QOZ Final Rules Part III: Additional Clarity for QOF and QOZ Business Qualifications
In this third installment of our series, we will discuss the new details provided to taxpayers regarding various tests to be met to qualify as a Qualified Opportunity Fund (QOF) and Qualified Opportunity Zone Business (QOZ Business). Some of these provide welcome clarity or flexibility to qualifying, but one places a new restriction on QOZ Business operations.
Triple Net Leases as Active Trades or Businesses
The proposed regulations provided that, solely for the purposes of determining whether a trade or business qualified as a QOZ Business, the ownership and operation – including leasing – of real property qualifies as an active conduct of a trade or business. The proposed rules, however, also provided that merely entering into a triple net lease with respect to real property owned by a taxpayer does not constitute an active conduct of a trade or business by such taxpayer. The Treasury Department and the IRS determined that, solely for purposes of determining QOZ Business qualification, triple net leases constitute inappropriately passive activities similar to holding publicly-traded stock or securities.
In reality, simply requiring the lessee of property to pay for certain costs of maintaining the leased property does not prevent a QOZ Business owner from actively participating in the leasing of the property.
For example, a taxpayer may meaningfully participate in the management or operation of the trade or business of the lessee. Similarly, an obligation to maintain certain structural or operating systems of a building would qualify as a meaningful capital obligation, while obligations to provide cleaning or groundskeeping services would qualify as meaningful operating obligations. Moreover, under the case law in Section 162, a deduction is permitted for ordinary and necessary expenses paid or incurred in carrying on any trade or business related to a triple net lease if the landlord, or an employee, agent or contractor of the landlord, performs the services related to the taxes, maintenance, insurance and similar fees even though the landlord receives payment for these services from the tenant.
In general, the final regulations confirm that merely entering into a triple net lease with respect to real property owned by a taxpayer does not constitute the active conduct of a trade or business by such taxpayer. To illustrate the application of this rule, the final regulations set forth examples describing a triple net lease as a lease arrangement pursuant to which the tenant is responsible for all of the costs relating to the leased property (for example, paying all taxes, insurance and maintenance expenses), in addition to paying rent. In an instance in which the taxpayer’s sole business consists of a single triple net lease of a property, the final regulations confirm that the taxpayer does not carry out an active trade or business with respect to that property.
However, the Treasury Department and the IRS note that, in certain cases, a taxpayer that utilizes a triple net lease as part of the taxpayer’s leasing business could be treated as conducting an active trade or business. Accordingly, the final regulations provide an example in which a lessor leases a three-story mixed-use building to three tenants, each of whom rents a single floor. In that example, (i) the lessor leases one floor of the building under a triple net lease but leases the remaining two floors under leases that do not constitute triple net leases, and (ii) the employees of the lessor meaningfully participate in the management and operations of those two floors. As a result, the example provides that the lessor is treated as carrying out an active trade or business with respect to the entire leased building notwithstanding that part of the property was leased in a triple net basis.
Nevertheless, this still does not clarify whether the taxpayer would be carrying out an active trade or business if all three floors were leased under triple net terms but the taxpayer was actively involved in the management and operations of all three floors. Rather, it appears that the final regulations retain the concept that leasing a building pursuant to a triple net lease does not constitute an active trade or business, notwithstanding any meaningful participation in the management and operation of the building. The opposite may be argued but it's not clear whether such a position will hold water. Some investors may see this ambiguity as an opportunity, depending on their level of risk aversion.
Sin Business Prohibition Expanded
Code Section 1400Z-2 defines the term QOZ Business as a trade or business that, in addition to other requirements, is not a business described in Code Section 144(c)(6)(B) (commonly referred to as a sin business). Section 144(c)(6)(B) lists as a sin business any (i) private or commercial golf course, (ii) country club, (iii) massage parlor, (iv) hot tub facility, (v) suntan facility, (vi) racetrack or other facility used for gambling or (vii) a store the principal business of which is the sale of alcoholic beverages for consumption off premises.
Notably, this prohibition relates to the definitional requirements for a QOZ Business and not a QOF. The definitional requirements of a QOF do not include such a prohibition on directly operating any sin businesses.
Because Section 1400Z-2 explicitly prohibits QOZ Businesses from operating sin businesses but does not set forth a similar prohibition for QOFs, the final regulations do not extend the prohibition on sin businesses, an issue of statutory construction discussed previously in this blog series. However, the Treasury Department and the IRS have extended this prohibition as it relates to QOZ Businesses.
