The IRS released its second set of proposed regulations implementing the new opportunity zone tax incentives on April 17, and the largely generous rules will make it easier for taxpayers to use asset sales to exit funds and use leased property within a fund, even when leased from related parties.
Opportunity zones were created by the Tax Cuts and Jobs Act to encourage investment in specific geographic areas. Taxpayers investing in qualified opportunity funds (QOFs) can defer and even exclude capital gain if they meet certain requirements. The new proposed regulations (REG-120186-18
) clarify parts of the proposed regulations issued in October (Reg-115420-18
), and address many of the other significant unresolved questions. Some of the most important developments include:
- Offering an election to treat the sale of QOF assets as tax-free after the 10-year holding period
- Allowing QOFs a year to reinvest the proceeds from the sale of qualified property for purposes of passing the asset test and remaining a QOF, but declining to provide that those sales are tax-free
- Providing that leased property can be qualified property in some circumstances, even when leased from a related party
- Allowing buildings that have been vacant for five years to be considered “original use.”
- Providing that the various “substantially all” tests generally mean 70% when referring to value or use but 90% when referring to holding periods
- Creating a broad anti-abuse rule allowing the IRS to recast any transaction intended to achieve a tax result inconsistent with the purpose of the statute
Taxpayers can generally rely on the proposed rules now, and the rules likely offer enough guidance for many QOFs to comfortably structure investments. But there are still several unresolved questions and issues for which the IRS is soliciting comments. Treasury officials said they hope to avoid a third round of proposed regulations, but changes to the current proposed regulations are likely when they are finalized.
There are more than 8,700 census tracts designated as opportunity zones across all 50 states, the District of Columbia and Puerto Rico, and there are multiple qualifying areas in nearly every major city. The opportunity zone program offers a potentially valuable tax incentive for investors looking to defer gains, real estate and operating businesses active within opportunity zones, and investment funds looking to match investors with qualifying projects. The new guidance is discussed in more detail below.
Incentives for investing in QOF
New Section 1400Z-2 provides up to three tax benefits for taxpayers investing in QOFs.
Grant Thornton Insight: The unique nature of the Dec. 31, 2026, mandatory gain recognition date requires taxpayers to make investments in a QOF by Dec. 31, 2019, in order to receive the additional 5% basis increase for holding the asset for seven years before the deferred gain is recognized.
- Taxpayers can elect to defer the recognition of gain from any capital asset up to the amount invested in QOFs. The taxpayer’s basis in the QOF is set at zero, so the deferred gain is essentially recognized when either the investment is disposed of or at the mandatory recognition date of Dec. 31, 2026.
- Taxpayers who hold the QOF investment for five years receive a basis increase of 10% so that only 90% of the original deferred gain is recognized. If the investment is held for seven years, the basis is increased another 5%, so the taxpayer recognizes only 85% of the original deferred gain.
- If the investment is held 10 years, the taxpayer will receive a step-up in basis to fair market value upon disposition, so no gain would be recognized on any appreciation of the QOF investment itself. The only gain recognized throughout the investment period would be the original gain that was deferred when making the QOF investment and recognized on Dec. 31, 2026.
Only gain from the sale or exchange of a capital asset to an unrelated party may be deferred by investing in a QOF. A taxpayer generally does not need net capital gain on the year, and can defer gain even if it only increases a net capital loss. The investment must be made within 180 days after the sale or exchange that created the gain. Ordinary gains are not eligible.
Grant Thornton Insight: A taxpayer is precluded from making the election to exclude gain for assets held at least 10 years unless the original election was made to defer gain when the investment in the QOF was made. So taxpayers without gain to defer will essentially receive no tax benefit from investing in a QOF.
