Under the Tax Cuts and Jobs Act ("TCJA"), Congress sanctioned qualified opportunity zones ("QOZs") as a tax incentive to promote investment in low-income communities. Specifically, when investors put capital into a QOZ they may defer, reduce or remove taxes on certain capital gains.
The IRS released its first round of guidance on October 19, 2018, answering several questions to help taxpayers begin using the incentive. However, limitations in the proposed guidance left complex and potentially substantial problems unaddressed. So, on April 17, the IRS issued a second round of proposed regulations to address existing questions, specifically with respect to qualified opportunity funds (“QOFs”).
The new regulations provide different methods for investors to take advantage of the tax benefits, particularly as they relate to operating businesses. In effect, assuaging many investors’ fears that the regulations could lead to more funds being directed toward real estate development instead of startups. The following provides an overview of the most salient parts of these regulations to help you actively invest in QOZs.
What is the definition of “substantially all” and what are the “use” requirements?
The proposed regulations expand on the “substantially all” requirement necessitating that during 90% of the period that a QOF or Qualified Opportunity Zone Business (QOZB) holds tangible property, at least 70% of the property’s use must be in an Opportunity Zone (OZ), and 70% or more of the property owned or leased by a QOZB must meet the definition of QOZB property. Furthermore, for a minimum of 90% of the time that a QOF holds qualified opportunity zone business stock or qualified opportunity zone partnership interests, those entities must meet the definition of a QOZB.
How are businesses expected to actively conduct a trade or business while meeting the gross income requirements?
When it comes to conducting a trade or business while satisfying gross income requirements, a QOZB is required to derive at least 50% of its gross income from the active conduct of a trade or business within the OZ. The proposed regulations clarify that the leasing of real property is considered a trade or business, as long as the leases are not triple net leases. If the taxpayer plans on perusing triple net leases, they may be able to hire an outside management company and incorporate management fees into the leases.
What are the three safe harbors?
- At least 50% of all the hours employees, independent contractors and employees of independent contractors spend on performing services for the QOZB occur within the OZ.
- A minimum 50% of all payments the QOZB makes for services are performed within the OZ by employees, independent contractors and employees of the independent contractors.
- A facts and circumstances test in which:
- the tangible property of the business is in an OZ and, the
- management or operational functions performed in the OZ are necessary for the generation of at least 50% of gross income.
If a QOZB meets one of the three safe harbors, the 50% gross income test is satisfied.
How should leased property be treated?
The new proposed regulations provide more flexibility, as leased tangible property qualifies as QOZB property if two conditions are met:
- the QOF or QOZB enters into the lease after December 31, 2017; and
- substantially all (70%) of the property’s use occurs in an OZ for substantially all (90%) of the time that the business leases the property. Further, all leases must have market rate terms.
If the lease is between related parties, there are two additional requirements:
- A QOF or QOZB may not prepay its lease payments beyond one year.
- If the leased property is tangible personal property, then the property:
a) must have its original use with the QOF or QOZB; or
b) the QOF or QOZB must purchase tangible property that meets the QOZB property requirements. Its intended use will be in OZs that substantially overlap with the OZs where the leased property is used.
If the QOF or QOZB is required to purchase tangible property, the value of the purchased property must be equal to or more than the leased tangible personal property’s value. The purchase must occur by the earlier of: the end of the lease term, or 30 months from when the QOF or QOZB received possession of the leased property.
How to navigate the working capital safe harbor.
In a QOZB less than 5 percent of the average of the unadjusted bases of property can be attributable to nonqualified financial property, including cash. However, under the working capital safe harbor, cash is considered a qualified asset in a QOZB as long as there is a written plan that identifies the cash as being held for a project, and that the business substantially complies with a written schedule to deploy the cash within 31 months.
The proposed regulations add that the development of a trade or business in an OZ is an allowable use of planned working capital for the safe harbor. Further, relief is provided if the 31-month period is exceeded due to waiting for “government action.” This is allowable if the application was completed during the 31-month period.
How should transactions causing the immediate inclusion of the deferred gain into taxable income be managed?
The statute generally provides that a QOF investor’s deferred gain is not subject to tax until the earlier of:
- the date the investor sells or exchanges the qualifying investment; or
- December 31, 2026.
Deferred gain becomes taxable to the extent a transaction reduces the taxpayer’s equity interest in the qualifying investment. The regulations provide an extensive list of such transactions, including sales of the taxpayer’s interest in the QOF, sales of an interest in an S corporation or partnership that is a QOF investor, and gifts of the QOF interest.
Provided that distributions from QOF partnerships and S corporations do not exceed the partner’s or shareholder’s basis, there is no inclusion event. Similarly, dividend distributions from C corporations are not an inclusion event, unless the dividends are in excess of basis.
When there is an inclusion of the deferred gain, the proposed regulations require the QOF investor to include the lesser of two amounts in income, minus the investor’s basis. The first is the fair market value ("FMV") of the investment disposed of. The second amount, per the IRS wording in the proposed regulations, equals “an amount which bears the same proportion to the remaining deferred gain as” the first amount bears to the “fair market value of the total qualifying investment immediately before the inclusion event.”
The proposed regulations do not treat a transfer of a qualifying investment by reason of the taxpayer’s death as an inclusion event. Further, a transfer as a result of death does not restart the holding period for the QOF investment for purposes of the 5- and 7-year basis step-ups or the 10-year exclusion.
