Recently issued final regulations (TD 9889) on qualified opportunity zones (OZs) address a number of outstanding issues and answer some questions that taxpayers have been struggling with when trying to enter into OZ transactions. In addition to clarifying some previously unclear topics, this new guidance makes some significant changes to the OZ landscape.
The Tax Cuts and Jobs Act (P.L. 115-97) (TCJA) created OZs as a new type of federal tax benefit. Specifically, the TCJA added Sections 1400Z-1 and 1400Z-2 to the Internal Revenue Code of 1986, as amended (IRC), to encourage long-term investment in economically distressed areas by giving tax benefits to taxpayers who invest capital gain into OZs through qualified opportunity funds (QOFs). A QOF is a corporation or partnership that holds at least 90% of its assets in qualified opportunity zone property (QOZP). QOZP consists of stock or partnership interests in Qualified Opportunity Zone Businesses (QOZB) or qualified opportunity zone business property (QOZBP), which are direct holdings of qualifying tangible property in OZs.
In general, the tax benefits work as follows. Taxpayers must make QOF investments within 180 days of when capital gain was realized. Investors can defer federal income tax on eligible gains invested in a QOF until the earlier of the date on which the investment in a QOF is sold or exchanged, or Dec. 31, 2026. If the QOF investment is held for longer than five years by the end of the deferral period, 10% of the deferred gain is excluded; a 15% exclusion applies if the investment is held for more than seven years by the end of the deferral period. If the investment is held for at least 10 years, the investor is eligible for a basis increase equal to the QOF investment’s fair market value on the date that the QOF investment is sold or exchanged, thus excluding the gain that would have been realized from disposing of the appreciated QOF.
The Treasury Department and Internal Revenue Service first released proposed regulations on Oct. 10, 2018 (2018 proposed regulations (REG-115420-18)) and then issued additional proposed regulations on May 1, 2019 (2019 proposed regulations (REG-120186-18)), collectively the proposed regulations. On Dec. 19, 2019, Treasury and the IRS modified and finalized the proposed regulations in a 544-page document. By our count, the final regulations tackle more than 40 issues.
Significant changes from the OZ proposed regulations
The final regulations made significant changes to the rules describing the gains eligible for qualifying investment in QOFs.
- Section 1231 gain: Under the final regulations, items of Section 1231 gain can be invested on a gross basis and the 180-day investment clock starts on the day of sale. Taxpayers can still rely on the proposed regulations, which required that Section 1231 gain be invested on a net basis with the 180-day investment clock starting on the last day of the taxable year. However, such taxpayers must rely on each section of the proposed regulations (except for Prop. Reg. Section 1.1400Z2(c)) consistently and completely, which may prevent them from benefiting from some of the other taxpayer-friendly items in the final regulations until 2021.
- Gain passed to taxpayer through a Form K-1: Under the final regulations, an investor can elect to start the 180-day investment clock for gains reported on a Form K-1 on the passthrough entity’s original return due date (i.e., the date that the passthrough entity’s return was originally due without extensions). Investors in passthrough entities that issue Forms K-1 can still elect to follow the passthrough entity’s 180-day clock or begin the 180 days on the passthrough entity’s year-end. This new provision should make it easier for individuals to invest in OZs because, based on our observations in the market and several comments on the proposed regulations, many taxpayers who invested in tiered partnerships had struggled to get reliable information prior to June 28 (180-days from the passthrough entity’s year-end), assuming a calendar-year taxpayer.
- Gain from investment in REITs and RICs: The 180-day investment clock for capital gain dividends starts on the close of the shareholder’s taxable year in which the shareholder would otherwise recognize the capital gain. REIT and RIC investors can still elect to start the 180-day clock on the capital gain dividend distribution date.
