IRS provides clarity in second round of opportunity zone regulations

By Tony Nitti, CPA

 PHOTO BY PEETERV/ISTOCK
PHOTO BY PEETERV/ISTOCK
 

EXECUTIVE
SUMMARY

 
  • The IRS issued proposed regulations in April 2019 amending and supplementing proposed regulations it had issued the previous October concerning investments in qualified opportunity zones (QOZs), which were established by the legislation known as the Tax Cuts and Jobs Act, P.L. 115-97.
  • Among questions addressed in the April proposed regulations is how Sec. 1231 gains are netted as gain eligible to be deferred upon reinvestment into a qualified opportunity fund (QOF) and specifying that the 180-day period for reinvesting such gain begins on the last day of the taxpayer's tax year in which the gain is realized.
  • The April proposed regulations also clarified the definition of qualified opportunity zone business property (QOZBP) by providing details of the requirements for leased property to be QOZBP and answered several outstanding questions regarding when raw land qualifies as QOZBP.
  • Other provisions in the April proposed regulations address the manner of constructing or improving real estate in a QOZ, how a qualified opportunity zone business (QOZB) earns at least 50% of its income from within a QOZ, and how the original use of business property (including leased property) arises with, or its substantial improvement is performed by, a QOZB or a QOF.
  • Sec. 1400Z-2 refers to "substantially all" of QOZBP and its holding period for a QOF or QOZB, but the statute and the earlier October proposed regulations did not define the term. The April proposed regulations provide percentage-based definitions of "substantially all" for these purposes.
  • The April proposed regulations also provide the criteria for "inclusion events" by which deferred gain is recognized.

As part of the legislation known as the Tax Cuts and Jobs Act,1 Congress enacted two companion provisions designed to encourage investment and economic growth in certain low-income communities. First, Sec. 1400Z-1 paved the way for more than 8,700 such low-income communities and qualifying contiguous census tracts to be designated as qualified opportunity zones (QOZs). In turn, Sec. 1400Z-2 offers three federal income tax incentives to a taxpayer who invests in a business located within one of these zones: (1) the temporary deferral of capital gains, to the extent the gains are reinvested into a qualified opportunity fund (QOF); (2) the partial exclusion of previously deferred gains when certain holding period requirements in a QOF are met; and (3) the permanent exclusion of post-acquisition gains from the sale of an investment in a QOF held longer than 10 years.

In the May issue of The Tax Adviser (Nitti, "Opportunities Beckon in New Qualified Opportunity Zones," 50 The Tax Adviser 356 (May 2019)), the author of this update article examined the requirements for qualifying for these tax benefits, as provided by Sec. 1400Z-2 and proposed regulations that were published in October 2018 (the "October proposed regulations").2 The conclusion of that article identified key questions that were raised by the October proposed regulations that, until addressed and answered by the IRS, would threaten to slow investment into QOZs.

On April 17, 2019, the IRS published a second round of proposed regulations under Sec. 1400Z-2 (the "April proposed regulations").3 The April proposed regulations provided taxpayer-friendly responses to the questions raised by the October proposed regulations; as a result, taxpayers may finally move forward with opportunity zone investments with the level of certainty and confidence they have sought.

For the full background on the various requirements and benefits of a QOZ investment, please read the May article in its entirety before continuing with this article. This discussion focuses solely on the questions raised by the October proposed regulations that were subsequently addressed by the April proposed regulations.

Sec. 1400Z-2 and the associated proposed regulations contain a number of critical terms that are often abbreviated. See the chart, "Glossary of Key Terms and Abbreviations," (below) for these terms and their abbreviations, which are used throughout this article.

Glossary of key terms and abbreviations


The April proposed regulations provided much-needed clarity by addressing the following questions raised by the October proposed regulations.

Sec. 1231 gains as 'eligible gains'

The October proposed regulations made clear that gain from the sale of a Sec. 1231 asset is eligible gain that may be deferred upon reinvestment into a QOF because it is "treated as capital gain."4 Sec. 1231 requires a netting process, however; only net Sec. 1231 gains, after reduction for Sec. 1231 losses, are treated as capital gain. This netting process posed a problem in several ways.

Example 1: An individual sells a Sec. 1231 asset for a gain of $1 million on Jan. 2, 2019. The 180-day window for reinvestment (see definition of QOF in the sidebar, "Glossary of Key Terms and Abbreviations") would seem to begin on that date. On Dec. 5, 2019, the same individual sells a second Sec. 1231 asset, this time recognizing a loss of $1.2 million. The taxpayer has no net Sec. 1231 gain for the year, but that was revealed to be the case only after the 180-day window related to the Jan. 2 sale had expired. How could the individual have reinvested the Sec. 1231 gain of $1 million within 180 days of Jan. 2, 2019, when it would not be clear whether the individual has a net Sec. 1231 gain for the year until Dec. 31, 2019?

