An Update on Opportunity Zones | April 2019 Proposed Regulations
The Tax Cuts and Jobs Act (TCJA) introduced §1400Z as an incentive to spur economic investment in state-designated areas. An initial set of proposed regulations was released in October of 2018 (REG-115420-18, see our original article) and the second set was released on April 17, 2019 (REG-120186-18).
The provision allows capital gain to be invested into qualified opportunity funds to allow for immediate deferral of tax on the capital gain and, depending on how long the investment is held, a potential for permanent deferral of a portion of the gain as well as tax-free appreciation of the investment.
Terminology to Know
Opportunity Fund – can be a partnership or corporation where 90% of assets are held in qualified opportunity zone property that is not a sin business defined below.
Qualified Opportunity Zone Property – can be stock in a domestic corporation, domestic partnership interest, or business property acquired after 12-31-17. If it’s business property, it has to be original use and substantially all of the use of the property is in a qualified opportunity zone during substantially all of the qualified opportunity funds’ holding period of the property. The fund has 30 months beginning after the date of the acquisitions to substantially improve the property (unless the funds are in cash and cash equivalents, then you have 31-months unless there are governmental delays such as permits, inspections, etc.)
Qualified Opportunity Zone Business – §162 trade or business in which substantially all of the tangible property owned and leased is qualified opportunity zone business property.
Qualified Opportunity Zone Business Property – tangible property used in a trade or business that meets the acquisition and other use and holding period requirements outlined above and at least 50% of the qualified opportunity zone business’ gross income is derived from the active conduct of the trade or business.
50% test for Qualified Opportunity Zone (QOZ) business’ gross income – the newly issued regulations provide safe harbors for making this determination. If relying on the safe harbor, you only have to meet one of the following:
- 50% of the services performed (based on hours) occurs within a QOZ;
- 50% of the services performed (based on amounts paid) occurs within a QOZ; or
- tangible property and management or operational functions performed for the business occurs within a QOZ.
Substantially All – for purposes of a holding period designation, 90%; other items, 70%; intangibles, 40%.
Original use – commences on the date when that person or a prior person first places the property in service in the QOZ for purposes of depreciation or amortization. Buildings or other structures that have been vacant for at least five years prior to being purchased by a QOF or QOZ business will satisfy the original use requirement. Improvements made by a lessee to the leased property also satisfy the original use requirement and are considered purchased property for the amount of the unadjusted cost basis of such improvements.
Sin business – private or commercial golf course; country club; massage parlor; hot tub facility; suntan facility; racetrack or other facility used for gambling; any store the principal business of which is the sale of alcoholic beverages for consumption off premises
Land can be treated as QOZ only if it is used in a trade or business of a qualified opportunity fund (QOF) or QOZ business.
What do we know now?
The first set of proposed regulations focused primarily on the operation and investment in real estate; leaving many questions unanswered on the operation of a QOZ business outside the context of real estate. Additional clarification was provided on a few of these non-real estate related items in the latest round of guidance.
Inventory in transit
The regulations provided a safe harbor for inventory that may be in transit, indicating “inventory of a trade or business does not fail to be used in a QOZ solely because the inventory is in transit from a vendor to a facility of the trade or business that is in a QOZ, or from a facility of the trade or business that is in a QOZ to customers of the trade or business that are not located in a QOZ.” Comments have been requested related to this provision.
Assets subject to a lease
Assets subject to a lease may be treated as QOZ business property for purposes of satisfying the 90% asset test and the substantially all requirements if the leased property is acquired pursuant to a lease entered into after 12-31-17 and substantially all of the use of the leased property is in a QOZ during substantially all of the period for which the business leases the property. There is no requirement to substantially improve the leased property, as the lessee most likely does not have a depreciable interest in the property.
Property within and outside a QOZ
Numerous concerns had been raised regarding the ease of understanding the designated census tracts outlining the opportunity zones. The regulations have indicated real property located within the QOZ should be considered substantial and eligible for the favorable treatment if the unadjusted cost of the real property inside a QOZ is greater than the unadjusted cost of real property outside of the QOZ.
