Qualified Opportunity Zones: What We Know From New RegulationsJuly 16, 2019
Interest continues to increase in a promising new program contained in the 2017 Tax Cuts and Jobs Act, which provides significant tax incentives for investors in Qualified Opportunity Zones (QOZ).
After releasing the first set of QOZ proposed regulations on October 19, 2018, and holding a public hearing for comments and recommendations on February 14, 2019, the U.S. Department of the Treasury released their second set of proposed regulations on April 17, 2019 (the “2019 Proposed Regulations”) which substantially clarify several key issues. The Department of Treasury also held a second hearing in Washington, DC on July 9, 2019 to obtain further comments and recommendations from the public.
Both sets of proposed regulations generally provide that until final regulations are promulgated, eligible taxpayers may rely on the proposed regulations, provided that they are applied in their entirety and in a consistent manner.
Catch up on our updates here: A Practical Guide to the Qualified Opportunity Zone Program, Qualified Opportunity Zones: Insights From the Government’s New Guidance, and Qualified Opportunity Zones: An Update
Below are the highlights you need to know from the 2019 Proposed Regulations:
When a taxpayer invests in a Qualified Opportunity Fund (QOF), its capital gain is deferred statutorily until the earlier of December 31, 2026 or when its qualifying investment in the QOF is “sold or exchanged.” The 2019 Proposed Regulations provide a list of “inclusion events” that cause investors to recognize their deferred gain and clarify, as a general rule, that an inclusion event results to the extent the transfer reduces the taxpayer’s equity interest in the QOF. The 2019 Proposed Regulations provide a non-exclusive list of inclusion events, all of which are subject to exceptions, including transfers by gift, worthlessness, liquidation or termination of the QOF, and receiving property in a distribution. However, a leveraged distribution by a QOF to its investors may not be treated as an inclusion event, depending on the facts and circumstances, if the distribution occurs two years after the investment in the QOF.
Section 1231 Gains
There is a special rule for Section 1231 gains under the 2019 Proposed Regulations. Under the tax law, Section 1231 gain generally results from the sale or exchange of property used in a trade or business, and held for more than one year. If a taxpayer’s Section 1231 gains exceed its Section 1231 losses, this net gain is treated as long-term capital gain and is eligible for investment in a QOF. This means that a taxpayer needs to determine the net amount of the Section 1231 gains and the Section 1231 losses for such year. Effectively, this would not be known until the end of the taxable year. The 2019 Proposed Regulations provide that the 180-day period for the investment in a QOF of any net Section 1231 capital gain for a tax year would begin on the last day of the taxpayer’s tax year. As such, if a taxpayer realizes Section 1231 gain at the beginning of a tax year, the taxpayer will not know if the gain is eligible (i.e., net Section 1231 capital gain) until the end of the tax year, and must wait to invest in a QOF the following tax year.
The 2019 Proposed Regulations provide that leased tangible property may be treated as Qualified Opportunity Zone Business Property (QOZBP) if certain requirements are satisfied. For the lease to qualify as QOZBP, the QOF must enter into the lease after December 31, 2017, and the terms of the lease must be at market rate at the time the lease was entered into. Additionally, substantially all (70%) of the use of the leased tangible property must be within the QOZ during substantially all (90%) of the period for which the business leases the property.
The 2019 Proposed Regulations also allow a QOF to lease tangible property from a related party and be treated as QOZBP if certain additional requirements are satisfied. For a lease with a related party to qualify as QOZBP, the lessee cannot make a prepayment to the lessor (or a person related to the lessor) related to a period of use of the tangible property that exceeds 12 months and the lease is on arm’s length, market terms in the locality that includes the QOZ. Additionally, if the “original use” of the leased tangible property does not commence with the lessee, the lessee must become the owner of the tangible property that is QOZBP during the earlier of the last date of the lease term or the 30-month period that begins on the date the lessee takes possession of the tangible personal property under the lease. The QOZBP must also have a value equal to or greater than the value of the leased personal property. This may become a common strategy to obtain the use of tangible property from a related party.
In order for property to qualify as QOZBP, the “original use” of the property must commence with the Qualified Opportunity Zone Business (QOZB) or the QOZB must substantially improve the property (i.e., the adjusted basis of the property, excluding land, should be doubled). The 2019 Proposed Regulations provide that the “original use” commences on the date the property is first placed in service for depreciation purposes within the QOZ or the property is first used in a manner that would allow depreciation if the taxpayer were the owner (in the case of leased property). Under this definition of “original use,” a QOF can purchase the developed property (for example, where a developer builds a mixed-use building and sells it) and not be required to make “substantial improvements” so long as the QOF acquires the property from an unrelated third party and the property has not yet been placed in service by the seller for depreciation purposes. The 2019 Proposed Regulations also provide that if a QOZB acquires raw land, it will satisfy the “original use” requirement and will not be required to make “substantial improvements” to the property so long as the raw land is used in the QOZB’s “active trade or business.” Additionally, the 2019 Proposed Regulations provide that if tangible property has been unused or vacant for an uninterrupted period of at least five years, the “original use” in the QOF commences on the date after that period when any person first uses or place the property in service.
Qualified Opportunity Zone Business
One of the requirements of a QOZB is that it must generate at least 50% of its total gross income from the active conduct of a trade or business in a QOZ. The 2019 Proposed Regulations provide three safe harbor and a facts and circumstances tests for a trade or business to satisfy the 50% gross income requirement. These safe harbor tests provide additional flexibility to service businesses to meet the 50% gross income requirement. The 2019 Proposed Regulations also clarify that that the ownership and operation (including leasing) or real property is the active conduct of a trade or business. However, merely entering into a triple-net lease with respect to property owned by a taxpayer is not the active conduct of a trade or business by such taxpayer.
The 2019 Proposed Regulations provide that a taxpayer with eligible gain to defer can acquire an interest in a QOF from someone other than the QOF, and elect to defer such eligible gain in an amount equal to the purchase price. This will allow for the creation of a secondary market for QOF interests, which could in turn provide potential liquidity for holders of QOF interests.
Sale of QOF Assets
The 2019 Proposed Regulations provide that if a taxpayer has held a qualifying investment in a QOF partnership or QOF S corporation for at least 10 years, and the QOF partnership or QOF S corporation disposes of QOZP after such 10-year holding period, then the taxpayer may make an election to exclude from gross income some or all of the capital gain (not ordinary income such as depreciation recapture) arising from such disposition reported on Schedule K-1 of the QOF partnership or QOF S corporation. This election appears to be available as long as the taxpayer’s holding period is 10 years or more, irrespective of the holding period of the QOF partnership or QOF S corporation. However, if a taxpayer has not held a qualifying investment in a QOF partnership or QOF S corporation for at least 10 years, the taxpayer may not make this election, and must report this income for tax purposes.
As a reminder, to maximize the full tax benefits of the QOZ program, eligible investors should invest in a QOF prior to December 31, 2019. For any questions about the QOZ Program, including the 2019 Proposed Regulations, please contact Hinckley Allen’s interdisciplinary team or a member of our real estate, tax, or corporate groups.
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This article is intended only as a high-level overview of the 2019 Proposed Regulations, and does not address each provision in the 2019 Proposed Regulations, including, but not limited to, all provisions related to the operation of a QOF. The 2019 Proposed Regulations are complex, subject to change, and not yet finalized. This article is for general information purposes and is not intended to be, and should not be taken as, legal advice.