The second round of regulations provide additional clarity for taxpayers, although some critical questions still remain.
On April 17, 2019, the Internal Revenue Service released the second round of proposed regulations for investments in Qualified Opportunity Zones (QOZ) and Qualified Opportunity Funds (QOF). Here are the key elements of the proposed regulations.
QOZ business and property
“Substantially all” thresholds become clear
Determining whether a property or fund qualifies for the program requires “substantially all” of it to be held and used in a qualified zone. However, the first proposed regulations did not clarify what constitutes “substantially all” in several instances. The new guidance indicates that 70 percent is the use threshold for tangible property by a QOF in a QOZ, and at least 90 percent of the property must occur in the fund’s holding period. Applying the “substantially all” thresholds collectively (also known as “stacking”) means taxpayers will be able to satisfy the threshold with 40 percent of the QOZ business’ tangible property being used in a QOZ.
Original use in tangible purchased property
The “original use” date for tangible property acquired by purchase begins on the date when the buyer or a prior person first places the property in service in the QOZ for purposes of depreciation or amortization (or first uses the property in the QOZ in a manner that would allow depreciation or amortization if that person were the property’s owner). Therefore, tangible property located in a QOZ that is depreciated or amortized by a taxpayer that is not a QOF or a QOZ business does not satisfy the original use requirement.
Original use in vacant property
A building or other structure that has been vacant for at least five years prior to being purchased by a QOF or QOZ business satisfies the original use requirement, which may make it more enticing for investors to improve unused or vacant buildings in these low income communities.
Original use in leased property
The original use requirement for purchased property may be applied to leased property. Improvements made to leased property by a lessee satisfy the original use requirement and are considered purchased property for the amount of the unadjusted cost basis of such improvements. This guidance was welcome relief for startups and operating businesses that typically lease property early on in their business cycle.
Treatment of land
Investors are also helped with unimproved land qualifying as QOZ business property if it is a part of a trade or business. The original use requirement does not apply and the land does not have to be substantially improved. However, land can only be treated as QOZ business property if it is used in a trade or business of a QOF or a QOZ business. Land held for investment purposes only does not constitute a trade or business and does not qualify. The IRS has indicated it will apply anti-abuse rules if unimproved lands were acquired for an inappropriate tax result.
Substantial improvement
The substantial improvement requirement of tangible property purchased by a QOZ business is determined on an asset-by-asset basis. Because a taxpayer may find the asset-by-asset basis approach to be administratively burdensome, the Treasury has welcomed comments on using an aggregate standard for determining substantial improvement. The proposed regulations also include an anti-abuse rule to prevent the use of leases to circumvent the substantial improvement requirement for purchases of real property (other than unimproved land).
Inventory in transit
A safe harbor is provided for inventory in transit for purposes of meeting the substantially all requirement. Specifically, inventory and raw materials are not disqualified solely because they are in transit between a vendor or customer and a trade or business in a QOZ.
Treatment and valuation of leased property
The preamble to the proposed regulations notes that taxpayers who typically lease property for purposes of investing in QOZ (e.g., tribal governments that occupy federal trust lands), may be disadvantaged if leased tangible property could not qualify as QOZ business property. To prevent preference towards taxpayers that purchase QOZ business property, the proposed guidance provide a criteria for treating lease tangible property as QOZ business property:
- Leased tangible property may be treated as QOZ business property for purposes of the 90 percent of assets held in a QOZ requirement and the 70 percent substantially all requirement. However, the leased property must be acquired under a lease entered into after December 31, 2017; and the use of leased tangible property must be in a QOZ during substantially all of the period in which the business leases the property.
- The original use requirement does not apply to leased tangible property. In addition, the lease of the tangible property must be at market rates determined under arms-length terms. The leased property may be acquired through a lease among related parties. However, there cannot be a prepayment of rent exceeding one year and the lessee may not purchase the leased property for less than the total value of the leased property.
- Two methodologies may be used for purposes of valuing leased tangible property for the 90 percent held test and the 70 percent substantially all requirement. The value may be determined by the value reported on an applicable financial statement or the present value of the lease payments. This flexibility with leased assets broadens the reach of the QOZ program by allowing more businesses to qualify as QOFs and QOZBs.
Qualified opportunity zone business
Real property straddling a qualified Opportunity Zone
What if a property straddles multiple census tracts, where not all of the tracts are designated as QOZ? Some have suggested that Treasury and the IRS adopt rules similar to other place-base tax incentives (e.g., Empowerment Zones), and the proposed regulations address this.
If the amount of real property square footage located within a QOZ is greater than 50 percent, as compared to real property outside of it, and the real property outside of the QOZ 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 QOZ.
50 percent gross income test
The original rules require 50 percent of the gross income to come from a trade or business within a QOZ, but taxpayers were unclear on how to satisfy the test. The proposed regulations provide clarity and broaden the income sourcing rules, which allows more types of business to qualify as a QOZ business if any of these three safe harbor calculations are met:
- At least 50 percent of services (measured by hours) are performed by employees or independent contractors within the QOZ.
- At least 50 percent of the payment is for services performed by employees or independent contractors within the QOZ.
- At least 50 percent of the gross income is generated from tangible property and management functions performed by the business in the QOZ.
If a taxpayer does not meet any of these safe harbors, they still may meet the 50 percent requirement on a facts and circumstances test.
Use of intangibles
A substantial portion (at least 40 percent) of the intangible property of a qualified business entity must be used in the active conduct of a trade or business of a QOZ.
Active conduct of a trade or business
The ownership and operation (including leasing) of real property used in a trade or business (as defined by Section 162) is treated as the active conduct of a trade or business. However, the leasing of real property by a QOZ business may not amount to the active conduct of a trade or business if the business has limited leasing activity (i.e., triple-net lease).
