On January 13, 2020, the Treasury Department and the Internal Revenue Service published final regulations (the “Final Regulations”) regarding “Qualified Opportunity Zones” (“QOZs”) and “Qualified Opportunity Funds” formed to invest in QOZs (“QOFs”). The first set of proposed regulations, released on October 19, 2018, contained helpful guidance but left numerous lingering issues and unanswered questions. A second set of proposed regulations, released on April 17, 2019 (together with the first set of proposed regulations, the “Proposed Regulations”), provided relief to QOFs and their investors and clarified the manner in which QOFs may be structured. The Final Regulations largely adopt the Proposed Regulations; most of the changes and additions made by the Final Regulations are clarifying in nature. A few of the changes, however, are significantly favorable to investors, which reflects the government’s continuing commitment to facilitate broad investment in QOFs by eligible investors. This note provides a detailed analysis of the most important clarifications and changes made by the Final Regulations, specifically focusing on those changes that will make it easier for investment vehicles to qualify as QOFs and for investors to make qualifying investments in QOFs.
Part I—Tax Benefits Derived from Investing in QOFs
Overview of Tax Benefits
A “qualifying investment” in a QOF is an equity interest in a QOF that has been acquired for cash (or property, subject to certain limitations) with respect to which the investor has made an election to defer eligible capital gain that would otherwise be recognized no more than 180 days before the day the interest in the QOF was acquired. An eligible investor may obtain three types of federal income tax benefits as a result of its qualifying investment in a QOF:
- a temporary deferral of any eligible gains invested into a QOF so long as such gains are invested within the 180-day investment period and the investor makes the gain-deferral election;
- if the investor holds its qualifying investment for at least 5 years, the tax basis of the qualifying investment is increased on the fifth anniversary of the investment by 10 percent of the amount of gain initially invested in the qualifying investment, and if the investor holds its qualifying investment for at least 7 years, the tax basis of the qualifying investment is increased on the seventh anniversary of the investment by an additional 5 percent of the amount of such gain; however, these basis increases apply only if the relevant anniversary occurs before December 31, 2026 and only to the extent the deferred gain has not already been recognized. Thus, for qualifying investments made in 2020 or 2021, only a 10 percent basis increase (and not a 15 percent increase) will be available; and
- if the investor holds its qualifying investment for 10 years or more, the investor may elect for the basis of such qualifying investment to be equal to its fair market value on the date such interest is sold or exchanged (the “FMV Basis Election”) and thus generally will not recognize gain on the sale of its qualifying investment 10 years or more after it acquired such interest.
Sale of Interests in a QOF Partnership does not Trigger Depreciation Recapture or Other Ordinary Income Items
The Final Regulations clarify that, if an investor in a QOF that is taxed as a partnership (i.e., a QOF partnership) makes the FMV Basis Election upon its sale of QOF interests after 10 years:
- the investor’s basis in its qualifying investment in the QOF is adjusted immediately before the investor sells or exchanges such interest so that its basis equals the greater of (1) the investor’s allocable share of the non-recourse debt of the QOF partnership and (2) the sum of the fair market value of such interest and the investor’s share of the QOF partnership’s liabilities under section 752, and
- the bases of the QOF partnership’s assets, and the assets of any partnership in which the QOF partnership holds an interest, are also adjusted, solely with respect to such investor, in a manner similar to the adjustments that would have been made to the QOF partnership’s assets if the investor had purchased the interest for cash equal to fair market value at the effective time of the FMV Basis Election and such partnerships had a valid section 754 election in effect.
The effect of these rules is to eliminate any gain upon the investor’s sale or exchange of a qualifying investment after a 10-year holding period, regardless of whether the investor has used net losses allocated by the QOF partnership and whether the investor has received substantial leveraged distributions from the QOF partnership. Under the Proposed Regulations, it was unclear whether the IRS might interpret the rules to require the inclusion by the investor of ordinary income with respect to depreciation that had been taken by a partnership in which the QOF partnership held an interest.
Investors in QOF Partnerships Who Have a Holding Period in Excess of 10 Years now Generally Allowed to Benefit from the Gain Elimination Provision where QOF or QOZB (or Other Lower-Tier Partnership) Sells Underlying Assets
The Final Regulations expand the reach of the 10-year gain elimination provision by providing that when a QOF partnership (directly or indirectly through a partnership in which the QOF partnership holds an interest) recognizes gain from the sale of any property (other than inventory sold in the ordinary course of business), any investor in the QOF partnership who has held a qualifying investment in such QOF partnership for more than 10 years can make an election to eliminate the gain attributable to the investor’s qualifying investment. In order to benefit from such gain elimination, the property that is sold does not need to be qualified opportunity zone property (“QOZP”), the gain that is recognized does not need to be capital gain, and, if a lower-tier partnership sells the property and allocates gain to the QOF partnership, the lower-tier partnership does not need to qualify as a qualified opportunity zone business (“QOZB”). The investor’s election to exclude such gain applies to all of the gains and losses (other than from dispositions of inventory in the ordinary course of business) allocable to the investor from the QOF partnership (including gains and losses of lower-tier partnerships) during the year to which the election relates. To the extent the QOF partnership directly or indirectly reinvests or retains the electing investor’s share of the net proceeds from any such sale during such year, that portion of the investor’s investment in the QOF partnership will become a non-qualifying investment (and thus ineligible for the benefits of the QOZ regime). Specifically, the QOF partnership is treated as distributing to the electing investor its share of net proceeds from the asset sales on the last day of the QOF’s taxable year. Immediately after the deemed distribution, the electing investor is treated as recontributing the amount received in exchange for a non-qualifying investment. The QOF partnership is treated as retaining or reinvesting the electing investor’s share of the net proceeds, except to the extent it makes an actual distribution of sales proceeds to the investor within 90 days of the asset sale.
