On April 17, 2019, the Treasury released long-awaited additional regulations and guidance with respect to Section 1400Z-2 of the Internal Revenue Code, concerning the Qualified Opportunity Zones (“QOZs”) Program (the “Proposed Regulations”). See our previous Legal Alerts for background on the federal tax incentive program promoting equity investments in low-income communities designated as QOZs. The first round of regulations with regard to QOZs was issued in October 2018.
Comments on the Proposed Regulations are due by July 1, 2019. In the interim, taxpayers may rely upon the Proposed Regulations as drafted, as long as the rules are applied in their entirety and consistently, with one exception. Specifically, until the Proposed Regulations are final, taxpayers may not rely upon the proposed rules permitting a Qualified Opportunity Fund (“QOF”) partnership, S corporation or REIT whose owners have held their investment in a QOF for at least 10 years to sell assets without recognizing capital gains on the sale of such assets; as these rules will not apply until January 1, 2028.
Key points in the second round of regulations respond to the many comments and written recommendations received during the initial comment period after the October 2018 regulations were released. Clarification is provided with regard to operating business qualification, fund operation issues and real estate projects in QOZs.
Guidance for Investors
As set forth in the initial regulations, investors who sell or exchange property to an unrelated party can defer a payment of capital gains on such a sale or exchange if the capital gains are invested in a QOF within 180 days of the transaction. When the investment is first made the investor’s basis will be zero. However, if the investment is maintained in the QOF for five (5) years, the investor’s basis will increase by 10 percent of the capital gains which were deferred. If the investment is kept in the QOF for an additional two years, or seven (7) years total, the basis will increase by another 5 percent of the original capital gains which were deferred. If after recognizing the capital gains, reduced by any basis gained, an investor keeps the investment in the QOF for 10 years or longer, the investor will not recognize any additional capital gains if it decides to sell or exchange its investment.
Gain Recognition Events – QOF investors will encounter a recognition event, resulting in capital gains to the investor on the first of the following dates: (i) the date the investment is sold or liquidated or (ii) December 31, 2026. However, the statute did not directly address whether other dispositions of an interest in a QOF requires a taxpayer to recognize its deferred gain. In response, the draft Proposed Regulations contain a nonexclusive list of gain “inclusion events” that generally require the inclusion of deferred gain in income. Included in the inclusion event list is a gift or charitable contribution of a qualifying QOF investment. However, death is not a gain inclusion triggering event. The proposed rules also allow for contribution of a QOF interest to another partnership entity without triggering recognition of deferred gain or disqualifying the QOF interest from the QOZ benefits.
Gain on Sale of QOF Assets – the Proposed Regulations clarified that investors will recognize gain from the QOF sale of Qualified Opportunity Zone Property (“QOZP”), unless the investor has held its interest in the QOF for at least 10 years, in which case may exclude capital gains on such sale. Alternatively, a QOF investor may elect to defer taxes on such realized capital gain by reinvesting in another QOF within 180 days.
Debt-Financed Distributions from QOF Partnerships – The Proposed Regulations clarify that a partner’s initial basis in its QOF partnership interest will be increased by such partner’s allocable share of the fund’s partnership liabilities. This will allow for leveraged distributions to partners for purposes of tax recognition events without triggering gains, provided such distributions by the QOF are made more than two years after the investor contributions and such distributions do not exceed the investor basis in the QOF interest.
Secondary Market – The Proposed Regulations allow for a taxpayer to treat a purchase of a QOF interest from another as a qualifying QOF investment. The purchaser of an eligible investment from a direct owner of the QOF may elect to defer capital gains in an amount equal to the purchase price of such interest in the QOF.
90 Percent Test – At least 90 percent of the assets in a QOF must be QOZP. QOZP includes stock, partnership interests and tangible property of Qualified Opportunity Zone Business (“QOZB”). The Proposed Regulations provide a six month safe harbor for a QOF to exclude contribution of cash, cash equivalents, and debt instruments with a term of 18 months or less, received during the prior six months for purposes of determining compliance with the 90% test. This grace period allows a reasonable amount of time for a QOF to deploy contributed capital into qualifying investments.
Reinvestment of Proceeds Received by QOF in Asset Sale – Under the Proposed Regulations, a QOF will have twelve months after an interim sale of QOZP to reinvest the proceeds without causing the fund to fail the 90 percent test. Notably, the interim sale will not reset the investor’s holding period in the QOF itself, and will not trigger gain inclusion from the original capital gain investment, as long as the return on capital is reinvested within the aforementioned one year.
Rules Related to Working Capital, Leased Property and Vacant Buildings
Working Capital Safe Harbor for QOZBs – The first draft of the Opportunity Zones regulations permits a QOZB that acquires, constructs and/or substantially rehabilitates tangible business property to treat cash, cash equivalents and debt instruments with a term of 18 months or less as a reasonable amount of working capital for up to 31 months if certain requirements are satisfied. The second tranche of regulations expands the working capital safe harbor to include the development of a trade or business in a QOZ, and allows for the 31-month period to be extended, to the extent of governmental inaction or delay so long as the application for such governmental action was completed within the initial 31-month period. Further, a QOZB may avail itself of multiple applications of the working capital safe harbor. Notably, the working capital safe harbor remains applicable to QOZBs, not to QOFs making direct investments into property in the QOZs.
