On December 19, 2019, the IRS and Treasury issued final regulations on the Opportunity Zone program. The Opportunity Zone program is intended to encourage investments in economically distressed qualified opportunity zones (QOZs) by allowing taxpayers to defer and, in some cases, reduce or eliminate tax on capital gains if they reinvest their gains within 180 days in qualified opportunity funds (QOFs), which, in turn, generally are required to invest at least 90% of their assets in (1) certain business property located in a QOZ (QOZ Business Property) and/or (2) equity in certain entities that hold QOZ Business Property (QOZ Subsidiaries and, together with QOZ Business Property, QOZ Property).
The IRS and Treasury previously issued two sets of proposed Opportunity Zone regulations. The final regulations largely follow the proposed regulations but include a number of taxpayer-friendly changes in response to comments received.
II. Overview of the Opportunity Zone Program
A. In General
Under the Opportunity Zone program, if a taxpayer realizes capital gain on a sale of appreciated assets to an unrelated person and reinvests the capital gain in a QOF within 180 days of the date that the taxpayer would otherwise recognize the gain for U.S. tax purposes, then the following tax incentives are available to the taxpayer:
- Tax Deferral. The taxpayer may elect to defer tax on the gain until the earlier of (1) the date that the taxpayer disposes of the QOF and (2) December 31, 2026 (collectively, the First Recognition Date).
- Tax Reduction. The amount of gain
that the taxpayer is required to recognize on the First Recognition
Date is reduced by:
- 10% if the taxpayer has, at that time, held the QOF for at least five years, or
- 15% if the taxpayer has, at that time, held the QOF for at least seven years.
In addition, the amount of any gain that the taxpayer is required to recognize if the taxpayer disposes of the QOF after December 31, 2026 (the Second Recognition Date) is reduced by:
- any gain that the taxpayer recognized on the First Recognition Date, and
- (x) 10% of the originally deferred gain if the taxpayer has, as
of the Second Recognition Date, held the QOF for at least five
years, or (y) 15% of the originally deferred gain if the taxpayer
has, as of the Second Recognition Date, held the QOF for at least
- Tax-Free Appreciation. Finally, if the taxpayer has held the QOF for at least 10 years on the Second Recognition Date, then the taxpayer is not required to recognize any gain on a subsequent sale of (1) the QOF, (2) assets directly owned by the QOF, or (3) assets owned by a QOZ Subsidiary in which a QOF invests. This rule applies on an investor-by-investor basis.
For purposes of these rules, if an investor disposes of a QOF and reinvests in another QOF within 180 days, the investor cannot "tack" its original holding period; instead, its holding period with respect to the second QOF begins on the date of its investment in the second QOF.
B. Qualified Opportunity Funds
1. In General
At the heart of the Opportunity Zone program is the concept of QOZs, which are low-income census tracts nominated by governors and certified by the Treasury Department.
An entity that is organized in the United States or a U.S. possession and is treated as a corporation or partnership for U.S. tax purposes generally is eligible to be a QOF if at least 90% of its assets consists of QOZ Property.
2. 90% Asset Test
The 90% asset test is a semi-annual test based on the average of the percentage of QOZ Property that the QOF holds. In addition, if the QOF fails to satisfy the asset test at the end of any one month, it is subject to a penalty equal to (1) the excess of 90% of its assets over the amount of its QOZ Property, multiplied by (2) the federal short-term rate plus 3%, unless the failure is due to reasonable cause.
A QOF generally must determine the value of its assets by reference to financial statements that the QOF files with the U.S. Securities and Exchange Commission or another U.S. federal agency, or other audited financial statements that are prepared in accordance with U.S. GAAP. If the QOF does not have any such financial statements, then it must use the cost of its assets.
The final regulations include the following taxpayer-favorable rules for purposes of applying the 90% asset test:
- Sale Proceeds Treated as QOZ Property. Proceeds received by a QOF from the sale or disposition of QOZ Property are, themselves, treated as QOZ Property, so long as the QOF reinvests the proceeds within 12 months of the sale or disposition and, in the interim, the proceeds are continuously held in cash, cash equivalents, or debt instruments with a term of 18 months or less.
- Relief for Newly Contributed Assets. A QOF can apply the 90% asset test without taking into account assets contributed to it in the preceding six months, so long as the assets are held in cash, cash equivalents, or debt instruments with a term of 18 months or less.
3. QOZ Business Property
As mentioned above, QOZ Property includes QOZ Business Property and equity interests in QOZ Subsidiaries. Tangible property generally qualifies as QOZ Business Property if:
- the property is used in a trade or business;
- the QOF or a QOZ Subsidiary acquires the property from an unrelated person after 2017;
- the property's original use commenced with the QOF or a QOZ Subsidiary, or the QOF or a QOZ Subsidiary substantially improved the property; and
- at least 70% of the use of the property is in a QOZ during at least 90% of the QOF's or QOZ Subsidiary's holding period.
