On April 17, 2019, the US Internal Revenue Service (IRS) issued its second set of proposed regulations (the April Regulations) regarding the new "qualified opportunity zone" (QOZ) tax incentives that were enacted in December 2017 as part of the Tax Cuts and Jobs Act (Tax Act). Although the first set of proposed regulations, issued on October 19, 2018 (the October Regulations), provided much-needed guidance with respect to the new tax incentives1, a number of significant open issues and questions remained. The April Regulations address several of these items.
OVERVIEW OF QOZ LEGISLATION
As discussed in more detail in a previous Arnold & Porter Advisory, under the Tax Act, taxpayers who invest through special vehicles known as "qualified opportunity funds" (QOFs) in certain economically distressed areas across the United States that have been designated as QOZs are entitled to the following three tax incentives:
- Temporary deferral of taxable capital gain from the disposition of property to the extent invested in a QOF within 180 days. The deferred gain must be recognized on the earlier of (1) the date the QOF investment is "disposed of" and (2) December 31, 2026.
- Elimination of 10 to15% of the deferred gain if the taxpayer holds the QOF investment for at least five to seven years.
- Permanent elimination of gain on any post-acquisition appreciation with respect to a QOF investment held by the taxpayer for at least 10 years.
To qualify as a QOF, at least 90% of the QOF's assets must consist of QOZ Property (the 90% Test). QOZ Property includes (1) certain tangible property located in a QOZ (QOZ Business Property) and (2) certain equity interests in a corporation or partnership (QOZ Subsidiary).
QOZ Business Property is tangible property that satisfies the following requirements:
- The QOF acquires the property by purchase from an "unrelated" person after December 31, 2017.
- The QOF uses the property in a trade or business.
- Either the "original use" of the property in the QOZ commences with the QOF or the QOF "substantially improves" the property.
- During "substantially all" of the QOF's holding period for the property, "substantially all" of the property's use is in a QOZ.
A QOZ Subsidiary is a corporation or partnership that satisfies the following requirements:
- The QOF acquires its equity interest in the corporation or partnership after December 31, 2017.
- During "substantially all" of the QOF's holding period for its equity interest in the corporation or partnership, the corporation or partnership is a "QOZ Business," i.e., (1) "substantially all" the tangible property owned or leased by it is QOZ Business Property (by applying the requirement for qualifying as QOZ Business Property at the level of the QOZ Subsidiary rather than the QOF), (2) at least 50% of its gross income is derived from the active conduct of a trade or business and (3) less than five percent of the average of its properties' aggregate bases is attributable to certain "financial assets."
Below is an overview of several significant points addressed by the April Regulations. Although the April Regulations are not effective until finalized, investors and QOFs generally are permitted to rely on them immediately (subject to certain significant exceptions, discussed below), provided they apply them consistently and in their entirety.
Eligible QOF Investments
The April Regulations clarify that a taxpayer can make an eligible QOF investment either by (1) investing cash or other property in a QOF directly, or (2) acquiring an interest in a QOF from another investor. In contrast, a QOF interest acquired in exchange for services (such as a carried interest) is not an eligible QOF investment, and does not qualify for tax incentives under the QOZ regime.
Exit Under the 10 Year Rule
The April Regulations provide taxpayers with greater flexibility to structure their exit from a QOF. As noted above, one of the tax incentives of the QOZ regime is the permanent elimination of gain on any post-acquisition appreciation with respect to a QOF investment held by a taxpayer for at least 10 years.The Tax Act indicated that a taxpayer would be required to sell its entire equity interest in the QOF after 10 years in order to benefit from the foregoing tax incentive. This type of exit would make it difficult for a QOF to hold multiple properties. The April Regulations, however, permit an investor with a 10 year or greater holding period in a QOF (that is established as a partnership or S corporation) to exclude from the investor's gross income some or all of the investor's allocable share of the capital gain from the disposition of the QOF's QOZ Property. This exclusion does not apply to ordinary income from depreciation recapture, which may cause some QOFs to continue to plan an exit as a sale of equity interests in the QOF. However, in some cases, this relief will allow investors to structure their exit from a QOF through separate sales of the QOF's QOZ Property. However, unlike most of the April Regulations which can be relied on immediately, this rule is not effective, and cannot be relied on, until finalized.
Reinvestments Under the 90% Test
The 90% Test is applied on an annual basis, by measuring the percentage of the QOF's QOZ Property at the end of each six-month period of the QOF's taxable year, and averaging the two amounts. The April Regulations helpfully provide that proceeds received by a QOF from the sale or disposition of QOZ Property will themselves be treated as QOZ Property for purposes of the 90% Test if (1) the QOF reinvests such proceeds within 12 months (except that any failure to satisfy this requirement on account of a delay in governmental action with respect to an application completed by the QOF before the end of such 12-month period will be disregarded), and (2) the proceeds are continuously held in cash, cash equivalents or debt instruments with a term of 18 months or fewer. As a result of this rule, a QOF that sells its QOZ Property shortly before the semi-annual testing dates will have a reasonable period of time to bring itself into compliance with the 90% Test.
