Final QOZ Regulations—Better Late than Never
Over the last six months, FactRight has reviewed a number of qualified opportunity funds (QOFs) that are targeting development projects in qualified opportunity zones (QOZs). In each of our due diligence reports on these programs, we noted the following:
“Treasury and the IRS have released two rounds of Regulations, which reflect their current approaches to many items that the Code leaves open for interpretation. However, these Regulations are not final and further regulatory guidance is forthcoming, the impact of which on the company is unknown and may be applied retroactively.”
However, in December 2019, the IRS and Treasury released the final regulations on investments in QOFs, which allows us to kiss this customary disclosure…goodbye. The final regulations retain the basic approach and structure of the proposed regulations, which were issued in October 2018 and May 2019, but provide certain revisions and guidance regarding a number of matters. In this post, we’ll touch on some of the most significant QOZ investment-related questions that we believe are answered by the final regulations.
Did the IRS extend the timeframe for the five- and seven-year step-ups?
Investors in a QOF will receive a 10% increase in the cost basis in their deferred gains if they maintain their investment for at least five years prior to the December 31, 2026, and an additional 5% increase (15% total) if they maintain their investment for at least seven years prior to December 31, 2026. This meant that in order to be eligible for the five- and seven-year step-ups, Investors needed to invest by December 31, 2019, or December 31, 2021, respectively. Many commentators requested an extension to the five- and seven-year statutory periods in order to provide Investors additional time to consider investing in a QOF. However, the IRS and Treasury did not adopt this recommendation because the December 31, 2026, cutoff date is mandated by statute. As such, going forward, QOF Investors will not be eligible for the 15% step-up and will be required to invest prior to December 31, 2021, in order to be eligible for the 10% increase. From our vantage point, the additional 5% step-up is a relatively minor incentive compared to the other potential tax benefits associated with investing in QOZs, and we don’t anticipate this will have a significant adverse impact on QOF capital raising efforts going forward.
Do Investors have to wait until the end of the year to invest Section 1231 gains?
Under the proposed regulations, only net Section 1231 gains for the taxable year were eligible for QOZ tax benefits. Because of the net approach, the 180-day window for reinvestment would not begin until December 31st of the taxable year, meaning Investors could not invest Section 1231 gains into a QOF until year-end. In 2019, this resulted in some of the QOFs not accepting Section 1231 gain proceeds until the last day of the year and other QOFs using creative structures for such Investors to raise that capital in a more timely manner.
Fortunately for Investors, the IRS has adopted a gross approach for Section 1231 gains in the final regulations, whereby eligible Section 1231 gains are determined on an item-by-item basis and not reduced by Section 1231 losses. This means the 180-day period for reinvestment begins on the date of the sale that gives rise to the Section 1231 gain and that Investors no longer have to wait until the end of the year to determine whether their Section 1231 gains are eligible for investment into a QOF.
When does the 180-day timeline for reinvestment begin for gains received from a partnership?
The final regulations provides partners in a partnership, shareholders in an S corporation, and beneficiaries of a decedent’s estate, with the option of treating the-180 day timeline for reinvestment as beginning on the due date of the entity’s tax return. This allows such Investors to take advantage of the full 180-day window even though they may experience delays in receiving information necessary to determine the existence of eligible gains because of the timing of Schedule K-1 issuances.
Original Use and Substantial Improvement Requirements:
Do the final regulations allow for aggregation of original use and non-original use property or multiple buildings under the substantial improvement test?
In order to be considered QOZ business property, the original use of the property must commence with the QOF or the QOF must substantially improve the property (meaning it needs to double the adjusted basis of the property within 30 months of acquisition). The final guidance provides a number of aggregation regulations that should make it easier for QOFs to satisfy the substantial improvement test.
First, final regulations specifically allow the value of purchased original use property to count towards the determination of whether non-original use property has been substantially improved if the original use property improves the functionality of the non-original use property. For example, the cost of new furniture for use within an existing building would count toward the substantial improvement test.
Additionally, a QOF may aggregate multiple buildings into a single property for purposes of the substantial improvement test if the properties are located within a piece of land in a single deed or on contiguous parcels. This guidance expands the number of existing buildings a QOF could purchase because one expensive renovation project could provide excess improvement expenses that could be applied to adjacent buildings.
Can the development of vacant buildings satisfy the original use requirement?
Generally, we think of original use property as ground-up development of a new property. However, the proposed regulations stated that an existing property that was vacant for at least five-years would also satisfy the original use requirement. The final regulations have reduced this time frame from five-years to one-year (if the property had been vacant for at least one year at the time the associated census tract was designated as a QOZ) or three-years (if it was not vacant for at least a year at the time of the designation). The final regulations further clarified that a building will be considered vacant if more than 80% of the building’s square footage of useable space is not being used. The vacancy requirements in the final regulations increase the pool of potential properties that QOFs may target under the original use test and may potentially cause QOFs to pursue more rehab projects of vacant properties than originally anticipated because the QOF would not have to technically “substantially improve” such properties.
