Final Opportunity Zone Regulations Clarify and Expand Opportunity Zone Investment Benefits
Just in time for the holidays, the Treasury Department and IRS have released final Qualified Opportunity Zone (QOZ) regulations. At 544 pages, the regulations will take some time to digest, but an initial reading shows them generally to be more taxpayer-favorable than the prior proposed regulations. Our initial observations on some key changes made by the final regulations are summarized below.
Effective Dates and Grandfathering
The final regulations make significant changes to the rules regarding what gains may be deferred by investment in a Qualified Opportunity Fund (QOF) and to qualification requirements for both QOFs and subsidiary Qualified Opportunity Zone Businesses (QOZBs). These changes generally will be effective for taxable years beginning 61 days or later after publication of the final regulations in the Federal Register, but taxpayers may elect to apply the final regulations to prior periods, provided that they apply all of the new rules consistently for all periods. Thus, for a limited time, taxpayers will need to decide whether they want to apply the prior proposed regulations or the new final regulations to their QOZ transactions. While the final regulations are generally more taxpayer-friendly, this is not uniformly true.
Gains That May Be Invested in Qualified Opportunity Funds
Section 1231 gain: Proposed regulations would have forced taxpayers seeking to reinvest section 1231 gains (which includes gains from the sale or exchange of real property used in a trade or business) to wait until the last day of their taxable year, when total 1231 gains and losses would be aggregated and netted, to qualify as QOZ investments. The section 1231 gain that could be reinvested in a QOF could only be determined at year end, and had to be determined on a net basis. The final regulations change the rule to apply on a gross basis with respect to each separate asset sale (netting of gains and losses is no longer required) — and start the 180-day period on the date of sale. This generally is a good rule, but investors who delayed making investments in QOFs because of the year-end rule may wish to continue to rely on the proposed regulations.
Income from partnerships, S corporations, and non-grantor trusts: Proposed regulations allowed taxpayers to start their 180-day period to invest in a QOF from either the date on which the partnership incurred a capital gain or to wait until the last day of the partnership’s tax year. Recognizing that pass-through entities might not provide all necessary information to their owners or beneficiaries by June (the last date to make an investment under the proposed regulations), final regulations add a third alternative 180-day period beginning on the due date (without extensions) of the pass-through entity’s tax return.
Installment sales: The final regulations treat gains deferred under the installment method as qualifying when the gains are recognized under the installment method, regardless of when the original installment sale occurs. A taxpayer may elect to apply the 180-day period separately from the date each gain is recognized or to aggregate all installment gains from a taxable year and start the 180-day period from the last day of the taxpayer’s taxable year.
Gain recognized by foreigners: The final regulations clarify that capital gain (including section 1231 gain) effectively connected with a U.S. trade or business qualifies for deferral under the QOZ rules, provided that the foreigner waives any treaty benefits that might have limited tax with respect to that gain.
Gain recognized by tax-exempt entities: Any capital gain (including section 1231 gain) treated as “unrelated business taxable income” may be invested and qualify for QOZ benefits.
Original Use and Substantial Improvement Tests
In order for property located in a QOZ to be considered “qualified opportunity zone business property” (QOZBP), the property must be acquired by purchase after December 31, 2017 from an unrelated person and either (i) the “original use” of the property must commence with the QOF or QOZB or (ii) the purchaser must “substantially improve” the property. The final regulations clarify and liberalize the original use and substantial improvement rules.
Vacancy: Under the final regulations, real property that has been vacant for an uninterrupted period of three years, and is vacant on the date it was purchased, will satisfy the original use requirement. Moreover, if property was vacant prior to the date that the QOZ was listed as a designated QOZ, the required period of vacancy may be as short as one year. Under the proposed regulations, a property had to be vacant for at least five years. Real estate will be considered vacant if more than 80% of the useable space in the building was not being used.
Distressed property: The final regulations contain special rules making it easier for a brownfield site or for abandoned or foreclosed real property acquired from a local government to satisfy the original use requirements.
Substantial improvement: A QOF or QOZB that purchases a previously used building must “substantially improve” the building by, within a 30-month period, incurring expenses that increase the basis of the building by an amount at least equal to the original purchase price of the building. The final regulations provide a very useful “aggregation” election that allows the entity to include the cost of newly purchased property (such as furniture and equipment) that “improves the functionality” of the building as a substantial improvement to the building. Thus, functionally related equipment can count as a substantial improvement to the building, regardless of whether the equipment actually becomes part of the building structure. The owner of the building must still improve the building itself, however, by “more than an insubstantial amount.” There is no definition of “insubstantial amount” for this purpose.
The final regulations also permit two or more buildings located on the same parcel of land to be aggregated in certain circumstances, and treated as a single building for purposes of satisfying the substantial improvement test. In certain circumstances, buildings on continuous parcels of land can also be treated as a single property. This will be very helpful in situations where one of the buildings, by itself, would not satisfy the substantial improvement test.
Satisfaction of 90% asset test: If property held by an “eligible entity” (which includes a QOF or QOZB) is reasonably expected to be substantially improved over a 30-month period, then a QOF may treat the asset as a “good” asset for purposes of the 90% of assets test for the entire 30-month period. The preamble states that this rule is intended to apply to the 70% of assets test applicable to a QOZB as well.
Cash and Working Capital Safe Harbors
The final regulations have generally liberalized the safe harbor rules that permit a QOF or a QOZB to hold working capital reserves for start-up expenses or for making substantial improvements to property.
Multiple Working Capital Safe Harbors: A QOZB is severely limited in the amount of cash and other financial property it can hold (generally, no more than 5% of the average unadjusted tax basis of its assets). Proposed regulations had provided a safe harbor permitting cash and certain short-term financial instruments in excess of this 5% limit to be held as working capital provided that there was a plan to spend the reserves for use in the development of a trade or business in a QOZ and the assets were actually used consistently with that plan. The final regulations clarify that a QOZB may use this safe harbor multiple times as long as each application of the safe harbor independently satisfies the working capital safe harbor. However, the regulations limit the total time that the working capital safe harbor can be applied to a total of 62 months from the initial cash infusion.
Active business income: In order for an entity to qualify as a QOZB, at least 50% of its gross income must be derived from the active conduct of a trade or business in a QOZ. The final regulations count income from working capital covered by the safe harbor as “good” income for purposes of this 50% test.
70% tangible property test: At least 70% of a QOZB’s tangible property must be property located in a QOZ that is purchased or constructed by the QOZB and either first placed in service or substantially improved by the QOZB. The final regulations count working capital that is intended to be spent toward the acquisition, construction, or improvements of any such property as a “good” asset for purposes of the 70% test.
Federal disaster areas: If a QOZB is located in a federally designated disaster area, the working capital period can be extended by up to 24 months, provided that the cash is ultimately invested as originally planned.
Sale of Assets by QOZBs
Under the proposed regulations, a taxpayer could exclude gains from a QOF after the 10-year holding period only on the sale of a QOF interest or on a QOF’s sale of a QOZB interest. In contrast, if an asset was sold by the QOZB after the 10-year holding period, the investors in the QOF would have to pay tax on their share of the gain from sale. This anomaly has been rectified. Final regulations allow an investor in a QOF to exclude flow-through capital gains from sale by a QOZB partnership of its assets, provided the 10-year holding period has been satisfied. This is a significant change that many taxpayers and advisers had clamored for, that will greatly facilitate planning for future exit transactions because assets can be sold separately, rather than in bulk.