The Final Regulations are more taxpayer-favorable than the Proposed Regulations insofar as the Proposed Regulations only allowed investors to exclude capital gain from the disposition of QOZ property by the QOF partnership. As a result, under the Final Regulations, a direct disposition by the investor of its qualifying investment in the QOF partnership after 10 years generally would not be more advantageous to the investor than a sale by the QOF of the assets it holds directly and indirectly. A fund platform composed of multiple side-by-side QOF partnerships, however, still allows the investors in the platform to recognize losses recognized in respect of one or more of the QOFs while electing to eliminate gains recognized in respect of one or more other QOFs, which will not be possible in the case of multi-asset QOF partnerships to the extent gains and losses are recognized by the QOF during the same taxable year.
A similar election is available to shareholders of a QOF REIT with respect to capital gain dividends of the REIT attributable to long-term capital gain recognized by the REIT on any sale or exchange of QOZ property after the 10-year holding period for the shareholder has been achieved. The Final Regulations provide that electing shareholders exclude from income any capital gain dividend to which the election applies, which generally will allow the shareholders to avoid state and local income tax on the dividend in states that have conformed their income tax laws to federal law in respect of QOF investments (or conform to federal income tax law generally); the Proposed Regulations had required electing shareholders to include the dividend as income to which a zero percent rate of federal tax applied. Because a QOF REIT can pass through this benefit only with respect to gross items of long-term capital gain the REIT recognized “on any sale or exchange of” QOZP, it remains unclear whether capital gains recognized by a partnership in which the REIT has invested are eligible. Furthermore, ordinary income recapture recognized by a REIT will, outside the context of a liquidation of the REIT, give rise to REIT ordinary dividends that cannot be eliminated from the investor’s income. The Final Regulations apply the same rules to QOF RIC capital gain dividends as to QOF REIT capital gain dividends.
Events that Trigger Inclusion of Deferred Gain
The statute provides that the amount of gain that is deferred with respect to a qualifying investment generally must be included in the investor’s income in the taxable year that includes the earlier of (A) the date on which the qualifying investment is sold or exchanged, or (B) December 31, 2026. The Proposed Regulations interpret the phrase “sold or exchanged” in an expansive manner generally to include any transaction that reduces the investor’s interest in the qualifying investment.
However, a tax-free contribution of a qualifying investment to a partnership (governed by section 721) is not an event requiring the inclusion of previously deferred gain (“inclusion event”), provided there is no reduction in the amount of the remaining deferred gain that would be recognized by the transferring partner on a later inclusion event (such as a later sale by such partner of the partnership interest it acquired). While the Proposed Regulations made this exception applicable only to contributions of a direct or indirect partnership interest in a QOF to another partnership, the Final Regulations provide that the contribution of qualifying QOF stock to a partnership may also qualify for the exception.
Part II—Qualified Opportunity Fund Qualification Considerations
Overview of the 90-Percent Asset Test
In order to qualify as a QOF, an entity must hold at least 90 percent of its assets in QOZP, which is defined to mean QOZ business property, QOZ stock and QOZ partnership interests. This test (the “90-Percent Asset Test”) is applied by taking the average of the percentage of QOZ property held by the QOF (1) on the last day of the first six-month period of the taxable year of the QOF and (2) on the last day of the taxable year of the QOF.
Cash or Cash Equivalents are Ignored for 6 Months After Investment
The Final Regulations helpfully provide that, in applying the 90-percent asset test on any testing date, a QOF may exclude any property received by the QOF in the preceding 6 months as a contribution to capital to the extent such property was contributed in the form of cash, cash equivalents or short-term debt instruments or the QOF converted the property into cash, cash equivalents or short-term debt instruments within five business days of such contribution. If a QOF holds only cash, cash equivalents or short-term debt instruments on its first testing date and chooses not to take its assets into account in applying the 90-percent asset test, such that the numerator (the value of the QOF’s QOZP) and the denominator (the value of the QOF’s assets) are both zero, the preamble to the Final Regulations (“Preamble”) seems to indicate that the IRS will neither decertify the QOF because it lacks QOZP on the first testing date nor impose a penalty on the QOF for a failure to meet the 90-percent asset test that results from the fact that the QOF lacks QOZP on the first testing date.
Sales Proceeds Reinvested by a QOF within 12 Months do not Affect QOF Qualification
The Final Regulations follow the Proposed Regulations by providing that (i) proceeds received by a QOF from the sale or disposition of QOZ business property or an interest in a QOZB and (ii) amounts distributed to the QOF as a return of capital from a QOZB are treated as QOZP for purposes of the 90-percent asset test so long as:
- the QOF reinvests such proceeds in QOZP during the 12-month period beginning on the date of the transaction giving rise to such proceeds; and
- the proceeds are continuously held in cash, cash equivalents and short-term debt instruments until reinvested in QOZP.
