Treasury Issues Additional Proposed Regulations on Qualified Opportunity Zones

On April 17, 2019, Treasury and IRS released a second set of proposed regulations (the New Proposed Regulations) with respect to Qualified Opportunity Zones (QOZs). The New Proposed Regulations clarify a number of requirements for QOZ investors seeking to defer taxation of capital gains invested in a qualified opportunity fund (QOF) and expand upon earlier proposed guidance to address various operational requirements and to define certain terms used within the statutory language.

Background

Treasury and IRS issued the first set of proposed regulations on the QOZ tax incentives in October 2018. For general background on the new QOZ incentives and information on the first set of proposed regulations, please see our prior Tax Release.

Highlights from Proposed Regulations

The New Proposed Regulations update portions of the first set of proposed regulations and provide additional details on the operational aspects of the QOZ program. Below are some highlights:

Substantially All Tests – The New Proposed Regulations clarify the respective thresholds required to satisfy the asset use and holding period requirements for QOZ Property (a defined term), thus providing additional clarity to taxpayers.

QOF Reinvestment Rule – The proceeds a QOF receives from the return of capital from investments in QOZ stock or QOZ partnership interests, and/or from the disposition of QOZ business property, are treated as QOZ Property to the extent that a) the proceeds are reinvested within a 12-month period into another type of qualifying investment and b) the proceeds were continuously held in cash, cash equivalents or debt instruments with a term of 18 months or less until reinvested.

Inclusion Events – Subject to certain exceptions, an inclusion event (i.e., an event that triggers taxable gain) may result from a transaction involving the transfer of a qualifying investment to the extent the transfer reduces the taxpayer's equity interest or other transactions to the extent the taxpayer receives a distribution from the QOF.

Used Property – Used tangible property will satisfy the original use requirement with respect to the QOZ so long as the property was not previously used within that QOZ in a manner that would have allowed the property to be depreciated or amortized by any taxpayer. Further, a purchased building or structure will satisfy the original use requirement if the property has been vacant for at least five years prior to purchase by a QOF or QOZ business.

Leased Tangible Property – Under the New Proposed Regulations, there is not an original use requirement with respect to leased tangible property, nor is there a requirement that a lessee substantially improve leased tangible property. There are separate requirements to prevent abuse in the event that a lessee acquires leased tangible property from a related person.

QOZ Business – The New Proposed Regulations provide even more flexibility and clarity around the qualifications for QOZ businesses:

• A safe harbor provides that inventory in transit does not fail the asset use requirement for tangible property within a QOZ.
• For a QOZ business that straddles a QOZ, the new guidance provides a rule that compares the relative square footage of the business inside and outside the QOZ.
• The New Proposed Regulations provide three safe harbors and a facts and circumstances test for determining whether a QOZ business derives at least 50% of its total gross income from the active conduct of a business within a QOZ.
• For purposes of the requirement that a substantial portion of the intangible property of a QOZ business be used in the active conduct of such trade or business within a QOZ, the term substantial portion means at least 40%.
• Solely for purposes of the QOZ rules, ownership and operation (including leasing) of real property is generally considered the active conduct of a trade or business. This treatment would generally not apply to triple-net leases.

Relief for Newly Contributed Assets – A QOF may apply the 90% asset test without taking into account any investments received in the preceding six months if the new assets were held in cash, cash equivalents, or certain debt instruments since invested with the QOF.

Special Election for Direct Investors in QOF Partnerships and QOF S Corporations – A taxpayer that is the holder of a direct qualifying QOF partnership interest or qualifying QOF stock of a QOF S corporation may make an election to exclude from gross income some or all of the capital gain from the disposition of QOZ Property reported on Schedule K-1 of such entity, provided the disposition occurs after the taxpayer’s 10-year holding period.

Methods for Valuing Property of a QOF or QOZ Business – Taxpayers are provided with two methods for purposes of valuing assets for the 90% and substantially all tests. A QOF or QOZ business with an applicable financial statement (AFS) may utilize the value reported in the AFS. Alternatively, a QOF or QOZ business may use the initial present value of leases for leased assets and the unadjusted cost basis for all other assets under an alternative valuation method.

Transfers by Reason of Death – Neither a transfer of a QOF interest to a deceased owner’s estate nor the distribution by the estate to the decedent’s legatee or heir is an inclusion event that would trigger recognition of the deferred gain. Similarly, neither the termination of grantor trust status by reason of the grantor’s death nor the distribution by that trust to a trust beneficiary by reason of the grantor’s death is an inclusion event.

Effective Date – The New Proposed Regulations generally apply to tax years ending after the date the final regulations are published in the Federal Register, but taxpayers may rely on the rules prior to finalization if they apply the proposed rules consistently and in their entirety. This reliance does not apply to rules on the election to adjust the basis in a qualifying investment in a QOF or certain eligible property held by the QOF (i.e., the Special Election discussed above), which are applicable on January 1, 2028.

The Takeaway

The New Proposed Regulations provide significant guidance on the operation of QOFs and QOZ businesses and offer important details for QOF investors. Additional data collection and reporting requirements were among items absent from the New Proposed Regulations, but these are expected to be addressed in future guidance. Treasury and IRS are still requesting comments on specific items.

If you have any questions, please contact your Andersen advisor.