Second Round of Qualified Opportunity Zone Proposed Regulations Addresses Many Unanswered Questions
On April 17, the Department of Treasury and IRS released the much-awaited second round of proposed regulations on Qualified Opportunity Zone investments (the "Regulations"). The Regulations make it clear that Qualified Opportunity Funds can own multiple projects or businesses, and provide mostly favorable guidance for both real estate businesses and other types of businesses. This Alert addresses some key takeaways from the Regulations. We will provide more in-depth guidance in the coming weeks.
Treatment of asset sales by a QOF, and the potential for multi-asset funds
Prior to these Regulations, most Qualified Opportunity Funds ("QOFs") were organized to own only a single business or real estate project. While it was clear that an investor could exclude capital gains from income if the investor sold an interest in a QOF that had been held for more than 10 years, it was far from clear whether the exclusion from gain would apply if the QOF sold its assets after the 10-year holding period had been satisfied. This critically important question has now been answered: The Regulations provide that if a QOF sells qualified opportunity zone property after the 10-year holding period applicable to the investors has been satisfied, the investors in the QOF may elect on their individual income tax returns to exclude from their gross income their allocable shares of the capital gain realized by the QOF from the sale of assets (as reported to the investors on Form K-1).
This new provision is hugely beneficial and will make it easier to form and operate QOFs. Due to this rule, a QOF can be liquidated by selling its assets, in one or more separate sales to one or more different buyers. This makes it much easier to obtain full and fair value for the assets owned by the QOF. In addition, this rule makes it practical for QOFs to own multiple businesses or real estate projects, since the different businesses and projects can be sold at different times, to different buyers. This makes it feasible to organize much larger QOFs more like “traditional” real estate investment or venture funds.
The new election can be made on an asset by asset basis, as long as the QOF separately states capital gains arising from the sale or exchange of any particular qualified opportunity zone property. Thus, the election could be made only for those assets that are sold for a gain.
Reinvestment of proceeds from sale of assets by QOF
The ability to exclude capital gains from income discussed above only applies if a QOF sells assets after the investors have satisfied their 10-year holding periods. If a QOF sells assets before the 10-year holding period has been satisfied, the gain from sale will pass through to the investors in the QOF and there is no way to exclude or defer this gain from income (other than by a new investment in a QOF). Many commentators had asked for the ability to “roll over” such gains from sale by investing in replacement qualified opportunity zone property, but the Treasury Department and the IRS concluded that there was no legal basis for such a rule.
Another concern with asset sales is that if a QOF sold qualified opportunity zone property with the intention of re-investing the proceeds, and it took time to find suitable replacement property, holding the cash proceeds might cause the QOF to violate the requirement that at least 90% of the QOF’s assets must be "QOZ business property." For purposes of this 90% rule, the Regulations give a QOF a year to reinvest the proceeds from the sale of QOZ business property.
Real estate companies, in particular, but other businesses treated as partnerships for tax purposes, often make debt-financed distributions to give their owners the benefit of capital appreciation. Under general partnership tax principles, these distributions generally are not taxable as long as they do not exceed an owner’s basis in the investment. The Regulations follow this approach and allow distributions from QOFs that are treated as partnerships up to the amount of the owner’s basis (which includes the owner’s share of partnership debt) without adverse tax consequences. Distributions in excess of basis, however, will be treated as "inclusion events" that can accelerate deferred gain.
Special rules apply to distributions from QOFs organized as corporations, and they generally are not taxpayer-favorable.
Prior to the issuance of the Regulations, it was unclear whether leased tangible property could meet the requirements that "QOZ business property" must (1) be acquired by purchase from an unrelated person and (2) be originally used by the taxpayer. The Regulations give us very favorable rules addressing these issues.
The Regulations allow leased tangible property to qualify as “QOZ business property” provided that certain tests (discussed below) are met. These rules are very helpful for businesses that intend to use leased premises and equipment in connection with their business activities in a qualified opportunity zone. Even property leased from related parties can qualify as QOZ business property, although additional requirements apply to related party lease transactions. This will allow many property owners to lease property they already own to a QOF, even if they are considered related to the QOF.
For any leased tangible property to qualify as QOZ business property:
- It must have been acquired by a lease entered into after December 31, 2017.
- The lease terms must be market rate at the time the lease is entered into.
