Final opportunity zone regulations: key takeaways
The Department of Treasury recently released finalized opportunity zone (OZ) regulations, combining and revising two sets of proposed rules issued in October 2018 and May 2019 into a single regulatory package. The final regulations are comprehensive and generally taxpayer-favorable. For additional background and details regarding OZ and the proposed regulations.
The most significant takeaways from the final regulations are:
Additional types of gains excluded for investors with a 10-year holding period: The statute and proposed regulations allow taxpayers holding a qualified opportunity fund (QOF) interest for a requisite 10-year period to exclude any gain (1) from the disposition of the QOF interest itself, and (2) any capital gains arising from the QOF selling its qualified opportunity zone (QOZ) property, if the QOF is organized as a partnership or s corporation.
The difficulty presented by these options was that the only way to fully benefit from the income exclusion provision was to dispose of the taxpayer’s entire equity interest in the QOF. If a QOF disposed of its investment in a qualified opportunity zone business (QOZB), the taxpayer could elect only to exclude capital gain flowing through the QOF as a result of the transaction. However, any ordinary income or depreciation recapture would be subject to taxation.
Moreover, if the QOZB disposed of its assets, including qualified opportunity zone business property (QOZBP), the transaction would be fully taxable. This caused frustration among investors, project sponsors and practitioners alike, as the only sure-fire way to realize the full benefit of excluding any gain on exit was to set up multiple single-asset or single-project funds, creating organizational and compliance-related inefficiencies.
The final regulations address these issues by allowing eligible investors to exclude:
- Gains on sales of any property, with the exception of inventory, by the QOF and by any subsidiary QOZB, and
- Any ordinary income associated with such property sales.
Apart from the obvious benefit of allowing investors to exclude nearly all gains after achieving a 10-year hold, this provides critical flexibility in structuring QOZ deals. Specifically, a single QOF can now invest in multiple projects, falling in line with how a typical investment portfolio operates. In other words, the final regulations facilitate the creation of multi-asset QOFs.
Investment of gross section 1231 gains – sales of property used in a trade or business: As covered in detail in our previous Tax Alert, gains from singular sales of property used in a trade or business are eligible for investment in a QOF, with the 180-day window beginning on the date of sale. These gains no longer have to be reduced by losses on trade or business property sales the taxpayer incurred in the previous five tax years.
Longer investment window for eligible gains reported on Schedule K-1: Under the proposed rules, a taxpayer who is allocated eligible gains on a Schedule K-1 (K-1) generally has 180 days from the end of the K-1-issuing entity’s tax year to invest. Alternatively, they can elect to have 180 days from the date of the transaction that triggered the reported gain, if they were privy to such information. Acknowledging the significant time lapse that can occur between the end of an entity’s tax year and when an owner receives their corresponding K-1, Treasury now allows investors a third elective option: to have their 180-day window begin on the due date of the entity’s tax return (without extensions).
Substantial improvement: To qualify as QOZBP, the property must either be originally used in a QOZ or be substantially improved during a 30-month period after purchase. The rules associated with the latter requirement are updated as follows:
- Aggregation permitted. Under the proposed regulations, each item of non-original use property must be substantially improved to qualify as QOZBP; aggregating assets was not permitted. The final rules allow for aggregation to meet this requirement, if the subsequently purchased original use assets being aggregated:
– Are used in the same trade or business in the QOZ (or a contiguous QOZ) that the asset being improved is used, and
– Improve the functionality of the asset being improved in the same QOZ or a contiguous QOZ.
The final regulations provide an example in which a QOF that purchases a non-original use hotel is able to count the purchase of original use property including mattresses, linens and furniture in measuring whether the hotel has been substantially improved. Conversely, if the QOF purchased similar assets to refresh an apartment building it owns and operates as a separate trade or business, these assets would not count toward the substantial improvement of the hotel, even if the buildings are located in the same QOZ.
Further, buildings located on the same parcel of land and described in the same deed can be aggregated. Buildings located on contiguous parcels of land and described in separate deeds can also be aggregated if they:
– Are operated exclusively by the QOF or QOZB,
– Share facilities or significant centralized business elements (i.e., personnel, accounting, legal, manufacturing, etc.), and
– Are operated in coordination with, or reliance upon one or more of the QOF’s or QOZB’s trades or businesses (i.e., supply chain interdependencies, mixed-use facilities, etc.). - Satisfaction of asset tests. Property in the process of being substantially improved is considered QOZBP, therefore satisfying a QOF’s or QOZB’s asset test.
