On April 17, 2019, the U.S. Treasury Department and the Internal Revenue Service (IRS) issued a second round of proposed regulations (the “proposed regulations”) regarding investments in Qualified Opportunity Funds (QOFs), a significant tax incentive program created by the 2017 Tax Cuts and Jobs Act. As discussed in our previous tax alert, this program encourages investments in economically distressed and lower-income communities designated as Qualified Opportunity Zones (QOZs) by allowing taxpayers to elect to defer the recognition of capital gain up to the amount of any capital gain invested in a QOF and eliminate certain gain on the sale of an interest in a QOF held for at least ten years.
The proposed regulations provide clarity and additional guidance regarding a number of critical items and questions left unanswered by the first round of proposed regulations and guidance issued on Oct. 19, 2018, including the following:
- Meaning of “Substantially All”. The statute applicable to QOZs neither defines the meaning of “substantially all” for the QOF’s holding period for QOZ stock, QOZ partnership interests and QOZ business property, nor defines it for purposes of testing the use of QOZ business property in a QOZ. Under the proposed regulations, in testing the use of QOZ business property in a QOZ, the term "substantially" is defined as 70 percent. With respect to owned or leased tangible property, the proposed regulations provide identical requirements for determining whether a QOF or QOZ business has used "substantially all" of such tangible property within the QOZ and propose that the "substantially all" requirement regarding “use” is satisfied if at least 70 percent of the use of such tangible property is in a QOZ. The proposed regulations provide that the term "substantially all" as used in the holding period context is defined as 90 percent.
- Relief for Newly Contributed Assets with Respect to the 90-Percent Asset Test. A QOF must generally hold at least 90 percent of its assets in QOZ property. The proposed regulations allow a QOF to apply the 90-percent asset test without taking into account any investments received in the preceding six months if the new assets are held in cash, cash equivalents or debt instruments with a term of 18 months or less.
- 50 Percent of Gross Income of a Qualified Opportunity Zone Business. A QOF is an investment vehicle that is set up as either a partnership or corporation for investing in eligible property that is located in a QOZ. In general, the corporation or partnership must derive at least 50 percent of its total gross income from the active conduct of a business within a QOZ. The proposed regulations provide three safe harbors and a facts and circumstances test for determining whether sufficient income is derived from a trade or business in a QOZ for purposes of the 50-percent test.
The first safe harbor requires that at least 50 percent of the services performed (based on hours) for such business by its employees and independent contractors (and employees of independent contractors) are performed within the QOZ.
The second safe harbor is based upon amounts paid by the trade or business for services performed in the QOZ by employees and independent contractors (and employees of independent contractors). Under this test, if at least 50 percent of the services performed for the business by its employees and independent contractors (and employees of independent contractors) are performed in the QOZ, based on amounts paid for the services performed, the business meets the 50-percent gross income test.
The third safe harbor is a conjunctive test concerning tangible property and management or operational functions performed in a QOZ and provides that a trade or business may satisfy the 50-percent gross income requirement if (i) the tangible property of the business that is in a QOZ and (ii) the management or operational functions performed for the business in the QOZ are each necessary to generate 50 percent of the gross income of the trade or business.
Even if a taxpayer does not meet any of the three safe harbors referenced above, the 50-percent requirement may still be satisfied if, based on all the facts and circumstances, at least 50 percent of the gross income of a trade or business is derived from the active conduct of a trade or business in the QOZ.
- Reasonable Period for a QOF to Reinvest Proceeds from Sale of Qualifying Assets. QOFs have a reasonable period of time to reinvest the return of capital from investments in QOZ stock and QOZ partnership interests and to reinvest proceeds received from the sale or disposition of QOZ property. The proposed regulations provide that proceeds received by the QOF from the sale or disposition of (i) QOZ business property, (ii) QOZ stock and (iii) QOZ partnership interests are treated as QOZ property for purposes of the 90-percent investment requirement, as 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. The one-year rule is intended to allow QOFs adequate time in which to reinvest proceeds from QOZ property. Further, in order for the reinvested proceeds to be counted as QOZ business property, from the date of a distribution, sale or disposition until the date proceeds are invested in other QOZ property, the proceeds must be continuously held in cash, cash equivalents and debt instruments with a term of 18 months or less.
- Treatment of Leased Tangible Property. The proposed regulations allow leased tangible property to be treated as QOZ business property if (i) the property is acquired through a lease that is entered into after Dec. 31, 2017; (ii) the terms of the lease reflect common, arm's length market practice in the locale that includes the QOZ at the time that the lease was entered into; (iii) during "substantially all" of the holding period of the QOF (or QOZ business, if applicable) for the tangible property, "substantially all" of the use of the tangible property is in a QOZ; (iv) and if the lessor and lessee are related. Then, (i) the lessee may not make a prepayment to the lessor (or a person related to the lessor) relating to a period of use of the leased tangible property that exceeds 12 months (i.e., no more than 12 months of rent can be prepaid); and (ii) if the "original use" of leased tangible personal property in a QOZ does not commence with the lessee. Then, during the 30-month period that begins on the date that the lessee receives possession of the property under the lease (or, if shorter, the period ending on the last day of the lease), the lessee must become the owner of tangible property that is QOZ business property having a value not less than the value of that leased tangible personal property (with values being determined in accordance with the valuation methodologies described below, and such value in the case of leased tangible personal property being determined on the date the lessee receives possession of the property under the lease). There must also be a substantial overlap of the QOZ in which the owner of the property so acquired uses it and the QOZ in which that person uses the leased property. Under an anti-abuse rule in the proposed regulations, leased real property (other than unimproved land) is not QOZ business property at any time, if, at the time the lease is entered into, there was a plan, intent or expectation for the real property to be purchased by the QOF for an amount of consideration other than the fair market value of the real property determined at the time of the purchase without regard to any prior lease payments.
- Unimproved Land. The proposed regulations provide that unimproved land that is within a qualified opportunity zone and acquired by purchase is not required to be substantially improved. However, the proposed regulations further provide that a QOF may not rely on the foregoing rule if the land is unimproved or minimally improved and the QOF or the QOZ business purchases the land with an expectation, an intention or a view not to improve the land by more than an insubstantial amount within 30 months after the date of purchase.
- Debt-Financed Partnership Distributions. The proposed regulations confirm that an investor is not required to recognize gain on a debt-financed distribution on its QOF interest provided that the amount of the distribution does not exceed the investor’s tax basis (increased by the investor’s debt allocation) in the QOF interest.
- Treatment of Section 1231 Gains. The first round of proposed regulations clarified that only capital gains are eligible for deferral under the QOZ rules. Because the capital gain income from the disposition of Section 1231 property is determinable only as of the last day of the taxable year (netting Section 1231 gain for the taxable year against Section 1231 loss), the proposed regulations provide that the 180-day period for investing such capital gain income from Section 1231 property in a QOF begins on the last day of the taxable year in which the Section 1231 gain is recognized.
Additional guidance is expected within a few months regarding the rules applicable to a QOF that fails to maintain the required 90-percent investment standard and information-reporting requirements for an eligible taxpayer. For more information and to discuss planning opportunities, please contact any member of Taft’s Tax practice group.