On April 17, 2019, the U.S. Treasury released the second highly anticipated set of proposed regulations (the proposed regs) regarding the Tax Cuts and Jobs Act’s (TCJA) opportunity zone provisions in an effort to provide a higher degree of certainty in this area. The proposed regs add to the initial guidance released by the Treasury in proposed regulations issued on Oct. 19, 2018. While the October proposed regulations clarified many questions regarding the opportunity zone provisions and the structure and operation of and investments in qualified opportunity zone funds (QDFs), they left uncertainty in some areas.
TCJA Opportunity Zone Provisions
The TCJA contained two provisions known as the “opportunity zone provisions” (Internal Revenue Code Sections 1400Z-1 and 1400Z-2) to encourage investment and job creation in economically distressed communities designated as qualified opportunity zones (QOZs). More specifically, Section 1400Z-2 provided three federal income tax benefits to incentivize investment in QOZs: (1) deferral of recognition of realized capital gains that are reinvested in a QOF), (2) reduction of the gains deferred if the QOF is held over certain periods of time, and (3) elimination of gain within the QOF itself if the fund is held for more than 10 years.
Key Areas of Clarity
The proposed regs provided clarity in the following five key areas:
- A trade or business must derive at least 50% of its total gross income from the active conduct of a trade or business in a QOZ to qualify as a QOZ business. The proposed regs provide three alternative safe harbors plus a facts and circumstances test to determine whether a QOZ business meets the gross income test. Prior to the issuance of the proposed regs, there was significant uncertainty as what it would mean for a business to derive 50% of its total gross income in a QOZ. The alternative tests provide that this test can be met if: (1) at least 50% of the services performed based on hours are performed within a QOZ, (2) at least 50% of the services performed by its employees are performed in the QOZ based on amounts paid for such services (for example, based on W-2 wages), or (3) the tangible property of the business is in a QOZ and the management or operational functions performed in the QOZ are necessary to generate at least 50% of the gross income of the business (that is, where the headquarter’s functions of the business are performed). Finally, if none of these safe harbors is met, there’s a facts and circumstances test that could apply.
- QOFs can sell assets directly after the 10-year hold with investors still getting the benefit (that is, tax free to investors who’ve held fund interest for 10 years or more) and can sell assets on a piece-by-piece basis with each successive sale also being tax-free to the investors. However, gains generated by the QOF in the first 10 years are taxable to the investors.
- There are two provisions in the proposed regs providing more time to the fund to make investments:
(1) the working capital safe harbor is tolled for delays caused by needed government approval;, and
(2) cash contributed to a fund within the last six months isn’t subject to the 90% test.
- The proposed regs provide clarity on what’s considered “original use” for abandoned property, partially constructed buildings and other tangible property and leased property within the QOZ. Especially relevant to operating businesses is the confirmation that the businesses don’t need to substantially improve leased property. For example, if the business rents office space in a zone, it won’t need to improve that leased office space.
- Also of note, the proposed regs provide a lengthy list of transactions that are inclusion events (which immediately subject the taxpayer to tax liability on the deferred capital gain), including gifts of QOF interests and certain corporate reorganizations and distributions of cash and other property to a QOF partner when the value of distribution exceeds the partner’s basis in the partnership. However, certain corporate reorgs aren’t inclusions events if the reorganized companies all qualify as QOFs.
More to Come
The proposed regs answered many, but not all, questions for QOFs and investors, and this brief overview is meant to as a short introduction to the key provisions. Final regulations concerning QOZs are expected to be issued sometime after a notice and comment period, however, the preamble to the proposed regs states that most of the provisions may be relied on prior to adoption of final regulations as long as taxpayers apply the proposals consistently and in their entirety. Stay tuned for an article in the June issue of Trusts & Estates that addresses the gift and estate tax considerations when investing in QOFs.