Opportunity zone regulations: Tranche II clarifies important information
Despite a stealthy introduction in late 2017 as part of the landmark Tax Cut and Jobs Act, the opportunity zone program has garnered tremendous interest throughout the real estate, municipal development and financial advisory worlds. Chances are you are fielding questions regularly from clients who are interested in deferring or minimizing their capital gains while helping underserved communities.
Already several hundred qualified opportunity funds and 8,700 qualified opportunity zones have been established nationwide to help economically challenged census tracts attract investment dollars that normally would have passed them by. While a portion of OZ investors have socially conscious motivations, the bigger driver has been the program’s generous tax deferral and tax exemptions for investors with capital gains.
If you’re just getting up to speed on the OZ program, here’s a quick primer.
Despite those early signs of optimism, billions of dollars and thousands of additional investors had been sitting on the sidelines until the latest set of proposed opportunity zone regulations (aka Tranche II) were finally released last month. Although the Tranche II Regs did not address every open issue that the OZ community has been waiting for, the guidance indeed clarified a multitude of issues that should benefit investors, municipalities and local entrepreneurs alike. Here are seven key updates:
1. Timing Issues
- According to the new regulations, the “original use” of tangible property acquired by purchase by any person commences on the date when that person or a prior owner or lessee first placed the property in service in the QOZ for purposes of depreciation or amortization.
- Both real estate and QOZ businesses are allowed to treat documented working capital as QOZ property for up to 31 months (for purposes of the 90 percent and 70 percent semi-annual testing). Note: A QOF must generally hold at least 90 percent of its assets in qualified opportunity zone property and 70 percent of the tangible property “owned or leased” by a business must be qualified OZ property for a business to be considered a QOZ Business.
Example: A few of our clients have sold large concentrations of publicly traded stock and others are sitting on appreciated assets that they plan on selling this year. At least half of the gains will be directed to starting a number of operating businesses. The new regulations give our clients great comfort since they now have clear guidance about their ability to deploy the QOF funds into subsidiary QOZ businesses and then have up to 31 months to invest to funds into equipment, intangibles and other qualified property without failing the semi-annual testing.
- Note that in general, net Section 1231 losses (from trade or business assets) are treated as ordinary losses, net Section 1231 gains are treated as capital gains, and the 180-day clock starts ticking at year-end.
- If the QOF sells QOZ property shortly before the 90 percent testing date (i.e., prior 180-day period), it has a “reasonable period of time” to reinvest the proceeds back into a QOZ. This is generally defined as 12 months, but the funds must be invested in cash or debt instruments with maturities of less than 18 months. Such a reinvestment does not, however, defer the reporting of the tax gain triggered on the sale.
2. Definitions of improvement and original use
- The new regulations clarify that raw land is not required to be “substantially improved” (e.g., capital improvements equal to 100 percent of original basis within 30 months).
- With respect to the “substantial improvement” requirement for used tangible personal assets (e.g., non-real estate), including those used in an existing business, the new regulations take a somewhat restrictive view and require that the “substantial improvement” test must be applied on an asset-by-asset basis, rather than on an aggregate basis. This will complicate the relocation or purchase of an operating business into an OZ.
- The Treasury Department and the IRS are proposing that if a building or other structure has been vacant for at least five continuous years prior to being purchased by a QOF or QOZ business, the purchased building or structure will satisfy the “original use” requirement without needing to “substantially improve” the property.
- Leased assets, both personal and real, are generally treated as “original use” by the lessee and treated as “purchased property.” No substantial improvement is required for either real or personal property.
3. Clarifying “substantially all”
The Tranche II Regulations now defines “substantially all” with the following terms:
- The “substantially all” threshold is 70 percent for the “use in an OZ” threshold. The test for intangible use is only 40 percent.
- The “substantially all” threshold is also 70 percent for the tangible property “owned or leased” that must be qualified OZ property for a business to be a QOZ business.
- The “substantially all” threshold is 90 percent when used to measure a QOF’s holding period of tangible property as qualified OZ business property, QOZ partnership or corporation.
- From a valuation standpoint, the new regulations also clarify that either GAAP valuations or an alternative valuation method may be used for leased asset qualification testing. Alternative valuation methods can include a net present value approach applied to future lease payments.
- The new regulations clarify as long as the QOF meets certain active management rules, residential rental activities can qualify as a QOZ business and/or QOZ property. However, a QOF merely entering into a single triple-net-lease with respect to real or personal property is generally not sufficient to qualify as an active trade or business.
4. Capital contributions, equity interests, disposition
The new regulations clarify that taxpayers can make capital contributions of property other than cash to a QOF. In such cases, the taxpayer’s qualified investment in the QOF will be the lesser of the tax basis in the property contributed or the fair market value of the equity interest in the QOF. Of course, any liabilities on the contributed asset will reduce the qualified investment and the tax basis of the asset contributed.
Example: One of our clients is developing a $300 million mixed-use project in an OZ. They were very pleased to receive guidance about their ability to contribute a large piece of land to the project rather than selling it to the QOF. Selling to the QOF would have required our client to deal with the OZ “related party” rules which can disqualify the property from eligibility. There is also a state conformity issue for the taxpayer. The rules on contributed property can be complex and will generally result in a “mixed fund,” but will still give investors the flexibility to use cash or property to participate in a QOF.
