INSIGHT: Opportunity Zone Houses Require Substantial Improvement

The most common type of building in the U.S. is the single-family house. Accordingly, a frequent question concerning the qualified opportunity fund (QOF) program, and perhaps the most frequent question among smaller businesses seeking to use the QOF program, is: Can a single family house located in a qualified opportunity zone (QOZ), which house is purchased and then converted to business use without substantial rehabilitation, constitute qualified opportunity zone business property (QOZBP)?

For example, suppose an aspiring QOF, or aspiring qualified opportunity zone business (QOZB), buys from an unrelated seller a currently owner-occupied existing single-family house located in a QOZ for $700,000. Suppose $500,000 of the price is allocable to building and $200,000 is allocable to land. Suppose the QOF or QOZB buyer spends $200,000 in renovating the house and spends $100,000 for new related personal property that improves the functionality of the house, in order to convert the house into a store, restaurant, professional office, or other qualifying business. Applying the analysis of Treasury Regulation Section 1.1400Z2(d)-2(b)(4)(iii)(D), the house is not substantially improved, since the improvement costs are only $300,000/ $500,000 = 60%, i.e., less than 100%, of the basis of the house.

Therefore, the non-substantially-improved house will be QOZBP only if it is not viewed as “used” property. That is, the determination of whether the QOF or QOZB is disqualified may well depend on whether the house is viewed as used property. Suppose, in this example, the house was used by the seller to the QOF or QOZB as her personal residence up to the sale date. The question then becomes whether a personal, non-depreciable, use house is non-qualifying used property.

Despite the practical importance of this question to small businesses, and several iterations of proposed and final QOZBP regulations, even after the final QOZBP regulations published in January 2020 and corrected in April 2020, the answer has been unclear. Final Treas. Reg. Section 1.1400Z2(d)-2(b)(3)(i) states that “the original use of purchased tangible property in a qualified opportunity zone commences on the date any person first places the property in service in the qualified opportunity zone for purposes of depreciation.”

Used Property?

Language in the Preamble to final Treas. Reg. Section 1.1400Z2(d)-2(b)(3)(i) could be read to support the position that so long as all the prior use of a house was non-depreciable personal use, the house was not used property, and need not be substantially improved to constitute QOZBP. The Preamble states: “The final regulations [provide] that a property’s ‘original use’ commences on the date on which the property is first (i) placed into service in the QOZ and is depreciated or amortized, or (ii) used in a manner that would allow depreciation or amortization.” (Italics added).

On the other hand, there is other authority suggesting that non-depreciable personal use of a house causes the house to have been “placed in service … for purposes of depreciation,” the litmus test in Regulation 1.1400Z2(d)-2(b)(3)(i), which thereby causes the house to be used property. CCA 201211011 states that for “placed in service … for purposes of depreciation . . . see . . . Rev. Rul. 84-23.“ Rev. Rul. 84-23 held that a building purchased and used as a non-depreciable owner-occupied house, and then converted to depreciable rental use four years later, was placed in service when first used as an owner-occupied house four years earlier. The 2020 Preamble to final Treas. Reg. Section 1.1400Z2(d)-2(d) states: “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,” suggesting that a even a personal use preexisting building must be substantially improved. The Preamble further states: “A rule treating historically used property in a QOZ as ‘original use property’ because such property’s prior use was nonbusiness in nature … would fail to sufficiently encourage the introduction of new capital investments in QOZs.”

Even in the event Treas. Reg. Section 1.1400Z2(d)-2(b)(3)(i) could be interpreted to allow the QOF or QOZB buyer to treat a purchased continuously owner-occupied non-depreciable house as not used property, since Rev. Rul. 2018-29 considered pre-2018 years of depreciable use in determining whether a building was used property, it may be difficult for the QOZB to establish with certainty that there has never been any pre-purchase disqualifying depreciable use. The National Association of Homebuilders has estimated that about 38% of U.S. owner-occupied houses were built before 1970, and therefore could theoretically have had some disqualifying depreciable use during the past 50 years. For example, the city of Baltimore was founded in 1729. Depreciation has existed in the Internal Revenue Code since 1909. If a QOZB was to buy a very old house in a Baltimore QOZ, would the QOZB have to prove no disqualifying depreciable use since 1729? Since 1909? Or would the three calendar-year look-back period for vacant buildings be sufficient?

The June 2020 IRS FAQ 44 seems to confirm the adverse IRS view that a non-depreciable owner-occupied house has been placed in service, and thus is used property subject to the substantial improvement requirement. A44 states: “Original use of tangible property occurs when the property is first placed in service in a manner that would start depreciation … if the property were being used in a trade or business.” In other words, A44 allows the IRS to envision hypothetical past depreciation notwithstanding actual non-depreciable personal use of a house. This hypothetical depreciation establishes used property characterization under A44, thereby subjecting the house to the substantial improvement requirement.

Conclusion

The June 2020 FAQs state that those FAQs “do not amend, modify or add to the Income Tax Regulations or any other legal authority.” However, A44 indicates that the IRS view is that QOFs and QOZBs contemplating buying single family houses in a QOZ for the purpose of converting them to QOZBP must satisfy the substantial improvement test.

This column doesn’t necessarily reflect the opinion of The Bureau of National Affairs Inc. or its owners.

Author Information

Alan S. Lederman is a shareholder at Gunster, Yoakley & Stewart, P.A. in Fort Lauderdale, Fla.