INSIGHT: Proposed Opportunity Zone Regulations—The Sequel

On April 17, 2019, the U.S. Treasury Department and the IRS released the long-awaited second set of proposed regulations on the qualified opportunity zone regime. This article discusses the new regulations, which provide much needed guidance, raise new issues, and leave certain questions unanswered.

THE ‘TOP 10' CHANGES IN THE NEW REGULATIONS

1. Refinancing Distributions are Permitted: An investor in a partnership opportunity fund may receive tax-free refinancing distributions, subject to certain modified “disguised sale” rules.

2. 10-Year Gain Exclusion on Sale of Assets: The 10-year gain exclusion is extended to capital gain attributable to the sale of qualifying property by the opportunity fund. However, significant technical issues remain, and taxpayers cannot rely on this rule until it is finalized.

3. Clarification and Uncertainty on “Section 1231 Gains”: Net tax code Section 1231 gain (from the sale of real property or depreciable business property, held for more than one year) may be invested in an opportunity fund, but the 180-day period begins on the last day of the tax year instead of the sale date. It is uncertain whether a partnership or S corporation may invest Section 1231 gain.

4. Limited Relief of the 31-Month Working Capital Safe Harbor: The 31-month time limit announced in the first set of regulations may be extended on account of governmental delay. Overlapping and consecutive 31-month periods are permitted in some circumstances.

5. Clarification of “Original Use”: “Original use” occurs when property is first placed in service for depreciation purposes. An existing building may qualify if it has been unused or vacant for five years.

6. Treatment of Land: Land does not generally need to satisfy the “original use” or “substantial improvement” requirements, but “land banking” may be challenged.

7. Guidance on Leases: Leased property generally does not need to satisfy the “purchase,” “original use,” or “substantial improvement” tests. Related party leases are permitted. Leases are valued generally based on discounting future lease payments.

8. Active Trade or Business is Defined and Leasing Business is Permitted: General rules are provided, with clarification that holding real property for rent satisfies the “active trade or business” requirement, but a “triple net lease” does not.

9. Carried Interest: An opportunity fund investment is not eligible for Opportunity Zone benefits to the extent an interest therein is received for services, including a sponsor’s “carried interest.”

10. Limited Relief on “Recycling”: An opportunity fund may sell an asset and reinvest the proceeds in a new qualifying investment, without violating asset tests. However, gain from the sale is subject to tax.

OVERVIEW OF THE OPPORTUNITY ZONE REGIME

The Tax Cuts and Jobs Act of 2017 created new U.S. federal income tax incentives for certain investments in designated low-income census tracts known as “qualified opportunity zones” (Opportunity Zones). The provisions generally provide three tax benefits for a taxpayer who has capital gain derived before 2027 from the sale or exchange of any property with a person who is not more than 20 percent related. If the taxpayer invests an amount equal to its gain in a qualified investment entity (an opportunity fund) during the 180-day period beginning on the sale or exchange date, the taxpayer may benefit from:

1. permanent exclusion of up to 15 percent of the gain so invested (10 percent after five years and an additional 5 percent after seven years of holding the opportunity fund interest);

2. deferral of the remaining gain so invested, generally until Dec. 31, 2026; and

3. permanent exclusion of gain from any post-investment appreciation in the opportunity fund, if the opportunity fund interest is sold or exchanged after 10 years or more (through 2047).

An opportunity fund is generally a corporation or partnership (including an LLC taxed as a corporation or partnership, and including a corporation that has elected to be classified as a REIT or an S corporation), if at least 90 percent of its assets consist of three types of assets acquired in 2018 and later:

1. Opportunity zone business property,

2. Opportunity zone stock in a lower-tier corporation, and

3. Opportunity zone partnership interest in a lower-tier partnership.

The 90 percent asset test is measured generally every six months and at year end, based on GAAP financial statements or the unadjusted cost basis of the assets. The general requirements for each type of opportunity zone property are set forth in the following chart:

OPPORTUNITY FUND DEBT

One significant area of uncertainty and confusion has been the interaction between the opportunity zone rules and existing partnership tax provisions. Under general tax rules, when a partnership incurs debt, that is treated as a deemed contribution of money by the partners, which increases the partners’ tax basis in their partnership interests. The October 2018 regulations provide that the deemed contribution of money that results from new partnership debt is not treated as a new investment by the investors in the opportunity fund and does not result in a so-called “mixed investment” of qualifying and non-qualifying investments. The new regulations clarify that the investor nevertheless generally receives the corresponding tax basis increase in its opportunity fund interest.

