The Opportunity Zone legislation went into effect on January 1, 2018, but parameters of the program weren’t fully articulated – prompting multiple rounds of additional guidance from the Department of the Treasury (“Treasury”). The first set of proposed regulations, released on October 19, 2018, addressed many critical gating issues for investors wanting to roll their capital gains into Qualified Opportunity Funds and access the associated tax benefits of the Opportunity Zone legislation.
The second set of guidance released on April 17, 2019, provides clarity on many of the operational aspects of Qualified Opportunity Funds – especially regarding the deployment of capital into Qualified Opportunity Zone real estate and operating businesses.
Given both the density of information and the broad nature of topics covered in the 169 pages of new proposed regulations, we have broken our summary of critical new guidance into two categories:
- Guidance that our team was tracking for the Fundrise Opportunity Fund.
- Other important clarifications and guidance for the success of Opportunity Zones.
Guidance Tracked by Fundrise
Qualified Opportunity Funds (“QOFs”) are required to have at least 90% of their assets invested in Qualified Opportunity Zone Property (“QOZ Property”), subject to semi-annual testing. In general, cash is not a qualifying asset unless it is part of a Qualified Opportunity Zone Business’s (“QOZB”) working capital plan. As a result, prior to the latest guidance, an investment in a QOF shortly before a testing date could have created a situation where a QOF would not meet the 90% asset test.
To help mitigate capital deployment issues, the new guidance provides that a QOF has up to 6 months to invest new capital for the purposes of the 90% asset testing requirements. In other words, the regulations now allow a ramp-up period at the QOF and QOZB level.
It should be noted that the proposed regulations again implied that failure to meet the 90% asset test on a testing date will not ordinarily cause the fund to lose its QOF classification, but only give rise to penalties. Further guidance on such penalties is expected in the third tranche of regulations (if any) or other communication from Treasury.
The new proposed regulations address the ability for a QOF to buy and sell assets over the course of the investor’s holding period. In general, the sales proceeds related to the sale of QOZ Property will be a qualifying asset for the purposes of the 90% asset test so long as the proceeds are reinvested into QOZ Property within 12 months of the sale. The reinvestment by the QOF should have no impact on a QOF investor’s holding period. But it should be noted that the ability to reinvest proceeds does not prevent the QOF from recognizing capital gain income associated with a sale.
This round of guidance is the first to specifically address QOFs that have elected or intend to elect Real Estate Investment Trusts (“REIT”) status for US federal income tax purposes. Capital gain dividends paid to a REIT shareholder who has held their Qualified Opportunity Fund Real Estate Investment Trust (“QOF REIT”) investment for at least 10 years may benefit from a zero percent tax rate applied to those capital gain dividends. This means that there is a clear exit strategy for REITs to sell assets after the 10-year hold period, without triggering capital gains tax for QOF investors. The ability for a QOF REIT to sell assets piecemeal and over time will help allow for the maximization of asset disposition proceeds.
The initial formation of the working capital provision only allowed for the acquisition, construction, and/or substantial improvement of tangible property, which left many QOZBs unable to benefit from this safe harbor. The new proposed regulations add “the development of a trade or business” to that list of qualifying activities for the written working capital plan.
In addition, the new guidance provides some clarity surrounding the application of the 31-month period stipulation. While the first round of proposed regulations alluded to the ability to have several working capital plans in the provided example, the regulations did not explicitly state that as fact. The new guidance states that businesses can benefit from multiple overlapping or sequential working capital plans, as long as each plan meets the requirements outlined under the safe harbor rules.
Lastly, the new guidance clarifies that an inability to meet the 31-month timeline due to government action delays (such as permitting issues) would not be considered a failure of the working capital safe harbor provision. This exception provides major relief to QOFs who want to develop and rehabilitate real estate but have concerns about the potential for delays caused by permitting issues outside of their control.