The April proposed regulations directly address this question, providing that a taxpayer may not reinvest Sec. 1231 gain until the netting process has completed. Because this process is not complete until the end of the taxpayer's tax year, the 180-day period begins on the last day of the tax year.5

Thus, in the case of the individual taxpayer discussed above, the individual would not be permitted before the end of 2019 to reinvest the $1 million of gain recognized on Jan. 2, 2019, because the netting process is not yet complete. And because, when that process is complete, the individual's Sec. 1231 gains and losses for the year result in a net loss, there is no eligible gain that may be deferred. If, instead, the Sec. 1231 loss on Dec. 5, 2019, were only $600,000, the individual would have $400,000 of net Sec. 1231 gain eligible to be reinvested into a QOF, with the 180-day period beginning on Dec. 31, 2019.

If a partnership or S corporation recognizes a Sec. 1231 gain that it intends to reinvest and defer at the entity level, presumably, the partnership or S corporation would be treated as a "taxpayer" for these purposes. Thus, the partnership or S corporation would determine its own net Sec. 1231 gain at the end of its tax year and have 180 days from the last day of the year to invest any net gain amount into a QOF.

Operating a QOF or QOZB

Trade-or-business requirement

QOZBP must be "used in a trade or business" of a QOF or QOZB."6 Sec. 1400Z-2 and the October proposed regulations, however, did not address this critical question: What is a "trade or business" for purposes of Sec. 1400Z-2?

The April proposed regulations addressed the trade-or-business ­requirement by stating that whether it is conducted directly by a QOF7 or through a subsidiary QOZB,8 the term "trade or business" means a trade or business within the meaning of Sec. 162. In general, an activity qualifies as a Sec. 162 trade or business if the taxpayer is involved in the activity "with continuity and regularity" (and not merely sporadically), and the taxpayer's primary purpose for engaging in the activity is for income or profit. As a result, whether an activity constitutes a Sec. 162 trade or business is generally a factual determination.9

While reaching the standard of a Sec. 162 trade or business has at times proved problematic for rental activities, the April proposed regulations clarified that, for purposes of meeting the definition of a QOZB, the ownership and operation (including leasing) of real property is the active conduct of a trade or business. Merely entering into a triple-net lease with respect to real property owned by a taxpayer, however, is not the active conduct of a trade or business by a taxpayer.10 The IRS recently defined a triple-net lease (for purposes of Sec. 199A) as any "lease agreement that requires the tenant or lessee to pay taxes, fees, and insurance, and to be responsible for maintenance activities for a property in addition to rent and utilities."11

Thus, if a QOF or QOZB constructs or renovates a building that is then rented, for example, to Walmart on a triple-net basis, the proposed regulations default to the conclusion that the building is not used in a trade or business and should not count toward the 90% or 70% test (see the definitions of QOF and QOZB in the sidebar, "Glossary of Key Terms and Abbreviations"). This treatment echoes a previous conclusion by the IRS that holding property rented on a triple-net basis is an investment rather than a Sec. 162 trade or business.12

In summary, the April proposed regulations generally take a forgiving approach whereby all rental activities — other than properties rented on a triple-net basis — will satisfy the trade-or-business requirement. As a result, a QOF or QOZB should structure any lease arrangement to avoid its being classified as a triple-net lease.

Challenges in investing in an operating business

The October proposed regulations provided taxpayers enough guidance to move forward with constructing or improving real estate in a QOZ. The 30-month substantial-improvement rule, the 31-month working-capital safe harbor, and the 70% and 90% asset tests combined to provide a framework within which a QOF or QOZB could enter into a construction or rehabilitation project with a degree of certainty as to how those projects would comply with the requirements of Sec. 1400Z-2.13

What remained far less clear, however, was how a QOF or QOZB may conduct a non—real estate operating business. Sec. 1400Z-2 requires — via cross-reference to Sec. 1397C — that a QOZB earn at least 50% of its income each year from within the QOZ.14 The October proposed regulations did not address how this 50% test could be satisfied in the context of an operating business. For example, if an online retailer was headquartered within a QOZ but its products were sold worldwide, was the 50% test satisfied only if at least half of the sales were to residents of the QOZ?

Fortunately, the April proposed regulations addressed the issue. They provide three safe harbors and a facts-and-circumstances test that a QOZB may use to satisfy the at-least-50% test.

First, the test is satisfied if at least 50% of the hours spent by employees, independent contractors, and employees of independent contractors are performed within the QOZ.15 Thus, in the example above involving the online retailer, provided all the employees were located within the QOZ, the business would satisfy the 50% test regardless of the location of the purchasers of its products.

Second, the test is satisfied if at least 50% of the amount paid by the entity for services performed during the year by employees, independent contractors, or employees of independent contractors is for services performed within a QOZ.16 Thus, a taxpayer can have employees outside the QOZ, provided at least half of the total compensation is paid for services performed by employees within the QOZ.