Example: An investor defers $100 of gain by investing $100 of cash in an almost wholly owned opportunity fund, which acquires $100 of assets. The investor has a basis of $0 in its opportunity fund interest, while the opportunity fund has a basis of $100 in its assets. The opportunity fund borrows an additional $50 and spends it on $50 of personal property, which gives rise to $50 of bonus depreciation.

The $50 borrowing increases the investor’s basis in its partnership interest by $50, which allows the investor to be allocated $50 of tax losses.

After 10 years and assuming all amounts remain the same, the investor may sell its opportunity fund interest for $100 of net value and is allowed a basis step-up to $150, equal to the net equity value plus the investor’s almost 100 percent share of the $50 debt. The investor has no gain on the sale, because the amount realized ($100 of net value plus $50 of debt relief) is entirely offset by the $150 of basis. As a result, there might not be any depreciation recapture at the investor level.

The same results may apply if the opportunity fund borrows the $50 and distributes the $50 to the investor, who has $50 of additional basis that is reduced to zero by the distribution. However, the new regulations provide that the opportunity fund investment and opportunity fund cash distributions may be recharacterized under the disguised sale rules, but without regard to certain favorable provisions about debt-financed distributions. The complex disguised sale rules are beyond the scope of this discussion, but generally there is a presumption that a contribution and a distribution within two years are considered a disguised sale, which can disqualify the original opportunity fund investment.

The “normal” basis rules do not apply in determining the amount of deferred gain that is recognized on Dec. 31, 2026, for which the debt basis is ignored.

OPPORTUNITY FUND EXIT AFTER 10 YEARS

Prior to the new regulations, an investor could claim the gain exclusion after 10 years only by selling its interest in the opportunity fund. The gain exemption is achieved by the investor electing to increase the tax basis of its opportunity interest to fair market value immediately before the sale or exchange. If the opportunity fund is a partnership, the new regulations provide that the opportunity fund also increases the basis of its assets by the same amount, which can benefit an opportunity fund partnership that owns assets that would otherwise generate some ordinary income upon disposition, such as renewable energy investments.

The new regulations propose that if an opportunity fund organized as a partnership, S corporation, or real estate investment trust (REIT) sells a directly owned opportunity zone property, the allocated capital gain or REIT capital gain dividend can be tax-free for the investor. Special timing rules apply to ensure that the opportunity fund investor has met the 10-year holding period. The tax-free REIT capital gain dividend is generally achieved by a special 0 percent federal income tax rate, while the gain allocated by a partnership or S corporation is excluded from gross income. However, unlike most other rules in the new regulations, taxpayers are not permitted to rely on this proposed rule until it is finalized.

The rule for exempting gain recognized at the opportunity fund level applies only to capital gain from the disposition of qualifying property, and therefore does not explicitly apply to any ordinary income recognized upon disposition (such as depreciation recapture for personal property) nor to any gain recognized with respect to assets that do not qualify under the 90 percent asset test.

If the opportunity fund owns equity in a qualifying lower-tier entity in a so-called “two-tier structure,” the exemption applies to gain that the opportunity fund recognizes from selling interests in the lower-tier entity, but it does not appear to apply to gain recognized by the lower-tier entity from selling its assets.

SECTION 1231 GAIN

The Treasury regulations provide that the only gain that may be deferred with an opportunity fund investment is capital gain for federal income tax purposes. The deferred gain is generally the investor’s gross capital gain from a sale or exchange of capital assets, without regard to any losses, except for certain mark-to-market contracts and offsetting positions.

In contrast, for “Section 1231 property,” which generally includes real property and depreciable personal property used in a trade or business and held for more than one year, the new regulations provide that the only gain that may be deferred with an opportunity fund investment is “capital gain net income” for a taxable year, which is equal to the net amount of capital gains and losses for the taxable year on all of the taxpayer’s Section 1231 property. For comparison, a taxpayer with both Section 1231 gains and losses could defer the gains by using a Section 1031 like-kind exchange or an installment note, and claim ordinary deductions for the losses.