Important clarification was also provided regarding the requirements of methodologies QOZs may use to report the value their assets for their compliance with the 90% asset test and 70% tangible property test. The original proposed regulations had required that QOFs with “applicable financial statements” were required to use that financial statement valuation method for the purposes of valuing QOZ Property. The updated guidance provides that QOFs may only use the applicable financial statement valuation if the financial statements are prepared according to US generally accepted accounting principles (“GAAP”).
QOFs may now also elect to use an alternative valuation method for compliance tests, which would generally use the unadjusted cost basis of the assets. This flexibility in valuation method will help prevent QOFs from the unintended consequences of certain GAAP nuances, such as impairment rules, changing the components of the 90% asset test.
As you may recall, the original Opportunity Zone legislation dictated that in order to be considered qualified Opportunity Zone Business Property, “the original use of such property in the Qualified Opportunity Zone commences with the Qualified Opportunity Fund or the Qualified Opportunity Fund substantially improves the property.” Some additional clarity on the definition of “original use” is included in this latest round of regulations.
The IRS has now clarified that “original use” will commence on the date in which the property is “placed in service” in the Qualified Opportunity Zone (“QOZ”). This provision generally points to when the asset is first depreciated as an indication of placed in service.
Nonetheless, an exception to the new original use language is extended to buildings or other structures that have been vacant for at least 5 years prior to the acquisition by the QOF. The purchased vacant structure will instead qualify for original use and will not need to be substantially improved.
The first round of proposed regulations left some practitioners questioning whether rental real estate activities would qualify as an active trade or business for the purposes of the 50% gross income requirement. The second round of proposed regulations addresses rental activities by stating that ownership and operation of real property (including leasing) qualifies as an active trade or business. Nonetheless, the new guidance explicitly states that triple net leases do not rise to the level of an active trade or business.
Other Important Guidance
The previous round of guidance imposed a requirement that 50% of the gross income of a QOZB must derive from the active conduct of a trade or business within the QOZ. Many worried that the sourcing requirement was restrictive to types of businesses that could qualify under the Opportunity Zone program, which was not the intent of the legislation.
Arguably one of the biggest gating issues for businesses, Treasury provided three safe harbors and a facts and circumstances test to help clearly outline if business income is derived from the active conduct of a trade or business in an Opportunity Zone:
- At least 50% of the services performed by employees (based on hours) are performed in a QOZ.
- At least 50% of the amounts paid for services are for services performed by employees in the QOZ.
- At least 50% of the tangible property and management or operational functions performed are in the QOZ.
These new safe harbors vastly expand the number and types of business that may qualify as QOZBs, thereby increasing the incentive for businesses to establish themselves in QOZs and magnifying the economic impact of the Opportunity Zone legislation.
The first round of regulations unintentionally excluded leased property as QOZ Property. The latest guidance provides that leased tangible property may qualify as QOZ for the 90% asset test and the 70% substantially all requirement, subject to some related party restrictions. This means that both a QOF and a QOZB may meet Opportunity Zone testing requirements with the use of leased property.
In the original statute, there were many references to “substantially all” that were not defined. The first round of guidance dictated a 70% threshold for determining whether substantially all of a QOZB’s tangible assets are located in a QOZ. The IRS requested feedback on this threshold, and due to overwhelming comments, the threshold was not changed in the second round of proposed regulations.
Treasury went on to define substantially all as 90% when used to measure a QOF’s holding period of tangible property as QOZB property, or an interest in a business as a qualified OZ partnership interest or qualified OZ stock, and 90% to measure the holding period of QOZB’s tangible property as QOZ Property.
Prior to this new guidance, there were many unanswered questions surrounding the application of Opportunity Zone legislation to land. The original proposed regulations had provided that original use can never commence with land, and that land did not need to be substantially improved along with structural improvements.
The second round of proposed regulations further clarified that land does not need to be improved; however, land is only a qualifying asset for the purposes of the 90% asset test if the land is being used in a trade or business. The preamble explicitly addresses that land held for investment does not give rise to a trade or business and is not a qualifying asset.