Finally, the test is satisfied if the tangible property located in a QOZ and the management or operational functions performed in the QOZ are each necessary for the generation of at least 50% of the gross income of the business.17

In addition to the three safe harbors, the 50%-of-income test is satisfied if, based on all the facts and circumstances, at least 50% of the gross income of a QOZB is derived from the active conduct of a trade or business in the QOZ.18

It is also important to note that the April proposed regulations expanded the 31-month working-capital safe harbor, which allows a QOZB time to convert cash into real property without violating the 70% test. Previously, the safe harbor applied to working-capital amounts that are designated in writing for the acquisition, construction, and/or substantial improvement of tangible property in a QOZ. Under the proposed regulations, the safe harbor applies to working-capital amounts that are designated in writing for the development of a trade or business in a QOZ, including, when appropriate, the acquisition, construction, and/or substantial improvement of tangible property in such a zone.19

Example 2: QOF F creates a business entity E to open a fast-food restaurant and acquires almost all of the equity of E in exchange for cash. E has a written plan and a 20-month schedule for the use of this cash to establish the restaurant. Among the planned uses for the cash are identification of favorable locations in the QOZ, leasing a building suitable for such a restaurant, outfitting the building with appropriate equipment and furniture (both owned and leased), making necessary security deposits, obtaining a franchise and local permits, and hiring and training kitchen and wait staff. Not-yet-disbursed amounts are held in working capital, and these assets are eventually expended in a manner consistent with the plan and schedule. E's use of the cash qualifies for the working-capital safe harbor.

Qualification as QOZBP

Satisfying the 'original use' test

QOZBP is tangible property used in a Sec. 162 trade or business of a QOF or QOZB that meets the following requirements:

  • In the case of property owned by the QOF or QOZB, the property must have been acquired by purchase20 from an unrelated party21 after Dec. 31, 2017;22
  • As discussed more fully below, in certain cases, leased property may also qualify as QOZBP;23
  • In the case of property owned by the QOF or QOZB, either: (1) the "original use" of the property within the QOZ must commence with the QOF or QOZB, or (2) the property is "substantially improved" within the meaning of Prop. Regs. Sec. 1.1400Z(d)-1(d)(4);24 and
  • During "substantially all" of the QOF or QOZB's holding period for the property, "substantially all" of the use of the property was in a QOZ.25

The October proposed regulations provided little clarity on how a QOF or QOZB satisfies the original-use test. For example, consider the case where a QOF purchases a building that is 97% complete, puts on the finishing touches, and places it into service for the first time. Is the original-use test met? Or what if a taxpayer buys a building that has sat empty for several years? If the taxpayer gets it up and running, would that satisfy the original-use test?

The April proposed regulations addressed these questions. The original use of tangible property in a QOZ commences on the date any person first places the property in service in the QOZ for purposes of depreciation or amortization (or first uses the property in a manner that would allow depreciation or amortization if that person were the property's owner).26

Example 3: AQOF purchases a building under construction. The building is nearly complete but has not yet been finished and placed into service. After purchasing the building, the QOF completes the remaining construction, places the building into service, and begins depreciating the building. The building satisfies the original-use requirement because, despite the fact that the building was nearly complete when acquired by the QOF, it had not yet been placed in service for purposes of depreciation.

In addition, if property has been unused or vacant for a period of five years, original use commences on the date after that period when any person first places the property into service in the QOZ.27

Example 4: In 2019, a QOF purchases a hotel that was placed in service and depreciated from 2009 through 2013 but that has sat vacant since the end of 2013. The QOF places the hotel into service and begins depreciating the property almost immediately after purchase. Despite the fact that the hotel was previously placed in service and depreciated within the QOZ, because it was vacant for a period of five years prior to the purchase by the QOF, when the QOF places the hotel in service, it satisfies the original-use test and need not be substantially improved.

Presumably, a QOF or QOZB could acquire a personal residence, place it into service as a rental property, and satisfy the original-use requirement because, as a personal residence, the home had never been depreciated.

Raw land as QOZBP

When a QOF or QOZB acquires land, the land cannot satisfy the requirement that the original use of the QOZBP begin in the QOZ with the taxpayer.28 This cast doubt on whether the value of land is counted toward the 90% or 70% test.

Rev. Rul. 2018-29 provides some clarity by stating that when a QOF or QOZB acquires land and a building together, provided the building is substantially improved within a 30-month period, the original-use requirement does not apply to the land on which the building is located. Thus, the value of both the land and the building will meet the definition of QOZBP. What the October proposed regulations did not address, however, was the result if a QOF or QOZB acquires only raw land and then constructs a new building. In that case, does the land qualify as QOZBP despite the fact that it does not satisfy the original-use test and is not substantially improved?

The April proposed regulations provide tremendous relief in this regard by providing that a QOF or QOZB may purchase raw land and, despite the fact that the land cannot satisfy the original-use test, the land does not need to be substantially improved to meet the definition of QOZBP.29

The inclusion of all raw land within the definition of QOZBP could lead to potential abuses where a QOF engages in land speculation by, for example, purchasing raw land, opting not to construct a structure on the land, and selling the land after 10 years tax-free. The April proposed regulations prevent such a result, however, by requiring that a QOF or QOZB use QOZBP in the active conduct of a Sec. 162 trade or business; merely holding raw land for investment will not satisfy this requirement.