Leased Property – The Proposed Regulations provide favorable treatment for improvements to leased property, in that improvements made by a lessee to leased property will now satisfy the requirement that the “original use” of QOZBP must commence in the QOZ, and such leasehold improvements will be considered “purchased” property for purposes of the statute. Further, leased property will be considered QOZBP (and satisfy the 90 percent requirement and/or the 70 percent “substantially all” requirement) if (i) leased property is acquired pursuant to a lease entered into after December 31, 2017; and (ii) substantially all of the use of such leased tangible property is in a QOZ during substantially all of the period for which the business leases the property. Notably, such leased property need not be acquired from a lessor who is unrelated to the QOF or QOZB that is the lessee under such lease, with certain restrictions. Additionally, the Proposed regulations do not impose a requirement for a lessee to “substantially improve” leased tangible property within the meaning of the statute, recognizing that taxpayers generally do not have a basis in leased tangible property that can be depreciated because they are not the owner of such property. However, the Proposed Regulations include an anti-abuse rule to prevent the use of leases as a way around the substantial improvement requirement for purchases of real property.
Land and the Original Use Requirement– As set forth in the initial regulations, in order to qualify as QOZBP, the “original use” of the property in the QOZ must begin with the QOF or QOZB, or, if property that is in a QOZ is acquired, it must be “substantially improved”. The Proposed Regulations state that unimproved land in a QOZ acquired by purchase does not need to be substantially improved, nor does it need to meet the original use test, as long as such land is used in a trade or business of the QOF or QOZB, and at the time of purchase, the QOF or QOZB has expectations to improve the land by more than an insubstantial amount within 30 months. The IRS recognizes that land banking could be a potential concern, and emphasized that its anti-abuse rules will be strictly enforced in such instances.
Vacant Buildings –The Proposed Regulations responded to many comments concerning the treatment of vacant structures in QOZs by clarifying that a QOF may treat an investment in land with a structure that has been vacant for at least five consecutive years as meeting the “original use” requirement. Further, the QOF or QOZB would not need to invest additional capital to substantially improve the structure in such a scenario.
Operating Business Qualifications
Meeting the “Substantial Improvement” Requirement. If QOZBP does not have original use commencing in a QOZ, then the QOF or QOZB must substantially improve the property in question. The first draft of the QOZ regulations explained that QOZBP is substantially improved if, during any 30-month period beginning after the date of acquisition of such property, additions to basis with respect to such property in the hands of the QOF or QOZB exceed an amount equal to the adjusted basis of such property at the beginning of such 30-month period. The Proposed Regulations clarify that the determination of whether the substantial improvement requirement is satisfied for purchased tangible property will be made on an asset-by-asset basis, without aggregating such costs. However, the Treasury and IRS have requested comments on the potential advantages of adopting an aggregate approach for the substantial improvement test.
Substantially All Test – A business will qualify as a QOZB if substantially all of its tangible property, either owned or leased, is QOZBP and the business meets the statutory requirements of a QOZB. The Proposed Regulations provide clarity for the meaning of the phrase “substantially all”, as follows:
- During 90 percent of a QOF’s holding period of its interest in a QOZB, the entity must qualify as a QOZB.
- At least 70 percent of the tangible property owned or leased by a QOZB must be QOZBP.
- During 90 percent of a QOF’s or QOZB’s holding period for QOZBP, 70 percent of the use of the property must be in the QOZ as part of a trade or business.
Further, the Proposed Regulations clarify at least 40 percent, or a “substantial portion” of the intangible property of a QOZB, must be used in the conduct of trade or business of a QOZB.
50 Percent Gross Income Test – One of the proposed requirements in the first set of regulations that generated many comments is the requirement that at least 50 percent of the gross income of a QOZB must be derived from the active conduct of a trade or business in the Opportunity Zone. The most recent regulations provide three scenarios in which the 50 percent gross income requirement may be met:
- Hours of Services Performed – at least 50 percent of the services performed for such business by its employees and independent contractors (and employees of independent contractors) are performed within the QOZ, measured by hours of services performed; or
- Compensation Paid for Services Performed – 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 QOZ, based on amount paid for such services; or
- Property and Management in the Zone – The tangible property of the QOZ business and the management or operational functions performed for such QOZB are each necessary to generate 50 percent of the gross income of the trade or business.
In a catch-all provision, the Proposed Regulations state that any QOZB which does not meet the three safe harbor options may instead apply a “facts and circumstances” test to determine compliance with the 50 percent gross income test.
Anti – Abuse Rules and Request for Information
As stated in the preamble to the Proposed Regulations, the “purposes of sections 1400Z-a and 1400Z-2 are to increase business activity and economic investment in qualified opportunity zones.” To that end, the IRS has proposed a comprehensive anti-abuse rule, which provides that the IRS commissioner can recast a transaction (or series of transactions) for federal tax purposes, if a significant purpose of a transaction is to achieve a tax result that is inconsistent with the purposes the QOZ rules.
In addition to the second round of regulations, Treasury and the IRS published a Request for Information (RFI) to gather information from the public regarding recommendations as to how to measure economic activity within the QOZs and how to collect such information. In particular, the RFI announced two anticipated changes to Form 8996 to require reporting of (i) Employer Identification Number (EIN) of the QOZ Business, and (ii) the amount invested in particular census tracts.
In the future, the Treasury and the IRS intend to issue additional rules addressing information reporting requirements and the penalty under section 1400Z-2(f) for failure to meet the 90-percent asset test.
This alert does not purport to be a substitute for advice of counsel on specific matters.
Harris Beach has offices throughout New York State, including Albany, Buffalo, Ithaca, New York City, Rochester, Saratoga Springs, Syracuse, Uniondale and White Plains, as well as New Haven, Connecticut and Newark, New Jersey.