On-Demand: QOF Incentives for Real Estate Investors
- Mar 12, 2020
The Treasury and IRS issued their final guidance on Qualified Opportunity Zones on December 20, 2019. Our speakers will discuss how the guidance will affect real estate investing in the O-Zone.
Kenneth Weissenberg:Good afternoon. Here's a little overview of the opportunities of the program. It was created as part of the Tax and Jobs Act in 2017. There has been a series of regulations issues. The first one came out in October of 2018. The second set of regulations came out in April of 2019. And the final regs were a Christmas present to all us professionals. They were released on December 19th, 2019.
The intended goal of the opportunities on benefits are to simulate investment within economically distressed areas throughout the United States including its territories and possessions.
So, there are 8,722, I believe, zones throughout the country and including the possessions. Mostly down in the Puerto Rico is an economically distressed zone right now and it qualifies for opportunities on benefits. And the benefits are very significant.
Jessica Millet:Hi everybody. Good afternoon. Ken mentioned, even though the final regulations were released and everyone got to read them back in December of 2019, the regulatory process actually requires that that regulations be published in the Federal Register. And that publication happened in January, last month on January 13, 2020. So, the way that the effective date will work is that technically, the final regulations are effective for taxable years that begin 60-days after that publication date, which is why you come up with this funny March 13th date.
What that really means in practice is that for most individual tax payers, and most partnerships, the final regulations are the only choice beginning in 2021. However, you can rely on the final regulations now. The regulations permit that. The regulations also give you the ability before 2021 to use the proposed regulations. However, there's currently a little bit of or maybe a lot of confusion in the random opportunity zones now about how things work in 2020 if you want to pick and choose.
If you look at actually, the preamble, the language of the preamble, it implies that it's all or nothing. It implies that if you want to choose the proposed regulations for 2020, you can do so or you have to choose the final regulations.
If you look at the actual text of the regulations, the regulations are broken up into, I think, five or so different sections and each of those sections has effective date language at the end. And if you look at the effective date language at the end of those sections, it implies that you can choose on a section by section basis. Even more confusing, is that we've had a couple inconsistent statements coming out of treasury on speaking at different conferences or being interviewed in articles. So, right now, nobody's entirely sure what the rule is in terms of what you can do in 2020, so if you're in a situation, you may what to pick and choose, make sure you speak with an advisor to figure out that you're doing things in accordance with the rules as best as we can interpret them right now.
Just so you know, the way that Ken and I are going to be splitting up this webinar for you guys, we're going to focus first on investor related issues about eligible gains, and timing, and how the benefits work. Next we'll move to issues qualified opportunity fund level. And then if we're moving down the structure chart, we'll talk about issues related to qualified opportunities on business, and property, and finally, with some anti-abuse rules.
In fact, I think Ken is going to get us started on investors.
Kenneth Weissenberg:First off, the benefits or opportunities zones are a deferral of tax on capital gain until December 31, 2026. That gain is treated as being recognized then, so you have 180-days to invest that gain. But the way they wrote these rules, 180-days is not necessarily 180-days. For direct sales of assets, you have 180-days from the sale of that asset, so you have to invest in the qualified opportunities. The exceptions are, for installment sales, you can do it from the date of the sale, you can do it from the date you get a payment, so if you get multiple payments during the year, you might have multiple 180-day periods. Or you can do it from the end of the year that you're getting payments. You have a little bit of flexibility that way.
To use an installment sale, it has to be a capital gain or a 1231 gain. It doesn't work for ordinary short-term gains. Dividends from RIC and REIT can be invested the 180-days from the tax payers year-end, but it could also be done from the date you receive a dividend that's declared to be a total gain dividend, so you have multiple choice there.
And then we get to the fun rules, the partnerships. And this implies to any kind of flow-through entities, S-corporations, trusts, or estates. You have three options. One is 180-days from the sale of the asset by the entity, which is pretty simple. The entity sells a share of stock on January 2nd, you have 180-days from January 2nd to invest. Another choice is to 180-days from the year-end, so a partnership sells an asset on January 2, 2020, you have until... Or the starting date, you could make is December 31, 2020 and you have until 6/28/21 to invest. Or you could wait till the partnerships due date of its tax return because you might not necessarily know what the partnership did until they tell you what the K1 looks or may look like until you have 180-days from the due date as a partnerships return, which 3/15 in the case of partnerships or S-corporations. That gives you until September 11th of 2021 for a January 20 sale.
The handy dandy chart illustrates that, so you can see the three tiers but there's a hole in the middle. If you have a sale in the first half of the year, you can do it during those 180-days following the sale, but you can't do it from day 181 until December 31st, so you have to be careful about that.
If you make an investment in the qualified opportunity zone and you don't have a gain to invest in the opportunity zone, it just looks like a good deal and you put the money in, you don't get the benefit of opportunity zone statutes for doing that. So, you have basically, non-qualified investment. And you have a mixed investment if you have some qualified investment. It's treated as two separate partnership interests.
1231 gains was a subject with some controversy with the proposed regulations. So, if you do adopt to follow the proposed regs versus the final regs, you're under the old 1231 gain rule, which is in the second set of regs but not in the first set of regs, to make things clear. With 1231, which is basically gained from property use in the trade of business of sale of depreciable property. You have 180-days under the new regs, the final regs that came out. You have 180-days from the date of sale if it came through a partnership, you're following the partnership rules. And it's the gross gain under 1231.
For example, if I have a $500 gain on 1231 assets and I have a $300 loss at any time during the year on other assets that are sold, I can invest the 500 into a qualified opportunity fund and take the 300 as ordinary loses under section 1231. This gross capital gain investment also ignores the recapture provisions from previous 1231 losses, which have a five-year look-back. So, it's a pretty beneficial rule on 1231 gains now.
