The final regulations on opportunity zones released on Dec. 19 (T.D. 9889
) add helpful flexibility that will make it easier for taxpayers to qualify for the incentives. The most significant revisions not only ease restrictions on how and when the initial investment can be made, but also expand opportunities for funds to satisfy the operational rules.
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 the funds and taxpayers meet certain requirements. T.D. 9889 finalizes two sets of proposed regulations (REG-120186-18
) and resolves much of the outstanding ambiguity in favorable ways. Beneficial changes in the final regulations include rules that will:
- Allow taxpayers to aggregate new and existing property for the substantial improvement test
- Treat certain buildings as original use if they have been vacant for as little as one year
- Expand and extend the safe harbor period for start-up funds and businesses
- Provide a six-month period to “cure” a defect in an opportunity zone business before penalties apply
- Allow taxpayers to elect begin their 180-day period to reinvest gain from a pass-through entity on the original deadline for the entity to file a return
- Create a presumption that property leased from an unrelated party is market-rate
- Allow taxpayers to defer incremental gain from selling business asset under Section 1231 even if they have a net Section 1231 loss
The guidance addresses most of the unresolved issues, but lingering uncertainties remain. The IRS even acknowledged additional clarity is needed is some areas, including the safe harbors for determining whether 50% of gross receipts come from a business within the zone. Although most of the changes are helpful, there are some unfavorable changes. For example, the final regulations bar real estate businesses from renting more than 5% of their property to a business defined as “disqualified.”
The rules are generally effective for tax years beginning after March 13, 2020. For prior periods, taxpayers can choose to rely on either the proposed or final regulations in most areas, but generally must rely on one or the other in their entirety. Although not every uncertainty has been fully resolved, the guidance is extensive and should give taxpayers and funds confidence to structure and launch their investments.
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 guidance is discussed in more detail below.
Incentives for investing in QOF
New Section 1400Z-2 provides tax benefits aimed at both the gain from a prior transaction and future gain from the appreciation of investing in the QOF itself:
- Taxpayers can defer gain from disposing any capital asset by investing up to an equal amount in a QOF. 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. In addition, this deferred gain can be recognized at a potential discount:
- Taxpayers receive a 10% basis increase if they hold the investment for five years (so only 90% of the original deferred gain is recognized).
- Taxpayers receive an additional basis increase of 5% if they hold the investment seven years.
Making the investment
- 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 is recognized on any appreciation of the QOF investment itself.
Only gain from the sale or exchange of a capital asset to an unrelated party may be deferred by investing in a QOF. Ordinary gains are generally not eligible, with special treatment for Section 1231 gain discussed later. A taxpayer generally does not need net capital gain for the year, and can defer gain even if it only increases a net capital loss. The final regulations retain a rule allowing taxpayers to make a qualified investment in a QOF by contributing property, but acknowledge that the property itself can never be qualified Opportunity Zone business property because the property is not purchased, leased or self-constructed.
The investment must be made within 180 days after the sale or exchange that created the gain. If the gain is triggered by a deemed sale or exchange, then the 180-day period generally begins on the date the gain would be recognized for federal income tax purposes. Gain from Section 1256 contracts must be aggregated and netted, so the 180-day period begins on the last day of taxable year. The final regulations retain a rule that gain on a Section 1256 contract may not be deferred if the contract is subject to an offsetting position such as a straddle, but make technical changes the rules for determining if there is an offsetting position.
There are multiple options in the final regulations for making investments when gain is received through a pass-through entity such as a partnership, S corporation, estate or trust. The entity itself can make an investment within 180 days of the sale or exchange and defer gain at the entity level. If the entity does not defer the gain, the owner of the pass-through interest can make an investment and elect to defer the gain. When the gain flows from a pass-through entity, the owner has three choices for when to begin the 180-day clock for making the investment. The proposed regulations allowed taxpayers to use either the entity’s 180-day period (the date the entity actually makes the sale or exchange) or the last day of the entity’s taxable year. The final regulations allow a third option: the entity’s tax return deadline without extensions. The final regulations also clarify that a grantor trust is not considered a pass-through entity eligible for this treatment.
The final regulations add similar rules for shareholders of real-estate-investment trusts (REITs) and regulated investment companies (RICs). RIC and REIT shareholders receiving capital gain distributions may use either the last day of their taxable year or the date the dividend is distributed to begin the 180-day period. For undistributed capital gains, shareholders may use either the last day of their taxable year or the last day of the entity’s taxable year.
The gain from selling property used in a trade or business under Section 1231 raises issues 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, but if there is a net gain, all gains or losses are considered capital. The proposed regulations provided that only net Section 1231 gain over Section 1231 loss could be deferred and that the 180-day period for making the investment would not start until the final day of the taxable year (when the ultimate character is determined by overall net gain or loss). The final regulations change this rule, allowing taxpayers to defer incremental Section 1231 gain even if there is an overall loss or the deferral itself creates an overall loss. The final regulations also provide that the 180-day period starts on the day of the sale or exchange that creates the gain and not the last day of the table year.