The Final Regulations further extend the 12-month reinvestment period if and to the extent the failure to meet the 12-month deadline is attributable to a delay in government action or to a natural disaster that has been federally declared in the QOZ.
The Preamble confirms that this 12-month relief provision applies only to dispositions of property by a QOF and does not apply to dispositions of property by a QOZB for purposes of determining whether the QOZB has maintained its status as a QOZB. Further, this 12-month relief provision does not shield the QOF and its investors from the tax consequences stemming from interim direct or indirect dispositions of property by a QOF even where the proceeds from such dispositions are reinvested within that timeframe.
Status of QOF Assets as QOZP after a Restructuring
The statute provides that a QOF’s directly held interest in a partnership or corporation will be treated as a QOZ partnership interest or QOZ stock, and thus QOZP, for purposes of the 90-percent asset test, only if the QOF acquired the interest or stock from the partnership or corporation, respectively, solely in exchange for cash after December 31, 2017 and, at the time of issuance of the interest or stock as well as during substantially all of the QOF’s holding period for such interest or stock, the entity qualifies as a QOZB (or, if newly formed, must have been organized for such purpose). Taken literally, this statutory language would lead to the result that a partnership interest or stock acquired by a QOF in any manner other than solely in exchange for a contribution of cash to the issuing entity would not qualify as QOZP.
The Final Regulations provide relief to QOFs that acquire partnership interests and/or stock in certain nonrecognition transactions. First, if two or more QOZBs merge and a QOF receives an interest in the surviving entity in the merger in exchange for a QOZ partnership interest or QOZ stock, the interest in the surviving entity will not fail to be QOZP because it was acquired in such a manner. Second, if two or more QOF corporations merge, or two or more QOF partnerships merge, the QOZP of each QOF generally will not lose its status as QOZP solely as a result of its transfer by the transferor QOF to the acquiring QOF in a nonrecognition transaction. On the other hand, when a QOF is converted from a partnership to a corporation (or from a corporation to a partnership) for federal income tax purposes, (1) the resulting entity will not qualify as a QOF because it will be deemed to have acquired its assets by contribution, and (2) the interests of the investors in the surviving entity will not be qualifying investments going forward.
Safe Harbor for Tangible Property Being Substantially Improved
The Final Regulations create a new safe harbor for tangible property undergoing the substantial improvement process held directly by a QOF. Tangible property undergoing the substantial improvement process which has not been placed in service or used in a trade or business by a QOF or a QOZB is treated as QOZ business property for the 30-month substantial improvement period if the property is reasonably expected to be QOZ business property by the end of the 30-month substantial improvement period.
Part III—QOZB Treatment
As stated above, a QOF must hold at least 90 percent of its assets in QOZP (i.e., QOZ business property, QOZ stock or QOZ partnership interests). Equity interests constitute QOZ stock or QOZ partnership interests only if the underlying corporation or partnership is a QOZB. From a practical perspective, in a typical QOF structure the principal assets of the QOF will be QOZ partnership interests in one or more partnerships structured to qualify as QOZBs.
Largely following the Proposed Regulations, the Final Regulations provide that an entity is a QOZB only if, among other requirements:
- substantially all (i.e., at least 70 percent) of the tangible property owned or leased by such entity is QOZ business property;
- at least 50 percent of the total gross income of such entity is derived from the active conduct of a trade or business in QOZs;
- such entity does not operate, and does not lease more than de minimis property to, any (i) private or commercial golf course, (ii) country club, (iii) massage parlor, (iv) hot tub facility, (v) suntan facility, (vi) racetrack or other facility used for gambling, or (vii) store the principal business of which is the sale of alcoholic beverages for consumption off premises; and
- at least 40 percent of the intangible
property of such entity is used in the active conduct of a trade or
business in QOZs and such use is normal, usual, or customary in the
conduct of the trade or business and in the performance of an
activity of the trade or business that contributes to the
generation of gross income.
As described below, the Final Regulations provide a number of beneficial clarifications and changes regarding these requirements.
QOZ Business Property Requirements
Overview of QOZ Business Property Definition
QOZ business property is defined by the statute as tangible property used in a trade or business of a QOF or a QOZB if:
- such property was acquired by purchase from an unrelated party after Dec. 31, 2017;
- either the “original use” of such property in the QOZ commences with the QOF or QOZB or the QOF or QOZB “substantially improves the property”; and
- during substantially all of the holding period for such property, substantially all of the use of such property was in a QOZ.
Abandoned or Vacant Property Treated as Original Use Property in Certain Cases
The Proposed Regulations provided that, in certain circumstances property that has been used previously in a QOZ will be treated as originally used in a QOZ by an entity that seeks qualification as a QOZB or QOF (i.e., an “eligible entity”) once the eligible entity places the property in service in a trade or business in the QOZ. The Final Regulations clarify this rule by providing that vacant property will be treated as original use property only if either:
- the property was vacant on the date of publication of the QOZ designation notice designating the location of the property as a QOZ and remained vacant through the date on which the property was purchased by the eligible entity; or
- the property was vacant continuously for at least 3 years prior to the date on which the property was purchased by the eligible entity.