- Real property (other than unimproved land) leased by a QOF will not be considered QOZ business property if, at the time the lease is entered into, there was a plan, intent, or expectation for the real property to be purchased by the QOF for an amount of consideration other than the fair market value of the real property determined at the time of purchase.
If tangible property is leased by a QOF of QOZ Business from related party, the following additional requirements must be satisfied:
- The lessee cannot make prepayments on the lease relating to a period of use that exceeds 12 months.
- If the original use of the leased tangible personal property in the qualified opportunity zone does not commence with the lessee, (i) the QOF or QOZ Business must become the owner of tangible property that is QOZ business property and that has a value not less than the value of the leased tangible property and (ii) there must be a "substantial overlap" of the zone(s) in which the leased property is used and the zone(s) in which the other QOZ business property is used. The value of leased tangible property generally equals the present value of the payments due under the lease, though some QOZ Businesses will be able to use the financial statement value of the lease.
- A lessee will be deemed the "original user" of property already located in a zone, however, if the property has been unused or vacant for an uninterrupted period of at least five years.
Active trade or business test: 50% test
The initial round of proposed regulations issued in October 2018 (the "October Regulations") stated that in order for a QOZ Business to qualify as engaged in an “active trade or business” in a QOZ, at least 50% of its gross income must be derived from the active conduct of a trade or business in the QOZ. (A "QOZ Business" is a subsidiary entity or other entity in which a QOF invests that is organized for purposes of doing business in a QOZ and that satisfies a number of technical requirements, including this "active trade or business" requirement.) It was not clear until the release of the Regulations what rules would be applied to determine whether at least 50% of a non-real estate business’s gross income is in a QOZ.
The Regulations provide two enormously helpful safe harbors based on compensation and another (possibly less helpful) safe harbor based on other factors. A business that satisfies any one of these three safe harbors is deemed to derive 50% of its gross income from the active conduct of a trade or business in the QOZ:
1. At least 50% of the hours worked by employees and independent contractors for the QOZ Business are performed in a QOZ during the taxable year;
2. At least 50% of the total amount paid for services by the QOZ Business (whether by employees or independent contractors) is paid for services performed in a QOZ during the taxable year; or
3. The tangible property of the trade or business located in a QOZ, and the management or operational functions performed in a QOZ, are each necessary for the generation of at least 50% of the gross income of the trade or business.
The compensation-based safe harbors should be particularly helpful for pre-revenue start-up businesses. A business that does not satisfy any of the safe harbors may still rely on "facts and circumstances" to determine whether it satisfies the 50% gross income test.
Active trade or business test: real estate leasing
Because the rules regarding working capital only apply to QOZ Businesses and not to QOFs, most QOFs are acquiring real estate through QOZ Businesses. Unlike QOFs, which only have to be engaged in a "trade or business," a QOZ Business must be engaged in an "active trade or business." The Regulations state that for purposes of qualification as a QOZ Business, rental real estate that is a "trade or business" will be deemed to be an "active trade or business." This addresses a concern that some investors had about whether real estate leasing was sufficiently "active."
Working capital safe harbor
The October Regulations provided an extremely important “safe harbor” rule that permitted a QOZ Business (but not a QOF) to hold working capital for up to 31 months, provided that certain requirements were satisfied.
The new Regulations expand the working capital safe harbor in two important ways:
- First, the written designation for the planned use of working capital has been expanded to include the development of a trade or business in the qualified opportunity zone (and not just the acquisition, construction and/or substantial improvement of tangible property). This is very useful for QOZ Businesses formed to engage in an active trade or business other than real estate.
- Second, the 31-month safe harbor period will not be violated if the delay in using the working capital is attributable to waiting for government action (e.g., zoning and development approvals), provided that the application for approval is completed during the 31-month period. This is very important for real estate projects that require zoning or development approvals.
The working capital safe harbor still only applies to QOZ Businesses, not to QOFs. Largely for this reason, in most cases a QOF will need to conduct its operations through a QOZ Business, rather than directly.
Limitation of benefits for carried interests
The regulations take a dim view of carried interests. They require that if an investor has “promoted” equity, only the portion attributable to capital is eligible for the exclusion from capital gains after the 10-year holding period. For instance, if an investor who is a member of management team contributes 10% of the capital to a fund, but receives 20% of the profits above an IRR hurdle in addition to the 10% pro-rata participation with other capital investors, that 20% promoted interest would not be eligible for the capital gains exclusion, but the 10% pro-rata participation would be eligible for the exclusion. This rule applies even if the promoted equity is embedded in a single class of equity including capital rights.
