We have previously published Client Alerts summarizing the new opportunity zones tax incentive program (OZ program)created by Sections1400Z-1 and1400Z-2 of the Internal Revenue Code (Code) and proposed regulations published by the Department of the Treasury and the Internal Revenue Service in October 2018 and April 2019 (the proposed regulations). Click here to see our November 2018 Client Alert and click here to see our April 2019 Client Alert, each of which includes links to other important OZ program information.
The proposed regulations provided clarity on some key issues, however, uncertainties remained regarding many issues faced by investors seeking the benefits of the OZ program. After months of reviewing and considering hundreds of comment letters on the proposed regulations, in late December 2019 Treasury and the IRS issued 544 pages of final regulations with extensive commentary and examples which revise and clarify the proposed regulations and give investors a reasonably clear road map for making investments that will provide the tax benefits envisioned by the OZ program. Click here to see the final regulations.
This Client Alert will identify and discuss some of the important changes and clarifications in the final regulations. However, in order to understand these changes, a reader will need to have a general understanding of the OZ program as outlined in our prior Client Alerts. The discussion in this Alert is necessarily both simplified and incomplete, so readers are also cautioned that this is not intended to be legal advice that might apply to a particular transaction, but rather a high-level overview of these complex regulations.
Background
Under the OZ program, a taxpayer can elect to defer recognition of capital gains by investing the gain proceeds in a qualified opportunity fund (QOF) within 180 days after the transaction giving rise to the gain, provided that the QOF timely invests those funds in qualified opportunity zone property (QOZ Property) and continues to hold 90% or more of its assets in QOZ Property. QOZ Property includes qualified opportunity zone business property (QOZ Business Property) as well as equity ownership in a qualified opportunity zone business (QOZ Business). See our prior Client Alerts for a more detailed discussion of these terms which is critical to understanding the OZ program.
Key Provisions of the Final Regulations
Eligible Gains. Only capital gains are eligible to be deferred and, if invested properly, to obtain the benefits of the OZ program. The final regulations made several changes and clarifications with regard to how different types of gains are treated for this purpose.
Section 1231 Gains. Section 1231 property is generally defined in the Code as depreciable or real property that is used in the taxpayer’s trade or business and held for more than one year. Under the proposed regulations, gains from dispositions of 1231 property were only eligible for deferral to the extent they exceeded losses from dispositions of 1231 property during the same taxable year. As a result, a taxpayer needed to wait until year-end to determine if they had an eligible net 1231 capital gain and the 180-day QOF investment period would begin to run at that time. In contrast, the final regulations adopted a taxpayer-friendly “gross approach” to 1231 gains without regard to any potentially offsetting 1231 losses. As a result, it is not necessary for a taxpayer to wait until year-end to determine any 1231 gains. Rather the gross amount of the gains becomes eligible, and the 180-day QOF investment period begins to run, on the date of the transaction that gives rise to the 1231 gain (without any reduction or offset by 1231 losses incurred in the same taxable year).For any taxpayers that had 1231 gains during 2019 but did not invest those gains into a QOF within 180 days in reliance on the proposed regulations, they may continue to rely on the proposed regulations for this purpose and deem their 180-day QOF investment period to have begun as of the end of 2019.
Installment Gains. The final regulations clarify the treatment of gains recognized for sales using the installment method, which generally allows a taxpayer to report gain in the taxable year(s) when payments are received rather than in the year of the sale. The final regulations allow the taxpayer to elect to have the 180-day period begin on either the date a payment is received or the last day of the taxable year the eligible gain under the installment method would otherwise be recognized. As a result, there might be multiple 180-day periods or a single 180-day period.