For this purpose, real property, including land and buildings, is considered to be vacant if more than 80 percent of the building or land, as measured by the square footage of useable space, is not being used. In addition, all real property purchased by an eligible entity from a local government that the local government held as the result of an involuntary transfer (including through abandonment, bankruptcy, foreclosure, or receivership) satisfies the original use requirement. Lastly, all real property composing a brownfield site, including land and structures located thereon, will be treated as satisfying the original use requirement if the eligible entity makes investments to ensure that the site meets basic safety standards for human health and the environment. With respect to the brownfield site’s qualification as QOZ business property, the Final Regulations provide that the cost of remediating of contaminated land is taken into account for purposes of determining whether the land has been more than “minimally improved.”
Land Generally Treated as QOZ Business Property if Used in a Trade or Business
The Final Regulations follow the Proposed Regulations in providing that land in a QOZ that is acquired by an eligible entity by purchase or by a qualifying lease (as discussed below) can become QOZ business property without satisfying the requirement that either (i) the original use of property in the QOZ commence with the eligible entity or (ii) the property be substantially improved. Instead, such land generally is treated as QOZ business property if it is used in a trade or business (within the meaning of section 162) of the eligible entity. However, an eligible entity may not treat land that has not actually been substantially improved during any 30-month period as QOZ business property if the land is unimproved or minimally improved when purchased by the eligible entity and the eligible entity purchased the land with an expectation, an intention or a view not to improve the land by more than an insubstantial amount within 30 months after the date of purchase. The Preamble states that improvements to the land, such as the addition of an irrigation system for a farming business or the grading of land with a sufficient nexus to a trade or business of the eligible entity, will be regarded by the IRS as more than an insubstantial amount of improvement, but the Final Regulations themselves provide only that those items are improvements which then would need to be tested to determine whether they are more than insubstantial.
Substantial Improvement Requirement
Tested on Aggregate or Asset-by-Asset Basis, at the Election of the QOZB
Proposed Regulations had required the substantial improvement requirement to be tested on an asset-by-asset basis. Commenters pointed out that this could present substantial hurdles in circumstances where an integrated project consists of multiple significant assets and it is neither necessary nor useful to double the tax basis of each asset.
In response to those comments, the Final Regulations give eligible entities the right to elect to treat two or more buildings located within a QOZ or a single series of contiguous QOZs (an “eligible building group”) as a single property, such that the amount of basis required to be added to those buildings on an aggregate basis by the eligible entity must exceed the total amount of the adjusted basis of those buildings (determined as of the beginning of the 30-month substantial improvement period). (The basis of land generally is not included in the substantial improvement calculation.) More specifically, for purposes of the substantial improvement test, an eligible entity (i) may treat all buildings located entirely within the geographic borders of a parcel of land described in a single deed as a single property, and (ii) may treat buildings located entirely within the geographic borders of contiguous parcels of land described in separate deeds as a single property to the extent each building is operated as part of one or more trades or businesses that (a) are operated exclusively by the eligible entity, (b) share facilities or share significant centralized business elements, and (c) are operated in coordination with, or reliance upon, one or more of the trades or businesses.
Application to Property that is Improved by the Functional (But Not Structural) Addition of Purchased Property
In determining whether a non-original use asset has been substantially improved, the Final Regulations permit eligible entities to take into account the basis of purchased original use assets that otherwise would qualify as QOZ business property in calculating the additions to basis of the non-original use asset if the purchased assets (i) are used in the same trade or business in the QOZ (or a contiguous QOZ) for which the non-original use asset is used, and (ii) improve the functionality of the non-original use asset in the same QOZ (or a contiguous QOZ). However, purchased non-original use real property always must be improved by more than an insubstantial amount, without taking into account the previous sentence, in order to be treated as substantially improved (subject, however, to application of the optional aggregation rules above). For example, the basis of new fixtures in a building that a QOZB purchased and rehabilitated generally may be treated as additions to the basis of the building itself for purposes of the substantial improvement test, even if they are treated as separate items of property for other federal income tax purposes. This change should make it easier to qualify buildings and other structures as “substantially improved.”
Betterment expenses are included in the calculation of basis of an eligible building group (or a single building, as the case may be) for purposes of the substantial improvement requirement, even if those expenses are properly chargeable to the basis of the land on which the property is located for other federal income tax purposes. For example, the Preamble states that all capitalized costs of building residential rental property are taken into account, even in cases where they generally must be capitalized into the basis of the land.
Safe Harbors Relating to Infusions of Working Capital into QOZBs
Clarification and Expansion of Working Capital Safe Harbors
The Proposed Regulations adopted, and the Final Regulations have clarified and expanded, a 31-month working capital safe harbor for QOZBs that hold cash, cash equivalents and short-term debt instruments (working capital assets) which will be needed to develop a trade or business in the QOZ, or for the acquisition, construction, and/or substantial improvement of tangible property. Under this safe harbor, working capital assets are treated as a “reasonable” amount of working capital so that the entity is not disqualified from being a QOZB due to it holding such assets, so long as:
- there is a written plan that identifies the working capital as held for the acquisition, construction or substantial improvement of tangible property in a QOZ or for the development of a trade or business in the QOZ;
- there is a written schedule consistent with the ordinary start-up of a trade or business for the expenditure of the working capital assets within 31 months of the receipt by the business of the assets; and
- the business substantially complies with the schedule.