The determination of whether a partnership’s Section 1231 gains are capital or not is typically made at the partner level, which may mean that the partnership itself does not have any capital gain net income that can be deferred with an opportunity fund investment by the partnership. It may be that only the partner may defer Section 1231 gain by making an opportunity fund investment, after netting all of its Section 1231 gains and losses from all sources. The issue affects many real estate partnerships and does not appear to be explicitly clarified by the new regulations. The same technical issue could affect S corporations and their shareholders.

For Section 1231 gain, the new regulations provide that the 180-day period for making an opportunity fund investment begins on the last day of the taxable year. For example, the 180-day periods for gain recognized by a partnership on Jan. 1, 2019 are:

WORKING CAPITAL SAFE HARBOR

In a one-tier structure, the opportunity fund must have 90 percent of its total assets consist of qualifying opportunity fund property, which does not include cash and certain other financial assets. In contrast, in a two-tier structure, the lower-tier entity has a 70 percent test only for its tangible property and may hold a greater amount of working capital in the form of cash, cash equivalents or certain short-term debt instruments.

Example: A taxpayer invests cash on June 1, 2019 into an opportunity fund. If the opportunity fund holds the cash, the cash is not a qualifying asset for the 90 percent asset test. The new regulations provide that the cash may be ignored for the first subsequent testing date six months later on Nov. 30, 2019, but not the next testing date on Dec. 31, 2019, at which point the opportunity fund may fail the 90 percent asset test and may be subject to a monthly monetary penalty.

Instead, the opportunity fund may contribute the cash to a lower-tier entity, which holds the cash as working capital under a newly-expanded safe harbor for amounts that will be spent over the next 31 months, or longer if there are certain government-related delays. The cash should be spent pursuant to a written plan to develop an opportunity zone trade or business or to acquire, construct or substantially improve tangible property in the opportunity zone. The new regulations confirm that the lower-tier entity may receive additional cash contributions later, which start new 31-month periods for spending the new cash.

The new regulations do not clarify how the working capital safe harbor interacts with the 70 percent tangible property test. For example, an opportunity fund’s lower-tier entity owns $100 of contributed land and $500 of working capital. The land does not qualify under the entity’s 70 percent tangible property test. Depending on the proper interpretation of the safe harbor, the lower-tier entity may have to construct $234 of opportunity zone property quickly, in order to have at least 70 percent of its tangible property qualify before the next applicable testing date.

ORIGINAL USE OR SUBSTANTIAL IMPROVEMENT OF OPPORTUNITY ZONE BUSINESS PROPERTY

For purposes of both the opportunity fund’s 90 percent asset test and the lower-tier entity’s 70 percent tangible property test, qualifying tangible property owned by the opportunity fund (or lower-tier entity) must generally meet various requirements:

1. It must be used in a trade or business of the opportunity fund (or lower-tier entity);

2. It must be purchased from an unrelated party in 2018 or later; and

3. Either the original use in the opportunity zone is with the opportunity fund (or lower-tier entity), or the opportunity fund (or the lower-tier entity) substantially improves the property.

An opportunity fund (or lower-tier entity) may be able to meet the original use test by acquiring land with a building before the building has been first placed in service for depreciation purposes. For example, a developer can sell a building under construction to an opportunity fund before any portion of the building is placed in service; the opportunity fund finishes construction, places the building in service, and could then be considered the original user of the building.

The opportunity fund (or lower-tier entity) may also acquire land with a building that has been vacant for at least five years, and is treated as the building’s original user when it is again placed in service.

For a building that has been used in the past five years, the opportunity fund (or lower-tier entity) cannot satisfy the original use test and must instead use the substantial improvement test. The opportunity fund (or lower-tier entity) must more than double the adjusted tax basis of its purchased assets within 30 months, on an asset-by-asset basis. The preamble to the new regulations requests comments as to whether to adopt an aggregate approach for this test.