Property Contributed to a QOF or Sold to a QOF/QOZB
A number of issues have swirled around whether a taxpayer can contribute property to a QOF and, if so, how will that transaction be treated. A taxpayer may contribute property (as opposed to cash) to a QOF in exchange for an interest in the QOF, but the final regulations have clarified a number of uncertainties as to how such a contribution will be treated for purposes of the OZ program. Here are the key takeaways, which touch on several different areas of the regulations:
- Eligible Gains. Is any gain on the sale (or exchange) of appreciated property to (or with) a QOF eligible gain under the OZ program? No. Gain from a sale or exchange of property with an unrelated QOF as part of a plan that includes the investment of the consideration received by the eligible taxpayer (including any gain proceeds) back into the acquiring QOF, is not eligible gain to the taxpayer because, due to the circular nature of the transaction, it would not be characterized as a sale or exchange to an unrelated person for federal income tax purposes.
- QOZB Property. Would property contributed to the QOF/QOZB in exchange for an interest in the QOF meet the definition of QOZB Property? No. QOZB Property is defined as having been purchased by the QOF/QOZB. In a case where property is contributed, or where property is sold to a QOF and the proceeds used to invest in the same QOF/QOZB, there is deemed to be no purchase of the property and therefore the property will not be QOZB Property. Recall that, in the case of a QOZB, at least 70% of its assets must be held in property that meets the definition of QOZB Property. Therefore, any property contributed or sold in the manner described above would reduce the amount of other non-QOZB Property assets that could be held by the entity.(An alternative is for the QOF/QOZB to sell the contributed property and use the cash to purchase other assets that are QOZB Property.)
180-Day Investment Period. The final regulations provide taxpayers with greater timing flexibility with respect to gains realized by a pass-through entity (partnership, LLC taxed as a partnership, or S-Corporation) where the entity does not elect to defer the gains. In that case, the partners or shareholders of the entity can elect to defer their allocable share of the gain using any one of the following as the first day of the 180-day QOF investment period: (i) the date on which the entity sold the property that generated the gains; (ii) the last day of the entity’s taxable year; and (iii) the due date of the entity’s tax return for the year of the sale (without considering any extensions). These alternatives provide flexibility to the taxpayer; for example, allowing time to confirm the amount of gain they will be allocated by the entity which may not be known until the entity has completed its tax work for the year of the sale.
Recycling of QOF Investments. The proposed regulations provided that a taxpayer could dispose of its entire interest in a QOF and then make a second election to further defer the original gain by reinvesting the gain proceeds in another QOF within 180 days. (Remember that all deferred gains will be recognized not later than December 31, 2026.) The final regulations provide added flexibility by allowing taxpayers to similarly “recycle” their deferred gains where only a portion of their QOF investment is disposed of.
Inclusion Events. The final regulations revise and clarify many of the inclusion events (i.e., events that will cause deferred gains to be recognized prior to December 31, 2026) set forth in the proposed regulations, including numerous types of corporate reorganizations and partnership transactions. However, they essentially retained the principle that events or transactions that result in a reduction in a QOF owner’s direct investment in the QOF will result in the recognition of previously deferred gains. The final regulations also clarify a number of technical matters, such as the calculation of basis adjustments resulting from a variety of inclusion events, that are beyond of scope of this Alert. Taxpayers are urged to consult these rules carefully before engaging in a transaction that might have the effect of reducing their QOF investment.
QOZBs and QOZ Business Property. The final regulations address several matters impacting whether a QOF subsidiary qualifies as a QOZB, including whether property of a QOF/QOZB will meet the definition of QOZB Property for the purpose of the 90/70% investment standards.
Raw Land. The proposed regulations clarified that undeveloped land does not need to meet an original use or substantial improvement test in order to be QOZB Property. However, to ensure that undeveloped land is treated in a manner that is consistent with the OZ program’s principal goal of attracting investment capital to opportunity zones, the final regulations make clear that in order for land to be QOZB Property it must be both used in a trade or business and be “more than insubstantially improved” within 30 months after acquisition. The final regulations provide examples to illustrate these principals, including (A) the acquisition of vacant land that is merely paved and used as a parking lot which would not be QOZB Property because the land was not more than insubstantially improved, and (B) the acquisition of vacant land that is cleared, equipped with a new irrigation system, and used as a farm which would be QOZB Property due to the more significant improvements made.
