Treasury clarifies the qualified opportunity zone program with additional guidance
On April 17, 2019, the Treasury Department released a highly anticipated second round of proposed regulations (“Proposed Regulations”) clarifying certain open issues surrounding the “Qualified Opportunity Zone” tax incentive program introduced in the 2017 Tax Cuts and Jobs Act. The Proposed Regulations provide rules making it easier for qualified opportunity funds (“QOFs”) to comply with 90% asset test, expanding the working capital safe harbor, and providing clarity on treatment of gains on long-term investments, leased property, ownership and operation of a qualifying business, and what constitutes qualified opportunity zone business property, among other rules and clarifications. Overall, the Proposed Regulations provide helpful guidance for investors, fund managers and developers and a more defined framework for the launch of QOFs and their underlying investments.
The following provides background on the QOF requirements contained in the tax code and earlier released proposed regulations which is necessary to understanding the Proposed Regulations, and highlights of the 169-page Proposed Regulations.
Background of QOF Requirements
In order to understand the Proposed Regulations, some general background information and defined terms contained in the tax code and initial round of proposed regulations are needed. The deferral of gain under the qualified opportunity zone (“QOZ”) program applies to gain derived by a taxpayer from the sale or exchange of certain property if the taxpayer invests such gain in a QOF within 180 days of the sale or exchange. A QOF is any investment vehicle organized as a corporation or partnership for the purpose of investing in property in a designated QOZ”. In order to qualify as a QOF, at least 90% of the fund’s assets must be so called “QOZ property”, as determined over certain designated periods (the “90% Asset Test”).
A QOZ property is defined as property which is: (1) stock or partnership interests in an entity engaged in a QOZ business or (2) QOZ business property. A “QOZ business” is a trade or business in which:
- “substantially all” (defined as at least 70%) of the tangible property owned or leased by the taxpayer is a QOZ business property, as described below (the “Property Test”);
- at least 50% of the gross income of the QOZ business is derived from the active conduct of a trade or business (the “Gross Income Test”);
- a substantial portion of any intangible property is used in the active conduct of a trade or business;
- less than 5% of the average of the aggregate unadjusted bases of the property of the entity is attributable to “nonqualified financial property”; and
- the QOZ business is not a specifically excluded business.
A QOZ business has 31 months to hold the capital it receives from QOFs as working capital, as long as it has a plan for a qualifying project in a QOZ with a schedule for the use of the proceeds within the 31-month period (the “Working Capital Safe Harbor”).
A “QOZ business property” generally includes tangible property used in a trade or business of the QOF if:
- the property was acquired after December 31, 2017 from an unrelated person;
- the “original use” of the property in the QOZ commenced with the QOF or QOZ business (the “Original Use Test”) or the QOF or QOZ business “substantially improves” the property (the “Substantial Improvement Test”); and
- during substantially all of the QOF’s holding period for such property, substantially all of the use of such property was in a QOZ.
Highlights of Proposed Regulations
The following are some of the highlights of the Proposed Regulations:
- More Flexibility for QOFs to Invest Cash from Investors. The Proposed Regulations apply the 90% Asset Test without taking into account any investments received from investors during the preceding six months, as long as those new funds are held in cash, cash equivalents, or debt instruments with terms of 18 months or less. This rule effectively provides QOFs with six months from when they receive investor funds to purchase assets that qualify for the QOZ program and satisfy the 90% Asset Test.
- Working Capital Safe Harbor. The Proposed Regulations expand the Working Capital Safe Harbor to allow the written designation for planned use of capital to include the development of a trade or business in a QOZ as well as the acquisition, construction and/or substantial improvement of tangible property. Also, the Proposed Regulations provide that exceeding the 31-month period does not violate the Working Capital Safe Harbor if the delay is due to waiting for government action, provided that the application for the action is completed during the 31-month period.
- Investment into a QOF. The Proposed Regulations allow investors to use deferred gains to buy an interest in a QOF for cash or buy an interest in a QOF from another taxpayer. In addition, the Proposed Regulations allow a qualifying investment of property into a QOF, not just cash.
- Clarification of Original Use Test. The Proposed Regulations provide that, for purposes of the Original Use Test, the original use of tangible property other than land acquired by purchase begins on the date when the investor or a prior owner first places the property in service in the QOZ for purposes of depreciation or amortization (or first uses it in a manner that would allow for depreciation or amortization if that person was the property’s owner). Used property can qualify as original use if it was never used in a manner that would have allowed it to be depreciated or amortized. If a building or other structure has been vacant for at least five years prior to being purchased by a QOF or QOZ business, it can qualify as original use property. This is important because if property satisfies the Original Use Test, it does not need to meet the requisite investment requirements of the Substantial Improvement Test.
