United States

Opportunity knocks, will investors answer the call?

The second round of QOZ regulations may spur taxpayer confidence

INSIGHT ARTICLE  | 

Overview

The 2017 Tax Cuts and Jobs Act provided a new initiative to bring capital into specified underdeveloped areas known as Opportunity Zones (OZ). While the IRS and Treasury Department issued proposed regulations in October 2018 to put substance around this new initiative, the proposed regulations did not provide the requisite guidance to make investors feel sufficiently comfortable to invest in these designated areas. Fortunately, a second set of proposed regulations were released by the IRS and Treasury Department in April, 2019 which addressed many taxpayer concerns that may very well set the stage for capital deployment into these designated areas.

Generally, the OZ program provides a deferral mechanism for all or a portion of a capital gain which is invested into a Qualified Opportunity Fund (QOF). This gain is deferred until the earlier of the investment sale date or Dec. 31, 2026.  For this reason, Dec. 31, 2026 is often referred to as the “day of reckoning” since gain recognition will be required regardless of the amount of cash distributed to satisfy tax obligations associated with the gain.  The amount of gain recognized if the investment is held to Dec. 31, 2026 is dependent upon the time the investment is held when the “day of reckoning” arrives.  If the investment is held less than five years, 100% of the gain is recognized.  However, if the investment is held at least five years, only 90% of the gain is recognized (with a permanent 10% basis increase) and if the investment is held at least seven years, only 85% of the gain is recognized (with a permanent 15% basis increase).

The OZ program also offers a large incentive related to those investments held at least 10 years.  If a taxpayer holds an investment in a QOF for at least 10 years, an election is available to treat the basis of the property sold as its fair market value. This eliminates gain recognition on any appreciation related to the OZ investment.         

Issues addressed

Types of property available for investment into a QOF

The April 2019 regulations expand the scope of property qualifying for investment into a QOF. While the property must still represent an amount of capital gain to defer, a taxpayer may contribute cash OR other property to a QOF in exchange for an eligible interest. Although an eligible interest must be an equity interest, the transfer of property to a QOF can be effectuated in a taxable or nontaxable transaction, providing taxpayers with flexibility to determine initial deal structuring.   

If property (other than cash) is contributed to a QOF in a taxable transaction, the amount of qualifying investment for deferral purposes is the fair market value of the transferred property. The transferee will recognize gain measured by the difference between the property’s fair market value and basis immediately prior to the transfer and the taxpayer’s initial basis in the investment will be zero.

If property (other than cash) is contributed to a QOF in a nontaxable transaction, the amount of qualifying investment for deferral purposes is equal to the lesser of the taxpayer’s basis in the QOF investment (without regard to the zero basis rule pursuant to section 1400Z-2(b)(2)(B)) or the fair market value of the eligible interest received, determined immediately after the contribution. Again, taxpayer’s initial basis in the investment will be zero.

Depending on the facts, a taxpayer could have an eligible and non-eligible interest associated with a non-cash contribution. In this event, a taxpayer will be treated as having received a mixed-fund investment. Additional guidance is needed regarding the treatment of allocations associated with mixed-fund investments.

INSIGHT 1:  Oddly, it does not appear that a QOF can in turn contribute non-cash property to a qualified opportunity zone business (QOZB) (which may be a separate entity owned in part by the QOF), making entity structuring key.

INSIGHT 2:  Profits interest are not a qualifying investment for this purpose. For this reason, it may be prudent to hold profits interests separately from qualifying interests.  

Types of gain available for deferral into a QOF

The April, 2019 regulations provide clarity regarding the types of gain available for deferral and how those rules operate with respect to related entities.  While it was clear based on the first round of regulations that capital gain is the only type of gain that qualifies for deferral, it was unclear how section 1231 gains would be treated or measured and how a “taxpayer” would be defined for this purpose.

The April 2019 regulations provide that, as it relates to §1231 gain, only capital gain net income is available for deferral.  Therefore, if a taxpayer has both section 1231 gains and section 1231 losses in any given year, a deferral is achievable only to the extent the section 1231 gains exceed the section 1231 losses.  These regulations also provide that the 180 day period to reinvest net capital gain from section 1231 property into a QOF begins on the last day of the taxpayer’s year rather than when the properties are sold.

