Updated Qualified Opportunity Zone Guidance Released by Treasury
By George Moffa and Adam Liebman
May 16, 2019
The Internal Revenue Service (IRS) and US Department of the Treasury (Treasury) recently issued a second set of proposed regulations (“the 2019 proposed regulations”) related to Qualified Opportunity Zones (QOZ). These proposed regulations are a follow up to the October 2018 proposed regulations.
For additional information regarding the October 2018 proposed regulations please see our alert “Qualified Opportunity Zone Guidance Released By Treasury”
The 2019 proposed regulations address several questions which may have kept investors, fund managers, business owners and developers reluctantly waiting in the wings before starting a fund or business in a QOZ.
Qualified Opportunity Zone (QOZ) Investors May be Able to Exclude Gains on Qualified Opportunity Fund (QOF) Dispositions of QOZ Property
The 2019 proposed regulations provide some welcome clarity with respect to gains arising from the disposition of QOZ property held by a QOF. As long as the investor has held its interest in a QOF for ten years, the investor may elect to exclude from gross income some or all of the capital gain generated by the QOF’s disposition of QOZ property. QOF real estate investment trusts (QOF REITs) may also designate special capital gain dividends, not to exceed the QOF REIT’s long-term gains on sales of QOZ property, which are tax free to shareholders who could have elected a basis increase in case of a sale of the QOF REIT shares.
Mazars Insight: Prior to these proposed regulations, investors would have needed to dispose of their interest in a QOF to get the full benefit of the 10-year holding period income exclusion. This clarification allows multi-asset funds to operate and plan around disposing assets with more flexible exit strategies.
Events that Trigger Inclusion of Deferred Gains (Inclusion Events) and the Impact of Partnership Liabilities
The proposed regulations set forth a nonexclusive list of what is termed “inclusion events” and the underlying principles guiding them. There are eleven specific inclusion events, with one inclusion event further broken down into 11 “nonrecognition transactions.” The general principle states an inclusion event results from a transfer of a qualifying investment in a transaction to the extent the transfer reduces the taxpayer’s equity interest in the qualifying investment for federal tax purposes.
With respect to partnership distributions, the proposed regulations provide that a distribution of cash or property from a QOF to a partner will not trigger an inclusion event, so long as the distribution does not exceed the partner’s basis in its partnership interest. As long as the partner’s basis in a QOF is increased by liability allocations, a distribution below this amount should not trigger an inclusion event.
Mazars Insight: QOFs in the real estate industry will be able to provide liquidity for partners’ tax needs with refinancing strategies.
Treatment of 1231 Gains
Internal Revenue Code Section 1231 gains are gains from the sale of real property used in a trade or business which have been held for longer than one year. Section 1231 losses are treated as ordinary losses.
Taxpayers are required to net their section 1231 gains and losses from all sources together on their tax return to determine if they have an overall gain or loss from those transactions. Net section 1231 gains are treated as long-term capital gains and are eligible for the deferral election if invested in a QOF. Since a taxpayer cannot determine if they will have net section 1231 gains, which will be treated as long-term capital gains until the last day of the tax year, the 180-day period to invest the net gains into a QOF will start on the last day of the tax year.
Mazars insight: Careful planning is required to ensure proper calculation of deferable gains available for investment in a QOF.
Qualifying as a Qualified Opportunity Zone Business (QOZB)
To qualify for the opportunity zone benefits the taxpayer must be engaged in an “active trade or business.” The 2019 proposed regulations define a trade or business for purposes of section 1400Z-2 as a trade or business within the meaning of IRC section 162.
In addition to the requirements for being classified as an active trade or business under IRC section 162 the QOZB must source at least 50% of its gross revenue from within a QOZ. The 2019 proposed regulations provide three safe harbors to meet the 50% revenue requirement. The QOZB only needs to meet one of the following safe harbor tests listed below.
