On April 17, 2019, the Treasury Department issued a highly anticipated second set of proposed regulations on opportunity zones (2019 proposed regulations). The opportunity zone program has received significant national attention as an ambitious and generous tax incentive aimed at driving investment into the nation’s most distressed communities.
It is clear from these regulations that the government is trying to incentivize investment by broadening the tests and providing flexibility to investors with respect to the types of investments and projects that qualify.
Not every question has been answered, but this additional guidance goes a long way toward providing investors with regulatory certainty regarding the tax consequences of their opportunity zone investment.
There is at least one much-needed provision that was not included – a provision that would allow funds to sell as sets and reinvest the sales proceeds in qualified opportunity zone property without recognizing gain. This is a significant remaining issue and will likely require legislative action. The sales proceeds can be reinvested within 12 months so that the property remains qualifying property, but the sales transaction is otherwise a taxable transaction. Treasury and IRS concluded they did not have authority to avoid gain recognition.
Like the previous set of proposed regulations, taxpayers are allowed to rely on these new regulations as long as certain requirements are met.
Here are some of the highlights of the newest guidance:
- One of the most critical outstanding issues was how and to what extent the program could work in the context of investment in operating businesses. These regulations have provided much-needed answers with respect to this issue. The regulations provide generous, flexible income sourcing rules that will allow many different types of businesses to satisfy the 50 percent of gross income test; there are 3 separate safe harbors that a business can rely on and if none of those apply, a general facts and circumstances test can be applied. The regulations also expand the working capital safe harbor to include the development of a trade or business.
- The regulations clarify that the ownership and operation of real property, including leasing, is considered the active conduct of a trade or business.
- The regulations allow a qualifying investment of property into a qualified opportunity fund (QOF) – not just cash. In addition, an investor can use deferred gain to purchase a QOF investment from another taxpayer.
- No OZ benefits attach to any interest received for services (e.g., a carried interest).
- QOFs do not need to take into account investments made in preceding 6 months when applying the 90/10 test as long as as sets are held in cash, cash equivalents or short-term (18 months or less) debt.
- Original use of tangible property other than land begins on the date when the investor (or a prior person) first places the property in service in the QOZ for purposes of depreciation/amortization (or first uses it in a manner that would allow depreciation/amortization if that person were the property’s owner); used property can qualify as original use if it was never used in a manner that would have allowed it to be depreciated/amortized; If a building has been vacant for 5 years it is able to qualify as original use property (does not need to be substantially improved).
- There is no substantial improvement test applicable to the purchase of unimproved land but the land has to be used in the active conduct of a trade or business; there is a general anti-abuse rule in the regulations that could be used in circumstances in which no new investment is really being made (“land-banking”).
- Treasury and IRS are considering allowing for an aggregate approach to substantial improvement (grouping as sets together) but as of now it is asset-by-asset.
- QOFs and qualified opportunity zone businesses (QOZBs) have a choice of valuation method for purposes of valuing as sets for the 90/10 test and valuing tangible property for the 70/30 test – can use financial statement valuation or unadjusted cost basis (for owned property) and present value of lease payments (for leased property).
- The regulations allow for an extension of the 31-month period to spend funds for delays attributable to a waiting period for governmental actions.
- The regulations allow a QOF partnership to make debt-financed distributions as long as the distribution does not exceed the investor’s basis (which will include the investor’s share of the liability). However, there is guidance in the regulations that limits the ability make these distributions without affecting the OZ investment in the early years of the fund (within 2 years of investment). Thus, these distributions are generally allowed but may be subject to limitations.
- The regulations provide rules regarding whether and how leased property qualifies and how it is valued – any lease must be a market rate lease; the rules do not prohibit related party leases, although there are a few additional requirements that must be met, including that the lease be a market-rate lease.
- Improvements to leased property made by a lessee are treated as original use property.
- The regulations provide a long list of gain inclusion events (events that trigger an investor’s inclusion of previously deferred gain) including a distribution in excess of basis, most gifts of a fund interest, a charitable contribution of a fund interest, and certain (but not all) nonrecognition events.
- A transfer of an investment in a QOF at death or contribution to a grantor trust is generally not an inclusion event and recipient may tack the decedent or donor’s holding period.
There is so much more information in these regulations, including special rules for S corps, C corps and REITs and significant details regarding each of the bulleted points above.
The Opportunity Zones Practice Team at Buchanan Ingersoll & Rooney is continuing to analyze this new guidance and is ready to help clients structure opportunity zone investments in a manner that complies with all of the statutory and regulatory requirements.