To mitigate the impact on investors who may have invested §1231 gains before these regulations were issued, the FAQs on the IRS website were updated to state that if §1231 gains were invested prior to the end of the taxpayer’s tax year and prior to the release of the April, 2019 regulations and were less than their net §1231 gains for the taxable year, then they are still eligible to make the deferral election with respect to those gains.

Additionally, these regulations clarify that each member of a consolidated group is treated as a separate taxpayer.  Therefore, one member of a consolidated group cannot make a contribution to a QOF on behalf of another consolidated group member which would have recognized capital gain but for these provisions.

INSIGHT 1:  It appears only §1231 losses from the current year are taken into account when determining net capital gain exclusion availability.  The concept of recapturing prior year §1231 losses and offsetting them with current year §1231 gains has been omitted from the regulations.

INSIGHT 2:  It may be prudent to sell a partnership interest rather than the underlying §1231 assets in a year with other §1231 losses when deferral is desired under this provision.

Clarifications related to qualified opportunity zone businesses

The April, 2019 regulations provide much needed clarity regarding not only what business property qualifies as opportunity zone business property (QOZBP), but also the parameters surrounding how to qualify a business as a QOZB.  In particular, the new regulations provide an avenue for leased property to qualify, expand the definition of original use, and set forth additional rules in the area of substantial improvements.

An activity will be considered a trade or business for purposes of these provisions if it is considered a trade or business for purposes of section 162.  While an examination of the section 162 statute and related case law is beyond the scope of this paper, essentially an activity has to be actively engaged in for profit and cannot be merely portfolio in nature to be treated as an active trade or business.  This is welcome news to those engaged in the operation of real estate, including the leasing of real property, as these activities will qualify as an active trade or business.

The statute defines QOZBP as any tangible property used in a trade or business when (i) the original use in the QOZ commences with the taxpayer or (ii) the taxpayer substantially improves the property. The April 2019 regulations make clear the original use of purchased tangible property commences on the date a taxpayer first places the property into service within the QOZ for depreciation or amortization purposes.  The following other clarifications related to original use are contained in these April 2019 regulations:

  1. If property within a QOZ has been unused or vacant for an uninterrupted period of at least 5 years, original use commences on the date after the five year non-use period when any person then uses or places the property in service within the QOZ.    
  2. Used property qualifies as QOZBP if it has never been used or placed in service in a QOZ before its purchase since original use commences when it is used or placed in service in the QOZ.
  3. Leasehold improvements made by a lessee meet the original use requirement as purchased property in an amount equal to the unadjusted cost basis of the improvements.

Regarding leased property, these regulations provide that leased property will be considered QOZBP (to the lessee) if:

  1. The lease is entered into after Dec. 31, 2017.
  2. The lease contains market rate terms at the time the lease becomes effective.
  3. Substantially all of the use of the property is in a QOZ during substantially all of the QOF’s holding period of the property.

If the lease is between related parties, the following rules must be met to qualify:

  • The lease cannot contain a prepayment of more than 12 months
  • If the original use of leased tangible personal property does not commence with the lessee, the lessee, in addition to its leased property, must acquire tangible QOZ business property of value at least equal to the value of the related-party leased tangible personal property. Note the additional property acquired must be acquired during the relevant testing period which is generally the earlier of 30 months after the date the lessee receives possession of the leased property or the last day of the lease term. There must also be substantial overlap with regards to usage within the QOZs.   

Taxpayers are considered related if there is more than 20% common ownership for purposes of applying these particular related party rules.

In general, substantial improvement occurs if during any 30-month period beginning after the purchase date, additions to a taxpayer’s basis in building (not land) exceed an amount equal to the taxpayer’s adjusted basis of the building at the beginning of such 30-month period. The April 2019 regulations clarify that unimproved land located within a QOZ which is acquired by purchase does not have to be substantially improved. One caveat to this rule, however, is that the land must be used in a trade or business to constitute QOZBP. The Preamble to the April 2019 regulations caution taxpayers not to rely on these regulations if a significant purpose for acquiring the land is to achieve an abusive result (i.e. purchasing the land with an expectation, intention, or view not to improve the land more than an insubstantial amount within 30 months of the purchase date).  In such cases, a general anti-abuse rule applies.    

INSIGHT 1:  Caution should be exercised when making determinations surrounding triple net leases. If no services or other activities are provided in connection with a triple net lease, it will not qualify as QOZB. Facts and circumstances should be examined to determine if the triple net lease activity rises to the level of a trade or business under §162.

