On December 19, 2019, the Internal Revenue Service (the “IRS”) and the U.S. Department of the Treasury (the “Treasury”) issued final regulations (the “Final Regulations”) under section 1400Z-2 of the Internal Revenue Code regarding the opportunity zone program, which was enacted as part of the law commonly referred to as the “Tax Cuts and Jobs Act”. The opportunity zone program is designed to encourage investment in distressed communities designated as “qualified opportunity zones” (“opportunity zones”) by providing tax incentives to invest in “qualified opportunity funds” (“QOFs”) that, in turn, invest directly or indirectly in the opportunity zones.
The opportunity zone statute left many uncertainties regarding the fundamental operations of the opportunity zone program. The IRS and Treasury issued two sets of proposed regulations under section 1400Z-2 in October 2018 and April 2019 (the “Proposed Regulations”). The Proposed Regulations were discussed in two of our earlier blog posts, found here and here. The Final Regulations address the many comments received in response to the Proposed Regulations and retain the basic approach and structure set forth in the Proposed Regulations, but include clarifications and modifications to the Proposed Regulations. The Final Regulations are generally taxpayer-favorable, and incorporate many of the provisions requested by commentators. However, there are certain provisions that are worse for taxpayers than under the Proposed Regulations.
The Final Regulations will be effective on March 13, 2020, and are generally applicable to taxable years beginning after that date. For the portion of a taxpayer’s first taxable year ending after December 21, 2017 that began on December 22, 2017, and for taxable years beginning after December 21, 2017 and on or before March 13, 2020, taxpayers and QOFs generally may choose to apply the Final Regulations or the Proposed Regulations, so long as, in each case, they are applied consistently and in their entirety.
This blog summarizes some of the important aspects of the Final Regulations. It assumes familiarity with the opportunity zone program.
This section lists some of the most important changes in the Final Regulations.
- All gain on the sale of a QOF interest or underlying assets after 10 years is excluded, other than gain from ordinary course sales of inventory. The Proposed Regulations provided that if a taxpayer held an interest in a QOF for at least 10 years, then upon a sale of the QOF, all gain could be excluded, including any gain attributable to depreciation recapture or ordinary income assets. The Proposed Regulations also permitted an investor that held a qualifying interest in a QOF partnership or S corporation for at least 10 years to elect to exclude capital gains (but not other gains) realized by the QOF partnership or S corporation on the sale of underlying qualified opportunity zone property. The Final Regulations very helpfully provide that an investor that has held a qualifying interest in a QOF for at least 10 years may elect to exclude all gain realized upon its sale of an interest in a QOF as well as all gain realized upon the sale of assets by the QOF or a lower-tier partnership or S corporation QOZB, except to the extent the gain arises from the sale of inventory in the ordinary course of business.
- Eligible gain includes gross section 1231 gain, and not net section 1231 gain. Section 1231 gains and losses generally arise when a taxpayer disposes of depreciable or real property that is used in the taxpayer’s trade or business and held for more than one year. The portion of any section 1231 gain that reflects accelerated appreciation is “recaptured” under sections 1245 or 1250 and is treated as ordinary income. If, at the end of the taxable year, the taxpayer has net section 1231 gains, then all section 1231 gains and losses are treated as long-term capital gains and losses. Alternatively, if, at the end of the taxable year, the taxpayer’s section 1231 losses equal or exceed its section 1231 gains, then all of the taxpayer’s section 1231 gains and losses are treated as ordinary income and losses. The Proposed Regulations provided that only net section 1231 gain would be eligible for deferral under section 1400Z2-(a)(1) (i.e., only section 1231 gain that would be characterized as long-term capital gain after the netting process had been completed). The Final Regulations very helpfully provide that eligible gains include gross section 1231 gains (other than section 1231 gain that is recaptured and treated as ordinary income under sections 1245 or 1250) unreduced by section 1231 losses.