Recognizing deferred gain
Any deferred gain retains its character when eventually recognized. For example, deferred short-term capital gain is still treated as short-term gain when the interest in the QOF is eventually sold or the gain is recognized on Dec. 31, 2026. If different investments were made in a QOF at different times, the gain related to earlier investments must be recognized first. If a single investment covers multiple types of deferred gain, then the gains realized earlier are considered the earlier investments. If two eligible gains were realized on the same day, the gains are allocated pro rata. However, the final regulations create a special rule allowing shareholders of QOFs organized as a C corporations to specifically identify which shares are sold and to recognize the specific deferred gain associated with the acquisition of those shares.
The final regulations retain with some tweaks 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.
Exiting the fund after 10 years
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 seems to limit the step-up in basis to sales of the interest in the QOF itself, making asset sales impractical.
The final regulations expand the relief offered in the proposed regulations for when assets of the QOF are sold instead of an interest in the fund. Under the final regulations, 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 gain from the sale of any assets (not just capital assets) except for inventory. After the sale, the QOF is treated as distributing to each QOF owner the net proceeds solely for QOF investment purposes in order to eliminate QOF benefits from the reinvestment of proceeds. A similar rule allows owners of QOF’s organized as REITs to exclude capital gain dividends from income after the 10-year holding period.
A QOF is defined as a partnership or corporation for tax purposes (including a C corporation, or S corporation or REIT) that holds at least 90% of its assets in qualified Opportunity Zone property, tested every six months. 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 draft Form 8996 for 2019 has been substantially revised to require significant additional reporting on the assets of the QOF and any qualified Opportunity Zone businesses (QOZBs).
The only assets that qualify for the 90% asset test are qualified Opportunity Zone business property and qualified interests in entities that themselves qualify as a QOZB by holding sufficient qualified Opportunity Zone business property and meeting other tests. Taxpayers generally value their assets using cost basis with some exceptions, but can elect to use the financial statement valuation if they have an applicable financial statement under Treas. Reg. Sec. 1.475(a)-4(h).
The final regulations retain a rule providing that the QOF asset test does not take into account any cash, cash equivalents, or debt-instruments (with a term of 18 months or less) if received in the prior six-months.
Qualifying Opportunity Zone business
A QOZB must be partnership or corporation, and the QOF must acquire its interest in the entity as an original interest solely in exchange for cash after Dec. 31, 2017. Under the final regulations, the partnership or corporation must qualify as a QOZB for 90% of the time the QOF holds the investment. But the final regulations also provide a new safe harbor grace period that gives QOFs six months to cure a defect in a QOZB without having to pay a penalty for failing the QOF’s asset test. A QOF can also request relief for reasonable cause. Under the final rules, a QOZB is a trade or business in an Opportunity Zone in which:
Trade or business
- 70% of the tangible property owned or leased is qualified Opportunity Zone business property
- At least 50% of gross income is derived from the active conduct of the business in the Opportunity Zone
- 40% of the intangible property is used in the active conduct of the business
- Less than 5% of the average of the aggregate unadjusted bases of the property of such entity is attributable to nonqualified financial property
- The business is not a golf course, country club, massage parlor, hot tub facility, suntan facility, racetrack, casino or liquor store
The final regulations generally rely on the rules in Section 162 to determine if a trade or business exists, with an exception for real property. The ownership and operation (including leasing) of real property is always considered the active conduct of a trade or business unless the taxpayer merely enters into a triple net lease.
Gross income test
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 following safe harbors:
- 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 or operational functions actually located inside the zone are necessary to generate 50% of gross income
The IRS received many comments on the tangible property and operational function test. The IRS acknowledged taxpayers would benefit from additional guidance, but said it was still studying the issue.
Intangible property test
The final regulations provide that intangible property is considered used in the QOZB’s trade or business if the use of the intangible property is customary in the conduct of the trade or business and it is used in the qualified Opportunity Zone in the performance of an activity of the trade or business that contributes to the generation of gross income for the trade or business.
In one of the few unfavorable new rules, the final regulations provide that QOZB cannot lease more than 5% of property to the disqualified businesses listed above even if under the statute the QOZB itself is engaged in the trade or business of leasing and not a disqualified business.
Nonqualified financial property
The final regulations significantly expand a proposed 31-month working capital safe harbor for spending cash that would otherwise violate the ban on holding more 5% of more of property in nonqualified financial property. Under the proposed rules, a QOZB was allowed to hold cash, cash equivalents, and debt instruments with a term of 18 months or less for up to 31 months if it had a written plan earmarking all the capital for the acquisition, construction, or substantial improvement of tangible property in the Opportunity Zone, and complied with a written schedule that was consistent with the ordinary business operations of the business. The proposed version also provided relief from the 50% gross receipts test during the safe harbor period and allowed QOZB’s to have multiple 31-month safe harbor periods if new working capital was contributed.
