New QOF Proposed Regulations Released

April 18, 2019

By Michael Torhan, CPA

On Wednesday, April 17, the Internal Revenue Service released the second round of proposed regulations for qualified opportunity funds (“QOFs”). This second set of proposed regulations has long been awaited by all market participants. While the first set of proposed regulations issued in October 2018 provided a great deal of clarity, many questions remained unanswered.

The following key points are ten highlights we have noted so far in the new proposed regulations:

  1. Original Use
    1. Original use of tangible property acquired by purchase commences on the date when the purchaser or a prior owner first places the property in service in the qualified opportunity zone (“QOZ”) for purposes of depreciation or amortization.
    2. Where a building or other structure has been vacant for at least five years prior to being purchased by a QOF or QOZ business, the purchased building or structure will satisfy the original use requirement.
  2. Land
    1. Land can be treated as QOZ business property only if it is used in a trade or business (“ToB”) of a QOF or QOZ business.
  3. Substantial Improvement
    1. The substantial improvement test is performed on an asset-by-asset basis.
  4. Leased Property
    1. Leased tangible property meeting the following two general criteria may be treated as QOZ business property for purposes of satisfying the 90% asset test:
      1. Must be acquired under a lease entered into after December 31, 2017 and
      2. Substantially all of the use of the leased tangible property must be in a QOZ during substantially all of the period for which the business leases the property.
    2. There is no original use requirement or substantial improvement requirement imposed on leased tangible property due to the nature of such property.
    3. Leased property does not need to be from a lessor that is an unrelated party but there are certain requirements that need to be met for this to be a valid option under the QOF rules.
  5. QOZ Businesses
    1. In testing the use of qualified opportunity zone business property in a QOZ, the term substantially all in the context of “use” is 70%.
    2. Substantially all as used in the holding period context is defined as 90%.
    3. In order to satisfy the 50% gross income test, the following safe harbors are provided:
      1. At least 50% of the services performed (based on hours) for such business by its employees/independent contractors are performed within the QOZ.
      2. At least 50% of the services performed (based on amounts paid for the services) for the business by its employees independent contractors are performed in the QOZ.
      3. (1) The tangible property of the business that is in a QOZ and (2) the management or operational functions performed for the business in the QOZ are each necessary to generate 50% of the gross income of the ToB.
    4. A ToB for the QOF rules is defined as a ToB within the meaning of IRC Sec. 162. Ownership and operation (including leasing) of real property used in a ToB is automatically treated as the active conduct of a ToB for purposes of the QOF rules.
  6. Working Capital Safe Harbor
    1. The written plan for the use of working capital includes the development of a ToB in the QOZ as well as acquisition, construction, and/or substantial improvement of tangible property.
    2. Exceeding the 31-month period allowed for the use of working capital does not violate the safe harbor if the delay is due to waiting for government action, the application for which is completed during the 31-month period.
  7. Relief for 90% Asset Test
    1. A QOF applies the test without taking into account any investments received in the preceding six months as long as those new assets are held in cash, cash equivalents, or debt instruments with terms of 18 months or less.
    2. Proceeds received by a QOF from the sale of QOZ business property, stock, and partnership interests are treated as QOZ property for the 90% investment requirement so long as the QOF reinvests the proceeds during the 12-month period beginning on the date of such sale.
  8. Gain Inclusion Events
    1. Several transactions are listed in the proposed regulations that would cause an early recognition of the deferred gain including the distribution to a partner of a QOF partnership of cash or other property that has a value in excess of basis of the partner’s qualifying QOF partnership interest.
      1. Therefore, partnership distributions in the ordinary course of partnership operations may, in certain instances, also be considered inclusion events.
      2. Debt that is allocated to a partner (such as from a refinancing) provides basis to such partner for distribution purposes.
    2. Transfer of qualifying investments by gift are also considered inclusion events.
  9. Ten-Year Fair Market Value Step-Up
    1. An election is available for a taxpayer that is the holder of a qualifying investment in a QOF partnership or a QOF S corporation to exclude from gross income some or all of the capital gain from the disposition of QOZ property reported on Schedule K-1 of such entity, provided the disposition occurs after the taxpayer’s ten-year holding period.
  10. Structural Considerations
    1. Any gain attributable to a service component of an interest in a QOF partnership (i.e., carried interest) is not eligible for the benefits afforded qualifying QOF investments.
    2. QOF REITs are authorized to designate special capital gain dividends, not to exceed the QOF REIT’s long-term gains, on sales of QOZ property.

In addition to the above, rules on partnership mixed-funds investments as well as the application of rules to S corporations are also discussed. Furthermore, there is guidance on the application of the gain inclusion rules as they relate to certain nonrecognition transactions, such as asset reorganizations under IRC Sec. 381, liquidations under IRC Sec. 332, and distributions under IRC Sec. 355. For taxpayers with consolidated tax returns, special provisions are also noted including that QOF stock is not stock for purposes of affiliation, as well as the application of rules for different members of a consolidated group.

The QOF team at EisnerAmper continues to read through and analyze the new proposed regulations. We plan to release a more detailed analysis in the next few days.

About Michael Torhan

Michael Torhan is a Tax Partner in the Real Estate Services Group. He provides tax compliance and consulting services to clients in the real estate, hospitality, and financial services sectors.

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