Jessica Millet:One question that came up has come up pretty frequently for me, and Ken I imagine, you've gotten this question as well over the past two years is, "Well, if I have a qualified opportunity fund that invested in a traditional real estate investment, can I do a refinancing and pull out the cash because that's how all these deals work?"
And the reason why this question has been asked so many times in the qualifies opportunity fund context is because of some of the funny basis rules that apply to qualified opportunity fund investors. Normally, if you invest $100 into a partnership, you have basis in your partnerships interest of $100. However, if you invest $100 in eligible gain into a qualified opportunity fund, your initial basis is zero. And the reason for this is that the way that the ultimate tax benefits are conveyed to the investors, the five-year rule, the seven-year rule, the 10-year rule, those are actually implemented through special basis adjustments. So, in order to make the tax benefits work, they said, "On day one, a qualified opportunity fund investor has zero basis in their partnership venture."
We did get confirmation in some of the earlier proposed regulations that the normal debt allocation rules in section 752 still apply. So, if your partnership or the lower tier project takes on debt, then any of the up tier partners, all of the up tier partners in some instances will be allocated their proportionate share of the debt. So, by having basis in the debt, this allows you to actually get a distribution up to your basis without necessarily triggering an inclusion event or resulting in gain.
There's a couple things to keep in mind however, because the idea behind the opportunity zone program is for investors to put their dollars into these zones, have that money be at work and at risk for a certain amount of time that the regulation should refer you back to this other area, the tax law called the disguised sale rules. And essentially, under the disguised sale rules, if you put property or money in and then get money or property out, you just have to worry about the characterization of that.
There is a safe harbor presumption actually, in the disguised sale rules that says that as long as your two transactions are at least two years apart, there's a presumption that you don't have a disguised sale. So, the general rule to keep in mind is that, make sure that your qualified opportunity fund investors are in for at least two years before you send a distribution and a refinancing and get these out to them. But also, keep in mind that because nothing in the tax law is simple or straightforward, the disguise sales have a lot of nuances in there, so make sure that you're speaking to an advisor before you go down that path-
Kenneth Weissenberg:Very good point.
Jessica Millet:... because your fact matter in this instance. One other red flag and note of warning here, is that if you end up being tripped up by the disguised sale rules, it's not just that the distribution can be taxable to the investors, that it could actually invalidate the initial investment by those two QOF investors, which means that they would not have an eligible qualified opportunity fund interest at all. So, this is certainly an area where you want to tread lightly and make sure that you're crossing your T's and dotting your I's before you do that.
Kenneth Weissenberg:One thing you should note that if you have multiple investors going in over a period of time, because you would have several rounds of capital raises. Right? It's applies basically, to the last investor. If they put money in and investors pull that money out within two years of the money going in, they treat it as the sale of the interest funding that you might see and it could have triggered the same results. So, it's really, two years from the contribution in that you have to keep your eye on.
Jessica Millet:Yep. Okay. Probably, the biggest swing in the final regulations at least from my perspective, was some clarity that treasury finally provided on the exit. But the big tax benefit for investors of course, is the 10-year benefit and that says that if the investors have been for 10 years, making the exit tax free.
The reason why this was such a big issue was that it drafted into the internal revenue code, the 10-year benefit implied that you needed to sell the equity in your qualified opportunity fund in order to get the benefit. And that made a lot of these deals very cumbersome, a bit clunky, the market was really focused for the most part on single asset qualified opportunity funds. But again, the market didn't really love that restriction so much. Sponsors wanted to be able to set up multi-asset funds, investors wanted the exposure of a co-mingled fund with multiple assets in it.
And the final regulations finally clarify that as long as an investor has been in the qualified opportunity funds for at least 10-years, they can be able to select the 10-year benefit either by selling a qualified opportunity fund interest or if there's a down tier sale of property either by the qualified opportunity fund or by a lower tier QOZB, qualified opportunity zone business, investors can exclude the allocation gain to them.
The one carve out to this very generous rule is gain from the sales inventory. You cannot claim the 10-year benefit on that. But again, also going to Ken's point about investors coming in at different times, every investor has their own individual 10-year clock. That means that if a single investor puts cash in at two different times, that single investor now has two different clocks running, so you have a split holding period.
Hypothetically speaking, if Ken puts cash eligible gain into a qualified opportunity fund in 2019 and he puts more eligible gain into that same qualified opportunity fund in 2021, and now there's a sale that happens in 2030, and gain is allocated to Ken, he will only be able to claim the 10-year benefit on a portion of that gain because he will not have held his entire interest for 10-years.
Again, the rule is very generous, but you do have to keep in mind the way that these timing rules all work together. So, it you're thinking about doing a co-mingle fund and calling capital from investors at different times, you would have to be very mindful of these rules and the way they interact.
Okay. Moving down the structure chart a bit to qualified opportunities funds, there are a couple issues we want to highlight here for you. The first, is just a lot of flexibility that treasury came out with when it comes to structuring issues. They basically, allow you to move things around, move your investment around, restructure it, merge partnerships. A lot of those transactions can now be down on a tax-free basis and without triggering an inclusion event for your investors.
Again, there's a lot of nuances here, a lot of detail that we're not going to go into today, so be mindful of it. But you can for example, merge your qualified opportunity fund partnerships together. There're some other rules applicable obviously, to S-corporations and C-Corporations, so that's all very helpful.
One issue that I want to make sure everyone is aware of because it's come up a couple times for our clients is that, the regulations allow qualified opportunity fund investors to essentially contribute their QOF interest down into a new feeder partnership for example. But the regulations explicitly disallow setting up your structure on day one with feeder partnership. So, if you've got a group of 10 investors, the 10 investors can invest in the qualifies opportunity fund and then subsequently contribute their qualifies opportunity fund into a feeder partnership that would then be between the investor in the qualifies opportunity fund. And that's okay, that's allowed.
