Treasury issues second round of proposed rules for opportunity zones
After a long and highly anticipated wait, Treasury has finally lifted the veil on a new set of proposed regulations that attempts to bring additional clarity to tax breaks on investments in economically disadvantaged communities that are designated as qualified opportunity zones (QOZs).
The proposed regulations, some 169 pages in length, were released on April 17, and supply additional guidance under Section 1400Z-2 of the Internal Revenue Code.
On the heels of the first phase of regulations and a public hearing that was standing-room only, this phase provided greater clarity to a host of unresolved issues. The release occurred during an opportunity zone conference at the White House that was attended by state, local, tribal, and community leaders and with participation by the president, chairman of the Council of Economic Advisers, secretaries of HUD and Treasury, and a host of industry practitioners.
The excitement for this new tax provision has been palpable, and the activity is poised to dramatically accelerate, now that there is additional clarity to the rules. While there may be some incremental fine-tuning over the ensuing months, the guidance to date has been very well received and should provide the foundation to spur additional economic development. We applaud Treasury for their thoughtfulness and look forward to the comments they have requested and the public hearing regarding the regulations.
Five Significant Changes in the Regulations
1. Investor exits from a qualified opportunity fund (QOF)
The 10-year hold period
The proposed regulations address investor and fund manager concerns relating to multi-asset funds and attempt to minimize some of the structuring workarounds previously contemplated by fund managers.
In the original guidance, the investor gets a tax benefit from the 10-year hold – a tax-free appreciation on the QOF investment – through the sale of their ownership interest in the QOF. In a multi-asset fund, the QOF may sell various assets over multiple years, thereby creating a taxable flow-through gain to the QOF investor prior to the allowable sell date of the accrued interest on the QOF.
The QOF investor would now be allowed to make an election to exclude from gross income some, or all, of the capital gain from the disposition of a qualified opportunity zone property (QOZP) reported on the investor’s Schedule K-1 after the 10-year holding period. This change allows an investor to retain the tax-free benefit from a sale of the QOZP by the QOF while allowing the QOF to conduct an orderly liquidation of assets.
2. “Substantial improvement”
The opportunity zone statute was intended to ensure net new economic activity in a QOZ by requiring that, in general, any tangible property acquired would either have its “original use” in a QOZ or be substantially improved. This substantial improvement concept has confused stakeholders, given the concerns about timing as applied to real estate assets and its application to operating businesses.
The issue was addressed in the regulations by further defining original use. Principally, the original use of tangible property begins on the date such property is first placed in service in the QOZ and as depreciation (or amortization) standards are applied. This makes it possible for a QOF to acquire an asset prior to placement in service (the last money in).
Also, original use is satisfied for any property that has been previously used or placed in service, but outside of the QOZ, such as relocation. Additionally, the original use requirement is satisfied if property that has been unused or vacant for at least five uninterrupted years is then constructed or refurbished and then placed in service. The regulations create a parallel application for leased property related to the application of both principles above.
While land within a QOZ that is purchased is NOT subject to original use and unimproved land is not subject to substantial improvement, the land does have to be used in a trade or business to be qualified business property. Likewise, if the acquisition of land is deemed to be in pursuit of an inappropriate tax result, the anti-abuse rules will apply.
3. Interim gains on property disposition
Interim gains are among the top issues on which investors have been seeking clarity. This issue is particularly critical because it addresses flexibility in trading assets in a fund, which can help encourage broader economic development through investment in operating businesses, which will serve as a balance to real estate investment.
The newly proposed regulations address the issue in the context of whether a QOF maintains the critical investment standard manifest in the 90 percent asset test. If a QOF receives proceeds from the sale, disposition, or return of capital on QOZP, reinvestment of such proceeds within 12 months will ensure compliance with the 90 percent asset test. A caveat is that the proceeds generally must be held in liquid assets – that is, cash, cash equivalents, and debt instruments with a term of 18 months or less – in the intervening period.
What many investors sought from the regulations was relief from any federal tax consequences associated with receipt of such proceeds. Treasury, however, did not believe it had the authority to change the tax outcome that would otherwise be realized. Consequently, a QOF will either:
- Reinvest all proceeds, whereby investors will incur phantom income, or
- Distribute cash to ensure there is no phantom income
A third option is a hybrid approach: Cash is distributed pursuant to the interim gain, and the cash is invested in a new QOF scenario and pursuant to a deferral of such interim gain. Note that an interim gain deferral will still be subject to the Dec. 31, 2026, deadline and therefore have diminishing utility over time. Also, keep an eye out for new, creative approaches to being continuously invested as investors seek to minimize the tax burden from the interim gain.