For tangible property to constitute QOZBP, it must be new or substantially improved property. The proposed regulations set forth a substantial improvement test that required the test be met on an asset-by-asset basis. The proposed regulations did not, however, specifically define the term “asset,” which made the test difficult to apply (as noted in comment letters to the 2019 proposed regulations). The final regulations apply an “aggregation approach” to the substantial improvement test, describing how these rules will be applied in response to a series of fact patterns raised by commentators to the proposed regulations.
- Aggregation approach allowed in certain instances: The final regulations allow for an aggregation approach under which new assets can be counted toward the substantial improvement of a non-original asset if they (1) are used in both the same trade or business and the same OZ (or contiguous OZ to) where the non-original asset is used, and (2) improve the functionality of the non-original use assets. The final regulations also extend this aggregation approach to multiple buildings requiring substantial improvement in order to constitute QOZBP using similar rules as described above.
- Capitalized soft cost: In the preamble to the final regulations, Treasury and the IRS clarified that capitalized soft costs could count toward meeting the “substantial improvement” requirement.
10-year exclusion benefits
For many taxpayers the real benefit of OZs is not in the deferral and potential reduction of the initial capital gain, but the ability to allow a QOF investment to grow and not be subject to any federal income tax on exit. For example, a QOF could invest in real estate and then depreciate it to reduce current taxable income. And, if the QOF investment is held for at least 10 years and exited correctly, the investor could exit without paying any federal income tax on the investment, including any ordinary income on depreciation recapture.
- Sales of a QOZB or QOZBP after 10 years are now fully tax free: Under the proposed regulations, only the sale of a QOF interest was eligible for full tax exclusion. In the event that a QOZB or QOZBP was sold by a QOF partnership, S Corporation, RIC, or REIT, only the capital gain was tax free, meaning the investor had to recognize ordinary income on depreciation recapture related to its QOF investment. This made it very difficult to efficiently create multi-asset QOFs. The final regulations allow for the disposition of QOF partnership or S Corporation assets, including interests in QOZBs and property sold by QOZBs, to be eligible for the 10-year exclusion benefit. The final regulations provide a similar rule for shareholders in QOF RICs or REITs so they can receive capital gain dividends that are excluded from federal taxable income. Although this change makes exiting multi-asset QOFs significantly easier, it will be interesting to see if the market switches from almost entirely single-asset funds to multi-asset funds given the myriad of timing restrictions that investors have around investments and that QOFs have around deployment.
Consolidated return rules
The 2019 proposed regulations surprised many practitioners by stating that a wholly owned QOF could not be part of the same consolidated group as the investor parent company. This unexpected provision in the proposed regulations was negatively received, particularly by taxpayers that had already entered into transactions where the only assumption they could have reasonably made prior to the 2019 proposed regulations was that a 100%-owned QOF was a member of the federal consolidated group. This was particularly damaging to those who set up a QOF to invest in affordable housing, as the tax credits and deductions generated by the investments were in essence trapped in the QOF, making the investments uneconomical. Similarly, the proposed regulations took an entity-based approach as to who could invest in a QOF, as opposed to treating the consolidated group in the aggregate. The final regulations reversed course on several of these issues, and provide the following welcome changes:
- Subsidiary QOF C Corporations can consolidate in certain fact patterns but don’t have to: The final regulations permit the consolidation of a subsidiary C Corporation if, among other things, all QOF investors are wholly owned directly or indirectly by the common parent of the consolidated group.
- ELA accounts: To prevent abuse, the final regulations require that a QOF investor must take into account any excess loss account (ELA) when adjusting QOF stock to fair market value (FMV) for purposes of the 10-year exclusion from income provided by Section 1400Z-2(c). Interestingly, the final regulations are silent as to whether the ELA needs to be accounted for in determining FMV under Section 1400Z-2(b)(2)(A), which provides for the amount of gain includable at the end of the deferral period.
- Dividend deductibility: For QOFs that are not consolidated, the final regulations provide that QOF stock is not treated as stock only for purposes of determining eligibility to join in the consolidated return under Section 1501 and not for the general purposes of Section 1504 (which determines, among other things, dividend received deductions for members of a federal consolidated return group).