A QOZB that ultimately needs more than 31 months to comply with the written plan does not lose the benefit of the safe harbor if the delay is attributable to waiting for government action the application for which is completed during the 31-month period. The Final Regulations further provide that if a project that otherwise would have met the requirements of the 31-month working capital safe harbor is located within a QOZ designated as a part of a Federally declared disaster area, the QOZB may receive up to an additional 24 months to consume its working capital, to the extent the disaster delayed the project. The Preamble indicates that a QOZB is not permitted to substantially exceed the 31-month period due to other circumstances outside of the QOZB’s control (such as unanticipated construction delays or non-disaster force majeure events).
The Final Regulations follow the Proposed Regulations by providing that a single QOZB can utilize multiple overlapping or sequential 31-month safe harbor periods, provided that for each such period, the QOZB satisfies all of the requirements that would apply if such period were the only one utilized by the QOZB. The Final Regulations clarify that in any case where multiple working capital safe harbors apply to the same unit of tangible property, the total length of time the working capital safe harbors apply to that unit is 62 months. This clarification provides certainty to QOFs pursuing certain multi-phase real estate development projects that may have been concerned that each QOZB could utilize only one 31-month safe harbor period with respect to a development site. While this clarification is welcomed, questions remain regarding whether the first phase of a real estate development project must be placed in service in a trade or business (for depreciation purposes) by the end of the first 31-month safe harbor in order for the site to qualify as QOZ business property during that period. It is possible that the government will provide additional guidance in the coming months regarding the criteria for qualification for the 62-month safe harbor.
Another facet of the 31-month and 62-month safe harbor rules that should be clarified is in what circumstances a QOZB’s acquisition of working capital assets will benefit from the safe harbors. The Preamble refers to QOZBs acquiring such assets by means of contribution, but the Final Regulations themselves do not place any such restrictions on a QOZB’s ability to utilize these safe harbors; many QOZBs will obtain their working capital assets by drawing down construction loans.
Active Conduct of a Trade or Business Requirement
A Trade or Business Includes a Leasing Business, Other than One Engaging Solely in Triple Net Leasing
The Final Regulations follow the Proposed Regulations in providing 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 for these purposes, while clarifying that merely entering into a triple net lease with respect to real property is not considered the active conduct of a trade or business for this purpose. In response to requests to clarify what leasing arrangements are considered triple net leases, the Preamble describes a triple-net lease as a lease arrangement pursuant to which the tenant is responsible for all of the costs relating to the leased property in addition to paying rent. The Final Regulations confirm that when a QOZB’s sole business consists of a single triple-net lease of a property, the QOZB does not carry on an active trade or business with respect to that property. But if a QOZB is engaged in a trade or business under section 162 with respect to rental property as a landlord by meaningfully participating in the management and operations of such property, the fact that a triple-net lease applies to some of the property will not prevent such property from being treated as being used in the active conduct of a trade or business.
Treatment of Leased Tangible Property
The Final Regulations continue the Proposed Regulations’ treatment of leased tangible property as QOZ business property, where:
- the leased tangible property is acquired under a lease entered into after December 31, 2017;
- substantially all (at least 70%) of the use of the leased tangible property is in a QOZ during substantially all (at least 90%) of the period for which the business leases the property; and
- the lease is a “market rate lease” (i.e., the terms of the lease must reflect common, arm’s-length market practice in the locale that includes the QOZ).
In the case of a lease that is between unrelated persons, the Final Regulations include a rebuttable presumption that rents are market rate.
If the lessor and lessee are related, however, the leased tangible property must also satisfy the following requirements to be treated as QOZ business property:
- the lessee at no time may make a prepayment to the lessor in connection with the lease relating to a period of use of the property that exceeds 12 months; and
- if the original use of leased tangible personal property in a QOZ 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.
The Final Regulations include a revised version of the Proposed Regulations’ anti-abuse rule to prevent the use of leases to circumvent the substantial improvement requirement for purchases of real property. Under this rule, if, at the time a lease is entered into, there was a plan, intent, or expectation for the real property to be purchased by the lessee for an amount of consideration other than the fair market value of the real property determined at the time of the purchase without regard to any prior lease payments, the leased real property is not QOZ business property. This rule applies regardless of whether the lessor is related to the lessee. The Preamble indicates that if a lease gives the lessee a fixed rate purchase option, the IRS will closely scrutinize the transaction and may conclude that the leased property is not QOZ business property. A fixed price purchase option is consistent with the treatment of the leased property as QOZ business property only if the option is so unlikely to be exercised that there was no plan, intent, or expectation for the property to be purchased by the lessee.
