Land of Tax Opportunity Zones II
Treasury Issues Second Set of Proposed Regulations for the Implementation of Opportunity Zone Program
On April 17, 2019, the Treasury Department released a comprehensive second set of proposed regulations (the “Second Proposed Regulations”) for the implementation of the special tax regime applicable to investments in qualified opportunity zones (the “Opportunity Zone Program”). These Second Proposed Regulations supplement and, in certain cases, override the initial set of proposed regulations issued on October 19, 2018 (the “Initial Proposed Regulations”) for the implementation of the rules relating to the Opportunity Zone Program contained in Section 1400Z-2 of the Internal Revenue Code (the “Code”). See our earlier coverage of the Initial Proposed Regulations here.
While the Second Proposed Regulations do not answer all outstanding issues, together with the Initial Proposed Regulations they do provide meaningful guidance and additional flexibility for the implementation of the Opportunity Zone Program. It is expected that both sets of regulations will be finalized together and industry participants and practitioners hope that these regulations will help finally unlock the economic growth anticipated by Government officials when the Opportunity Zone Program was introduced as part of the 2017 Tax Cut and Jobs Act.
As described in our earlier coverage, the Opportunity Zone Program is intended to spur economic development in population census tracts (mostly low-income tracts) nominated by governors and certified by Treasury (each, an “Opportunity Zone”) in exchange for significant U.S. federal income tax benefits.
The program generally allows taxpayers to defer tax with respect to capital gains from sales to unrelated persons to the extent proceeds are reinvested into one or more qualified opportunity funds (“Opportunity Fund”) within 180 days of the recognition of such gain. Under the Opportunity Zone Program, the gain is deferred until the earlier of the disposition of the underlying qualified investment and December 31, 2026. If the interest in the Opportunity Fund is held for at least five years, the taxpayer is entitled to permanently exclude 10% of the initial gain and if the interest is held for at least seven years, 15% of the initial gain is permanently excluded. In addition, if the taxpayer holds the interest in the Opportunity Fund for at least ten years, any appreciation in the Opportunity Fund is generally exempt from U.S. federal income tax (the “10-Year Exemption”).
For these purposes, an Opportunity Fund must, among other requirements, hold at least 90% of its assets (the “90% Asset Test”) in qualified opportunity zone property which include an interest in other entities that are treated as “qualified opportunity zone businesses” (“Opportunity Zone Business”). At least 50% of the gross income of an Opportunity Zone Business (i.e., an entity in which an Opportunity Fund invests) must derive from the active conduct of a trade or business in an Opportunity Zone. In addition, “substantially all” of the tangible property owned or leased by the trade or business of such Opportunity Zone Business must be in “qualified opportunity zone business property” (“Opportunity Zone Business Property”). Pursuant to the Initial Proposed Regulations, such “substantially all” requirement is generally satisfied if at least 70% of the entity’s tangible property is comprised of qualified opportunity zone property. To qualify as Opportunity Zone Business Property, among other things, the original use of the subject property must generally commence with the Opportunity Fund or such property must be “substantially improved” by the Opportunity Fund (generally requires capital expenditures that exceed the initial tax basis of such property made within 30 months from the acquisition thereof). An Opportunity Zone Business is also limited in its ability to hold “nonqualified financial property.” The Initial Proposed Regulations provided a safe harbor for reasonable amounts of working capital held in cash, cash equivalents, or debt instruments with a term of 18 months or less provided that certain conditions were satisfied, including that such amounts be expended within 31 months of receipt.
Additional Insights Under Second Proposed Regulations
Following is a brief summary of certain additional insights provided by the Second Proposed Regulations.
The Second Proposed Regulations provide that, in testing the use of Opportunity Zone Business Property, the term “substantially all” means 70%. With respect to owned or leased tangible property, the Initial Proposed Regulations provide for a similar 70% requirement in determining whether an Opportunity Fund or an Opportunity Zone Business has used “substantially all” of such tangible property.