Vacant Buildings. The final regulations significantly shorten the period during which an existing building or other structure needs to be vacant in order to satisfy the original use requirement for QOZB Property (i.e., If acquired by a QOF/QOZB such property will be deemed to be QOZB Property by virtue of having its “original use” in the opportunity zone notwithstanding that the structure already existed). Under the proposed regulations such a building/structure needed to have been vacant for at least five years in order to meet this requirement. Under the final regulations, the required vacancy period is shortened to: (A) one year for property that was vacant on the date that the tract in which it sits was designated as an opportunity zone; (B) three years for property that was not vacant at the time of designation as an opportunity zone; and (C) immediately in the case of property that is acquired from a local government which holds it as a result of an abandonment, foreclosure or other involuntary transfer. The regulations also now define vacancy to mean “significantly unused,” meaning that more than 80% of the property’s usable space is not being used.
Brownfield Properties. The final regulations provide that any real property located in a Zone that has been designated as a brown field site under federal law (i.e., CERCLA) will satisfy the original use requirement and meet the definition or QOZB Property.
Newly Constructed Buildings Acquired Before Being Placed in Service. The final regulations clarify that newly constructed buildings that are acquired by a QOF/QOZB prior to being placed in service in the opportunity zone (for purposes of depreciation or amortization)will satisfy the original use test and qualify as QOZB Property. A QOF/QOZB that wishes to acquire such a building will need to be careful to ensure that that the property has not been used in any way that would deem it to have been placed in service for tax purposes prior to the acquisition.
Substantial Improvement Rules. In order for property to meet the definition of QOZB Property, it either has to have its original use with the QOF/QOZB or be substantially improved by the QOZB. Several questions around the meaning of substantially improved have been addressed in the final regulations.
- Asset-by-Asset vs. Aggregation. Many commenters pointed out that the proposed regulations appeared to require that each individual asset held by a QOF/QOZB that did not pass the original use test had to be substantially improved in order to be QOZB Property; and that this asset-by-asset approach created many difficulties and complexities for investors. The final regulations allow, with some limitations, aggregation of assets when determining substantial improvement. In order to be aggregated, assets must be used in the same trade or business and must improve the functionality of the other property. The final regulations give an example of a hotel renovation to illustrate that the cost of new, or original use, assets such as linens, furniture and equipment can be used to calculate the substantial improvement of the hotel building itself.
- 30-month Substantial Improvement Period. The final regulations confirm that tangible property that is undergoing substantial improvement but has not yet been placed in service will be treated as QOZB Property (for purposes of the 70/90% asset test) for the 30-month substantial improvement period, so long as the QOF/QOZB has a reasonable expectation that the property will be substantially improved and used in a trade or business by the end of the 30-month period.
Working Capital Safe Harbor. Recall that the definition of a QOZB includes a requirement that not more than 5% of its assets be held in cash or other financial instruments, but excluding a reasonable amount of working capital. The proposed regulations provided details on this working capital safe harbor, including that the QOZB[1] have a written plan and schedule to deploy the working capital over a 31-month period and that the working capital actually be used in accordance with that plan. The final regulations make it clear that 31-month safe harbor periods may overlap as new capital comes into the business and the business plan continues to develop, so long as: (i) the total safe harbor period does not extend beyond 62 months; (ii) the subsequent cash infusion is independently covered by an additional working capital safe harbor; and (iii) the working capital for the subsequent cash infusion forms an integral part of the working capital plan that covered the initial cash infusion.
Active Trade or Business. QOZB Property must be “used in the trade or business of” a QOF or QOZB, with trade or business being defined with reference to Code Section 162. The final regulations include several clarifications regarding this term, including with regard to start-up businesses (clarifying among other things that property purchased or leased during the 62-month working capital safe harbor period will count as QOZB Property) and certain real estate operations, particularly with regard to triple net leases (clarifying that a QOZB may lease a portion of its real property on a triple net basis and still be deemed to be conducting an active trade or business).
