Introduced as part of the law known as the Tax Cuts and Jobs Act, P.L. 115-97, Secs. 1400Z-1 and 1400Z-2 were designed to incentivize taxpayers to reinvest capital gains into low-income and economically distressed communities through qualified opportunity zone funds (QOFs). In exchange, a taxpayer can receive three federal income tax benefits: the temporary deferral of capital gains that are reinvested into a QOF, the partial exclusion of those deferred capital gains to the extent that the holding period requirements are met, and the permanent exclusion of gains from the sale of the investment in a QOF that has been held for at least 10 years.
Since the inception of the program, taxpayers have been in need of additional guidance to clarify the definitions of terms used in the statute, to explain certain operational aspects of how the program is intended to work. The lack of guidance has led to many taxpayers remaining “on the sidelines” and not making investments while they wait for this cloud of uncertainty to be lifted.
The IRS responded to this need for additional guidance by issuing the first set of proposed regulations on Oct. 29, 2018 (REG-115420-18). While this set of regulations provided taxpayers with a great deal of the guidance they needed, many questions were still left unanswered. This item discusses the clarifications and questions that were answered with the issuance of a second set of proposed regulations on May 1, 2019 (REG-120186-18).
Treatment of Sec. 1231 gain
The first round of proposed regulations made it clear that the only gains eligible for deferral were those that are treated as capital gains for federal income tax purposes. This meant that gross short- and long-term capital gains, unrecaptured Sec. 1250 gain, net gains from Sec. 1256 contracts, and Sec. 1231 gains all qualify. Short- and long-term capital gains are not required to be netted against losses, while Sec. 1231 gains are required to be netted against losses. The second set of proposed regulations further specified that the only Sec. 1231 gains that were eligible for deferral were net Sec. 1231 gains. Since the netting process cannot take place until the end of the tax year, the proposed regulations provide that the 180-day period for reinvestment into a QOF of net Sec. 1231 gains does not begin until the last day of the tax year.
Prop. Regs. Sec. 1.1400Z2(d)-1(c)(4)(ii) defines a trade or business of a QOF as a trade or business within the meaning of Sec. 162. This same standard was extended to a qualified opportunity zone business (QOZB) under Prop. Regs. Sec. 1.1400Z2(d)-1(d)(2)(ii). Unfortunately, neither the Code nor the regulations thereunder provide a definition of a trade or business. Rather, the Supreme Court in the case of Groetzinger, 480 U.S. 23 (1987), defined a trade or business for purposes of Sec. 162 to mean an activity that is conducted with continuity and regularity and is entered into with the primary purpose of making a profit.
During the comment period on the first round of proposed regulations, taxpayers expressed concern about whether the activity of leasing real property would be considered an active conduct of a trade or business for purposes of the qualified opportunity zone (QOZ) program. The proposed regulations clarified that the ownership and operation (including leasing) of real property used in a trade or business is treated as the active conduct of a trade or business for purposes of Sec. 1400Z-2(d)(3). However, the proposed regulations also made a point to highlight for taxpayers that “merely entering into a triple-net-lease with respect to real property owned by a taxpayer is not the active conduct of a trade or business by such taxpayer” (Prop. Regs. Sec. 1.1400Z2(d)-1(d)(5)(ii)(B)(2)).
Definition of ‘substantially all’
The term “substantially all” is used in several places in Sec. 1400Z-2(d). This phrase not only establishes conditions for property to be treated as qualified opportunity zone business property (QOZBP), it also establishes holding period requirements for a QOF in an underlying stock or partnership interest in order for that underlying stock or partnership interest to be treated as a QOZB. The first set of proposed regulations set a 70% threshold for this phrase in the context of the amount of owned or leased tangible property that a QOZB must have to meet the definition of a QOZBP. The second set of proposed regulations keeps this same 70% threshold for property owned or leased and applies that threshold in the context of the use of tangible property in the QOZ. In instances where “substantially all” references a holding period, the second set of proposed regulations reflects a higher threshold to “preserve the integrity of the statute and for the purpose of focusing investment in the designated opportunity zones” (preamble, REG-120186-18) and, as a result, define “substantially all” in that context to mean 90%.
One requirement for a QOZBP is that its original use in the QOZ begins with the QOF or the QOF substantially improves it (Sec. 1400Z-2(d)(2)(D)(i)(II)). The second set of proposed regulations generally provides that the original use of tangible property acquired by purchase by any person commences on the date that person 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). Used tangible property will still satisfy the original-use test as long as it has never been used within that QOZ in a manner that would have allowed it to be depreciated or amortized by any taxpayer. Practically speaking, this allows businesses currently located outside a QOZ to move their property into a QOZ and have it meet the original-use test (assuming that all of the other requirements have been met for the property to be treated as QOZBP).
