Final OZ Regulations Provide a Smoother Path to Tax Savings
1.29.20 | Client Alert
The release of final IRS regulations eases the way ahead for taxpayers to leverage the tax benefits offered by qualified opportunity zone investments. The December 2019 final regulations, released under Section 1400Z-2 of the Internal Revenue Code (Code), adopt in part and revise in part two sets of proposed regulations published in October 2018 and May 2019. Overall, the final regulations provide helpful guidance and important changes to the proposed regulations for taxpayers seeking to invest in qualified opportunity zone funds.
In explaining key elements of the program below, we summarize provisions where the final regulations differ from the prior guidance under the proposed regulations.
Eligible Gains from the Sale of Trade or Business Property. A significant change made in the final regulations was to convert from a net approach to a gross approach for investable gains from the sale of trade or business property. As a general requirement, a taxpayer needs capital gains to make an investment in a Qualified Opportunity Fund (QOF) and to defer the recognition of gain as income. Gains from the sale of marketable securities are typical examples of capital gains. However, gains arising from the sale of property used in a trade or business, called “Section 1231” gains, are also treated as capital gains and can be eligible for deferral under the Code. Before the new rules, Section 1231 gains were required to be netted with Section 1231 losses. This created issues for some investors. Net gains could not be invested until the end of the year when the gains would be known. Moreover, Section 1231 losses could eliminate or substantially reduce eligible gains.
After much criticism from commenters, the Treasury and IRS decided to drop the net approach and adopt a gross approach under the new guidance. Thus, if a taxpayer has both Section 1231 gains and losses, they can now be bifurcated, and the gains may be invested without regard to losses. This change is important because there will be more eligible gains that can be deferred into a QOF and the taxpayer does not need to wait until the last day of the year to make a qualified investment. Instead, the investment can be made beginning on the date of the sale. Moreover, Section 1231 losses, unlike regular capital losses, which are generally limited to offsetting capital gains, are treated as ordinary losses. So, when separated from Section 1231 gains to make an election for deferral, the ordinary loss can offset ordinary business income in the current year. For those with both Section 1231 losses and gains, this creates a new tax planning opportunity.
More Time and Flexibility for Investors. The final rules provide an investor, who is a partner or a shareholder in a pass-through entity, the ability to start an investment period on the un-extended due date of the entity’s tax return for the investor’s share of allocable gain from the pass-through entity. Therefore, in the case of 2019 gains from a partnership or S corporation, the partner or shareholder can start the 180-day investment period on March 15, 2020. Under the proposed regulations, this option was not available, and the taxpayer could only begin the investment period on the last day of the taxable year or on the date of the sale if the partnership did not elect to defer all of its eligible gain. This third option was added to provide investors with more time to identify eligible gains and to alleviate concerns about missed opportunities because of the lack of awareness of gains from partnerships or S corporations.
For investors with gains from a Regulated Investment Company (RIC) or Real Estate Investment Trust (REIT), the final rules allow the 180-day investment period to start at either the close of the shareholder’s taxable year or when the shareholder receives capital gain dividends from the RIC or REIT. This helps to ensure that shareholders do not have to wait until the close of their taxable year to invest capital gain dividends received during the year. For installment sales, taxpayers have the option to start the investment period when each installment payment is received or on the last day of the year when the gain is recognized. This timing flexibility is available even if the actual installment sale occurred before 2018.
Exclusion of Gain for Assets Sales by a Qualified Opportunity Zone Business (QOZB). While the proposed regulations allowed an investor meeting the ten-year holding period requirement to exclude gains from the sale of a qualifying QOF investment or property sold by a QOF, there was no such authority for an asset sale by a subsidiary entity owned by a QOF. The final regulations added the ability for a subsidiary QOZB to sell an asset and allow the owners of the QOF to exclude gain if they held their QOF interest for at least ten years. This change facilitates establishing multi-asset QOFs and will be well received by fund managers seeking diversification and mixed-fund investments.
Important: With respect to asset sales either at the QOF or subsidiary levels, when the asset and business requirements are otherwise met, gains from the sales of nonqualifying assets can also be excluded from gain recognition. Since the mechanics of the asset testing rules do not require 100% of qualifying assets to meet the criteria for a QOF or QOZB, some flexibility for both structuring and exiting investments exists.
Easier Qualification for Original Use for Unused Property. In general, for a property to be a good asset and to meet the definition of Qualified Opportunity Zone Business Property (QOZBP), it must be originally used in the Qualified Opportunity Zone (QOZ) or be substantially improved within the meaning of the statute. The proposed regulations provided that if the property had been unused or vacant for an uninterrupted period of at least five years, original use in the QOZ could commence on the date when any person first uses or places the property in service in the QOZ. Thus, a five-year vacancy period allowed an unused property to qualify for the original use requirement. The final regulations shorten the proposed five-year vacancy period to a one-year period if the property was unused for at least one year prior to the QOZ designation and the property remained vacant through the date of the purchase. For all other vacant property, not meeting the one-year period prior to the QOZ designation, the final rules reduce the proposed five-year vacancy requirement to three years. Real property is generally considered to be in a state of vacancy if the property is significantly unused. For a property to be considered “significantly unused”, more than 80% of the building must not be used as measured by the square footage of useable space. The shortened vacancy period is a welcome change as the Treasury and IRS received comments that the five-year vacancy period was inappropriately long.
