New Qualified Opportunity Zone Regulations Provide Clarity for the Development of Real Property
Gibbons Corporate & Finance News - Legislative Tax Alert
June 21, 2019
In the short period since the Internal Revenue Service (“IRS”) released the second set of Qualified Opportunity Zone (“QOZ”) proposed regulations (the “New Regulations”) on April 17, 2019, QOZ activity has increased as investors have gained sufficient confidence to move capital into qualified opportunity funds (“QOFs”). The New Regulations provided much needed clarity in many areas, while leaving some questions unanswered. Much of the investment to date has been targeted towards real property, and that is the focus of this update.
Guidance on Real Estate Owned by a QOF
The New Regulations make clear that land can be treated as QOZ business property only if it is used in a trade or business of a QOF or a QOZ business conducted by a QOF’s subsidiary partnership or corporation. As clarified by Revenue Ruling 2018-29, the potentially challenging original use requirement does not apply to the land on which buildings are located, nor does the requirement to substantially improve the property (by spending 100% of basis within a 30-month period) include the value of the underlying land in its calculations. There is a similar exception to both the original use and the substantial improvement requirements for buildings that have been vacant for the previous five years, which may be acquired and treated as qualifying assets.
The holding of land merely for investment does not give rise to a trade or business that would qualify the property as a QOZ property or QOZ business property. This restriction was partly designed to prevent investors from buying and “hoarding” land in QOZs without actually developing the property into a revenue generating business or rental property that would increase the economic activity of the relevant low income census tract.
Related party restrictions on the source of qualifying property may still discourage a purchase of property by a QOF from a related party (using a tight 20% common ownership test), because any such property will not count as qualifying property in the numerator for purposes of a QOF’s 90% test to meet the QOZ property test or a subsidiary’s 70% test to meet its QOZ business property test.
Leasing May Provide Additional Flexibility
The New Regulations offer fairly favorable rules for leased property operated by a QOF or its subsidiary. For instance, improvements made by a lessee to leased property will satisfy the original use requirement and are considered purchased property for the amount of the unadjusted cost basis of such improvements.
More importantly, the New Regulations make clear that investors will be able to utilize existing owned property in QOZs by leasing it to a QOF in which they have an equity interest. Unlike tangible property that is purchased by a QOF or QOZ business, the New Regulations do not require leased tangible property to be acquired from an unrelated lessor – but several conditions apply. First, regardless of whether the lease is with a related party, the terms of the lease must be market rate as determined under Section 482 of the Internal Revenue Code (the “Code”). Second, a QOF or QOZ business may not at any time make a prepayment to the related lessor (or a person related to the lessor) with respect to a period of use of the leased tangible property that exceeds 12 months (this is to prevent indirect stripping of investment commitment made in a QOZ). There is also an anti-abuse rule to prevent the use of leases to circumvent the substantial improvement requirement for purchases of real property.
Logically, the value of leased property must be taken into account in both the numerator and the denominator of the 90% QOZ property test and the 70% QOZ business property test for subsidiaries of a QOF. The New Regulations provide that the value of leased property is determined based on the sum of the present values of the lease payments for the leased asset, using the appropriate applicable federal rate as a discount factor.
Of special relevance to lessors, for purposes of determining whether a leasing activity qualifies as the active conduct of a trade or business, the New Regulations provide 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. The New Regulations specifically state, however, that “merely entering into a triple-net-lease with respect to real property owned by a taxpayer is not the active conduct of a trade or business by such taxpayer.” Despite this apparent disqualification of triple-net-leases, recent statements from IRS officials and practitioners have indicated that a level of participation which falls short of the substantial Code Section 469 hours test for “material participation” may be sufficient for a triple-net-lease to constitute a trade or business of the landlord. At this stage, QOZ investors should proceed with caution when entering into triple-net-lease arrangements. The better play for a lessor that wants its leased property to qualify as QOZ business property or a QOZ business is to plan on and structure in a greater degree of management and operational activities with respect to the property.
Contribution of Low Value Property May Not Create a Problem
As referenced above, if a QOF acquires property from a more-than-20% related party, such property will not be treated as qualifying property and will therefore not be counted in the numerator for purposes of a QOF’s 90% test to meet the QOZ property test or a subsidiary’s 70% test to meet its QOZ business property test. But if the value of that related party property is relatively low, these limitations should be manageable.