For this purpose, a QOF or QOZ Subsidiary generally is treated as having "substantially improved" property if, within 30 months of acquiring the property, its capital expenditures with respect to the property exceed its cost basis in the property. The final regulations include the following taxpayer-favorable rules for purposes of determining whether property has been substantially improved:
- Cost Basis of Land Disregarded. If a QOF or QOZ Subsidiary purchases an existing building located on land within a QOZ, then (1) the substantial improvement test applies only with respect to the cost basis attributable to the building (and the cost basis attributable to the land is disregarded), and (2) if the substantial improvement test is satisfied, then the entire cost basis (including cost basis attributable to the land), as well as the cost of the improvements, qualify as QOZ Business Property.
- Aggregation of Improvements. Improvements to buildings on contiguous parcels, or buildings located on a single parcel, can be aggregated, so long as (1) each building receives some improvement, (2) the buildings are operated exclusively by one QOF or QOZ Subsidiary, (3) the properties share common business elements (such as human resources or accounting), and (4) the properties have a common or interdependent trade or business.
- Inclusion of Assets. The cost of new assets can apply toward the substantial improvement test, so long as (1) the rehabilitated building and the new assets are used in the same trade or business in the QOZ or a contiguous QOZ and (2) the new assets improve the functionality of the building. For example, the purchase of new furniture for an old hotel would qualify as a capital expenditure toward the improvement of the hotel.
- No Substantial Improvement Requirement for Vacant Land. A property's original use is treated as having commenced with a QOF or QOF Subsidiary (so that substantial improvement is not required) if either (1) the property was vacant for one year when the applicable census tract was designated a QOZ, or (2) the property was not vacant at the time of designation, but was vacant for three years before the QOF or QOZ Subsidiary acquired the property.
4. QOZ Subsidiaries
An entity generally qualifies as a QOZ Subsidiary if:
- the entity is treated as a domestic corporation or domestic partnership for U.S. tax purposes;
- the QOF acquired equity interests in the entity from the entity, solely in exchange for cash, after 2017; and
- both at the time that the QOF acquired the equity interests, and for substantially all of the QOF's holding period, the entity was engaged in a qualified opportunity zone business (a QOZ Business).
A QOZ Subsidiary generally is treated as being engaged in a QOZ Business if:
- at least 70% of the tangible property that the QOZ Subsidiary owns or leases is QOZ Business Property;
- at least 70% of the use of any leased tangible property is in a QOZ during at least 90% of the period for which the QOZ Subsidiary leases the property;
- at least 50% of the QOZ Subsidiary's gross income is from the active conduct of the business;
- at least 40% of the QOZ Subsidiary's intangible property is used in a way that is "normal, usual, or customary" to the business and is used within the QOZ in a way that contributes to the business' gross income;
- less than 5% of the average of the aggregate unadjusted bases of the QOZ Subsidiary's property is attributable to "nonqualified financial property" (i.e., debt, stock, partnership interests, options, futures contracts, forward contracts, warrants, notional principal contracts, annuities, and other similar property, other than reasonable amounts of working capital held in cash, cash equivalents, or debt instruments with a term of 18 months or less, or accounts receivable acquired in the ordinary course of a trade or business); and
- the QOZ Subsidiary's trade or business does not comprise certain "sin businesses."
The final regulations include the following taxpayer-favorable rules for purposes of applying these rules:
- Working Capital Safe Harbor. As
mentioned above, the code generally limits a QOZ Subsidiary's
ability to hold certain "nonqualified financial
property." Under a regulatory safe harbor, a QOZ
Subsidiary may exclude working capital (i.e., cash, cash
equivalents, and debt instruments with a term of 18 months or less)
from the definition of "nonqualified financial assets,"
so long as:
- the working capital is designated in writing for the acquisition, construction, and/or substantial improvement of tangible property in a QOZ or for the development of a trade or business in a QOZ,
- there is a written schedule consistent with the ordinary start-up of a trade or business for the expenditure of the working capital within 31 months of receipt, and
- the working capital is actually used in a manner that is substantially consistent with the written designation and schedule.
Moreover, the final regulations allow an additional 31-month exclusion (up to a maximum period of 62 months), provided that each 31-month period satisfies the above requirements and the periods are part of an integral plan.
Any tangible property that is being acquired, constructed, and/or substantially improved with this working capital and that is expected to qualify as QOZ Business Property by the end of the 31-month safe harbor period generally qualifies as QOZ Business Property that is used in the active conduct of a trade or business during that period.
- 50% Gross Income Test Safe
Harbor. A QOZ Subsidiary must derive at least
50% of its total gross income from the active conduct of a trade or
business within a QOZ. The regulations provide three safe harbors
for satisfying this requirement:
- Hours safe harbor: At least 50% of the total number of hours spent during a taxable year by the QOZ Subsidiary's employees and independent contractors in performing services is spent within a QOZ.
- Amounts paid safe harbor: At least 50% of the total amount paid by a QOZ Subsidiary for employee and independent contractor services is for services performed within a QOZ.
- Conjunctive test: The tangible property located in a QOZ and the management or operational functions performed in the QOZ are each necessary to generate at least 50% of the QOZ Subsidiary's gross income.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.