- New 62-month working capital safe harbor. The Proposed Regulations included a working capital safe harbor that permitted a QOZB that acquires, constructs, and/or substantially rehabilitates tangible business property to treat cash, cash equivalents and debt instruments with a term of 18 months or less as a reasonable amount of working capital for a period of up to 31 months if certain requirements are satisfied. The Final Regulations provide that tangible property may benefit from an additional 31-month safe harbor period, for a maximum of 62 months, in the form of either overlapping or sequential applications of the working capital safe harbor. To qualify for the 62-month safe harbor, the business must receive multiple non-de minimis cash infusions during each 31-month safe harbor period, and the subsequence cash infusion must form an integral part of the plan covered by the first working capital safe harbor.
- Triple-net-lease. The Final Regulations contain an example concluding that a QOZB that owns a three-story mixed-use building, and (i) leases one floor of the building under a triple-net-lease, (ii) leases the other two floors under leases that are not triple-net-leases, and (iii) has employees with offices located in the building who meaningfully participate in the management and operations of building, is engaged in an active trade or business with respect to the entire leased building solely for purposes of the opportunity zone trade or business requirement. While this example is helpful because it confirms that a portion of an active trade or business may consist of a triple-net-lease, it leaves unanswered what level of activity is necessary for a real property rental business to qualify as a trade or business for purposes of the opportunity zone rules.
- Asset aggregation approach for determining substantial improvement. In order for non-original use tangible property to be treated as zone business property, it must be “substantially improved”, which generally requires an original use investment of an amount at least equal to the property’s purchase price. For purposes of determining whether non-original use tangible property purchased by a QOZB has been substantially improved, the Final Regulations permit certain original use assets used in the same trade or business as the non-original use property and that improve the functionality of the non-original use property, to be counted for purposes of the substantial improvement test. For example, a QOF that intends to substantially improve a hotel may now count the cost of mattresses, linens, furniture, and electronic equipment for purposes of the substantial improvement test.
- Partnership interests valued at fair market value for purposes of the 90% test. For purposes of the 90% test, the Final Regulations require an asset that has a tax basis not based on cost, such as a partnership interest or other intangible asset, to be valued at its fair market value (rather than the unadjusted cost basis). Accordingly, the fair market value of a carried interest or even a QOZB partnership must be re-determined at each semi-annual testing date.
- Sin Businesses. The Final Regulations prohibit a QOZB from leasing more than a de minimis amount of its property to a sin business, but also provide that de minimis amounts of gross income (i.e., less than 5% of gross income) attributable to a sin business will not cause the business to fail to be a QOZB (e.g., a hotel with a spa that offers massage services).
- Tangible property that ceases to be zone business property. The statute contains a special rule pursuant to which tangible property that ceases to be zone business property will nonetheless continue to be treated as such for the lesser of: (1) five years after the date such property ceases to be qualified as zone business property; and (2) the date on which the tangible property is no longer held by the zone business. The Final Regulations prohibit a QOZB from relying on this rule unless the zone business property was used by a QOZB in a QOZ for at least two years not counting any period during which the property was being substantially improved or covered by the working capital safe harbor.
- Expanded anti-abuse rule. The Proposed Regulations included a general anti-abuse rule under which the IRS has broad discretion to disregard or recharacterize any transaction if, based on the facts and circumstances, a significant purpose of the transaction is to achieve tax results inconsistent with the purposes of section 1400Z-2. However, the Proposed Regulations did not explain the purposes of section 1400Z-2. The Final Regulations state that the purposes of section 1400Z-2 are (i) to provide specified tax benefits to owners of QOFs to encourage the making of longer-term investments, through QOFs and QOZBs, of new capital in one or more opportunity zones and (ii) to increase the economic growth of opportunity zones, and include seven new examples illustrating the application of the anti-abuse rule. These examples demonstrate that acquiring land with a significant purpose of selling it at a profit is abusive