Issues Addressed in Second Round of Proposed Opportunity Zone Regulations
On April 16, 2019, the Treasury released its long-awaited second set of proposed regulations (“OZ Regs II”) with regards to Section 1400Z of the IRC collectively referred to as the Opportunity Zone (“OZ”) regulations. Those who develop and invest in real estate, along with those who invest and operate active businesses, were given some reprieve from guessing how to apply the first set of regulations. We find what was once hailed as an easy, self-certified way to roll over capital gains to invest in areas of the U.S. desperate for needed capital has become a very complex tax law. And while we see a tax law that is taxpayer-friendly, flexible in a lot of structuring options, and creative in achieving various long-term tax-free accumulation of value while investing in disadvantaged areas, we also now see many complications associated with the OZ Regs II. These rules can cause some anxiety for those attempting to comply but falling short due to specific rules and regulations that will prevent a rollover and the entitlement to the tax benefits of the OZ. Please consult with Cherry Bekaert professionals to help assist in the proper structuring of your next investment in OZ.
Below is a summary of the new regulations that affect Qualified Opportunity Zones (“QOZ”), Qualified Opportunity Zone Funds (“QOZF”), Qualified Opportunity Zone Business Property (“QOZBP”) and Qualified Opportunity Zone Businesses (“QOZB”).
Deployment of Capital
The OZ Regs II gave us clarity on receipt of capital gain rollover equity invested in a QOZF. The prior regulations gave no guidance on timing of the deployment of capital. The OZ Regs II provide that a QOZF will have six months to invest capital contributions into QOZ property. This six-month time frame creates a cushion for the QOZF to receive capital and to deploy such capital in the QOZF investments.
The OZ Regs II provided various inclusion events that would cause the taxpayer’s investment in a QOZF or QOZB to become taxable. These events, which would disallow future OZ tax benefits and include the deferred gain in income, include gifting interests and other individual specific events that were listed in the OZ Regs II.
Contribution Of Property OZ Equity
The OZ Regs II allow a taxpayer to contribute property as part of their capital contribution for the QOZF. While this allows a taxpayer with liquidity issues to comply with the rollover provisions, this can create problematic structure issues, and there is no clear determination from the Treasury on how this property is treated at the Qualified Opportunity Fund (“QOF”) or QOZB level. Until further clarity is provided, Cherry Bekaert considers this property to be non-QOZBP, and should be included as such in the calculation of the 90% asset test and 70% asset test.
Definition of “Substantially All”
While the term “substantially all” made an appearance five times in the initial OZ Regs and is vague in meaning, the OZ Regs II give us clarity and definition on items such as QOZB rules, holding periods and QOZBP.
“Original Use” Definition Expansion
The OZ Regs II expanded the “original use” definition with tangible property. Tangible property will qualify as QOZBP if the original use of the property commences with the QOF or QOZB and the tangible property has not been previously depreciated or amortized by the QOF or QOZB. We have seen several QOFs already utilize this special rule by formulating funds that will hold real estate that was purchased mid-construction and the placed-in-service date of the buildings had not yet occurred. Additionally, the expanded rules allow for used personal property to be considered QOZBP to the extent they were not previously depreciated in the QOZ. Buildings that have been vacant for at least five years also meet the original-use requirement. Property that is leased by a QOF or a QOZB generally meets the original-use requirement to the extent that such lease was entered into an at arms-length terms after December 31, 2017.
For a building that has been vacant continuously for at least five years, the building will be deemed to meet the “original-use” requirement when it is acquired by the QOF or QOZB. This rule greatly mitigates the redevelopment requirements for abandoned buildings located in blighted areas.
Depreciation and its associated recapture has been a subject of conversation since the release of the initial regulation and the application of the step up in basis. With the OZ Regs II giving clarity to a step up of the QOZBP assets to fair market value (“FMV”) after the 10-year holding period, there is no mention of any recapture provisions for depreciation. Specifically discussed in the OZ Regs II are “hot assets,” including inventory and receivables where these assets can be stepped up to FMV after the 10-year holding period. Applying the same logic to real estate, we believe no depreciation recapture would apply as well since the depreciated basis could be stepped up to FMV. This topic will likely be given some attention by the IRS during the future commentary period.
Land and Existing Buildings
The OZ Regs II provide that unimproved land acquired as QOZBP is not required to be substantially improved.
If the QOF or QOZB has no intention to improve land within the 30 months after the date of acquisition, the acquired land value should be considered non-QOZBP. However, if a QOF or QOZB uses the land in the trade or business and only minimally improves the property for business purposes, we believe that this would qualify as QOZBP for the 90% and 70% asset tests.
Also, existing buildings will be treated on an asset-by-asset basis. In a multi-building acquisition scenario, each building would need to be assigned a separate valuation and would need to be substantially improved during the 30-month period beginning on the acquisition date. Capital expenditures for newly built buildings on land purchased with existing buildings does not qualify as improvements made to the existing buildings for substantial improvement purposes.
For real property that is located both inside and outside of an OZ, the OZ Regs II require that the property located within the OZ must be substantial (based on its unadjusted cost basis being greater than the unadjusted cost basis of the property located outside the OZ), for the entire property to be considered QOZBP for purposes of the asset tests. Certain anti-abuse rules apply to land banking techniques.
The OZ Regs II provide clarification for valuation of property leased by a QOF or QOZB, and the requirements for such leased property to be treated as QOZBP. The leased property must also meet the original-use requirement; the lease terms must be market rate, the lease must be entered into after December 31, 2017, and substantially all of the use of the leased tangible property must in the OZ. Leased property is not required to be substantially improved.
