IRS Finalizes Rules for Opportunity Zone Investments by Arkadiy (Eric) Green
Posted on February 20, 2020
The IRS issued final regulations on the Qualified Opportunity Zone (QOZ) program at the end of 2019, two years after Congress introduced it as part of the Tax Cuts and Jobs Act (TCJA). While the final regulations are generally taxpayer favorable and clarify many unanswered questions about the new tax-saving program, they do not make the law or compliance any less complex.
In general, the QOZ program allows taxpayers to defer tax on gains from the sale of certain appreciated assets (including stocks, real estate and business assets) until as late as December 31, 2026, when they rollover those gains into qualified opportunity funds (QOFs). Eligible taxpayers may also potentially exclude 10 percent of originally deferred gains from gross income if they hold investments in QOFs for at least five years (15 percent if they hold investments in QOFs for at least seven years) prior to December 31, 2026. The third and arguably most significant benefit investors can receive from the QOZ program is the ability to potentially exclude from gross income all post-acquisition gains from the sale of their eligible investments in QOFs after holding such investments for at least 10 years.
In turn, QOFs must invest in operating businesses and development projects located in any of more than 8,700 predominantly low-income census tracts certified as QOZs by the U.S. Treasury. QOF entities are required to hold at least 90 percent of their assets in qualified opportunity zone property (QOZP), which may include direct investment in qualified opportunity zone business property (QOZBP) or investments in other companies treated as qualified opportunity zone businesses (QOZBs). In order to comply with the rules and the spirit of the QOZ program, QOFs and QOZBs are required to satisfy many complex and onerous qualification and testing requirements.
Following are some of the key provisions contained in the final regulations that affect individual and entity investors:
Gains Eligible for Reinvestment
The final regulations clarify that taxpayers may defer gross eligible gains resulting from the sale of Section 1231 trade or business property that is reinvested into a QOF within 180 days of the sale that triggers the gain. Previously proposed regulations required taxpayers to net Section 1231 gains against Section 1231 losses on the last day of the investor’s tax year.
In addition, the final regulations allow taxpayers to defer gains recognized from installment sales, even if the initial sale occurred prior to Dec. 22, 2017. Taxpayers have the option to begin the required 180-day reinvestment period on each date they receive installment sale payments during the tax year, or on the last day of their tax year.
Timing of Reinvestment for Gains from Flow-Through Entities
Generally, a partner or shareholder’s 180-day period for their distributive share of gains allocated by flow-through entities begins on the last day of the entity’s tax year. However, under the final regulations, partners and shareholders also have the option to elect to start the 180-day period for such gains as beginning on either 1) the date of the underlying sale by the flow-through entity or 2) the due date of the flow-through entity’s tax return, not including extensions.
Exits from QOF and QOZB Investments After 10 Years
Generally, investors who sell their qualifying equity interest in a QOF after holding it for 10 years may elect to exclude all the gain on such equity sale from income. The final regulations provide much-needed relief with regard to the exit issue. Under these regulations, investors that hold qualifying interests in QOFs formed as partnerships or S corporations for at least 10 years may elect to exclude all the gain resulting from a sale of property by either the QOF or the QOZB (with the exception that any ordinary income from the sale of inventory would still have to be recognized). Previously, investors could only exclude gains from their sale of interest in a QOF or from a QOF’s sale of assets.
Original Use Requirement and Vacant Properties
In general, to be treated as QOZBP, the original use of the property in the QOZ must begin with the QOF or the QOZB that acquires the property, or the property must be “substantially improved” by the QOF or the QOZB within 30 months of acquisition. The final regulations further clarify that real property that was vacant for three consecutive years (rather than the proposed regulation’s five years) prior to acquisition will qualify as original-use property and avoid the substantial improvement requirement. Further, property that was vacant for one year prior to the date the surrounding area was designated as QOZ can also be treated as original-use property that does not need to be substantially improved. Generally, real property is considered vacant if more than 80 percent of its usable space is not being used, as measured by square footage. In addition, the final regulations specify that brownfield sites may be treated as original-use property as long as the QOF or the QOZB make investments within a reasonable time to ensure the property is safe and compliant with environmental standards.
Substantial Improvements to Real Property
The final regulations clarify that, generally, for purposes of satisfying the substantial-improvement requirements, it is the adjusted tax basis of the property (as opposed to the original cost) that must be doubled during the 30-month period, starting from the date of the acquisition.
In satisfying the substantial-improvement requirements, the final regulations allow QOFs or QOZBs to treat two or more buildings located on the same parcel of land as a single property. Buildings located on contiguous parcels may also be aggregated, but only provided certain conditions are met that indicate these buildings are related in management or use. As a result, additions to the basis of all buildings in the “eligible building group” may be aggregated to satisfy the substantial-improvement requirements. Therefore, a group of buildings may now meet the substantial-improvement test, even when some of them do not require significant rehabilitation.
QOFs or QOZBs may also satisfy the substantial improvement requirements by electing to aggregate the costs of newly purchased original-use assets (such as furniture, equipment or other personal property) that are used in the same trade or business and that improve the functionality of the building, regardless of whether that property is part of the building’s structure or included in the building’s basis. However, the building owner still has a requirement to improve the building itself by “more than an insubstantial amount,” which the final regulations do not define.
70 Percent Use Test for QOZBs
QOZBs are required to satisfy the “substantially all” threshold, which generally means that at least 70 percent of all tangible property owned or leased by a QOZB must meet the definition of QOZBP which, among other things, requires that not less than 70 percent of total use of such qualified tangible property occur at a location within a QOZ. The final regulations also provide two helpful safe harbors that can be used for purposes of the 70 percent tangible property standard (1) for tangible property utilized in rendering services both inside and outside a QOZ, and (2) for tangible property owned by short-term leasing businesses with offices in a QOZ.
New 62-Month Working Capital Safe Harbor
The proposed regulations provided for the 31-month working capital safe harbor, which allowed QOZBs to delay deployment of reasonable working capital for up to 31 months, so long as the QOZB has in place and substantially complies with a written plan that shows how the working capital will be spent for acquisition, construction or substantial improvement of tangible property in a QOZ within 31 months of the receipt of such working capital. The final regulation provide that certain qualifying start-up businesses may be able to extend the working capital safe harbor to as much as 62 months. This will provide entrepreneurial businesses with additional time to satisfy the requirements that 70-percent of the QOZB’s tangible property be located in a QOZB and 50-percent of its gross income be derived from the active conduct of a trade or business in a QOZ.
About the Author: Arkadiy (Eric) Green, CPA, is a director of Tax Services with Berkowitz Pollack Brant Advisors and CPAs, where he works with real estate companies, commercial and residential developers, property management companies, real estate investors and high-net-worth individuals to structure investments and complex transactions for maximum tax efficiency. He can be reached at the CPA firm’s Boca Raton, Fla., office at (561) 361-2000 or via email at firstname.lastname@example.org.
Information contained in this article is subject to change based on further interpretation of tax laws and subsequent guidance issued by the Internal Revenue Service.