The Treasury Department and the IRS agree that Section 1400Z-2 does not explicitly prohibit a QOZ Business from leasing its property to a sin business. However, they have determined that the purpose of sin business prohibition is to prevent QOZ Businesses from operating sin businesses, which a QOZ Business nonetheless could carry out simply by leasing its property to a sin business. This situation seems like a good candidate for a related party rule. Yet the final regulations prohibit any QOZ Business from leasing more than "5 percent" of its property to a sin business to ensure that the purpose is effectuated. The "5 percent" de minimis threshold is intended to reduce the risk of a QOZ Business inadvertently violating the sin business prohibition.
Measurement of Use for the 70 Percent Use Test
For tangible property to qualify as QOZ Business property, during at least 90 percent of the QOZ Business's holding period of the property, substantially all of the use of that tangible property must be in the QOZ. The proposed regulations noted that the term "substantially all" means 70 percent and described the fraction used to determine this percentage. But they did not provide any guidance as to how such tangible property must be used in connection with the QOZ to be included in the numerator of that fraction.
The Treasury Department and the IRS determined that guidance regarding the meaning and application of the term “use” would be significantly helpful to taxpayers. As a result, the final regulations expand on this term and provide that tangible property of a trade or business is counted for purposes of satisfying the 70 percent use test (qualified tangible property) to the extent the tangible property is utilized in the QOZ in the performance of an activity of the trade or business that contributes to the generation of gross income for the trade or business.
In addition, many trades or businesses rely on delivery vehicles, construction equipment, service trucks and other types of mobile tangible property that operate both inside and outside a QOZ, or in multiple QOZs, to generate gross income. Previously, it was not clear how the 70 percent use test would be met for these types of mobile tangible property. To provide standards that more effectively respond to the day-to-day customary operation of trades or businesses, the final regulations set forth specific rules clarifying the application of the 70 percent use test to mobile tangible property.
For example, the final regulations provide a safe harbor for tangible property utilized in rendering services both inside and outside the geographic borders of a QOZ. Under this safe harbor, a limited amount of such tangible property may be excluded from the general time of use calculation underlying the 70 percent use test. Specifically, the safe harbor permits up to 20 percent of the tangible property of a trade or business to be treated as satisfying the 70 percent tangible property standard if the tangible property is utilized in activities both inside and outside of the geographic borders of a QOZ, and if (i) the trade or business has an office or other fixed location located within a QOZ (QOZ office), and (ii) the tangible property is operated by employees of the trade or business who regularly use a QOZ office in the course of carrying out their duties and are managed directly, actively and substantially on a day-to-day basis by one or more employees of the trade or business at a QOZ office. But the tangible property must not be operated exclusively outside of the geographic borders of a QOZ for a period longer than 14 consecutive days for the generation of gross income for the trade or business.
In addition, the final regulations provide a similar safe harbor for short-term leased tangible property. Under this rule, tangible property leased by a trade or business located within the geographic borders of a QOZ to a lessee that utilizes the tangible property at a location outside of a QOZ is qualified tangible property if the following two requirements are satisfied. First, consistent with the normal, usual or customary conduct of the trade or business, the tangible property must be parked or otherwise stored at a location within a QOZ when the tangible property is not subject to a lease to a customer of the trade or business. Second, the lease duration of the tangible property (including any extensions) must not exceed 30 consecutive days.
Buildings Located on Brownfield Sites as Original Use Property
The final regulations also incorporate new rules regarding brownfield site redevelopment. A brownfield site comprises “real property, the expansion, redevelopment, or reuse of which may be complicated by the presence or potential presence of a hazardous substance, pollutant, or contaminant.” The Environmental Protection Agency has defined these sites as “abandoned, idled or under-used industrial and commercial facilities where expansion or redevelopment is complicated by real or perceived environmental contamination.” Cleaning up and reinvesting in these properties increases local tax bases, facilitates job growth, utilizes existing infrastructure, takes development pressures off from undeveloped, open land, and both improves and protects the environment.
Specifically, the final regulations provide that all real property composing a brownfield site, including land and structures located thereon, will be treated as satisfying the original use requirement if, within a reasonable period, investments are made to ensure that all property composing the brownfield site meets basic safety standards for human health and the environment. The final regulations also make clear that remediation of contaminated land is taken into account for determining if the land has been more than minimally improved, and that the QOF or QOZ Business must make investments into the brownfield site to improve its safety and environmental standards.
Substantial Improvement: Aggregation of Property for Calculation
In the May 2019 proposed regulations, the Treasury Department and the IRS requested comments regarding the relative strengths and weakness of determining whether tangible property meets the substantial improvement test based on an asset-by-asset approach, as compared to asset aggregation and similar approaches. Many commenters requested that the final regulations adopt an aggregate approach to determining substantial improvement, or otherwise permit taxpayers to elect such an approach. Similarly, other commenters requested that the final regulations permit asset aggregation based on (i) asset location within a QOZ, or (ii) whether the assets were acquired as part of the same transaction or business decision. In contrast, a commenter suggested that the final regulations adopt an approach similar to an integrated unit approach that treats two or more buildings or structures on a single tract or parcel (or contiguous tracts or parcels) of land that are operated as an integrated unit (as evidenced by their actual operation, management, financing and accounting) as a single item of property. The Treasury Department and the IRS also received several recommendations to retain the asset-by-asset approach set forth in the May 2019 proposed regulations.
