IRS Issues Proposed Regulations on Qualified Opportunity Zones
By Michael D'Addio, Principal, Tax & Business Services
Treasury and IRS issued a new set of proposed regulations on Qualified Opportunity Zones (QOZ) last week, which provides additional guidance and offers considerably greater flexibility in structuring business arrangements which satisfy the QOZ rules.
Highlights of the key items covered under the new proposed regulations include the following:
1. Expansion of the Working Capital Exception Rule
The law requires that a QOZ business (which includes operations performed through a QOZ subsidiary partnership or corporation) establish that no more than 5% of the average unadjusted basis of its property is attributable to nonqualified financial property. This creates a problem where the business holds significant cash, debt, stock, partnership interests, and other financial assets. The prior regulations excluded from the term “nonqualified financial property” amounts of reasonable working capital, defined as amounts designated in writing and actually spent pursuant to a written plan, during a 31-month period, for the acquisition, construction, and/or substantial improvement of tangible property in the QOZ. While useful for acquiring real estate or other tangible business assets, it had limited utility in other circumstances.
The new proposed regulations provide that the working capital exception applies where the planned use of the funds is for the development of a trade or business. This expansion of the working capital exception permits it to apply to operating businesses.
2. Special Election for Investors in Qualified Opportunity Fund Partnerships and S Corporations
A major benefit of the QOZ rules is the ability to eliminate all gain on the disposition of a Qualified Opportunity Fund investment after a 10-year holding. A QOZ can be structured as a partnership or S corporation operating the business in the QOZ directly but, due to several operational rules, is most likely to own interests in a subsidiary partnership or corporation which operates the Qualified Opportunity Zone business. Prior regulations made clear that the 10-year holding period benefit could only be obtained if the investor sells his or her interest in the Qualified Opportunity Fund. If the Qualified Opportunity Fund sells its interest in directly owned Qualified Opportunity Zone property, or gains were generated by a subsidiary partnership, these gains would pass through to the investor under normal tax rules. There was no way to take advantage of the 10-year rule.
The new proposed regulations provide a special election to an investor in a Qualified Opportunity Fund partnership or S corporation with a 10-year holding period, permitting the exclusion of capital gain from the disposition of Qualified Opportunity Zone business property which is separately stated on the Schedule K-1 issued by the Qualified Opportunity Fund. A similar rule permits Qualified Opportunity Fund REITs to designate capital gain from the sale of Qualified Opportunity Zone business property so that shareholders with the appropriate holding period can exclude the gain from income.
While still not as beneficial as the gain exclusion for the disposition of a Qualified Opportunity Fund interest (which covers all gain and not only capital gain related to Qualified Opportunity Zone business property), this rule may simplify and change the structure of many funds.
3. Investment Period for Section 1231 Gains
While the exclusion of gain under the QOZ rules applies to the extent that the gain is invested in a Qualified Opportunity Fund within 180 days from the date of sale, the new proposed regulations provide a special rule for section 1231 gains (i.e., assets used in the operation of a business). Since treatment as capital gain depends on netting all section 1231 gains and losses during the year, the 180-day investment period begins on the last day of the tax year, and the amount eligible for investment is the net amount of the taxpayer’s section 1231 gains.
4. Non-cash acquisition of Qualified Opportunity Fund Interest
The statute and prior regulations implied that an eligible taxpayer could defer eligible gain only through a cash investment directly into a Qualified Opportunity Fund. The new proposed regulations makes two clarifications: i) the Qualified Opportunity Fund interest can be with an investment of cash or property; and ii) a Qualified Opportunity Fund interest can be acquired by purchase from another investor.
The proposed regulations provide that the gain cannot be deferred where the Qualified Opportunity Fund interest is acquired for services. This is, in part, intended to address carried interests.
5. Inclusion Events
All or a portion of the current deferred gain under the QOZ rules is subject to income inclusion on the earlier of December 31, 2026, or the occurrence of an ”inclusion event.” The new proposed regulations provide that there is an inclusion event where the taxpayer reduces his or her equity interest in a qualifying investment. In addition, certain receipts of cash or property which are treated as distribution gains under federal tax law principles are considered inclusion events.
Inclusion events include gifts, corporate redemptions, or non-dividend distributions, certain partnership distributions. The regulations conclude that a transfer due to the death of the investor will not cause an inclusion event.
Where a transaction causes an inclusion event, the proposed regulations provide for certain basis- ordering rules so as to avoid a possible doubling of the taxable gain.
