Investing In Opportunity Zones
OPPORTUNITY ZONES: April 2019 Proposed Regulations
The Investing in Opportunity Act, a special provision in the 2017 Tax Cuts and Jobs Act, is an innovative economic development tool designed to spur long-term private sector investments in designated Qualified Opportunity Zones (QOZs), located in 8,762 low-income urban and rural census tracts, throughout the U.S. With an estimated $6.1 trillion of unrealized capital gains eligible for reinvestment in Opportunity Zones, the Act could create several hundred-thousand jobs and generate enormous loan demand from community and regional banks to facilitate construction.
The Investing in Opportunity Act allows a taxpayer to invest realized capital gains into an investment vehicle called a Qualified Opportunity Fund (QOF) in a designated QOZ in exchange for capital gains tax incentives. The tax benefits include:
- Deferral of tax on invested gains until the earlier of 12/31/2026 or disposition of the QOF
- 10% of the deferred gain is permanently forgiven if the QOF is held for at least 5 years
- 15% of the deferred gain is permanently forgiven if the QOF is held for at least 7 years
- An investor would pay no further tax on any additional gain if the QOF is held for at least 10 years
In October 2018, the U.S. Treasury published its first tranche of proposed guidelines, clarifying what gains qualify for deferral as well as which taxpayers and investments are eligible. On April 17, 2019, the Treasury released a second set of proposed regulations and further details, including additional legal guidance, on Opportunity Zone legislation. The proposed new regulations provide much needed clarification to encourage the future use of the OZ tax benefit.
The following are some of the major highlights from the U.S. Treasury’s April proposed regulations:
90% Asset Test
The QOF must hold at least 90% of its assets in a QOZ property and it must be either newly built or substantially improved to qualify for the 90% Asset Test. The QOF must calculate the average percentage of QOZ business property halfway through the year and at the end of the year in order to meet the 90% requirement. The new regulations provide relief with respect to this test as follows:
- New capital investments in the QOF (contributions received in the prior six months), will not be included in the semi-annual testing
- Proceeds from sales of the QOF’s underlying QOZ property will not result in penalties if reinvested in a new QOZ property within 12 months
Working capital safe harbor and “substantial improvement”
The new proposed regulations establish that substantial improvement to QOZ business property applies on an asset-by-asset basis and must be substantially improved to qualify as QOZ business property. Previously, the standard for “substantial improvement” required adding improvements equal to the property’s initial cost within a 180-day period. But, because developing a new trade or business or the construction/rehab of real estate may take longer than 180 days, the proposed regulations now provide a working capital safe harbor for QOF investments that allows the working capital to be held for up to 31 months, if there is a written plan and schedule that it will be used within 31 months and complies with the schedule. The safe harbor applies to the development of a trade or business as well, making the safe harbor more useful for operating companies. In addition, the 31-month safe harbor can be extended if a written plan is not completed due to government delays.
“Substantially all” defined
In order to qualify as a QOZ business property, “substantially all” of the property’s use must be in a QOZ for “substantially all” of the QOFs holding period in the property. The new regulations set the respective thresholds at 70% of the property’s use and 90% for the QOFs holding period in the property. “Substantially all” was previously undefined for these purposes.
50% Gross Income Test
The proposed regulations provide three safe harbors and a facts and circumstances test to determine whether sufficient income is derived from a trade or business in a QOZ for purposes of the 50% Gross Income Test. Businesses only need to meet one of these safe harbors to satisfy the test. The safe harbors are as follows:
- At least 50% of the business services (based on employee and independent contractor hours) are performed within the QOZ
- At least 50% of the services (based on amounts paid) are performed within the QOZ
- At least 50% of the gross income of the business is derived from tangible property and management functions located in the QOZ
Investors not meeting any of the three safe harbor tests above may meet the 50% requirement based on a facts and circumstances test if at least 50% of the gross income of a trade or business is derived from the active conduct of a trade or business in the QOZ.
Original use clarification
To qualify as a QOZ business property, the property must be either substantially improved or originally used in a QOZ. Original use of the property commences on the date when a person first places the tangible property in service in the QOZ for purposes of depreciation or amortization. Property located in the QOZ that is depreciated or amortized by a taxpayer other than the QOF or QOZ business would not satisfy the original use requirement. Conversely, property (other than land) located in the QOZ that has not yet been depreciated or amortized by a taxpayer other than the QOF or QOZ business would satisfy the original use requirement.
However, if a building or structure has been vacant for at least five years prior to being purchased by a QOF or QOZ business, the purchased property will satisfy the original use requirement. Land does not need to be substantially improved to be a QOZ business property, but it must be used in a trade or business. Land banking is not allowed and anti-abuse rules can be applied where land is acquired without a legitimate business purpose.
Property on multiple census tracts
If the real property straddles multiple census tracts, where not all of the tracts are designated as a QOZ, the investor may satisfy the relevant business requirements if the unadjusted cost of the real property inside a QOZ is greater than the unadjusted cost of real property outside it.
Since the second set of “proposed” regulations merit further examination and will require follow-up guidance and clarification from the U.S. Treasury and the IRS, investors should expect further changes and additions when the regulations are issued in final form. The Treasury will accept written comments until June 16, 2019 and topics will be discussed at a public hearing scheduled for July 9, 2019.
All information is obtained from sources recognized as reliable but Greysteel makes no guarantees as to the accuracy thereof.
Sources: Greysteel Research; Baker Tilly Virchow Krause LLP; Duane Morris LLP; Internal Revenue Service; Novogradac; U.S. Department of the Treasury
Investing in Qualified Opportunity Funds
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