The Second Round of Qualified Opportunity Zone Proposed Regulations Are Here and They Are Worth the Wait!
The Treasury Department and the IRS released a second more robust set of Qualified Opportunity Zone (“QOZ”)/Qualified Opportunity Fund (“QOF”) proposed regulations on April 17 (the “April proposed regulations”), approximately six months after the first round of QOZ/QOF proposed regulations (the “October proposed regulations”). See our alert, dated October 23, 2018, on the October proposed regulations. The largely taxpayer friendly 169-page guidance resolves many of the unanswered questions from the QOZ legislation contained in the Tax Cuts and Jobs Act (“TCJA”) and the October proposed regulations. The following is a brief summary of the April proposed regulations.
“Substantially All” and Working Capital Safe Harbor
In order to qualify as a QOF or QOZ business, “substantially all” of the investment or assets are required to be in a QOZ. Substantially all is defined in the April proposed regulations as:
- 70% for testing use of QOZ property within a QOZ,
- 90% for holding period requirements for QOFs,
- 70% for ownership (or leasing) of tangible property (from October proposed regulations), and
- 40% (“substantial portion”) for intangible property used in the active conduct of trade or business in the QOZ.
The October proposed regulations provided for a working capital safe harbor based on a written plan for acquisition, construction and/or substantial improvement of tangible property within 31 months. The April proposed regulations extend this safe harbor to the development of a trade or business within a QOZ and also allow for the extension of the 31-month period if the delay is due to the need for government action for which an application has been completed within the 31-month period.
It is possible for a business to have multiple overlapping or sequential working capital safe harbors. For example, a distributor of men’s clothing takes in capital in October, 2019 and has a working capital plan that satisfies the requirements of the April proposed regulations. A year later the business decides to expand into women’s apparel. The business can have a separate plan for the new investment that it receives in October, 2020. It can apply the 31-month safe harbor to that capital while still maintaining the original working capital safe harbor.
This safe harbor should pave the way for many investments in real estate and other trades or businesses that otherwise might have been problematic due to the fear that the money could not be put to work fast enough, with resulting significant penalties.
Generally, tangible property located in a QOZ that is depreciated or amortized by a taxpayer other than the QOF or QOZ business will not be considered to have its original use in the QOZ. An exception to this is if the property was depreciated/amortized but was not used in the QOZ while it was being depreciated/amortized; in that case, it will qualify for original use. A second important exception is if a building or structure has been vacant for five years or longer prior to being purchased by a QOF or QOZ business. Then its use within the QOZ will be considered its original use regardless of whether it has been previously depreciated. This affects the requirement for substantial improvement, which was addressed in the October proposed regulations. There is some debate as whether five years is too long a period and may work to delay investment in certain property in order to meet the five-year vacancy period and thereby avoid the substantial improvement requirement post-acquisition. It is also unclear how a vacant building will be defined and what documentation the seller and purchaser will be required to have to support the five-year vacancy period.
Leased Tangible Property
Leased tangible property meeting the following two general requirements is treated as QOZ business property for purposes of meeting the 90% asset test to qualify as a QOF and the 70% substantially all requirement of a QOZ business:
- Must be acquired under a market rate lease entered into after December 31, 2017 and
- 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.
There is no original use or substantial improvement requirement for leased tangible property, and the property can be leased from a related party if certain criteria (noted below) are met. Improvements made by a lessee to leased property in a QOZ are considered as having their original use in the QOZ, as purchased property for the amount of the unadjusted cost basis.
For property leased from a related party (20% common ownership is considered a related party for QOZ/QOF purposes), these additional requirements must be satisfied:
- There cannot be prepayments on a lease that exceeds 12 months.
- If the original use of leased tangible personal property in a QOZ does not commence with the lessee, then the property is not QOZ business property unless the lessee becomes the owner of tangible property that is QOZ business property having a value not less than the value of the leased tangible personal property. There must be substantial overlap of the zone(s) in which the owner of the property so acquired uses it and the zone(s) in which that person uses the leased property. This acquisition of property must occur during a period that begins on the date that the lessee receives possession of the property under the lease and ends on the earlier of the last day of the lease or the end of the 30-month period beginning on the date that the lessee receives possession of the property under the lease.
- An anti-abuse rule prevents the use of the lease to circumvent the substantial improvement requirement for the purchase of real property (other than unimproved land). If at the time the lease is entered into there is a plan, intent or expectation for the real property (other than unimproved land) to be purchased by the QOF for an amount other than the fair market value of the real property without regard to prior lease payments, then the leased real property is not QOZ business property at any time.
