On Dec. 22, 2017, the Qualified Opportunity Zone tax incentive program was signed into law as part of the Tax Cuts and Jobs Act of 2017. The goal of the Qualified Opportunity Zone program is to encourage investment in designated economically distressed communities throughout the U.S. (QOZs) through qualified opportunity funds (QOFs) by offering investors (i) the opportunity to defer the recognition of capital gains otherwise includible in their taxable income, (ii) the ability to exclude up to 15 percent of such capital gain if a QOF interest is held for seven or more years prior to Dec. 31, 2026, and (iii) the ability to completely exclude the appreciation on such QOF investment upon a sale of a QOF interest if held for at least 10 years. For a general overview of the Qualified Opportunity Zone program, please click here.
The Internal Revenue Service (IRS) published proposed QOZ regulations on Oct. 29, 2018 (the 2018 Regulations). Although the 2018 Regulations provided guidance with respect to some issues, many areas of uncertainty remained. On April 17, 2019, the IRS released a second set of proposed regulations (the 2019 Regulations) to address comments on the 2018 Regulations and areas previously reserved under the 2018 Regulations.
The 2019 Regulations are generally taxpayer-friendly and try to interpret the rules consistent with the intent of the statute. However, they remain a work in progress, and the IRS continues to request comments. In addition, several open issues still remain.
Issues addressed by the 2019 Regulations include the following:
Original Use/Substantial Improvement. In general, in order to qualify as QOZ Property, the property must be acquired by purchase after Dec. 31, 2017, and have its "original use" in a QOZ commencing with a QOF (or QOZ Sub) or be "substantially improved" (both referred to as "QOZ Property"). A number of issues had been raised with respect to the treatment of land, vacant property and used property. The 2019 Regulations provide:
- Land can be treated as QOZ Property if it is "used in a trade or business" of a QOF or QOZ Sub, even if it does not satisfy the original use or substantially improved requirements. For this purpose, leasing (other than triple net leases) is considered an active trade or business. However, general broad anti-abuse rules will apply to prevent improper use of land.
- A building or other structure that has been vacant for at least five years can also satisfy the original use requirement.
- With respect to leased property, improvements made by a lessee will satisfy the original use requirement and be considered purchased property for the amount of the unadjusted cost basis of such improvements.
Sale of Underlying Assets/Leverage by QOF. A number of issues had been raised as to whether a sale of an asset by a multi-asset QOF will be treated as a sale of a QOF interest eligible for gain exclusion. Questions were also raised about the ability to make leveraged distributions without gain being recognized.
- Under the 2019 Regulations, if a QOF disposes of a portfolio investment, the QOF (and its investors if taxed as a partnership or S corporation) will report the gain on such sale. The IRS is unsure whether it has the authority to allow the QOF and its investors to exclude gain from such sales, although Treasury and the IRS continue to consider this issue. A QOF has up to 12 months to reinvest the proceeds in other qualifying property for purposes of satisfying the QOF asset test.
- Notwithstanding the foregoing, an investor in a QOF (that is taxed as a partnership or S corporation) can make an election to exclude capital gain from a sale of an asset by the QOF if the investor held its QOF interest for at least 10 years.
- The 2019 Regulations prescribe a number of "inclusion events" that are treated as dispositions of an interest in a QOF, resulting in acceleration of recognition of deferred gain and potentially diminishing the benefit of investing in a QOF. These events include gifting of a qualifying investment, distributions with respect to a QOF stock treated as gain from sale or exchange, certain corporate redemptions, certain nonrecognition transactions and other transactions where the taxpayer's equity interest is reduced or the taxpayer is viewed as "cashing out." Transfers to disregarded entities, including grantor trusts, are not inclusion events.
- The 2019 Regulations appear to allow tax-free leveraged distributions to investors (subject to the "disguised sale" rules), provided such distributions do not exceed the investor's basis in the QOF (including an allocated portion of the QOF debt).
- Fifty percent of the gross income of a QOZ Sub must be derived from an active trade or business conducted in a QOZ in order for the business to be considered a QOZ business. Many taxpayers were concerned that sales outside of a QOZ would cause a business to fail this requirement. To address this concern, the 2019 Regulations provide three safe harbors that should allow many businesses to satisfy the 50 percent gross income requirement: (i) 50 percent of services performed are performed in the QOZ, based on the number of hours performed by employees; (ii) 50 percent of the services performed are in the QOZ, based on the amounts paid to employees; or (iii) the tangible property of the business that is in a QOZ and the management or operational functions of the business that are performed in a QOZ generate 50 percent of the gross income of the trade or business. If none of the safe harbors are met, the taxpayer may still meet the 50 percent gross income requirement based on all facts and circumstances.
- Interests in a QOF received for services (including carried interests) will not be treated as an eligble investment and will not qualify for QOZ benefits.
- Leased property, pursuant to a market rate lease entered into after Dec. 31, 2017, will generally be considered QOZ property. Note that additional restrictions apply if the property is leased from a related party.
- In addition to cash, the 2019 Regulations allow an investment in a QOF to be funded through a contribution of property to the QOF, subject to complex basis and holding period rules.
- An investor may acquire an interest in a QOF from a direct owner of the QOF, rather than directly from a QOF.
- There is some flexibility on the working capital safe harbor for QOZ Subs, which allows for the safe harbor to be extended if such extension is attributable to government delays outside the control of the QOZ Sub.
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.