However, if the investors contribute their eligible gain on day one to a feeder partnership, then subsequently contribute to a qualified opportunity fund, that does not work. So, there's a little bit of making sure you're playing by the book here to make sure that you invalidate your structure. So, if your structure is going to involve a feeder, again, make sure you set it up the right way with the right stuff.
The qualified opportunity fund structure is... And I know Ken is going to talk about this in a little bit. ... they have two basic flavors. There's the single tier qualified opportunity fund, which is a structure where the qualified opportunity fund owns property directly. And then there's the two tier structure, which is really how most of these deals are getting done, which involves a qualified opportunity fund owning an equity interest in a lower tier partnership for the most part and that lower tier partnership is a qualified opportunity zone business, QOZB.
Now, the reason that works is because the code in the regulations say that a partnership interest in a qualified opportunity zone business is a good asset in the hands of the QOF for purposes of the 90%r test. But it's only a good asset as long as you meet obviously, a number of requirements. And one of those requirements is a holding period test. And the rule says that the qualified opportunity zone business has to be a good qualified opportunity zone business for at least 90% of the QOF holding period.
Well, the holding period test is baked into the internal revenue code and treasury clarified the 90% aspect of it. There was still a lot of confusion on how this worked and treasury finally addressed it in the final regulations. There are a couple points and this can get a little nuance, so I'll try and just give you the highlights. But the first one is that the holding period test is applied cumulatively going forward.
So, if you think about the fact that a qualified opportunity then may typically have a 10-year investment of qualified opportunities zone business, you cannot for example, decide, "Well, I'm going to blow the first year and not have a good QOZB, and I'm going to make it up by being a good QOZB for the next nine years. And then collectively, I'll complete my hold period test." That does not work. They said, "You start on day one and you go forward." There is a cure right that we'll talk about in a second, but you really need to make sure that you're a good QOZB from day one.
Second, they clarified that measuring whether or not a QOZB is a good QOZB happens twice a year on the two semi-annual testing dates for the qualified opportunity fund, which are typically going to be June 30th and December 31st. But if you think about some of the QOZB tests, for example, there's a 50% growth income test and it's 50% of the gross income for the year has to be good qualifying income. But if you have a full year to meet the test, then you may not necessarily know if you've met it on June 30th. So, the reg give you a little bit of flexibility and say that on the June 30th testing date, you can rely on your QOZB status at the end of the previous year, which I think is helpful.
But the way that I read the rules... Again, I'm not sure what you think. ... that safe harbor does not seem to apply in the first year. It seems like on the first year, if you set up your qualified opportunity zone business in January, you need to be a good QOZB on June 30th. You don't get the benefit of waiting until the end of the year. So, unless we get a little bit of clarity from treasury on that, we're assuming that you have to be a good QOZB on your first testing date no matter what.
And as I mentioned previously, you get a one-time cure right, so if you blow a test, you get one chance to fix it and you have to fix it within six months. And that's one string a lifetime on the qualified opportunity zone business, so it's like your get out of jail free card, but you only get one of them.
Kenneth Weissenberg:Okay. It sounds like if you blow the first half of the year, you could fix it by the end of the year.
Jessica Millet:Yes. I think in your first year, if you blow it on your first testing date, you can fix it by the end, but then you're really out of luck.
Kenneth Weissenberg:You have to stay in there.
Jessica Millet:At least for the first nine years.
Kenneth Weissenberg:When does a qualified opportunity fund not want to continue as a qualified opportunity fund? If for some reason, they sold their property and they know they're not going to reinvest the property in the fund level, they might want to recertify so that the investors basically can reinvest a gain somewhere else if it's before December 31, 2026.
The procedure is, they can elect voluntarily to be certified. It becomes effective on the first day of the month following the month which they elected to certify and it's treated as an inclusion event for the investor, so they're picking up a gain under the fair gains at a specific time. But then they have 180-days to invest that deferred gain into another qualified opportunity fund in order not to pay tax currently.
The 10-year holding period starts fresh with a new invest, but other than that, they're not really harmed. And why would they do that? Well, if you have a fund that basically, is not going to be a qualified opportunity fund or meet the 90% of the of its assets test going forward, it'll be subject to a penalty to their partners. And rather than incur the penalty to the risk that it would be de-certified by the IRS involuntarily, they can do the voluntary de-certification.
The final regs did not address when the IRS can come in and say that it doesn't qualify. There is something in the anti-abuse rules, which I'll discuss later, which says that, "If you didn't intend to meet the qualifications all along, well, you're just trying to take advantage of the tax benefits, you weren't good all along." So, we'll see how that plays out.
Jessica Millet:Yeah, I did hear... Well, some statements from treasury on the involuntary de-certification issue and they implied that they're waiting to see how things go essentially. They're not entirely sure what they're going to see in terms of possible abuses or non-compliance, so rather than box themselves into a corner, I think they're waiting to see how people behave.
Kenneth Weissenberg:Tax payers and tax professionals can be very creative as far as to taking advantage of a tax benefit. I'm going to talk a little bit about structure and how you do your investment. The qualified opportunity fund, basically, you have to cash all properties in a qualified opportunity fund to acquire your interest. The qualified opportunity fund has to invest in qualified opportunity zone property or qualified opportunity zone businesses. Qualified opportunity zone businesses can be partnerships or corporations.
If it goes directly into qualified opportunity zone business property, basically, 90% of the assets have to be in as businesses property and cash would not be considered a good asset. There's no working capital rules at the qualified opportunity fund level. So, if they're holding on to cash and then you see 10% of their assets even if they're using it to substantially improve the assets that they've acquired or to close on an asset they're going to acquire, it wouldn't be good property.
On the other hand, if you do an indirect investment, so invest in qualified opportunities on businesses, there is a working capital rule of the opportunities on business levels. Now, working capital rule says that cash can be held as long as it's cash equivalent, so short-term debt less than 18 months or 31 months by the qualified opportunity zone business and it meets the qualifications.
