United States: Second Round Of Opportunity Zone Proposed Regulations Provide Answers To Many Questions

Last Updated: June 10 2019
Article by Adam Sweet, Joe C. Monty and Mac Stevens

Since the enactment of the Tax Cuts and Jobs Act ("Act") at the end of 2017 and the subsequent release of the first round of proposed regulations in October 2018, many taxpayers and practitioners have been puzzling over various aspects of the Act's Opportunity Zone tax incentives. Questions have abounded, including those surrounding how to form and structure the investment entity, a Qualified Opportunity Fund (QOF). Those questions then lead to others about owning Qualified Opportunity Zone Business Property (QOZBP) or a Qualified Opportunity Zone Business (QOZB) and selling or otherwise exiting a QOF investment. Many potential investors have delayed investment and are awaiting more detailed guidance before moving forward with QOFs.

New proposed regulations released by the government on April 17, 2019, and officially published May 1, 2019, answer most, but not all, of the questions. However, for many taxpayers, they provide enough guidance to begin reviewing investments designed to take advantage of the Opportunity Zone tax incentives.

This insight will outline some of the key provisions of the second round of proposed regulations following a quick summary of the Opportunity Zone tax incentives.

Opportunity Zones and Tax Incentives

The Qualified Opportunity Zone tax incentives are designed to encourage taxpayers to invest capital gains in economically distressed communities designated as "opportunity zones." A map and list of the Qualified Opportunity Zone communities can be found here.

The tax incentives permit taxpayers to defer reporting capital gains generated from sales to unrelated parties as taxable income if the gains are reinvested in a QOF within 180 days after being realized (subject to special rules in the case of capital gains recognized by pass-through entities such as partnerships, S-corporations, trusts and estates). The reinvested gain amount is deferred until the QOF interest is sold, or, if earlier, December 31, 2026. The deferred capital gain amount can be reduced by 10% if the QOF investment is held for five years and by another 5% if held for seven years. In addition, if a taxpayer holds the interest in the QOF for at least 10 years, gains ultimately realized from the sale of the QOF investment can be tax-free.

Specific requirements are set forth in the statute including:

  • To qualify as a QOF and avoid penalties, an entity must hold at least 90% of its assets in QOZBP during substantially all the holding period of the property.
  • QOZBP can be either tangible property acquired after 2017 and used in a trade or business located in a Qualified Opportunity Zone or an ownership interest in a corporation or partnership that qualifies as a QOZB.
  • To be a QOZB, a business must:
    • hold substantially all (70% under the first round of proposed regulations) of its tangible assets in QOZBP
    • generate at least 50% of its gross income from the active conduct of a trade or business within a Qualified Opportunity Zone
    • hold limited assets (no more than 5%) in "nonqualified financial assets" such as cash, stock, bonds, etc.
    • use a "substantial portion" of its intangible assets in the active conduct of a trade or business
    • not be a "sin business" (golf course, country club, massage parlor, hot tub facility, suntan facility, racetrack or other facility used for gambling, or any store for selling alcoholic beverages for off-premises consumption)
  • For tangible property to be QOZBP, it generally must be "original use" property or "substantially improved" and acquired by purchase from an unrelated party (applying a 20% common ownership threshold). Specific requirements and exceptions are set forth in the statute and proposed regulations.

To illustrate the potential tax incentives, assume a taxpayer sells publicly traded stock generating a capital gain of $100,000 and, within 180 days of sale, invests that amount in a QOF during 2019. At the taxpayer's election, none of the gain is subject to federal income tax in 2019. The taxpayer continues to hold the QOF investment through 2026, meeting the seven-year holding period for reducing the deferred gain amount by 15%. But, even though the taxpayer continues to hold the QOF investment past 2026, on December 31, 2026, the taxpayer recognizes $85,000 of the original gain from the 2019 sale taxed at the then current 2026 Federal capital gain rates. In 2030, after holding the QOF investment for 10 years, the taxpayer sells the QOF interest for $400,000, realizing a gain of $300,000. If the taxpayer properly elects, none of this gain is subject to federal income tax. The newly issued proposed regulations confirm that the excluded gain includes any depreciation recapture items. Note: state income tax consequences will vary by state and type of entity used by the QOF.