The Treasury Department determined that a higher threshold is necessary in the holding period context to preserve the integrity of the rules. Accordingly, the Second Proposed Regulations provide that the term “substantially all” as used in the holding period context of the Opportunity Zone Program is defined as 90%.
Original Use and Substantial Improvement
The Second Proposed Regulations clarify that the “original use” of tangible property generally commences when such property is first placed in service for purposes of depreciation. Used tangible property (for which another taxpayer previously claimed depreciation) will satisfy the “original use” requirement of the Opportunity Zone Program if the property has not been previously used within an Opportunity Zone. The use of a building or other tangible property that has been vacant (unused) for at least five years in an Opportunity Zone will be considered to meet the “original use” requirement.
Consistent with the Revenue Ruling that accompanied the Initial Proposed Regulations, the Second Proposed Regulations provide that land itself is generally not subject to the “substantial improvement” requirement, subject to the following limitation. An Opportunity Fund may not rely on such rule if unimproved land is purchased with intent not to improve the land by more than an insubstantial amount within 30 months. In addition, a general anti-abuse rule that is included in the Second Proposed Regulations may apply if the Opportunity Fund does not invest new capital into, or increase any economic activity or output of, such unimproved land.
Leases of Tangible Property
The Second Proposed Regulations contain specific rules applicable to leased tangible property intended to qualify as Opportunity Zone Business Property. Unlike tangible property, the Qualified Opportunity Program does not require leased tangible property to be acquired from a lessor that is unrelated. However, in general, each such lease must be entered into after December 31, 2017, and the terms of the lease must be market rate (as of the time the lease was entered into). In the case of leased real property, upon entering into the lease, there may not be a plan for the Opportunity Fund to purchase the real property, other than for the fair market value of the real property at the time of purchase without regard to any prior lease payments.
As a general matter, leased property is not subject to the “substantial improvement” or the “original use” requirements. However, in cases involving “related parties,” additional limitations apply. First, the lessee may not make any prepayment in connection with the lease relating to a period of the property’s use that exceeds 12 months. Second, if the original use of such property in the Opportunity Zone does not commence with the lessee, the lessee must become the owner of tangible property that is an Opportunity Zone Business Property at least equal to the value of the leased property within 30 months of taking possession of the leased property, and there must be substantial overlap of the Opportunity Zones in which the acquired and leased property are used. Finally, the Second Proposed Regulations include an anti-abuse rule to prevent the use of leases to circumvent the substantial improvement requirement for purchases of real property (other than unimproved land).
The Second Proposed Regulations provide methodologies for valuing leased tangible property for purposes of satisfying the applicable 90-percent asset test and the “substantially all” requirement. In general, on an annual basis, leased tangible property may be valued using either an applicable financial statement valuation method or an alternative valuation method as further set forth in the Second Proposed Regulations. Once elected with respect to a given taxable year, such valuation method must be applied consistently to all leased tangible property valued with respect to such taxable year.
Active Conduct of a Trade or Business
The Second Proposed Regulations establish three alternative safe harbors for purposes of determining whether at least 50% of the gross income of an Opportunity Zone Business is derived from the active conduct of a trade or business within an Opportunity Zone. The first safe harbor is satisfied if at least 50% of the services performed (based on hours) for such business by its employees and independent contractors (and employees of independent contractors) is performed within the Opportunity Zone. The second safe harbor is satisfied if such 50% test is met measured by the amounts paid for the services performed. The third safe harbor is satisfied if (1) the tangible property of the business located in an Opportunity Zone and (2) the management or operational functions performed for the business in the Opportunity Zone are each necessary to generate 50% of the gross income of the trade or business.