Now, there's other rules for qualified opportunity zone business, there's basically, gross income test, a management type test where intangibles are used. But for the most part, if we're dealing with real estate, the real estate's either in the zone or not in the zone, and because it's this threshold for the qualified opportunity zone, assets for qualified opportunity zone business is 70%. By having the business in place, it really dilutes what the fund has to have in actual ownership of assets to 63%, to 90% of 79%. It really gives you much more flexibility and it gives you much more time to invest the cash that you receive in to business especially, if you're developing a business. And with the new regs, there's some working capital safe harbors in tolling.
Jessica Millet:Yeah. And one of the reasons I think why... Well, I think that a lot of people had asked treasury I think, in the various comment with respect to the proposed regulations, "Can you equalize the treatment that is between those single tier structure where the QOF owns property and the two tire structure with a QOZB?" Because oddly enough, the more complicated structure on the right was a QOZB, was the one that's easier to comply with giving the flexibility and the timing.
And treasury came back in the final regulations and said, "No, we can't because this is how the internal revenue code set up the definition and set up the requirements."
Jessica Millet:Yep. And so I think that they felt that their hand were really tied by the language in the internal revenue code. Then they tried to give as much flexibility as they could overall, but this was one were they couldn't really go against the language in the statute.
Kenneth Weissenberg:Right. So, for the most part, I think the leap both Jessica and I are recommending, even if there's a single asset deal, to use the qualified opportunity zone business structure just because it gives you more flexibility.
Jessica Millet:Yep. Absolutely.
Kenneth Weissenberg:The working capital is a really great opportunity for funds to gather cash and use the cash to develop property or do the substantial improvement for use property that is required to be done for use property. As I said, cash has to be held in cash, cash equivalence or short-term debt left at 18 months. There is a reference to an enterprise zone section, which talks about non-qualified financial property. For a business and even after the 31 month rule is over, the business can't have more than 5% of its assets in non-qualified financial property. So, yes, you can have stock or interest in partnerships, which aren't qualified opportunity zone businesses, but they can't be more than 5% of your value.
And in order to be eligible for the working capital exception, it has to be a written plan. The plan should basically lay out the timeline in which the money will be sent, it should be followed fairly closely and it should be basically, able to be audited by the IRS if they come in and audit it. If there's a delay because of government action, you get a tolling of the 31 month rule. And if you have subsequent capital raises of disaster areas, you have an additional 24 months, so Puerto Rico got lucky twice.
Jessica Millet:Yeah. And one item just to note on the tolling because in the proposed regulations, they said, "Well, you can toll if you're waiting for government action on an application that you submitted." And there are a lot of questions about how does that work if you're waiting? If you submit an application and you're waiting six months, but you get the approval before the end of your 31 months, can you still toll or do you only have to be waiting at the end? And the language in the final regulations did tighten up this requirement a bit and they said, "Your project actually has to be delayed." So, if you're waiting on an application and you're literally sending everybody home because there's nothing to do because you cannot move your project forward, then that's when you can toll the 31 months. But it you submit an application and you're able to progress the project in other ways, then you're not able to toll.
Again, I was happy to get the guidance just so we knew how it worked. But keep in mind that the tolling is not a blank check. They really want you to be progressing these projects as quickly as you possible can.
Kenneth Weissenberg:Right. And at the end of the working capital safe harbor, the assets have to be used in an... Oh, 70% of your assets have to be used in a trade or business. That means that you really should be done at the end of your period. But for startup companies, there's a new rule.
Jessica Millet:This new 62 month working capital safe harbor, this is really critical to helping these projects get off the ground and to really give investors certainty on how that startup period works. Because as Ken mentioned, at the QOZB level, they hide a lot of these requirements to making sure that your property is used in a trade or business. And while you're building your building or improving your building and it's not up and running, it's not being used, you're not generating income, you're not actually in a trade or business. And so how do you use the rules?
And so treasury came out with this 62 month working capital safe harbor. And this is probably one of the more confusing aspects of the regulations, so I'm going to try and break it down for you. But the way to think about it is there's really two different safe harbors going on here. The first is the 31 month working capital safe harbor that Ken discussed and what that safe harbor does, is it allows you to treat your cash as a good cash essentially. Because as Ken mentioned, one of the requirements of the QOZB is that no more than 5% of your assets can be cash or other financial property, but you can have a reasonable amount of working capital.
And everyone was wondering what that meant and so they said, "Okay. Well, if you comply with the safe harbor and you have a plan and a schedule to send your cash, you can be sure that you're in that bucket of your cash being a good reasonable amount of working capital. They kept that framework in the final regulations and they said, "And you can have multiple 31 month working capital safe harbor periods running either sequentially, overlapping and as long as you meet the requirements, you can be comfortable that your cash is a reasonable amount of working capital. That's one safe harbor.
The second safe harbor is the one that's really critical to your startup business. You're making sure that you're really developing property and you can pretend essentially, that engaged in a trade or business even when you're not. And this is intangible property safe harbor. And what this safe harbor says is that, "If the property, the tangible property that you identify in your written plan for your 31 month working capital safe harbor, if that tangible property is expected to be good qualifying eligible property at the end, then you can pretend that you're already done and that, that property that you're going to build or that you're going to improve is already good property during your safe harbor period."
And this is really helpful because people were getting very nervous about this. However, treasury did put a limit on this one and they said, "Your limit is 62 months." The way that I read the rules, you can have the 31 month working capital safe harbor for cash. I read that as you're able to do it again, and again, and again. There's no explicit outsizes limit on that safe harbor.
Kenneth Weissenberg:Yeah, as long as you have additional capital raises, you have a 31 month for those.
Jessica Millet:Exactly. But keep in mind, you do need to be able to... Any cash that's covered by 31 months working capital safe harbor, you have to spend it by the end of the 31 months. And so even if you start a new one because you get new cash in, that doesn't necessarily mean you can then bring all the with you. You really do need to spend the cash by the expiration of the 31 month for each safe harbor period. For the tangible property, this is-
Kenneth Weissenberg:Also, that applies to cash that's borrowed by the qualified opportunity zone business.