The gain from selling an asset used in a trade or business under Section 1231 created uncertainty because its character depends on whether there is a net gain or loss on all Section 1231 property for the year. If there is a net loss, all Section 1231 gains and losses are considered ordinary and none of the incremental Section 1231 gain can be deferred for an investment in a QOF. For this reason, the new proposed regulations provide that the 180-day period for investing after incurring Section 1231 gain does not begin until the last day of the taxable year, when the ultimate character is determined. This rule also appears to apply for Section 1231 gain recognized at the pass-through entity level even though its character could change at the owner level.
Grant Thornton Insight: The approach for Section 1231 gain is consistent with other rules on the 180-day period. The earlier proposed regulations provided similar rules for other types of gain that are not determinable until year-end, such as Section 1256 contracts. (Gain on a Section 1256 contract may not be deferred at all if the contract is subject to an offsetting position such as a straddle.) The earlier proposed regulations also provided a generous rule for gain recognized at the pass-through entity level. If the pass-through itself does not make an investment and defer the gain at the entity level, the owner can make an investment and defer gain using the 180-period beginning on either the last day of the entity’s year (when the owner would be required to recognize the gain) or when the entity itself would begin the 180-day period (the date the entity actually makes the sale or exchange).
The proposed regulations offer extensive guidance on the treatment of interests in a QOF pass-through entity depending on the character of the interest and how it was acquired. Most notably, the proposed regulations provide that an interest for services will be considered a separate interest from any capital interest solely for Section 1400Z-2, meaning that a carried interest will not qualify and must be segregated from any capital interest.
Any deferred gain retains its character when eventually recognized. For example, deferred short-term capital gain is still recognized as short-term gain when the interest in the QOF is eventually sold or the gain is recognized on Dec. 31, 2026. The new proposed regulations provide a long list of nonexclusive “inclusion events” meant to prevent taxpayers from cashing out of a QOF while not triggering the gain they deferred upon investment. These include distributions of property from the QOF in excess of basis, transfers by gift, and many nonrecognition transactions like reorganizations and exchanges.
The statutory construction of Section 1400Z-2(c) created significant uncertainty surrounding the ability of taxpayers to receive their step-up in basis after 10 years and exit the fund without recognizing gain. The statutory language itself seemed to limit the step-up in basis to sales of the interest in the QOF itself, making asset sales impractical. For this reason, taxpayers with multiple qualifying projects would commonly create a separate QOF for each project so that projects could be sold to separate buyers.
The proposed regulations offer relief for taxpayers selling assets rather than the fund. Taxpayers who have owned a QOF organized as a partnership or S corporation for the 10-year holding period can elect to exclude from their income any capital gain from a QOF’s sale of capital assets. A similar rule allows owners of QOF’s organized as real estate investment trusts (REITs) to exclude capital gain dividends from income after the 10-year holding period.
Grant Thornton Insight: The IRS declined to offer relief on a related issue. Section 1400Z-2(e)(4) instructs Treasury to issue regulations providing QOFs a reasonable period of time to reinvest proceeds from selling qualified property for the asset test described below. Many taxpayers asked the IRS to provide that if a QOF reinvests in qualified property within the time allowed by regulations, the QOF should not recognize gain. The proposed regulations allow QOFs a 12-month period to reinvest for purposes of the asset test, but the preamble states the IRS could find no authority to exclude the proceeds from gain. The IRS did not foreclose the possibility altogether, asking for taxpayers to identify any precedent or authority that would support such a rule and provide them in comments.
A QOF is generally defined under Section 1400Z-2 as a partnership or corporation that holds at least 90% of its assets in qualified opportunity zone property, tested every six months. The proposed regulations provide that this definition includes any entity treated as a partnership or a corporation for federal tax purposes. A QOF self-certifies by filing new Form 8996
with its annual income tax return. The form allows the QOF to select the taxable year and the month in which the entity chooses to become a QOF and therefore subject to the requirements.
The Form 8996 is then filed each year to report compliance with the 90% asset test and calculate penalties for any failures. The IRS said it anticipated revising the form to require additional reporting, including the employer identification number (EIN) of any qualified opportunity zone businesses (QOZBs) owned by a QOF and the amount invested by QOFs and QOZBs.
