The second round of proposed regulations issued on April 17, 2019 provide additional guidance on some of the questions and issues that remained unclear after the initial round of proposed regulations that were issued in October 2018.
The Opportunity Zone program was created by the Tax Cuts and Jobs Act (TCJA) to stimulate economic development and job growth in low income communities across the US, DC and the five US territories by providing tax breaks to investors in the qualified zone areas.
Tax Incentives offered by the program:
- Tax Deferral
- Step-up in basis
- Permanent Exclusion
Most capital gains can be deferred with tax savings to the taxpayer until 12/31/2026 or until the investment in the Qualified Opportunity Fund (QOF) is sold, whichever is earlier, if the original capital gains are invested in a QOF within 180 days of the sale of the asset.
- Gain from sale or exchange of assets between related parties as provided in the proposed regulations does not qualify.
- Investment in QOF must be an equity interest and cannot be a loan or another debt instrument.
- The deferred gain retains its attributes
Step-up in basis:
The basis in the capital gains invested in the QOF is increased by:
- 10% if the taxpayer holds the QOF investment for at least 5 years, or
- 15% if the taxpayer holds the QOF investment for at least 7 years
Thus, the taxpayer can defer and effectively exclude up to 15% of the original capital gains from taxation.
The capital gain on the sale or exchange of the investment in the QOF can be permanently excluded from taxation if the QOF investment is held for at least 10 years.
- John has a capital gain of $ 100,000 from sale of Apple stock as on 7/1/18.
- He invests $ 100,000 in QOF on 11/1/18 (within 180 days of 7/1/18):
- Does not pay any tax on the entire gain in 2018
- Holds the QOF investment until 11/30/23 (past 5 years) and sells the QOF investment at a gain of $ 20,000:
- Gets a step-up in basis of 10% or $ 10,000 on the original gain and pays tax only on the remainder of the original gain of $ 90,000. The $ 20,000 gain on the sale of QOF investment is also subject to tax in 2023.
- Holds the QOF investment until 11/30/25 (past 7 years) and sells the QOF investment at a gain of $ 35,000:
- Gets a step-up in basis of 15% or $ 15,000 on the original gain and pays tax only on the remainder of the original gain of $ 85,000. The $ 35,000 gain on the sale of QOF investment is also subject to tax in 2025.
- Holds the QOF investment until 11/30/28 (past 10 years) and sells the QOF investment at a gain of $ 65,000:
- The $ 65,000 gain on the sale of QOF investment is permanently excluded from taxation. Must pay tax on the deferred gain of $ 85,000 in 2026.
The key topics clarified and addressed in the second round of proposed regulations are as follows:
Tangible property used in a trade or business of the QOF will be considered as Qualified Opportunity Zone Business Property (QOZBP) if during substantially all of the QOF’ s holding period for such property, substantially all of the use of such property was in a Qualified Opportunity Zone (QOZ).
The term “substantially all” is:
• 70% in the context of “use” in testing the use of QOZBP in a QOZ.
• 90% in the context of holding period.
Original Use of Tangible Property Acquired by Purchase:
For tangible property to be considered QOZBP as defined in the initial proposed regulations, the original use of such property in the QOZ must commence with the QOF or must be substantially improved by the QOF.
The proposed regulations clarify that:
- The original use of tangible property acquired by purchase by any person commences on the date when that person or a prior person first places the property in service in the QOZ for purposes of depreciation or amortization (or first uses the property in the QOZ in a manner that would allow depreciation or amortization if that person were the property’s owner).
- Tangible property located in the QOZ that is depreciated or amortized by a taxpayer other than the QOF or qualified opportunity zone business (QOZB) would not satisfy the original use requirement under these proposed regulations.
- Used tangible property will satisfy the original use requirement with respect to a QOZ so long as the property has not been previously used (that is, has not previously been used within that QOZ in a manner that would have allowed it to be depreciated or amortized) by any taxpayer.
- A building or other structure that has been vacant for at least five years prior to being purchased by a QOF or QOZB will satisfy the original use requirement.
