Treasury issued the long-awaited second round of Proposed Regulations yesterday (April 17, 2019), clarifying some key issues in connection with investing in and forming Qualified Opportunity Funds (“QOF”) and the OZ Fund’s investments in Qualified Opportunity Zone Businesses (“QOZB”).1 Many of the topics covered in the first set of Proposed Regulations were expected and are quite favorable to investors.2 However, the second set of Proposed Regulations also contained some unwelcome surprises. These additional Regulations are only proposed, and are therefore subject to further revisions based on comments received by Treasury. Taxpayers can rely on many of these proposed rules, provided that the taxpayer applies the rule in its entirety and in a consistent manner. A summary of key issues and Polsinelli observations is below.
- Debt-Financed Distributions Allowed. Example 10 of the Proposed Regulations specifically approves a debt-financed distribution so long as the distribution does not exceed the investor’s basis (as increased by the investor’s share of the debt) in its QOF.
Polsinelli Observation: Investors and sponsors were concerned that Treasury might severely limit their ability to take distributions when refinancing.
- Mostly Favorable Resolution to Sales of OZ Fund Assets vs. OZ Fund Interests. The Proposed Regulations allow QOFs organized as partnerships, S corporations and REITs to sell their assets and, assuming that the investor has held the investment in the QOF for more than 10 years, the investor will pay no tax on the gain. This benefit does not apply to investors in QOF organized as C corporations.
Polsinelli Observation: This change will allow fund sponsors to organize more traditional multi-asset investment funds. It is important to note that most QOFs will continue to operate through QOZBs and will have to sell these entities, rather than the assets held by the QOZBs, in order for investors to avoid tax after holding for 10 years. Nevertheless, this aspect of the Proposed Regulation is very welcome, since equity funds are well-versed in selling portfolio companies and real estate funds should be able to adapt to this style of transaction sale with minimal or no discount to the sale value.
- Carried Interests Received For Services is Not a Qualifying Opportunity Zone Investment. The Proposed Regulations provide that any interest received in exchange for services is not a qualifying Opportunity Zone investment eligible for the 10-year benefit (the complete exclusion of additional gains) and that a service provider’s interest can be split between the qualifying investment relating to invested capital gains and the non-qualifying investment received for the performance of services.
Polsinelli Observation: Developers should consider clearly classifying which portion of their interest is in exchange for services (such as the development fee and management fees) and treat those as a non-qualifying investment. Developers may be able to receive special allocations on qualifying investments, but this will be an obvious area of scrutiny moving forward.
- Leasing Bad Property Can Turn it Into Qualified Property. Tangible property acquired under a lease entered into after December 31, 2017 will be qualified opportunity zone business property if the lease is a “market rate lease.” The property does not have to be substantially improved or meet the original use requirement. This applies even if the property is leased from a related party provided the following two requirements. First, the lease cannot also allow prepayments relating to a period of use exceeding 12 months. Second, within the term of the lease or 30 months (whichever is earlier), the lessee must become the owner of qualified opportunity zone business property whose value is at least equal to the value of the lease. There must also be substantial overlap of time using both the leased and acquired property. Finally, there is a general anti-abuse rule for property other than unimproved land.
- Value of Leased Property. Generally, leased property is valued either at the reported value on an applicable GAAP financial statement, or at the present value of all lease payments, calculated at the time the lease is entered into. If the lease is valued based on the present value of lease payments, that value is used for all testing dates for the QOF for purposes of testing whether, as required, 90% of the QOF’s assets are held in qualified opportunity zone property.
- Tenant Improvements. Any improvements made by a lessee to leased property will be considered to meet the original use test, and treated as being purchased for the cost of the improvements. Substantially all of the use of the leased property must be in an opportunity zone during substantially all of the period for which the business leases the property.
Polsinelli Observation: The Proposed Regulations on leased tangible property make it much easier for an OZ investment to qualify where the owner of the land retains more than 20% of the OZ investment. The Proposed Regulations also clear the way for the QOZB to lease property in opportunity zones. Care should be taken to make sure that the lease qualifies as a “true lease” for Federal income tax purposes and that the lessee is not treated as the property owner for federal income tax purposes.
- Investment of Section 1231 Gain is Limited to 180 Days Beginning the Last Day of the Taxable Year. Section 1231 Property is real or depreciable property used in a trade or business and held for more than a year. Section 1231 Property has special tax status: If at the end of the taxpayer’s tax year, the total amount of gains from the sale of 1231 Property is greater than losses from the sale of 1231 Property, the gain is long term capital gain. However, if the net is a loss, then the loss is an ordinary loss (and can offset ordinary income). This favored treatment comes with a caveat – a taxpayer will not know for sure whether it has net 1231 gain until after the end of the year, and probably not within the 180-day investment period for OZ investments. Commentators generally believed that either the IRS would issue regulations allowing separate treatment of sales of section 1231 Property, or that this could lead to disqualification of OZ investments if it turned out that there was no section 1231 gain for the year of the investment.