Ongoing Compliance Requirements:
Are upfront selling fees and commissions considered assets for purposes of the 90% test?
A number of commentators had inquired as to whether selling commissions and offering expenses were included in the 90% valuation test. The IRS confirmed that expenses associated with organizing a QOF or its day to day operations are not considered assets for federal income tax purposes and are not taken into account to any extent in determining satisfaction of the 90% test. So essentially, this means QOFs will be evaluating the 90% test with assets that are purchased with net offering proceeds.
Can a QOF extend the working capital safe harbor?
Proposed regulations established a working capital safe harbor under which a QOZ business may hold cash for up to 31 months. The IRS and Treasury took the working capital safe harbor a step further, specifying that a QOZ business may use multiple 31-month safe harbors (overlapping or sequentially), so long as the total length of time does not exceed 62 months. The additional working capital safe harbor could provide QOFs a little more flexibility on when they raise and deploy capital for their development projects.
Do the final regulations provide any exceptions if a QOF fails the 90% test?
Treasury and the IRS determined that QOFs should have the ability to cure defects that prevent one of its subsidiaries from qualification as a QOZ business for purposes of the 90% test, without incurring a penalty. The final regulations provide QOF subsidiaries a six-month period for to cure any defect which caused that entity to fail to qualify as a QOZ business. During that 6-month cure period, the QOF can treat its interest in that subsidiary QOZ business as QOZ property. If the subsidiary entity fails again to qualify after the 6-month cure period then the QOF must determine if it meets the 90% standard while accounting for its interest in the non-qualifying subsidiary. If it does not, the applicable penalty would be applied to each month in which the QOF failed to meet the 90% test, including each month during the 6-month cure period. The final regulations clarified that each QOZ business can only use the six-month cure period only one time.
Additionally, the final regulations provide a reasonable cause exception, which states that the IRS will not impose a penalty on a QOF that fails to meet the 90% test due to reasonable cause. Reasonable cause is a factual question that would be evaluated by the IRS. And hopefully, it’s a question that we do not have to evaluate anytime soon!
Can investors in a QOF partnership exclude tax on post-investment capital gains upon the sale of a QOZ property or only upon the sale of their interest in the QOF?
Under the proposed regulations, Investors in a QOF partnership or S corporation could only take advantage of the 10-year elimination of tax on post-investment capital gains if the Investors sold their interest in the QOF or the QOF sold its QOZ property. However, these rules did not apply to a subsidiary QOZ business selling QOZ business property. This left some uncertainty regarding how QOF partnerships would be able to pursue liquidity events for individual properties held through QOZ businesses, while still taking advantage of the exclusion on post-investment capital gains. This was particularly important because most of the QOFs that we’ve reviewed have been structured as partnerships that own their properties through subsidiary QOZ businesses. Fortunately, the final regulations also now allow QOF investors to exclude all post-investment gains of a QOF partnership or S corporation, including gains from the sale of subsidiary QOZ business property which flow through to Investors. This should allow QOF partnerships greater flexibility in pursuing liquidity events for its individual properties owned through subsidiary QOZ businesses.
If an Investor sells only a portion of their QOF investment, can they reinvest into a new QOF and take advantage of a new deferral election?
The proposed regulations provided that if an Investor sold their entire investment in a QOF they could reinvest such amounts into another QOF within 180 days in order to make a new deferral election. The final regulations clarified that a gain arising from a sale is eligible for another deferral even if the Investor retains a portion of their investment in the original QOF after the inclusion event. In either scenario, the 180-day period for reinvestment would begin on the date of the disposition and the holding period for the second QOF investment would begin on the date that the corresponding amount was invested in the second QOF. The clarification regarding a partial sale does not change the rule regarding sales after December 31, 2026, as there is no deferral allowed for dispositions subsequent to that cut-off date. Additionally, Investors are not permitted to tack on the holding period of a disposed qualifying investment for purpose of the five-year step-up and 10-year elimination rules. The reinvestment into a new QOF would be a new deferral that would be subject to its own specific timelines.
Will the tax on deferred gains in 2026 be based on the then-current rate or the rate when the original gain arose?
The final regulations clarified that deferred gains are subject to tax at the applicable federal rate for the year of inclusion (presumably 2026) and not the year of investment/deferral. This means investors could have to pay a higher rate in 2026 if we’re feeling the Bern for a second term and capital gains tax rates increase in the future.