Forming and Operating a QOF

A QOF is a self-certified entity that can be a partnership, corporation, S-corporation, RIC or REIT; it cannot be an entity disregarded for tax purposes, however. As noted above, equity investments in a QOF can qualify for the Opportunity Zone tax incentives to the extent they represent eligible capital gains from sales to unrelated parties (gains from sales to related parties will not qualify for the tax incentives). Investments in QOFs from sources other than eligible capital gains are permitted, but those investments do not qualify for the tax incentives.

Eligible capital gains include short-term capital gains, long-term capital gains and so-called section 1231 gains (from sales of business assets) among other types of gains. Ordinary gains and equity interests obtained for services do not qualify.

The most recent proposed regulations add more certainty and flexibility for taxpayers looking to form or invest in a QOF. Some of the key points of clarification follow:

  • The 180-day period for reinvesting section 1231 gains from the sale of business assets starts at the end of the taxpayer's tax year. Consequently, the 180-day period for reinvestment began on December 31, 2018 (and ends on June 28th, 2019) for section 1231 gains recognized in 2018 by calendar year taxpayers. On the other hand, section 1231 gains generated in 2019 cannot be reinvested in a QOF until the 180-day period that will begin on December 31, 2019. This will make it difficult for these taxpayers to take advantage of the tax benefit related to holding a QOF interest for seven years by December 31, 2026.
  • Property other than cash can be invested in a QOF to achieve the Opportunity Zone tax incentives (although such property may not necessarily qualify as QOZBP). In addition, the proposed regulations allow a purchase of a QOF interest in the secondary market to qualify for the incentives. This feature should enhance the liquidity of these investments for some QOF investors, but it will certainly complicate a QOF's record keeping and tracking of investor holding periods.
  • A QOF structured as a partnership will be permitted to make debt-financed distributions to investors under the normal partnership tax rules. For real estate businesses, this should facilitate debt financed distributions from refinancing proceeds once projects reach the post-development/stabilization phase. Note: careful planning will be needed to avoid triggering taxable gain on the distributions.
  • A 31-month working capital safe harbor exception to the 5% limitation on nonqualified financial assets of a QOZB has been expanded to include periods of governmental delays or inaction and can apply for business development as well as tangible property acquisition and development in an opportunity zone. These changes are intended to encourage investments in start-up businesses within an opportunity zone and provide some relief for real estate developers awaiting permits from local governmental jurisdictions.

Acquiring and Investing in QOZBP and QOZBs

90% of a QOF's assets must be composed of QOZBP or interests in one or more QOZBs. The QOF self-certifies as a QOF by completing IRS Form 8996, and it uses this form for measuring the 90% asset test. The asset test is based on the average of a QOF's assets on two dates葉he last day of the first six months of a QOF's tax year and the last day of the QOF's tax year. (If a QOF has a tax year of less than six months, the test is done on the last day of the year.)

There are other requirements, some described above, that have been subject to uncertainty pending release of the second round of regulations. Key points addressed include:

  • A QOF must use substantially all (defined as 70%) of its QOZBP in a Qualified Opportunity Zone during substantially all (defined as 90%) of its holding period.
  • QOZBP can include leased property for both the QOF 90% asset test and the QOZB 70% asset test, even when leased from a related party, if certain requirements are met. Guidance is available on how to value leases for purposes of the asset tests.
  • "Original use" is met if tangible property has not previously been used in an opportunity zone, or if it was previously used in a zone, it has been abandoned or vacant for at least five years prior to purchase by the QOF. Thus, used tangible property can be QOZBP the first time it is used in an opportunity zone. Also, the proposed regulations confirm the "original use" requirement does not apply to land.
  • The requirement that used tangible property be "substantially improved" by effectively doubling the basis of the property during a 30-month period in order to be considered QOZBP only applies to tangible property previously used in the opportunity zone. Land used in a trade or business does not need to be substantially improved; however, the proposed regulations make it clear that holding land for speculation is not a trade or business.
  • Determining whether tangible property has been substantially improved is generally made on an asset by asset basis. While this will be a disappointment and compliance headache for some taxpayers, the Treasury Department has requested comments on whether they should consider some form of aggregation of properties exception. Aggregation of properties could be helpful, for example, where there are multiple buildings on a parcel of land located in an opportunity zone and only one will be developed. Affected taxpayers should consider providing comments during the comment period that ends July 1, 2019.
  • A "substantial portion" of intangible property used in the active conduct of a QOZB is defined as 40%.
  • Three safe harbors, plus a "facts and circumstances" alternative, are provided for purposes of determining whether 50% or more of gross income is derived by a QOZB through active conduct of a trade or business within an opportunity zone. The safe harbors should help operating businesses meet the 50% test. While generally acknowledging that the ownership and leasing of real property can be "active conduct of a trade or business," the proposed regulations provide that merely entering into a triple-net lease is not a trade or business. Consequently, real estate leasing activities in a QOF or through a QOZB will require careful planning.
  • A QOF that fails the 90% asset test will generally be subject to monetary penalties but not decertification as a QOF. The Treasury Department intends to address potential decertification and anti-abuse measures in future guidance.
  • To permit QOFs time to deploy invested cash or other property, they will be able to ignore amounts invested within 6 months of an asset testing date.