4. Inclusion events
While the code provides for “inclusion” (acceleration of deferred gain) upon a sale or exchange of an interest in a QOF, the regulations track the “disposition” language in the Conference Report. Generally, an inclusion results from any event that reduces the taxpayer’s equity interest in the QOF.
The regulations provide a nonexclusive list of 11 inclusion events with the 11th event providing an additional 11 inclusion events involving certain nonrecognition transactions. An exception from gain inclusion is provided for certain transfers of a QOF’s assets if the shareholder receives an interest in another QOF and there is no “cashing out” or reduction in equity interest.
The 11 inclusion events include:
1. Sale or exchange of a qualifying QOF investment
2. S corporation stock disposition that owns a QOF partnership or QOF corporation if the shareholders at the time of the deferral have changed by more than 25 percent
3. Transfer by a partner of a partnership interest that directly or indirectly holds a qualifying investment
4. Transfer by gift of a qualifying investment
5. Distribution of partnership property to a partner where the fair market value exceeds the partner’s basis in the qualifying QOF partnership interest
6. Distribution of property out of a qualifying QOF C corporation to the extent that it is treated as gain from the sale or exchange of property
7. Distribution of property out of a qualifying QOF S corporation to the extent that it is treated as gain from the sale or exchange of property
8. Redemption of qualifying QOF stock that is treated as an exchange
9. Disposition of qualifying QOF stock under Section 304
10. Liquidation of a QOF corporation under Section 331
11. Certain nonrecognition transactions
5. Debt-financed distributions
Debt-financed distributions, a specific area of concern for practitioners, has been addressed in this set of proposed regulations. Generally, a partner that receives a debt-financed distribution from a partnership would only recognize taxable income or gain to the extent that the distribution exceeds that partner’s basis in their partnership interest.
The newly proposed regulations provide two examples confirming that debt-financed distributions are treated – as under existing law, that is – the same as in non-QOF partnerships.
The example makes it clear that there is no gain recognition to the extent that a debt-financed distribution does not exceed the partner’s basis in their QOF interest, including that partner’s share of basis attributable to liabilities.
In a second example, a partner receives a distribution in excess of their basis in the QOF interest. In this example, there would be gain recognition to the extent that the distribution exceeds the partner’s basis in their QOF interest. Additionally, partners should consider the interest tracing rules and the deductibility of interest expense.
12 Quick Hits
1. section 1231 gains
Because capital gain income from Section 1231 property – that is, generally, property used in a trade or business and held for more than one year – can only be determined as of the last day of the taxable year, the 180-day investment period begins on that day – the last day of the taxpayer’s taxable year. The amount eligible to be invested is net Section 1231 gain.
2. Carried interests
An investment that arises from services to the QOF or an entity owned directly or indirectly by the QOF does not qualify for the QOF benefits. The taxpayer’s interest is a mixed fund with the portion of the interest related to equity contributed treated as an investment that qualifies for the QOF benefits. The balance does not qualify.
3. Timing flexibility
For purposes of the 90 percent test, the QOF may choose to determine compliance with the 90 percent test by excluding contributions received within six months of the testing date if the QOF continuously holds the contribution in cash, cash equivalents, or short-term debt. This will give a QOF no less than six months and no more than 12 months to put cash to work.
4. 50% gross income safe harbors
There are three safe harbors to document that a 50 percent gross income test for an active trade or business in the QOZ is met. First, 50 percent of the hours for services performed for the business are by employees and contractors located in the QOZ. Second, 50 percent of the amount paid for services performed for the business are by employees and contractors located in the QOZ. Third, the tangible property and management or operation functions located in the QOZ are each necessary to generate 50 percent of the business’s gross income. Finally, the test may be documented based on facts and circumstances.
5. Working capital
The 31-month window for use of working capital by a trade or business now includes the development of a trade or business, not just the acquisition or construction of substantial improvement of tangible property. If the 31-month period is exceeded due to government delays, the trade or business is still in compliance with the safe harbor requirement.