Even with this rule, however, there remains potential for abuse. To illustrate, assume a QOF purchases 100 acres of undervalued land and places a nominal structure on the land, for example, a hot dog stand. Provided the hot dog stand is conducted with continuity and regularity such that it meets the Sec. 162 trade-or-business standard, it is possible that the land could be sold tax-free after 10 years.

The April proposed regulations provide another safeguard, stating that raw land will not be treated as QOZBP if the land is unimproved or minimally improved and the QOF purchases the land with an expectation, an intention, or a view not to improve the land by more than an insubstantial amount within 30 months after the date of purchase.30

Leased property as QOZBP

The October proposed regulations provided that a QOF must "purchase" QOZBP, but a QOZB could "purchase or lease" QOZBP. It was unclear, however, how a lease satisfied the original-use requirement if the leased property was already located within a QOZ. In addition, how could a QOF "substantially improve" a lease in the event the original-use test was not satisfied?

The April proposed regulations allow both a QOF31 and a QOZB32 to lease property. For leased property to meet the definition of QOZBP, however, the lease must meet the following requirements:

  • The property must be acquired under a lease after Dec. 31, 2017;33
  • The terms of the lease must be market-rate (that is, the terms must reflect common, arm's-length market practice in the location that includes the QOZ as determined under Sec. 482) at the time the lease was entered into;34 and
  • In the case of a lease of real property, at the time the lease was entered into, there was no plan, intent, or expectation for the real property to be purchased by the entity for an amount of consideration other than the fair market value (FMV) of the real property determined at the time of purchase without regard to any prior lease payments.35

Importantly, the original-use requirement generally does not apply to leased property, nor does the requirement that the leased property be substantially improved. Thus, a QOF or QOZB can generally lease a building that has long existed in a QOF and need not substantially improve the property. This would enable, for example, a startup company to lease its office space and have that lease meet the definition of QOZBP.

If a lease is between a QOF (or a QOZB) and a related party, however, additional safeguards exist. First, the lessee cannot make a prepayment on the lease relating to a period of use that exceeds 12 months.36 In addition, in the case of a lease of tangible personal property, the property must either (1) satisfy the original-use requirement,37 or, (2) during the 30-month period38 beginning with the inception of the lease, the QOF or QOZB must acquire other tangible QOZBP with a value equal to the value of the leased property.39 There is an important distinction to be made: The QOF or QOZB does not need to substantially improve the lease itself; rather, it must acquire other QOZBP with a value equal to the value of the lease, and that property may be completely separate and distinct in use from the leased personalproperty.

For these purposes — as well as for purposes of satisfying the 90% or 70% test — leased property can be valued at either the value on an applicable financial statement40 or by using an alternative valuation method of computing the present value of all future lease payments on the date the lease is entered into.41 During each year, a QOF or QOZB must apply consistently either the financial statement method or the alternative valuation method to all assets valued for that year.42

Remaining definitions of 'substantially all'

The term "substantially all" is used five times in Sec. 1400Z-2, including in these three provisions:

  1. As discussed earlier, for property to qualify as QOZBP, for "substantially all" of the QOF's or QOZB's holding period of the property, "substantially all" of the use of the property must be in a QOZ.43
  2. A QOZB must hold "substantially all" of its property as QOZBP.44
  3. If a QOF holds as QOZP either QOZ stock or a QOZ partnership interest in a subsidiary, for the subsidiary to qualify as a QOZB, it must meet the definition of a QOZB for "substantially all" of the QOF's holding period of the subsidiary's stock or partnership interest.45

The October proposed regulations defined "substantially all" — only for purposes of No. 2 above — as at least 70%; the remaining definitions were reserved.

The April proposed regulations defined the term "substantially all" for the remaining purposes. For the first "substantially all" of No. 1 and the "substantially all" definition of No. 3 (the holding period terms), "substantially all" means at least 90%.46 For the second "substantially all" in No. 1 — the requirement that QOZBP be used in a QOZ — the term means at least 70%.47

After applying these respective requirements, a QOF can hold 90% of its assets in a subsidiary QOZB, but in turn, that QOZB must hold 70% of its assets as QOZBP. Then, to meet the definition of QOZBP, for 90% of the QOZB's holding period of the property, the QOZBP must be used in a QOZ for 70% of the time. Thus, a QOF operating a business through a subsidiary QOZB could pass the 70% test while having as little as 40% of QOZBP within a QOZ.

During the 10-year holding period of the QOF

Recognition of deferred gain

Eligible gain that is deferred upon reinvestment into a QOF will be recognized on the earlier of: (1) the date on which the investment is sold or exchanged, or (2) Dec. 31, 2026.48 The October proposed regulations reserved paragraphs intended to describe those transactions, in addition to sales or exchanges that would trigger recognition of previously deferred gains.

