INSIGHT: The Second Set of Proposed Opportunity Zone Regulations: Where Are We Now?—Part 1

On April 17, 2019, the Treasury Department issued a highly anticipated second set of proposed regulations on opportunity zones (the “2019 proposed regulations”). The opportunity zone (OZ) program has received significant national attention as an ambitious and generous tax incentive aimed at driving investment into the nation’s most distressed communities.

Although various forms of tax incentives have been available for years with respect to the economic development of low-income communities (e.g., LIHTC, NMTC, Enterprise Zones, etc.), there are many who believe that this program is the key to unlocking billions, perhaps trillions, of private capital, incentivizing its move into opportunity zone projects. Funds are being created and capital is being raised but much of that capital has been sitting on the sidelines waiting for a sufficient level of regulatory certainty around the rules. This has been particularly true in the context of capital waiting to be deployed into operating businesses in opportunity zones. The open issues, have, in many cases, made investment too risky.

This newest set of regulations brings much-needed clarity to critical questions with respect to the OZ program. The 2019 proposed regulations address a number of issues, including but not limited to:

• allowable qualifying investments in qualified opportunity funds (QOFs);
• the relevant definitions of “substantially all";
• the original use and substantial improvement tests;
• transactions that may trigger inclusion of previously deferred gain and the amount and timing of that gain;
• the treatment and valuation of leased property;
• the sourcing of income for purposes of the 50 percent of gross income test applicable to qualified opportunity zone businesses; and
• the definition of a “reasonable period” within which a fund may re-invest proceeds from the sale of an asset.

It is clear from these regulations that the government is trying to incentivize investment by broadening the tests and providing flexibility to investors with respect to the types of investments and projects that qualify.

As discussed more fully, below, there is at least one provision, however, that was much needed and was not included—a provision that would allow funds to sell assets without recognizing gain. This is a significant remaining issue and may require legislative action.

Quite significantly and similar to the first set of regulations, taxpayers are generally allowed to rely on most of this newest guidance in spite of the fact that it is merely proposed.

On Oct. 19, 2018, the IRS issued a first set of proposed regulations on opportunity zones (the “2018 proposed regulations”). The IRS contemporaneously issued Revenue Ruling 2018-29 that addressed the application of the original use and substantial improvement tests to the purchase of land with an existing building in an opportunity zone as well as a draft QOF self-certification form (Form 8996) and accompanying instructions.

Not surprisingly, the first set of proposed regulations left many unanswered questions with respect to the statutory language and the regulations themselves (along with the revenue ruling) created additional uncertainties. The IRS requested comments on a number of issues addressed in the 2018 proposed regulations. The IRS received a significant number of comment letters on the regulations, including extensive comments from the ABA Tax Section and the NYSBA Tax Section, and held a hearing on the 2018 proposed regulations on Feb. 14, 2019. The 2019 proposed regulations do make some changes to the 2018 proposed regulations.

As helpful as it is to have additional guidance, there are still unanswered questions with respect to the opportunity zone rules—some of which relate to issues that have been initially addressed in regulations and some of which have not yet been tackled in regulatory guidance. In addition, as we analyze and apply this second set of proposed regulations there is no doubt that additional uncertainty will arise with respect to the guidance in these regulations.

The IRS is aware of the fact that not all of the questions inherent in this new program have been answered but they have indicated that other than issuing these two sets of regulations in final form, they may not issue another round of proposed regulations. They have stated that they plan to address administrative rules related to a qualified opportunity fund’s failure to comply with the program and a set of information reporting requirements.

Although we may not have fully fleshed out final rules on opportunity zones for quite some time, there is enough guidance available at this point for investors to structure transactions with a sufficient level of certainty that they meet the opportunity zone requirements.

This article assumes a basic knowledge of the opportunity zone rules as well as an understanding of the 2018 proposed regulations and focuses on the questions addressed in the recently issued second set of proposed regulations as well as the questions that remain unanswered.

This article does not cover every regulatory provision. In particular, with respect to the rules related to the computation of amounts invested in a QOF as well as inclusion events, the article focuses on QOF partnerships and Subchapter K rules.

