The final Qualified Opportunity Fund (QOF) regulations provide that a QOF, or a QOF’s Qualified Opportunity Zone Business (QOZB), that buys newly constructed real estate located in a Qualified Opportunity Zone (QOZ) from an unrelated builder, before the real estate was placed in service by that builder, can treat that purchased real estate as new property. See Treasury Regulation Section 1.1400Z2(d)-2(b)(3)(i)(D). Accordingly, the purchasing QOF or QOZB need not further substantially improve the purchased real estate in order for that real estate to favorably be treated as Qualified Opportunity Zone Business Property (QOZBP).
This rule can make feasible the creation of QOFs and QOZBs dedicated to buying from QOZ residential condominium developers their unsold inventory and renting out those condominiums. For example, if the condominium association documents and local law allows it, the QOF or QOZB could rent the condominiums on successive annual leases. After 10 years, the condominiums could be sold, without tax to the QOF investors on either the gain attributable to the cumulative depreciation, or on the gain attributable to post-purchase price appreciation. The QOF investors also could defer until 2026 the tax on their gain invested in the QOF, with a 10% possible reduction in the 2026 gain. To illustrate, a single individual with sufficient capital gains for the condominium down payment might form a wholly owned S corporate QOF to buy one or more newly constructed QOZ condominiums for rental. The principal issues in maintaining qualification of the QOF or QOZB buying the condominiums is ensuring that the condominiums are not previously placed in service by the builder, so that the QOF or QOZB is exempt from the requirement to substantially improve. The second principal issue is ensuring the QOF’s rental activity constitutes a Section 162 trade or business; and, for a QOZB, that such Section 162 rental trade or business is active.
Not Previously Placed in Service
Where a manufacturer of an aircraft or other personal property builds the property with the intent and expectation to sell it to customers in the ordinary course of business, and indeed does sell it to a customer, the IRS views the manufacturer as not having placed the equipment in service, and views the customer, not the manufacturer, as the first user. That is true even though the manufacturer may hypothetically have been able to rent the completed machinery before the actual sale. See Treasury Regulation Section 1.168(k)-1(b)(3)(ii)(B); Revenue Ruling 69-272; and Private Letter Ruling 200502004.
The same principle has been applied to real property. See Treas. Reg. Section 1.1400Z2(d)-2(b)(3)(i)(D) and Private Letter Ruling 8349023. Neither Treas. Reg. Section 1400Z2(d)-2(b)(3)(i)(D) nor PLR 8349023 mentions a certificate of occupancy. The preamble to the final opportunity zone regulations rejected a proposed pro-buyer safe harbor whereby the builder’s failure to obtain a certificate of occupancy caused the buyer to necessarily be viewed as the first user. The preamble noted that the certificate of occupancy rules differ under various state laws and do not provide a uniform standard on the federal tax issue of whether the real estate has been placed in service.
In Florida, for example, a condominium builder typically obtains a temporary certificate of occupancy shortly before beginning closing on its condominium sales. This temporary certificate of occupancy indicates the condominium developer has met its contractual agreements to buyers to complete the project. See Pretka v. Kolter City Plaza II, Inc.. A Florida condominium builder’s temporary certificate of occupancy should not preclude a QOF or QOZB buyer of a condominium from being viewed by the IRS as the first user.
Trade or Business
Treas. Reg. Section 1.1400Z2(d)-2(a)(2)(i) states that, in order for a QOF’s or QOZB’s real property to be treated as QOZBP, the property must be used “in a trade or business within the meaning of section 162.” Questions abound as to when a rental of condominiums constitutes a Section 162 trade or business. For example, a case, without focusing on the level of activity, has allowed even the rental of a single house to constitute a Section 162 trade or business. See Hazard v. Commissioner, and General Counsel Memoranda 38779 (1981) and 39126 (1983). In Curphey v. Commissioner, the Tax Court held that a dermatologist who, in addition to his full-time practice, rented out three condominiums, two townhouses and one single family home was engaged in a Section 162 trade or business with respect to those six rental properties. By contrast, in Thomason v Commissioner, the Tax Court found that a condominium that was advertised for rental but not yet rented was not a Section 162 trade or business. Some QOFs might also argue that Revenue Procedure 2019-38 should apply by analogy to establish Section 162 status. Rev. Proc. 2019-38 generally provides a safe harbor to achieve Section 162 trade or business characterization, but only in computing the owner-lessor’s Section 199A deduction, where 250 hours are spent annually on the real estate rental activity by the owner-lessor and by its independent contractors.
Treas. Reg. Section 1.1400Z2(d)-1(d)(1)(ii) provide that a corporation or partnership “engaged in a trade or business within the meaning of section 162,” is a QOZB if it meets the regulatory tests under Section 1400Z-2(d)(3)(A). This suggests that QOZBs must necessarily meet the Section 162 tests with respect to their rental real estate.
Treas. Reg. Section 1.1400Z2(d)-1(d)(3)(iii)(A) provides that ownership and rental of real property, other than mere triple-net-leased property, is the active conduct of a trade or business, but “solely for” purposes of Section 1400Z-2(d)(3)(A). This leads, however, to the possible interpretation that a corporation or partnership that owns and rents out real property, not on a triple-net-lease, can qualify as a QOZB, or perhaps even a QOF, even if the rental activity does not meet the Section 162 tests. If Treas. Reg. Section 1.1400Z2(d)-1(d)(3)(iii)(A) were hypothetically viewed as creating a safe harbor as a Section 162 trade or business of all real estate non-triple-lease rental activity, then even a rental of a single condominium by a QOZB could qualify the condominium as QOZBP and its QOZB owner-lessor as an active business. The triple-net-lease exception to active business treatment in Treas. Reg. Section 1.1400Z2(d)-1(d)(3)(iii)(B) would seem inapplicable, although if the owner’s annual property taxes, insurance and homeownerś association monthly maintenance fees, and other maintenance costs for the coming year are fixed very shortly before an annual lease commences, such that the risk of a material price increase to be absorbed by the lessor during the lease term is nominal, perhaps the IRS may assert the triple net-lease exception applies.
QOFs and QOZBs created to buy unsold condominiums in QOZs from builders would permit smaller investors in rental condominiums, without incurring syndication fees if they chose to invest without intermediaries, to participate in the QOF program without the need for them to assume the business risks of new construction. Conversely, condominium builders in QOZs would have less business risk if QOFs and QOZBs were created to buy their unsold inventory. Accordingly, the Treasury should consider clarifying when condominium rentals can constitute qualifying activities for QOF and QOZB purposes.
This column doesn’t necessarily reflect the opinion of The Bureau of National Affairs Inc. or its owners.
Alan S. Lederman is a shareholder at Gunster, Yoakley & Stewart, P.A. in Fort Lauderdale, Fla.