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, please see our Tax Alerts from April and June of 2019.
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:
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:
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:
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:
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.
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.