TEN KEY TAKEAWAYS FROM THE 2019 PROPOSED REGULATIONS:

• The regulations provide much-needed guidance on investment in operating businesses; the income sourcing rules are generous and should be sufficient to qualify a number of different types of businesses; the working capital safe harbor has been extended to include the development of a trade or business.
• A taxpayer is able to invest cash or other property in a QOF.
• There is no substantial improvement test applicable to the purchase of unimproved land but the land has to be used in the active conduct of a trade or business; in addition a taxpayer is not allowed to rely on this rule if the land is unimproved or minimally improved and the QOF or qualified opportunity zone business (QOZB) purchased the land with an expectation, an intention, or a view not to improve the land more than an insubstantial amount within 30 months of the date of purchase.
• If a building has been vacant for five years it is able to qualify as original use property (does not need to be substantially improved).
• Subject to an anti-abuse rule applicable to all leases, leased property is qualified opportunity zone business property (QOZBP) as long as the lease is entered into after Dec. 31, 2017, the terms of the lease are market-rate, and during substantially all of the QOF’s holding period for the property, substantially all of the use of the property was in a QOZ.
• There is no prohibition on related party leases but these leases have to meet certain additional requirements.
• There was a lot of concern that the 31-month period in the first set of regulations would not be sufficient, especially in the context of projects that require extensive permitting and other types of governmental approvals. These regulations address that concern and allow for delays that are attributable to waiting periods for government action.
• The regulations generally allow a QOF partnership to make debt-financed distributions, subject to two limitations: first, if the investor has remaining deferred gain from a qualifying investment in the QOF, a distribution to that investor will trigger inclusion of that gain to the extent that the distribution exceeds the investor’s basis (which will include the investor’s share of QOF liabilities); in addition, if an investor receives a distribution from the QOF within the first two years of an investor’s contribution of cash or other property to the QOF, there are rules that could apply to re-characterize that original contribution as a non-qualifying investment (not subject to the OZ benefits).
• The regulations provide guidance on how a fund is able to reinvest proceeds resulting from a return of capital event or the sale or other disposition of QOZP. As long as the proceeds are reinvested in QOZP within 12 months, the proceeds are treated as qualified property. Unfortunately for investors, however, the regulations do not include a provision that would allow a QOF to sell assets without recognizing gain, so the sale is a taxable event; Treasury and the IRS did not feel that the statute gave them authority to provide for nonrecognition of gain. This is a significant remaining issue and may require legislative action.
• An investor who has held its QOF interest for at least 10 years is able to elect to exclude capital gain from gross income if that gain is reported on a Schedule K-1 from a QOF partnership or S corporation and is attributable to the QOF’s sale of QOZP; this rule goes a long way toward solving the exit issue that existed with respect to QOF partnerships and S corporations.

QUESTIONS THAT THE 2019 PROPOSED REGULATIONS ADDRESS:

Note that the 2018 proposed regulations defined an “eligible interest” as an equity interest issued by a QOF. The term “eligible interest” does not refer to an interest to which the OZ tax benefits apply. The 2019 proposed regulations provide that an eligible interest with respect to which a deferral election applies is a “qualifying investment” (an investment to which the OZ benefits apply). These regulations also refer to an interest in a QOF to which the OZ tax benefits apply as a “Section 1400Z-2(a)(1)(A) interest” in contrast to a “Section 1400Z-2(e)(1)(a)(ii) interest” which is an interest in a QOF to which the OZ benefits do not apply.

This article refers to an interest in a QOF to which the OZ tax benefits apply as a qualifying investment and a QOF interest to which the OZ tax benefits do not apply as a non-qualifying investment.

General Anti-Abuse Rule

What is the general anti-abuse rule applicable to OZ investments?

The 2019 proposed regulations add a general anti-abuse rule that requires the statutory and regulatory OZ rules to be applied in a manner consistent with the purposes of those rules. If a significant purpose of a transaction is to achieve a tax result that is inconsistent with the purposes of the OZ rules (based on all of the facts and circumstances), the IRS is able to recast the transaction (or series of transactions) for federal tax purposes in a manner that achieves tax results consistent with those purposes.

