Treasury, following an assessment by the White House’s regulatory review office, tweaked proposed opportunity zones regulations to make it easier for investors to take advantage of the tax breaks.
Several of the changes made to the rules (REG-115420-18) prior to their publication in October were substantive and stemmed from recommendations business groups and lobbyists provided in meetings with the Treasury Department and the Office of Management and Budget’s Office of Information and Regulatory Affairs.
The opportunity zone program is meant to encourage private investment in distressed communities. Investors who funnel capital gains they have earned—as a result of selling appreciated assets, such as stock and real estate—into “qualified opportunity funds,” which facilitate investments in the zones, can defer or reduce taxes on those gains.
The modifications to the rules, which came to light when OMB released an initial draft version of the document, illustrate the impact businesses groups and lobbyists can have on the regulatory process.
Mary Burke Baker, a government affairs counselor at law firm K&L Gates, said the changes were likely the result of a combination of industry input and a strong desire on the part of the White House, congressional champions like Sen. Tim Scott (R-S.C.), and certain communities to maximize the potential of the opportunity zone program.
OMB’s oversight of tax regulations is relatively new. Prior to an agreement reached in April 2018, Treasury’s tax rules were generally exempt from the office’s cost and benefit analysis that applies to most executive agencies.
Treasury didn’t return a request for comment. OMB declined to comment.
‘Substantially All’ Defined
The 2017 tax law requires an opportunity fund—which can be organized by a partnership or corporation—to hold at least 90 percent of its assets in qualified stock, partnership interests, or business property. Business property is an eligible investment if “substantially all” of its tangible property is held within an opportunity zone.
The published Internal Revenue Service rules define “substantially all” as 70 percent, meaning 30 percent of the business’s property could be held elsewhere.
The term wasn’t defined in the original draft rules Treasury sent to OMB. The 70 percent figure was, however, mentioned in handout from an Oct. 12 meeting that the Economic Innovation Group had with officials from both government bodies.
EIG, a policy and advocacy organization, is leading a coalition of groups hoping to ensure the opportunity zone program is successful. Coalition members at the meeting included Novogradac & Co. LLP and Louisville, K.Y.-based investment firm Access Ventures.
The definition that ended up in the rules is important because it allows businesses with certain types of “bad” property, including property outside of the opportunity zone, to qualify as an opportunity zone business, Baker said.
It is difficult to get involved in the opportunity zone program “if you don’t know how to evaluate your investment activity as being qualified or non-qualified,” said John Lettieri, president and CEO of EIG. Knowing what “substantially all” means gives some investors the clarity they need.
Several groups in meetings before the publication of the rules asked for clarifications on the meaning of “substantial improvement” in the 2017 tax law.
Opportunity funds may invest only in projects that satisfy one of two tests—the “original use test” or the “substantial improvement test.”
To satisfy the substantial improvement test, a fund must invest—within 30 months of acquiring property—an amount equal to the cost, also known as the basis, of the purchased property.
Treasury, after OMB’s review, added a “special rule” to the proposed regulations that says if a fund purchases a building on land within an opportunity zone, only the building—not the land on which it sits—has to be substantially improved.
This approach was recommended by EIG. A similar issue was raised in an Oct. 5 meeting that OMB and Treasury had with departments responsible for economic development in states including Colorado, Vermont, Pennsylvania, Rhode Island, Connecticut, and Utah.
The state groups had worried that if the standard for substantial improvement was too high, it would disincentivize many types of investment, such as building rehabilitation or brownfield development, according to a meeting handout.
Additional 10 Years
Investors can avoid capital gains taxes on appreciation resulting from opportunity zone investments held for more than a decade.
One change made to the proposed rules following OMB’s review would allow investors to hold onto opportunity zone investments made close to the program’s expiration date for an additional 10-year period. It isn’t clear that the change came from specific lobbying.
Still, it does show that the government wanted to facilitate long-term investments, which is part of the point of the policy of opportunity zones, Baker said.
All current opportunity zone designations—more than 8,700 census tracts that have been certified—expire after 2028.
Capital gains that are recognized on or before Dec. 31, 2026, and invested into a qualified opportunity fund by June 30, 2027, can take advantage of the tax benefits. The published regulations said that investors could hold onto their June 2027 opportunity zone investments for the entire 10 years described in the tax law, plus an additional 10 years.
This means the expiration of an opportunity zone designation won’t affect an investor’s ability to reap the benefits of the tax law as long as the investment is sold before 2048, instead of 2038.
Working Capital Safe Harbor
The proposed opportunity zone regulations offer relief from the 90 percent asset test for certain types of investments.
The rules say funds investing in businesses—such as real estate development companies—that are rehabilitating or constructing tangible business property in an opportunity zone can count cash provided to those businesses toward the 90 percent test as long as it is used on the project within 31 months. The regulations also stipulate other requirements that must be met.
The draft included this safe harbor, but several new details were added to the published rules.
EIG requested the safe harbor in its meeting with OMB and Treasury.
Not All OMB Requests
A former Treasury official who recently left the department said people shouldn’t overstate how many of the changes that occurred during the OMB review period were the result of direct requests from the office or non-government groups.
Treasury, in parallel, was using the time to tighten provisions that “we realized as we stepped back still needed to work,” said Tom West, who until recently was tax legislative counsel in Treasury’s Office of Tax Policy. West is now a principal in the passthroughs group of KPMG LLP’s Washington National Tax practice.
Treasury made most of the substantive and technical additions to the original draft rules, he said.
OMB spent more than a month reviewing the opportunity zone regulations, which gave Treasury extra time to think some issues through, West said. Under last year’s agreement, OMB has 45 days to assess rules before publication. But certain regulations implementing the 2017 tax law can be designated for an expedited review that lasts for up to 10 business days.
West and Lisa Zarlenga, a former tax legislative counsel at Treasury, both noted that OIRA still has very few “tax experts” on staff.
“As OMB staffs up or as OIRA staffs up with more tax expertise—as I’m told they’re going to do—it may be that they get more involved in some of the more substantive aspects of the regulations,” West said.
—With assistance from Cheryl Bolen.