Valuation of Leased Property
The Final Regulations adopt the approach of the second set of Proposed Regulations, under which leased tangible property was required to be valued, on an annual basis, using one of these two methods (as elected by the eligible entity):
- under the applicable financial statement valuation method, the value of leased tangible property is the value of that property as reported on the applicable financial statement (which must be prepared according to GAAP) for the relevant reporting period. If an eligible entity does not have an applicable financial statement, it cannot elect to use this method;
- under the alternative valuation method, the value of leased tangible property is the sum of the present values of each rental payment required to be made during the term of the lease, calculated at the time at which the lease was entered into and using the short-term applicable Federal rate as the discount rate. For this purpose, the term of a lease includes periods during which the lessee may extend the lease at a pre-defined market rate rent; in the case of real property, pre-defined market rate rent does not include fair market rent determined at the time of lease renewal.
The Preamble clarifies that a QOZB may use the alternative valuation method even when it has an applicable financial statement.
50 Percent Gross Income Requirement
A QOZB must derive at least 50 percent of its total gross income from the active conduct of a business within a QOZ. The Final Regulations generally follow the Proposed Regulations and provide that a QOZB will be treated as satisfying this requirement if it satisfies any of the following safe harbors:
- at least 50 percent of the services performed (based on hours) for such business by its employees (including partners, if the QOZB is a partnership) and independent contractors are performed within one or more QOZs. (With respect to partners’ services, only hours worked in exchange for guaranteed payments for services (within the meaning of section 707(c)) will be taken into account);
- at least 50 percent of the services performed (based on amounts paid for the services performed) for the business by its employees (including partners, if the QOZB is a partnership) and independent contractors are performed in one or more QOZs. (With respect to partners’ services, only guaranteed payments for services (within the meaning of section 707(c)) to a partner will be taken into account); or
- both (1) the tangible property of the trade or business located in a QOZ is necessary for the generation of at least 50% of the gross income, and (2) the management or operational functions performed in the QOZ are necessary for the generation of at least 50% of the gross income. (The Preamble indicates that this test generally is met by businesses that are headquartered in a QOZ and for which the bulk of business activity occurs in a QOZ.)
The Final Regulations changed the first two safe harbors by requiring services performed by partners (and not just employees and independent contractors) to be taken into account.
Facts and Circumstances Test
Businesses not meeting any of the safe harbor tests set forth above may still meet the 50-percent gross income requirement if, based on all the facts and circumstances, at least 50 percent of the gross income of a trade or business is derived from the active conduct of a trade or business in the QOZ. It is unclear how this test will be applied and in what circumstances a QOZB not satisfying any of the safe harbors would nevertheless be treated as satisfying this facts and circumstances test. In the Preamble, Treasury and the IRS declined to provide any further guidance regarding the application of this test.
Other Clarifications to the QOZB Requirements
Real Property Straddling a QOZ Boundary
The Final Regulations expand upon the Proposed Regulations by increasing the scope of the special rules for contiguous real property that sits both within and outside a QOZ. Specifically, for purposes of (i) determining whether real property outside a QOZ qualifies as QOZ business property, (ii) the requirement to use substantial portion of intangible property in the QOZ, and (iii) the requirement to derive 50 percent of gross income from active conduct of a business in the QOZ, if:
- a QOZB uses real property within a QOZ,
- the QOZB also uses real property located outside the QOZ that is contiguous to real property used by the QOZB in the QOZ, and
- the square footage of such real property in the QOZ is substantial compared to the square footage of the contiguous real property outside the QOZ,
then all the services performed for the QOZB within, all business functions that occur, and all tangible property that is located on, such contiguous real property is treated as occurring or being located in the QOZ. The Final Regulations have also added an optional cost-based test whereby a QOZB may choose to treat real property located outside the QOZ as though it were in the QOZ, for those purposes, if the unadjusted cost of the contiguous real property located within the QOZ that is held by the QOZB is greater than the unadjusted cost of the real property outside of the QOZ. Each QOZB may use only the square footage test or only the unadjusted cost test consistently throughout the holding period for any given grouping of contiguous real property.
Clarification of the Term “Substantially All” of a Holding Period
When (1) a QOF determines whether an eligible entity in which the QOF owns a partnership interest or stock qualifies as a QOZB for 90% or more of the QOF’s holding period, or (2) an eligible entity determines whether substantially all of the use of business property is in a QOZ during 90% or more of the holding period for the business property, the Final Regulations provide that the determination is made as of each testing date by looking back at the portion of the holding period that has already passed. Stock or partnership interests held by a QOF will satisfy the 90-percent requirement if during 90-percent of the portion of the QOF’s holding period that begins on (x) the later of (A) the date that its self-certification as a QOF is effective and (B) the actual start date of the holding period, and ends on (y) the relevant semiannual testing date, the issuing corporation or partnership qualified as a QOZB, provided that a QOF may elect to shorten the tested holding period so that it lasts only until the last day of the QOZB’s latest taxable year that ends on or before the relevant QOF testing date. The Proposed Regulations did not require or permit eligible entities to disregard any portion of the relevant holding period that begins after the relevant testing date.
The Final Regulations provide a six-month period for an entity in which a QOF has invested to cure a defect that caused the entity to fail to qualify as a QOZB. More specifically, an entity that would not be a QOZB as of the end of its last taxable year ending on or before a semiannual testing date of the QOF is treated as a QOZB with respect to the QOF for that taxable year of the entity if (i) a cure is achieved for the entity within six months of the date on which the stock or partnership interest lost its qualification, and (ii) the QOF files its federal income tax return for the taxable year of the QOF containing such testing date on a date that is timely (taking extensions into account) and that is not later than when that cure is achieved. Each QOF can utilize a six-month cure period only once. It is unclear whether (or how) a QOZB can cure a failure to satisfy one of the QOZB requirements that is tested on an annual basis (e.g., the gross income requirements) within a six-month period.
