On April 17, 2019, the U.S. Treasury Department and Internal Revenue Service issued a second installment of proposed regulations (the "Proposed Regulations") relating to the Opportunity Zone Fund ("OZ Fund") rules contained in Section 1400Z-2 of the Internal Revenue Code (the "Code"). The Proposed Regulations provide significant additional guidance and clarification in a number of important areas not addressed in the first set of proposed OZ Fund regulations, issued on October 19, 2018 (the "2018 Proposed Regulations"). For summaries of the relevant Code provisions and the 2018 Proposed Regulations, see our previous alert dated October 22, 2018. The following is a list, and brief description of some key highlights of the provisions contained in the Proposed Regulations.1
1. Sale by OZ Fund of OZ Property – If an OZ Fund that is a partnership or S corporation recognizes gain upon a disposition of qualified opportunity zone property ("OZ Property"), an investor that has held its interest in the OZ Fund with respect to which a gain deferral election was made (a "Qualifying Investment"), for at least 10 years, may elect to exclude from income some or all of its share of such gain attributable to such Qualifying Investment. If the OZ Fund is a REIT and elects to treat distributions as capital gain dividends (with an identified date), each shareholder who has held its shares for at least 10 years as of such identified date can exclude such gain from income to the extent attributable to a Qualifying Investment in the REIT.
2. Treatment of Newly Contributed Funds – For purposes of its semi-annual 90% asset tests, an OZ Fund may disregard funds contributed within the preceding 6-month period, provided the funds are held in the form of cash, cash equivalents, or debt instruments with a term not exceeding 18 months.
NOTE: Although this rule is not applicable to a subsidiary of an OZ Fund, referred to as a qualified opportunity zone business ("OZ Business"), the availability of the "reasonable working capital" exception (not available to OZ Funds) should generally render this rule unnecessary for OZ Businesses.
3. Contributions of Property to OZ Fund – If a taxpayer contributes property (other than cash) to an OZ Fund in a tax-free transaction (e.g., a tax-free contribution to a partnership), it can constitute a Qualifying Investment to the extent of the tax basis of the contributed property (or its fair market value, if lower). If the property is contributed in a taxable transaction (that is not recharacterized as something other than an investment in the OZ Fund, such as a disguised sale to the OZ Fund), the Qualifying Investment will equal the fair market value of the property contributed. However, no capital gain deferral election may be made for such contribution with respect to the gain recognized on that contribution transaction itself.
NOTE: Although a taxpayer may achieve capital gain deferral through the contribution of property, contributed property cannot qualify as OZ Property due to the requirement that such property must be acquired by the OZ Fund (or OZ Business) by purchase (from an unrelated party). Presumably, such contributed property would either go into the "bad asset" basket of the OZ Fund or OZ Business, or could be sold, with the proceeds utilized to acquire qualifying OZ Property.
4. Reinvestment of Sale Proceeds by OZ Fund – If an OZ Fund disposes of OZ Property, the proceeds from such disposition will, themselves, be treated as OZ Property for 12 months, provided the proceeds are continuously held in the form of cash, cash equivalents, or debt instruments with a term not exceeding 18 months.
NOTE: This rule, as drafted, would not apply to dispositions of OZ Property by an OZ Business. The Proposed Regulations request comments on whether an analogous rule should also apply to such dispositions.
5. Property Leased by OZ Fund or OZ Business
Non-Related Party Leases – The Proposed Regulations clarify that property leased to an OZ Fund or OZ Business by an unrelated party, qualifies as OZ Property, provided the following three requirements are satisfied: (i) The lease is entered into after December 31, 2017; (ii) the terms of the lease are "arms-length," as determined under the transfer pricing rules contained in Section 482 of the Code and the Regulations thereunder; and (iii) during at least 90% of the lease term, at least 70% of the use of the leased property was in an opportunity zone. There is no requirement that, if the "original use" of the property does not commence with the OZ Fund or OZ Business, the property be "substantially improved" (as is the case for property purchased by an OZ Fund or OZ Business).
Related Party Leases – There is no restriction against related party leases (as exists with respect to related party purchases). However, there are a number of additional requirements imposed on such leases in order for the leased property to qualify as OZ Property. These requirements generally relate to (i) restrictions against prepayments of rent; and (ii) in the case of personal property only, either (A) the "original use" of the leased property commences with the lessee, or (B) the lessee purchases additional personal OZ Property, within 30 months of the beginning of the lease term, at least equal in value to that of the leased property.