Taxpayers with financial statements under Treas. Reg. Sec. 1.475(a)-4(h) generally use the financial statement asset values for the 90% asset test. Taxpayers without an applicable financial statement must generally use the cost of the assets. The IRS offered only limited relief from the asset test for QOFs to deploy new capital received (cash is not a qualified asset). The proposed regulations provide that the QOF asset test does not take into account any investments received in the prior six-months.
Grant Thornton Insight: The IRS has created major differences in how cash is treated for the asset test at the QOF level and the tangible property test at the QOZB level. Cash contributed at the QOF level becomes an unqualified asset in six to 12 months depending on how long after a testing date it is contributed. But under a separate IRS safe harbor, QOZBs have as long as 31 months to deploy working capital held in cash, cash equivalents and debt with a term of 18 months or less if they have a written plan to deploy it and meet other requirements. In addition, the 31-month time period can be extended based on government delays for permitting or other issues. This rule and several others discussed below mean it is often more favorable for a QOF to operate a business or develop a project through a tiered QOZB structure rather than directly, even though it requires creating a separate regarded entity.
Qualifying opportunity zone property
Qualifying assets of a QOF include qualified opportunity zone business property, qualified opportunity zone stock or a qualified opportunity zone partnership interest. Qualified opportunity zone stock and qualified opportunity zone partnership interests are original interests in partnerships or corporations issued after Dec. 31, 2017, solely in exchange for cash. The partnership or corporation must be a QOZB for “substantially all” of the time the QOF holds the interest. The proposed regulations provide that “substantially all” for the purposes of this test is 90%. A QOZB is a trade or business in an opportunity zone in which:
- “Substantially all” of the tangible property owned or leased by the business is qualified opportunity zone business property.
- The proposed regulations provide that “substantially all” is 70% in this context.
- At least 50% of gross income is derived from the active conduct of the business in the opportunity zone.
- The proposed regulations offer three separate safe harbors and facts and circumstances test, discussed below.
- A “substantial portion” of the intangible property is used in the active conduct of the business.
- The proposed regulations provide that a “substantial portion” is 40%.
- Less than 5% of the average of the aggregate unadjusted bases of the property of such entity is attributable to nonqualified financial property.
- The proposed regulations provide a safe harbor for working capital held in cash of up to 31 months.
- The business is not a golf course, country club, massage parlor, hot tub facility, suntan facility, racetrack, casino or liquor store.
Qualified opportunity zone property must fulfill three requirements:
- The property must be acquired by the QOF or QOZB after Dec. 31, 2017.
- The original use of the property in the opportunity zone must commence with the QOF or QOZB or be substantially improved.
- Substantially all of the use of the property must be in the opportunity zone during substantially all of the QOF’s or QOZB’s holding period.
- The proposed regulations provide that this means that 70% of the use of the property must be in the opportunity zone during 90% of the holding period.
Original use is generally considered to commence when property is first placed in service for depreciation or amortization under the proposed regulations. Substantial improvement is defined as doubling the basis of property over a 30-month period. Although this is generally assessed on an asset-by-asset basis, the proposed regulations ask for comments on potential grouping rules. To satisfy the requirement that at least 50% of gross income is derived from the active conduct of the business in the opportunity zone, the QOZB can make a facts and circumstances determination or rely on any one of three new safe harbors. If the QOZB does not wish to apply a full facts and circumstances analysis, it needs only to satisfy one of the following:
Land and real property
- 50% of the hours spent on services are physically performed within the zone regardless of where the customer is located.
- 50% of the amounts paid for services come from services performed within the zone regardless of where the customer is located.
- The tangible property of the business and the management and control functions actually located inside the zone are necessary to generate 50% of gross income.
Both land and buildings are eligible for special rules. The original proposed regulations provided that land does not have to meet the “original use” or “substantial improvement” tests. In addition, the basis of any land is not included in the basis of a building for the substantial improvement test.
