On April 17, 2019, the IRS issued its much anticipated second tranche of guidance (the “2019 Proposed Regulations”) on the qualified opportunity zone (QOZ) program established by the 2017 Tax Cuts and Jobs Act. The 2019 Proposed Regulations discuss a number of issues that were left unaddressed by the initial set of proposed regulations issued by the IRS in October of 2018 (the “Initial Proposed Regulations”) and provide further clarity on some issues that were touched upon in those initial regulations. This is welcome news to eager investors interested in taking advantage of the benefits of investing their capital gains in qualified opportunity funds (QOFs), particularly those wishing to deploy capital in businesses outside the realm of traditional real estate development. While we have not attempted to describe every aspect of the 2019 Proposed Regulations, a summary of certain key provisions is set forth below.
Qualified Opportunity Zone Business Property. The 2019 Proposed Regulations provide the following guidance with regard to QOZ business property:
- The “Substantially All” Test: Under Section 1400Z-2(d)(2)(D) of the Internal Revenue Code of 1986, as amended (the “Code”), for tangible property to constitute QOZ business property, during substantially all of the QOF’s holding period for such property, substantially all of the use of the property must have been in a QOZ. Similarly, Sections 1400Z-2(d)(2)(B)(i)(III) and 1400Z-2(d)(2)(C)(iii) require that for QOZ stock and QOZ partnership interests, the corporation or partnership, respectively, must be qualified as a QOZ business during substantially all of the QOF’s holding period for such stock or interest. The QOZ statute and Initial Proposed Regulations were silent as to what constitutes “substantially all” for purposes of these requirements. The 2019 Proposed Regulations establish that, for purposes of the “use” requirement, the term substantially all means 70%. However, a higher threshold of 90% is proposed to constitute substantially all in the “holding period” context. Thus (in addition to the other requirements of Section 1400Z-2(d)(2)), to constitute QOZ business property, during 90% of the QOF’s holding period of such property, 70% of the use of the property must be in a QOZ; and to constitute QOZ stock or a QOZ partnership interest, during 90% of the QOF’s holding period of such stock or interest, such corporation or partnership must qualify as a QOZ business. The 2019 Proposed Regulations justify the higher standard in the holding period context by explaining that taxpayers are able to control and determine the period for which they hold property (as opposed to how the property is used). Unfortunately, the 2019 Proposed Regulations do not reconcile the “holding period” 90% requirement to the 31-month safe harbor contained in the Initial Proposed Regulations. For example, if a QOF invests in a QOZ partnership and, over the course of the ensuing 31 months, the QOZ partnership develops real property that is placed in service in a QOZ business, does the QOF’s ownership of the QOZ partnership interest during the 31-month development period constitute “good” holding period time that counts towards the 90% requirement, or is it “bad” time that falls into the remaining 10% basket? While the logical answer would be to treat the foregoing 31-month period as “good” time (as the alternative interpretation would require the QOF to own the QOZ partnership interest for an additional 31 months to satisfy the 90% “substantially all” test), the 2019 Proposed Regulations do not actually say that.
- Original Use: To qualify for the available tax benefits, the “original use” of QOZ business property must have either commenced with the QOF (or the QOZ partnership or QOZ corporation, as applicable) or the QOZ business property must be substantially improved. Although the Initial Proposed Regulations and contemporaneously issued Revenue Ruling 2018-29 expounded on the substantial improvement prong of the test (and made clear that the substantial improvement requirement did not apply to land), the meaning of “original use” was not explained. The 2019 Proposed Regulations provide that the “original use” of tangible property commences on the date that the property is first placed in service in the QOZ for purposes of depreciation or amortization. This is a significant clarification of the statute, as original use of property is defined not merely as having previously been placed in service but previously placed in service in the QOZ. Accordingly, a QOZ business can acquire used property and, if it has not been previously used in the QOZ, such property is exempt from the substantial improvement requirement. Further, even if property (such as a building or structure) has previously been placed in service for purposes of depreciation or amortization in the QOZ, it may still satisfy the original use requirement if such property has been unused and vacant for at least five years prior to being purchased by the QOF or QOZ business.
Expanding upon the concept originally contained in the Initial Proposed Regulations and Revenue Ruling 2018-29, the 2019 Proposed Regulations make clear that land is not subject to the original use or the substantial improvement requirements, but the land must be used in the trade or business of the QOF to constitute QOZ business property. For this purpose, merely holding the land for investment does not constitute use in a trade or business. The 2019 Proposed Regulations also indicate that if a significant purpose for acquiring such unimproved land was to achieve a tax result that is inconsistent with the intent of the QOZ program, under the anti-abuse rule, the unimproved land will be treated as non-qualifying property. The 2019 Proposed Regulations do not otherwise dwell on anti-abuse matters—it is anticipated that such rules will be the subject of future proposed regulations.
- Leased Property: Prior to the 2019 Proposed Regulations, the treatment of leased property was unclear. While the “substantially all” test for QOZ business property under Code Section 1400Z-2(d)(3)(A)(i) refers to property that is owned or leased, the definition of QOZ business property in Code Section 1400Z-2(d)(2)(D) requires that such property be acquired by “purchase.” This drafting left open the question of whether tangible property that is leased by a QOZ business can be treated as QOZ business property or, alternatively, if a leasehold interest in such property should be treated as intangible property. In the 2019 Proposed Regulations, Treasury surmises that the benefits of the use of tangible property in a QOZ will not vary greatly depending on how the business acquires the right to use the property, and thus leased tangible property is not categorically excluded from qualification as QOZ business property. In order for leased property to qualify as QOZ business property, (1) it must be acquired under a lease entered into after December 31, 2017, (2) substantially all of the use of the leased property must be in a QOZ during substantially all of the period for which the business leases the property, and (3) the terms of the lease must be “market rate.” Further, we note that the leased property is not subject to the original use and/or substantial improvement requirements under Section 1400Z-2(d)(2)(D)(i)(II) and additional requirements apply to leases of property from a related person. We note that these rules are of particular importance with regard to investments in tribal lands designated as QOZ’s, as these lands are typically leased for development purposes by the tribal governments that occupy the Federal land in trust.