- The new regulations also confirm that QOF investors receiving equity interests in return for services (e.g., IRC Section 83 carried interest) or receiving a QOF interest in exchange for appreciated assets will create a “mixed fund.” The investor will not be eligible for the various OZ benefits to the extent of the appreciation in the contributed property or QOF value received for services.
- Generally, a disposition of a QOF interest by an equity holder will be treated as an “inclusion event” and trigger immediate tax on any unrecognized deferred gain.
- Donating an interest in a QOF to a charity will be considered a termination of the donor’s interest in the QOF. Thus, it will trigger tax on the deferred gain to the donor under the new regulations. If the investment is treated as a gift to a grantor trust, it will not be treated as a QOF interest termination and no gain will be triggered.
- The IRS has concluded that the distribution of the qualifying investment (QOF) to a beneficiary by the estate or by operation of law is not an inclusion event.
5. Depreciation recapture
- The new regulations also add some clarity about “depreciation recapture” upon exiting. Upon exiting from a QOF after 10 years, it appears clear that any depreciation recapture will not be reportable due to the mechanics of the QOF basis step-up. However, if a QOF or QOZ business generates ordinary income from the sale of depreciated personal property (and likely amortization of intangibles), neither the code nor regulations exempt the gain from taxability. A disposition of a QOF interest held for more than 10 years, will, however, exempt the depreciation recapture.
6. What constitutes a qualifying businesses within an OZ?
Section 1397C of the tax code requires that 50 percent of the gross receipts of a qualified opportunity zone business (QOZB) must be attributable to income from an active business within a QOZ. The new regulations provide three optional methods for gross sourcing revenue within the OZ:
- Based on hours worked by employees and contractors (and their employees) of the OZ business. At least 50 percent of the hours must be performed within the QOZ census tract(s).
- Based on compensation paid by the QOZB to employees, contractors (and their employees). At least 50 percent of the compensation must be paid to the employee and/or contractors performing services in the QOZ.
- The tangible property located within the QOZB constitutes 50 percent or more of total property within the QOZ census tract(s).
- The new regulations also provide a “facts and circumstances” provision for unique situations.
- The new regulations allow a QOF to elect to apply the semi-annual qualification tests without considering QOF investments received in the preceding six months — thereby potentially providing the QOF a maximum of 12 months to reinvest the funds into a QOF business or property from the date received. This rule only applies to funds that were invested by the QOF or QOZB into cash, cash equivalents or debt with a maturity of 18 months or less during the pre-reinvestment period.
7. Partnership and basis treatment
Partner or member tax basis in the QOF is generally zero at the point of initial investment under Section 1400Z-2(b)(2)(B)(i) since the gain is being deferred (similar to a 1031 transaction). The basis is increased by the partner’s share of liabilities under Section 752(a). Therefore, when debt is added to the QOF, the partner’s share of liabilities increases outside basis. Prior suspended losses caused by “at-risk” rules may be released at that time.
- A transfer in a transaction governed by Section 721 (tax-free partnership contributions) or Section 708(b)(2)(A) (partnership mergers) is generally not an inclusion event.
- Partnership distributions in the ordinary course of partnership operations may, in certain instances, also be considered inclusion events. The new regulations confirm that cash-out refinances for QOF’s will generally be allowed subject to the general basis rules.
- Another taxpayer can purchase an existing QOZ investor’s equity interest and step into the original owner’s shoes, but the 10-year holding period starts fresh. At this point, it appears that the new QOZ investor must also roll a qualifying capital gain into the re-purchase in order to derive the various five-, seven- and 10-year benefits.
- The IRS clarified that the deferred gain to be recognized in 2026 will be taxed at the capital gain rates existing in 2026, rather than the rate in the year of the original sale.
- Consolidated C corps must reinvest gains into a QOF at the entity level that generated the initial tax gain, rather than on a consolidated level.
What was not in the Tranche II Regulations release?
More robust reporting requirements such as short-term and long-term employment increases, impact on census tract residents, etc., would have helped various federal, state and local government agencies evaluate the OZ program benefits. The original OZ statute had included this information reporting but was removed during the reconciliation process.
As of now, the new regulations do not impose specific reporting requirements that would allow the IRS, HUD and the public to determine the taxpayer’s compliance with the new regulations. Further, there are currently no methods available to analyze the immediate and long-term community impact of the OZ program.
- The IRS and the Treasury understand that adding more reporting requirements could create unwarranted administrative challenges. These additional requirements could prove to be burdensome to the QOF managers and investors, thereby limiting the attractiveness of the QOZ program. To be respectful of the QOZ investors’ and public’s concerns, the IRS and Treasury are requesting additional comments to be addressed in the next set of regulations.
The OZ program is a very powerful tax savings and economic development tool. The new Tranche II guidance answers many important questions and should give taxpayers and investors significant comfort to move forward with OZ investing. That being said, there are still some important unanswered questions. Treasury is expected to continue to issue guidance, and many of these items will likely be included. Visit our website for a more detailed look at the Tranche II Regulations and for future updates.