INSIGHT 2:  Developers of rental real estate within a QOZ not wishing to hold the real property after development may want to sell the building prior to receiving a certificate of occupancy to enable a buyer to classify the property as original use property.         

Debt-financed Distributions

The April 2019 regulations provide a path for investors to receive debt-financed distributions without having to recognize gain. There are, however, nuances associated with this favorable treatment as follows:

  1. The distribution cannot be, when viewed in conjunction with the original contribution, recast as a disguised sale. There is a presumption contained in the section 707 regulations that any distribution (excluding cash flow distributions, reimbursements of preformation expenses, and reasonable preferred returns) within two years from the date of contribution is deemed a disguised sale.
  2. The distribution cannot be in excess of the taxpayer’s basis.

INSIGHT 1:  This favorable provision may provide a mechanism for QOFs to provide the necessary capital for investors to pay taxes owed related to the “day of reckoning”, December 31, 2026.

INSIGHT 2:  QOFs may have an opportunity to alter their leverage ratios after the 2 year deemed disguised sale period has lapsed.

“Substantially All” Tests

The April 2019 regulations clarify the meaning of “substantially all” as it relates to both the holding period and the use of tangible and intangible business property when examining if property acquired after Dec. 31, 2017 qualifies as QOZBP as follows:

  1. Holding Period:  At least 90 percent of the property’s holding period must be with the QOF or QOZB.
  2. Use (Tangible Property):  At least 70 percent of the property must be used in a QOZ.
  3. Use (Intangible Property):  At least 40 percent of the property must be used in a QOZ.

Testing Rules

The April 2019 regulations provide additional guidance surrounding multiple testing requirements. Specifically, the 50% gross income test relating to a QOZB, the 90% asset test relating to a QOF, and the working capital safe harbor test all received attention.

A QOZB is a trade or business meeting the following requirements:

  1. Substantially all of the tangible property owned or leased by the QOZB is QOZBP
  2. At least 50% of the QOZB’s gross income is derived from the active conduct of a trade or business in the zone
  3. A substantial portion of the QOZB’s intangible property is used in the active conduct of the business
  4. Less than 5% of the average aggregated unadjusted bases of property is attributable to non-qualified financial property
  5. The business does not include the operation of a “sin” business (massage parlor, hot tub facility, suntan facility, racetrack or other gambling facility, golf course, country club, or a store if the principal business is the sale of alcohol for consumption off premises).

The April 2019 regulations provide four different ways that a QOZB can meet the above 50% gross income test as follows:

  1. Hours:  At least 50% of hours are performed in the QOZ measured by employee/independent contractor hours performed in the QOZ over total employee/independent contractor hours.
  2. Amount Paid:  At least 50% of amounts paid are for services of employees/independent contractors in the QOZ measured by services performed in the QOZ over the total amount paid for services in a given year.
  3. Location of Property and Business Function:  Tangible property located within a QOZ as well as 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.
  4. Facts and Circumstances:  Demonstrating that at least 50% of the QOZB’s gross income is derived from the active conduct of a trade or business located within the zone.   

In order for an entity to be treated as a QOF, it must, among other requirements, meet the “90-Percent Asset Test”. A QOF must invest and hold at least 90% of its assets in QOZ property determined by the average of the percentage of QOZ property held in the QOF, measured as of the first 6 month period and on the last day of the QOF’s tax year. It would be difficult for an entity to satisfy this test if it held cash related to virtually any material transaction. The April 2019 regulations addressed this concern by relaxing this rule in three ways:

  1. A QOF may exclude from the computation capital contributions made within the previous six months if such amounts are continuously held in cash, cash equivalents, or debt instruments with a term of 18 months or less.
  2.  A QOF can choose between two different valuations methods to meet this test if they have applicable financial statements (essentially financial statements prepared in accordance with GAAP) as follows:

a.     Financial Statement Valuation Method:  This method may be elected if an applicable financial statement is prepared in accordance with GAAP.
b.     Alternative Valuation Method:  This method prescribes that assets owned by the QOF are treated as having a value equal to their unadjusted cost bases pursuant to section 1012. Lease value would be determined based on the present value of the leases (discounted using the applicable federal rate).

