Naya Pearlman, J.D., LL.M.
5.20.19 | Client Alert
This article is an update on new developments related to qualified opportunity zone legislation. By way of background, the 2017 Tax Cuts and Jobs Act created new tax law provisions that (i) allow states to designate the areas that qualify for opportunity zone tax incentives and (ii) permit taxpayers to qualify for certain tax benefits when investments in qualifying opportunity zone funds are made. The qualified opportunity zone (QOZ) tax laws were enacted to spur economic growth in designated low-income and distressed areas by providing tax benefits to qualified participants.
On April 17, 2019, the Internal Revenue Service (IRS) and Department of Treasury (Treasury) released the second set of proposed regulations to provide much needed guidance on the QOZ tax laws. These new regulations partially withdraw and replace portions of the first proposed regulations issued on October 19, 2018. While the newly proposed regulations do not become law until finalized, other than select portions, taxpayers may rely on these rules prior to finalization. A public hearing for the second proposed regulations is scheduled for July 9, 2019. After the hearing, it is expected that Treasury and the IRS will finalize the separate sets of proposed regulations at the same time.
To put the new guidance in context, below is a general overview of the QOZ tax laws. For those who are familiar with the QOZ rules, skip to New Guidance below.
In general, the QOZ tax breaks consist of the following three parts. First, beginning in 2018, taxpayers may exclude capital gains in the year of the sale if the gain amount is reinvested in a qualified opportunity fund (QOF) within 180 days from the sale. Eligible capital gains include net gains from the sale of a trade or business asset that qualify for long-term capital gain treatment. If a qualifying investment is made, the taxpayer can defer the gain until the earlier of December 31, 2026 or a disposition event (sale or exchange of QOF investment), which means the latest possible deferral of the original gain is 2026. Note that under this rule, only the gain amount needs to be reinvested in a QOF, and not the entire proceeds. Therefore, it is possible for taxpayers to pocket some cash proceeds and still defer the entire capital gain, unlike a like-kind exchange where the entire proceeds need to be reinvested in order to qualify for a complete deferral.
Second, after a five-year holding period in a QOF investment, the basis of the investment in the QOF is increased by 10%, resulting in a 10% reduction of the deferred gain. After a seven-year holding period, the basis is increased by an additional 5%, for a total elimination of gain of 15%. Since the latest recognition of the deferred gain is 2026, this means that taxpayers will need to reinvest by the end of 2019 to fully benefit from a seven-year hold. In other words, assume in December 31, 2019 that taxpayer S sold marketable securities that had a basis of $100 with a value of $200. Assuming S immediately reinvested the $100 capital gain into a QOF, S would need to hold her QOF interest until December 31, 2026 to qualify for a seven-year hold. If S continues to hold her QOF interest on December 31, 2026 at a time when the investment has a fair market value of $150, she will recognize $85 of gain, which is the lesser of the amount of gain excluded or the fair market value of the investment over the taxpayer’s new basis of $15.
Third, at any time before 2048, the taxpayer is eligible to exclude the appreciation from the sale of the QOF investment after a ten-year holding period. Under the QOF rules, the qualified investment has an initial basis of zero. The basis is then adjusted to the full investment amount when gain is recognized upon the earlier of December 31, 2026 or the inclusion event of the QOF investment. Thus, in the example above, S’s basis in her QOF investment would be increased by $85 to $100 in 2026. Then, when S has held her QOF investment until December 31, 2029 for at least ten years, she may sell her QOF interest and completely eliminate all appreciation. If the value of her QOF interest is then $300, S’s basis is deemed to be stepped up to $300 right before the sale and S pays no tax on the $200 gain.
There are a number of qualification and regulatory requirements that the initial guidance explains, including qualifying as a QOF, which requires a QOF to hold 90% of its assets in QOZ property. The 90% asset test is measured by specific metrics and is determined by the average of the percentage of QOZ property held in the fund on the last day of the first six-month period of the fund and again on the last day of the taxable year of the fund. QOF investors can be subject to a penalty if the asset test is not complied with. QOZ property includes QOZ business property (QOZBP), QOZ stock, and QOZ partnership interests. Therefore, a QOF can either directly own QOZBP or indirectly hold a subsidiary in the form of QOZ stock or a QOZ partnership interest. When a QOF holds QOZ stock or QOZ partnership interest, the lower tier corporation or partnership must be a QOZ business (QOZB).