Property that has been unused or vacant for an uninterrupted period of at least five years can also qualify as original-use property. Original use will be considered to have commenced when any person first uses the property in the QOZ after the period of vacancy.
Rev. Rul. 2018-29, which was released in conjunction with the first set of proposed regulations, addressed situations in which a QOF or QOZB acquires land and a building by purchase and clarified that the cost of the land does not have to be considered when determining whether the building has been substantially improved. If the QOF or QOZB meets the substantial-improvement test for the building, then both the land and the building will be considered QOZBP. In response to the revenue ruling, taxpayers questioned how raw (unimproved) land would be treated under this program. Despite the fact that land can never meet the original-use test, the second set of proposed regulations clarified that unimproved land does not have to be substantially improved to be considered QOZBP. This provision will not apply to a QOF that purchases raw land with the expectation and intention of not improving the land by more than an insubstantial amount within 30 months of the date of purchase.
Even though Treasury and the IRS acknowledged that this may be onerous for certain types of business, the second round of proposed regulations affirmed that, for assets that cannot meet the original-use test, the substantial-improvement test is applied on an asset-by-asset basis. Operating businesses with a significant number of assets may find the tracking requirements unduly burdensome to meet on an asset-by-asset basis and would greatly benefit from an aggregate standard, which Treasury said it would consider for future guidance.
A QOZB is required to have substantially all (70%) of the tangible property it acquires by purchase or lease be considered QOZBP. The first round of proposed regulations did not define how property that was leased could satisfy either the original-use or the substantial-improvement requirement. This question was answered in the second set of proposed regulations, which stated that both a QOF and a QOZB could lease property and have it qualify as QOZBP as long as certain conditions are met: (1) The lease has to be entered into after Dec. 31, 2017; (2) at the time the lease is entered into, the terms of the lease are market rate, as determined under Sec. 482; and (3) during substantially all (90%) of the holding period of the property, substantially all (70%) of the use of the property was in a QOZ.
There is no prohibition against related-party leases; however, two additional conditions are imposed when the lessee and lessor are related. First, the lessee cannot make a prepayment in connection with the lease for the use of the property for a period of more than 12 months. Second, the proposed regulations do not permit leased tangible personal property to be treated as QOZBP unless, during the relevant test period, the lessee becomes the owner of tangible property that is QOZBP and that has a value not less than the value of the leased personal property. The relevant testing period begins on the date they receive possession of the leased tangible personal property under the lease and ends on either the date 30 months after the date they receive possession of the property or the end of the lease, whichever is earlier. In addition, there must be substantial overlap of zone(s) in which the owner of the property so acquired uses it and the zone(s) in which that person uses the leased property.
In the case of leased real property other than unimproved land, any expectation or plan at the start of the lease for the QOF or QOZB to acquire the leased property at anything less than fair market value (FMV) as determined at the time of purchase will disqualify the property, and it will not be considered QOZBP.
To determine whether a QOF meets the 90% asset test, the first round of proposed regulations imposed two available valuation methods, one of which was required if the QOF or QOZB had an applicable financial statement (as defined under Regs. Sec. 1.475(a)-4(h)). Taxpayers welcomed a change ushered in with the second round of proposed regulations, which kept the same valuation methods but now allows QOFs and QOZBs to use either method regardless of whether they have an applicable financial statement. The second round of regulations also allows a QOF or QOZB to change valuation methods from one year to the next, but once it chooses a method for a particular tax year, it must consistently apply that method for the entire year to all its assets.
The first valuation method is known as the applicable financial statement valuation method. Under it, the value of each asset owned or leased by the QOF or QOZB is based on the asset’s value as reported on the applicable financial statement for the relevant reporting period. This method can be used for leased assets of the QOF or QOZB only if the applicable financial statement is prepared in accordance with U.S. GAAP and requires an assignment of value to any lease of the asset.
The second valuation method is known as the alternative valuation method. Under it, the value of each asset owned by the QOF or a QOZB is its unadjusted cost basis, as determined under Sec. 1012. The value of each asset that is leased by the QOF or QOZB is the sum of the present value of the payments made under the lease, as determined at the time the lease is entered into (and, once calculated, will remain the same for all future testing dates). For purposes of the present value calculation, the discount rate is the applicable federal rate under Sec. 1274(d)(1), and the term of the lease includes periods during which the lessee may extend the lease at a predefined rent.