3. A QOF has 12 months to reinvest proceeds from a return of capital or asset sale into a new qualified property before counting it against this test. If the QOF reinvests the proceeds in QOZP within 12 months, the proceeds are treated as QOZP for purposes of this test.

The October 2018 regulations provided a working capital safe harbor so that cash held would not be counted in the 90-Percent Asset Test noted above. Pursuant to these initial regulations, working capital would be deemed reasonable if used for the acquisition, construction, or improvement of tangible property in an QOZ within 31 months and (i) there was a written designation of working capital, (ii) there was a reasonable schedule to use the working capital within 31 months, and (iii) the working capital was used reasonable consistent with (i) and (ii). The April, 2019 regulations expanded the use of the working capital safe harbor in the following ways:

  1. The safe harbor now applies to the development of a trade or business within a QOZ, rather than limiting it merely to the acquisition, construction, or improvement of tangible property.
  2. The clock begins to run on the on the 31 month period based on the date cash is secured by the QOF. This cash infusion could be, for example, through member capital contributions or loan proceeds and gives the QOF the ability to develop a project in stages with cash infusions over time. The above criteria must be met for each capital infusion event and tracked separately.
  3. The 31 month period may be extended in the event a delay is the result of waiting for governmental action, assuming the QOF has completed an application for the aforementioned action.
  4. Relief related to delays resulting from governmental inaction are also available for the requirement to reinvest proceeds from a return of capital or asset sale event within 12 months.

INSIGHT 1: While the April, 2019 regulations provide an avenue to redeploy cash related to a return of capital or asset sale event, the regulations fall short in providing that these events are treated as non-recognition events for income tax purposes such that no gain is recognized. This could be problematic for investors with a holding period of less than 10 years (there would be gain exclusion for investors with a holding period of at least 10 years).      

Other Provisions

If a QOF purchases real property which straddles designated and non-designated census tracts, if all other requirements are met, the real property will be considered QOZBP if the unadjusted cost of the real property inside the designated census tract is greater than the unadjusted cost of real property outside the designated census tract.

The transfer of a QOF investment to a deceased owner’s estate will not result in the loss of the QOF investment benefit. Likewise, the distribution by the estate to the decedent’s heir will not result in the loss of the QOF investment benefit.

A taxpayer electing the benefits afforded by the OZ regulations is able to sell its eligible interest in a QOF to a third party buyer, allowing buyer to defer capital gain and to claim other OZ benefits.

Financial implications

The financial implications of this legislation will likely be the primary driver for OZ investments. A sample analysis demonstrates why this legislation may be viewed from different lenses. Some may view this program as a powerful tool to spur economic development into these designated areas while others may find caution their friend.

Assumptions:

QOZ investment

Capital Gain Deferred (Investment in QOF) $1,000,000
Annual Appreciation  5%
Discount Rate (Current Treasury Rate)                                   2.45%
Federal Tax Rate (20% Long-term Capital Gain Rate + 3.8% Investment Income Tax Rate) 23.8%
Federal Unrecaptured section 1250 Gain Rate  25%
Annual Loss Generated by Depreciation ($50,000)
No Distributions Except at End of Term  
Required Federal Tax is Paid at End of Term  

 

Standard Investment

Cash Investment ($1,000,000 net of tax paid @23.8%) $762,000
Annual Appreciation 5%
Discount Rate (Current Treasury Rate)   2.45%
Federal Tax Rate (20% Long-term Capital Gain Rate + 3.8% Investment Income Tax Rate) 23.8%
Federal Unrecaptured section 1250 Gain Rate  25%
Annual Loss Generated by Depreciation ($50,000)
No Distributions Except at End of Term  
Required Federal Tax is Paid at End of Term  

 

Project Level (After-Tax)

 Holding Period   OZ Investment IRR   Standard Investment IRR   OZ IRR Benefit
5 Year 1.80% 0.22% 1.58%
7 Year 3.28% 1.51% 1.77%
10 Year 5.03% 2.53% 2.50%

 

Investor Level (After-Tax)

 Holding Period   OZ Investment IRR   Standard Investment IRR   OZ IRR Benefit
5 Year 0.77% 0.04% 0.73%
7 Year 2.24% 1.27% 0.97%
10 Year 4.82% 2.20% 2.62%

AUTHORS



Subscribe to Tax Insights


How can we help with your individual or business taxes?