The Internal Revenue Service has issued its second round of proposed regulations on the Qualified Opportunity Zone provisions included in the Tax Cuts and Jobs Act. While the first set of regs, issued Oct. 19, 2018, answered many questions regarding the opportunity zone provisions, the new set further clarifies a number of areas.
QOZs were added to the Tax Code in Section 1400Z late in the legislative process leading up to the TCJA, and attracted little attention at first. Once investors understood the potential for deferring or abating capital gains offered by the provision, interest mushroomed. However, investors, for the most part, stayed on the sidelines until the provision was “fleshed out” by the regs. (For more, see Tax Strategy, opposite page.)
QOZs are an attempt to attract investment to designated low-income communities, as the term is defined by Code Section 45D. The zones were designated by the Treasury based on recommendations by state governors using census tract data. There are nearly 9,000 such zones, comprising both rural and urban areas. The goal is that private investments in these zones will spur economic growth and job creation.
The new regs are extensive, and are generally taxpayer-friendly, according to Marla Miller, tax managing director at Top 10 Firm BDO USA.
“The regs clarified matters for businesses waiting on the sidelines because of uncertainty over the 50 percent rule [to qualify as an OZ business, the business must receive at least 50 percent of its gross income from the active conduct of a business in the QOZ]. This was important to get venture capital involved. And for real estate investors, they made it clear that leasing property — other than a triple net lease — or rentals would be considered a trade or business,” Miller explained.
The regs reflect a good deal of work on the part of the Treasury, indicated Jim Lang, a subject matter expert at law firm Greenberg Traurig.
“There are still some areas that need to be clarified, but for real estate investors it closed some holes,” Lang said. “Many who were not moving forward are now moving ahead because of the clarity in these regulations.”
There are two distinct advantages to an investment in a Qualified Opportunity Fund, according to Trey Webb, a partner at Top 100 Firm Bennett Thrasher.
“If a taxpayer has capital gain and makes an investment in a QOZ Fund, they can defer that gain up to the amount of the investment in the fund,” he explained. “So if they have $100,000 gain and they make that investment in the QO fund, they can defer the recognition of that gain until the earlier of the date it is sold or exchanged, or Dec. 31, 2016. If I hold that investment for five years, I get a step-up in basis — a permanent exclusion — of 10 percent of that gain. So if I hold the $100,000 for five years, I can exclude $10,000 from tax. And if I hold it for an additional two years, for a total of seven years, I can permanently exclude an additional 5 percent, so that I will only recognize $85,000 of gain. But if I hold the investment for three more years, or for 10 or more years, and it grows to $125,000, I never have to recognize gain on the $25,000 gain on the initial investment in the fund.”
“Hearings on the first set of proposed regs were heard Feb. 14, 2019, and the second set of proposed regs was issued on April 18, 2019,” he said. “The second set clarified somewhat the first-round regs, modified some of the other regs, and provided additional guidance based on comments the IRS received and those made in the public hearing.”
The second set has provided a lot more clarity for taxpayers to be comfortable in making investments in QO funds, according to Webb: “One of the challenges was what would happen when a fund disposed of its assets after the taxpayer had held for more than 10 years. If a taxpayer held multiple properties, could they exclude gain on the sale of those properties? The new proposed regs allow this. It would have been hard to sell an ownership interest in a real estate fund with multiple properties to one buyer if that weren’t the case. Now the fund has the flexibility to dispose of the properties individually.”
BDO’s Miller agreed. “This opens the gates,” she said. “Now you can sell the underlying asset and exclude the gain without selling the fund itself.”
Some of the comments on the first set of regulations were incorporated into the new regs, according to Miller: “We thought there would be a third set after the hearing on these, but it’s been indicated that there will be no third set, but additional guidance will come in the form of notices.”
“Importantly, the regs sewed up how funds can unwind their transactions after 10 years,” said Lang.
This presents a question in multiple-asset funds, Lang indicated, since an investor must sell an interest in the fund to get the step-up in basis. The regs’ solution is to allow each investor holding an interest in the fund to elect to exclude the capital gain passed through from the fund, with the basis in the fund’s assets stepped up.
“We have a good direction as to where the Treasury is headed, but we can’t rely on this until the regs are finalized,” said Lang.
From the standpoint of private equity and real estate funds, there were two issues that needed to be addressed in the regs, according to John Lore, managing partner at Capital Fund Law Group, a law firm focused on advising such funds.
“Our interest is in the investment side,” he said. “One issue was the ability of qualified funds to reinvest in another qualifying asset and have that count toward the period you need for deferral [five or seven years], and the other is to sell and reinvest and have it count toward the 10 years needed for exclusion of gain within the fund. The regs allow the fund to have one year to reinvest the proceeds into another QOZ asset without penalty and without accelerating the deferral. But for now the regs stopped short of providing the second benefit, which would be a complete step-up in basis. They don’t allow the fund to have an interim asset that isn’t held for 10 full years to have capital gain nonrecognition.”
“They addressed this issue extensively — as opposed to simply not addressing it — and said that the congressional language does not provide adequate support for nonrecognition, and they opened it up for public comment,” he continued. “So that’s half of the desired solution. It provides that private equity funds can invest on an ongoing basis and obtain some of the benefit, but they have to hold the underlying asset for a full 10 years to obtain all the benefits.”
Another concern after the first round of regulations was the fact that the IRS said that at least 50 percent of gross income of a business of the QOF had to be derived from the active conduct of a business in that zone, according to Webb. “There was concern that this requirement would prevent a lot of businesses other than real estate, retail or restaurants from qualifying as being actively conducted in the QOZ — for example, a startup internet company that is selling to a worldwide customer base.”
The IRS, in the second round of regs, added three safe harbors:
1. At least 50 percent of total hours performed by employees and independent contractors are performed in the zone;
2. 50 percent of amounts paid to employees and independent contractors is paid for services performed in the zone; and,
3. Tangible property and management functions located in the zone produce at least 50 percent of the income of the business.
The new regs are more technical than the first set, according to Edward Renn, a principal at law firm Withers Bergman LLP.
“Some of the focus is in places you wouldn’t expect them to spend as much time on, like consolidated groups,” Renn said. “They’ve made it clear that management fees are non-qualified — that’s not surprising, but it wasn’t clear before.”
“The real takeaway is the inclusion events that subject the taxpayer to recognition of the deferred capital gain,” he said. “Virtually any kind of gift is an inclusion event.”
Webb agreed. “The regs increase the concept of an inclusion event, with a list of 11 nonexclusive events,” he cautioned. “They create a number of ways that the deferred gain on a QOZ can be accelerated if the investor is not careful. Taxpayers who invest in these funds need to be aware of what these inclusion events are and not trigger the deferred gain earlier than anticipated.”