Kenneth Weissenberg:Right? So, if you get financing in the beginning of your construction period and they sometimes give all the cash up front in an escrow account and sometimes not. But if they give you all the cash up front, that cash would be part of your 31 month spend.
Jessica Millet:Yes. Absolutely. It's any cash regardless of whether if it was borrowed, it's contributed by a qualified opportunity fund, it's contributed by a non-qualified opportunity fund, if it's cash from any source. You have a total of a little over five years to build your building, get your property into service, so that you can meet the trade or business requirement because the regulations were very clear and they said, "Look, if you've got working capital assets left over in month 63, then those do not qualify as good tangible property for purposes of your 70% test." So, you get the benefit of treating your cash as good cash indefinitely as long as you meet the requirements, but your tangible property really needs to be able to stand on its own without any safe harbor benefits starting in month 63.
Kenneth Weissenberg:For most real estate projects, they really want you to have a place and service at the end of that 62 month period.
Jessica Millet:Yeah. Absolutely. Yeah. And this goes back to the idea that Treasury tried to implement rules that reflect the policy of the opportunity zone program and the treasury with the regulations. They want these dollars in these communities as soon as possible. They want them to work as soon as possible. They do not want you to claim these tax benefits for not doing anything, so they really want to make sure that you're encouraged or maybe even forced to put your dollars to work as soon as possible.
Kenneth Weissenberg:I think there's a statistic that 60% of every dollar spent in a local community stays within the local community and gets reinvested. So, the ripple effect for having these investments in the distressed areas, can really lift up an area significantly.
Jessica Millet:We got a few helpful clarifications on the original use test. Remember that in order for tangible property to be good qualifying property in the hands of the QOZB or in QOF even for that matter, you have to meet one of two tests. It's either or. It's either originally used or substantial improvement. So, I'm going to tick off a few helpful things on the original use test and then Ken will pick up the substantial improvement.
The original use test is crafted in such a way that property will be deemed to meet the original use test if it is first placed in service in the hands of a qualified opportunity zone business or into a single use structure. In that place and service requirement, really applies to new property. The proposed regulation gave you a little bit more flexibility there and said, "Okay. Either your new property is a new place and service or if there's a building that's been vacant and you put that vacant building back into service, that building can meet the original use test. You don't need to worry about meeting the requirements of the substantial improvement test.
However, the time period under the proposed regulations for vacancy was five years and a lot of people grumbled that, that was too long, so treasury came back and said, "Okay. We'll drop it down to three." So, if a building has been vacant for at least three years and you put it back into that building can as original use property. There's another rule that they came out with, which is quickly going to become obsolete just due to the pass of time, but they did say that if a building was vacant for at least one year, if it's prime, the zoning, which that building sits was actually designated as an opportunity zone, that would be December of 2018. If a building has been vacant for at least a year in December of 2018, then you can put that building back into service and meet the original use test.
Again, given the years, I think soon, everyone's only going to have to rely on the 3-year rule, but at least-
Kenneth Weissenberg:Now, it's already two and a half
Jessica Millet:Right. So, act quickly if you want to take it into that rule. The second clarification is that they said that all property on brownfields sites both land and buildings can qualify as original use property. You do need to obviously meet the safety standards of environmental cleanup and everything else, but it can be something that is there, it can be something that is already in use and they really were very flexible with this particular rule. And both of these, both the vacancy rule and brownfields rule, it just shows that treasury really wanted to expand the possible projects in the zones that can qualify. They wanted to see these vacant buildings put back into service. They wanted to see these environmental sits cleaned up. So, they really made an effort to broaden the possible projects to try and get more investor dollars in the door for the program.
Kenneth Weissenberg:All right. One of rules for existing assets is that it would have to be substantially improved. So, if it wasn't vacant for the 3-year and you buy the asset, you have to basically double the basics of the asset within a 30 month period. They clarified that rule a little bit. And then first off, they came out and said, "Land doesn't have to be improved if there's a structure existing on it. You only have to improve the structure." That gives you somewhat flexibility, so instead of arguing that all of the basis goes to the building so you get more depreciation, you're already arguing that more of the basis goes to the land, so you have less to improve.
That being the case, what you allocate to the building has to be doubled with improvements within a 30 month period. As part of those improvements, furniture and fixtures are qualified property, which are treated as improvements to that asset. So, if you buy a hotel, and you redo the lobby of the hotel, and redo the furnishing, and fixtures within the rooms, you might meet with the doubling of the asset just through those kind of limited expenditures.
But they also came up with rules with... A lot of questions came up. If there were multiple buildings on a site, or you're buying a group of buildings that are on a group of sites that are contiguous to each other as to whether you would have to improve every building within that group or just one of the buildings enough so that feed the certainty of the doubling of the basis for all of the buildings. They did come up with rules allowing for aggregations. So, if it's all on one deed, it's treated as one property. You have to exceed the basis the tangible property other than the land within the 30 month period.
So, if you buy a site that has a shopping center and an apartment building, and a parking center on it, and its one deed, you can redo the apartment building and not touch the shopping center or the parking and as long as you're exceeding the doubling of the basis for the three buildings together, you're okay. If for some reason they were on different deeds, you might not be so okay because if they're a contiguous parcels of land, but in separate deeds, there's three things you have to overcome.
They have to be operated exclusively buy the QOF or QOZB, which in this case it would be, they have to have shared facilities, significant centralized business elements, personal, accounting, legal. That should be pretty easy. They might have a central heating thing for the three properties or central power for the three properties. But they have to be operated in coordination with one of more trades or businesses, supply chain and independence or mixed-use facilities. So, an apartment building doesn't necessarily tie into a shopping center or pay for parking lot that's on the same site. That might not qualify.