- Instead, the Proposed Regulations state that section 1231 gain can only be invested in the 180 days beginning on the last day of the taxable year of the sale. The regulations flatly prohibit investing gains from section 1231 Property in QOFs during the 180-day period after the sale. Treasury’s reasoning behind this rule is that a taxpayer cannot know whether there is any section 1231 gain until the end of the tax year.
Polsinelli Observation: This Proposed Regulation is problematic for many early OZ investors and is expected to generate a lot of criticism. Most of the QOF investments in 2018 were real estate developments, and many of them may have been funded with what was thought to be section 1231 gain. However, under the Proposed Regulation, there was no reasonable opportunity to invest section 1231 gain in QOFs in 2018. Treasury may have therefore retroactively disqualified a significant number of OZ investments.
- Treatment of Interim Sales of Qualified Business Property is Mixed. The Proposed Regulations provide that sales or dispositions of assets by a QOF do not affect investors’ holding periods or trigger the inclusion of deferred gain so long as they do not sell or otherwise dispose of their investment in the QOF. In addition, the QOF has 12 months to reinvest the proceeds from the sale or disposition before the funds will count against the QOF for purposes of the 90% asset test. On the other hand, the Proposed Regulations confirm that a QOF and its investors must recognize any gain on the sale of the assets.
Polsinelli Observation: While investors will recognize gain from the sale of property by the QOF or QOZB, if that gain arises on or before December 31, 2026 it should be eligible to be invested into a QOF. Depending on when the property is sold, there could still be some opportunity for deferral of tax on the gain.
- Substantial Improvement is Asset-by-Asset. The Proposed Regulations state that whether property is substantially improved is made on an asset-by-asset basis. The Proposed Regulations note that this approach could be onerous for certain operating businesses, and Treasury is seeking comments regarding the advantages and disadvantages of using an aggregate approach.
Polsinelli Observation: While this asset-by-asset approach could be favorable for operating companies and/or business with some non-qualifying property, it will also be problematic for complex real estate redevelopment projects that occur over multiple parcels and include multiple buildings and asset classes.
- Original Use. The Proposed Regulations state that the “original use” of tangible personal property begins on the date when it is first placed in service inside the Qualified Opportunity Zone for purposes of the depreciation or amortization rules. In addition, the Proposed Regulations confirm that used property can satisfy the original use requirement so long as the property has not been previously used in the relevant opportunity zone in a manner that would allow it to be depreciated or amortized. The Proposed Regulations also provide that existing buildings and other structures can satisfy the original use requirement if they have been vacant for at least five years.
Polsinelli Observation: The Proposed Regulations establish that if a QOZB purchases a development prior to the receipt of a temporary certificate of occupancy, the development will meet the original use requirement and be qualified opportunity zone business property. In addition, the ability to bring used property into an opportunity zone and have it be qualified opportunity zone business property without having to substantially improve it could lead to the purchase and relocation of operating businesses into opportunity zones.
- Treatment of Inventory. The Proposed Regulations clarify that inventory and raw materials are qualified opportunity zone property and counts for purposes of the asset test. There was discussion about simply excluding inventory from the test but Treasury did not adopt this rule.
Polsinelli Observation: Including Inventory in the asset test calculation should help make it easier for operating businesses to qualify, as most company’s inventory will have turned over and with therefore inventory will generally have been acquired after 2017, and if located or assembled in an opportunity zone should qualify as a “good asset” for asset test purposes.
- Active Trade or Business. QOZBs must derive 50-percent of their gross income from an “active trade or business” in the opportunity zone. The Proposed Regulations specifically state that the ownership and operation (including leasing) of real property is the active conduct of a trade or business. However, the Proposed Regulations also state that “merely entering into a triple-net-lease” is not an active trade or business.
- 50% of Gross Income “in the Opportunity Zone” Clarified. The Proposed Regulations provide 3 safe harbors that meet this requirement, and a general “facts and circumstances” test. The safe harbors are:
- First, if 50% percent of the services performed for the business, based on hours, are performed by employees and independent contractors in the opportunity zone;
- Second, if at least 50% the services performed for the business, based on amounts paid for the services, are performed by employees and independent contractors in the opportunity zone;
- Third, if the tangible property in the opportunity zone and management or operational functions performed in the opportunity zone are both required to generate 50% of the gross income of the business.
Polsinelli Observations: The safe harbors provide welcome numerical measurements rather than ephemeral guesstimates. The safe harbors along with the regulations relating to leasing and working capital open the door to QOF investments in operating businesses.
- Working capital Safe Harbor Expanded. The Proposed Regulations expand the working capital safe harbor to cover expenditures used in the development of an operating business. These expenditures can include inventory and occupancy costs, and possibly payroll relating to start-up. In addition, if the expenditure of the working capital within 31 months is delayed by government action (where the application is completed within 31 months), the delay does not cause a failure of the safe harbor.
Polsinelli Observation: The expansion of the time limit due to government action will be helpful in areas where permitting and licensing may take a very long time.
1This summary assumes familiarity with general opportunity zone requirements. Polsinelli’s general summary of opportunity zones can be found here.
2Polsinelli’s summary of the regulations proposed in October 2018 can be found here.