The Tax Cuts and Jobs Act created various tax benefits for investors in designated qualified opportunity zones (QOZs). Through an investment vehicle called a qualified opportunity fund (QOF), a taxpayer can invest realized capital gains into a QOF in exchange for three tax benefits: (1) deferral of tax on invested gains until the earlier of 2026 or disposition of the QOF, (2) partial forgiveness of tax on invested gains if the QOF is held for at least five years, and (3) an exemption for all gain upon the sale of the QOF if held for at least 10 years. In October 2018, the Department of Treasury released a first set of proposed regulations related to investments in these QOZs. (For more information on the fundamentals of QOZs, QOFs and the first set of proposed regulations, please see our previous Tax Alert and July Tax Reform Progress Report.)
The Treasury recently released a second set of proposed regulations, which expand upon and attempt to clarify the October 2018 proposed regulations as well as the original legislation. The new proposed regulations are 169 pages long and address a wide array of issues. In the coming weeks, Baker Tilly will release additional guidance on these regulations.
The most significant takeaways from the new proposed regulations are:
Safe harbor for 50 percent gross income test: To qualify as an opportunity zone business (QOZ business), a business must receive at least 50 percent of its gross income from the active conduct of a business in a QOZ. The regulations provide a facts and circumstances test and three safe harbors to determine whether sufficient income is derived from a business in a QOZ. The safe harbors are as follows:
Clarification of original use requirement: To qualify as qualified opportunity zone business property (QOZ business property), the property must be either substantially improved or originally used in a QOZ. Original use generally commences when the property is first placed in service within the QOZ for purposes of depreciation. Consequently, existing structures being depreciated will not qualify under the original use requirement. However, the new proposed regulations establish an exception for buildings that have been vacant for at least five years.
“Substantially all” defined: In order to qualify as QOZ business property, “substantially all” of the property’s use must be in a QOZ for “substantially all” of the QOF’s holding period in the property. Previously, “substantially all” was undefined for these purposes; the new regulations set the respective thresholds at 70 percent of the property’s use and 90 percent for the QOF’s holding period in the property.
Substantial improvement determined on an asset-by-asset basis: The new proposed regulations establish that substantial improvement to QOZ business property applies on an asset-by-asset basis. In short, each asset must be substantially improved to qualify as QOZ business property. Assets cannot be aggregated. The preamble to the new proposed regulations does acknowledge the administrative difficulty of asset tracking and requests public commentary on this issue.
Inclusion events: The new regulations contain a nonexclusive list of 11 so-called “inclusion events,” i.e., events that cause the inclusion of the deferred gain. For example, a gift is generally deemed an inclusion event, but not a gift made to a grantor trust. Likewise, a transfer to the beneficiary of an estate is not an inclusion event. The new regulations also provide that a QOF selling its underlying assets does not trigger recognition of an investor’s deferred capital gain.
Working capital safe harbor: The new proposed regulations make two changes to the 31-month working capital safe harbor. Under the prior regulations, only the acquisition or construction of and substantial improvements to tangible property were permissible over a 31-month period. In effect, the prior safe harbor was generally applicable to real estate development projects. Under the new proposed regulations, the safe harbor applies to the development of a trade or business as well, making the safe harbor more useful for operating companies. Moreover, the 31-month safe harbor can be extended if a written plan is not completed due to government delays.
Land – original use and land banking: The new proposed regulations establish that land does not need to be substantially improved to be QOZ business property. However, the land in a QOZ must be used in a trade or business. As such, land banking is not allowed. Moreover, the new regulations make clear that anti-abuse rules can be applied where land is acquired without a legitimate business purpose.
90 percent asset test relief: 90 percent of the assets in a QOF must be QOZ business property or penalties will be imposed upon the fund. Generally, to test this 90 percent requirement, the QOF must calculate the average percentage of QOZ business property halfway through the year and at the end of the year. The new regulations provide relief with respect to this test as follows:
The new investments and sales proceeds must be kept as cash, cash equivalents or debt instruments with a term of fewer than 18 months to qualify for this relief. With respect to the underlying asset sales, while they do not trigger an investor’s deferred gain as mentioned above, the gains from the transactions are generally taxable. The new regulations do, however, provide for a taxpayer invested in a QOF taxed as a partnership or S corporation to exclude these gains if they’ve held their QOF interest for at least 10 years.
Section 1231 netting rules: The new regulations establish that gains from section 1231 property (property used in a trade or business) must be netted at the end of the year before determining how much, if any, gains can be invested in a QOF. Only this net gain shall be treated as eligible gain. Consequently, a taxpayer that sells a piece of section 1231 property during the year cannot immediately invest gains on the sale. Accordingly, the 180-day window to invest capital gains into a QOF is delayed until the end of the year for section 1231 property (not the date on which the section 1231 property is sold).
Carried interests not exempt: The new proposed regulations make clear that only the portion of the investment in a QOF to which an election under section 1400Z-2(a) is in effect is treated as a qualifying investment. As such, gains attributable to a service component of the interest in the QOF are not eligible for the various benefits afforded qualifying investments. In short, carried interests are ineligible for the post-investment gain exemption.
Unresolved issues: As noted above, questions remain unanswered. These include:
Additionally, it was anticipated that a third set of proposed regulations would be forthcoming later in the year, but senior Treasury officials said the latest round might be the last. However, since these regulations remain “proposed,” we can always expect further changes and additions when the regulations are issued in final form.
Please reach out to your Baker Tilly advisor with questions on how you may benefit from the OZ program.
For more on opportunity zones, please visit our opportunity zones page.
For more information on this topic, or to learn how Baker Tilly specialists can help, contact our team.