Working capital safe harbor
Two changes are made to the safe harbor for working capital.
- Written designation for planned use of working capital now includes the development of a trade or business in the qualified opportunity zone, as well as acquisition, construction, and/or substantial improvement of tangible property.
- Exceeding the 31-month period does not violate the safe harbor if the delay is attributable to waiting for government action on an application that has been completed during the 31-month period.
Note that a single QOZ business may be able to benefit from multiple or sequential applications of the working capital safe harbor.
Special rule for Section 1231 gains
The 180-day period for investing any capital gain income from Section 1231 property in a QOF begins on the last day of the taxable year. This rule treats Section 1231 gains less favorably than other eligible capital gains. For a deeper look into deferral rules, see IRS Clarifies 180-Day Rule for Opportunity Zone Investment.
Relief of 90 percent asset test
The start-up rule that allows a QOF to delay the start of the 90 percent assets test did not account for an existing QOF that receives new capital from an equity investor shortly before the next semi-annual test. The proposed regulations allow a QOF to apply the 90 percent asset test without taking into account any investments received in the preceding six months. However, the new assets must be held in cash, cash equivalents, or debt instruments with a term of 18 months or less.
QOF 12-month reinvestment rule
Under the new guidance, a QOF has 12 months to reinvest the return of capital from investments in QOZ stock, QOZ partnership interest, and QOZ property, for purposes of meeting the 90 percent investment requirement. The clock starts ticking on the date of such distribution, sale, or disposition. The sale or disposition of assets by a QOF does not impact the holding periods of investors or include any deferred gain as long as the investors do not sell or otherwise dispose of their qualifying investment. The Treasury and the IRS do not believe there is authority to support the non-recognition of gain that would otherwise be included in taxable income. They are seeking public input that gives Treasury this authority without requiring Congressional action.
Amount of an investment for a deferral election
A taxpayer may acquire QOF interest by making a qualifying investment in a QOF through the contribution of property other than cash or through the purchase of a QOF interest from a direct owner of the QOF.
The proposed regulations provide special rules for determining the amount of an investment for purposes of the deferral election if a taxpayer transfers property other than cash to a QOF. A taxpayer can make a mixed-funds investment to a QOF, where part of the investment is qualifying investment and another portion is a nonqualifying investment.
There are special rules for determining the amount of mixed-fund investments made to a QOF partnership and QOF S corporation. These rules are complex and will be further explained in a future article.
Nonexclusive list or inclusion (taxable) events:
The proposed regulations provide descriptions of several transactions that are considered an inclusion event (a taxable event). The premise of an inclusion event is that the taxpayer’s interest in the qualifying investment is reduced or eliminated and thus constitutes a “cashing out” of the QOF investor’s qualifying investment. To prevent taxpayers from abusing the tax deferment of gain, the proposed regulations provide a nonexclusive list of inclusion events that require the taxpayer to include any amount of their previously deferred gain in gross income.
Examples of the inclusion events:
- A taxable disposition of all or a part of a qualifying investment (qualifying QOF partnership interest) in a QOF partnership, or of a qualifying investment (qualifying QOF stock) in a QOF corporation.
- A taxable disposition of interests in an S corporation that itself is a direct investor in a QOF corporation or QOF partnership if there is a greater-than-25 percent change in ownership of the S corporation.
- A transfer by a partner of an interest in a partnership that itself directly or indirectly holds a qualifying investment.
- A transfer by gift of a qualifying investment, including a charitable contribution.
- The distribution to a partner of a QOF partnership of property that has a value in excess of basis of the partner’s qualifying QOF partnership interest.
- Certain types of nonrecognition transactions where the taxpayer does not retain ownership in a direct qualifying investment or the amount of ownership in a direct qualifying investment in a QOF is reduced. For example, Section 351 transfer to corporation controlled by transferor, and a Section 368 corporate reorganization.
Note: The transfer of a qualifying investment to the beneficiary by the estate is not an inclusion event.
The proposed regulations provide guidance on determining the amount the taxpayer must include in gross income due to an inclusion event. There are separate rules for inclusion events involving a partnership and those involving a QOF shareholder that is an S corporation.
Timing of basis adjustments
The electing taxpayer’s initial basis in a qualifying investment is zero and is increased automatically to 10 percent of the deferred gain for an investment held for five years, and increased again by an additional 5 percent if the investment is held for seven years. A basis adjustment is made upon the earlier of December 31, 2026, or an inclusion event. The proposed regulations provide clarity on the basis adjustment due to an inclusion event.
Consolidated return provisions and 1400Z-2
Section 1400Z-2 and the consolidated return system are based on incompatible principles and rules. This means that the deferral of gain granted under the Opportunity Zone rules may only be applied separately to each member of a consolidated group.
General anti-abuse rule
The proposed regulations provide a general anti-abuse rule that examines the facts and circumstances to determine if a transaction or series of transactions is meant to achieve a tax result inconsistent with the purposes of the Opportunity Zone tax incentive.
Outstanding questions and how we can help
While the guidance provided helpful clarification for taxpayers, some questions remain, including:
- How penalties are applied.
- Whether amended 2017 returns can defer gain into a QOF and if 2018 or later years can be amended to take advantage of QOZ election.
Furthermore, these proposed rules include a request for comments to gauge success of the program. It also asked for comments on property that is not purchased but is substantially improved.
How will subsequent comments alter the final rules expected later this year? We will be sure to keep you informed.
Whatever road leads you to Opportunity Zones, CLA is right there with you. Our business tax planning professionals and wealth advisors are immersed in the real estate field, the investment market, tax reform, and the industries our clients operate businesses in. We can help you make clear decisions and realize the full benefits of the Opportunity Zone program before the initial December 31, 2019, deadline.