Qualified Opportunity Zones (QOZ) were first introduced as part of the Tax Cuts and Jobs Act and provide significant tax breaks for those real estate investors and businesses who invest in economically distressed areas. On December 19th, 2019, the Internal Revenue Service (IRS) and the Department of the Treasury (Treasury) released final regulations clarifying many outstanding questions. This article will highlight some of the key points in the final regulations.
Section 1231 Gains
Section 1231 gains are gains from the sale or exchange of land and tangible depreciable property used in a trade or business and held for more than one year. The proposed regulations required Section 1231 gains to be netted against Section 1231 losses, and only the net Section 1231 gain could be deferred into a qualified opportunity zone fund (“QOF”). As a result, the 180-day window to invest Section 1231 gains into a QOF did not begin until the end of the taxable year, when the amount of net Section 1231 gains could be determined.
In a taxpayer favorable move, the final regulations adopted a gross approach to Section 1231 gains, meaning that gross Section 1231 gains can be deferred into a QOF, and are not first required to be netted against Section 1231 losses. Because eligible gains include the gross amount of eligible Section 1231 gains unreduced by Section 1231 losses, it is not necessary for an investor to wait until the end of the year to determine whether any eligible Section 1231 gains are eligible gains. Therefore, under the final regulations the 180-day investment period for Section 1231 gains begins on the date of sale, and not the last day of the taxable year.
180-Day Investment Period
The final regulations included several changes and clarifications regarding the 180-day investment period for investing and deferring eligible capital gains into a QOF:
- As discussed above, for Section 1231 gains the 180-day period begins on the date of the sale, and not the last day of the year.
- The 180-day period for REIT and RIC capital gain dividends begins at the close of the shareholder’s taxable year in which the capital gain dividend would otherwise be recognized.
- For an installment sale, the taxpayer can elect to choose the 180-day period to begin on either: (1) The date a payment under the installment sale is received, or (2) the last day of the year the eligible gain under the installment method would otherwise be recognized.
- For eligible gains flowing through to a taxpayer from a flow-thru entity, such as a partnership or S corporation, the taxpayer has three options. The taxpayer can elect the 180-day period to begin on the last day of the partnership’s taxable year, the date the flow-thru entity recognized the gain, or the un-extended due date of the flow-thru entity’s tax return.
The final regulations clarified that certain events, other than those already encompassed in the proposed regulations, will be treated as an inclusion event. An inclusion event results in the recognition of all or part of the deferred gain. Inclusion events encompass the voluntary or involuntary decertification of a QOF, a change in the tax status from a partnership to a corporation or vice versa, and the transfer of the qualified opportunity zone fund to a spouse during a divorce proceeding. It is important to note that an inclusion event is subject to taxation at the applicable federal income tax rate in effect during the year of inclusion, rather than the year of the deferral.
The transfer of the QOF interest as a result of the owner’s death is not an inclusion event. However, the beneficiary is required to recognize the deferred capital gain as income in respect of a decedent in 2026, and the qualifying QOF interest does not receive a tax basis adjustment to fair market value at death.
Tangible property owned by a QOF or QOZ Business (“QOZB”) is required to have been acquired by purchase from an unrelated party after December 31, 2017 in order to meet the definition of qualified opportunity zone business property. However, the final regulations clarify that property that is manufactured, constructed or produced rather than purchased is not precluded from qualification so long as it was constructed with the intent to use in a trade or business. The acquisition date of self-constructed property would be the date significant work begins. In addition, land must be improved by more than an insubstantial amount under the final regulations.
A building that is newly constructed and purchased by the QOF or QOZB prior to being placed in service in the QOZ satisfies the original use requirements.
Relaxation of the Vacancy Rules
The proposed regulations specified that a building or other structure that had been vacant for 5 or more years prior to being purchased by a QOF or QOZB would satisfy the original use requirement, and therefore not be required to be substantially improved by the QOF. The original use requirement is normally satisfied if the original use of the tangible property in the QOZ begins with the QOF or QOZB. A property that fails the original use test must be substantially improved by the QOF or QOZB. Under the substantial improvement requirement, the cost of the property must be doubled through improvements to the property within 30 months.
The final regulations relaxed the vacancy requirement. Under the final regulations, if a property is vacant at the time of the qualified opportunity zone designation through the date on which the QOF or QOZB purchased it, only a 1-year vacancy period is required for the property to meet the original use requirement and consequently does not require substantial improvement. Otherwise, the vacancy requirement is reduced to 3 years from the original 5 years in order to meet the original use requirement.
Aggregation Rules for the Substantial Improvement Requirement
The final regulations provide aggregation rules for the substantial improvement requirement. This means that instead of substantially improving every individual piece of tangible property that does not meet the original use requirement owned by a QOF or QOZB, certain tangible property can be aggregated and treated as a single piece of property for purposes of the substantial improvement requirement.
Buildings on a single-deeded property may be treated as a single property. Buildings that are on contiguous parcels of land can be treated as a single property provided they are (1) operated exclusively by the QOF or QOZB, (2) share business resource elements (back office functions) or employees, and (3) are operated in coordination with one or more of the trades or businesses (e.g., supply chain interdependencies or mixed-use facilities).
With respect to operating assets, the final regulations take into account the functionality of the assets. The cost of purchased property that qualifies as QOZB property and is original use (i.e., is not required to be substantially improved) can be added to the basis of purchased non-original use assets to meet the substantial improvement requirement for the non-original use assets, if the original use property:
- Is used in the same trade or business in the QOZ in which the non-original use asset is utilized, and
- Improves the functionality of the non-original use asset in the same
QOZ. The final regulations provide an example of a QOF that purchases an existing, non-original use hotel. In the example, the QOF can count the basis of purchased original use items, including mattresses, gym equipment, and furniture and renovations of the in-hotel restaurant towards the substantial improvement of the hotel property.
The final regulations on qualified opportunity zones are extremely complex and span 544 pages. However, if you or someone you know is contemplating investing in a qualified opportunity zone, it is imperative that you speak with someone informed on this topic to ensure that all matters are being handled appropriately from inception. Please feel free to contact Steven Bokiess, Tax Partner at 212-897-6427 or Heather Goldstein, Tax Principal at 212-897-6402 or via email at firstname.lastname@example.org or email@example.com.