The April proposed regulations expand upon the "sold or exchanged" language in the statute by providing that a taxpayer recognizes deferred gain on the date of any "inclusion event."49 In general, there are two types of inclusion events:

  • Transactions that reduce a taxpayer's equity interest — directly or indirectly — in the QOF.50 These include dispositions of all or a portion of an interest in a QOF by sale or exchange, gift,51 the liquidation of the QOF,52 certain liquidations of an owner of an interest in a QOF,53 the disposition of an interest in a partnership that is an owner in a QOF,54 and an aggregate change in ownership in excess of 25% of an S corporation that holds an interest in a QOF.55
  • Distributions of property, regardless of whether the taxpayer's direct interest in the QOF is reduced.56 This inclusion event occurs whenever taxpayers cash out a portion of their investment in the QOF by receiving a distribution of property with an FMV in excess of their basis in the QOF. This includes any distribution from a QOF corporation or partnership that exceeds the owner's basis and is thus taxed as a sale or exchange under either Sec. 301, 731, or 1368.57 As discussed more fully below, these types of inclusion events will trigger deferred gain on a dollar-for-dollar basis.

The April proposed regulations also identify transactions that generally are not inclusion events, including certain transfers of an investment in a QOF upon the death of a taxpayer,58 the contribution of an ownership interest in a QOF to a grantor trust,59 Sec. 721 contributions,60 and certain Sec. 381 transactions.61

Once an inclusion event has been identified, the taxpayer must determine the amount of the inclusion. For transactions that reduce a taxpayer's direct or indirect interest in the QOF, the inclusion amount depends on the portion of the QOF investment that is sold or exchanged. When the QOF is a C corporation, the amount of deferred gain recognized is equal to:62

  • The excess of:

    The lesser of:

    • The FMV of the disposed interest divided by the FMV of the total qualifying investment, multiplied by the remaining deferred gain; or
    • The FMV of the disposed interest;
       
  • Over the taxpayer's basis in the portion of the investment sold (this will be zero until at least year 5, unless a previous inclusion event occurred).

When the QOF is a partnership or S corporation, however, the amount of deferred gain that is triggered upon an inclusion event is equal to the lesser of:63

  • The percentage of the investment sold, multiplied by the remaining deferred gain (including any basis adjustments at the five- or seven-year holding period); or
  • The gain that would have been recognized on a fully taxable sale of that portion of the investment in the QOF that was disposed of in the inclusion event.

Example 5: In October 2018, A and B each realize $200 of eligible gain, and C realizes $600 of eligible gain. On Jan. 1, 2019, A, B, and C form Q, a QOF partnership. A contributes $200 of cash, B contributes $200 of cash, and C contributes $600 of cash to Q in exchange for qualifying QOF partnership interests in Q. A, B, and C hold 20%, 20%, and 60% interests in Q, respectively.

On Jan. 30, 2019, Q obtains a nonrecourse loan from a bank for $1,000. Under Sec. 752, the loan is allocated $200 to A, $200 to B, and $600 to C. On Feb. 1, 2019, Q purchases QOZBP for $2,000. On July 31, 2024 — after the five-year anniversary had been reached and A, B, and C have each increased their basis (and reduced their deferred gain) by 10% — A sells 50% of its qualifying QOF partnership interest in Q to B for $400 cash. Prior to the sale, there were no inclusion events.

Because A held its qualifying QOF partnership interest for at least five years, A's basis in its partnership interest at the time of the sale is $220 (the original zero basis with respect to the contribution, plus the $200 debt allocation, plus the 10% increase of its original $200 of deferred gain for interests held for five years). The sale of 50% of A's qualifying QOF partnership interest to B requires A to recognize $90 of eligible gain, the lesser of:

  • 50% of the remaining $180 deferred gain ($90); or
  • The gain that would be recognized on a taxable sale of 50% of the interest ($400 cash + $100 debt relief ‒ $110 basis), or $390.

When an inclusion event occurs upon the distribution of property, deferred gain is recognized dollar for dollar by the amount of gain recognized on the distribution.64

Example 6: On Jan. 1, 2019, A and B form Q, a QOF partnership, each contributing $200 of eligible gain to Q in exchange for a qualifying investment. On Nov. 18, 2022, Q obtains a nonrecourse loan from a bank for $300. Under Sec. 752, the loan is allocated entirely to B. On Nov. 30, 2024 — after the five-year holding period has been met and A has increased its basis from $0 to $20 — Q distributes $50 to A. A is required to recognize $30 of deferred gain because the $50 distributed to A exceeds A's $20 basis in its qualifying investment (the original zero basis with respect to its contribution, plus $20 created after the five-year holding period was met).

