On April 17, 2019, United States Department of Treasury (“Treasury”) released the highly anticipated second round of proposed regulations pertaining to Qualified Opportunity Zones (the “Proposed Regulations”). While still leaving certain questions open, the Proposed Regulations provide much needed guidance and clarity on a number of major outstanding questions. The Proposed Regulations cover a wide variety of new rules, but in general focus on three distinct issues: investing in a Qualified Opportunity Zone Fund (“QOF”) and holding such investment, the 90 Percent Test and how a QOF must calculate it, and what assets and activities a Qualified Opportunity Zone Business (“QOZB”) may utilize.
Investing in a QOF
The Proposed Regulations include a number of rules which answer questions involving investing in a Qualified Opportunity Fund (a “QOF”) by an investor with gains. First, the Proposed Regulations clarify that Section 1231 gains qualify as capital gains which may be invested in a QOF but add a limitation with respect to the timing of such gains which will likely impact investors. Specifically, under the Proposed Regulations, a taxpayer’s Section 1231 gain amount is determined as of the last day of the taxpayer’s tax year after netting all Section 1231 gains with Section 1231 loses. Therefore, the 180 days a taxpayer has to invest such gain in a QOF begins as of the last day of a taxpayer’s taxable year (December 31 for a calendar year taxpayer). While this is generally a favorable rule, it does have the downside of potentially delaying a taxpayer’s investment in a QOF during the year. If a taxpayer sells a Section 1231 property during the tax year, they will not be able to invest any gain attributable to such sale until the last day of that tax year at the earliest.
The Proposed Regulations also provide additional rules with respect to how to acquire an interest in a QOF. For instance, the Proposed Regulations provide that a QOF interest can be acquired either directly from a QOF or from the holder of an existing QOF interest. Additionally, the Proposed Regulations provide rules stating that any interest in a QOF received for reasons other than the contribution of gain (e.g. providing the QOF with services or a carried interest) will not be treated as an interest eligible for tax free appreciation, etc. Therefore, a QOF cannot offer tax free recognition for an interest given as compensation to the manager of the QOF. However, it may be possible for Section 1231 gains incurred from a carried interest to in turn be invested into another QOF.
The Proposed Regulations make clear that partners in a QOF partnership receive basis with respect to their share of non-recourse liabilities of the QOF, and as a result, QOFs may make debt-financed distributions without triggering the recognition of deferred gain (an “Inclusion Event”), so long as the QOF does not distribute proceeds in excess of an investor partner’s basis and the distribution does not constitute a step in a disguised sale transaction. With respect to the “disguised sale” issue, this generally means a QOF may not refinance and distribute the proceeds within the first two years of the QOF’s existence.
Exiting a QOF
When it comes to exiting a QOF, the Proposed Regulations provide much sought relief, but also seek to prevent any transactions which the IRS might view as suspect. With respect to suspect transactions, the Proposed Regulations lay out an extensive list of transactions which would cause an investor in a QOF to recognize their deferred gain (“Inclusion Events”). In general, a transaction which reduces the investor’s equity interest in a QOF, either directly or indirectly, will be considered an Inclusion Event. With this list, the IRS is seeking to prevent investors from attempting to cash out of the QOF prior to the 2026 recognition date without recognizing the deferred gain.
