On April 17, 2019, the Internal Revenue Service (IRS) released the second round of proposed regulations regarding Qualified Opportunity Zone (QOZ) incentive, providing additional guidance and clarifying the “substantially all” requirements for the holding period and use of tangible property.
The QOZ incentive was implemented as part of the Tax Cuts and Jobs Act of 2017. It provides substantial tax incentives to promote job growth and economic investment in underdeveloped communities. The QOZ incentive provides a tax advantage for investors to diversify their portfolio into new growth opportunities, while helping to spur economic development in low-income areas. This provides potential for long-term investors to obtain tax reduction and federally tax free appreciation. QOZ investments appeals to a large number of investors with unrealized capital gain.
The QOZ incentive provides three federal tax benefits to investors to encourage investment in businesses that acquire and use qualifying assets:
- Deferral of Capital Gains Taxes. Any capital gains reinvested in a corporation or partnership that elects to be treated as a Qualified Opportunity Fund (QOF) may be deferred until the earlier of the sale of the investment or December 31, 2026.
- Reduction in Capital Gains Taxes. Investment in a QOF which is held for at least five years, the basis of the QOF is increased by 10% of the amount of gain temporarily deferred. This reduces the amount by 10% on which future taxes are calculated on, when due. When the QOF is held for at least seven years, there is an additional 5% basis increase, resulting in a 15% total reduction in the amount on which future taxes are calculated on when due.
- Exclusion of Future Gain. If a qualifying investment is held for at least 10 years, any appreciation after the date of a QOF is excluded from income, which means federal tax-free appreciation.
The newly released guidance addresses many of the questions that have lingered since the incentive was originally established, including:
- 90% Asset Test and Recent Investments. Although a QOF is required to maintain 90% of its assets in a QOZ Property (90% Asset Test) as of certain measuring dates, it can exclude from that calculation cash on hand from the QOF made during the prior 6 month period. This relieves a concern that accepting investments near a 90% Asset Test measuring date could threaten the QOF compliance and can result in penalties.
- Leased Tangible Property. Leased tangible property can qualify as QOZ business property). This resolves any uncertainty about whether real estate projects on leased land, such as tribal land, in QOZs is eligible for the incentive and whether leased equipment could qualify as QOZ business property. There is no original use requirement or substantial improvement requirement imposed on leased tangible property due to the nature of the property. Leased property may be from a lessor that is not an unrelated party if certain requirements are met for this to be a valid option under the QOF rules.
- Disposition of Fund Assets. A QOF may sell its assets during the life of the QOF without disrupting the investor’s deferral of capital gains or their holding period, provided that the QOF reinvests the proceeds into another qualifying investment within twelve months, and so long as the investor does not sell or otherwise dispose of his or her interest in a QOF.
- Investor Sale of Interest and Reinvestment. An investor who sells his or her interest in a QOF may reinvest the proceeds into another QOF within 180 days without ending their deferral period; however, the holding period begins to run again as of the date of the second investment (i.e. there is no tacking).
- Active Trade or Business. Unlike QOFs, which only have to be engaged in a “trade or business,” a QOZB must be engaged in an “active trade or business.” The guidance clarifies the meaning of what constitutes an “active trade or business” for purposes of qualifying for treatment as a QOZ Business (QOZB). If a business is eligible to deduct ordinary business expenses under IRC 162, then it will qualify. In short, that means that there is regular and continuous business activity with a profit motive. In response to concerns expressed by some in the industry as to whether real estate leasing was sufficiently “active,” the new guidance also clarifies that certain rental real estate qualifies as an “active trade or business.” Notably, however, “merely entering into a triple-net-lease” would not constitute an active trade or business.