Relief from the 90% asset test
The 90% asset test requires a QOF to have 90% of its assets on average invested in qualifying property on two testing dates during the fund’s tax year (for most funds on a calendar-year basis, this will be June 30 and Dec. 31). Taxpayers were greatly concerned about a QOF’s ability to deploy investments into qualifying property that were received very close to each of these testing dates and requested that the QOFs be granted relief. The second set of proposed regulations responded to this concern and provides that a QOF does not have to include in either the numerator or denominator of its assets the amount of any property contributed to the QOF in exchange for a membership interest in the QOF during the six-month period prior to the testing date, provided that the contributions were continuously held in cash, cash equivalents, or debt instruments with a term of 18 months or less.
Expansion of the working capital safe harbor
One of the most favorable provisions introduced as part of the first set of proposed regulations was the working capital safe harbor. This safe harbor allowed QOZBs to apply the definition of working capital in Sec. 1397C(e)(1) to property held by the business for a period of up to 31 months if there is a written plan that identifies the financial property as held for the acquisition, construction, or substantial improvement of tangible property in the QOZ. There must also be a written schedule consistent with the ordinary startup of a trade or business that provides for the property’s use within 31 months of its receipt by the business. Finally, the business must substantially comply with this plan and schedule.
Many taxpayers requested that this safe harbor also be available in the context of starting and growing an operating business within a QOZ. The second set of proposed regulations responded to these comments and amended the guidance to allow for the working capital safe harbor to apply not only in the real estate context but also to amounts designated in writing for the development of a trade of business in a QOZ. A QOZB is allowed to have concurrent 31-month periods running for each contribution made to it from the QOF, as long as the requirements for a written plan and schedule (described above) are satisfied for each contribution.
Note that the working capital safe harbor is available at the QOZB level only. A similar provision is not available at the QOF level.
50% gross income safe harbors
The statute requires that for an entity to be considered a QOZB, it must derive at least 50% of its total gross income from the active conduct of the business (Sec. 1400Z-2(d)(3)(A)(ii), by reference to Sec. 1397C(b)(2)). The first set of proposed regulations expanded on that requirement and stated that at least 50% of the total gross income must be sourced in a QOZ. This expansion made it far less clear how a QOF subsidiary could conduct an operating business in the QOZ if it had sales and personnel both within and without a QOZ.
The second set of proposed regulations answered this critical question by providing three safe harbors and a facts-and-circumstances test that would allow a QOZB to meet this requirement. Businesses need to meet only one of these safe harbors or the test to satisfy the requirement. The first safe harbor requires that at least 50% of the services performed (based on hours) for the business by its employees, independent contractors, and employees of its independent contractors are performed in the QOZ. The second safe harbor is the same as the first, but it measures services performed by amounts paid rather than hours.
The third safe harbor provides that if the tangible property of the business in the QOZ and the management or operational functions performed for the business in the QOZ are each necessary to generate 50% of the gross income of the trade or business, then the requirement is satisfied. Finally if the business cannot meet one of the three safe harbors listed above, the business can still meet the 50% requirement if, based on all the facts and circumstances, at least 50% of the gross income of the trade or business is derived from the active conduct of a trade or business in the QOZ.
QOF reinvestment rule
Sec. 1400Z-2(e)(4)(B) specifically authorizes Treasury and the IRS to prescribe rules to “ensure a qualified opportunity fund has a reasonable period of time to reinvest the return of capital from investments in qualified opportunity zone stock and qualified opportunity zone partnership interests, and to reinvest proceeds received from the sale or disposition of qualified opportunity zone property.” The second set of proposed regulations provides that proceeds received by the QOF from the sale or disposition of QOZ stock, a QOZ partnership interest, or qualified opportunity zone property (QOZP) is treated as satisfying the 90% asset test for a period of 12 months following receipt, as long as the proceeds are continuously held in cash, cash equivalents, or debt instruments with a term of 18 months or less. This gives the QOF some time before the proceeds are subject to the 90% test, without restarting the holding period of the QOF interest.
The guidance did clarify that even though additional time was provided to reinvest the proceeds in new QOZ property, Treasury did not think it had the authority to permit taxpayers to avoid the recognition of any gain on the interim sales of QOZP.
After the release of the first round of regulations, taxpayers had questions surrounding the ability of a carried interest to qualify as eligible to receive the benefits of the program (this was assuming that the interest holder also invested more than a de minimis amount of gain, in addition to receiving the partnership interest). The second round of regulations clarified that a QOF partnership interest received in exchange for services is treated as a mixed-funds investment, with the portion attributable to services being a nonqualifying investment that is ineligible for the program’s benefits. It is important to note that although the carried interest is not eligible for the program’s benefits, it does not disqualify the QOF in any way.
