Newly Proposed Opportunity Zone Regulations
The IRS recently released a set of proposed updated guidance around opportunity zones. You can view a qualified opportunity zones map by clicking here, or read our previous article on the subject by clicking here. Additionally, if you’d like to download a free handout on the current state of opportunity zones, you can do so at the following link.
The proposed regulations provide needed guidance for those who are looking into these zones. Read on for frequently asked questions with a discussion of what some of the proposals clarify in the opportunity zone guidance.
What is a qualified opportunity zone?
A qualified opportunity zone (“QOZ”) is a designated economically distressed community where new investments may be eligible for preferential tax treatment. The Treasury has certified 8,700 opportunity zones throughout the U.S. The Tax Cuts & Jobs Act provides tax incentives for investment into opportunities zones via qualified opportunity funds.
What is the benefit of a qualified opportunity fund?
A taxpayer may defer capital gains by reinvesting in a qualified opportunity fund within a 180-day window. In addition, once the fund is held for 10 years, the taxpayer is able to exclude capital gain on the appreciation in the reinvested gains when they sell their interest in the fund (or in certain circumstances, discussed further below, allocated capital gains from the sale of assets within an S Corporation or partnership fund).
What is a qualified opportunity fund?
A qualified opportunity fund (“QOF”)—a corporation or partnership organized for investing in qualified opportunity zone property, other than another QOF. The QOF must hold at least 90 percent of its assets in qualified opportunity zone property.
What is qualified opportunity zone property?
Qualified opportunity zone property—property that is one of the following: 1) qualified opportunity zone stock; 2) a qualified opportunity zone partnership interest or 3) qualified opportunity zone business property.
- Qualified opportunity zone stock—stock acquired at original issue solely in exchange for cash after December 31st, 2017, from a corporation qualifying as a qualified opportunity zone business (“QOZB”) at the time the stock was issued and during “substantially all” of the QOF’s holding period for such stock.
- Qualified opportunity zone partnership interest—any capital or profits interest in a domestic partnership—provided it was acquired solely in exchange for cash after December 31st, 2017, and the partnership was a qualified opportunity zone business at the time the interest was acquired, and during “substantially all” of the QOF’s holding period for such interest.
- Qualified opportunity zone business property “QOZBP”—tangible property used in a trade or business of the QOF if: (1) such property was purchased by the QOF after December 31st, 2017; (2) the original use of the property in the qualified opportunity zone commences with the QOF or the QOF substantially improves the property; and (3) during substantially all of the QOF’s holding period for such property, substantially all of the use of such property was in the qualified opportunity zone.
What is a qualified opportunity zone business?
Qualified opportunity zone business “QOZB”—a trade or business in which:
- Substantially all (defined as 70%) of the tangible property owned or leased by the taxpayer is qualified opportunity zone business property;
- At least 50% of the total gross income of such entity is derived from the active conduct of such business;
- A substantial portion of the intangible property of such entity is used in the active conduct of any such business; and
- Less than 5% of the average of the aggregate unadjusted basis of the property of such entity is attributable to nonqualified financial property (e.g. stock, debt, options, annuities other than certain reasonable amounts held in working capital).
The business cannot be a private or commercial golf course, country club, massage parlor, hot tub facility, suntan facility, racetrack or other facility used for gambling, or any store if the principal business of which is the sale of alcoholic beverages for consumption off premises.
What do you mean when you say the QOF needs to substantially improve the property?
Property will be treated as substantially improved by the QOF if, during any 30-month period beginning after the date of acquisition of such property, additions to basis with respect to such property in the hands of the QOF exceed an amount equal to the adjusted basis of such property at the beginning of the 30-month period in the hands of the QOF.
Under the proposed regulations, the determination of whether the substantial improvement requirement is met for tangible property that is purchased is made on an asset-by-asset basis. The IRS and the Treasury Department have requested comments on the potential advantages and disadvantages of adopting an aggregate approach for substantial improvement. They are also studying and requesting commentary on circumstances under which tangible property that had not been purchased, but which has been improved by a QOF or qualified opportunity zone business may be considered as satisfying the original use requirement.
Can land qualify as qualified opportunity zone business property?
Under the proposed regulations, the original use requirement does not apply to land. However, property must be used in an active trade or business to qualify as QOZBP, so the land cannot be merely land held for investment purposes.
Can I count my leasehold improvements as qualified opportunity zone business property?
Yes, the proposed regulations provide that improvements made by a lessee to leased property satisfy the original use requirement and are considered purchased property for the unadjusted cost basis of such improvements.
I’m planning to start a fund to invest in a new construction business which will be headquartered in a qualified opportunity zone—however, the construction projects will most likely be outside of the qualified opportunity zone. Can I still qualify this business?
To qualify as a qualified opportunity zone business, at least 50% of the income of a business is required to be earned in a qualified opportunity zone. There are three safe harbors established under which a qualified opportunity zone business could satisfy the 50% test:
- If at least 50% of the hours spent by employees and independent contractors are within the QOZ;
- If at least 50% of the amount paid by a business to employees and independent contractors are for services performed within a QOZ; or
- If the tangible property located in a QOZ and the management or operational functions performed in the QOZ are each necessary for the generation of at least 50% of the gross income of the business.
Although you may not be able to qualify the business under #1 or 2, you may be able to meet the third safe harbor.
In addition, to be a qualified opportunity zone business, substantially all (70%) of the property owned by the business must be qualified opportunity zone business property. To qualify as qualified opportunity zone business property, during substantially all of the QOZB’s holding period for such property substantially all of the use of such property must be in the qualified opportunity zone.
The proposed regulations clarify that “substantially all” for the use and holding period means 90%.
Under what circumstances will the deferred gain be recognized?
When you reinvest capital gains into qualified opportunity funds within the specified time period (generally, within 180 days), the gain is deferred to the earlier of two dates. The deferred gain will be included in your income in the taxable year that includes the earlier of 1) the date on which the qualifying investment is sold or exchanged, or 2) December 31st, 2026.
The proposed regulations expand on the definition of a sale or exchange by establishing a general principal requiring full or partial deferred gain recognition when a taxpayer either 1) reduces their direct equity investment in the QOF, or 2) takes a distribution of property with a FMV in excess of the taxpayer’s basis in the QOF. The proposed regulations further elaborate on this by identifying several specific transactions which will trigger gain recognition.
I’ve held my QOF for 10 years. Now what?
After holding the property for 10 years, the taxpayer is able to write up their basis to the fair market value on the date of the sale. This allows the taxpayer to permanently exclude any appreciation on the reinvested capital gains. Prior to the new proposed regulations, it appeared that to qualify the taxpayer had to sell their equity interest in the qualified opportunity fund. This would be disadvantageous to both S corporation and partnership owners, as sales of partnerships and S Corporations are often structured as asset sales.
The proposed regulations provide that if the QOF sells its assets after the 10 year holding period has been met, the capital gain generated from the sale of qualified opportunity zone property that is allocated to a partner or shareholder may be excluded. This may provide some limited benefit. However, such property is often subject to ordinary income recapture provisions, so only a portion of the gain on an asset sale, if any, would be eligible for the exclusion.
We are monitoring all developments around these proposed regulations and look forward to sharing more information at such time that they are further added to, amended, and/or ratified.