The term active conduct of a trade or business is generally not defined in the Second Proposed Regulations (rather referring to the meaning of that phrase under Section 162(m) of the Code), except they do provide that the ownership and operation (including leasing) of real property is treated as the active conduct of a trade or business for purposes of the Opportunity Zone Program. However, the Second Proposed Regulations clarify that merely entering into a triple-net-lease with respect to real property owned by a taxpayer, however, is not the active conduct of a trade or business for these purposes.
The Second Proposed Regulations make two helpful changes to the working capital safe harbor provided under the Initial Proposed Regulations. First, the written designation for planned use of working capital now includes the development of a trade or business in the Opportunity Zone as well as acquisition, construction, and/or substantial improvement of tangible property. Second, exceeding the 31-month period does not violate the safe harbor if the delay is attributable to waiting for government action the application for which is completed during the 31-month period.
Interplay with Section 1231 Gain
Pursuant to the Second Proposed Regulations only the net amount of gains from the disposition of Section 1231 property (i.e., in excess of any losses) is eligible for the benefits of the Opportunity Zone Program. Such net gain is deemed to be realized on the last day of the taxable year and accordingly the 180-day period by which gain must be reinvested in an Opportunity Fund begins on the last day of the taxpayer’s taxable year.
90% Asset Test
As mentioned above, an Opportunity Fund must meet a 90% Asset Test. For purposes of that test, the Second Proposed Regulations permit an Opportunity Fund to exclude for 6 months any capital contributions held in cash, cash equivalents, or debt instruments with a term of 18 months or less. The Second Proposed Regulations also permit proceeds from a sale or disposition of an Opportunity Zone Property to be treated as Qualified Opportunity Zone Property for purposes of the 90% Asset Test if the Opportunity Fund reinvests the proceeds within the 12-month period following the sale or disposition, and the proceeds are held in cash, cash equivalents, or debt instruments with a term of 18 months or less. A delay in reinvestment of such proceeds while waiting for governmental action will not cause a failure of the 12-month requirement.
Investment Amount; Disguised Sale
The Second Proposed Regulations clarify that a taxpayer may obtain the benefits of the Opportunity Zone Program through the investment of cash or property in the Opportunity Fund. In a non-recognition contribution of property to an Opportunity Fund, the amount invested equals the lesser of the taxpayer’s adjusted basis in the equity received in the transaction and the fair market value of the equity received in the transaction (both as determined immediately after the transaction). In the case of a contribution to an Opportunity Fund that is treated as a partnership, the basis in the equity received is determined without regard to any partnership liabilities allocated to the taxpayer under the provisions of Section 752 of the Code.
A taxpayer may also purchase an interest in an Opportunity Fund from another investor. In such case, the investing taxpayer is treated as making an investment in an amount equal to the amount paid for the interest. In all cases, the amount eligible for the benefits of the Opportunity Zone Program is limited to the amount of gain that may be deferred.
Taxable dispositions of property to an Opportunity Fund in exchange for an interest in such Opportunity Fund are specifically treated as qualifying transfers. The Second Proposed Regulations provide, however, that to the extent a distribution to an investor in an Opportunity Fund would be treated as a disguised sale under existing partnership tax rules (with certain modifications), the investor’s eligible investment in the Opportunity Fund that is entitled to the benefits of the Opportunity Zone Program will be reduced to the extent re-characterized as a sale.
A non-recognition contribution of property that has a fair market value in excess of the property’s adjusted basis, results in a mixed-funds investment. Similarly, mixed-funds investment will result if the amount of the investment that might otherwise support an election exceeds the amount of the taxpayer’s eligible gain.
Carried Interest in an Opportunity Fund Not Entitled to Benefits of Opportunity Zone Program
The Second Proposed Regulations clarify that the share of gain attributable to the service component of an interest (e.g., a “carried interest” or “promote”) in an Opportunity Fund classified as a partnership is not eligible for the benefits of the Opportunity Zone program.
