then borrowed funds could be drawn down as needed to improve the property.
But if a QOF investor invests amounts in a QOF in addition to its capital gain eligible to be rolled into the QOF, then such excess investments will not be eligible for any of the benefits of the Opportunity Zone program, regardless of the source of the investor's fund for excess investment. Thus, an investor cannot take advantage of the exclusion benefit with respect to investments that it makes in a QOF in addition to its capital gain rollover.
If land and a building are to be improved, how does the substantial improvement requirement apply to them?
The QOF must substantially improve the building by spending an amount on improvements to the building at least equal to the QOF's cost basis in the building. The separate cost basis of the land does not affect the substantial improvement calculation for the building, and the land does not need to be improved in order for the substantial improvement requirement to be satisfied with respect to the overall project.
How is the exclusion benefit realized by a taxpayer that holds its QOF investment for at least 10 years?
If a taxpayer holds an equity interest in a QOF for at least 10 years, the taxpayer can increase the basis of his or her equity interest to the fair market value of that equity interest on the date the interest is sold or exchanged. As a result, all of the gain attributable to appreciation in the QOF's value would be tax-free. The basis step-up is available only to the extent that the taxpayer elected to defer the recognition of capital gain. Accordingly, if a taxpayer invests cash (for which no deferral election has been made) and proceeds from a capital transaction (for which a deferral election has been made), the investment will need to be bifurcated, and the appreciation with respect to the cash portion will be subject to tax on the eventual sale or exchange of the QOF interest. The Proposed Regulations make it clear that on disposition of an equity interest in a QOF, all types of gain (including any "hot asset" gain or depreciation recapture that could exist if the QOF is a partnership) are excluded from the investor's income.
If a taxpayer holds an equity interest in a QOF for at least 10 years, the taxpayer can elect to exclude from its gross income any capital gain recognized by the QOF as a result of the disposition of the QOF's Qualified Opportunity Zone Business Property. There are two unresolved issues here. First, the exclusion only applies to a sale by the QOF of its directly held property, including interests in subsidiary partnerships and corporations. If a QOF has a subsidiary partnership that sells an asset, the subsidiary partnership's gain (which ultimately would flow through to the investor) would not be eligible for the exclusion. Second, any "hot asset" gain and depreciation recapture would be recognized by the investor under the Proposed Regulations as currently drafted.
What happens if an investor makes a gift of his or her QOF investment?
A gift of a QOF investment is an Inclusion Event. Accordingly, any gift to another person would result in the investor immediately recognizing his or her deferred gain. The recipient of the gift would have a new holding period in the QOF investment.
What happens if an investor dies while holding a QOF investment?
Under the Proposed Regulations, death of an investor prior to December 31, 2026 does not trigger recognition of the deferred gain. Instead, the recipient of the QOF investment must recognize the deferred gain on the earlier of an Inclusion Event or December 31, 2026. The recipient of the QOF investment gets to "tack" the investor's holding period for purposes of determining whether the 5, 7, and 10 year holding requirements are satisfied.
What is the "general anti-abuse rule"?
The Proposed Regulations make repeated references to the "general anti-abuse rule." Under this provision of the Proposed Regulations, the IRS can re-characterize a transaction if the IRS determines that a significant purpose of the transaction was to achieve a result that is inconsistent with the purposes of the Opportunity Zone program.
To what extent can these 2019 Proposed Regulations be relied on?
Taxpayers can rely on the Proposed Regulations with respect to any gains recognized, and investments made, after April 17, 2019, provided that the taxpayer applies the Proposed Regulations consistently and in their entirety. Note, however, that a taxpayer cannot rely on any rules in the Proposed Regulations involving the election to adjust the basis, or exclude gain attributable to, an investment held for more than 10 years.
What further guidance can be expected from the IRS?
The immediate focus of the IRS is on finalizing the 2018 Proposed Regulations and the 2019 Proposed Regulations. Until those regulations are finalized it is uncertain whether any additional guidance will be issued.
Among the many topics on which new, enhanced or revised guidance can be expected as the Proposed Regulations are revised and finalized are those topics on which the IRS expressly solicited comments, including the following:
- the definition of "original use" for real and other tangible property;
- whether prior use of property should be disregarded for purposes of the original use requirement and, if so, under what circumstances;
- whether tangible property that has not been purchased but has been overwhelmingly improved can satisfy the original use requirement;
- the advantages and disadvantages of applying the substantial improvement test on an asset-by-asset basis;
- how the substantial improvement test applies to property that is not capable of being substantially improved;
- whether and when inventory is considered used in an opportunity zone;
- the treatment of leased tangible property, as provided for in the Proposed Regulations;
- whether Section 1397C(f) (which provides special rules for businesses straddling census tracts) should apply to other requirements of Section 1400Z-2;
- the safe harbors established for purposes of determining whether the 50% gross income requirement is satisfied and whether any additional safe harbors should be established;
- the proposed definition of a trade or business and whether any additional rules are needed to determine if a trade or business is being conducted;
- the proposed treatment of Section 1231 gains;
- whether the 12-month reinvestment rule also should apply to proceeds from the sale of assets by QOF subsidiaries;
- whether there is any legal support for the position that gains from the sale of assets by a QOF or subsidiary thereof should not be recognized;
- Inclusion Events generally
- the calculation of deferred gain that should be recognized on an Inclusion Event;
- whether taxpayers could engage in any abusive transactions designed to take advantage of an inside-outside basis disparity in a QOF taxed as a partnership;
- alternative ways to handle mixed fund investments (including whether an ordering rule should apply to require distributions to be offset fully against qualifying or non-qualifying investments first);
- the proposed provisions regarding changes in ownership of S corporations that own interests in QOFs; and
- the operation of the election to exclude pass-through gain by a direct owner of a QOF.
As noted above, the IRS plans to revise Form 8996 for 2019 and subsequent tax years and those revisions are likely to refine the procedural aspects of qualifying as a QOF and maintaining compliance as a QOF under the 90% investment in Qualified Opportunity Zone Business Property test.
When can such additional guidance be expected from the IRS
A public hearing on the 2019 Proposed Regulations occurred on July 9. Thus, movement by the IRS toward finalizing both the 2018 Proposed Regulations and the 2019 Regulations could happen any time, but realistically can only be expected after time is allowed for the IRS to review and react to the many written and oral comments submitted suggesting alterations and additions to the Proposed Regulations.