The final regulations allow QOZBs to stack safe harbor periods up to a total of 62 months and provide that working capital designated for acquiring intangible property and for purchasing, leasing or improving tangible property will qualify for the intangible and tangible property tests for the duration of the safe harbor period.
Qualifying Opportunity Zone business property
Qualified Opportunity Zone business property must fulfill three requirements under the final regulations:
- 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.
- 70% of the use of the property must be in the Opportunity Zone during 90% of the QOF’s or QOZB’s holding period.
The final regulations provide a safe harbor for determining where “use” occurs if tangible property used both inside and outside the Opportunity Zone. This property will be deemed to satisfy the use test if there is an office or fixed location inside the zone and the property is operated by employees who regularly use the location and are managed by employees housed in the location. However, the safe harbor can only be used on up to 20% of the entity’s tangible property.
The final rules give taxpayers the option to treat inventory stored inside the zone as qualified property or to remove it from the test altogether. The final regulations also provide very favorable guidance on original use and substantial improvement, particularly related to land and real property.
“Original use” is generally considered to commence when property is first placed in service for depreciation or amortization. The final regulations add an example that makes clear that acquiring a newly constructed building that has not been placed in service is considered original use. However, self-constructed property will be treated as “acquired” on the date physical work of a significant nature begins.
The final regulations make the original use rules for land and real property even more generous. Original use now includes land and buildings purchased from a local government that holds the property because of an involuntary transfer like a foreclosure, bankruptcy, or abandonment. In addition, the final regulations shorten the proposed five-year period a building was required to be vacant before returning it to service could be considered original use. The final rules provide a one-year period for property that was vacant when the qualified Opportunity Zone was designated, and three years for all other buildings. Vacancy is defined as more than 80% of usable space or square footage going unused.
Land is generally exempt from the original use and substantial improvement requirements, but is still subject to some restrictions. Taxpayers cannot rely on the general exemption from the original use requirement if the land is unimproved or minimally improved when acquired and the taxpayer does not intend to improve the land by more than an insubstantial amount in 30 months. The final regulations decline to provide an explicit definition of “insubstantial,” but do state that improvements such as grading, clearing, remediation, or acquisition of equipment for facilitating use of the land are all taken into account when determining a taxpayer’s intent to improve the land. In addition, land and all qualified property must be “used in a trade or business,” and the IRS noted in the preamble that this requirement would help prevent “land banking.” The IRS has also noted a broad anti-abuse rule can prevent abuse in these circumstances.
Substantial improvement is defined as doubling the basis of property over a 30-month period. The basis of land is not included in a building’s basis for the building’s substantial improvement test and the land itself does not need to be substantially improved. The final rules also allow taxpayers to treat property as qualified while it undergoes substantial improvement as long as the taxpayer reasonably expects the property to be substantially improved by the end of the 30-month period.
In one of the most favorable changes in the final regulations, taxpayers can combine new original use assets with non-original use property for determining substantial improvement as long as the new assets are used in the same trade or business and improve the functionality of the non-original use asset. In this case, the original use assets will not be treated as separate assets for the 70% and 90% tests, but will instead be taken into account as additions to basis for the property being substantially improved. Two buildings can also be aggregated into a single asset for determining substantial improvement as long as they either share a parcel of land on a single deed or are on contiguous parcels of land and are operated only by the QOF or QOZB, share centralized business elements or facilities, and are operated with the QOF’s or QOZB’s trade or business.
The final regulations retain and enhance 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. 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 taxpayer 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 lease must be market rate under the transfer pricing rules under Section 482, but the final regulations create a rebuttable presumption that any lease to an unrelated party is considered market rate. Tangible property leased from a state, local, or tribal government is not considered from a related party. 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.
Property leased from a related party is subject to several additional requirements and conditions. The taxpayer cannot prepay the lessor more than 12 months, and if leasing personal property that is not original use in the zone, the taxpayer must purchase qualifying personal property of equal value during the lease term and there must be substantial overlap of zones in which both types of properties are used.
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 based on the IRS short-term Applicable Federal Rate.
The rules are generally effective for tax years beginning after March 13, 2020, meaning they are not actually in effect for calendar years 2018-2020. But taxpayers can rely on them and most will benefit as they are largely favorable. Taxpayers can also choose to rely on the proposed version, and may want to in limited circumstances, but generally must rely on one or the other consistently and in their entirety. Although not every uncertainty has been fully resolved, the guidance is extensive and should give taxpayers and funds confidence to structure and launch their investments.
Taxpayers should also remember the IRS has broad authority to enforce anti-abuse rules, and the final regulations include a number of examples that show the IRS’s willingness to apply them in many types of circumstances. Taxpayers should consider both the specific requirements and whether investments, transactions and structures are consistent with Congress’s intent to spur new investment within the zone.
For more information contact:
Washington National Tax Office
Grant Thornton LLP
+1 202 861 4144
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