- Working Capital “Safe Harbor” Period. The working capital “safe harbor” only applies to QOZBs and not to QOFs. A QOZB that fails to expend its working capital within the 31-month safe harbor will not lose that safe harbor if the delay results from governmental delays (e.g. timely approval of plans and issuance of permits), if the application for that action is completed during the 31-month period. This flexibility in applying the working capital safe harbor will be especially beneficial in jurisdictions in which obtaining approvals for zoning, licensing and permitting may take a long time. The written plan for the use of working capital may include expenditures used in the development of an active trade or business in the QOZ (and not merely the acquisition, construction and/or substantial improvement of tangible property). These expenditures could include inventory and occupancy costs, and possibly payroll relating to the start-up of a business. This expansion of the working capital safe harbor is especially beneficial for QOZBs formed to engage in an active trade or business other than real estate.
- 50% Income Test. The guidance also provides three safe harbors for calculating whether or not a QOZB has satisfied the 50% gross income test (i.e. that 50% of its gross income is derived from its activity in the QOZ). The safe harbor allows testing based on (1) the number of relative services performed (based on hours worked) by employees and independent contractors of such business in the zone is at least 50% of the total number of services performed (based on hours worked) for such business by its employees and independent contractors; or (2) the compensation paid to employees and service providers in the zone is at least 50% of the total compensation paid by the QOZB; or (3) that the tangible property in the zone plus the operations and management in the zone are necessary to produce at least 50% of the gross income of the QOZB.
- Original Use Test. The new guidance provides that the “original use” of tangible personal property begins on the date when it is first placed in service inside the QOZ for purposes of the depreciation or amortization rules. In addition, certain used property can satisfy the original use requirement so long as the property has not been previously used in the applicable opportunity zone in a manner that would allow it to be depreciated or amortized. The new guidance further clarifies that property can be treated as “originally used” by a QOF or QOZB if it was unused or vacant for an uninterrupted period of at least five years prior to being placed in service by the QOF or QOZB. This means that if a QOZB acquired an abandoned building that has been vacant for over five years and needs some rehabilitation before being placed in service again, the “substantial improvement” test would not have to be satisfied.
- Property straddling census lines. The new guidance recognizes that some businesses may operate in parcels that straddle (are partially located inside and partially outside) a QOZ. Essentially, if a QOF or QOZB holds and uses such a contiguous parcel and if the square footage inside the QOZ is substantial relative to the square footage outside the QOZ, the entire parcel would be deemed to be inside a QOZ. Real property located within a QOZ should be treated as “substantial” if the unadjusted cost of the portion inside a QOZ is greater than the unadjusted cost of the portion outside a QOZ.
- Gain Inclusion Events. The new guidance suggests that several transactions would cause an early recognition of deferred gain including the distribution to a partner of a QOF partnership of cash or other property that has a value in excess of basis of the partner’s qualifying QOF partnership interest. Partnership distributions in the ordinary course of partnership operations may, in certain instances, be considered inclusion events. Debt that is allocated to a partner (such as from a refinancing) provides basis to that partner for distribution purposes. Example 10 of the new proposed regulations specifically approves a debt-financed distribution so long as the distribution does not exceed the investor’s basis (as increased by the investor’s share of the debt) in its QOF.
- Limitation of benefits for “promoted” equity. The new guidance requires that if an investor has “promoted” equity (i.e. in exchange for performing services to a QOF), only the portion attributable to capital is eligible for the exclusion from capital gains after the 10-year holding period. A service provider’s interest can be split between the qualifying investment relating to invested capital gains and the non-qualifying investment received for the performance of services. For example, if an individual managing member of a QOF contributes 10% of the capital to the QOF and also receives 20% of the profits above a specified internal rate of return plus the 10% pro-rata participation with other capital investors, his 10% pro-rata participation would be eligible for the capital gains exclusion, but his 20% promoted interest would not. This rule would apply even if the promoted equity is embedded in a single class of equity including capital rights. As such, it will be critical for sponsors/developers to classify which portion of their interests in a QOF is being issued in exchange for services (such as a development fee and management fees) and treat those as non-qualifying investments.