Section 1397C Requirements. In addition to the other requirements set forth in Code Section 1400Z-2, QOZ businesses must satisfy the requirements described in Code Sections 1397C(b)(2), (4) and (8), which mandate that (1) at least 50% of the total gross income of the business be derived from the active conduct of such business within a QOZ (the “50% Gross Income Test”), (2) a substantial portion of the intangible property of such entity be used in the active conduct of such business, and (3) less than 5% of the average of the aggregate unadjusted basis of the property of such entity be attributable to nonqualified financial property. The 2019 Proposed Regulations offer the following insight as to compliance with these requirements:
- 50% Gross Income Test – Questions have been raised as to how to determine whether a QOZ business has met the 50% Gross Income Test. In response to these questions, the 2019 Proposed Regulations provide the following three safe harbors for satisfying the 50% Gross Income Test:
(i) at least 50% of the services performed by employees and independent contractors of the business are performed within the QOZ based on the number of hours worked;
(ii) at least 50% of the services performed by the employees and independent contractors of the business are performed within the QOZ based on the amounts paid for services performed; or
(iii) both the tangible property of the business that is located within the QOZ and the management or operational functions performed for the business in the QOZ are each necessary to generate at least 50% of the gross income of the business.
If any of the above three safe harbor tests are met, then the 50% Gross Income Test is satisfied. Further, even if a taxpayer does not satisfy any of the three safe harbor tests, the 50% Gross Income Test is still deemed satisfied if, based on all the facts and circumstances, at least 50% of the gross income of the business is derived from the active conduct of the business in the QOZ.
- Real Property Partially in a QOZ – In determining whether the foregoing 50% Gross Income Test is met, commenters have questioned how property straddling multiple census tracts, not all of which are QOZs, should be treated. The 2019 Proposed Regulations adopt a rule analogous to that set forth in Code Section 1397C(f)—that is, if the amount of real property based on square footage located within the QOZ is substantial as compared to the amount of real property based on the square footage outside of the QOZ, and the real property outside of the QOZ is contiguous to part or all of the real property located inside the QOZ, then all of such property is deemed to be located within the QOZ. Real property located within the QOZ shall be considered “substantial” if the unadjusted cost of the real property inside the QOZ is greater than the unadjusted cost of the real property located out of the QOZ.
- Intangibles – Another empowerment zone requirement incorporated into the QOZ statute is that, in a given tax year, a substantial portion of the intangible property of a qualified business entity must be used in the active conduct of the business in the QOZ. The proposed regulations advise that for purposes of meeting the “substantial portion” threshold, at least 40% of the intangible property of the business must be used in the active conduct of the business in the QOZ.
Inclusion Events: Code Section 1400Z-2(b)(1) provides that a capital gain deferred pursuant to Code Section 1400Z-(a)(1) shall be includible in the taxpayer’s income in the taxable year that includes the earlier of December 31, 2026, or the date on which such investment is “sold or exchanged.” The 2019 Proposed Regulations address the treatment of dispositions of investments other than by sale or exchange by clarifying that any transfer of a qualifying investment, to the extent that such transfer reduces the taxpayer’s equity interest in the qualifying investment for Federal income tax purposes, constitutes an inclusion event. Further, the 2019 Proposed Regulations provide a series of complex rules describing situations that may result in an inclusion event that may not involve a sale or exchange. For example, while a distribution of cash by a QOF partnership to the taxpayer may not ordinarily constitute an inclusion event, it will be treated as an inclusion event to the extent that the cash distributed exceeds the taxpayer’s basis in the QOF partnership interest. The regulations include a formula for calculating the amount required to be included in income, with special rules delineated for partnerships and S corporations. Specific transactions, including transfers of a qualifying investment to a deceased owner’s estate and transfers of a qualifying investment to an entity that is disregarded as separate from the taxpayer for Federal income tax purposes, are specially designated as not triggering inclusion.
As previously noted, we have only highlighted selected key provisions of the 2019 Proposed Regulations. In addition to the items discussed above, the 2019 Proposed Regulations establish special rules for 1231 gains, newly contributed assets to QOFs, reinvestment of proceeds received by a QOF from the sale of QOZ business property, stock, and partnership interests, and transfers of property other than cash to a QOF in a carryover basis transaction; clarify procedures for determining holding periods of various assets; and confirm that QOFs may be organized under the laws of a Federally recognized Indian tribe if the entity’s domicile is located within one of the 50 states.
The IRS and Treasury have requested comments on the guidance set forth in the 2019 Proposed Regulations, which will be discussed at future public hearings. In the meantime, the preamble to the 2019 Proposed Regulations states that taxpayers may generally rely on the proposed rules for periods prior to finalization if they apply the rules consistently and in their entirety. Thus, anxious investors and fund managers who have remained on the sidelines waiting for the fog of uncertainty to lift may find some comfort in these proposed rules and begin deploying funds into investments in designated QOZs.
(Please contact the authors with any questions on this topic.)