If the taxpayer still holds an investment in the QOF on Dec. 31, 2026, the amount included in income on that date is equal to:

  • The lesser of:65
    • The remaining deferred gain; or
    • The FMV of the investment on Dec. 31, 2026;
       
  • Over the taxpayer's basis in the investment (after taking into consideration any increases to basis on the five- and seven-year holding period anniversaries).

Example 7: Assume the same facts as in Example 5. On Dec. 31, 2026, A's and B's basis in their investment — without taking into consideration any debt basis under Sec. 752 — is $30 ($0 plus an increase of $20 after the five-year holding period requirement was met, and another $10 when the seven-year holding period requirement was met). C's basis in its investment is $90 ($0 plus a $60 increase when the five-year holding period requirement was met and another $30 increase when the seven-year holding period requirement was met). The FMVs of A's, B's, and C's interests on that date are $400, $400, and $1,200, respectively.

On Dec. 31, 2026, A and B must recognize $170 of deferred gain, the lesser of the remaining deferred gain ($200) or the FMV of the interest ($400), over A's and B's basis in the investment ($30). C must recognize $420 of deferred gain, the lesser of the remaining deferred gain ($510) or the FMV of the interest ($1,200), over C's basis in the interest ($90).

Relief from the 90% test for a QOF

A QOF must hold at least 90% of its assets as QOZP, determined by the average of the percentage of QOZP held in the fund, as measured on the last day of the first six-month period of the tax year and the last day of the tax year of the fund.66 This affords a newly formed QOF a six-month grace period to convert contributed capital into QOZP. Commenters to the October proposed regulations, however, raised an important question: If a QOF received an influx of capital shortly before a testing date that was not converted into QOZP, would the QOF fail the 90% test on that date and potentially be subject to a penalty?

The April proposed regulations provide that a QOF, when measuring its compliance with the 90% test, may choose to exclude from both the numerator and the denominator of its assets the amount of any property received by the QOF as a contribution in exchange for a membership interest in the QOF during the six-month period prior to the test, as long as during the period after the contribution and before the testing date, the contribution was continuously held in cash, cash equivalents, or debt instruments with a life of 18 months or less.67 Thus, the QOF will not fail the 90% test merely because it received a large cash contribution immediately prior to a testing date.

Sales of assets of a QOF during the 10-year holding period

A QOF might not wish to hold its QOZBP for the full 10 years. The October proposed regulations stated that future regulations would provide a QOF a "reasonable amount of time" to reinvest the proceeds from a sale but provided no additional clarity.

The April proposed regulations provide that a QOF will have 12 months to reinvest the proceeds from a sale of QOZBP or return of capital from a subsidiary QOZB, and, provided the proceeds are held in cash, cash equivalents, or debt instruments with a life of 18 months or less until they are reinvested, the proceeds will be treated as QOZP and count toward the 90% test.68 While the QOF's sale of assets will not trigger the deferred gain of any investor, any gain recognized by the QOF on the sale of its assets will be fully taxable to the QOF. Thus, if the QOF is a partnership or S corporation, the gain will be allocated to the partners and shareholders and fully recognized.

After the 10-year holding period is met

Sale of a QOF held longer than 10 years

A taxpayer may exclude the gain from the sale of an investment in a QOF that: (1) relates to a contribution of deferred gain, and (2) has been held longer than 10 years.69 The use of the word "investment" in the statute implies that to benefit from the exclusion, a taxpayer must sell the equity interest in the QOF. Presumably, if the QOF were to instead sell its assets, any gain realized inside the QOF would be recognized.

The April proposed regulations provide partial relief from a forced equity sale. The regulations provide that if a QOF formed as a partnership or S corporation sells its assets, a partner or shareholder who has held an interest in the QOF for 10 years may elect to exclude any capital gain allocated to the partner or shareholder on Schedule K-1, Partner's [Shareholder's] Share of Income, Deductions, Credits, etc., resulting from the sale of QOZBP.70 Note, this does not require that the QOF generate the capital gain directly but rather that it must pass capital gain through to the owners of the QOF. Presumably, this protects investors in a QOF that operates through a subsidiary partnership, with that subsidiary partnership selling its assets after 10 years and passing capital gain to the QOF, which in turn passes the capital gain to the partners or shareholders on Schedule K-1.

While taxpayer-friendly, the April proposed regulations do not fully protect an investor in a QOF from gain if the QOF sells its assets after 10 years. Only capital gain generated from the sale of QOZBP that is allocated to a partner or shareholder may be excluded. Thus, if the partnership or S corporation sells inventory, cash-basis receivables, or assets subject to ordinary-income depreciation recapture, a sale of the assets by the QOF after 10 years will result in some degree of ordinary income recognition to the investors. Likewise, if the QOF were to sell non-QOZBP assets, any gain would be required to be recognized by the investors. In addition, an investor in a C corporation QOF is unable to exclude gain upon the QOF's sale of assets.