- Substantial Improvement Test. The IRS and Treasury have indicated that they are considering allowing for the Substantial Improvement Test to be applied on an aggregate basis (allowing assets to be grouped together), but the Property Regulations provide that the Substantial Improvement Test is performed on an asset-by-asset basis.
- Land as QOZ Business Property. The Proposed Regulations allow land to be treated as QOZ business property, eligible for investment by a QOF or QOZ business. The Substantial Improvement Test is not applicable to the purchase of unimproved land but the land has to be used in the active conduct of a trade or business by a QOF or QOZ business (i.e., the holding of land for investment is not permissible). The Proposed Regulations apply an anti-abuse rule in circumstances in which no new capital investment or increased economic activity or output is being made with respect to a land investment.
- Leasing. Under the Proposed Regulations, tangible property acquired by a QOZ business after Dec. 31, 2017 under a market rate lease can qualify as QOZ business property if during substantially all of the holding period of the property, substantially all of the use of the property was in a QOZ. The Proposed Regulations allow for related party leases, but impose additional requirements for these leases. The Original Use Test and the Substantial Improvement Test do not apply to leased tangible property.
- Clarifications for Multi-Asset Funds. The Proposed Regulations provide more clarity for QOFs set up to hold more than one asset. A one-year grace period is provided for QOFs to sell assets and reinvest proceeds from the sale of QOZ business property, stock and partnership interests without causing a violation of the 90% Asset Test.
In addition, the Proposed Regulations provide that an investor with a qualifying investment in a QOF partnership or S corporation can make a special election to exclude from the investor’s gross income some or all of the capital gain from the disposition by the QOF or QOZ business of QOZ property reported on Schedule K-1 of the QOF provided that the disposition occurs after the taxpayer’s 10-year holding period for its QOF investment. This much needed clarification allows a QOF to sell off one or more assets and make distributions to investors after each investor’s 10-year holding period without the recognition of tax by the investors.
However, additional guidance is needed for interim sales of assets by a QOF prior to the attainment of such 10-year holding period to allow a QOF to sell assets and reinvest the sales proceeds in a QOF business property without causing investors to recognize gain on the sales. The Proposed Regulations only allow the sales proceeds to be reinvested within 12 months so that the property remains qualifying property, but, under the current rules and regulations, investors would have to recognize any gain on such sales if they held their QOF interest for less than 10 years as of the time of sale. Treasury and the IRS indicated that it is not authorized to make such change by regulation, rather legislative action would be required.
- “Substantially all” Test Clarification. The Proposed Regulations establish the following thresholds for satisfying the “substantially all” requirements in the QOZ regulations for the holding period and use of the tangible business property (other than with respect to the Property Test, which has already be set at 70% by the prior regulations):
- For the “use” of the property, at least 70% of the property must be used in a QOZ.
- For the holding period requirements, tangible property must be a QOZ business property for at least 90% of the QOF’s or a QOZ business’s holding period.
- Operating Businesses. The Proposed Regulations also provide more clarity around how an operating business can qualify for the QOZ program. A business can rely on one of the following safe harbors to determine whether sufficient income is derived from a trade or business in a QOZ for purposes of the Gross Income Test (and if none of those apply, a general facts and circumstances test can be applied):
- at least 50% of the services performed (based on hours) by employees or independent contractors for the business are performed within the QOZ;
- at least 50% of the services performed (based on amounts paid for the services) by employees or independent contractors for the business are performed within the QOZ; or
- the (1) tangible property of the business that is in a QOZ and (2) management or operational functions performed for the business in the QOZ are each necessary to generate 50% of the gross income of the trade or business.
- Gain Inclusion Events; Transfers on Death. The Proposed Regulations provide a nonexclusive list of transactions that result in an early recognition of an investor’s deferred gain. Gain is recognized on a distribution by a QOF to a partner of cash or other property that has a value in excess of the partner’s basis in its QOF interest. Also, gain is triggered by most gifts of a QOF interest and a charitable contribution of a QOF interest. However, gain will not be triggered by a transfer of a QOF interest on death or a contribution to a grantor trust and the recipient may tack on the decedent’s or donor’s holding period for the interest transferred.
- Refinancing Proceeds. The Proposed Regulations allow a QOF partnership to make debt-financed distributions as long as the distribution does not exceed the investor’s basis in its QOF interest. The Proposed Regulations provide that investors in the QOF receive an increase in their basis for their share of the refinanced liability under the general partnership debt allocation rules in the tax code.
- Carried Interest. The Proposed Regulations clarify that no QOZ benefits attach to any QOF interest received for services (e.g., a carried interest).
In addition to the above highlights, the Proposed Regulations include special rules for S corporations and REITS, guidance on the application of gain inclusion rules to certain non-recognition transactions and much more. We will continue to analyze these new Proposed Regulations and will keep you posted as expected additional regulations and further guidance is forthcoming from Treasury.
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