In October 2018, the IRS published proposed regulations to the Tax Cuts and Jobs Act program known as Qualified Opportunity Zones. While the proposed regulations identified some issues of contention, it opened up some questions and concerns that left stakeholders seeking clarification.
In April of 2019, the IRS issued a second set of proposed regulations which addressed many questions and added some clarity, and since then, has conducted two public hearings on how to conduct business within a QOZ and how to properly structure a Qualified Opportunity Fund.
Here, we take a closer look at some of the more critical clarifications that came from those meetings and summarize what fund managers need to consider when structuring a QOF.
Timeframe for assets to be invested
Section 1231 gains (capital gain rates) are required to be netted with losses to determine the amount of capital gains a taxpayer has to invest under the deferment option. Moreover, capital gains are determinable as of the last day of the taxable year for the taxpayer. So, for individual taxpayers with capital gains generated during 2019, the 180-day rollover investment period begins December 31, 2019, and ends on June 28, 2020.
It is also important to note that the last day to qualify for the 15% deferment basis for investments into Qualified Opportunity Funds will be December 31, 2019. After that, investors will only be eligible to receive the basis step-up of 10%.
“Substantially all” clarification
The proposed regulations define the substantially all requirement threshold as follows:
- “Substantially all” threshold is 90% when used to measure a QO Fund’s holding period of tangible property as qualified OZ business property, QOZ partnership, or corporation.
- “Substantially all” threshold is 70% of the property’s use must be in a QOZ, and 70% or more of the property owned or leased by a QO Zone Business must meet the definition of a QO Zone Business.
Clarification about the death of an investor during the investment period
If an investor dies during the investment period, the investment will be passed on to his or her heirs. The heirs of the investor will now receive the benefits from the original QOF investment, including any tax carryover basis of such investment. In the event an investor dies during the investment period, the holding period does not restart for the fund investment period.
This addresses when a fund enters into a lease agreement with a landowner to develop the land and operate the rental activities after the build. This type of arrangement comes with several restrictions.
- Lease payments must be based on “market lease rates.”
- The lessee cannot make any prepayments to the lessor that exceeds 12 months.
- For purposes of the 90% asset test, the value of the leasehold improvements would be based on either the applicable financial statements or present value of each payment under the negotiated lease.
- The “substantial improvement” requirement does not apply to this type of arrangement.
- Only the portion of capital gains related to the leasehold improvement is eligible for the 10-year permanent deferral.
Real Property Straddling a QOZ
If a taxpayer owns property near a QOZ and wants to expand by acquiring adjacent land located within an OZ, the following conditions may apply:
- The QOF could purchase the adjoining property as part of the development project.
- The adjacent property counts towards a QOZ investment if its square footage is greater than the property located outside the QOZ.
- Once acquired, the property outside of the QOZ is contiguous as part of the entire development project, and the whole project would be deemed to be a QOZ Business Property.
Treatment of Operating Businesses in a QOZ
Outside of real estate development, operating businesses can also qualify as long as they meet one of the following three safe harbors:
- At least 50% of the hours the employees or contractors work in performing services for the QOZ Business occur within the QOZ.
- A minimum 50% of all payments the QOZ Business takes in for services are performed within the QOZ by employees, contractors, and employees of contractors.
- Facts and circumstances test in which:
- The tangible property of the business is located within a QOZ and,
- The management or operational functions performed in the QOZ are necessary for the generation of at least 50% of gross income.
QO Funds will have a 12-month reinvestment window to sell assets and reinvest the proceeds into another eligible opportunity zone investment.
It a vacant building or structure has not been used within the past five years prior to purchase by a QOF, it will satisfy the original use requirement of the regulations.
Triple Net Leases Prohibited
Leases structured as triple net leases, whereas a tenant is required to pay a portion or all of the taxes, insurance, and maintenance costs for the property, are ineligible investments for a QOF due to the passivity it provides the landlord.
Ability to Roll Up All QOF Interest into a Single Parent Partnership
The new proposed regulations will allow, under certain circumstances, for an investor who transfers his or her interest in the QOF to another partnership (Parent Partnership), it will not be deemed an “inclusion event” and would qualify for tax deferral as long the QOF remains alive. The Parent Partnership will own the interest in the QOF, and it will step into the investor’s shoes for purposes of reporting the deferred gain.
Purchase of a QOF Partnership Interest
An investor can defer its capital gains by purchasing a QOF partnership interest from a direct owner of the QOF. The investor could choose to defer gains in the amount equal to the price of the QOF partnership interest.
Treatment of Carried Interest Gain
If a person receives an interest in a QOF in exchange for services rendered to the QOF, the portion of such person’s interest received is not treated as a qualifying investment. Therefore, under such circumstances, the profits of carried interest in a QOF are not eligible for QOZ benefits, as well as any other capital interest in exchange for such services.
The previous two hearings in April and July are most likely the last that will be held on the proposed regulations. The Treasury Department is set to issue final Qualified Opportunity Zone rules sometime over the next two months.