Greater confidence for investors

A taxpayer that invests in an opportunity zone has the potential to enjoy a bevy of tax benefits, provided the various statutory and regulatory requirements are met. While the ­October proposed regulations were a step forward in providing clarity as to the application and interpretation of these requirements, those regulations raised nearly as many questions as they answered. Fortunately, the April proposed regulations filled in the gaps, allowing investors to finally move forward with confidence. 

 

Footnotes

1P.L. 115-97.

2REG-115420-18. The earlier article numbered the proposed regulations as they appeared in the IRS's notice of proposed rulemaking for the October proposed regulations, which retained the hyphen of the statute numbers (e.g., Prop. Regs. Sec. 1.1400Z-2(a)-1). However, both the official version of the October proposed regulations published in the Federal Register (83 Fed. Reg. 54279 (Oct. 29, 2018)) and the IRS in its April proposed regulations (and, again, in the Federal Register (84 Fed. Reg. 18652)) omit the initial hyphen (e.g., Prop. Regs. Sec. 1.1400Z2(a)-1). The convention of omitting the hyphen is followed in this second article.

3REG-120186-18.

4Prop. Regs. Sec. 1.1400Z2(a)-1(b)(2)(i)(A).

5Prop. Regs. Sec. 1.1400Z2(a)-1(b)(2)(iii).

6Sec. 1400Z-2(d)(2)(D)(i).

7Prop. Regs. Sec. 1.1400Z2(d)-1(c)(4)(ii).

8Prop. Regs. Sec. 1.1400Z2(d)-1(d)(2)(ii).

9Groetzinger, 480 U.S. 23 (1987). See also Stanton, T.C. Memo. 1967-137 (sporadic activity without expectation of profit did not qualify as engaging in a trade or business); Niemann, T.C. Memo. 2016-11 (continuity and regularity require a showing of "extensive business activity over a substantial period").

10Prop. Regs. Sec. 1.1400Z2(d)-1(d)(5)(ii)(B)(2).

11Notice 2019-7. This includes a lease agreement that requires the tenant or lessee to pay a portion of the taxes, fees, and insurance and to be responsible for maintenance activities allocable to the portion of the property rented by the tenant.

12Rev. Rul. 73-522.

13For a fuller description of these provisions, see the prior article, Nitti, "Opportunities Beckon in New Qualified Opportunity Zones," 50 The Tax Adviser 356 (May 2019).

14Sec. 1400Z-2(d)(3)(A)(ii).

15Prop. Regs. Sec. 1.1400Z2(d)-1(d)(5)(i)(A).

16Prop. Regs. Sec. 1.1400Z2(d)-1(d)(5)(i)(B).

17Prop. Regs. Sec. 1.1400Z2(d)-1(d)(5)(i)(C).

18Prop. Regs. Sec. 1.1400Z2(d)-1(d)(5)(i)(D).

19Prop. Regs. Sec. 1.1400Z2(d)-1(d)(5)(iv).

20Under the meaning of Sec. 179(d)(2).

21Under the meaning of Sec. 1400Z-2(e)(2).

22Sec. 1400Z-2(d)(2)(D)(i)(I); Prop. Regs. Secs. 1.1400Z2(d)-1(c)(4)(i)(A) and 1.1400Z2(d)-1(d)(2)(i)(A).

23Prop. Regs. Secs. 1.1400Z2(d)-1(c)(4)(i)(B) and 1.1400Z2(d)-1(d)(2)(i)(B).

24Prop. Regs. Secs. 1.1400Z2(d)-1(c)(4)(i)(C) and 1.1400Z2(d)-1(d)(2)(i)(C).

25Prop. Regs. Secs. 1.1400Z2(d)-1(c)(4)(i)(D) and 1.1400Z2(d)-1(d)(2)(i)(D). See the ensuing discussion on the definition of "substantially all" for these purposes.

26Prop. Regs. Sec. 1.1400Z2(d)-1(c)(7)(i).

27Id.

28See Rev. Rul. 2018-29.

29Prop. Regs. Sec. 1.1400Z2(d)-1(c)(8)(ii)(B).

30Prop. Regs. Sec. 1.1400Z2(d)-1(f).

31Prop. Regs. Sec. 1.1400Z2(d)-1(c)(4)(i)(B).

32Prop. Regs. Sec. 1.1400Z2(d)-1(d)(2)(i)(B).

33Prop. Regs. Sec. 1.1400Z2(d)-1(c)(4)(i)(B)(1); Prop. Regs. Sec. 1.1400Z2(d)-1(d)(2)(i)(B)(1).

34Prop. Regs. Sec. 1.1400Z2(d)-1(c)(4)(i)(B)(2); Prop. Regs. Sec. 1.1400Z2(d)-1(d)(2)(i)(B)(2).

35Prop. Regs. Sec. 1.1400Z2(d)-1(c)(4)(i)(E); Prop. Regs. Sec. 1.1400Z2(d)-1(d)(2)(i)(E).

36Prop. Regs. Sec. 1.1400Z2(d)-1(c)(4)(i)(B)(4); Prop. Regs. Sec. 1.1400Z2(d)-1(d)(2)(i)(B)(4).