- Improvements to nonqualifying property are not QOZBP. One of the few taxpayer-unfriendly clarifications in the final regulations provides that improvements made to nonqualifying property (i.e., contributed property, property purchased prior to 2018 or from a related party) are not considered QOZBP. To illustrate, if a QOF received a contribution of raw land in exchange for an equity interest and subsequently constructed a parking lot and fencing on the land, neither improvement would qualify as QOZBP. Treasury noted that allowing such property to count could require extensive record-keeping requirements and place an administrative burden on taxpayers and the IRS that would far outweigh any associated benefits.
Selling property to a QOF does not create gain eligible for investment in the same QOF: This is another situation where Treasury became more restrictive. The seller of an asset to a QOF or QOZB cannot reinvest gain from that asset sale for a qualifying investment in the QOF, even if that ownership interest is 20% or less to avoid the related-party rules. In response to requests for clarification whether this was a viable strategy, Treasury notes that general federal income tax principles would recast this transaction as a property contribution, given the cash, as a matter of substance, never truly changes hands. As a result, from the investor’s standpoint, there is no sale and, therefore, no eligible gain to invest. Further, with respect to the QOF, there is no purchase and, in turn, the property does not qualify as QOZP.
Installment proceeds eligible for investment in year of receipt: The final regulations clarify that capital gains recognized on current payments received pursuant to an installment sale agreement are eligible to be invested in a QOF, even if the sale was executed prior to 2018. With respect to the 180-day window to invest such payments, taxpayers can choose between having it begin on the date a payment is received during the tax year or the last day of the tax year in which a payment is received. Note that taxpayers receiving multiple installment sale payments in a single tax year would have multiple 180-day periods, should they choose the former option. Lastly, to clarify, taxpayers interested in investing the entire capital gain arising from the sale within 180 days of the transaction date would need to eschew the installment method to be eligible to do so.
Reduced timeline for vacancy rule: The proposed regulations provide that property previously used within a QOZ will satisfy the original use requirement if it had been vacant for five years prior to purchase. The final rules shorten this timeline, allowing the following to be considered original use property:
- Property vacant for one year prior to the date the location received its QOZ designation,
- Property vacant for three years after the QOZ designation and before purchase.
A 62-month working capital safe harbor for startup businesses: Working capital a QOZB uses within 31 months pursuant to a written plan to construct, acquire or substantially improve tangible property, or to develop a trade or business within a QOZ will not cause the QOZB to fail an asset test. The finalized rules provide a new safe harbor for startup businesses, providing that during a maximum 62-month period in which a QOZB is developing a trade or business:
- Working capital it holds will not cause it to fail an asset test,
- Gross income the trade or business earns will be counted toward the satisfaction of the 50% of gross income test,
- Tangible property it purchases, leases or improves pursuant to the written plan will count as QOZB, and
- Intangible property it purchases or licenses pursuant to the written plan will count toward the satisfaction of the 40% intangible property use test.
The 25% aggregate S corporation ownership change inclusion event repealed: In our 2019 year-end tax letter, we cautioned against investing eligible gains realized by an S corporation into a QOF. This was due to the proposed regulations listing changes in excess of 25% in the ownership of the S corporation as an inclusion event, which would terminate the benefits associated with the QOF interest. The final regulations remove this rule.
What’s next?
These many taxpayer-friendly changes and clarifications will provide investors, QOFs and QOZBs considerable added flexibility to take advantage of the OZ program’s benefits and comply with its governing provisions. However, areas of uncertainty remain. Specifically, while the final regulations sought to provide guidance regarding when a triple net lease sufficiently rises to the level of a trade or business for QOZ purposes, the examples provided lack detail and clarity. Additionally, the administration of penalties for a QOF’s asset test failure and the implications to a QOF that repeatedly fails its asset tests are reserved for future guidance. At this time, it is unclear whether additional proposed regulations will cover these topics in greater detail, or if they will be addressed via subregulatory guidance.
We encourage you to reach out to your Baker Tilly advisor to discuss whether you may benefit from the OZ program.
For more information on this topic, or to learn how Baker Tilly specialists can help, contact our team.
The information provided here is of a general nature and is not intended to address the specific circumstances of any individual or entity. In specific circumstances, the services of a professional should be sought. Tax information, if any, contained in this communication was not intended or written to be used by any person for the purpose of avoiding penalties, nor should such information be construed as an opinion upon which any person may rely. The intended recipients of this communication and any attachments are not subject to any limitation on the disclosure of the tax treatment or tax structure of any transaction or matter that is the subject of this communication and any attachments.