The Preamble to the 2019 proposed regulations describes the purposes of the OZ rules as follows:

“Sections 1400Z-1 and 1400Z-2 seek to encourage economic growth and investment in designated distressed communities (qualified opportunity zones) by providing federal income tax benefits to taxpayers who invest new capital in businesses located within qualified opportunity zones through a QOF.”

This general anti-abuse rule makes it clear that first and foremost, investment in an OZ needs to be structured in a way that comports with the intent of the program. As an example, there has been a lot of commentary regarding potential abuse of the holding in Rev. Rul. 2018-29. That ruling provides that if a taxpayer purchases land and an existing building, the land itself does not have to be separately “improved” and the basis in the land is not part of the basis that needs to be doubled in order to meet the substantial improvement test for the building. There are certainly facts and circumstances in which the revenue ruling can be applied in a way that could be considered abusive.

What if a taxpayer purchases land and an existing building for $4 million but $3,9 million is allocated to the land because it is a large, valuable tract and the “building” is a two-car garage on the edge of the land? What if the taxpayer spends another $100,000 to expand the garage? Technically, the taxpayer meets the requirements of the revenue ruling but it certainly seems counter to the intent behind the ruling as well as the intent behind the OZ program to allow this transaction to qualify. Of course, this is an extreme example and in this instance the taxpayer may well not meet the active trade or business requirement. However, the point is that the revenue ruling leaves open the important issue of the ratio of the value of the existing building to the land and whether there should be some minimum ratio required in order to apply the revenue ruling.

In navigating this issue and many of the other outstanding questions and issues that remain, the general anti-abuse rule should be considered and used as a general guideline.

Qualified Opportunity Fund (QOF) Investments

How do the OZ rules apply to the deferral of tax code Section 1231 gain?

Under the 2019 proposed regulations, the only Section 1231 gain that is eligible for deferral through investment in a QOF is capital gain net income.

Tax code Section 1231 applies to gains and losses on the sale or exchange of, among other things, non-inventory depreciable property and real property used in a trade or business and held for more than one year. If Section 1231 gains for the taxable year exceed Section 1231 losses for the taxable year, the net gains are treated as long-term capital gains, subject to a recapture rule. If Section 1231 losses exceed Section 1231 gains for the year, the net loss is treated as an ordinary loss. The proposed regulations provide that with respect to gain that arises from Section 1231 property, only capital gain net income can be deferred and the 180-day period for investment into a QOF begins on the last day of the taxable year.

Note that this rule treats Section 1231 items in a less favorable manner than other capital gains and losses, where the rules generally allow a taxpayer to defer gross capital gain, and carry forward capital losses.

Can a member of a consolidated group invest and defer gain that was realized by another member of the group?

No. The 2019 proposed regulations provide that the OZ rules apply separately to each member of a consolidated group. Thus, the same member of the group must realize the capital gain to be deferred and invest some or all of that gain in a QOF to qualify for the OZ tax benefits.

Is a taxpayer able to make a qualifying investment in a QOF by transferring property other than cash to the QOF?

Yes. A taxpayer can make a qualifying investment by transferring cash or other property to a QOF in exchange for an eligible interest (an equity interest) and this rule applies regardless of whether the transfer is a recognition or nonrecognition event. That is, a taxpayer could transfer the property to a QOF in a taxable transaction (e.g., a transfer to a QOF corporation as to which tax code Section 351 does not apply) or a nontaxable transaction (e.g., a contribution to a partnership to which tax code Section 721(a) applies) in exchange for an eligible interest.

If a taxpayer receives an eligible interest in a QOF in exchange for property other than cash, what is the amount of the taxpayer’s qualifying investment?

The answer to this question depends upon whether a taxpayer transfers property to a QOF in a carryover basis transaction (in whole or in part) or a taxable transaction. There are also special rules that apply when property is transferred to a QOF partnership.

Carryover Basis Transaction (Nonrecognition Transaction):

If property is transferred in a carryover basis transaction (e.g., a contribution to a QOF partnership under tax code Section 721(a)), the amount of the taxpayer’s qualifying investment for deferral purposes is equal to the lesser of (1) the taxpayer’s basis in the QOF investment without regard to the special zero basis rule in tax code Section 1400Z-2(b)(2)(B), or (2) the fair market value of the eligible interest received, both determined immediately after the contribution. This rule is applied separately to each piece of property contributed to the QOF. The taxpayer’s initial basis in the qualifying investment is zero (which preserves the deferred gain that is being deferred under the OZ rules).

