Qualified Opportunity Zones (QOZ) have spurred a lot of interest as a tax planning strategy since their enactment as part of tax reform in December 2017. While doubters and skeptics abound regarding their effectiveness as an economic development tool, we’ve seen deals get done as a result of the preferential tax treatment for investments in QOZs that investors say wouldn’t otherwise have been done at the same level of investment. While the tax benefits can be significant, it’s important to note the investment also needs to make economic sense beyond the tax play. It’s a critical time for the QOZ regime, as the developments currently in the works—which are no doubt creating economic activity and jobs made possible by the regime—must be successful to avoid the risk of running off good investors in the future.
While a first round of proposed guidance was issued by the U.S. Department of the Treasury (Treasury) and IRS in late October 2018, there were enough unanswered questions that investors generally have been cautious, and investing in QOZs has been relatively slow to date. The second round of guidance released by Treasury and the IRS on April 17, 2019, is a good next step to answering many of those outstanding questions. This article will overview some highlights of this latest round of proposed guidance and examine how it affects an investment in a QOZ through a Qualified Opportunity Fund (QOF). For more on the QOZ program and the first round of proposed guidance, watch the archive of our November 2018 webinar “Critical New Insights on Proposed Opportunity Zone Regulations.”
The recent IRS guidance provides clarity on a number of outstanding questions around the types of property and some operating requirements for a QOF and Qualified Opportunity Zone business (QOZB). Here are some of the highlights:
- A QOF can own more than one investment and still take advantage of the 10-year hold providing tax-free treatment. After holding the QOF for more than 10 years, selling one of the assets receives the same tax-free treatment for the QOF investors.
- Section 1231 gains that are treated as capital gain net income are eligible for the possible gain deferral under the QOZ regime, and the 180-day period for investing eligible net gains under §1231 into a QOF begins on the last day of the tax year. This guidance was clarified because under the mechanics of the statute, it’s often not possible to know if a §1231 gain will result in a net capital gain under §1231 until it’s netted with any other §1231 gains and losses recognized during the tax year.
- The 10-year hold requirement starts when the investor first puts gain dollars into the QOF for equity. Basically, the 10-year hold requirement restarts and the QOF is treated as a bifurcated fund for the required 10-year hold. This treatment creates an increased tracking and documentation burden for taxpayers.
- The latest round of proposed guidance provides additional definitions related to the “substantially all” requirement for the use and holding of QOZB property by a QOF:
- QOZB property must be used within a QOZ at least 70 percent of the time.
- QOZB property must be held 90 percent of the time within a QOZ.
- The term “trade or business” is defined as a trade or business within the meaning of §162 for purposes of the requirements that a QOF or QOZB conduct a trade or business.
- The original use requirement for tangible property acquired by a QOF or QOZB doesn’t start until the property is first placed in service in the QOZ for depreciation or amortization purposes. Further, the original use period restarts if property has been unused or vacant for at least five uninterrupted years.
- Leased tangible property generally is treated as QOZB property as long as the QOF or QOZB enters into the lease after December 31, 2017; substantially all (70 percent) of the property’s use occurs in a QOZ for substantially all (90 percent) of the lease period; and the lease has market-rate terms, i.e., is arm’s-length.
- Section 1400Z-2 provides that at least 50 percent of gross receipts must come from the active conduct of a trade or business in the QOZ. The second round of proposed QOZ guidance provides three safe harbors for meeting this requirement:
- 50 percent or more of the services provided by the QOZB or its independent contractors are performed within a QOZ (based on time).
- 50 percent or more of employee and independent contractor expense is based in a QOZ (based on cost or fair market value).
- Tangible property located in a QOZ and the management or operational functions performed in the QOZ are each necessary for the generation of at least 50 percent of the gross income of the business.
- A facts-and-circumstances test also is available for purposes of meeting this test if taxpayers can’t avail themselves of one of the three safe harbors listed above. This clarification should help reduce investor concerns about meeting the 50 percent gross income test.
The latest proposed QOZ guidance also provides additional, much-needed clarity for investors, including:
- A six-month grace period for holding property received by the QOF as a contribution in exchange for an interest in the QOF before it counts toward the 90 percent qualified asset test. To qualify, the contribution must be held in cash, cash equivalents or debt instruments with a term of 18 months or less.
- Investors can transfer eligible property other than cash to a QOF provided the transfer isn’t recharacterized as a transaction other than an investment in the QOF, such as a disguised sale.
- A QOF has one year from the date of sale, distribution or disposition to reinvest some or all of the proceeds from the sale of assets by the QOF as long as the proceeds are continuously held in cash, cash equivalents or debt instruments with a term of 18 months or less until the proceeds are reinvested. This taxpayer-favorable guidance applies to the return of capital or the sale or disposition of QOZB property or an interest in a QOF.
- Delays attributable to waiting for government action won’t count against the 31-month period required to complete a project’s construction. This is a huge win for QOF investors; however, it could open the QOF to abuse based on the definition of government approvals, and it appears some jurisdictions may have more leeway than others.
- Land held for use in a trade or business in the QOZ is considered QOZB property. Examples include buying additional land to store equipment and car dealerships that purchase additional land to store inventory for sale to customers.
- Land banking and land held for future sale as an investment generally don’t rise to the level of a trade or business.
- An investor’s deferred gain isn’t recognized until a transaction reduces their equity interest in the qualifying investment or the QOZ distributes property to the investor that’s treated as a distribution for federal income tax purposes.
The IRS also concurrently issued a request for additional information or ideas on what type of information should be collected on QOF investments, e.g., total development costs, number of new jobs created, location of new businesses or developments and other items. This information can add a substantial burden onto the QOF, and our hope is the IRS keeps the required information to be reported at a high level.
The latest proposed QOZ guidance provides welcome clarifications on many fronts, and we expect investors to take comfort in many of the new proposed rules. Still, unanswered questions remain, such as what happens if a QOF no longer meets the requirements. In addition, the proposed guidance places additional record-keeping and tracking burdens on the QOF that hopefully will be reduced as the guidance is finalized. Overall, we hope the guidance is well received by investors and the regime continues to spur investment in QOZs across the country.
For more information on QOZs and the latest round of proposed guidance, reach out to your trusted BKD advisor or use the Contact Us form below.