On April 17, 2019, the Internal Revenue Service issued the second round of proposed regulations relating to investments in qualified opportunity zones. We previously issued an alert entitled “Qualified Opportunity Zones – New Opportunities in Real Estate” last November. This report clarifies certain matters covered in the earlier proposed regulations.
The new proposed regulations, for the first time, deal with the subjects of dispositions of assets within a qualified opportunity fund (both with regard to taxability of such dispositions and the time within which to acquire new assets needed to satisfy the requirement that a qualified opportunity fund [“QOF”] hold at least 90% of its assets in QOZ property) without paying a penalty; treatment of distributions to investors, and the qualification of non-real estate businesses as a QOF business.
Overview
The summary preceding the discussion and proposed regulations noted the need for further clarification of:
- The “reasonable period” for a QOF to reinvest proceeds from the sale of qualifying assets without paying a penalty;
- Transactions that may trigger the inclusion of gain that was otherwise deferred;
- Qualification of operating businesses as a QOZ businesses (“QOB”), that is, satisfying the 50% active trade or business requirement;
- The treatment of leased property used by a QOF business; and
- Meanings to be given the definition of “substantially all” in each of the various places it appears.
1. “Reasonable period” for a QOF to reinvest proceeds from the sale of qualifying assets without paying a penalty
Failure of a QOF to hold at least 90% of its assets in QOZ property will result in disqualification of the QOF and loss of deferral. The recent regulations provide that proceeds received by a QOF from the sale of QOZ business property, stock, and partnership interests will be treated as QOZ property for the 90% investment requirement so long as the QOF reinvests the proceeds in qualifying assets during the 12-month period beginning on the date of such sale.
2. Transactions that may trigger the inclusion of gain that was otherwise deferred
While the recent regulations permit sale and timely reinvestment of proceeds in qualifying assets for purposes of satisfying the 90% test, gain realized from such dispositions of assets will generally be recognized by the QOF or its subsidiary and, in the case of a partnership, will be passed through to the QOF’s partners. However, the proposed regulations clarify that an election is available for a taxpayer that is the holder of a qualifying investment in a QOF partnership for at least 10 years and to exclude from gross income some or all of the capital gain from the disposition of QOZ property reported on Schedule K-1. (A similar exclusion also applies to an entity organized as an S corporation.)
Comments accompanying the proposed regulations state that the statute did not authorize gain deferral. However, if a disposition would otherwise be a tax-free exchange under a non-recognition section of the Code, the gain could continue to be deferred/eliminated so long as the property received in the exchange constitutes QOZ property. An example would be a section 1031 exchange of real estate. Of course, the requirements of 1031, which are more onerous than those for deferral under the QOZ rules, must be followed. Other opportunities for deferral may also be possible.
The IRS has requested comments on any tax deferral techniques. A similar arrangement may also apply to transfers to another partnership so long as the transfer does not result in an “investment company”.
Several other transactions are listed in the proposed regulations that would cause an early recognition of the deferred gain. This includes:
- The distribution to a partner of a QOF partnership of cash or other property that has a value in excess of the basis of the partner’s qualifying QOF partnership interest. Therefore, partnership distributions in the ordinary course of partnership operations may, in certain instances, also be considered inclusion events. This is less likely in the case of a distribution of refinancing proceeds since an increase of partnership debt will generally result in debt allocation to the various partners, thereby increasing each partner’s basis in their partnership interest.
- Transfer of qualifying investments by gift are treated as taxable events.
- Any gain attributable to a service component of an interest in a QOF partnership (i.e., carried interest) is not eligible for the benefits afforded qualifying QOF investments.
- Death will not be treated as an inclusion event. The estate of the deceased investor will continue with the same tax deferral benefits.
3. Qualification of operating businesses as a QOZ businesses (“QOB”), that is, satisfying the 50% active trade or business requirement
The statute establishing the QOZ program provides that the term “qualified opportunity zone business” means any corporation or partnership if for such year at least 50% of the total gross income of such entity is derived from the active conduct of such business. The new proposed regulations now provide that in order to satisfy the 50% gross income test to constitute a qualified opportunity zone business, qualification can be satisfied with any one of the following three “safe harbors”:
- At least 50% of the services performed (based on hours) for such business by its employees/independent contractors are performed within the QOZ;
- At least 50% of the services performed (based on the compensation paid for the services) for the business by its employees/independent contractors are performed in the QOZ; or
- (1) The tangible property of the business that is in a QOZ and (2) the management or operational functions performed for the business in the QOZ are each necessary to generate 50% of the gross income of the trade or business.
Alternatively, the business may attempt to qualify under a “facts and circumstances” test.
A “trade or business” has a historical meaning which is generally applicable in determining whether “ordinary and necessary business expenses” are deductible for tax purposes. Thus, instances could arise where a technical interpretation would require analysis of authorities in this area. However, it is our expectation that interpretation of these authorities will tend to be broader rather than restrictive.
While the ownership and operation (including leasing) of real property is considered to be the active conduct of a trade or business for purposes of the QOZ rules, the proposed regulations are clear that the mere entering into a triple net lease with respect to real property owned by a taxpayer is not the active conduct of a trade or business.
4. The treatment of leased property used by a QOF business
Leased tangible property will be generally treated as QOZ business property for purposes of satisfying the 90% asset test if it was acquired under a lease entered into after December 31, 2017 and substantially all of the use of the leased tangible property must be in a QOZ during substantially all of the period for which the business leases the property.
There is no original use requirement or substantial improvement requirement imposed on leased tangible property due to the nature of such property.
Leased property does not need to be from a lessor that is an unrelated party, but there are certain requirements that need to be met under the QOF rules.
5. Meanings to be given the definition of “substantially all” in each of the various places it appears
Under the statute providing for QOFs, the term “qualified opportunity fund” means any investment vehicle which is organized as a corporation or a partnership for the purpose of investing in qualified opportunity zone property (other than another qualified opportunity fund) that holds at least 90 % of its assets in qualified opportunity zone property. In making this determination, several quantitative requirements must be taken into account by reference to the term “substantially all”.
Specifically, the term “qualified opportunity zone property” means property which is
qualified opportunity zone stock, a qualified opportunity zone partnership interest, or qualified opportunity zone business property. Each of these entities/asset groups requires participation in a “qualified opportunity zone business”. The term “qualified opportunity zone business” means a trade or business in which substantially all of the tangible property owned or leased by the taxpayer is qualified opportunity zone business property.
The term “qualified opportunity zone business property” means tangible property used in a trade or business of the qualified opportunity fund if, among other requirements, during substantially all of the qualified opportunity fund’s holding period for such property, substantially all of the use of such property was in a qualified opportunity zone.
The proposed regulations provide that, in testing the use of qualified opportunity zone business property in a qualified opportunity zone, the term “substantially all” in the context of “use” is 70% whether such tangible property is owned or leased. Substantially all requirement regarding “use” is satisfied if at least 70 % of the use of such tangible property is in a qualified opportunity zone.
The proposed regulations also provide that the term “substantially all” as used in the holding period is defined as 90%. The IRS noted that using a percentage threshold that is higher than 70% in the holding period context is warranted as taxpayers are more easily able to control and determine the period for which they hold property.