If a taxpayer has realized gain to defer through investment in a QOF and contributes built-in gain property in exchange for a QOF interest equal to the fair market value of the contributed property, the taxpayer will end up with a mixed-funds investment (a qualifying investment and a non-qualifying investment).

Note: The language in the regulations with respect to the calculation of the amount of the non-qualifying investment (specifically Treasury Regulation Section 1400Z2-(1)(b)(10)(i)(B)(2)) appears to be inaccurate. The regulations provide that the amount of a taxpayer’s non-qualifying investment when the fair market value of the eligible interest received exceeds the taxpayer’s adjusted basis in that interest (without regard to the zero basis rule) is equal to the excess of the “fair market value of the investment to which Section 1400Z2-2(e)(1)(A)(i) applies over the taxpayer’s adjusted basis therein, determined without regard to section 1400Z-2(b)(2)(B).” The “investment to which Section 1400Z2-2(e)(1)(A)(i) applies” is the qualifying investment—this language would have you compute the difference between the fair market value of the taxpayer’s qualifying investment and the adjusted basis in that investment without the zero basis rule. That does not get you to the right place. The non-qualifying investment should be equal to the excess of the fair market value of the eligible interest received over the taxpayer’s adjusted basis in the interest without regard to the special zero basis rule in tax code Section 1400Z-2(b)(2)(B). In fact, this is the calculation used in Example 1 in the relevant section of the regulations. The calculation in the example does not match the language in Treas. Reg. Section 1400Z2-(1)(b)(10)(i)(B)(2).

The taxpayer’s basis in the non-qualifying investment is equal to the taxpayer’s basis in all QOF interests received without regard to the tax code Section 1400Z-2(b)(2)(B) zero basis rule, reduced by the basis of the taxpayer’s basis in the qualifying investment determined without regard to the tax code Section 1400Z-2(b)(2)(B) zero basis rule. Thus, if the transaction is a carryover basis transaction in whole, the taxpayer’s basis in the non-qualifying investment will also be zero (which is preserving the built-in gain that is not recognized on the contribution).

Example: On Jan. 15, 2019, Taxpayer A realizes $5 million of capital gain that it can defer through investment in a QOF. A also owns unencumbered Asset X with a fair market value of $10 million and an adjusted basis of $5 million. On June 1, 2019, A contributes Asset X to a QOF in exchange for an equity interest (an eligible interest) with a fair market value of $10 million. A’s basis in the QOF interest, without regard to the zero basis rule in tax code Section 1400Z-2 would be $5 million (a carryover basis). A’s investment is treated as an investment with mixed funds (two separate investments). A’s qualifying investment in the QOF (to which the OZ tax benefits apply) is $5 million. A’s basis in the qualifying investment is zero under tax code Section 1400Z-2(b)(2)(B)(i). A has a separate non-qualifying interest in the QOF equal to $5 million (the excess of the fair market value of the eligible QOF interest received ($10 million) over the taxpayer’s basis in that interest without regard to the zero basis rule ($5 million)). A’s basis in the non-qualifying interest is zero (A’s basis in all interests received without regard to the zero basis rule ($5 million) minus A’s basis in the qualifying investment but for the zero basis rule ($5 million)).

Note: Note that the example above uses the language and calculations in the regulation example and not in the regulation text to compute the non-qualifying investment. If the language in Treas. Reg. Section 1400Z2-(1)(b)(10)(i)(B)(2) is applied to this example, the non-qualifying investment is zero (the fair market value of the qualifying investment ($5 million) minus A’s basis in that interest but for the zero basis rules ($5 million)). That is not the right result.

In all cases, the amount of the qualifying investment is limited to the amount of gain that can be deferred under the tax code Section 1400Z-2(a)(1) election. So, if in the example above, A contributed Asset X to a QOF but only had $4 million of realized capital gain to defer through investment in a QOF, the qualifying investment in the QOF would be limited to $4 million. A would have a non-qualifying investment of $6 million with a basis of $1 million.