Sin Businesses. Numerous commenters requested clarity on the definition of the so-called “sin businesses” which cannot qualify as a QOZB. The final regulations clarify that a QOF could own/operate a sin business because the statute does not expressly prohibit this as it prohibits a QOZB from owning/operating a sin business. However, given the disadvantages of having a QOF own/operate a business as opposed to a subsidiary QOZB, it is unlikely many QOFs will take advantage of this loophole. The final regulations also confirm that a QOZB cannot lease more than 5% of its property to a sin business as a way of circumventing this prohibition. Finally, Treasury and the IRS declined to provide more specific guidance on whether various types of businesses fit the definition of sin business or not. So while a liquor store is clearly a sin business, it is not entirely clear that a brewery or distillery that also sells product to retail customers from its manufacturing location would (or would not) be a prohibited sin business. Investors and their advisors will need to look at each situation carefully and make a judgment as to whether the QOZB’s business runs afoul of the sin business restriction.
Exiting a QOF Investment After 10 Years. The most important benefit available to taxpayers under the OZ program is the full exclusion of taxes on gains generated from appreciation in the value of a QOF investment held for more than 10 years. Under the statute and proposed regulations, the full benefits of this exclusion were only available for exit transactions that were structured in a limited number of ways – such as a sale of the equity of the QOF or in some cases the sale by a QOF of its ownership interest in a QOZB. These limitations exclude many of the structures typically used by real estate and other investors to exit investments, such as sales of assets by the operating company (the QOZB) and the subsequent distribution of proceeds to investors.
In response to many comments on these limitations, the final regulations provide investors with much more flexibility in structuring exit transactions in a way that will provide the most value for the assets to be disposed of and provide the full benefits of the OZ program. Some of the significant changes included in the final regulations are: (i) to permit a QOF to dispose of interests in its subsidiary QOZBs at different times, rather than all in a single transaction; (ii) to permit exclusion of gains from sales of assets by a QOZB where proceeds are distributed to the QOF investors; and (iii) to expand the exclusion to include all income generated by the disposal transaction. This includes, for example, 1231 gains and depreciation recapture, but does not include gains from the sale of inventory in the ordinary course of business.
There are numerous other technical provisions in the final regulations regarding the treatment of disposition transactions, including with regard to the determination of basis, the effect of various inclusion events on the availability of the 10-year exclusion, treatment of REIT distributions and others which are beyond the scope of this Alert. Needless to say, each exit transaction that intends for QOF investors to get the full benefit of the 10-year investment period will need to be looked at carefully at that time to ensure that it comports with the regulations and other guidance then available.
Conclusion
The final regulations issued by Treasury and the IRS in December 2019 added clarity to many of the issues causing concern to potential opportunity zone investors and their professional advisors, including many of the concerns around investing in an operating business. However, the fluid nature of an operating company, particularly a high-growth start-up or early stage business, make it far more difficult to anticipate the future developments that could impact the company’s ability to meet the QOZB definition during the long life of a QOF investment. Real estate and infrastructure development projects will continue to be far easier to analyze and structure and, for that reason, will likely continue to attract the lion’s share of QOF investments. Notwithstanding this, entrepreneurs seeking lower cost capital and investors looking for attractive tax structures will find ways to get comfortable making some QOF investments in operating businesses; partly on the assumption that regulators will, in future reviews and audits, continue to be supportive of investors and companies that make good faith efforts to comply with the letter and spirit of the OZ program and to bring much needed new capital investment to needy communities.
[1] Under the regulations, the working capital safe harbor is only available to QOZBs and not to QOFs. This, along with the 70% asset test for QOZBs versus 90% for QOFs, makes it preferable in most cases to use a two-tiered structure in which a QOF invests in a QOZB and the QOZB undertakes the project development or operating business.
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