However, the Proposed Regulations do allow for QOFs formed as partnerships or S corporations to sell individual assets and pass the gains to investors who have held their interest in the QOF for at least 10 years tax free. This allows QOFs to hold multiple assets and sell them individually while still allowing investors to take advantage of the ten-year tax-free appreciation rule. Investors were seeking a rule similar to this, as the first round of proposed regulations required the investor to sell their interest in the QOF to take advantage of the tax-free ten-year exit rule and holding multiple assets in a single QOF might make selling the interest difficult. Under these rules, the QOF may sell assets individually and pass the proceeds up to its investors on their Schedules K-1 who may then elect to not recognize any capital gains taxes from the sale. In addition, each investor will increase his or her basis in the QOF interest by the amount of the capital gain eliminated, which allows the investor to receive the proceeds without incurring any tax as a result. While this in general provides significant relief, there are still possible issues. First, the Proposed Regulations only allow for this at the QOF level: if a Qualified Opportunity Zone Business held by the QOF sells individual assets, there is no comparable rule allowing for the capital gains to be eliminated. Second, the Proposed Regulations only allow capital gains to be eliminated under this rule: other possible gains, such as ordinary income associated with depreciation recapture are not per se eliminated. This is opposed to the elimination of gain from the sale of an investor’s QOF interest, which eliminates all gain, not just capital. Finally, this rule only applies to pass-through entities such as partnerships and S-corporations; no comparable rule exists for QOFs organized as C-corporations. The Treasury Department and IRS have requested comments on the eligibility and mechanics of this rule.
The 90 Percent Test
The Proposed Regulations also provide new rules which help relax the application of the requirement that a QOF must hold at least 90 percent of its assets as Qualified Opportunity Zone Property (the “90 Percent Test”). First, the Proposed Regulations provide relief with respect to cash contributions made to a QOF. Now, in calculating its 90 Percent Test, a QOF may disregard new assets received in the preceding six months as long as such assets are held as cash, cash equivalents, or debt instruments. Additionally, the Proposed Regulations provide guidance as to how a QOF may reinvest the proceeds of the sale of Qualified Opportunity Zone Property (“QOZP”). Specifically, the proceeds of a sale of an asset of the QOF will be considered QOZP if such proceeds are reinvested within 12 months from the date of the sale. This rule only applies so long as the proceeds of the sale are held as cash, cash equivalents, or debt instruments. Additionally, any delay in reinvestment attributable to waiting for government action (e.g. waiting for a construction permit) will extend the 12-month reinvestment period. It is important to note, however, that, though a QOF may reinvest the proceeds from the sale of QOZP, there is no deferral on any gain recognized in such sale. The QOF or its partners will recognize gain on the sale of the QOZP in the year the sale occurs.
Similarly, the Proposed Regulations slightly modify the Working Capital Safe Harbor to make it more flexible and taxpayer friendly. First, the Working Capital Safe Harbor now includes the development of a trade or business, not just acquisition and improvement of real estate. Secondly, any delay in construction/development of a business attributable to government inaction (e.g. waiting for construction permits) will not count against the 31-month limit under the Working Capital Safe Harbor.
Qualified Opportunity Zone Property
Finally, the Proposed Regulations provide additional guidance as to what property may qualify as QOZP. First, under the Proposed Regulations, the “Original Use” of an asset begins as of the date on which the QOF/QOZB or prior taxpayer began taking depreciation or amortization on such asset, or otherwise would have been able to take either but elected not to claim. In other words, tangible property placed in service prior to being acquired and placed in service by the QOF or QOZB will not qualify as QOZP. However, as an exception to this general rule, under the Proposed Regulations, an existing building can meet the “Original Use” standard if such building has been vacant for five or more years prior to acquisition by the QOF. Furthermore, tenant improvements made to leased property by a lessee will be considered to be an “Original Use” and will be considered QOZP up to unadjusted basis of such improvements under Section 1012.
The Proposed Regulations also provided much anticipated guidance with respect to the use of leased property by a QOF or QOZB (“Leased Property”). Under the Proposed Regulations, “Leased Property” may be considered QOZP if:
Unlike with property owned by a QOF or QOZB, there is no original use requirement for leased property, so whether the property has been used previously is irrelevant. However, the Proposed Regulations contain additional rules limiting leases from related parties. These rules are:
Furthermore, there must be substantial overlap between the acquired QOZP and leased QOZP in terms of which opportunity zone in which they are substantially used. For example, a QOZB leases a building for use in its trade or business with a lease worth $100,000. The QOZB must, within 30 months of entering into such lease, acquire other QOZP worth at least $100,000 (e.g. machining equipment), and such acquired QOZP must be substantially used in the same opportunity zone in which the leased building is located. Finally, if there is an agreement by the lessor and lessee to have the lessee acquire leased property for an amount other than fair market value of such property at the time of the purchase (disregarding prior lease payments), then the leased property is not QOZP. In other words, a QOF cannot use a “lease to own plan” to avoid original use or related party rules.