A taxpayer defers paying tax on the original deferred gain until the earlier of two events: a sale of the taxpayer’s interest in the QOF or Dec. 31, 2026. The first round of proposed regulations did not address transactions or events (in addition to the sale of the QOF interest) that would trigger recognition of the original deferred gains. The second round of proposed regulations greatly expand on this subject and provide a long list of “inclusion events.”
The second round of proposed regulations provides a general rule that an inclusion event results (and some or all of the original deferred gain must be recognized) when either the taxpayer reduces its direct equity investment in the QOF or the taxpayer effectively “cashes out” of its investment in the QOF by receiving a distribution of property (including money, securities, or any other property) with an FMV exceeding the taxpayer’s basis in the QOF.
The preamble to the second set of proposed regulations provides a nonexclusive list of inclusion events. Two worth highlighting are:
- A transfer by gift of a qualifying investment; and
- A charitable contribution, as defined in Sec. 170(c), of a qualifying interest.
The proposed regulations also addressed transactions that are not treated as inclusion events, and a few are worth highlighting here as well:
- Despite the fact that most transfers by reason of death terminate the owner’s qualifying investment in the QOF, Treasury and the IRS have concluded that neither transfer of a qualifying investment to the deceased owner’s estate nor the distribution by the estate to decedent’s legatee or heir is an inclusion event for purposes of Sec. 1400Z-2(b)(1).
- A transfer of a qualifying investment to an entity that is disregarded as separate from the taxpayer (including a grantor trust) is not an inclusion event because the transfer is disregarded for federal income tax purposes. However, if there is a change in the entity’s status as disregarded (including the change in the grantor status of the grantor trust), that would be considered an inclusion event at that time.
- A transfer of a qualifying interest to a partnership in exchange for a partnership interest under Sec. 721 is not an inclusion event.
A big concern for taxpayers with a desire to invest in real estate projects after the release of the first round of the proposed regulations was whether QOFs could execute a debt-financed distribution. The second round of proposed regulations clarified that this will generally be permitted and not result in an inclusion event to the extent of the taxpayer’s tax basis in the QOF.
An important exception to this general rule is for distributions made within the first two years of a taxpayer’s qualifying investment into the QOF. This is because the second round of proposed regulations added a provision that would require the QOF to apply the Sec. 707 disguised-sale rules to any qualifying investments, and to the extent the application would result in a deemed disguised sale, the taxpayer’s original qualifying investment would be recast as a nonqualifying investment that would no longer be eligible to receive the benefits under the program. (It should be noted that this analysis applies to any distribution from the QOF and not just debt-financed distributions.)
The most meaningful tax benefit that taxpayers receive by participating in the QOZ program is the ability to exclude the post-acquisition gains from the sale of the investment in a QOF that has been held for 10 years or longer. Taxpayers were uncertain if this exclusion applied to both the capital gain treatment and any portion of the gain recharacterized as ordinary income upon the sale of the QOF interest. The second round of regulations clarified that just prior to a sale of a QOF partnership interest that has been held at least 10 years, the basis of all assets of the QOF partnership is deemed to be stepped up to FMV in an adjustment that is calculated in a manner similar to a Sec. 743(b) adjustment. As a result, taxpayers who sell their QOF interest will be able to exclude all gain, both capital and ordinary.
Unfortunately, not all sales can be structured as sales of membership interests. Rather, some are structured as asset sales. The second set of proposed regulations provides some relief on this issue by providing that if a taxpayer has held a qualifying investment in a QOF partnership or a QOF S corporation for at least 10 years and the QOF disposes of QOZP after that 10-year holding period, the taxpayer can elect to exclude from gross income its share of the capital gain arising from the disposition of QOZP that is reported on the Schedule K-1 it receives and is attributable to the qualifying investment. An important distinction under this scenario is that a QOF can hold up to 10% of its assets as non-QOZP. This election applies only to capital gain arising from the sale of QOZP. A second consideration for taxpayers is that the election will allow them to exclude any capital gain generated from the sale, but they will not be able to exclude any amounts that are treated as ordinary income under the Sec. 751 hot-asset rules. Finally, it should be noted that this provision is not effective until the final regulations are issued, and thus taxpayers cannot rely on it at this time.
As of this writing, it is unclear whether a third set of regulations will be forthcoming or if the remaining guidance will be provided in a different manner. Despite not answering all of the issues that taxpayers requested guidance on, this second set of regulations provides stakeholders with answers to many key questions and provides some much-needed certainty surrounding the program. Taxpayers now have a way to confidently move forward with structuring funds and making investments into the economically distressed and low-income communities this program was intended to benefit all along.
From Angeline Rice, CPA, MT, MAcc; and David Sobochan, CPA, Cleveland