To be a QOZB, among other requirements, (i) at least 70% of the tangible property owned or leased by the taxpayer must be QOZBP, (ii) at least 50% of the business income must be derived from the active conduct of business in a QOZ each year, and (iii) no more than 5% of the assets can be attributable to non-qualified financial property. However, to allow for the retention of some cash and reasonable working capital, the proposed rules allow for a 31-month safe harbor. Under this safe harbor, working capital assets are not treated as nonqualified financial property if the amounts are designated in writing for certain qualified purposes. The plan must also be supported by a written schedule consistent with the trade or business for the expenditure of the working capital assets within 31-months of receipts and the working capital must actually be used in a manner that is substantially consistent with that written plan.
QOZBP is defined as tangible property used in a trade or business of the QOF provided such property is (i) acquired in a taxable transaction from an unrelated party (with no more than 20% common ownership threshold) after December 31, 2017, (ii) the original use of the property in the QOZ commences with the QOF or such property is substantially improved by the QOF; and (iii) during substantially all of the fund’s holding period of such property, substantially all of its use was in a QOZ. The substantial improvement test is met if during any 30-month period, the QOF makes additions to tax basis that are at least equal to the original tax basis in the property. Neither the original use nor the substantial improvement requirements apply to land. Thus, when renovating or refurbishing a building, the QOF needs to invest only an amount equal to the cost of the acquired building and not the land.
As the foregoing indicates, there is a difference between a QOF that operates a QOZB directly and a QOF indirectly operating through a QOZ subsidiary. The subsidiary is required to hold only 70% of its assets in QOZBP while a QOF that operates a business directly is required to hold 90% of its assets in QOZ Property. Thus, the asset tests favor a two-tier structure over a single fund structure in terms of relaxing of these requirements, since effectively a QOF would need to hold only 63% of its assets in QOZBP (90% x 70%).
The second set of proposed regulations establishes new rules and provide clarification on existing technical requirements. Overall, the new set of guidance provides flexibility in allowing for different types of business arrangements and structures. Below are some of the most impactful changes and highlights.
I. Investor Provisions
- Partnership Debt. The new guidance confirms that QOF partnership debt allocated to a partner increases the basis of a QOF partnership interest, and does not impact the amount of the deferred gain in 2026 nor the elimination of gain from appreciation when the QOF investor sells its interest in the QOF after the ten year holding period. Furthermore, the new proposed regulations explain that a taxpayer is not required to recognize gain on debt-financed distributions on its QOF interest to the extent that the amount of such distributions does not exceed the taxpayer’s tax basis in the QOF, including the investor’s share of QOF partnership debt.
- Carried Interest. Under the new proposed rules, services rendered to a QOF are not considered the making of a qualified investment. Thus, a profits interest received by a partner or promoter, in exchange for services rendered to the QOF, is not treated as a qualifying investment, and the share of gain attributable to the service component of the interest in the QOF partnership is not eligible for any of the tax benefits afforded for QOZ investments.
- Taxpayer Election for Asset Sale. The new proposed regulations clarify that the sale of a QOF asset can qualify for the exclusion of appreciation after a ten-year holding period. For purposes of the gain exclusion, if a taxpayer has held a qualifying investment in a QOF for at least ten years, the taxpayer may make an election to exclude capital gain arising from such disposition reported on Schedule K-1 of the QOF partnership or QOF S corporation provided the QOF disposes of QOZ property after the investor’s ten year holding period. The exclusion of gain recognized at the asset level provides flexibility to dispose of assets at the fund level instead of at the investor level. It remains unclear; however, whether this rule applies to gain recognized by a lower tier QOZ partnership, which should be clarified in the final regulations.
- Transfers of QOF Interests. To prevent taxpayers from prematurely cashing out of a qualifying QOF investment without including income deferred gain, the proposed rules provide detailed guidance on the types of QOF interest transfers that can cause inclusion events. They also carve out non-inclusion events. For example, transfers of QOF interests by reason of death and transfers to grantor trusts are not considered inclusion events. However, taxable dispositions, distributions in excess of basis, transfers of QOF interests by gift, and other types of transfers that result in the reduction of equity in the QOF investment, will trigger recognition of deferred gain.