If you have a factory that sits, manufacturing one part of the supply chain going to the next factory building, which manufactures with that next component, which goes to another factory, which is also contiguous, which manufactures the finished product, that should work. But in uninterdependent businesses that are located in contiguous parcels, even if they're purchases in one shot, as long as they're not on the same deed, you'll have more of a problem with.
Jessica Millet:Yeah. Putting aside for a second some of these nuances for if they're continuous but not on the same deed, overall, I think the aggregation rules, they make a lot to sense. Because in the simple example where you buy three buildings on the same deed, you still have to double the basis in all three buildings. But if you happen to focus those dollars on just one building, then you're still overall meeting the requirement in the code. That makes sense.
Some of these other requirements about having shared facilities and centralized business elements, the only rational that I can really come up with in looking at those rules is that, again, they want you to be making a targeted investment in communities. And now that you can sell assets and get the tax benefits, I think the goal is, "Well, look, we actually want you to... If you're buying separate things on separate deeds, then you really need to make sure that you're investing in all of them collectively with a purpose." It's a little bit of a fuzzy logic, but I think that's the reason why the rules came out the way that they did.
Kenneth Weissenberg:I worked with one client who had a property that they acquired that had two unrelated buildings on the same deed yet they wanted to build a new apartment house. And the two buildings were in a park, they couldn't knock them down. And they were basically little office buildings, like full store office buildings. And so the question was, "Did they have to improve those," which didn't need anything. They were occupied. Or just the development site that they were building the building on?" And so I suggest you should put a hole in the back door and combine them, so it's just an entrance made into one building and that would meet the rule since it was on one lot. They didn't have to be related to use it, they could be completely separate.
So, all of these ruled, which apply to assets that are purchased, don't apply to leases. They really created a very nice alternative for properties they lease to a qualified opportunity zone business and qualify as good property. And basically, the value of the leased property based on present value of the rent that you would be paying treated as good property. The lease can be from an unrelated party or a related party. It's supposed to be an on-going lease and in the final regs, they basically said that if it's from an unrelated party, it is presumed to be arm’s length. And also, if it's from a state government or an Indian tribe, federal government probably too, if it's deemed to be arm’s length.
So, the only one that you really have to show is arm’s length is when it's a related party. And the related part is a person who owns 20% or more of the qualified opportunity fund or qualified opportunity zone business. That's directly or indirectly. If it's a related party, it basically has to have arms' length terms. You can't have an option to purchase associated with the lease at other than fair market value and you can't have a rent prepayment of more than 12 months, otherwise leases work beautifully. So, if you have a building that was acquired before December 31, 2017, or land acquired before December 31, 2017, that you lease to a QOF that you own it qualifies as a good asset. And that creates a lot of opportunity for people who were reinvesting in these depressed areas to take those investments and lease it into a qualified fund.
Any improvements of a lease property qualify as having the original use in QOZ, so any kind of improvement program. Now, there's a problem for existing structures that were acquired before December 31, 2017. So, if you had a piece of property that had a very dilapidated building on it, that you acquired in December 2017, if you transferred it to a qualified opportunity fund and you spent 90% of your original cost fixing up that property, it's not a qualified investment according to the regs. So, by leasing it to the fund, the leased property is a qualified asset and the improvements are a qualified asset, so you would have 100% qualified assets in your qualified opportunity fund or business. The gain on the original acquisition, would be outside of it because that's basically a landlord position and it's not in the qualified opportunity fund. But the improvements would get the full benefit of the opportunity zone regime without having too much worry.
Jessica Millet:It's that they... Because they gave you this ability in the lease context for newly constructed improvements to qualify as original use property. Somebody asked... Which if you read through their preamble, you'll see all the different things that people asked. But somebody asked for you to confirm, "Okay. Well, if I can do it in the lease, what if I own a building?" As Ken said. "What if I own a building that I bought before December 31 2017 and I'm not going to double my basis on it? I also don't want to transfer it. I already own it in a partnership for example, can I turn that into a QOZB? Can I admit qualified opportunity fund dollars and build new improvements on the building and get there that way?" And treasury said, "No." And they didn't say no with a very convincing reason either.
They said it would be difficult to track, which doesn't really resonate. But keep in mind, if you have an existing building and as in a lease structure, if you already own it, there's not a whole lot you can do with it. You really would have to sell it and have the purchasing QOZB double the basis of the building.
Okay. Sin businesses, we also got some welcomed flexibility here. One of the requirement at the QOZB level is that QOZB cannot operate a sin business, which is golf courses, hot tub facilities, liquor stores, gambling facilities, et cetera. And in other context where this or other similar sin business lists are used... In certain context, you've got a de minimis exception. And so everybody was asking for that and treasury did grant it. And they said, "As long as you're under 5%, then you're okay and the sin business won't blow up your QOZB." So, for example, if you're a QOZB owning property and you lease property, as long as less than 5% of your property's use to a sin business, you're okay.
And if you're operating the business, no more than 5% of your gross income can be attributable to the sin business. But this gives you a little of cushion for example, if you have a huge hotel and you want to have a spa in there, and spa offers massages, you can do it as long as it's a very de minimis amount. Going back for a second to the distinction between qualified opportunity fund single tier structure and the QOZB two tier structure. The sin business rules only apply to the qualified opportunity zone business, they do not apply to qualified opportunity funds. And we had always told people... Well, it was "Don't push your luck. You can still do a sin business if you have a single tier structure.
But treasury came out ein the regulations with an example where the qualified opportunity fund had a sin business and they specifically allowed it. So, I guess if you really want to have a golf course...
Kenneth Weissenberg:Basically. Or you build a building and you lease the liquor store to the fund directly.
Jessica Millet:Again, I probably still wouldn't walk into that rule, but if you're feeling lucky, you can do it.
Kenneth Weissenberg:And what do you feel about the cannabis business? It wasn't specifically excluded as a sin business in the enterprise zone. But then when they wrote the enterprise zone laws, and that's where the definition comes from, it was illegal.