In all cases, land itself does not need to meet either the original use or substantial improvement test. The only applicable tax requirements for opportunity zone land owned by an opportunity fund (or lower-tier entity) are that it must be purchased from an unrelated party in 2018 or later and be used in a trade or business. However, before the new regulations are finalized, an opportunity fund (or lower-tier entity) cannot rely on the new regulations’ proposed rule (that land does not need to be substantially improved) for unimproved or minimally improved land if the opportunity fund (or lower-tier entity) purchased the land with an expectation, intention, or view to not improve the land by “more than an insubstantial amount” within 30 months. The new regulations also include a general anti-abuse rule that discourages opportunity funds and their lower-tier entities from achieving tax results that are inconsistent with the purposes of the opportunity zone regime.

LEASED REAL PROPERTY

The new regulations provide favorable rules for properties leased to an opportunity fund (or lower-tier entity). In contrast to purchased opportunity zone properties, which must be purchased from an unrelated party and then either substantially improved or originally used by the opportunity fund (or lower-tier entity), an opportunity fund (or lower-tier entity) may lease tangible property from a related party and is not required to be the original user of the leased property or substantially improve it. The lease must be entered into in 2018 or later and must be a market rate lease that reflects common, arms-length market practice in the locale that includes the opportunity zone, as determined under the Section 482 transfer pricing rules. Leased property is generally valued based on the present value of rent payments, for purposes of the opportunity fund’s 90 percent asset test (or the lower-tier entity’s 70 percent tangible property test).

For example, a developer owns a land and building in an opportunity zone. The building does not require enough renovations to more than double its basis. The developer cannot sell its property to a related opportunity fund, because of the related party rules and the original use or substantial improvement requirement. The developer may instead lease the property to a related opportunity fund. The opportunity fund may build leasehold improvements, which are opportunity zone business property.

If the lessor is related to the opportunity fund (or lower-tier entity) lessee, the lessee cannot prepay rent for a period of more than 12 months to the lessor (or a related party). For leases of used personal property with a related party, the new regulations require the lessee to generally also own a substantial amount of personal or real property in the opportunity zone, but there is no similar rule for leases of real property.

An anti-abuse rule provides that real property (other than unimproved land) cannot be leased by an opportunity fund (or lower-tier entity) if there was a plan, intent or expectation for the real property to be purchased by the lessee for an amount that is not the fair market value at the time of purchase (determined without regard to any prior lease payments). In other words, land and building can be leased from related or unrelated parties only with a fair market value purchase option, though fixed purchased options are apparently allowed for leases of unimproved land.

ACTIVE CONDUCT OF A TRADE OR BUSINESS

The new regulations provide that the ownership and operation of real property used in a trade or business, including a leasing business, is treated as the active conduct of a trade or business for opportunity zone purposes, unless the lease is a “triple net lease.” The new regulations do not define a “triple net lease,” though recent guidance in the Section 199A context (Notice 2019-7) has broadly defined the term to include “a lease agreement that requires the tenant or lessee to pay taxes, fees, and insurance, and to be responsible for maintenance activities for a property in addition to rent and utilities. This includes a lease agreement that requires the tenant or lessee to pay a portion of the taxes, fees, and insurance, and to be responsible for maintenance activities allocable to the portion of the property rented by the tenant.”

CARRIED INTEREST AND NON-CASH INVESTMENTS

The new regulations provide that the opportunity zone tax benefits are not available to an opportunity fund interest acquired in exchange for services, including a carried interest. The new regulations do not address whether a similar rule applies to an opportunity fund’s stock or interests in lower-tier corporations or partnerships, which under the statute must be issued “solely for cash,” in situations in which the opportunity fund, related persons, or their owners provide services to the lower-tier entities.

The statute does not require an investor to acquire its opportunity fund interest for cash. The new regulations confirm that an investor may contribute property to an opportunity fund. For a tax-free contribution of appreciated property, the unrealized appreciation portion is not eligible for opportunity zone tax benefits. It is unclear how often this provision will be used, as any property contributed in a fully or partially tax-free transaction is generally not acquired by “purchase” and therefore does not qualify under the opportunity fund’s 90 percent asset test.

In addition, an investor does not have to make a primary investment in an opportunity fund in order to access the opportunity zone tax benefits. The investor can purchase an opportunity fund interest from an existing investor in a secondary transaction and is eligible for the opportunity zone tax benefits with respect to its purchased interest, as long as the investor is within the 180-day period after recognizing eligible gain.