Original use test
For property to qualify as QOZ business property, its “original use” in a QOZ must be by the QOF or the QOZ Business or it must be substantially improved by the QOF or QOZ Business. The Regulations clarify what “original use” means and, as discussed above, provide an analog to the “substantial improvement” rules for leased property.
For purposes of the "original use" test, property will be treated as originally used in a QOZ on the date that the property is first placed in service in the QOZ. Property generally is deemed placed in service when it first becomes depreciable. Used property can qualify as “originally used” in a QOZ if it was previously used outside the QOZ and not previously used or placed in service in the QOZ.
In addition, property can be treated as "originally used" by a QOF or QOZ Business if it was unused or vacant for an uninterrupted period of at least five years prior to being placed in service by the QOF or QOZ Business. For example, a QOZ Business could acquire an abandoned building that needs modest rehabilitation before being placed in use again, and if that building has been vacant for over five years prior to acquisition by the QOZ Business, the QOZ Business would not need to satisfy the "substantial improvement" test.
An investment in a QOF can be made in the form of cash or other property. Services to an LLC do not constitute an investment. If an investor makes a non-cash contribution, the amount of investment for purposes of computing deferred capital gain is equal to the lesser of the adjusted basis or fair market value of the QOF interest received in exchange for that contribution, applying ordinary tax principles. Property characterized as transferred other than as a contribution (for example, property transferred in a “disguised sale” transaction) is not treated as an investment in a QOF for purposes of the QOZ rules.
Treatment of Section 1231 gains
Under section 1231(a) of the Code, a taxpayer’s net gains from the sale of depreciable assets used in a trade or business (including rental real estate) are treated as long-term capital gains. The amount of a taxpayer’s section 1231(a) gain can only be determined as of the last day of the taxable year, however, because all sales made during the year have to be taken into account. The Regulations provide that when a taxpayer sells section 1231 property and has a net section 1231 gain for such year, the 180-day period for investing such capital gain income in a QOF starts on the last day of the taxable year (rather than on the date the asset was sold).
Property straddling census lines
Because QOZs are established based on census tracts, some businesses operate in parcels that are partly within and partly outside a QOZ. In such a case, the new regulations borrow from the “enterprise zone” rules of section 1397C. If a QOF or QOZ Business holds and uses such a contiguous parcel, the entire parcel is deemed to be inside a QOZ if the square footage inside the QOZ is substantial relative to the square footage outside the QOZ. The preamble to the Regulations states that real property located within a QOZ should be treated as “substantial” if the unadjusted cost of the real property inside a QOZ is greater than the unadjusted cost of real property outside a QOZ.
Special issues for Federally recognized Indian tribes and tribal lands
The Regulations clarify that interests in entities treated for tax purposes as corporations or partnerships that are chartered by a Federally recognized Indian tribe will be treated as QOZ stock or partnership interests as long as their domicile is located within one of the 50 states. This had been unclear under the October Regulations, which referred only to entities organized under the laws of the 50 states, the District of Columbia, and the US possessions.
In addition, the rules discussed above regarding leases particularly benefit Indian tribes and tribal lands because Indian tribal governments occupy Federal trust lands, which are leased rather than owned by their users.
Gifts and transfers at death
The Regulations state that a gift of a QOF interest generally will be treated as a disposition for purposes of triggering any capital gain that was deferred on contribution to the QOF. However, transfers to a grantor trust, even if treated as a gift for gift tax purposes, are not treated as a gift for this purpose unless and until the trust ceases to be treated as a grantor trust for income tax purposes.
In contrast, a transfer by reason of death (whether as a result of a direct transfer to heirs or a trust by will or otherwise or as a result of a former grantor trust becoming a non-grantor trust on death) will not be treated as a disposition and will not trigger acceleration of previously deferred gain.
The Regulations include guidance in a number of other areas, such as treatment of mergers, divisions, and nonrecognition transactions. We will address a number of these provisions that we believe are most relevant to our clients in future guidance.
At the same time as the release of the Regulations, the Treasury Department issued a notice indicating that it intends to gather more information about how capital is deployed by QOFs and what community development results they achieve. This notice invites public comments on what information should be gathered and how best to do it.