Leased property that has been leased from a related party is subject to two additional requirements in order to meet the original-use requirement: at no point can lease payments longer than 12 months be prepaid by the lessee, and the QOF or QOZB must either purchase the leased property or purchase other tangible property equal to the present value of the leased property within a certain time period. Special stipulations apply to related party lease transactions, so consult your local Cherry Bekaert tax professional.
Triple Net Leases
The Treasury determined that “Triple Net Leases” do not qualify as an active QOZ business and therefore assets subject to a triple net lease will not be counted as QOZBP. Proper deal structuring and having the QOF or QOZB lessor retain responsibility for certain expenses can allow that property to be designated as a non-triple net lease property and therefore be considered QOZBP.
Section 1231 Gains
The Treasury and IRS added a slight twist in the treatment of Section 1231 gains as capital gains. Under the OZ Regs II, all Section 1231 gains and losses would have to be netted to determine the amount eligible, if any, for deferral as capital gain net income. According to the OZ Regs II, net Section 1231 capital gains are deemed to be realized on the last day of the tax year. While we believe this is an oversight by Treasury, this rule becomes problematic for real estate investors with Section 1231 net capital gains for the year, when sales/dispositions occur early during the year. Because the reinvestment of the net gain must occur within the 180-day period after the gain is realized, taxpayers with net Section 1231 gains may not be able to take advantage of available investment opportunities prior to the end of the tax year.
Clarification on Asset Disposition Rules
In the original language of the OZ Regs I, QOZF allowed an investor who held their investment for at least 10 years to elect to step up the basis of their investment in the QOZF to be equal to the fair market value of such QOF investment on the date the investment is sold or exchanged (“the 10-Year Election”). The OZ Regs II provide a special rule where if a QOF disposes of the assets after the 10-Year Election period, the basis of the assets inside the QOF will be stepped up as well as the basis in the ownership interest of the QOF. This was problematic in the original regulations, which required a sale of the investment in the QOF to obtain the tax benefit of gain exclusion. Under the new rule, a QOF will be allowed to have ownership of multiple assets and be able to sell its assets through an orderly liquidation and still be able to pass through the stepped-up basis for each asset. This will allow the application of the 10-Year Election to be available when the QOF disposes of assets after the investor’s 10-year holding period, as opposed to requiring the QOF investor to dispose of their interest in the QOF after that same holding period. Recent discussions from the Treasury indicate this pass-through election to step up the basis of the assets upon disposition will not be allowed for lower-tier QOZ partnerships, and is applicable only to QOF structures. Accordingly, a QOF holding a lower-tier QOZ partnership would have to liquidate the partnership interests and avoid an asset sale at the QOZ partnership level to obtain the benefit of the gain exclusion. While this can become problematic in a tiered structure, we understand there is a secondary market in purchasing these interests to help facilitate liquidity in the marketplace. Additionally, from discussions with prominent real estate development companies, the purchase of a partnership interest by a buyer is not necessarily problematic depending on the facts and circumstances.
“Churning” Of Assets within the QOZF
We received disappointing rules regarding the “churning” of assets inside the QOF. Sales of QOZ by a QOF can occur, which is a positive development. The QOF will have 12 months to reinvest all of the gross proceeds into other QOZ property in order to maintain the 10-Year Election benefit and for the investor’s requisite holding period to remain. Partial reinvestment is also allowed, with some tax consequences. The entire proceeds must be continuously held in cash, cash equivalents or debt instruments with a term of 18 months or less.
The disappointing part of the proposed regulation is that the gain recognized by the QOF is fully taxable for the partners in the year of the disposition. This gain inclusion will require careful structuring and liquidity planning for any cash distributions that may be necessary to fund tax distributions required for the investors to report the phantom income gain on their tax returns and end up in a “net zero” cash position due to the taxes due.
Debt Financed Distributions
The OZ Regs II allow for debt-financed distributions from refinancing or recapitalization events. Such distributions are not Inclusion Events, as discussed above, and are generally allowed to be tax free as long as the distribution is not in excess of their basis in the QOZF. All distributions would be subject to the disguised sale rules which generally prohibit distributions within two years of the investment.
Real estate developers and sponsors who receive a carried interest or “profits” interest will not get the tax benefits from the OZ based on the OZ Regs II. The interest that the developer/sponsor receives will be treated as a mixed fund investment for OZ purposes. The regulations indicated that a bifurcation of the fund will be required, however, specific guidance on how the allocation should be structured is forthcoming from the IRS.
50% of Gross Income Rule
Significant confusion prevailed for QOZBs from the initial regulations with respect to the requirement that “50% of gross income be derived from the active conduct of the trade of business in the opportunity zone.” Private equity investors and future owners were unclear if the new QOZB needed to be a Starbucks-type operation, serving customers locally only in the QOZB, or whether the QOZB could be the next Amazon and have revenue outside the QOZ. The OZ Regs II give three safe harbors to allow the QOZB to have revenue outside of the QOZ, if one of the following apply:
- At least 50% of the hours necessary to produce the revenue for the QOZB was conducted by employees and independent contractors located within the QOZ.
- At least 50% of the amount paid for services necessary to produce the revenue for the QOZB was paid to employees and independent contractors located within the QOZ.
- Management is located in the QOZ and tangible property of the QOZB is located in the QOZ necessary to generate at least 50% of the gross income of the QOZB.