Opportunity Zone Update – IRS Releases Second Set of Proposed Regulations
Gibbons Corporate & Finance News - Legislative Tax Alert
April 26, 2019
On April 17, 2019, the Internal Revenue Service (“IRS”) released the second set of Qualified Opportunity Zone (“QOZ”) proposed regulations (the “New Regulations”). The New Regulations provide answers to many unresolved questions, as well as needed definitions where uncertainties were impeding investment into QOZs, particularly with respect to QOZ businesses. The guidance also addresses issues relating to the operation of qualified opportunity zone funds (“QOFs”).
This update highlights a few of the more impactful provisions of the New Regulations.
Original Use of Property (the “Original Use Test”)
The New Regulations clarify that the required original use of tangible property acquired by purchase commences when it is placed in service by any person in a QOZ for the purposes of depreciation or amortization. Therefore, tangible property located in a QOZ that had been depreciated by a taxpayer other than the QOF or QOZ business would not satisfy the original use requirement, but could satisfy the substantial improvement test. Used tangible property will satisfy the original use requirement with respect to a QOZ as long as the property has not been previously used within that QOZ in a manner that would have allowed it to be depreciated or amortized by any taxpayer. Of interest to taxpayers with longstanding property holdings in QOZs, a purchased building which was previously placed in service will meet the original use requirement if it has been vacant for at least 5 years before being purchased by a QOF or a QOZ business.
The New Regulations offer a great degree of parity between owned and leased property. First, 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. In addition, leased tangible property may be treated as QOZ business property for purposes of satisfying the 90% asset test for QOZ property if: (i) the lease is entered into after December 31, 2017 and (ii) substantially all of the use of the leased tangible property is in a QOZ during substantially all of the period for which the business leases the property. Critically, there is no original use requirement with respect to leased tangible property, nor is there a requirement to “substantially improve” such property.
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. Finally, with respect to tangible personal property leased from a related person, if the original use of such property does not commence with the lessee, the lessee must become the owner of tangible property that is QOZ business property having a value not less than the value of the leased tangible personal property. Therefore, the QOF or QOZ business must become the owner of at least as much other tangible property as tangible personal property that it leases from a related person. There is also an anti-abuse rule to prevent the use of leases to circumvent the substantial improvement requirement for purchases of real property.
Of special relevance to lessors, for purposes of whether an activity qualifies as the active conduct of a trade or business for purposes of the QOZ regulations, 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.”
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 subsidiary partnership or corporation. The holding of land for investment does not give rise to a trade or business, so that such land could not be QOZ business property. Again, the New Regulations provide that acting as a lessor on a triple-net-lease with respect to real property is not the active conduct of a trade or business.
QOZ Businesses – Active Conduct of a Qualified Trade or Business
The New Regulations provide guidelines with respect to whether a corporation or partnership held by a QOF derives at least 50% of its gross income from the active conduct of a qualified business within a QOZ, through 3 alternative safe harbors and a facts and circumstances test.
- The first safe harbor requires that at least 50% of the services performed (based on hours) by the QOZ business’s employees and independent contractors are performed within the QOZ.
- The second safe harbor, based on amounts paid for the services performed, requires that at least 50% of the services performed for the QOZ business by its employees and independent contractors are performed in the QOZ.
- This second safe harbor may be particularly relevant to startups that have high-paid employees in a QOZ and lesser-paid sales staff or call-center operators at other locations.
- The third safe harbor relies upon both property and management or operational functions, and requires that: (i) the tangible property of the business that is in a QOZ and (ii) the management or operational functions performed for the business in the QOZ are each necessary to generate at least 50% of the gross income.
- Finally, taxpayers may also qualify if, based on a facts and circumstances test, at least 50% of the gross income of a trade or business is derived from the active conduct of a trade or business in the QOZ.
Inclusion Events – Triggering a Reduction or Termination of QOZ Benefits
The New Regulations enumerate a detailed non-exclusive list of events which will trigger the inclusion of the deferred capital gain on the taxpayer’s original investment which was sold to fund the QOF. These events also reduce or terminate the QOF investor’s qualifying investment (and thus preclude tax-free appreciation), and include:
- Taxable dispositions of qualifying interests;
- Transfers of interests in an S corporation that is a QOF owner if there is a more than 25% aggregate ownership change in the S corporation;
- Distributions to a partner of a QOF partnership of property that has a value in excess of basis of the partner’s qualifying QOF partnership interest;
- Distributions of property with respect to qualifying QOF stock under Section 301 to the extent treated as gain from the sale or exchange of property under section 301(c)(3);
- Liquidations of QOF corporations under Sections 331 and 332;
- Gifts, but not most transfers by death; and
- Charitable contributions of qualifying investments.
The New Regulations also provide for exceptions to what might otherwise be inclusion events, including certain disregarded transfers. Transfers to grantor trusts are not inclusion events because, for federal income tax purposes, the owner of the grantor trust is treated as the owner of the property held in trust. The same logic applies to transfers to entities which are disregarded for federal income tax purposes. Acquisitive asset reorganizations described in Code Section 381(a)(2) and spin-off distributions under Code Section 355 are generally not inclusion events, as long as the successor corporation, or both the distributing and the controlled corporation, respectively, are QOFs immediately afterwards (except to the extent of boot received, which is treated as an inclusion event).
Additional Clarifications Promulgated in the New Regulations
- If a taxpayer has held a qualifying investment in a QOF partnership or QOF S corporation for at least 10 years, such that the gain on a sale of the taxpayer’s interest in the QOF would not be subject to tax, and the partnership or S corporation disposes of QOZ property, the taxpayer may make an election to exclude from gross income part or all of the allocated capital gain reported on the taxpayer’s Schedule K-1. Note that this election does not appear to apply to gain recognized through a sale of QOZ business property by a lower tier entity.
- The New Regulations introduce a one-year rule to allow QOFs to reinvest the proceeds from the distribution, sale, or disposition of QOZ property during a 12-month period beginning on the date of such distribution, sale, or disposition before they are included with respect to meeting the semiannual 90% asset test. (This relief for reinvestment does not prevent the taxation of gain recognized on the distribution, sale, or disposition of the QOZ property). Similar to the prior item, this reinvestment rule does not apply to sales by a lower-tier entity that sells its assets.
- The New Regulations introduce a helpful delay for newly contributed assets with respect to meeting the semiannual 90% asset test, allowing a QOF to choose to apply the test without taking into account contributed cash or property received in the preceding 6 months, provided that the new assets are held in cash, cash equivalents, or debt instruments with a term of 18 months or less.
- The first set of proposed regulations reserved the meaning of the phrase “substantially all” in four of the five places where it is used in the QOZ statute. The New Regulations supply these definitions, including with respect to holding periods, property used in the QOZ, and owned or leased property held in a QOZ. The New Regulations also clarify that substantial improvement of tangible property that is purchased is determined on an asset-by-asset basis.
The New Regulations provide numerous helpful examples which will assist taxpayers in complying with the new rules. The IRS is asking for commentary on many items, including several of the more complex proposed regulatory structures, so taxpayers may expect further changes when the final regulations are released. In the meantime, taxpayers are generally permitted to rely on the proposed regulations in their current form, as long as they are applied consistently and in their entirety.
We would be happy to talk with current and potential clients who have questions on the New Regulations and on QOZs in general, including setting up of QOFs, rolling over gain into a QOF, and structuring QOZ investments for maximum flexibility in meeting the statutory requirements.
A prior Gibbons Corporate & Finance News – Legislative Tax Alert regarding the first set of proposed regulations can be found here.