Selling/Exiting a QOF Investment

Under the statute and first round of proposed regulations, the owner of an eligible interest in a QOF that has been held for 10 years can sell the interest and recognize no gain. The newly issued proposed regulations also provide that certain gains from a QOF's sale of assets can also be excluded from taxable income provided the 10-year holding requirements are met.

In addition, the proposed regulations provide guidance on events other than a sale of a QOF interest that can trigger gain recognition. Highlighted below are some of the potential issues when considering a sale or other transfer of an interest in a QOF or a sale of QOF assets:

  • Sales of assets by QOFs during an investor's 10-year holding period will result in taxable gain. However, for purposes of a QOF's 90% asset test, proceeds from the sale of assets will be treated as QOZBP to the extent they are reinvested in QOZBP within 12 months of the sale. This will allow QOFs to sell and reinvest in other QOZBP, and it may encourage the use of tax-deferred like-kind exchanges by QOFs in order to avoid the recognition of taxable gains.
  • Capital gain from sales of assets by QOFs operating as partnerships or S-corporations after an investor's 10-year holding period may be excluded from an investor's taxable income. However, non-capital gain items, like depreciation recapture, will be taxable when assets are sold or exchanged in a taxable transaction. Consequently, in many instances, the sale of the ownership interest in the QOF, if possible, may be preferable if a buyer is willing to purchase the interest.
  • An investor may recognize gain upon the transfer of a QOF interest to charity, family members, or others by gift. Examples of other "inclusion" events are listed in the proposed regulations.
  • The receipt of a QOF interest by an heir or beneficiary upon the investor's death will not, on its own, trigger gain recognition. In addition, gain will not be triggered upon the transfer of a QOF interest to a disregarded entity or a grantor trust.

Existing Owners of Property or a Business in an Opportunity Zone

One common question concerns what opportunities exist for current owners of real property located in an opportunity zone. While just owning or selling the property does not provide any opportunity zone tax benefits, there are three distinct possibilities for an owner to consider in order to make use of the Opportunity Zone tax incentives. An owner could sell property to a QOF and roll over the gain into the QOF, but the owner must own 20% or less of the QOF to avoid the related party rules. Perhaps a more attractive option for a taxpayer wanting to maintain control is to lease the property to a QOF. If lease payments are based upon market-based rates, there are no related party prohibitions, although when related parties are involved, lease prepayments are forbidden and, in the case of leased tangible personal property, a QOF must acquire additional tangible personal property at least equal in value to the leased property. Finally, a taxpayer with otherwise qualifying gain could contribute real property to a QOF (in lieu of investing the gain), but, as discussed earlier, this may raise issues for the QOF regarding the status of the property as non-qualifying property.

Conclusion

Although there are still open questions, the second round of proposed regulations on Opportunity Zone tax incentives provide welcome guidance that will allow many investors and QOF developers to move forward with plans to form and operate QOFs. The Treasury Department has requested comments on several topics, so it will be important to monitor changes. In addition, states have taken varying approaches to conforming to the Opportunity Zone tax incentives and, in some cases, offer additional incentives for development in opportunity zones.

We will host a webinar on Opportunity Zone tax incentives Tuesday, July 30, 2019, at 12:30 CDT. Registration information can be found here.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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