Part IV—Investor Considerations: Acquisitions of QOF Interests
Deferral of Section 1231 Gains
While the Final Regulations confirm the position of the Proposed Regulations that only capital gains are eligible for deferral under the QOZ regime, the Final Regulations take a drastically different approach from the Proposed Regulations with respect to investors’ eligibility to defer gross gains from the sale of section 1231 property through an investment in a QOF. The Proposed Regulations provided that only net section 1231 gains were eligible for deferral and that the 180-day period for investing such net section 1231 gains in a QOF begins on the last day of the taxable year in which such gains are generated (i.e., after the amount of net section 1231 gain can be determined).
Under the Final Regulations, gross gains from the sale of section 1231 property are eligible gains to the extent they are not recharacterized as ordinary income under section 1245 or 1250. Further, because it is not necessary for an investor to wait until the end of the taxable year to determine whether any section 1231 gains are eligible gains, the 180-day investment period generally begins on the date of sale of the section 1231 property.
Under the Final Regulations, section 1231(c), which recharacterizes section 1231 capital gain as ordinary income to the extent such gain does not exceed the non-recaptured net section 1231 losses, applies only in the year in which the deferred gain is included in income (generally 2026) and applies only if and to the extent there are non-recaptured section 1231 losses from the five most recent taxable years preceding the taxable year of inclusion. In other words, whether eligible section 1231 gain would have been recharacterized as ordinary income under section 1231(c) absent a deferral election is not an attribute associated with the deferred eligible section 1231 gain taken into account in the year in which the deferred gain is included in income.
Step Transaction Doctrine May Apply to a Sale and Purchase Between a QOF or QOZB and a Person Who Later Becomes a QOF Investor
The Preamble states that, under generally applicable federal income tax principles (including the step transaction doctrine), in a case where a taxpayer recognizes gain from the sale of property to an unrelated QOF (or QOZB) as part of a plan that includes the investment by the taxpayer of the gain into the QOF (or, directly or indirectly, into such QOZB), the gain is not eligible gain because the transaction is not characterized as a sale or exchange for federal income tax purposes and the property acquired by the eligible entity is not QOZ business property, because it has not been acquired by “purchase.”
Furthermore, the Preamble warns that, pursuant to the Final Regulations’ general anti-abuse rule, the IRS may treat as a non-qualifying investment a taxpayer’s interest in a QOF that was acquired, as part of a plan, through the contribution of cash from the taxpayer’s sale of property to a QOZB that is owned by the QOF, even if the QOF retains the cash (rather than transferring the cash to the QOZB). It is not clear whether the authors of the Preamble were trying to expand how the step transaction doctrine would apply to such facts or were illustrating the IRS’s powers under the Final Regulations’ anti-abuse rules to deny QOF benefits to transactions that are otherwise characterized in accordance with their form.
Gain from a Position that is Part of an Offsetting-Positions Transaction
The Proposed Regulations included a very broad prohibition on the deferral of gain derived from a position that was, at any time, part of an “offsetting-positions transaction.” Furthermore, the Proposed Regulations essentially treated as a single offsetting-positions transaction all of the taxpayer’s section 1256 contracts settled in a taxable year if any one or more of such contracts were part of an offsetting-positions transaction at any point during such taxable year. The Final Regulations have substantially narrowed this prohibition. Specifically, under the Final Regulations the rule applies to disallow gain from being treated as eligible gain only where the gain is derived from a position in a straddle (i.e., offsetting positions in actively traded property) and only where such position was either (i) part of a straddle during the taxable year when the gain was realized or (ii) part of a straddle in a prior taxable year if a loss from that straddle is carried over under the straddle rules to such taxable year. Net gain from any section 1256 contract that was not part of a straddle is not prevented from being eligible gain under the Final Regulations.
Additional 180-Day Window for Investment into a QOF of Investor’s Allocable Share of the Eligible Gain of a Partnership
Under the Final Regulations, partners of a partnership, shareholders of an S corporation, and beneficiaries of decedents’ estates and non-grantor trusts may elect to have the 180-day period commence upon the due date of the entity’s tax return, not including any extensions. This elective 180-day period is in addition to the other elective 180-day periods made available, under the Proposed Regulations, to owners of such pass-through entities.
Acquisition of Qualifying Investment by Issuing a Promissory Note is not Allowed
The Preamble clarifies that an investor cannot acquire a qualifying investment in a QOF in exchange for the investor’s promissory note or other mere promise to pay. The position taken by the Preamble is consistent with other authorities that deny basis to investors that contribute a promissory note to a corporation or partnership in exchange for shares or a partnership interest unless and until the investor satisfies its obligations under the promissory note, but is inconsistent with certain court cases that have concluded that an investor does receive basis for a contribution of its own promissory note to a corporation in exchange for stock. It should still be possible to acquire a qualifying investment in a QOF to the extent the promissory note is satisfied by the investor through a principal payment on the note made directly to the QOF within the taxpayer’s 180-day investment period with respect to an eligible gain.