QOZ Businesses – 50% Test
The Internal Revenue Code (the “Code”) and the October proposed regulations require that 50% or more of the gross income of the QOZ business must be from the active conduct of such trade or business within a QOZ. The April proposed regulations remove much of the uncertainty regarding what income is considered as derived from the QOZ. The April proposed regulations provide three annual safe harbors for the 50% gross income test, of which just one has to be satisfied:
- At least 50% of the services performed based on hours worked by employees and independent contractors (and employees of independent contractors) are performed within the QOZ;
- At least 50% of the compensation paid for work done by employees and independent contractors (and employees of independent contractors) are paid for services done within the QOZ; or
- The tangible property of the business in the QOZ and the management or operational functions performed for the business in the QOZ are each necessary to generate 50% of the gross income of the trade or business.
In addition, the April proposed regulations provide for a “facts and circumstances” test if none of the safe harbors are met. These safe harbors should facilitate significant investment into non-real estate ventures in QOZs.
The April proposed regulations define a trade or business for purposes of the QOZ/QOF rules as a trade or business under IRC Sec. 162 (“trade or business expense”). However, for purposes of the definition of a QOZ business, the ownership and operation (including leasing of real property used in a trade or business) is treated as the active conduct of a trade or business. Merely entering into a triple-net-lease with respect to real property owned by a taxpayer is not the active conduct of a trade or business by such taxpayer.
IRC Sec. 1231 Gains
Net IRC Sec. 1231 gains in a given year are treated as capital gains for QOZ purposes. Since IRC Sec. 1231 gains are netted with IRC Sec. 1231 losses, the April proposed regulations treat any net IRC Sec. 1231 gain as if it occurred on the last day of the taxable year, rather than on the date of the IRC Sec. 1231 gain(s) throughout the year.
Interim Gains and 90% Asset Test
A QOF that sells QOZ property prior to meeting the ten-year holding period can reinvest the proceeds within 12 months without the QOF failing the 90% asset test, but that gain will be taxable to partners in the QOF. This one-year rule is intended to allow QOFs adequate time in which to reinvest proceeds from QOF property. In order for the reinvested proceeds to be counted as QOZ business property from the date of sale until the proceeds are invested in other QOZ property, the proceeds must be continuously held in cash, cash equivalents and debt instruments with a term of 18 months or less. However, sales or other dispositions of assets by a QOF do not impact an investor’s holding period in the QOF or trigger the inclusion of deferred gain so long as the interest in the QOF is not sold or otherwise disposed.
Also, in applying the semi-annual 90% asset test, new capital investments received by QOFs in the prior six months are not included in the semi-annual 90% asset test as long as the new assets are held in cash, cash equivalents of debt instruments with terms not exceeding 18 months. This rule is particularly helpful when capital is received shortly before a testing date.
A nonexclusive list of eleven types of inclusion events are included in the April proposed regulations. Some examples of these events, which cause all or part of the deferred gain to be taxable, are the more obvious dispositions of investments or entity interests as well as transactions such as an IRC Sec. 351 transfer of QOF stock and certain reorganization transactions.
- Transfers by gift will generally be considered inclusion events with the exception of gifts to grantor trusts, since grantor trusts are taxed to the grantor as long as they are alive.
- Distributions in excess of basis will trigger gain recognition.
- Contrary to the gift rule, most transfers caused by death to an estate and then subsequently to individual beneficiaries or to trusts are not considered inclusion events. When the deferred gain of property received upon death prior to December 31, 2026 is included in income on the earlier of a disposition or December 31, 2026, the income will be treated under IRC Sec. 691 as income in respect of a decedent. Also, when a grantor dies and the trust distributes its assets, or automatically converts to a non-grantor trust, it will not be considered an inclusion event.
Sales by Multi-Asset Funds
Few multi-asset QOFs are currently in existence due to the uncertainty with the treatment of the sales of individual assets by the QOFs. We now have clarity that if a QOF sells assets after the ten-year holding period has been satisfied, then the partners will be able to elect on their returns to exclude some or all of the gains realized from these qualified assets. This should result in the formation and operation of more multi-asset funds, since they will no longer have to sell all of their assets in a short time window, which could result in lower returns and potential fire sales for some assets. This will create additional K-1 reporting requirements for the QOF to disclose each qualified gain arising from the QOF.