Jessica Millet:It was illegal. Yeah. I mean, even though I think Mnuchin made a public comment... Was it last year at some point? ... saying he wouldn't recommend doing it. I think legally, you could and if you were worried about it of course, you could just do it through a qualified opportunity fund where the sin business rules don't apply at all.
Kenneth Weissenberg:And I don’t think there's a distinction between operating a sin business and leasing to a sin business. I think if you can lease to a sin business it's just like you're operating the property, the sin business itself, which is not a good business function for a qualified opportunity zone business.
Jessica Millet:Okay. The straddling rules and we have a couple of slides left. But just so everybody knows, we are going to save a little bit of time at the end for questions, so if you have questions, you can type them into the chat box and Ken and I can hopefully run through a few of them at the end.
Okay. The straddling rules, the basic straddling rule in the regulations said, that "Look, if you have certain property and certain property is in a qualified opportunity zone and certain properties out of a qualified opportunity zone and you're in a straddling position, then for purposes of certain QOZB requirements, such as the 50% gross income test, and the intangible property test, the regulation said, "We'll treat you as if everything is in the zone as long as you're more than half in the zone." And that was a pretty welcomed rule. And the final regulations came out with some helpful clarifications and some I think particularly less helpful clarifications.
The helpful clarifications that they said is that, "The property in the zone and the property out of the zone have to be contiguous." That was said in the proposed regulations. And the final regulations clarified that, that's the rule and you're okay if there's a street running through the middle of it, or a stream, or something like that. People were getting nervous about, "What does contiguous really meant?" So, they said, "Don't worry if you have a street running down the middle. You're okay."
They also clarified in terms of measuring if you're at least 51% in. There's two different ways that you can measure that. You can either use the square footage to measure that or the unadjusted cost of the property to measure that. Again, two helpful clarifications.
The clarification that I personally thought was less helpful is that if you read the language in the preamble, it sounds like they were trying to extend the benefit of the straddling rules to real property for real estate that was in the zone for purposed of making sure that the real property qualifies as good property. I don't think that what they do actually accomplished that though because they said that the straddling rules can now also be used to satisfy the 70% use test. And to make things even more confusing, the 70% use test is different from the 70% tangible property test.
And so we present the tangible property test as at least 70% of the tangible property in the QOZB has to be good qualifying property otherwise it meets the original use test, or the substantial improvement test. But this is not the test that was addressed in the final regulations. Separately, there's a 70% use test. And the 70% use test says that at least 70% of the property has to be used within the zone. And this is a little bit more for operating businesses than real estate. And hopefully, typically, in real estate, when you build a building, hopefully, it doesn't move. So, the 70% use test wasn't really such an issue that many people in the real estate industry focused on and the final regs extend the straddling rules to the 70% use test, but do not really extend the straddling rules to meeting the requirements in the 70% tangible property test.
So, I think that if you buy a piece of land that is partly in and partly out of the zone, call it 60 in, 40 out, and you build a building that's level all the way across, 60% of it is in the zone, 40% of it is out of the zone, technically, you can't use the straddling rules to meet the original use test on that building because only 60% of your building is in the zone. So, there may be some nuances there and some way that smart advisors can get creative about it, but on a technical basis, I think that they missed a step there when they were trying to take it all the way there.
Kenneth Weissenberg:Like everything else in the code, there's an anti-abuse language in this regulation and basically, and I quote, "The purposes of section 1400Z-2 and section 1400Z-2 regulations are to provide specific federal income tax benefits to owners of QOFs to encourage the making of longer-term investments through QOFs and qualified opportunity zone businesses of new capital in one or more qualified opportunity zones and to increase the economic growth of such qualified opportunity zones."
So, that's just the basic purpose of the anti-abuse rules incentive, you're basically putting money into a zone but don't really intend to use it in the zone, you don't have a good qualified opportunity fund. And they said a couple of examples. One of which is someone who buys gold bullion and keeps the gold bullion in the zone and they sell half the gold bullion every year and they have one employee watches it for them. It's in a safe deposit box and the one employee conducts the sales. They said it doesn't qualify because it's basically just an investment activity and you're not increasing economic activity in the zone by doing that.
They also site, if you create an opportunity zone business or opportunity funds for purposes of creating the benefits... So, you have two foreigners and a tax exempt who have no to tax on a gain who form a partnership and that partnership then sells their assets that they put into the partnership. And they have a gain at the partnership level and the partnership does a QOF investment. And that doesn't work because it was available for purposes of taking the advantage of the benefits here. So, you have to take a look at that. You can't really structure stuff in such a way that you're getting benefits that you would not otherwise get.
Jessica Millet:Yeah, there was another example in the anti-abuse section, which relates to the uncertainty that still exists about involuntary de-certification. And I think the example said that investors who qualify for that opportunity fund, they bought property that they knew was not going to qualify. They had no intention that the property was ever going to qualify, but they thought that it would appreciate significantly. So, they had an un-qualifying property. They paid the penalty every year and then after 10 years, sold the property presumably at a value that made it worth paying a penalty all along, with enough appreciation and they're hopefully paying no tax on the end. And that turns into that's obviously not within the scope of the purposes of the program. That's a pretty extreme example. But again, treasure wants you to keep in mind-
Kenneth Weissenberg:So, they're not going to give you the benefits and you don't get your penalty back. It's the worst of both worlds.
Kenneth Weissenberg:So, you just have to keep in mind that if you're doing an investment in the qualified opportunity fund, the fund actually has to have economic activity within the zone. There's no requirements for jobs or for different types of housing that's created, but they do want to see economic activity within the zone whether it's a business that's operating, a restaurant, a software company, a car service. Whatever it is, it has to be operating within the zone and meet the qualification of a business within the zone.