In addition, there is a special rule applicable to the transfer of built-in loss property in a transaction that is a nonrecognition transaction in whole or in part and to which tax code Section 362 applies. In that case the taxpayer is deemed to have made a Section 362(e)(2)(C) election (related to the transfer of built-in losses in a tax code Section 351 transaction).

Taxable Transaction:

If a taxpayer transfers property other than cash to a QOF in a taxable transaction, the amount of the qualifying investment in the QOF is the fair market value of the transferred property, determined immediately prior to the transfer. This rules applies separately to each piece of property transferred.

Example: On Jan. 15, 2019, Taxpayer A realizes $10 million of capital gain that it can defer through investment in a QOF. A also owns unencumbered Asset X with a fair market value of $10 million and an adjusted basis of $5 million. On June 1, 2019, A transfers Asset X to a QOF in a fully taxable transaction in exchange for an equity interest (an eligible interest) with a fair market value of $10 million. A’s qualifying investment in the QOF (to which the OZ tax benefits apply) is $10 million. A’s basis in that interest is initially zero.

Note that in this circumstance the taxpayer is not allowed to defer the $5 million of gain recognized on the transfer of the property to the QOF in exchange for an interest in the QOF.

Transfer of Property to a QOF Partnership:

Assuming that a transfer of property to a QOF partnership is eligible for a deferral election (e.g., it is not treated as a sale under tax code Section 707), the amount of a taxpayer’s qualifying investment is the lesser of (1) the taxpayer’s net basis (adjusted basis minus debt) in the property contributed, or (2) the net value (gross fair market value over debt) of the property contributed. The amount of the non-qualifying investment is the excess, if any, of the net value of the contribution over the amount treated as a qualifying investment.

The taxpayer’s basis in the qualifying investment (prior to application of the zero basis rule in tax code Section 1400Z-2(b)(2)(B)) is the net basis of the contributed property determined without regard to the zero basis rule or any share of debt under tax code Section 752. The basis in the non-qualifying investment (without regard to any share of debt under Section 752) is the remaining net basis. After Section 1400Z-2(b)(2)(B) is applied to the qualifying investment, the taxpayer’s basis in that interest will be zero, increased by the taxpayer’s share of any debt allocated to that investment. The basis in the non-qualifying investment will also be increased by the taxpayer’s share of debt allocated to that interest.

Note: The language in Treas. Reg. Section 1.1400Z2(a)-1(b)(10)(ii)(B)(4) could be easily misunderstood the way it is written. It states that a taxpayer’s basis in the qualifying investment “is the net basis of the property contributed, determined without regard to section 1400Z-2(b)(2)(B) or any share of debt under section 752(a).” However, it is important to understand that this determination of basis is only relevant for purposes of determining the basis in the non-qualifying investment. Once the basis in the non-qualifying investment is determined, the taxpayer applies tax code Section 1400Z-2(b)(2)(B) and takes an initial basis of zero in the qualifying interest, increased by any allocable share of debt under tax code Section 752(a).

Example (1): On Jan. 15, 2019, Taxpayer A realizes $5 million of capital gain that it can defer through investment in a QOF. A also owns unencumbered Asset X with a fair market value of $10 million and an adjusted basis of $5 million. On June 1, 2019, A contributes Asset X to a Partnership QOF in a transaction that is characterized as a contribution. The amount of A’s qualifying investment is $5 million (the lesser of A’s net basis in Asset X ($5) or the net value of Asset X ($10 million)). The non-qualifying investment is $5 million (the excess of net value ($10 million) over the qualifying investment ($5 million). For purposes of computing A’s basis in the non-qualifying investment, A’s basis in the qualifying investment is $5 million (net basis without regard to the zero basis rule). A’s basis in the non-qualifying investment is zero (net basis remaining). A’s basis in the qualifying investment after application of the zero basis rule is also zero.