A QOF must either have its QOZ Property’s original use commence with the QOF, or the QOF or QOZB must substantially improve the property. Property is substantially improved if, within a 30-month period beginning after the acquisition of the property, additions to basis exceed the adjusted basis of the property at the beginning of the 30-month period. As noted above, in the instance of real estate, only the value of the building (and not the land) must be doubled.
Many commenters requested that the substantial improvement requirement should be met on an aggregate basis, and that each specific asset not have to be substantially improved. While the aggregate basis could be advantageous for a QOZB with a parcel of land with multiple buildings, it could also help an operating business with multiple pieces of machinery. However, the preamble to the proposed regulations states that the substantial improvement test should be applied on an asset-by-asset basis.
That said, Treasury signaled that they are still considering applying an aggregate standard for substantial improvement and requested comments regarding the advantages and disadvantages of aggregation.
In the proposed regulations, the IRS defined what constitutes a qualifying investment in a QOF, stating that the acquisition of a QOF interest may be made by the contribution of property other than cash. It was further clarified that an interest in a QOF may be purchased from an investor in a QOF, and does not have to be directly purchased from the QOF. Additionally, interest in a QOF received in exchange for services (like carried interest) will not qualify for the tax benefits of the statute. Finally, the IRS clarified that QOF interests received as a transfer upon death may retain tax benefits.
In a perfect world, the Opportunity Zone census tracts would directly correlate to how land parcels are mapped. Unfortunately, that’s not the case, and QOF’s have been unsure how to handle real property that is both inside and outside of a QOZ. The second round of regulations included a new provision stating that where the amount of real property (based on square footage) inside the Opportunity Zone is substantial as compared to the amount outside of the Opportunity Zone, and the property outside of the Opportunity Zone is contiguous to that inside, then the entire real property would be deemed to be within the Opportunity Zone. Real property located within the QOZ is considered substantial if the unadjusted cost of the real property inside a QOZ is greater than the unadjusted cost of real property outside of the QOZ.
While the first round of regulations clarified that only capital gains qualified for the deferral benefits offered by the Opportunity Zone legislation, the new regulations provide additional clarity with respect to section 1231 gains. Section 1231 gains must be netted with section 1231 losses in order to determine the net gain amount which may be invested into a QOF. In addition, because the net gains related to section 1231 property are determined on the last day of the taxable year, the 180-day period for investing these net gains also begins on the last day of the taxable year. This may impact the ability of some investors with section 1231 gains in 2019 to take full advantage of the tax benefits of the Opportunity Zone legislation.
According to the second round of proposed regulations, the proposed rules may be relied upon by individuals and fund managers prior to their finalization. A second public hearing on Opportunity Zones is scheduled for July 9, 2019, and we expect that this round of guidance will be finalized shortly thereafter.
Overall, the second set of proposed regulations address numerous open questions for investors and fund managers. The wide array of clarifications will likely spur investment into QOFs and bolster the success of the Opportunity Zone program.
As was expected, this set of proposed regulations did not address the ongoing reporting requirements of QOFs. Concurrent with the second set of proposed regulations, the IRS released a “Request for Information on the Data Collection and Tracking of Qualified Opportunity Zones” (“RFI”). The RFI solicits public comment on how best to measure the effectiveness of the Opportunity Zone legislation, and how to balance the costs and benefits of collecting information.
In order to better collect data on Opportunity Zones, the IRS announced two anticipated changes to tax Form 8996: the collection of EINs of QOZBs, and amounts invested in particular census tracts.
While the proposed regulations allow for the sale of assets before 10 years and the reinvestment of those proceeds within a 12-month timeline, the regulations suggest that interim gains, as a result of normal operations, will be subject to taxation. Treasury and the IRS have expressed concern that they do not have the authority to exempt interim gains from taxation and have requested comment from the public on examples of tax regulations that have exempted gain that would otherwise be considered taxable income.
The preamble to the second set of proposed regulations notes that Treasury and the IRS expect to address the handling of QOFs that fail to meet the 90% test, and possibly a couple of other minor issues.