- Improvements made by a lessee to leased property satisfy the original use requirement and are considered purchased property for the amount of the unadjusted cost basis of such improvements.
- The original use of tangible property in the QOZ commence with a QOF requirement is not applicable to land, whether the land is improved or unimproved. Likewise, unimproved land that is within a QOZ and acquired by purchase is not required to be substantially improved.
- The determination of whether the substantial improvement requirement is satisfied for tangible property that is purchased is made on an asset-by-asset basis.
As an alternative, the Treasury Department and the IRS have contemplated the possibility of applying an aggregate standard for determining compliance with the substantial improvement requirement, potentially allowing tangible property to be grouped by location in the same, or contiguous, qualified opportunity zones and have requested comments on the potential advantages, as well as disadvantages, of adopting an aggregate approach for substantial improvement.
Land can be treated as QOZBP only if it is used in a trade or business of a QOF or QOZB.
- Only activities rising to the level of a trade or business within the meaning of section 162 may qualify as a trade or business for purposes of section 1400Z-2.
- The holding of land for investment does not give rise to a trade or business and such land could not be QOZBP.
Property leased by a QOF or QOZB will be treated as QOZBP for the purposes of satisfying the 90% asset test and the “substantially all” requirement if the following two general criteria are satisfied:
- Leased tangible property must be acquired under a lease entered into after December 31, 2017.
- Substantially all of the use of the leased tangible property must be in a QOZ during substantially all of the period for which the business leases the property.
These proposed regulations:
- Do not impose an “original use” or “substantial improvement” requirement with respect to leased tangible property.
- Discuss the methodologies of lease valuations.
- Do not require leased tangible property to be acquired from a lessor that is unrelated to the QOF or QOZB that is the lessee under the lease. However, certain additional requirements are imposed on related party leases to qualify as QOZBP.
- Include a warning that at the time the lease is entered into, there was a plan, intent, or expectation for the real property to be purchased by the QOF 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 QOZBP at any time.
The QOF or QOZB may want to consider entering into long term leases at least ten years or more to satisfy the ten year holding period for gain exclusion.
50% gross income test:
In order to be a qualified business entity with respect to any taxable year, a corporation or partnership must derive at least 50% of its total gross income from the active conduct of trade or business.
The proposed regulations provide three safe harbors and a facts and circumstances test for determining whether sufficient income is derived from a trade or business in a QOZ for purposes of the 50% test, of which only one of these safe harbors is sufficient to be met.
- The first safe harbor requires that at least 50 percent of the services performed (based on hours) for such business by its employees and independent contractors (and employees of independent contractors) are performed within the QOZ. This test is intended to address businesses located in a QOZ that primarily provide services.
- The second safe harbor is based upon amounts paid by the trade or business for services performed in the QOZ by employees and independent contractors (and employees of independent contractors).
- The third safe harbor states that a trade or business may satisfy the 50% gross income requirement if (1) the tangible property of the business that is in a QOZ and (2) the management or operational functions performed for the business in the QOZ are each necessary to generate 50% of the gross income of the trade or business.
- If a business cannot satisfy any of the above three safe harbors, then the proposed regulations provide for the facts and circumstances test under which a business may meet the 50% gross income test if, based on all the facts and circumstances, at least 50% of the gross income of a trade or business is derived from the active conduct of a trade or business in the QOZ.
Use of Intangibles:
The proposed regulations clarify that the term “substantial portion” means at least 40% for the purposes of determining whether a substantial portion of intangible property is used in the active trade or business in the QOZ for the business to be considered a QOZB.
Working Capital Safe Harbor:
The following two changes have been made to the previously issued proposed regulations relating to working capital safe harbor:
- The written designation for planned use of working capital now includes the development of a trade or business in the qualified opportunity zone as well as acquisition, construction, and/or substantial improvement of tangible property.
- Exceeding the 31-month period does not violate the safe harbor if the delay is attributable to waiting for government action the application for which is completed during the 31-month period.
These new regulations have expanded the use of the working capital to include development of trade or business in the QOZ rather than just the acquisition, construction or substantial improvement of tangible property thereby allowing some flexibility in the use of funds to operating entities.