- Aggregate treatment for members of a consolidated group for purposes of gain/investment: The final regulations allow any member of a consolidated group to invest eligible gain generated by any other member of the consolidated group. This change is important when dealing with regulated industries such as banks, insurance companies, or utilities, as they may have gains from regulated entities that cannot hold or are not the appropriate holders of OZ investments. This new rule will likely encourage taxpayers in these regulated industries and banks to invest in OZs.
Working capital safe harbor for start-up companies
While the real estate industry was off to the races using the working capital safe harbor (WCSH) in the proposed regulations, many operating businesses struggled to figure out how this safe harbor might apply to their fact patterns. The funding of operating businesses is the ultimate yardstick for the success of the OZ program as the operating businesses will create a permanent job base for the low-income communities the tax benefits are ultimately intended to benefit. The final regulations took a big step in making it easier for businesses—particularly for startups—by clarifying how a business can benefit from multiple applications of the WCSH, which the preamble to the final regulations refers to as a 62-month WCSH for start-up businesses.
While a business is within a WCSH, it provides ancillary safe harbors for all the QOZB requirements, with the exception of the prohibition on “sin businesses,” which are listed in Section 144(c)(6)(B) and include golf courses, country clubs, massage parlors, and stores primarily selling alcohol. One such ancillary safe harbor provides that tangible property can be treated as QOZBP during multiple applications of the WCSH for up to 62 months. To benefit from multiple applications of the WCSH, a business (such as a start-up business) must receive multiple cash infusions. This provides great flexibility to operating businesses, but it remains to be seen whether the flexibility will cause the composition of QOZB investments to shift away from almost entirely real estate or tangible-asset-focused businesses.
Smaller changes and clarifications
- Straddle rules/offsetting positions: The proposed regulations were unclear on how eligible gain is determined from an offsetting position. They generally provided that if a capital gain is from a position that “is or has been” part of an offsetting-positions transaction, then the gain is not eligible gain for investment in a OZ. The final regulations only limit the use of gains from a straddle position to a net gain if that position was part of a straddle during the taxable year or part of a straddle in the prior taxable year if a loss from that straddle is carried over under Section 1092(a)(1)(B) to the taxable year.
- Installment sales: The proposed regulations did not address the treatment of gain from installment sales. The final regulations clarify that a taxpayer can elect to start the 180-day investment clock on either (1) the date a payment under the installment sale is received for that taxable year, or (2) the last day of the taxable year in which the eligible gain under the installment method would be recognized.
- Selling property to a QOF and reinvesting in the same QOF: The final regulations explicitly provide that gain earned from selling an asset to a QOF cannot be reinvested back into the same QOF. This puts an end to all of the proverbial handwringing by practitioners over whether such a transaction would be recharacterized as a part sale, part contribution, potentially causing the QOF to fail the 90% test.
- Partnerships investing in a QOF: The final regulations clarify that when a partnership invests in a QOF, the partnership generally doesn’t need to look through to the ultimate taxpayers and determine whether they would be eligible to directly invest in a QOF and receive OZ tax benefits. This guidance is welcome as it makes investment determinations easier. Prior to the final regulations, many practitioners anticipated that partnerships investing in QOFs comprised of partners with varying eligibility to be QOF investors would be treated similarly to how non-profits are treated for depreciation purposes.
- Six-month cure for a QOF that fails the 90% test due to a QOZB not being a QOZB: Under the final regulations, during a six-month cure period, a QOF can treat the interest held in the entity as QOZP (meaning that the QOF doesn’t fail the 90% test due to the QOZB not qualifying). The cure period can only be used once. If at the end of the cure period the QOZB still is not qualifying, penalties are assessed retroactively to the beginning of the cure period.
- Five percent limit on leasing to “sin” businesses: Section 1400Z-2(d)(3)(A)(iii) prohibits a QOZB from being a “sin” business, but doesn’t specify whether a QOZB can lease real property to a “sin” business. For example, could a QOZB that is a shopping mall rent a portion of its space to a liquor store? The final regulations answer this question by putting a 5% limit on QOZB assets leased to “sin” businesses.