OPPORTUNITY FUND RECYCLING OF PROCEEDS

Cash and debt instruments are normally not qualifying assets for an opportunity fund’s 90 percent asset test. The new regulations provide a “recycling” rule, under which an opportunity fund can sell or dispose of its directly-owned assets, such as interests in lower-tier entities, and reinvest the sales proceeds within 12 months without violating the 90 percent asset test, or even longer in the case of certain government-related delays. The proceeds must be held in cash, cash equivalents or debt instruments of less than 18 months. The 12-month recycling rule does not relieve the opportunity fund and its owners from any tax on the gain derived from the sale.

There is no “recycling” rule for an opportunity fund’s lower-tier entity that sells its assets and needs time to reinvest the sales proceeds.

INCLUSION EVENTS

A taxpayer recognizes its deferred gain upon the sale or exchange of its opportunity fund interest before Dec. 31, 2026. The new regulations describe some situations that result in inclusion of the deferred gain (inclusion events) and situations that do not result in such inclusion (non-inclusion events).

Some inclusion events include:

1. A gift of an opportunity fund interest, including to a charity;

2. Certain direct or indirect transfers of interests in an opportunity fund partnership;

3. A distribution of property from an opportunity fund partnership, to the extent that the distributed property has value in excess of the investor’s tax basis in its opportunity fund interest;

4. A sale or other taxable disposition of an interest in an opportunity fund partnership or opportunity fund corporation, including certain stock redemptions and distributions; and

5. For an S corporation that owns an opportunity fund interest, any transaction that causes more than 25 percent of the S corporation’s ownership to change, which triggers all of the S corporation’s deferred gain.

Some non-inclusion events include:

1. Transfer of an opportunity fund interest to a grantor trust or other disregarded entity;

2. Death of an owner of an opportunity fund interest, in which case the estate or beneficiaries step into the shoes of the decedent, have a tacked holding period for opportunity zone purposes, and generally recognize the deferred gain on Dec. 31, 2026;

3. A tax-free contribution of an opportunity fund interest to a partnership, which may facilitate the use of aggregator partnerships and feeder funds; and

4. Generally tax-free mergers and spinoffs involving two opportunity fund corporations.

OPERATING BUSINESSES

The new regulations provide guidance on how operating businesses may benefit from the opportunity zone regime. As noted above, the new regulations expand a lower-tier entity’s working capital safe harbor to generally include cash that will be used to develop a trade or business in an opportunity zone within 31 months. For example, working capital may pay payroll, research, and other operating expenses.

For the 50 percent gross income test, the new regulations confirm that startups and other operating businesses may have customers all over the world, as long as the business meets any one of three safe harbors or a general facts and circumstances test. Safe harbors 1 and 2 apply if at least 50 percent of the business’s services (based on either hours or employee compensation) is performed by employees and independent contractors (including the employees of independent contractors) within an opportunity zone. Safe harbor 3 requires that (i) the business’s tangible property in an opportunity zone and (ii) the business’s management or operational functions in the opportunity zone are each necessary to generate at least 50 percent of the business’s gross income. It is not entirely clear whether a business may qualify based on activities in more than one opportunity zone.

The new regulations contain rules on other topics for operating businesses, such as the treatment of leased tangible personal property, special rules about raw materials and inventory, and consolidated groups. The regulations do not explicitly prohibit marijuana businesses.

CONCLUSION

The new regulations provide favorable guidance in many respects for opportunity funds and their investors, particularly the original use test and treatment of leased property. They also provide helpful rules that may allow an investor to benefit from the 10-year gain exclusion without disposing of its opportunity fund investment. The regulations leave some unresolved issues and traps for the unwary, including the treatment of Section 1231 gain and its uncertain effect on partnerships and S corporations.

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

Robert Cassanos, Colin S. Kelly, and Libin Zhang are partners in Fried Frank’s New York office. Mr. Cassanos is in the firm’s tax practice and is the former co-chair of the firm’s tax department. Mr. Kelly’s practice focuses on tax and asset management. Mr. Zhang’s practice focuses on tax, real estate, and corporate real estate transactions.