There are some still open area. One, which is involuntary de-certification. When can the IRS step in and say, "You're no longer a good qualified opportunity zone business." There will be additional reportings this year for qualified opportunity investors and qualified opportunity funds. Basically, the investors have to list every investment they make in a qualified opportunity fund and the type of gain that was deferred. The funds have to list the type of assets they have and if they are investigating qualified opportunities on businesses, they have to provide information about the qualified opportunity zone businesses. So, it's a lot more robust. Any specific position of assets would also have to be disclosed.
They did not talk too much in the preamble on the interplay between the QOF benefits and other tax incentive, saying they were too complex and to focus on it. Those essential benefits are low income housing credits, rehabilitation tax credit for historic structures, the new markets credit, and for solar energy tax credits within the fund. They didn't talk about the use of synthetic equity for qualified opportunity fund interest. And they punted on what actually happens as we get closer to 2047. We are available for questions as they come in. And stay tuned for further updates as they come around.
Jessica Millet:There was one question that came through asking about the one-year vacancy period. And the question was, "Within one year before or one year after the designated timing zones?" It is one year before. So, if it's a timing zone in December of 2018, and it's a building that's been vacant for a year, then you can put it back into service and it will count as an original use property. But again, now if you're taking this fund and the building's been vacant almost for two and a half years or as long as it's three, you can put a building back into service and it will qualify for the original use test.
Kenneth Weissenberg:There's an interesting same question on leasing. The regs talk about leases entered into it after December 31, 2017. They don't talk about leases that were entered into before they were provided by the fund, so I don't believe those are considered good assets no matter what the terms of those leases are. You can create a sub-lease of the master, lease that probably does qualify.
Jessica Millet:There's another question about if you have a qualified opportunity fund that shows a qualified opportunity zone business. All right. "If the qualified opportunity zone business sells property and it sounds like it distributes the gain of the qualified opportunity fund, does the qualified opportunity fund then have a created time to reinvest that gain without restarting the 10-year clock?" The 10-year clock is an investing dust bubble, so if the qualified opportunity fund receives cash and wants to invest it, the qualified opportunity fund can reinvest it and that does not reset the clock of the investor in the qualified opportunity fund.
If you're prior to 10-years, then the gain will be taxable, but if you're after 10-years, then the gain is tax-free and the qualified opportunity fund can reinvest in qualified opportunity zone business property.
Kenneth Weissenberg:If the fund doesn't reinvest right away, they basically have you 90-days to distribute the cash to the investors without it being treated as a bad asset for purposed of the 90% rule. So, that's something that they put in there so that when the funds start to liquidate and they sell an asset on December 30th and they're holding all the cash on December 31st, it's not a bad asset. They have until March to distribute it.
Jessica Millet:And there was one other questions about during a construction period, if you're generating expenses and how that ties in with the working capital safe harbor. The working capital safe harbor is a rule that treats your cash as your cash. So, if you're generating expenses related to the building, that stands totally apart from the working capital rules. The working capital safe harbor rules treat your extra cash on hand as being good cash.
Kenneth Weissenberg:So, the answer to the question is that if you have a debt on a piece of property, you look at the property value's net or gross. I think you're looking at the value of the property as gross. So, the question was, "400 in real estate, 300 on mortgage, $200 of cash, do you show the cash at 300 out of 700 or is it 300 out of 400?" I think it's 300 out of 700.
Jessica Millet:Yeah. We can actually stop for a second and talk about the valuation rule because that's a topic that needs some clarification. Because at the level of the QOF for purposes of the 90% asset test, and at the level of the QOZB for purposes of the 70% test, there're two different ways to value the property or the assets of the QOF and QOZB. The first method that you can use is called the applicable financial statement method. If you have applicable financial statements that you're filing like a 10K or something like that or else audited financials that you may have to give to a lender for purposes of financing, those also qualify. So, if you have an applicable financial statement, you can use the asset values that are reported on that financial statement.
Alternatively, you can use the alternative evaluation method. And for this other method, you basically have to divide your property into two different types. If property is either purchased or self-constructed then you have to use the fair market value of the property. For any other type of property, you have to value that property on each six month testing date. And most people think that the rule was really meant to help a QOF measure equity in a QOZB. It was not necessarily meant to force a QOZB to have to measure its assets twice a year.
Kenneth Weissenberg:Someone asked, "What are the steps needed to take to start a QOF?" A QOF is either a partnership or a corporation that is formed to invest in qualified opportunity zone businesses. The steps you need to take are you form a partnership or a corporation, and capital gains is invested into a QOF, and the QOF then buys property directly or puts money into a qualified opportunity zone business with qualified property within a zone. Now the timeframe, we didn't go into this, cash contributing to a QOF is ignored for first testing period. Those are the questions if you put it in on December 30th and it’s your only asset on December 31st, your asset test is a zero over zero, or infinity which is greater than zero or greater than 100%, or it's at 0% and you have a penalty on it. I think that you're okay.
Jessica Millet:Yeah. I think that, that's really the only right practical answer is, they gave you the benefit of that rule to make it easier to pass your first testing date.
Kenneth Weissenberg:Yeah. So, you have 180-days to basically or your first testing date after the first 180-day period to invest the cash whether it's in property directly or into a QOZB. The QOZB when it gets the extra cash, basically, you have to have the 70% test pass on its first testing date and if it doesn't, then you can use it for six months under the one time six month cure period so by the second testing date it definitely has to meet the 70% test or fail as a QOZB. If it had planned to invest the cash in the qualified opportunity zone property, it would be within the 31-month rule for working capital. It would have to be a written plan.
Jessica Millet:Okay. I think that's all the questions that we have. Please look out for the follow-up email with a link to this survey and copy of the presentation. Thank you for joining our webinar today.
Transcribed by Rev.com
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Kenneth Weissenberg CPA, Tax Partner in Real Estate Services, is experienced in tax saving strategies and negotiating sales and acquisitions. He represents owners of some of the most well-known real estate properties in New York City.
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