Example (2): Assume the facts in Example (1) but also assume that Asset X is subject to $3 million of debt. A’s qualifying investment is $2 million (the lesser of $2 million net basis ($5 million minus $3 million) or $7 million net value ($10 million minus $3 million)). A’s nonqualifying investment is $5 million (excess of net value ($7 million) over amount treated as a qualifying investment ($2 million)). A’s basis in the qualifying investment is zero. For purposes of computing A’s basis in the non-qualifying investment, A’s basis in the qualifying investment is $2 million (net basis without regard to the zero basis rule or tax code Section 752(a)). A’s basis, without regard to Section 752(a) in the non-qualifying interest is zero (remaining net basis). After application of tax code Section 1400Z-2(b)(2)(B), A’s basis in the qualifying investment, without regard to Section 752(a) is also zero. A will increase its basis in each interest by its allocable share of the debt under Section 752(a). A will allocate its share of the debt under Section 752(a) between the two investments based on the relative capital contributions attributable to each (2/7 and 5/7).

Example (3): Assume the facts in Example (1) but also assume that Asset X is subject to $6 million of debt. A’s qualifying investment is zero (the lesser of zero net basis ($5 million minus $6 million, limited to zero) and $4 million net value ($10 million minus $6 million). The entire investment is a non-qualifying investment.

How do the tax code Section 707 disguised sale rules apply in the context of an investment in a QOF partnership?

The 2019 proposed regulations provide the following two rules with respect to tax code Section 707 (the disguised sale rules) and investments in QOF partnerships:

(1) First, if a contribution of property to a QOF partnership is characterized as something other than a contribution (e.g., a sale under the disguised sale rules), the transfer is not an investment eligible for the deferral election. This requires an analysis at the time of an investment of deferred gain in a QOF partnership to make certain the contribution is not a disguised sale under tax code Section 707.

(2) Second, assume that a taxpayer makes a contribution of property to a QOF partnership that is an investment for which a deferral election is available. Assume further that the partnership makes a distribution to the partner. If the contribution and distribution would be treated as a disguised sale if (a) any cash contributed is treated as non-cash and (b) in the case of a debt-financed distribution, the partner’s share of liabilities is zero, then the transfer to the partnership is not treated as an investment for which a deferral election could be made. In other words, upon any distribution from a QOF partnership, the distribute partner has to analyze its contribution to the partnership and the distribution under tax code Section 707 rules applying the assumptions in (a) and (b) above. This is more fully discussed in the context of debt-financed distributions, below.

Is a taxpayer able to make a qualifying investment in a QOF by providing services to the QOF? That is, do the OZ benefits apply to a carried interest (profits interest received in exchange for services)?

No. The regulations provide that if a taxpayer receives an interest in a QOF in exchange for services that the taxpayer provides to the QOF or a person in which the QOF holds any direct or indirect equity interest, the interest is not a qualifying investment—that is, it is not an interest to which the OZ tax benefits apply. It is, instead, an investment under tax code Section 1400Z-2(e)(1)(A)(ii). Thus, the OZ tax benefits do not apply to a carried interest in a QOF.

Is a taxpayer able to make a qualifying investment in a QOF by acquiring a QOF interest from someone other than the QOF?

Yes. A taxpayer is allowed to acquire an eligible interest in a QOF from another person for either cash or other property. The amount of the qualifying investment is the amount of cash, or the fair market value of the other property, as determined immediately before the exchange, that the taxpayer transferred in exchange for the eligible QOF interest. The amount of the qualifying investment is limited to the amount of gain that can be deferred under the tax code Section 1400Z-2(a)(1) election.

If a taxpayer transfers built-in gain property to an eligible taxpayer in exchange for an eligible interest in a QOF, any gain realized by the taxpayer on that transaction is not eligible for deferral through investment in a QOF.

This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.

Lisa is the Co-Chair of Buchanan, Ingersoll & Rooney’s Tax Section and the Co-Chair of its Opportunity Zones Practice Group. Her tax practice focuses on business tax planning with particular emphasis on pass-through taxation and real estate transactions.

The author wishes to thank Bruce Booken, co-chair of the Tax Section at Buchanan, Ingersoll & Rooney, for his review and insightful comments with respect to this article.

For a copy of the entire article as it appears in the Tax Management Memorandum, click here:

The Second Set of Proposed Opportunity Zone Regulations: Where Are We Now?