Qualified Opportunity Fund Update: Frequently Asked Questions About the Latest Round of Proposed IRS Regulations
Posted by Matthew Romano on Jul 19, 2019 3:47:00 PM
On April 17, 2019, Treasury and the IRS issued a second round of proposed regulations, which significantly addressed many of the questions that existed with respect to the operation of a Qualified Opportunity Fund (“QOF”). Below is a discussion about the main provisions of the new proposed regulations that would impact managers and advisors of a QOF. Additional references are made to the statute (IRC section 1400Z-2) as well as the first round of regulations (issued on October 19, 2018).
In the statute (IRC Section 1400Z-2), the term “Substantially All” is used in multiple contexts in the opportunity zone rules and definitions. What are the different meanings?
The new proposed regulations provided a bright line test for the following uses of substantially all:
Qualified Opportunity Zone Business (“QOZB”)
For a trade or business to be considered a QOZB, substantially all of the tangible property owned or leased by the trade or business must be qualified opportunity zone business property.
Substantially all for purposes of the QOZB test is met if at least 70% of the property in a trade or business meets the definition of qualified opportunity zone property.
Qualified Opportunity Zone Business Property (“QOZBP”)
This is defined as property acquired by purchase after 12/31/17 from an unrelated party, for the original use in the qualified opportunity zone or substantially improved by a QOF or QOZB, and where during substantially all of the QOF’s or QOZB's holding period in such property, substantially all of the use of that property was in a qualified opportunity zone.
Substantially all with respect to the “use” of the property is satisfied if at least 70% of the use of such tangible property is in a qualified opportunity zone.
Substantially all with respect to “holding period” by the QOF is defined as at least 90% of the QOF’s holding period in the property.
In order to meet the requirements of QOZBP, tangible property acquired by the purchaser must either be considered “original use” or the property must be “substantially improved.” What is the requirement for being considered “original use?"
The new proposed regulations state that “original use” of tangible property commences on the date when either the purchaser or the prior owner first places the asset into service in the qualified opportunity zone for purposes of depreciation or amortization. If tangible property located in a qualified opportunity zone is depreciated or amortized by a taxpayer other than the QOF or QOZB, then it would NOT satisfy the original use requirement. The new regulations further clarify that USED tangible property can meet the “original use” requirement so long as the property has not been previously used (in a manner that would allow for depreciation or amortization) within that opportunity zone.
In addition, the new regulations state that a building or other structure that has been vacant for at least five years would also satisfy the “original use” requirement. Further, improvements made by a lessee to leased property would also be deemed as satisfying the “original use” requirement.
If property does not meet the “original use” standard, what are the requirements to meet the “substantially improved” threshold? Is this threshold tested on an asset-by-asset basis, or can various assets be grouped for purpose of this test?
IRC section 1400Z-2 states that the “substantial improvement” requirement is met if within 30 months of the purchase of tangible property, additions to the basis of that property equal or exceed the original cost basis. Said another way, improvements equal to or greater than the original cost need to be made to meet his threshold.
In the new proposed regulations, Treasury and the IRS confirm that this test is an asset-by-asset test. However, they recognize that this process is administratively burdensome. It is stated that they are considering the possibility of some type of aggregate standard. For example, grouping all of the assets in a particular opportunity zone for purposes of determining compliance with the “substantial improvement” requirement.
Can land be considered Qualified Opportunity Zone Property? Can land meet the original use requirement or does it need to be substantially improved?
The new proposed regulations state that land can be treated as QOZP so long as it’s used in a “Trade or Business” of a QOF or QOZB. The new proposed regulations reference IRC Section 162 for the definition of “Trade or Business,” and note that holding land for investment purposes only does not constitute trade or business and therefore could not be considered QOZP.
Neither the “original use” nor the “substantial improvement” requirements apply to land. In the original proposed regulations, Treasury and the IRS confirmed that when a QOF purchases a building located on land wholly owned within a qualified opportunity zone, the “substantial improvement” requirement only applies to the original basis of the building.
Can leased property meet the requirements of QOZP? Do the “original use” or “substantial improvement” requirements apply?
The new proposed regulations confirm that leased tangible property can be treated as QOZP, provided the following two requirements are met:
- Leased property must be acquired after 12/31/17.
- Substantially all of the use of the leased tangible property must be in a qualified opportunity zone during substantially all of the period for which the business leases the property.
The new proposed regulations do NOT impose an “original use” or “substantial improvement” requirement on leased tangible property. However, the new proposed regulations do include additional requirements if the lease is between related parties.
- The lease under which a QOF or QOZB acquires rights with respect to leased tangible property must be “market rate” as determined by IRC Section 482.
- The lessee cannot make pre-payments on the lease for a period that exceeds 12 months.
- During the 30-month period beginning on the date that the lessee receives possession of the property under the lease, the QOF or QOZB must acquire tangible property equal to or greater than the leased property, which has the effect of imposing the “substantial improvement” requirement.
What are the requirements to be considered a Qualified Opportunity Zone Business (“QOZB”)?
There are three tests to be considered a Qualified Opportunity Zone Business. These tests are detailed in IRC Section 1400Z-2(d)(3)(A). It is important to note that only a QOF investing through a subsidiary must meet these requirements.
- The 70% Test – At least 70% of all tangible property owned or leased meets the definition of QOZBP (discussed above).
- Qualifying Business Test – Cannot be any business listed in IRC Section 144(c)(6)(B) (commonly referred to as a sin business). This list includes golf & country clubs, massage parlors, hot tub facilities, sun tan facilities, gambling, or any store where the principal business is the sale of alcoholic beverages.