6. Original Use/Substantial Improvement
In general, Qualified Opportunity Zone business property must be acquired after December 31, 2017, by purchase from an unrelated party. Additionally, either the original use of the property must begin with the taxpayer, or the Qualified Opportunity Fund or Qualified Opportunity Zone Business must “substantially improve” the property. Both the statute and prior regulations provide that property is substantially improved if over a 30-month period, the additions to basis with respect to the property is at least equal to the unadjusted basis at the beginning of the period.
Prior IRS guidance provided that if a building and land is acquired, there is “substantial improvement” if the costs of the additions to the building are at least equal the allocated cost of the building at the start of the 30-month period. The cost attributable to the land is disregarded and the land is not subject to the original use requirement.
The new proposed regulations examine the original use context in many situations and conclude:
- Prior Use: Original use in the QOZ of property does not look only to the use by the Qualified Opportunity Fund or Qualified Opportunity Zone business, but include use by any prior person. However, it defines “prior use” based on whether the property was, before its current use, eligible for depreciation or amortization.
- Vacant Property: Ignores the original use and substantial improvement requirements for a building or other structure that has been vacant for at least five years.
- Raw Land: If the Qualified Opportunity Fund or Qualified Opportunity Zone business acquires raw land, it must be used in a trade or business of the entity to be qualified property. The holding of land for investment purposes does not qualify. If unimproved land is purchased with the intent not to improve the land by more than an insubstantial amount within 30 months from the date of purpose, it generally will not qualify.
7. Leased Tangible Property
The new proposed regulations consider many issues related to leased property.
- Related Party Leases Allowed: The lease of tangible property must be under an arrangement entered into after December 31, 2017, and must meet certain requirements set out in the regulations. There is no ban on related party leases, although some additional restrictions are imposed.
- Original Use/Substantial Improvement Rule: A lease is considered to be qualified property without having to meet either the original use or substantial improvement rules. This means that an operating business conducted as a Qualified Opportunity Zone business can be the lessee of a building in a QOZ, and the lease will be counted as a qualified asset despite the fact that there was prior use of the leased space and that there will not be substantial improvement made to the leased unit.
- Valuation Methods: The proposed regulations provide for methods for determining the value of a lease for a Qualified Opportunity Fund meeting the 90% test or a Qualifying Opportunity Zone business meeting its 70% test.
8. 90% Assets Test
Under the law, a Qualified Opportunity Fund must demonstrate that the average of the percentage of its assets which are Qualified Opportunity Zone property held on two testing dates during the tax year is at least 90%. This test raised several concerns addressed in the new regulations.
- A Qualified Opportunity Fund can exclude from the 90% test, for six months, capital contributions received, if held in cash, cash equivalents, or debt instruments with a term of 18 months or less.
- If a fund holds proceeds from the sale of Qualified Opportunity Zone property, the proceeds can be considered to be qualified property if reinvested within 12 months in other Qualified Opportunity Zone property and during the period are held in cash, cash equivalents, or debt instruments with a term of 18 months or less.
9. Trade or Business
Under the law, Qualified Opportunity Zone business property must be used in a trade or business. Which “trade or business” applies for these rules? The new proposed regulations use the IRC section 162 rules to determine if there is a trade or business. This generally requires regular and continuous activity. This standard normally raises issues for real estate rental activities. The proposed regulations provide that the ownership and operation (including leasing) of real property is considered to be the active conduct of a trade or business. However, they also state that merely entering into a triple net lease with respect to real estate owned by the taxpayer is not the active conduct of a trade or business. Based on this language, triple net leases should be avoided.
10. Active Trade or Business
One qualification of a Qualified Opportunity Zone business is that at least 50% of the gross income derived must be from the active conduct of a trade or business with a QOZ. The proposed regulations provide three different safe harbor methods for proving that this test is satisfied, along with a catch-all facts-and-circumstances test.
The new regulations also provide a general anti-abuse provision, permitting the IRS to recast a single or integrated set of transactions where a significant purpose is to obtain a tax result which is inconsistent with the statutory purposes of the Qualified Opportunity Zone rules based on all facts and circumstances.
The QOZ rules offer many potential tax benefits but are extremely complex. The Service still has not issued guidance on the failure to satisfy all of the rules, though the October proposed regulations did suggest the possibility of decertification of a fund under certain circumstances.
If you have any questions, please contact your Marcum tax professional to guide you through these rules.