On April 17, 2019, the Department of Treasury and Internal Revenue Service released another set of proposed regulations on the Opportunity Zone (OZ) tax benefit. Until recently, many investors, funds, business owners and real estate developers explored initial steps to take advantage of the OZ tax incentives. Although unanswered questions remain, the proposed regulations provide timely and helpful guidance by bringing clarity to taxpayers in furtherance of the purpose of the OZ tax benefit.
Enacted as part of the Tax Cuts and Jobs Act at the end of 2017, the OZ tax benefit was designed to facilitate capital investment by qualified opportunity funds (QOFs) into low-income and distressed areas designated as opportunity zones through investments in QOFs. Taxpayers that invest in QOFs are permitted to defer (and in some cases, reduce or eliminate) capital gains tax liability. To qualify, 90 percent of the assets of a QOF must be “qualified OZ property,” which can consist of either “qualified OZ business property” or stock or partnership interest in a “qualified OZ business” (the 90 percent asset test). For background, see McGuireWoods’ prior alerts on Nov. 16, 2018, and March 22, 2019, outlining the OZ tax benefit and initial tranche of regulatory guidance.
Below is a brief summary of the key takeaways from the proposed regulations.
Qualified Opportunity Fund
- 12-Month Reinvestment Period – A QOF has up to 12 months to reinvest proceeds from the sale of its assets without running afoul of the 90 percent asset test.
- Six-Month Period for 90 Percent Asset Test – A QOF has a six-month grace period to invest any capital received from its investors before being considered for the 90 percent asset test.
- Technical Rules –The proposed regulations address tax consequences for certain transactions, including debt-financed distributions, property contributions, spinoffs, and mergers and consolidations for QOFs classified as C corporations, S corporations and partnerships.
Qualified OZ Business
- 50 Percent Gross Income Requirement Safe Harbors – The proposed regulations contain three safe harbor provisions and a facts-and-circumstances test to meet the requirement that 50 percent of the total gross income of a qualified business be derived from the active conduct of a trade or business within an OZ. These rules provide several options for a qualified OZ business to meet this requirement. The three safe harbors focus on the hours and cost of services provided within the designated opportunity zones.
- Trade or Business Definition – The term “trade or business” for OZ purposes is broadly defined to have the same meaning as such term under Internal Revenue Code Section 162, concerning the deductibility of trade or business expenses.
- Leasing Business – The proposed regulations provide that the ownership and operation (including leasing) of real property will constitute the active conduct of a trade or business; however, “merely” entering into a triple-net lease will not.
- Working Capital Safe Harbor Modification – The proposed regulations further expand the working capital safe harbor to allow a QOF’s written designation for the planned use of working capital within 31 months to include the development of a trade or business within an OZ as well as the acquisition, construction and/or substantial improvement of tangible property. Further, any delays attributable to government action will not count against the 31-month timeline.
- Vacant Buildings – Buildings or other structures within an OZ that have been unused or vacant for an uninterrupted period of at least five years prior to being purchased after 2017 will satisfy the original use requirement. (In general, the original use of tangible property within an OZ must begin with the QOF.)
- Used Property – Used tangible property cannot satisfy the original use requirement if it was used in the OZ before being purchased or placed in service for depreciation purposes. In such cases, the used tangible property would need to be substantially improved by doubling the basis of the property over any 30-month period after the property is acquired.
- Property Straddling an OZ – For real property straddling a designated OZ, such property is treated as being wholly within the OZ if the adjusted cost of real property within the OZ exceeds the adjusted cost of real property outside the OZ.
Investors
- Property Contribution – Taxpayers may invest cash or property in a QOF. Prior to the proposed regulations, it was unclear whether property could be contributed to a QOF directly in exchange for an interest in the QOF.
- Services Not Permitted – Taxpayers may not render services in exchange for a valid interest in a QOF.
- Secondary Purchase – Potential fund investors may purchase a valid QOF interest from a current QOF investor.
- Transfers at Death – A QOF investment held by an individual at the time of his or her death may transfer to the decedent’s heirs with the capital gains deferral intact.
Other
- Anti-Abuse Rules – The IRS and Treasury Department also proposed a general anti-abuse rule whereby, if a significant purpose of the transaction is not in line with the purpose of the OZ tax benefit, the IRS can recast the transaction as necessary.
- Additional Feedback – The IRS and Treasury Department have requested public comments on further specifics of the OZ tax benefit, including reporting requirements, further guidance on the anti-abuse rules, and original use requirement.
While some narrower questions remain, the proposed regulations alleviate many of the concerns presented to the investment community and should provide sufficient guidance for investors, developers and funds to continue moving forward with OZ eligible projects.