Treasury Issues New Proposed Qualified Opportunity Zone Regulations

The Department of the Treasury on April 17 released a highly anticipated second round of proposed regulations regarding investments in qualified opportunity zones. The opportunity zone incentive was enacted as part of the Tax Cuts and Jobs Act in late 2017 and provides certain tax benefits for investments of capital gain in qualified opportunity funds (QOFs). The newly proposed regulations follow the first round of proposed regulations, which were published in October 2018.

The opportunity zone statute is unclear in a number of respects and has given rise to many questions among investors, developers, and business owners. The initial proposed regulations addressed some of those open questions, including general issues regarding the requirements and process for gain deferral and exclusion, the types of gain eligible for deferral and exclusion, and the types of taxpayers eligible for the opportunity zone benefits. The initial proposed regulations also addressed a number of QOF and qualified opportunity zone business (QOZB) qualification requirements. The initial regulations left a number of open questions, however, and Treasury indicated that it would issue additional regulations after reviewing comments. Following are some of the highlights from the second round of proposed regulations.

Additional “Substantially All” terms defined

For property to qualify for opportunity zone benefits (either as qualified opportunity zone property or QOZB property), during “substantially all” of the QOF’s or QOZB’s holding period for the property (the holding period requirement), “substantially all” of the use of the property must be within an opportunity zone (the use requirement). The first round of proposed regulations defined “substantially all” for purposes QOZB property requirement as 70% of the entity’s tangible property, by value. The new proposed regulations define “substantially all” to mean 90% for purposes of the holding period requirement and 70% for purposes of the use requirement.

“Original Use” requirement

Generally for property to qualify as QOZB property, the original use of such property must begin with the QOF or QOZB, and the property must be located in a QOZ. The proposed regulations clarify the “original use” requirement such that the original use of property is considered to commence on the date “any person first places the property in service in the opportunity zone for purposes of depreciation or amortization.” In addition, property that has been unused or vacant for at least 5 years is treated as meeting the original use requirement when it is placed in service following such period of non-use. Inventory is not treated as originally used outside of an opportunity zone solely because it is in transit from a vendor to a facility in an opportunity zone or from a facility in an opportunity zone to customers outside the zone.

Treatment of leased tangible property

The proposed regulations provide that leased tangible property may be treated as QOZB property as long as, (1) the leased property is acquired pursuant to a lease entered into after December 31, 2017, and (2) substantially all of the leased tangible property is used in an opportunity zone during substantially all of the period for which the QOF or QOZB leases the property. Both of these requirements mimic comparable requirements for QOZB property that is purchased by a QOF or QOZB. Unlike owned QOZB property, however, the lessee is not required to be the original user of the tangible property and there is no substantial improvement requirement. In addition, leased property generally is not required to be leased from an unrelated lessor, subject to certain limitations. In all cases, a lease must be a “market rate lease” for the property to qualify as QOZB property. If the lessee and lessor are related parties, the lessee may not make prepayments on the lease for a period that exceeds 12 months, and the lessee must own other QOZB property that has a value equal to or greater than the value of the leased tangible property. The proposed regulations also contain an anti-abuse provision to prevent the use of a lease to avoid the substantial improvement requirement for the purchase of real property (other than unimproved land). The regulations also provide rules relating to the valuation of leased tangible property.

Real property that straddles a QOZ

The proposed regulations provide that if real property straddles an opportunity zone boundary, the property will be treated as being entirely within the zone if the amount of real property, based on square footage, located within the zone is “substantial as compared” to the amount of real property, based on square footage, located outside the zone, and the real property is contiguous to part or all of the real property located in the zone.

Gross income from active conduct of a business QOZB requirement

A QOZB generally must derive 50% of its income from the active conduct of a business within a qualified opportunity zone. The proposed regulations provide three alternative safe harbors for meeting the 50% requirement based on hours worked by service providers in the opportunity zone, compensation paid for services provided in the opportunity zone, or a conjunctive test based on the amount of tangible property located in and management or operational functions performed in the opportunity zone. If a business does not meet the requirements of any of the safe harbors, then all of the facts and circumstances are considered to determine whether 50% of the gross income of the trade or business is derived from the active conduct of a trade or business in an opportunity zone. The proposed regulations also clarify that 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 for purposes of the QOF and QOZB requirements.

Use of Intangible Property by QOZB

For a business to qualify as a QOZB, a “substantial portion” of its intangible property must be used in the active conduct of a trade or business in an opportunity zone. The proposed regulations provide that a “substantial portion” for this purpose means at least 40% by value.

Working Capital Safe Harbor clarifications

A QOZB generally is allowed to hold only a reasonable amount of working capital. The first round of proposed regulations provided a working capital safe harbor which allowed a QOZB to have excess working capital if, (1) the amounts are designated in writing for the acquisition, construction, or substantial improvement of tangible property, (2) there is a written schedule to spend such working capital within 31 months of the receipt by the business, and (3) the working capital is actually used in a manner that is substantially consistent with the written plan and schedule. The new proposed regulations modify this safe harbor by allowing the working capital to be used for the development of a trade or business (in addition to use for the acquisition, construction, or substantial improvement of tangible property) and by allowing a QOZB to exceed the 31-month period if the delay is attributable to certain delays in governmental action.

Investment timing for 1231 gain

The proposed regulations provide that the 180-day period for investment in a QOF of capital gain arising from a sale of section 1231 property begins on the last day of the taxpayer’s taxable year.

