On April 17, the Treasury Department (Treasury) released the second set of proposed regulations concerning investing in qualified opportunity funds (QOFs) and qualified opportunity zones (QOZs) under Section 1400Z-2 of the Internal Revenue Code, which was added as part of the Tax Cuts and Jobs Act of 2017. Treasury released 169 pages of proposed regulations and explanations, answering a number of significant questions that had kept many taxpayers on the sidelines.
New Proposed Regulations Highlights
Investments in QOFs and QOF Interests:
- A QOF interest may be acquired from an existing QOF interest holder and also in exchange for contributed property, but an interest received in exchange for services (i.e., a profits or carried interest) will not qualify for capital gain deferral or other tax benefits afforded by Section 1400Z-2.
- Taxpayers who own QOF partnership interests or QOF S corporation stock and have held their QOF interest for at least 10 years may elect to exclude the capital gain on the QOF's sale of qualified opportunity zone property (QOZP).
- If a taxpayer sells or exchanges its QOF interest in a partnership after 10 years and elects to step up the basis of the QOF interest, the bases of the partnership QOF's assets with respect to that partner will also be adjusted.
- A QOF may apply the 90 percent QOZP asset test without taking into account any investments received in the preceding six months.
- A QOF has a 12-month grace period to reinvest the proceeds from the sale of any of its QOZP without such proceeds being treated as nonqualifying assets.
- Section 1231 gains and losses must be netted at the end of the taxable year to determine the amount of capital gain from Section 1231 property, and accordingly, the 180-day period to invest such capital gain in a QOF begins on the last day of the taxable year of the taxpayer.
- There is enumerated a non-exclusive list of events treated as a "disposition" of a QOF interest that would require a taxpayer to recognize all or part of its deferred gain, including most gifts of a QOF interest and some but not all non-recognition transactions.
- A QOF may be the common parent of a consolidated group, but it may not be a subsidiary member of a consolidated group.
Qualified Opportunity Zone Business Property (QOZBP) and Qualified Opportunity Zone Businesses (QOZBs)
- Leased property may be QOZBP, and such property does not need to have its original use in the QOZ, provided the lease is entered into after Dec. 31, 2017. Further, leased property does not have to be leased from an unrelated party to qualify (subject to certain restrictions).
- Lessee improvements may satisfy the original use requirement and are considered purchased property for the amount of the unadjusted cost basis of the improvements.
- "Substantially all" for purposes of determining usage of QOZBP (whether leased or owned) is defined as 70 percent. Substantially all for purposes of determining a QOF or QOZB's holding period of QOZP or QOZBP is defined as 90 percent.
- "Original use" of property in a QOZ was clarified to mean when the property is first placed in service in the QOZ.
- Property that has been vacant for at least five continuous years may be considered to have its original use in the QOZ, and it need not be substantially improved to qualify as QOZBP.
- Land may qualify as QOZBP without being substantially improved if it is used in a trade or business. However, under an anti-abuse provision, if land is unimproved or minimally improved and a QOF or QOZB purchases it with an intention to not improve the land by more than an insubstantial amount within 30 months, it will not be QOZBP.
- A business may satisfy the 50 percent gross income QOZB requirement by complying with one of three safe harbors (or a general facts and circumstances analysis).
- The 31-month working capital safe harbor for nonqualified financial property is extended to amounts held for the development of a trade or business. Additionally, a QOZB may rely on multiple and overlapping working capital safe harbor periods.
- "Substantial portion" for purposes of intangible property is defined to mean at least 40 percent.
- Trade or business is defined as a trade or business under Section 162. Treasury specifically indicated that leasing real property may be the active conduct of a trade or business for opportunity zones purposes, but "merely entering into a triple-net lease" is not.
Open Items and Unanswered Questions
The new proposed regulations provide additional clarity regarding practical implementation of the opportunity zones rules, with most of the new guidance being favorable to taxpayers. However, several questions remain. Treasury is requesting comments on a number of items, including whether a similar 12-month reinvestment grace period afforded to QOFs would be beneficial for QOZBs.
Except for the limited exception available to taxpayers who have held their interests in QOFs organized as partnerships or S corporations for 10 years, Treasury indicated it did not believe Section 1400Z-2 grants it the authority to provide for the nonrecognition of gain on any interim sales of assets by a QOF or in any case involving the sale of assets by a QOZB. Even the limited exception referenced above does not appear to be available for capital gain attributable to gain allocated to a QOF by a QOZB upon the sale of the QOZB's assets.
Treasury also stated that within a few months of the publication of the new proposed regulations, it and the Internal Revenue Service expect to address the administrative rules applicable to a QOF that fails to maintain the required 90 percent of its assets in QOZP.
Upcoming Deadlines and Possible Near-Term Actions
Treasury is accepting comments on the new proposed regulations until July 1. Thus, interested parties still have time to provide input and submit their comments to Treasury. Our team is assisting clients and friends in this regard presently, and we would be happy to help others who would like to make their views known to Treasury as it seeks to finalize this regulatory guidance.
Taxpayers who are partners in partnerships or shareholders in S corporations who have been allocated flow-through capital gains from 2018 partnership or S corporation sales that were not reinvested in a QOF by the partnership or S corporation itself have until June 29 to invest up to the amount of their distributive share of those capital gains in a QOF. Additionally, taxpayers with net 2018 Section 1231 gains also have until June 29 to reinvest such gains in a QOF.
Our team at BakerHostetler would be glad to discuss any questions about QOFs, QOZs or related matters, and we are happy to help with structuring QOFs or providing other assistance to taxpayers trying to obtain the tax incentive benefits conferred by the Opportunity Zones program.
For a more detailed discussion of the new proposed regulations, please see our in-depth analysis of the new proposed regulations and their impact on the Opportunity Zones program here and for a summary of the initial proposed regulations under Section 1400Z-2 issued in October 2018, please find our previous Client Alert on Opportunity Zones and Opportunity Funds, here.
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.