Valuation of Leased Property under Asset Tests – For purposes of the OZ Fund (90%) or OZ Business (70%) asset tests, all leased property may be valued, on an annual basis, utilizing either (i) the value of the leased property as reported on the "applicable financial statements" of the entity; or (ii) the "alternative valuation method," which is the sum of the present value of all lease payments to be made under the lease (including extensions with pre-set rent), using as the discount rate the applicable Federal rate under Section 1274(d)(1) of the Code (by substituting "lease" for "debt instrument").
6. Purchase of Interest in OZ Fund – If a person acquires an interest in an OZ Fund from an existing owner of such interest, such interest can be a Qualifying Investment in the hands of the acquiror, to the extent of the cash and/or fair market value of property exchanged for the OZ Fund interest.
7. Recharacterization of Investments in OZ Fund Partnerships – The following transfers to an OZ Fund partnership will not constitute Qualifying Investments: (i) a transfer that is characterized as other than a contribution for Federal income tax purposes (e.g., transfers treated as "disguised sales" of property or as loans to the partnership); and (ii) a transfer that would be characterized as a "disguised sale" assuming (A) any cash contributed was non-cash property, and (B) in the case of debt-financed distributions, the partner's share of the liability is $0. This rule effectively prevents taxpayers from "cashing out" any part of their OZ Fund investment for at least two years, the period during which cash distributed would be presumed to part of a "disguised sale."2
8. "Original Use" of Vacant Real Property – If a building or structure has been vacant or unused for an uninterrupted period of at least five years, the original use of such property will be treated as commencing on any date after such period when the property is first placed in service in the opportunity zone.
9. Inclusion of Deferred Gains Prior to 12/31/26 – Capital gain deferred through a contribution to an OZ Fund will be recognized prior to December 31, 2026, upon the occurrence of an "inclusion event". An inclusion event generally occurs upon (i) a transfer by a taxpayer of an interest in an OZ Fund, to the extent it results in a reduction in its interest therein; (ii) the receipt by the taxpayer of a distribution (or deemed distribution) of property (other than partnership distributions described below); (iii) a transfer by gift; (iv) the liquidation of the OZ Fund (and, in certain cases, of the direct or indirect OZ Fund owner); (v) a claim of worthlessness with respect to the OZ Fund interest; and (vi) any transfer that results in the reduction in the amount of remaining deferred gain (A) of any direct or indirect partner, or (B) that would be recognized by any such person upon a fully taxable disposition of the interest in the OZ Fund partnership.
Generally, the following will not result in an inclusion event: (i) transfers by reason of a taxpayer's death; (ii) tax-free contributions to a partnership (that do not result in the liquidation of the OZ Fund or of the direct or indirect owner of the interest in the OZ Fund); and (iii) subject to clause (vi), above, distributions by an OZ Fund partnership, except to the extent the value of the property distributed exceeds the partner's basis in its interest.
10. 50% Qualifying Gross Income Safe Harbors – The Proposed Regulations provide that a trade or business will be deemed to satisfy the 50% gross income requirement (for qualification of an entity as an OZ Business) if any of the following safe harbors apply: (i) 50% of the services (by hours or cost) are performed within an opportunity zone; or (ii) the tangible property located in an opportunity zone, and the management or operation functions performed for the business in an opportunity zone, are each necessary to generate at least 50% of the gross income of the trade or business.
11. "Carried Interest" Not a Qualifying Investment – The portion of any interest in an OZ Fund partnership received in exchange for services, including a "carried interest", is not a Qualifying Investment. The portion of the interest treated as being in exchange for services is calculated based on the highest share of residual profits to which the partner could receive with respect to such interest.
12. Anti-Abuse Rule – The Proposed Regulations include a general anti-abuse rule, providing that if a significant purpose of a transaction is to achieve a tax result inconsistent with the purposes of the OZ Fund statute, the IRS can recharacterize a transaction (or series of transactions) as appropriate in order to achieve results consistent with the purpose of the statute. By way of example, the Preamble to the Proposed Regulations provides that this anti-abuse rule could apply to treat the acquisition of agricultural land that technically satisfies the trade or business requirement (but which may not result in any additional capital investment or increased economic activity or output) as the acquisition of non-qualified OZ Property.
1 Although the rules contained in the Proposed Regulations are not effective until published as final in the Federal Register, they provide that a taxpayer may generally rely on these rules to the extent they are applied in their entirety and in a consistent manner.
2 There are exceptions from disguised sale treatment for certain cash distributions that could be made without resulting in such a recharacterization, including (i) reasonable guaranteed payments, (ii) reasonable preferred returns, (iii) operating cash flow distributions, and (iv) reimbursement of preformation expenditures.
Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.
© Morrison & Foerster LLP. All rights reserved