QOF 90% investment requirement

To qualify as a QOF, a fund must invest 90% of its assets in qualified opportunity zone property on each testing date. Testing dates generally arise every six months. The proposed regulations allow a QOF to apply the 90% test without taking into account investments received during the immediately preceding six-month period, as long as the assets are being held in cash, cash equivalents, or debt instruments with a term of 18 months or less. The proposed regulations also provide that if a QOF sells or disposes of property (including QOZB stock, a QOZB partnership interest, or QOZB property), the proceeds of such sale or disposition are treated as qualified opportunity zone property if they are reinvested in other qualified opportunity zone property within the 12-month period following the sale or disposition.

Investment in QOF with property other than cash

A taxpayer may qualify for gain deferral by contributing either cash or property to a QOF. The proposed regulations provide that if a taxpayer contributes property other than cash to a QOF, such contribution may give rise to a “mixed-fund” in which the investment is bifurcated between a portion that is eligible for opportunity zone benefits and a portion that is not. The proposed regulations provide rules for determining the amount of gain eligible for opportunity zone benefits and the taxpayer’s basis in its mixed-fund investment. The proposed regulations also confirm that an investment in a QOF that is classified as a partnership for tax purposes, followed by a cash distribution from the QOF may be subject to the disguised sale rules.

Purchase of a QOF interest

The proposed regulations clarify that a taxpayer may qualify for opportunity zone benefits if the taxpayer purchases an interest in a QOF from a person other than the QOF . Prior to this clarification, some practitioners interpreted the statute to require that a QOF interest be acquired directly from the QOF to be eligible for opportunity zone benefits.

Deferred gain inclusion events

The proposed regulations provide that a taxpayer is required to recognize all or a portion of the deferred gain invested in a QOF upon certain “inclusion events” that reduce or terminate a QOF investor’s direct or indirect investment in a QOF. The proposed regulations give a nonexclusive list of events that will cause recognition of deferred gain, including, among others,

• the sale of all or part of a QOF interest,
• certain dispositions of interests in a partnership or S corporation that is directly invested in a QOF,
• gifts of QOF interests,
• distributions to a partner in a QOF partnership of property that has a value in excess of the partner’s basis in the QOF partnership interest,
• certain redemptions of QOF stock,
• liquidating distributions of a QOF corporation, and
• certain corporate nonrecognition transactions with respect to a QOF corporation, such as transfers to which IRC § 351 applies, certain types of reorganizations, and certain distributions and transfers to which IRC § 355 apply.

Basis adjustments

The proposed regulations clarify that the various basis adjustments provided for in the statute and the proposed regulations are effective for all purposes. Thus, for example, if an investor was allocated losses in a QOF partnership and those losses were suspended under IRC § 704(d), the losses would become available upon the automatic basis step-ups provided in the opportunity zone rules.

In addition, normal partnership basis adjustment rules generally apply in the case of a QOF that is classified as a partnership for tax purposes. However, the proposed regulations provide special rules for mixed-fund investments in QOF partnerships, including rules for QOF partnership profits interests granted with respect to services, such as carried interests. Under these proposed rules, a mixed-fund investment in a QOF partnerships can give rise to gain upon the distribution of cash or property with respect to the qualified-investment portion of the QOF interest, even if the distribution does not give rise to gain on an overall basis.

Election to exclude capital gains from sale of qualified opportunity zone property by a QOF

The proposed regulations permit direct investors in QOF partnerships and QOF S corporations to elect, after holding such interests for 10 or more years, to exclude from gross income some or all of the capital gain from the QOF’s disposition of qualified opportunity zone property. This has the effect of allowing for the disposition of qualified opportunity zone property, such as real estate assets or interests in a QOZB, without requiring the purchaser of such property to purchase all of the interests in a QOF. This proposed rule may significantly expand the ability to use a QOF for a multi-asset investment fund.

Special rules for QOF corporations

The proposed regulations include a number of provisions applicable to corporations seeking to qualify as QOFs. These include rules relating to carryover of tax attributes under IRC § 381, nonrecognition transactions under IRC § 351 transactions, and certain corporate reorganization transactions. The proposed regulations also provide that corporate distributions that give rise to taxable gain to the shareholder and redemptions of QOF stock, regardless of whether such redemptions are treated as dividends or a reduction of basis, constitute inclusion events. On the other hand, distributions paid out of earnings and profits that are treated as dividends for tax purposes generally are not inclusion events. The proposed regulations also include a complex set of provisions related to QOF stock held by a member of a consolidated group.

Holding Period and tacking

The proposed regulations provide that the holding period of property contributed to a QOF restarts at the time of contribution. Also, if an investor disposes of its entire interest in a QOF and, within the 180-day period following such disposition, acquires an interest in a second QOF, the holding period for the interest in the replacement QOF restarts, notwithstanding that the investor may qualify for gain deferral with respect to the second investment.

Anti-Abuse rules

The proposed regulations include a general anti-abuse provision, pursuant to which the Commissioner may recast a transaction if a significant purpose of the transaction was to achieve a “tax result that is inconsistent with the purposes of section 1400Z-2[.]”

Issues particular to tribally leased property

The proposed regulations address certain issues that may arise for entities that have been organized under a statue of a federally recognized Indian tribe and tribally leased property.