Easier Qualification for Substantial Improvement by Aggregation. There are circumstances where substantial improvement is required because original use of the property in the QOZ does not commence with the QOF. In these cases, the QOF must substantially improve the acquired property to meet the definition of a QOZBP. The substantial improvement test is met if, during any 30-month period, the QOF makes additions to the tax basis that are at least equal to the original tax basis in the property, excluding land. In certain cases, the final regulations allow a group of two or more properties located on the same parcel of land or located in a single series of contiguous QOZs (eligible building group) to be treated as a single property for substantial improvement. When buildings within contiguous parcels are not described by a single deed, aggregation for substantial improvement is available if the buildings:
- Are operated exclusively by the QOZB eligible entity;
- Share facilities or significant centralized business elements; and
- Are operated in coordination with, or reliance upon, one or more of the trades or businesses of the QOZB.
Accordingly, when this test is met, additions to the basis of the properties may be aggregated, making it easier to satisfy the doubling of basis requirement.
Clarification for Qualification of Unimproved Land. The final regulations confirmed that unimproved land does not need to meet the original use requirement or the substantial use requirement to be treated as a QOZBP. However, unimproved land must be more than insubstantially improved within 30 months in order to meet the definition of QOZBP and be used in a trade or business of the taxpayer. In this regard, while the Treasury and IRS agree that a QOF or QOZB should improve land by more than an insubstantial amount, they declined to assign a specific percentage threshold to determine insubstantial improvement. In their view, what constitutes an appropriate amount of improvement for a particular parcel of land is highly fact dependent. As an example, the Treasury and the IRS will treat grading of the land with a sufficient nexus to a trade or business of the QOF or QOZB to be more than an insubstantial amount of improvement.
Clarification for Treatment of Triple-net-leases. For triple-net-leases (TNLs), where the tenant is responsible for the payment of maintenance, property taxes, and insurance of the space the tenant occupies, the Treasury and IRS maintained their position that merely entering into a triple-net-lease with respect to real estate owned by a taxpayer does not give rise to the active conduct of a trade or business. Historically, the IRS has considered a TNL activity by the landlord as an investment activity as distinguished from a business activity, which is required for a QOZBP. While the final rules confirmed this historical position, the example provided in the final regulations leaves open the possibility that when a TNL is coupled with other activities, it might give rise to a trade or business. In this example, the lessor is engaged in a trade or business even though one of the leases, in a three-story building located in a QOZ, is a TNL. Two leases in the building were not TNL arrangements and the employees of the lessor participated in the management and operations of two floors. The example illustrates that under certain circumstances, leased property can be a QOZBP to a lessor notwithstanding the fact that the property is subject to a TNL.
Clarification for Leased Property. In general, property leased by a QOF or QOZB in a QOZ can qualify as QOZBP for purposes of satisfying the 90% investment standard and the 70% tangible property standard. The proposed regulations applied a market-rate lease requirement to leases between both unrelated parties and related parties. After considering arguments by commenters that the final regulations provide a presumption of arms-length for unrelated party leases, the Treasury and IRS decided to eliminate the market-rate lease requirement to leases between unrelated parties. Therefore, leases between unrelated parties entered into after December 31, 2017 are presumed to be at arms-length market rates. For related party leases, the arms-length requirement applies, and the final rules further clarify that prepayments of more than one year are not permitted. In addition, the acquisition of value requirement for non-original use leased property does not apply to real estate, but only to related party leases of personal property when the original use of the leased tangible personal property in a QOZ does not commence with the lessee.
Clarification for Debt-Financed Distributions by Partnerships. The proposed regulations provided that if a partnership makes a distribution to a partner, it could be recharacterized as a disguised sale. Many commenters requested clarification that the exceptions to the disguised sale rules also apply in determining whether a debt-financed distribution causes an inclusion event. In particular, they requested confirmation that operating cash flow distributions would not be presumed to be part of a disguised sale as an exception provided in Section 707 disguised sale regulations. While the language in the May 2019 proposed regulations is accepted without change, the Treasury and IRS confirmed that the exceptions to the disguised sale rules still apply for debt-financed distributions such that the operating cash flow distribution exception would be available. The implications for this rule are generally very favorable to the taxpayer, but partnership distributions within the first two years of the investor’s qualifying investment should still be carefully evaluated.
New 62-Month Working Capital Safe Harbor for Start-up Businesses. The final regulations added a new 62-month working capital safe harbor for start-up businesses, which includes new businesses engaged in a real estate trade or business activity. The general working capital safe harbor under the proposed regulations was previously 31 months. The new 62-month working capital safe harbor provides that, during the 62-month covered period, Nonqualified Financial Property (NQFP) in excess of the 5% NQFP limitation will not cause a trade or business to fail to qualify as a QOZB. In addition, gross income derived from property treated as reasonable working capital will be counted towards satisfying the 50% gross income requirement. Furthermore, during the 62-month covered period, tangible property purchased, leased, or improved by a business with cash covered by a working capital safe harbor will count towards satisfaction of the 70% tangible property standard, and intangible property purchased or licensed with cash covered by the working capital safe harbor will count towards the satisfaction of the 40% intangible property use test.
The final rules provide valuable guidance for taxpayers seeking to defer the recognition of capital gain as income and to avoid tax on a portion of those gains. As a reminder, eligible taxpayers include not only individuals, but also C corporations, RICs, REITs, partnerships, S corporations, trusts and estates. Currently, most states conform to the federal qualified opportunity zone tax rules. There are only three non-conforming states (California, Mississippi, and North Carolina) and four partially-conforming states (Arkansas, Hawaii, Massachusetts, and Pennsylvania). Therefore, in many instances, the tax savings can be preserved at both the federal and state levels. With 2019 ending on a high note for the stock market and private equity markets, 2020 is an opportune time to think about ways a QOZ investment can help avoid income recognition on taxable gains.
Berdon LLP provides this information for educational purposes only. This article should not be construed or relied on as tax advice and readers should not act upon this information without consulting their tax advisor. This information is not intended or written to be used and cannot be used by any person for the purpose of avoiding any tax penalties.