Based on the strengths and weaknesses of each of these various approaches, the Treasury Department and the IRS have concluded that permitting asset aggregation to a limited extent is appropriate for carrying out substantial improvement determinations.
Accordingly, the final regulations set forth an asset aggregation approach for determining whether a non-original use asset (such as a preexisting building) has been substantially improved. Under the approach adopted by the final regulations, QOFs and QOZ Businesses can take into account purchased original use assets that otherwise would qualify as QOZ Business property if the purchased assets (i) are used in the same trade or business in the QOZ (or a contiguous QOZ) for which the non-original use asset is used, and (ii) improve the functionality of the non-original use assets in the same QOZ (or a contiguous QOZ).
Finally, if an eligible entity chooses to use this approach, the purchased property will not be treated as original use property, and instead, the basis of that purchased property will be taken into account in determining whether the additions to the basis of the non-original use property satisfy the substantial improvement test. For example, if a QOF purchases and intends to substantially improve a hotel, the QOF may include original use purchased assets in the basis of the purchased hotel to meet the substantial improvement requirement if those purchased assets are integrally linked to the functionality of the hotel business. These original use purchased assets could include mattresses, linens, furniture, electronic equipment or any other tangible property. However, for purposes of the substantial improvement requirement, the QOF may not include in the basis of that hotel an apartment building purchased by the QOF that is operated in a trade or business separate from the hotel business.
The final regulations also provide that, for purposes of applying the substantial improvement requirement, certain buildings can be aggregated and treated as a single item of property (single property). Specifically, with respect to two or more buildings located within a QOZ or a single series of contiguous QOZs (eligible building group) that are treated as a single property, the amount of basis required to be added to those buildings will equal the total amount of basis calculated by adding the basis of each such building comprising the single property and additions to the basis of each building comprising the single property are aggregated to determine satisfaction of the substantial improvement requirement.
To clarify which buildings may be treated as a single property, the final regulations address eligible building groups located entirely within a parcel of land described in a single deed, as well as groups spanning contiguous parcels of land described in separate deeds. First, a QOF or QOZ Business may treat all buildings that compose an eligible building group and that are located entirely within the geographic borders of a parcel of land described in a single deed as a single property. In addition, a QOF or QOZ Business may treat all buildings composing an eligible building group that are located entirely within the geographic borders of contiguous parcels of land described in separate deeds as a single property to the extent each building is operated as part of one or more trades or businesses that meet the following three requirements: (i) the buildings must be operated exclusively by the QOF or by the QOZ Business; (ii) the buildings must share facilities or share significant centralized business elements, such as personnel, accounting, legal, manufacturing, purchasing, human resources or information technology resources; and (iii) the buildings must be operated in coordination with, or reliance upon, one or more of the trades or businesses (for example, supply chain interdependencies or mixed-use facilities).
Cure Periods and Reasonable Cause Relief
No relief is available to a QOF that discovered that the entity in which it invested failed to qualify as a QOZ Business. The 90 percent investment standard poses a high threshold with severe consequences for a trade or business that failed to qualify as a QOZ Business for a testing date.
The Treasury Department and the IRS agree that entities should be afforded appropriate relief to cure a defect that prevents qualification as a QOZ Business for purposes of the 90 percent QOZ property holding period, without penalty to the investing QOF. Accordingly, the final regulations provide a six-month period for an entity in which a QOF has invested to cure a defect that caused the entity to fail to qualify as a QOZ Business. The six-month cure period corresponds to the testing periods for both the QOZ Business and the QOF. The final regulations provide that during that six-month cure period, the QOF can treat the interest held in the entity as QOZ property. Upon the conclusion of the six-month cure period, if the entity again fails to qualify as a QOZ Business, the QOF must determine if the QOF meets the 90 percnet investment standard, taking into account its ownership in the non-qualifying entity. If the QOF fails to meet the 90 percent investment standard, the final regulations provide that the QOF must determine the penalty applicable to each month in which the QOF failed to meet the 90 percent investment standard, including each month during and prior to the six-month cure period. Lastly, a QOZ Business can utilize a six-month cure period only once. However, in addition to this six-month cure period, a QOF can assert a defense to these penalties if the QOF shows that such failure is due to reasonable cause.
Part IV Preview
In the last installment of this series, we will focus on how the final regulations improve the ability of investors to divest of their interests in their QOZ investments.