- S Corporation rules around 25% transfer: Reversing a position in the proposed regulations, the final regulations provide that a transfer of a 25% interest in an S Corporation does not cause an inclusion event, which would have meant an early termination of the deferral period in advance of Dec. 31, 2026, or the investor exiting the QOF.
- Guidance on 40% intangible property test: The final regulations provide some additional clarity, although it still isn’t perfectly clear how a QOZB determines if 40% of its intangible assets are used in the active conduct of a trade or business as required under Section 1400Z-2(d)(3)(A)((ii) and Section 1397C(b)(4) for an entity to constitute a QOZB.
- Vacancy rules to constitute “original use” tangible property: The final regulations changed the five-year vacancy requirement from the proposed regulations to either (1) a one-year requirement if the property was vacant prior to the selection of OZ eligible tracts, or (2) a three-year requirement if the property was not vacant at the time OZ eligible tracts were selected. The final regulations also went on to define “vacant” to mean that 80% or more of the square footage of usable space is not being used.
- State, local, and Indian tribal government leases: The final regulations create a carve-out from the rule in the proposed regulations that required that all property leased to a QOF or QOZB be at FMV. For leases between unrelated parties, a rebuttable presumption will apply that the lease terms reflect market rates, or FMV, and that leases from state, local, and Indian tribal governments are considered to be from an unrelated party and are therefore privy to the rebuttable FMV presumption. This is extremely helpful in the development of community facilities, as it is common for state or local authorities to lease land to the sponsor of such facilities at below-market rates to limit the financial burden and allow them to focus their resources on the local community.
- Contributed property: The final regulations clarify that contributed property can never be QOZBP, which effectively limits the amount of property that can be contributed to a QOF for use in a QOZB to 10%. Although this was the common reading of Section 1400Z-2(d)(2)(D)(i)(I), the preamble to the 2019 proposed regulations discussed the ability to contribute property to a QOF in exchange for a qualifying QOF interest, which led some to believe that contributed property could qualify as QOZBP.
- Feeder funds: The Preamble to the final regulations confirms that master-feeder structures aren’t allowed under the OZ program.
- Ordering for partnership QOF inclusion events: The final regulations clarify that the basis adjustment related to an inclusion event triggered by cash distributions in excess of basis is taken into account before the calculation of gain under Section 731(a) for a partnership.
- Disregarded entity for tax purposes: The Preamble to the final regulations clarifies that a QOZB must be a regarded entity and not solely an entity for legal purposes (i.e., a disregarded entity).
- Tax rate: The final regulations clarify that gain recognized in 2026 or via an inclusion event is taxed at the applicable rate for the year of inclusion, not the tax rate for the year of deferral.
- Certificates of Occupancy (CofOs): The Preamble to the final regulations clarifies that CofOs are not the determining factor in whether the original use of tangible property has begun. This mirrors the long-standing tax rule under which an asset is placed in service when it is in a state or condition of readiness for its intended use. CofOs are an indicium of being in a state or condition of readiness for intended use but are not the sole or even primary factor that needs to be considered.
- Inclusion events: The final regulations clarity that transfers in a divorce settlement are inclusion events, but transactions between grantor trusts and their owners are not.
Hopefully, the final regulations will help spur additional investment into Opportunity Zone Funds in economically distressed communities. While there is a lot to digest here, most of the open items have been resolved in a taxpayer-favorable way. Taxpayers now have a final set of rules for a program that offers a unique opportunity not just to reduce their current tax bill and defer taxation, but also to have their investments grow tax-free. New investments can be made for at least the next six years, which means this program will be around for a while.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
Mike Bernier is a partner and Rachel van Deuren is a manager with EY’s financial services tax practice.
The views expressed are those of the authors and are not necessarily those of Ernst & Young LLP or other members of the global EY organization.