The transfer of a QOF interest to a grantor trust that is disregarded is not an inclusion event if the taxpayer is deemed to be the owner.
How are the QOF’s sale of assets addressed?
The new guidance allows one year to reinvest some or all of the proceeds from the return of capital or the sale or disposition of:
- QOZB property;
- qualified OZ stock; and
- qualified OZ partnership interests.
The QOF must hold the proceeds in cash, cash equivalents or short-term debt instruments until the proceeds are reinvested. There is relief if there is a delay due to governmental action.
An investor’s holding period is not impacted by the sale of the underlying assets. However, the gain from the sale of a QOF/QOZB asset is subject to tax under the regular tax rules.
In a favorable move, the proposed regulations provide that if the investor has held an interest in a QOF partnership or QOF S corporation for at least 10 years, the investor can elect to exclude from gross income some or all of the capital gain from the QOF’s disposition of qualified OZ property. There is a similar provision for the holders of REIT stock. Curiously, the proposed regulations provide no such election to holders of stock in a QOF C corporation that is not a QOF REIT.
What is the definition of the original use of property?
Original use of property is defined as beginning on the date that the acquired tangible property is first placed in service in the OZ for depreciation or amortization purposes. If the property is leased, original use is deemed to occur when the property is first used in an OZ in a manner that would allow it to be depreciated or amortized if it was owned instead of leased.
How can taxpayers contribute property to a QOF?
A taxpayer can make an investment of non-cash property into a QOF and still reap all the QOF tax benefits. In the case of a property contribution, the amount of the investment eligible for deferral of capital gain is the lesser of the taxpayer’s adjusted tax basis in the equity received in the transaction, or the fair market value of the equity received in the transaction. To the extent the fair market value exceeds the tax basis, the excess is an investment in the QOF that is not eligible for capital gain deferral or for the permanent exclusion from taxable income of appreciation after a 10-year holding period.
How is Section 1231 gains treated?
When a partnership or S corporation has a 1231 gain, it cannot be determined whether it is capital or ordinary until it is allocated to the ultimate taxpayer. Then it is only a capital gain to the extent that the gain exceeds 1231 losses and 1231 loss recapture. Only Section 1231 gains treated as capital gains are eligible for deferral. Also, the 180-day period for investing eligible 1231 gains into a QOF begins on the last day of the tax year that the 1231 gain was realized.
How are carried interests on QOFs treated?
The proposed regulations state that a contribution of services to a QOF in exchange for ownership cannot be a qualifying investment.
Implications of the Proposed Regulations
Transactions causing deferred gain to be subject to immediate taxation
The rules regarding inclusion events are taxpayer friendly. Prior to the release of the proposed regulations, there was concern that any return of capital would be deemed to be an inclusion event. However, under the proposed regulations, QOF investors do not have an inclusion event until their entire tax basis in the investment is exhausted. This is particularly beneficial to real estate investors, as it allows for debt-financed distributions.
It is also a favorable result of the proposed regulations that death is not an inclusion event. Previously, there was concern that death would be an inclusion event and would jeopardize the 10-year exclusion. By clarifying that death is not an inclusion event, the amount of capital available for the QOF pool will probably increase, since a large part of the investor pool is comprised of high-net-worth individuals who may use the 10-year exclusion as part of their long-term planning.
QOFs asset sales
The provision in the proposed regulations allowing a 12-month reinvestment period for the proceeds from the sale of QOZBs and QOZB business property eliminates concern that funds having sold assets and sitting on cash from the sale would fail the asset test.
It is disappointing that investors with less than a 10-year holding period in a flow-thru QOF are required to report as taxable income the gain from the sale of fund assets flowing through from a QOF partnership, S corporation, or REIT. This applies even if the QOF reinvests the proceeds within the 12-month window into other QOZBs or QOZB business property. However, it is very favorable that investors with a 10-year or greater holding period are able to exclude the gain from fund level asset sales if the QOF is a partnership, S corporation, or REIT. This will make multi-asset flow-through QOFs much easier to implement.
Section 1231 gains
The rules in the proposed regulations regarding Section 1231 gains means that flow-through entities cannot, at the flow-through level, roll over their Section 1231 gains into a QOF. The Section 1231 gains need to be passed on to the investor, and the investor is required to use the last day of the tax year as the date of gain for starting the 180-day period. Further, the investor cannot make the election to use the underlying flow-through entity’s actual date of sale as the beginning of the 180-day period.
Given that Section 1231 gains are deemed to occur on the last day of the tax year, if a taxpayer participates in a Section 1031 transaction and receives taxable boot, which is a Section 1231 gain, the taxpayer can defer the Section 1231 gain by investing into a QOF. This must occur within the first 180-days of the tax year following the year the boot was received, because the Section 1231 gain is deemed to occur on the last day of the year. A taxpayer could defer gains through a Section 1031 exchange, and defer any taxable boot through an investment into a QOF of the amount of the taxable gain on the boot. In order to receive the 15 percent permanent exclusion or 10 percent permanent exclusion of the invested deferred gain, the investor must hold the interest in the QOF for 5 or 7 years, respectively. The timing of the boot receipt should be managed to maximize the holding period in the QOF for these purposes.
Friedman LLP has a practice group devoted to providing consulting and compliance services to QOFs. Please contact Steven Bokiess with any questions.