Special Rule for Section 1231 Gains:
The initial proposed regulations had clarified that only the net section 1231 gains after offsetting the section 1231 losses would be eligible to be invested as eligible capital gains in a QOF. The new proposed regulations now further clarify that the 180 day period for investing such section 1231 gain begins on the last day of the taxable year.
Mixed Fund Investments:
Mixed fund investments are created in situations where a partner:
- Contributes property to a QOF with a value in excess of it basis, or cash in excess of the partner’s gain eligible for deferral, or
- Receives a partnership interest for services (carried interest).
The proposed regulations clarify that:
- The portion of the investment in a QOF for which an election under section 1400Z-2(a) is in effect is treated as a qualifying investment.
- The gain attributable to any excess investment and/or service component of the interest in the QOF partnership is not eligible for the benefits under the QOZ program.
- With regard to mixed-funds investments in a QOF S corporation, if different blocks of stock are created to track the basis in qualifying investments, then these will not be treated as different classes of stock for the purposes of S corporation status.
The proposed regulations discuss various approaches to accounting for and tracking the qualified and non-qualified investment components in case of mixed-fund investments and set forth rules applicable to partnerships and S corporations.
Relief with Respect to the 90% Asset Test:
These proposed regulations allow a QOF to apply the 90% Asset Test without taking into account any investments received in the preceding 6 months as long as those new assets are being held in cash, cash equivalents, or debt instruments with term 18 months or less during the interim period.
Events That Cause Inclusion of Deferred Gain (Inclusion Events):
The deferred gain is recognized on the date on which the qualifying investment is disposed of or December 31, 2026 whichever is earlier.
These proposed regulations list several transactions which constitute inclusion events, meaning events that trigger the recognition of deferred gain and describe how to compute the amount to be included once an inclusion event occurs.
In general an inclusion event or transaction is one that has the effect of:
- Reducing or terminating the QOF investor’s direct (or, in the case of partnerships, indirect) qualifying investment for Federal income tax purposes or
Constitutes a “cashing out” of the QOF investor’s qualifying investment (in the case of distributions in excess of basis).
QOF Reinvestment Rule:
- Proceeds received by the QOF from the sale or disposition of (1) QOZBP, (2) QOZ stock, and (3) QOZ partnership interests are treated as QOZP for purposes of the 90-percent investment requirement so long as the QOF reinvests the proceeds received by the QOF from the distribution, sale, or disposition of such property during the 12-month period beginning on the date of such distribution, sale, or disposition.
- Another requirement is that the proceeds must be continuously held in cash, cash equivalents, and debt instruments with a term of 18 months or less.
Election to exclude gain after the 10 year holding period:
- If a taxpayer has held a qualifying investment in a QOF partnership or QOF S corporation for at least 10 years, and the QOF partnership or QOF S corporation disposes of QOZP after such 10 year holding period, the taxpayer may make an election to exclude from gross income some or all of the capital gain arising from such disposition reported separately on Schedule K-1 of the QOF partnership or QOF S corporation and attributable to the qualifying investment.
- If the QOF investor sells his or her QOF partnership interest or S corporation stock after 10 years, all of the gain may be excluded from income.
As a tax planning note taxpayers should take into consideration any expiring tax attributes such as tax credits or deductions prior to making the above election.
General Anti-abuse Rule:
The proposed regulations contain a general anti-abuse rule allowing the Commissioner to recast a transaction or a series of transactions that are inconsistent with the purposes of section 1400Z-2 for Federal income tax purposes as appropriate to achieve tax results that are consistent with the purposes of section 1400Z-2.
The Treasury Department and the IRS have invited suggestions as to other issues that should be addressed to further clarify the rules under section 1400Z-2, as well as comments on all aspects of these proposed regulations. The Treasury Department and the IRS expect to address the administrative rules applicable to a QOF that fails to maintain the required 90 percent investment standard as well as information-reporting requirements for an eligible taxpayer under section 1400Z-2, in separate regulations, forms, or publications.