6. Hot assets and depreciation recapture
If the taxpayer’s basis in the QOF is increased to fair market value because the 10-year hold election has been made, the basis of the underlying assets is also increased just prior to the sale. This mechanism avoids the potential for ordinary gain related to depreciation recapture and other hot assets while creating an equal capital loss.
7. Active business
The ownership and operation (including leasing) of real property is an active trade or business. However, this does not include triple-net-leased property.
8. Substantially all
The first round of guidance established that 70 percent was the threshold for satisfying the “substantially all” test, but only as referenced in one section of the statute and pertaining to tangible property owned or leased by a trade or business. This round clarified that the references in a prior section of the statute to the threshold for measuring the holding period is set at 90 percent. The increase is appropriate since it is more easily controlled. Incidentally, an additional reference to substantiality appears related to the use of intangibles. In that case, 40 percent meets the threshold for intangible property that must be used in the active conduct of a trade or business.
9. Other lease items
For valuation purposes, leased assets are included in both the numerator and denominator at the present value of all lease payments in calculating the 90 percent asset test and the 70 percent QOZB “substantially all” test. Leased property can qualify as QOZ business property (QOZBP) if the property is:
- Acquired under the lease after Dec. 31, 2017
- The terms are arm’s-length, market rate (by applying so-called “section 482” criteria)
- If the lease is from a related party, there are two additional requirements that must be met:
- Rent cannot be prepaid by more than 12 months; and
- If original use of leased tangible personal property in the opportunity zone does not commence with the lessee, the lessee must purchase other tangible personal property that is QOZB equal in value to the leased tangible personal property
10. Contributions to a QOF
The regulations explicitly state that qualifying contributions can come in the form of cash, or other property, subject to the disguised sale rules. To the extent property (other than cash) is contributed, the investment equals the lesser of their adjusted basis or the fair market value of the equity received. The fair-market value excess is treated as a mixed fund. Similarly, a mixed fund will exist if the amount of investment that would result exceeds the eligible gain.
In a significant positive change, the new proposed regulations allow an investor to make an eligible investment in a QOF by purchasing an ownership interest from an existing QOF investor. (That selling investor then will have an inclusion event.)
Treasury is expected to revise Form 8996 to require the employer identification number (EIN) of the QOZB owned by the QOF and the census tracts where investments are being made.
One structural consideration to keep in mind:
The newly issued regulations provide a series of rules under which gains that had been deferred under the opportunity zone general rules are later included in income. These rules, so-called “inclusion events,” may apply to full or partial dispositions of a direct investment in a QOZP, or indirect investments in a QOF, whether the QOF is a corporation or partnership. There are situations in which either QOF stock distributions or QOF direct or indirect investments in QOF partnerships are treated as inclusion events. Proper planning can help minimize any potential tax impact from these distributions.
Distributions of property treated as dividends or a return of capital are not inclusion events. An inclusion event will occur if the distribution is in excess of the stockholder’s basis in their stock.
In the partnership context, an actual or deemed distribution of cash or property by a QOF to a partner with respect to a qualifying investment is an inclusion event to the extent that the distributed property has a fair market value in excess of the partner’s basis in the qualifying investment. Similar rules apply to tiered partnerships.
Where a taxpayer has both qualifying and nonqualifying investments, or so-called “mixed fund investments,” the partner will be treated as holding two separate interests in the partnership – a qualifying interest and a non-qualifying interest. The qualifying interest would be subject to the inclusion rules in addition to the established partnership rules, where the non-qualifying interest would only be subject to the partnership rules.
An actual or constructive distribution of property by a QOF S corporation with respect to a qualifying investment is an inclusion event to the extent the distribution is treated as a gain from the sale or exchange of property due to a distribution in excess of basis or the distribution is out of prior C corporation earnings and profits.
As we continue to tease out the nuances in the proposed regulations, watch for our Tax Alert updates for deeper insights into how this new guidance will impact stakeholders in the opportunity zone ecosystem.
In the meantime, to hear an in-depth discussion from our tax and real estate specialists, register for our upcoming webinar on April 30, titled Opportunity Zones – Perspectives on the New Wave of Guidelines and Key Considerations.
Subject matter expertise
CPA, Partner, Affordable Housing Industry Leader
CPA, Partner, Practice Leader, Federal Tax Services
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