The preamble to the new proposed regulations acknowledged that the lack of any requirement to improve the land could thwart Congress’s intent to spur new investment. Still, the IRS declined to change the proposed rules, and instead noted that all qualified property, including land, must be “used in a trade or business.” The preamble said this would prevent land being held for investment from qualifying. In addition, the IRS cited its ability to attack land transactions with a new broad anti-abuse rule. Under the general anti-abuse rule in the proposed regulations, created under a statutory mandate to issue regulations to prevent abuse, the IRS can recast any transaction with a significant purpose to achieve a tax result inconsistent with the purposes of Section 1400Z-2.
Grant Thornton Insight: The long discussion in the preamble of the potential abuse of the rules for land investments indicates it could be a major area of focus. The IRS offered an example of a situation in which it would attack an agricultural land transaction using its general anti-abuse rule, and then repeated this same example when separately discussing its new rule. It also requested comments on other potential anti-abuse rules that could apply specifically to land. But whether an activity rises to the level of a trade or business under Section 162 is a facts and circumstances determination with guidance and case law that is ambiguous in some areas. Determining whether an activity involving land rises to the level of a trade or business could generate significant controversy.
The IRS offered some relief to the “original use” or “substantial improvement” for buildings. If a building or structure has been vacant for five years before being purchased by a QOF or QOZB, it will satisfy the original use test and does not have to be substantially improved. This may be slightly less generous than anticipated, as the first round of proposed regulations indicated the IRS was considering offering relief not only for vacant or abandoned structures, but also “underutilized” buildings.
The proposed regulations offer very favorable rules for leased property. There was some question as to how leased property could ever be considered qualifying since the rules generally provide that qualified property must be acquired by purchase. Under the proposed regulations, tangible property acquired under a lease entered into after Dec. 31, 2017, qualifies if 70% of the use is in a qualified opportunity zone during 90% of the period the QOF or QOZB leases it (the same thresholds for purchased property). In addition, leased property does not have to meet either the original use or substantial improvement tests.
The property can be leased from a related party subject to several requirements and conditions. The lease must be market rate under the transfer pricing rules under Section 482, and the QOF or QOZB cannot make a prepayment to the lessor. If the QOF or QOZB is leasing personal property, the QOF or QOZB must purchase personal property of equal value during the lease term and there must be substantial overlap of zones in which both properties are used. Leased real property other than unimproved land will not qualify if at the time of the lease, there was a plan, intent, or expectation for the real property to be purchased by the QOF for an amount other than the fair market value.
Grant Thornton Insight: The ability for property leased from a related party to qualify could open up opportunities for taxpayers who owned property in an opportunity zone before Jan. 1, 2018. Taxpayers could potentially create a related QOF and lease the land or other property to it. There are drawbacks. The most powerful tax incentive is the ability to exclude gain on the appreciation of the QOF investment, and the QOF will obviously not be able to benefit from tax-free appreciation on leased property.
Taxpayers with financial statements under Treas. Reg. Sec. 1.475(a)-4(h) may choose to use the financial statement valuation to value leases for purposes of the QOF and QOZB asset tests. They also have the option of using the alternative valuation method, which is required for taxpayers without an applicable financial statement. Under this method, taxpayers use the present value of the payments to be made under the lease calculated using the discount rate under Section 1274(d)(1).
The regulations are not proposed to be effective until finalized, but the taxpayers can generally rely on them immediately if applied in their entirety and in a consistent manner. The amount of guidance now available should allow many taxpayers to structure their funds and investments. Areas of uncertainty remain, however, and the rules are complex and require projects to be structured in specific ways. The IRS also has broad authority to enforce anti-abuse rules. Taxpayers should consider both the specific requirements and whether investments, transactions and structures are consistent with Congress’s intent to spur new investment.
For more information, contact:
Washington National Tax Office
Grant Thornton LLP
+1 202 521 1515
Washington National Tax Office
Grant Thornton LLP
+1 202 861 4144
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