Definition of "Substantially All"
The phrase "substantially all" is used several times throughout the legislation; however, it is not defined. The April Regulations clarify that any reference to "substantially all" in the context of a holding period means 90%, whereas any other references mean 70%. Accordingly, to qualify as (1) QOZ Business Property of a QOF, during 90% of the QOF's holding period for such property, 70% of the use of such property must be in a QOZ; and (2) a QOZ Subsidiary of a QOF, during 90% of the QOF's holding period for its equity interest in such subsidiary, 70% of such subsidiary's tangible property must be QOZ Business Property.
In order for property to qualify as QOZ Business Property, the "original use" of such property in the QOZ must commence with the QOF or the QOF must "substantially improve" the property. The April Regulations clarify that, as a general rule, the "original use" of tangible property acquired by purchase commences when the property is first placed in service in the QOZ for purposes of claiming depreciation or amortization deductions. As an exemption from the general rule, however, property (such as a building) that is vacant for at least five years prior to being purchased by a QOF or QOZ Business will be deemed to satisfy the "original use" requirement.
The April Regulations provide favorable rules for leased property. Specifically, the April Regulations clarify that, although the legislation implies that QOZ Business Property must be acquired by "purchase," leased property nevertheless will also qualify as QOZ Business Property so long as (1) the lease is entered into after December 31, 2017, (2) the lease reflects arm's length terms and (3) during "substantially all" (i.e., 90%) of the QOF's holding period for the leased property, "substantially all" (i.e., 70%) of the property's use occurs in a QOZ. Leased property generally does not need to satisfy the "original use" test or "substantial improvement" test to qualify as QOZ Business Property. In addition, leased property can be acquired from a related party; however, in such case, additional requirements must then be satisfied
50% Gross Income Test
In order for a business to qualify as a QOZ Business, 50% of its gross income must be derived from the active conduct of a trade or business in a QOZ. The April Regulation provide that a business will meet the 50% threshold if it satisfies either of the following safe harbors:
- At least 50% of the services performed for the business by its employees and independent contractors are performed within a QOZ, determined based on (i) hours of services performed, (ii) amounts paid by the business for services performed.
- the tangible property of the business that is located in a QOZ and the management or operational functions of the business that are performed in a QOZ are each necessary to generate 50% of the business's gross income.
A QOZ Business that does not meet one of these safe harbors nevertheless may meet the 50% threshold if it can show, based on all the facts and circumstances, that at least 50% of the gross income of a trade or business is derived from the active conduct of a trade or business in a QOZ.
The April Regulations also clarify that the ownership and operation of real property, including the leasing of real property (other than a triple net lease), will be treated as the "active conduct of a trade or business" for purposes of the 50% gross income test.
Inclusion of Gain
As noted above, one of the tax incentives of the QOZ regime is the temporary deferral of taxable gain from the disposition of property to the extent invested in the QOF within 180 days. The deferred gain must be recognized on the earlier of the date the QOF investment is disposed of (an Inclusion Event) and December 31, 2026. The April Regulations provide guidance as to what events constitute an Inclusion Event. An Inclusion Event generally includes, among other things, (1) any transfer of a QOF interest that reduces the investor's equity interest in the QOF, (2) gifts of a QOF interest, unless the interest is gifted to a trust that is treated as a grantor trust of which the investor is the deemed owner for US federal income tax purposes, (3) a non-dividend distribution by a QOF corporation in excess of the investor's tax basis in its QOF stock, and (4) a distribution by a QOF partnership in excess of the investor's tax basis in its QOF partnership interest.
Note that, under the QOZ regime, an investor that defers gain by investing in a QOF generally is treated as having an initial tax basis of zero in the QOF. However, the April Regulations clarify that basis adjustments taken into account in the partnership context in connection with partnership liabilities also should be taken into account for purposes of determining an investor's tax basis under the QOZ regime. Under the partnership tax rules, a partner's tax basis in its partnership interest generally is increased by its share of partnership liabilities. Accordingly, an investor that is allocated a portion of any partnership liabilities upon investing in a partnership QOF will have an initial tax basis greater than zero.
Gifts and Bequests
As noted above, a transfer of an investor's interest in a QOF by gift generally will constitute an Inclusion Event, thereby requiring the investor to include its deferred gain in income, unless the interest is gifted to a trust that is treated as a grantor trust of which the investor is the owner for US federal income tax purposes. The April Regulations clarify that a bequest of a QOF interest upon death is not treated as an Inclusion Event. However, the recipient of such a QOF interest is required to include the deferred gain in its income upon a subsequent Inclusion Event.
1 The October Regulations are discussed in a previous Arnold & Porter Advisory.
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.