37Identical rules exist for determining when original use commences with regard to leased property as for purchased property. See Prop. Regs. Sec. 1.1400Z2(d)-1(c)(4)(i)(B)(6); Prop. Regs. Sec. 1.1400Z2(d)-1(d)(2)(i)(B)(6).

38Prop. Regs. Sec. 1.1400Z2(d)-1(c)(4)(i)(B)(7); Prop. Regs. Sec. 1.1400Z2(d)-1(d)(2)(i)(B)(7). The period is the shorter of 30 months or the life of the lease.

39Prop. Regs. Sec. 1.1400Z2(d)-1(c)(4)(i)(B)(5); Prop. Regs. Sec. 1.1400Z2(d)-1(d)(2)(i)(B)(5).

40Prop. Regs. Sec. 1.1400Z2(d)-1(b)(2); Prop. Regs. Sec. 1.1400Z2(d)-1(d)(3)(ii)(B)(2).

41Prop. Regs. Sec. 1.1400Z2(d)-1(b)(3)(iii); Prop. Regs. Sec. 1.1400Z2(d)-1(d)(3)(ii)(B)(3).

42See Prop. Regs. Sec. 1.1400Z2(d)-1(b)(1); Prop. Regs. Sec. 1.1400Z2(d)-1(d)(3)(ii)(B)(1). It should be noted that because the alternative valuation method is determined on the date the lease is entered into and is used for the entire length of the lease, it would not accurately capture a downturn in the market that reduces the value of the leased property.

43Sec. 1400Z-2(d)(2)(D)(i)(III).

44Sec. 1400Z-2(d)(3)(A)(i).

45Sec. 1400Z-2(d)(2)(B)(i)(III).

46Prop. Regs. Sec. 1.1400Z2(d)-1(c)(5); Prop. Regs. Sec. 1.1400Z2(d)-1(d)(2)(iii).

47Prop. Regs. Sec. 1.1400Z2(d)-1(c)(6); Prop. Regs. Sec. 1.1400Z2(d)-1(d)(2)(iv).

48Sec. 1400Z-2(b)(1).

49Prop. Regs. Sec. 1.1400Z2(b)-1(b).

50Prop. Regs. Sec. 1.1400Z2(b)-1(c)(1)(i).

51Prop. Regs. Sec. 1.1400Z2(b)-1(c)(3).

52Prop. Regs. Sec. 1.1400Z2(b)-1(c)(2).

53Prop. Regs. Sec. 1.1400Z2(b)-1(c)(2)(ii). This does not apply, however, if the liquidation of the QOF owner is a tax-free liquidation into an 80% parent governed by Sec. 337. See Prop. Regs. Sec. 1.1400Z2(b)-1(c)(2)(ii)(B).

54Prop. Regs. Sec. 1.1400Z2(b)-1(c)(6).

55Prop. Regs. Sec. 1.1400Z2(b)-1(c)(7)(iii).

56Prop. Regs. Sec. 1.1400Z2(b)-1(c)(1)(ii).

57Prop. Regs. Sec. 1.1400Z2(b)-1(c)(6)(iii); Prop. Regs. Sec. 1.1400Z2(b)-1(c)(7)(ii); Prop. Regs. Sec. 1.1400Z2(b)-1(c)(8).

58Prop. Regs. Sec. 1.1400Z2(b)-1(c)(4).

59Prop. Regs. Sec. 1.1400Z2(b)-1(c)(5).

60Prop. Regs. Sec. 1.1400Z2(b)-1(c)(6)(ii)(B).

61Prop. Regs. Sec. 1.1400Z2(b)-1(c)(10).

62Prop. Regs. Sec. 1.1400Z2(b)-1(e)(1).

63Prop. Regs. Sec. 1.1400Z2(b)-1(e)(4).

64Prop. Regs. Sec. 1.1400Z2(b)-1(e)(2).

65Prop. Regs. Sec. 1.1400Z2(b)-1(e)(3).

66Sec. 1400Z-2(d)(1).

67Prop. Regs. Sec. 1.1400Z2(d)-1(b)(4).

68Prop. Regs. Sec. 1.1400Z2(f)-1(b).

69Sec. 1400Z-2(c).

70Prop. Regs. Sec. 1.1400Z2(c)-1(b)(2)(ii).

 

Contributor

Tony Nitti, CPA, MST, is a partner at RubinBrown in Aspen, Colo. For more information on this article, contact thetaxadviser@aicpa.org.

Newsletter Articles

TAX REFORM

Traps for the unwary: Tax Cuts and Jobs Act changes

By now many of us are familiar with the various provisions of the law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97. Here is a list of changes together with (perhaps) unexpected nuances.

DEDUCTIONS

Qualified business income deduction regs. and other guidance issued

The package includes final regulations, guidance on how to calculate W-2 wages, a safe-harbor rule for rental real estate businesses, and new proposed rules on the treatment of previously suspended losses.