Finally, in contrast to the taxpayer friendly rules related to original use and leased property, the Proposed Regulations added additional rules regarding the character of land held by a QOF to ensure that QOFs may not engage in “land banking”. Specifically, land, whether improved or not, will qualify as QOZP only if used as part of an active trade or business as defined under Section 162. In addition, the Proposed Regulations contain an anti-abuse provision that allows the IRS to disqualify land, even if it may qualify as used in a trade or business, if such land was acquired for abusive purposes.
Qualified Opportunity Zone Businesses
The Proposed Regulations also provide significant guidance related to what assets and activities qualify in determining whether an entity is a Qualified Opportunity Zone Business (“QOZB”). Specifically, they provide much needed guidance as to how a QOZB can own an operating business, as opposed to simply holding rental real estate. In general, the Proposed Regulations clarify that the “active conduct of a trade or business” for purposes of Qualified Opportunity Zones is the same definition as under Section 162 and all related regulations, revenue rulings, etc. However, despite deferring to the existing rules surrounding Section 162 generally, the Proposed Regulations did add a single caveat that, for purposes of QOZs, the ownership and operation (including leasing) of real property located in an opportunity zone is treated as active trade or business. Despite this caveat though, the Proposed Regulations also make clear that the “mere receipt of income from a triple net lease” does not constitute an active trade or business, so at least some active management of real property is required. What level of activity would overcome this limitation is currently unknown, but it can be assumed that some level of ongoing, active management of triple net lease property would be required.
The Proposed Regulations provided guidance as to how to determine whether a QOZB has generated at least 50% of its gross income within an opportunity zone. Specifically, the Proposed Regulations provide three safe harbors. A QOZB is deemed to generate at least 50% of its gross income from within an OZ if:
In addition to the above safe harbors, a QOZB may also meet 50% income test based on its specific facts and circumstances.
Additionally, the Proposed Regulations also provided much needed guidance as to the meaning of “Substantially All” with respect to the use of an asset by a QOZB as well as the QOZB’s holding period of such asset. With respect to what percentage of the use of an asset must occur within a QOZ, “substantially all” means 70%, regardless of whether the asset is owned or leased. For example, a lawnmower owned by a QOZB must be used at least 70% of the time in a QOZ in order to qualify as QOZP. With respect to whether an asset has been QOZP for “substantially all” of the time it has been held by a QOZB, “substantially all” means 90%. For example, a lawnmower must have met all the standards of QOZP for at least 90% of the time it has been held by a QOZB in order to qualify as QOZP in the QOZB’s hands. Finally, the Proposed Regulations clarify that the “substantial use” of intangibles in the QOZB’s trade or business equals 40% or more of such intangible’s use.
In general, the Proposed Regulations provide much needed guidance and clarity with respect to investing in a QOF and/or operating a QOZB. While some uncertainty remains, these rules should provide enough certainty to encourage investors who have been awaiting more guidance before forming QOFs, particularly those which were looking to invest in operating businesses rather than rental real estate. Treasury has also solicited comments with respect to several of the provisions within the Proposed Regulations, so it is likely that additional guidance will be released at some point in the next year.
Taxpayers interested in investing in a QOF should contact an FGMK representative.
The summary information in this document is being provided for education purposes only. Recipients may not rely on this summary other than for the purpose intended, and the contents should not be construed as accounting, tax, investment, or legal advice. We encourage any recipients to contact the authors for any inquiries regarding the contents. FGMK (and its related entities and partners) shall not be responsible for any loss incurred by any person that relies on this publication.