Debt Financed Distributions and Basis
QOFs faced uncertainty as to whether the general partnership tax regime would apply to QOFs and allow debt to create basis and permit tax-free distributions that would not trigger deferred gain recognition. With the issuance of the April proposed regulations, the uncertainty has been removed and QOFs now have the potential to provide distributions to partners to cover the capital gains tax due on the deferred gain in 2027 and/or simply to provide a return of investment. In addition, the 10% and subsequent 5% basis step-up after five and seven years, respectively, will create basis for suspended losses.
Example: On 1/1/19, A and B form Q, a QOF partnership. Each invests $500 of capital gains into Q and makes an election to defer that gain under IRC Sec. 1400Z-2(a). On November 30, 2020, Q obtains a nonrecourse loan from a bank for $600. Under IRC Sec. 752, the loan is allocated $300 to A and $300 to B. On November 30, 2020 when the values and bases of the original investments remain unchanged, Q distributes $100 to A. A does not recognize gain and A’s basis from the debt is reduced from $300 to $200.
Additional Partnership and S Corporation Provisions
- A mixed-funds investment will occur if one portion of an investment in a QOF partnership is a qualifying investment (to which a deferral election applies) and another portion is a non-qualifying investment. The mixed-funds investment solely for QOZ/QOF purposes is treated as two separate investments, one entitled to QOZ/QOF tax benefits and one that is not. All partnership items, such as income, debt allocations and property distributions, will affect each investment proportionately.
- Carried interests and other promote structures (i.e., equity received for services) do not qualify for the QOZ/QOF tax benefits and are treated as a separate non-qualifying investment, typically resulting in a mixed-funds investment.
- Conversion of an S corporation that holds a qualifying investment in a QOF to a C corporation (or a C corporation to an S corporation) will not result in the recognition of the deferred gain.
- A greater than 25% ownership change in an S corporation (aggregate change in ownership) which itself is the direct investor in a QOF corporation or QOF partnership will cause the qualifying investment in a QOF to be treated as if it was disposed.
Other Noteworthy Items Included in the April Proposed Regulations
- Unimproved land does not need to be substantially improved to be qualified if it is used in a trade or business.
- Real property straddling the QOZ will be considered as all QOZ property if the contiguous property inside of the QOZ has more square footage then the property outside of the QOZ. An alternative test is comparing the unadjusted cost within and outside of the QOZ; if greater inside, then it would all be considered QOZ property.
- Substantial improvement of assets is addressed on an asset-by-asset basis though comments have been requested on possible asset aggregation rules.
- Unrecaptured depreciation will not be taxed once the ten-year holding period is met; the basis step-up will apply to all assets.
- Inventory in transit (including raw materials) from a vendor or to a customer qualifies as being located at the QOZ business.
REITs, Consolidated Groups, Anti-Abuse Rules and Effective Date
- 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.
- Consolidated return groups cannot treat the capital gains of one member of the group as gains for other members of the group. In addition, a QOF can be a consolidated parent, but it cannot be a subsidiary in a consolidated group. QOF investors can acquire their interest in a QOF by direct purchase from an investor in the QOF.
- Consolidated return groups cannot treat the capital gains of one member of the group as gains for other members of the group. In addition, a QOF can be a consolidated parent, but it cannot be a subsidiary in a consolidated group.
- A seller cannot roll gains from sales to a QOF into that QOF.
- The April proposed regulations provide a broad anti-abuse rule for transactions that achieve tax results inconsistent with the purposes of the QOZ/QOF statute.
- Taxpayers may generally rely on the April proposed regulations prior to final regulations being issued if they are applied by the taxpayer consistently in their entirety.
While the regulations covered most areas in question, the Treasury Department and the IRS have indicated that within the next few months they expect to address administrative rules applicable to a QOF that fails to maintain the 90% investment standard, as well as information reporting requirements for eligible taxpayers to help measure the economic impact of the QOZ investments. In addition, it is anticipated that IRS Form 8996 (“Qualified Opportunity Fund”) will be revised for tax years 2019 and following. Revision could require additional information, such as (i) the employer identification number of the QOZ business owned by a QOF and (ii) the amount invested by QOFs and QOZ businesses located in QOZs.
Comments on the April proposed regulations must be submitted by mid-June, in advance of a public hearing scheduled for July 9.
Given the complexity of the rules governing QOZs and QOFs and the proposed status of the regulations issued, it is imperative that a tax professional be consulted before an investment in a QOZ or QOF is made or the establishment of a QOF is considered. The QOF team at EisnerAmper will continue to provide additional analysis of the April proposed regulations and overall QOZ/QOF rules in the coming weeks as new developments occur.