Clarity Provided with Release of Final Opportunity Zone Regulations
On December 19, 2019, the Treasury Department issued final regulations on the Qualified Opportunity Zone (“QOZ”) program, explaining the operation of the rules and providing much-needed guidance and clarity. Below is a summary of key changes in the final regulations (versus the proposed regulations) from both an investor perspective as well as a business/project perspective.
Unlike the proposed regulations, the final regulations do not require taxpayers to wait until the end of the taxable year to begin the 180-day period for rolling over any eligible section 1231 gain(s) into a Qualified Opportunity Fund (“QOF”), and do not require taxpayers to net section 1231 losses (if any) against section 1231 gain(s) that are being rolled over.
Taxpayers now have greater ability to roll over gains from QOF inclusion events. While the proposed regulations provided gains from inclusion events could only be reinvested if the taxpayer disposed of 100 percent of their initial QOF interest, the final regulations provide that any gain from an inclusion event is eligible to be rolled over if invested in a QOF with 180 days of the event.
Installment sale gains recognized after December 22, 2017, are now also eligible for deferral, even if the sale occurred prior to that date. Additionally, investors have two choices on the 180-day investment periods for installment sales: (1) start the period on the date the installment payment is received or (2) start the period on the last day of the year in which the installment sale gain would be recognized.
Timing of Investment Rollovers from Pass-Through Entities (“PTE”)
If a PTE does not elect to roll over all of its eligible gain, the owners have the option to roll over their share of eligible gains into a QOF during the 180-day investment period beginning with the last day of the PTE’s tax year (by default). Alternatively, each PTE owner may elect to treat its own 180-day investment period with respect to its share of that gain as being (1) the same as the PTE’s 180-day period or (2) the 180-day period beginning on the due date for the PTE’s tax return (not including any extensions).
Qualified Opportunity Zone Business (“QOZB”) and Project Perspective
Substantial Improvements for QOZB Property
The regulations provide a few aggregation rules that replace the asset-by-asset approach for determining if a property is substantially improved by the QOF or QOZB. Additionally, the final regulations provide specific aggregation rules for multiple buildings located within the same QOZ such that they may be aggregated for purposes of determining whether the substantial improvement requirement has been met on an aggregated basis.
Original Use – Vacancy
The period for determining vacancy (less than 20 percent of usable space being used) status has been reduced. If a building was vacant for at least one year prior to the date the QOZ designation commenced or vacant for an uninterrupted three calendar year period prior to purchase by the QOF or QOZB, it can now qualify as original use property.
Cure Period for QOZB Compliance Failure
The final regulations provide one six-month cure period for a QOZB that fails to meet the requirements on the QOF’s testing date; the QOF is able to treat its interest in the QOZB as qualified property (for purposes of its 90-percent asset test) as long as the QOZB corrects the failure within the following six-month period.
Use of Tangible and Intangible Property
The final regulations provide safe harbors for determining if at least 70 percent of tangible property is used in providing services inside and outside of a QOZ and for short-term leased property. It also provides clarity and factors for assessing whether a substantial portion of intangible property is used in the active conduct of a trade or business operated inside and outside of a QOZ.
The final regulations state that a triple net lease to a single tenant is not treated as the active conduct of a trade or business. However, the regulations provide examples of situations and factors that could be used to assess leasing activities that do qualify as a trade or business.
Working Capital Safe Harbor Period Extended
Final regulations allow for tangible property being substantially improved to benefit from two 31-month safe harbors as long as the additional working capital and working capital plans take into account certain prescribed requirements. One such requirement is that any subsequent infusion(s) of cash intended to be used as reasonable working capital must be an integral part of the plan covered by the initial 31-month period.
Post 10-Year Dispositions
The final regulations clarify and expand the exclusion of gains that qualify when an investor holds their QOF interest more than 10 years. The sale of assets by the QOF, the sale of an interest in a QOZB by the QOF, and sales of property by the QOZBs all qualify for the exclusion. The regulations also clarify that the exclusion applies to all gains (not just capital gains), other than gains from the sale of inventory in the ordinary course of business.
A partner’s stepped up basis in the QOF partnership after a 10-year election is equal to the net FMV of their interest plus the partner’s share of partnership debt related to the interest.
The final regulations are generally effective for taxable years beginning after March 13, 2020. For taxable years beginning on or before that date, taxpayers can choose to either apply the final regulations (in their entirety) or the proposed regulations (in their entirety).
These final regulations have a significant impact on taxpayers looking to make investments in QOFs, or in establishing their own QOF, as they look to make investments in QOZ trade or businesses or QOZ property in order to defer capital gains. Taxpayers including C corporations, individuals and pass-thru entities should consult your Cherry Bekaert professional who can help you evaluate the effect of these new rules.