The Second Proposed Regulations require the inclusion of all or part of deferred gain upon the occurrence of an inclusion event. Subject to certain exceptions, an inclusion event generally occurs when an investment in an Opportunity Fund is transferred in a transaction that (1) reduces the taxpayer’s equity interest in the Opportunity Fund or (2) involves the receipt of property (including cash) in a transaction that is treated as a distribution for U.S. federal income tax purposes.
The Second Proposed Regulations provide a nonexclusive list of inclusion events, including taxable dispositions of direct or indirect interest in Opportunity Funds, certain distributions in excess of basis and certain redemptions of stock and liquidating distributions from Opportunity Funds classified as corporations for U.S. federal income tax purposes.
A non-recognition contribution of an interest in an Opportunity Fund classified as a partnership to another entity classified as a partnership generally will not result in an inclusion event (and the taxpayer’s holding period for purposes of the 10-Year Exemption will continue). Distributions from an Opportunity Fund classified as a partnership generally are not treated as inclusion events unless the amount distributed exceeds the taxpayer’s basis (including allocable debt) in its partnership interest (subject to the special disguised sale rules briefly mentioned above). Similarly, distributions treated as dividends or as returns of capital from Opportunity Funds that are C corporations generally are not treated as inclusion events. A transfer of an interest in an Opportunity Fund by gift generally is an inclusion event, but a transfer of an interest in an Opportunity Fund by reason of the taxpayer’s death generally is not an inclusion event.
The amount of deferred gain recognized upon an inclusion event generally is the lesser of (a) the fair market value of the portion of the Opportunity Fund sold or (b) a proportionate amount of the remaining deferred gain, over the taxpayer’s basis for the interest sold. A special rule for partnerships requires a different calculation based on the percentage of the interest in the Opportunity Fund that was sold.
Special Rules for Opportunity Funds Classified as Partnerships, S Corporations and REITs
The Proposed Regulations clarify that sales or dispositions of assets by an Opportunity Fund will not impact investors’ holding periods in their qualifying investments. A taxpayer that is the direct holder of an interest in an Opportunity Fund treated as a partnership or an S corporation may elect to exclude from gross income some or all of the taxpayer’s distributive share of certain capital gain arising from the disposition of Opportunity Zone Property reported on such taxpayer’s Schedule K-1 under the 10-Year Exemption (provided such disposition occurs after the 10-year anniversary of the taxpayer’s acquisition of its interest in the Opportunity Fund). Such election by its terms only applies to capital gains and not gains from the sale that are taxed as ordinary income.
A similar rule allows Opportunity Funds that are real estate investment trusts (“REITs”) for U.S. federal income tax purposes, to designate capital gain dividends attributable to long-term gains from the sale of Opportunity Zone Property and to allow qualifying shareholders who have held the stock in such Opportunity Fund REIT for the applicable 10-year period, to exclude such gain under the 10-Year Exemption.
The Preamble to the Second Proposed Regulations acknowledges that the policy goals of the consolidated return regulations and the Opportunity Zone Program conflict and that, rather than attempt to resolve such conflict, the IRS and Treasury have elected to exclude an Opportunity Fund classified as a corporation for U.S. federal income tax purposes from being a member of a consolidated group for purposes of the consolidated return regulations. Accordingly, an Opportunity Fund may be the common parent of a consolidated group but may not be a subsidiary member of a consolidated group. The Second Proposed Regulations provide that the same member of a consolidated group must both engage in the sale of a capital asset giving rise to gain and make the corresponding investment in an Opportunity Fund. The tax benefits recognized by a member of a consolidated group as a result of an investment in an Opportunity Fund generally will “tier up” to other members of the consolidated group by increasing the basis of the stock in the consolidated group member holding interests in an Opportunity Fund.
The Second Proposed Regulations include a general anti-abuse rule allowing the IRS to recast a transaction (or series of transactions) such that it would not qualify for the benefits of the Opportunity Zone Program if a significant purpose of the transaction (or series of transactions) is to achieve a tax result that is inconsistent with the statutory purposes of such program.