As an example, consider a hypothetical taxpayer X who owns vacant land in a QOZ, with a current market value of $3 million. X and Y form a QOF, with each contributing $6 million in cash rolled over from qualifying capital gains. The QOF contributes the entire $12 million of cash to a new partnership AB, which will be the QOZ business, and X also separately contributes the vacant land worth $3 million for a separate proportionate interest in partnership AB. AB uses all of the cash within 31 months to build a parking deck on the land, which it then operates as a QOZ business.
Under the New Regulations, for purposes of running the 90% and 70% tests, the value of owned assets is based on the QOF’s applicable financial statement, or alternatively, the cost basis of the asset. With a book or cost value of $12 million for the parking deck and a book value of $3 million for the land, qualifying assets will represent 80% of the value of the QOZ business ($12 million / $15 million) and partnership AB will qualify under the 70% tangible asset test. If the cost adjusted basis of the land is even less than $3 million (upon contribution by X, X’s historical cost basis for the land should carry over to AB), the margin of compliance with the 70% test would only increase.
From this example, one can see that taxpayers who wish to contribute relatively low value property located in an opportunity zone to a QOF should be able to do so with a subsidiary entity of a QOF, where it would not count in the numerator of the 70% QOZ business property test, but would have a limited impact because of its low impact on the denominator.
Debt-Financed Distributions Should Largely be Tax-Deferred
Real estate projects such as rental residential or commercial properties typically refinance their debt once the project has stabilized, permitting the paying off of acquisition and construction loans and the distribution of excess cash. Outside of the QOF context, investors would not normally recognize gain upon such distributions because their basis in the JV partnership will include their share of partnership liabilities and the distribution likely would not exceed that basis. The OZ statute states that an investor’s basis in its QOF interest is initially zero, which would appear to prevent debt refinancing to generate partner basis. Fortunately, the New Regulations offer positive guidance with respect to the refinancing of real estate ventures in QOZs.
The New Regulations provide that an investor’s outside basis in a QOF partnership interest is increased by the investor’s share of that QOF partnership’s liabilities, including liabilities which are allocated to the QOF by a subsidiary partnership. This basis increase should be enough to allow investors to avoid gain recognition on a QOF’s distributions funded by a refinancing upon stabilization.
There are, however, two important limitations with respect to these rules. First, if a distribution would be characterized as a disguised sale under Code Section 707, the investors must recognize gain on that distribution. For the purposes of this rule, any cash contributed by the investor is treated as non-cash property and is therefore subject to the disguised sale rules, and the exception to disguised sales for leveraged distributions is denied. Practically, what this means for investors is that leveraged distributions made within the first 2 years of the initial contributions would trigger gain recognition as disguised sales, but those made after the 2-year mark should be clear of this rule.
Second, if one or more partners in a QOF partnership holds a mixed-funds investment (i.e., a portion of their investment consisted of qualifying capital gain, but some did not), part of a distribution might be taxable. Specifically, the New Regulations adopt the approach that a partner holding a mixed-funds investment will be treated as holding a single partnership interest with a single basis and capital account for all purposes of subchapter K (partnership taxation), but not for purposes of the QOZ rules. Under the QOZ rules, the mixed-funds investor will be treated as holding 2 interests, which must be tracked separately. For QOZ tax purposes, the allocation of income, debt, losses and distributions are generally based on relative capital contributions between qualifying investments and other investments. Under this rule, a mixed funds investor who receives distributions in excess of his overall basis is not allowed to allocate the excess distribution to his non-qualifying investments, but rather must treat the excess as a pro rata (in proportion to the relative FMV of capital contributions) redemption of his qualifying QOZ investments as well as his non-qualifying investments. Because of the low basis in the QOZ qualifying portion, a distribution with respect to that portion will likely be taxable.
We would be happy to talk with current and potential clients who have questions on the New Regulations and on QOZs in general, including rolling over gain into a QOF, setting up QOFs, and structuring QOZ investments for maximum flexibility in meeting the statutory requirements.