II. Fund Provisions
- Valuation. The new proposed regulations modify the initial round of proposed regulations by allowing a QOF or QOZB to select a method of valuation for purposes of asset testing. Property may be valued using the value as reported on an applicable GAAP financial statement or by using the unadjusted cost basis (alternate valuation method). If the alternate valuation method is elected for leased property, the QOF can value the leased property based on the present value of the lease payments using the applicable federal rate. The valuation method must be consistently applied to all valued assets for each taxable year.
- Original Use. For purposes of satisfying the original use requirement to qualify tangible property as QOZBP, the proposed regulations provide that the original use of owned tangible property in the QOZ commences on the date any person first places the property in service in the QOZ for purposes of depreciation or amortization. If property has been unused or vacant for an uninterrupted period of at least five years, however, original use in the zone commences when any person first uses or places the property in service in the QOZ. Used tangible property can also satisfy the original use requirement if the property has not been previously so used or placed in service in the QOZ. Similarly, in the case of leased tangible property, the new proposed rules explain that original use of leased tangible property in a QOZ commences on the date any person first places the property in service in the QOZ or first uses it in a manner that would allow depreciation or amortization if that person were the property’s owner.
- Leases. In the case of tangible property that a QOF leases, to be QOZBP, the new rules clarify that (i) the lease must be entered into after December 31, 2017 and (ii) the lease terms must be at market rate at the time the lease was entered into. In addition, during substantially all of the QOF’s holding period for the tangible property, substantially all of the use must be in a QOZ. For purposes of determining the holding period requirement, substantially all means at least 90%. These new rules permit a QOF to lease property that has already existed in a QOZ and still qualify the leased property as a good QOZBP asset, as no original use requirement is imposed, unless the lessor and lessee are related, as discussed below.
- Related Party Leases. Under the new rules, related party leases are not subject to disqualification as QOZBP, as with a sale. However, related party leases are subject to the requirements above plus two further requirements to prevent potential abuse. First, if the parties are related, leased property will be a non-qualifying QOZBP if, in connection with the lease, the lessee makes a prepayment to the lessor relating to a period of use exceeding 12 months. Second, when the lessor and lessee are related, the proposed regulations do not permit leased tangible personal property to be treated as a good QOZBP asset unless the lessee becomes the owner of tangible property that is QOZBP with a value not less than the value of the leased personal property, using the lease valuation methodology described above.
- Recent Contributions. To allow the QOF to accumulate cash contributions over a period of time, the proposed regulations allow a QOF to determine compliance with the six-month 90% asset test by excluding recent contributions when (i) the amount of the cash or property is received by the QOF partnership as a contribution or by the QOF corporation solely in exchange for stock of the corporation, (ii) the contribution or exchange occurs not more than six months before the test from which it is being excluded; and (iii) between the date of that contribution and the date of the asset test, the amount is held continuously in cash, cash equivalents, or debt instruments with a term of 18 months or less. Therefore, the new rules permit the exclusion of these recent contributions from the 90% asset test at the first six-month interval.
- Trade or Business. For purposes of qualifying as QOZB, the new proposed rules clarify that the ownership and operation of real property, including leasing, is considered the active conduct of a trade or business. However, consistent with the IRS view that a single rental property with minimal management requirements is an investment activity and not a trade or business activity, the new rules state that merely entering into a triple net lease will not be considered the active conduct of a trade or business for this purpose.
- Working Capital. Under the new guidance, the working capital safe harbor rule is broadened to provide a QOZB with further flexibility to hold cash without violating the asset test. There are two key changes in the latest round of proposed regulations. First, the written designation for planned use of working capital now allows for the development of a trade or business in the QOF, as well as acquisition, construction, and substantial improvement of tangible property. This new provision allows a QOZB to use the working capital for operating expense needs in addition to QOZBP. Second, if the delay is attributable to waiting for government action under certain circumstances, the exceeding the 31-month safe harbor will not violate the safe harbor.
With this new guidance, we expect there to be enhanced interest in the QOZ program, especially among the real estate community, financial industry, and investors. As always, we will be closely monitoring legislative, regulatory, and other relevant government updates and developments. For more information, please contact your Berdon LLP advisor.
Berdon LLP provides this information as a service to clients and friends for educational purposes only. This article should not be construed or relied on as tax advice and readers should not act upon this information without consulting their tax advisor. This information is not intended or written to be used and cannot be used by any person for the purpose of avoiding any tax penalties.