- Labor Input (Hours) – At least 50% of all employees and independent contractors (including their employees) work hours for services performed for the QOZB are located within a QOZ.
- Labor Input (Compensation) – At least 50% of all compensation for services performed for the QOZB by employees and independent contractors (including their employees) are located within a QOZ.
- Multiple Input – The tangible property of the QOZB is located in a QOZ and the management or operational functions performed in the QOZ are necessary for the generation of at least 50% of the gross income of the QOZB.
Mazars Insight: Certain types of lease investments, such as triple-net-leases, will need to be further analyzed to determine if they meet the “trade or business” test for opportunity zone property. The safe harbors tests for the 50% revenue test should give businesses the flexibility to meet the requirements to be classified as a QOZB.
Defining “Substantially All”
The October 2018 proposed regulations defined substantially all for section 1400Z-2(d)(3)(A)(i) at 70%; covering the threshold for use of assets but not holding period requirements.
The 2019 proposed regulations expanded the definition to include holding period thresholds which have been set at 90%. The combined proposed regulations require:
- A QOZB must hold at a minimum 70% of its property which is classified as Qualified Opportunity Zone Business Property (QOZBP).
- For QOFs or QOZBs that hold tangible property, for 90% of the holding period of such property, at least 70% of the property use must occur in a qualified zone.
- For 90% of the holding period of an investment made by QOF in a subsidiary entity, the entity invested in by the QOF must qualify as a QOZB.
Mazars Insight: QOZBs with activities and physical locations both inside and outside a QOZ will need to consider the best methods for tracking and maintaining where assets are being held and utilized, and where the business is operating.
The 2019 proposed regulations include leased tangible property as eligible QOZBP if the property meets the following conditions:
- The lease for the tangible property is entered into after December 31, 2017 and,
- “Substantially All” (Use Test 70%) of the tangible property’s use will be used in an QOZ for “Substantially All” (Holding Period Test 90%) of the period of the leased property.
- The lease terms must be arms-length with market rate terms.
The following requirements must be met if the lease is between related parties (for QOZ purposes, 20% common ownership is considered a related party):
- The lessee (QOF or QOZB) cannot make prepayments of rent that extend beyond one year.
- If the property leased is tangible personal property, the property must have its original use with the lessee (QOF or QOZB) or if the original use did not begin with the lessee, the lessee is required to become the owner of tangible property that meets the QOZBP requirements in an amount at least equal to the value of the property leased from the related party. In addition, there must be a substantial overlap in the QOZs where the leased property and the property acquired are being used. This property must be purchased by the earlier of the end of the lease term or 30 months from when the lessee received the leased property.
Mazars Insight: The addition of leased property as eligible for classification as QOZBP will provide much needed relief for businesses requiring financing alternatives for acquiring equipment for use in the QOZB.
The 2019 proposed regulations provide that a QOF has one year from sale or disposition of QOZP, or the return of capital from investments in qualified opportunity stock, or qualified opportunity zone partnership interest, to reinvest the proceeds in other QOZP. If reinvested within the one year period the associated gains from the proceeds reinvested will continue to be deferred and not recognized as taxable income.
Original Use – Vacant Property Relief
The October 2018 proposed regulations provided that if a QOF or QOZB purchased a building (not original use), the property must be substantially improved to be considered QOZB property. To meet the substantial improvement requirement the QOF or QOZB would need to make investments with costs that are at least equal to the original allocated basis to the building within any 30-month period beginning after the date of acquisition of the property.
The 2019 proposed regulations provide relief from the substantial improvement requirement if the building was vacant or unused for at least five years prior to the QOF or QOZB purchasing the building.
The above are highlights of the 2019 proposed regulations. There are still unanswered questions and the Treasury and IRS continue to take comments as they look to provide additional guidance to taxpayers on investing in, and operating, a business within QOZs.
In addition to the above, please see the Mazars Quick Reference Guide on Opportunity Zones for further details.
Please contact your Mazars USA LLP professional for additional information.