Last week, the IRS and Department of Treasury released a second round of proposed regulations on investments in qualified opportunity zone funds (QOFs). The proposed regulations clarify requirements that were not addressed in the initial proposed regulations released in October 2018. The IRS and Treasury are seeking comments and will hold a public hearing regarding the proposed regulations in June. Even though the regulations are merely proposed at this point, they reflect Treasury’s current approaches to many items that Section 1400Z-2 leaves open to interpretation and represent the best indication of where the final requirements will be fixed.
Previously on this blog, we surveyed the tax benefits of a QOF investment and 8 important questions answered by the initial proposed regulations on QOFs. In this fairly technical post, I’ll touch on some of the most significant QOF investment-related questions that we believe are answered by the second round of proposed regulations.
The various meanings of “substantially all”
The term “substantially all” is included in Section 1400Z-2 five times; however, the previously released regulations clarified what that meant in only one instance, detailing that in order to be a QOZ business, substantially all of the business’s tangible property (at least 70%) must be QOZ property. (In other words, at least 70% of a subsidiary partnership’s tangible assets must be QOZ property in order for the QOF’s investment in that subsidiary to count towards the 90% test.)
This round of proposed regulations provides that the “substantially all” requirement regarding “use” of QOZ business property will be satisfied if at least 70% of the use of such property is located in a QOZ, whereas “substantially all” in the context of “holding periods” requires a 90% threshold. As such, QOZ business property is defined as tangible property that, among other things, during substantially all of the QOF’s holding period (at least 90%), substantially all of the property was used in a QOZ (at least 70%). Additionally, this clarifies that, in order to be considered a QOZ partnership interest or QOZ stock, the partnership or corporation would need to qualify as a QOZ business for substantially all of the QOF’s holding period in such interests (at least 90% of the holding period).
These requirements are particularly important because we expect many QOF’s to be structured as a fund that invests 90% of its assets in QOZ partnership interests that are considered QOZ businesses that own QOZ business property. Clear as mud.
“Original use” begins when the party starts to “use” depreciation/amortization deductions
In order to be considered QOZ property, among other things, the original use of the property must either (i) commence with the QOF or (ii) the QOF must substantially improve the property. We already know that substantial improvement requires that additions to the property’s basis over a 30 month period exceed the original basis in the property at the time of acquisition. But what does original use actually require?
The proposed regulations state the “original use” of tangible property begins when a party places the property in service in the QOZ for purposes of depreciation or amortization. This means that if the property is depreciated or amortized by another taxpayer, other than the QOF or the QOZ business, the property would not meet the original use requirement. In other words, the QOF or QOZ business would need to substantially improve the property in order for it to qualify as QOZ property. However, the requirement would be satisfied if the tangible property has not been amortized or depreciated by another taxpayer, and substantial improvement would not be necessary.
Additionally, the proposed regulations provide that if a building has been vacant for at least five years prior to the QOF or QOZ business purchasing the property, the building will satisfy the original use requirement. This means that, in theory, a QOF could purchase a vacant building and have it qualified as QOZ property without actually substantially improving it.
Property that walks the line
It’s possible that real property could straddle two census tracts, one that is a QOZ and one that is not. The proposed regulations state that a property located partially within a QOZ and partially outside, will be treated as being located in a QOZ if the unadjusted cost of the real property inside the QOZ is greater than the unadjusted cost of the real property outside the QOZ.
Where to locate the active conduct that produces the income
In order for a trade or business to be considered a QOZ business, at least 50% of its total gross income must be derived from the active conduct of the business within the QOZ. This may not be a significant concern for real property investments located within QOZs, but what about programs that invest in operating businesses located in QOZs that derive portions of their income from other census tracts?
The proposed regulations provide three safe harbors for determining whether sufficient income is derived from a trade or business in a QOZ for purposes of the 50% test. A business is only required to satisfy one of the following safe harbors:
- 50% of the services performed by the business’s employees are performed within the QOZ based on the number of hours completed,
- 50% of the services performed for such business by its employees are performed within the QOZ based on the amounts paid for those services, or
- Tangible property of the business located in the QOZ and management (or operational) functions performed for the business in the QOZ are necessary to generate 50% of the gross income.
Treasury is specifically seeking comments on this safe harbor and also clarified that leasing of real property used in an active trade or business is treated as the active conduct of such trade or business.
Enlarging the working capital safe harbor
As Treasury has previously clarified, QOZ business may characterize working capital as QOZ business property for up to 31 months, provided they meet certain requirements, including that there be a written plan that earmarks working capital as held for the acquisition, construction, or substantial improvement of tangible property in a QOZ. The proposed regulations changed this requirement by also including working capital for the “development of a trade or business in a QOZ,” as well as the acquisition, construction, or substantial improvement of tangible property.
Reasonable periods for reinvestment
The Internal Revenue Code provides that a QOF has a reasonable period of time to reinvest the return of capital from investments in QOZ stock or partnership interests and reinvested the proceeds from such sale.
The recent proposed regulations provide that sale proceeds will be treated as QOZ property for purposes of the 90% test as long as the QOF reinvests the proceeds into other QOZ property within 12 months of the sale. This could potentially give investment programs some added flexibility in pursuing liquidity for its assets, instead of having to hold each of the individual assets for the 10-year hold period that is necessary to maximize the tax benefits associated with a QOF investment.
Potential relief from the 90% test
In order to qualify as a QOF, a fund will need to hold at least 90% of its assets in QOZ property, which is tested on a semi-annual basis. The 90% test will be determined by averaging the QOF property held by the fund on the last day of the fund’s first-six month period of the taxable year and the last day of the taxable year. But what happens if a QOF raises a significant amount of investors capital right before the end of the first six month period? The proposed regulations state that a QOF does not need to factor in any investments that have been received within the preceding 6 months when calculating its first 90% test.
How leased property can help satisfy the 90% test
Leased tangible property may be treated as QOZ business property for purposes of satisfying the 90% test, provided that it is acquired after December 31, 2017, and substantially all of the use of the leased property must be in a QOZ (at least 70%) during substantially all of the period in which the QOZ business leases the property (at least 90%). These requirements exist for any type of tangible property. However, the proposed regulations do not impose an original use or substantial improvement requirement with respect to leased property.
The proposed regulations also provide certain limitations on leases with related parties and the methodologies for valuing leased tangible property for purposes of satisfying the 90% test.
Treasury also provided clarification on numerous inclusion events, upon which investors would need to recognize portions of the deferred gains. All of these inclusion events are beyond the scope of this post; however, generally speaking, these events are transactions that would reduce or terminate the QOF investor’s investment for federal income tax purposes or constitute a “cashing out” of the QOF investor’s qualifying investment.
What questions remain?
I’ll end this post by highlighting items that remain open. Treasury stated in its commentary to the regulations that it is working on, and seeking comments on, additional proposals regarding the following items, which may be published in the future:
- Administrative matters related to QOFs (anticipated in next few months)
- Whether anti-abuse rules are needed
- Applying an asset-by-asset or an aggregate standard in determining whether QOZ business property has been substantially improved
- Consideration of inventory in determining whether a QOZ business has met the 70% test
- Treatment and valuation of leased property
- Whether additional rules are needed to determine whether a trade or business is actively conducted