Sale of assets by the qualified opportunity fund (QOF):
Proceeds received by the QOF from the sale or disposition of:
- QOZ business property
- QOZ stock and
- QOZ partnership interests
Are treated as QOZ property for purposes of the 90% investment requirement so long as the QOF reinvests the proceeds received by the QOF from the distribution, sale, or disposition of such property during the 12-month period beginning on the date of such distribution, sale, or disposition. Proceeds must be continuously held in cash, cash equivalents, and debt instruments with a term of 18 months or less. The sale of underlying assets does not in any way affect the treatment or trigger taxable gain if the requirements are met and the overall investment is held by the electing investor.
What events could trigger tax:
- Taxable disposition (sale) of all or a part of a qualifying investment in a QOF partnership or of an qualifying investment in a QOF corporation;
- Taxable disposition (sale) of interest in an S corporation which itself is the direct investor in a QOF if, immediately after the disposition, the S corporation shareholders at the time of the deferral election has changed by more than 25%
- In certain cases, a transfer by a partner of an interest in a partnership that itself directly or indirectly holds a qualifying investment;
- Transfer by gift of a qualifying investment;
- The distribution to a partner of a QOF partnership of property that has a value in excess of basis by the partner’s qualifying QOF partnership interest;
- Distribution of property with respect to qualifying QOF stock under section 301 to the extent it is treated as gain from the sale or exchange of property;
- Distribution of property with respect to qualifying QOF stock under section 1368 to the extent it is treated as gain from the sale or exchange of property
- Redemption of qualifying QOF stock that is treated as an exchange of property for the redeemed qualifying QOF stock under section 302
- Disposition of qualifying QOF stock in a transaction to which section 304 applies
- Liquidation of a QOF corporation in a transaction to which section 331 applies; and
- Certain non-recognition transactions
The amount includible as taxable income in the instance of an inclusion event is:
- The lesser of:
- Fair market value of the portion of the qualifying investment disposed; or
- The amount that bears the same ratio to the remaining deferred gain as the first amount bears to the total fair market value of the qualifying investment in the QOF immediately before the transaction.
- Less the taxpayer’s basis
Transfer on death is NOT considered an inclusion event. A transfer on death event would include:
- Transfer by reason of death to the deceased owner’s estate;
- Distribution of a qualifying investment by the deceased owner’s estate;
- Distribution of a qualifying investment by the deceased owner’s trust that is made by reason of the deceased owner’s death
- The passing of a jointly owned qualifying investment to the surviving co-owner by operation of law; and
- Any other transfer of a qualifying investment at death by operation of law
- EXCEPTIONS (inclusion events):
- Sale, exchange, or other disposition by the deceased taxpayer’s estate or trust
- Any disposition by the legatee, heir, or beneficiary who received the qualifying investment by reason of the taxpayer’s death; and
- Any disposition by the surviving joint owner or another recipient who received the qualifying investment by operation of law on the taxpayer’s death.
The holding period in the instance of a non-inclusion death event would include the time during which the qualifying investment was held by the donor or the deceased owner.
What amount is required to be recognized on December 31, 2026:
- Excess of:
- The lesser of:
- The remaining deferred gain; and
- The FMV of the qualifying investment held on December 31, 2026 over
- The taxpayer’s basis in the qualifying investment as of December 31, 2026 taking into account only §1400Z-2(b)(2)(B).
- The lesser of:
Although these regulations provide welcome clarity, additional questions still remain. An additional round of regulations may be released or the two versions currently in proposed form could be finalized with additional modifications. The regulations may be relied upon in their current state and could provide enough clarity and comfort to investors to move forward with pursuing the benefits of investing within opportunity zones.
Click here to view designated opportunity zones across the country.
Click here to view designated opportunity zones in Minnesota.
Check out the FAQs on the IRS website if you are interested in learning more about Opportunity Zones.