- Income & Asset Tests [IRC Section 1397C(b)] – At least 50% of gross income from the active conduct of a trade or business in the QOZ (50% income test), a substantial portion of the intangible property must be in the active conduct of a trade or business in a QOZ (intangible test), and less than 5% of unadjusted basis of property attributed to non-qualified financial property ( 5% asset test).
Regarding the 50% income test, in the new proposed regulations the Treasury and the IRS provided three safe harbors as well as a facts and circumstances test to meet this requirement. Meeting any of the below would ensure that the trade or business has fulfilled the income test:
- 50% of services performed (based on hours) by employees or independent contractors within the qualified opportunity zone.
- 50% of services performed (based on dollars paid) by employees or independent contractors within the qualified opportunity zone.
- Tangible property of the business that is in the qualified opportunity zone and the management or operational functions performed in the opportunity zone are necessary to generate 50% of the gross income of the trade or business.
Regarding the intangible test, the Treasury and the IRS confirmed in the new proposed regulations that substantial portion is at least 40%.
Regarding the 5% asset test, non-qualified financial property includes debt, stock, partnership interests, options, futures, etc. There is, however, a “working capital” exception which allows the QOZB to exclude working capital held in cash, cash equivalents, or debt instruments with a term of less than 18 months. The Treasury and IRS listed the requirements to meet this Safe Harbor in the original proposed regulations:
- Amount of working capital designated in writing for the acquisition, construction, and/or substantial improvement of tangible property a QOZ.
- Written schedule consistent with the ordinary business of the business that the property will be used within 31 months.
- The business complies with this schedule.
In addition, the new proposed regulations provided relief for exceeding the 31-month period if the delay is attributable to waiting for government action if the application was completed during the 31-month period.
What are the requirements for QOZ stock and partnership interest?
Qualified Opportunity Stock
Stock in a corporation can be treated as QOZ stock if the following three requirements are met:
- Acquired by a QOF after 12/31/17, directly from a corporation or through an underwriter, solely for cash.
- At the time the stock was issued, the corporation was a QOZB (or organized for the purposes of being a QOZB).
- During substantially all of the QOF’s holding period for the stock, the corporation was a QOZB.
Qualified Partnership Interest
- Acquired by the QOF after 12/31/17, directly from the partnership solely for cash.
- At the time the partnership interest was issued, the partnership was a QOZB (or organized for purposes of being a QOZB).
- During substantially all of the QOF’s holding period of the partnership interest, the partnership was a QOZB.
The original proposed regulations indicated that Section 1231 gains, because they are treated as long-term capital gains, are eligible for deferral under IRC Section 1400Z-2. Because Section 1231 gains are subject to netting, however, the net Section 1231 gain can only be determined at the end of the taxable year. The new proposed regulations state that because the capital gain income from Section 1231 property is determinable only as of the last day the taxable year, the 180-day reinvestment period begins on the last day of the taxable year.
Is there any relief for a QOF that does not meet the 90% asset requirement?
The new proposed regulations detailed two exceptions to the 90% asset test.
Relief for Newly Contributed Assets
QOFs can exclude any investment received in the preceding six months from the 90% asset test (from both the numerator and the denominator). The proceeds from new investment, however, must be held in cash, cash equivalents, or debt instruments with a term of 18 months or less.
Relief for Reinvestment
IRC Section 1400Z-2 indicated that the QOF would be afforded a “reasonable period of time to reinvest the return of capital from investments in QOZ stock or QOZ partnership interests, and to reinvest proceeds received from the sale or disposition of QOF property.” The new proposed regulations provide that the proceeds described above are treated as qualified opportunity zone property for purposes of the 90% test so long as the QOF reinvests the proceeds during the 12-month period beginning on the date of such distribution, sale, or disposition. Similar to the Contributed Assets rule, the proceeds must be held in cash, cash equivalents, and debt instruments with a term of 18 months or less.
Does the disposition of property by the QOF property result in the inclusion of the deferred gain?
In the new proposed regulations, Treasury and the IRS confirm that sale or dispositions of assets by a QOF do not trigger the inclusion of deferred gain so long as the QOF investment is not sold or otherwise disposed.
Are QOFs and their shareholders exempt from other income tax consequences from the sale or disposition of QOF property?
The IRS and Treasury state in the new proposed regulations that they do not believe they have the authority to grant QOFs and their investors an exclusion of income and gains from the sale or disposition of QOF property. The IRS and Treasury believe that non-recognition of gain or exclusion from income can only come from an operative provision in subtitle A of the code (such as IRC Section 351, 721, 1031).
What transactions can result in a recognition of the deferred gain at the QOF shareholder level?
The statute [IRC Section 1400Z-2(b)(1)] indicated that the deferred gain would be recognized at the earlier of 12/31/2026 or the date at which the investment in the QOF is “sold or exchanged.” Excluded from this language is non-sale or exchange dispositions. The new proposed regulations clarify that certain non-sale exchanges that reduce the taxpayer’s equity interest in a QOF or transaction that result in the result in the taxpayer receiving property in excess of their basis in a QOF would be an inclusion event. See below for some specific inclusion events included in the new proposed regulations (please refer to new proposed regulations for full list of inclusion events).
- Sale of a direct interest in a QOF.
- Termination or liquidation of a QOF.
- Transfer of an interest in a QOF by gift.
- Distribution to partner in QOF in excess of partner’s qualifying QOF basis.
- Distribution of property with respect to QOF stock that is treated as gain from sale or exchange.
What guidance is still to come from Treasury and the IRS?
In the new proposed regulations, Treasury and the IRS said they expect to release future guidance which addresses the administrative rules related to when a QOF fails the asset test (90% of assets in QOZB), taxpayer information reporting requirements, and a more comprehensive Form 8996.