Acquisition of Qualifying Investment Through the Investment of Gain not Subject to Federal Income Tax is Generally Prohibited
The Final Regulations clarify that non-U.S. taxpayers cannot make a deferral election with respect to an interest in a QOF that was acquired with capital gain other than gain treated as effectively connected with a U.S. trade or business. In the case of a capital gain that would otherwise be exempt from tax pursuant to a treaty because a non-U.S. taxpayer qualifies for treaty benefits, the non-U.S. taxpayer must waive any treaty benefits that would exempt such gain from being subject to U.S. tax upon an inclusion event, in order to make a deferral election.
Notwithstanding the foregoing, the Final Regulations provide that capital gain recognized by a partnership generally is treated as though it is subject to federal income tax even where some or all of the gain is allocable to partners that are not subject to tax on their distributive share of such gain. As a result, the partnership itself may acquire a qualifying investment in a QOF by investing capital gain that would not actually have been subject to federal income tax (at least in part), unless the partnership is subject to a new anti-abuse rule set forth in the Final Regulations. The new anti-abuse rule allows the IRS to look through any partnership formed or availed of with a significant purpose of avoiding the requirement that eligible gains be subject to federal income tax and to treat as a non-qualifying investment that portion of any investment by such partnership in a QOF which is attributable to partners that would not be subject to federal income tax on their share of the otherwise eligible gain.
Part V—Other Considerations
Relief Provided for a Transfer of a Qualifying Investment upon the Death of the Holder
The Final Regulations follow the Proposed Regulations in providing that, when a qualifying investment in a QOF is transferred upon the death of its holder, (i) neither the transfer of the qualifying investment to the owner’s estate nor the distribution by the estate to the decedent’s legatee or heir is an inclusion event, and (ii) the holding period of a qualifying investment held by a person who received that qualifying investment by reason of the prior owner’s death includes the time during which that investment was held by the decedent. However, the Final Regulations clarify that such a qualifying investment will not benefit from a fair market value step-up in basis under the basis adjustment rules generally applicable to transfers at death. The Final Regulations also confirm that the tax on the decedent’s deferred gain is the liability of the beneficial owner of the qualifying investment at the time of an inclusion event.
General Anti-Abuse Rule
The general anti-abuse rule of the Proposed Regulations has been retained in the Final Regulations. The anti-abuse rule empowers the government to recast a transaction (or series of transactions) for tax purposes as appropriate to achieve tax results that are consistent with the purposes of the QOZ regime, as determined based on all the facts and circumstances. The Final Regulations, however, add several examples to illustrate the application of the general anti-abuse rule. One such example shows that if a significant purpose for the acquisition of land by an eligible entity is to hold the land for speculative investment, the anti-abuse rule applies so that the land is not QOZ business property, even if the land otherwise qualifies under the “more than insubstantially improved” standard and is used in a trade or business. Another example shows that if the organizers of a QOF have no intention of acquiring QOZP, the organizers of the QOF will not be treated as having made a qualifying investment in a QOF. This is the only example in the Final Regulations of a circumstance in which a QOF is effectively decertified involuntarily by the government.
Special Rules for Consolidated Groups
Marking a change from the Proposed Regulations, the Final Regulations allow a QOF C corporation to be a subsidiary member (“QOF member”) of a consolidated group, but only if and for so long as (i) the consolidated group member (“QOF investor member”) that makes the qualifying investment in the QOF member maintains a direct equity interest in the QOF member, and (ii) the QOF investor is wholly owned, directly or indirectly, by the common parent of the consolidated group. Unlike an investor in a QOF partnership that has a negative capital account, a QOF investor member must take its excess loss account (“ELA”) (if any) with respect to the QOF member into account before its basis in the QOF member stock is adjusted under section 1400Z-2(c). Furthermore, a distribution by a QOF member is an inclusion event to the extent the distribution otherwise would create or increase an ELA in the QOF member stock.
The Final Regulations apply to any taxable year that begins more than 60 days after the Final Regulations are officially published in the Federal Register. In the case of calendar year taxpayers, the final regulations apply on and after January 1, 2021. For years prior to 2021, taxpayers may choose (1) to apply all of the Final Regulations, (2) to rely on all of the Proposed Regulations, or (3) rely on the plain meaning of Code section 1400Z-2.
1 For a detailed discussion of the first set of proposed regulations and a general overview of the QOZ regime, see our prior client publication dated October 22, 2018 entitled “Opportunity Zones: Government Issues Proposed Regulations.”
2 For a detailed discussion of the Proposed Regulations, see our prior client publication dated April 22, 2019 entitled “Opportunity Zones: Second Set of Proposed Regulations Provide Clarity.”
3 Although the statute and the Proposed Regulations did not limit a QOZB’s ability to lease property to any particular kinds of businesses, the Final Regulations prohibit each QOZB from leasing more than 5% of its property to any “sin business” (listed above).
4 The Final Regulations do not adopt a commenter’s recommendation that taxpayers be permitted to rely on certificates of occupancy for determining whether a building has become used in a trade or business or placed in “original use” because the standards and processes applicable to certificates of occupancy vary significantly by jurisdiction and therefore fail to provide a uniform standard.
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.