In April, the U.S. Department of the Treasury issued its second set of proposed regulations related to the new Opportunity Zones tax incentive. The tax benefit was created in 2017 to encourage long-term investments in economically distressed communities around the country. There are two ways to invest in an Opportunity Zone: Create your own fund or invest in an existing one.
The first round of proposed regulations were published in October 2018, however many questions remained. The new 169-page proposal provides guidance under new section 1400Z-2 of the Internal Revenue Code. Below are some of the highlights from the proposed regulations:
Substantially All Definition
One of the many questions that the new round of regulations addresses is the “substantially all” requirement. Previously, the threshold to determine whether a trade or business satisfies the substantially all test was 70 percent. In other words, at least 70 percent of the tangible property owned or leased by a trade or business had to be in a qualified opportunity zone. The proposed regulations raises that to 90 percent. Treasury and the IRS reasoned that “using a threshold lower than 90 percent in the holding period context would reduce the amount of investment in qualified opportunity zones to levels inconsistent with the purposes of section 1400Z-2.”
Original Use Requirement
The proposed regulations also clarifies the “original use” requirement stating that “used tangible property will satisfy the original use requirement with respect to a qualified opportunity zone so long as the property has not been previously used (that is, has not previously been used within that qualified opportunity zone in a manner that would have allowed it to depreciate or amortize) by any taxpayer.” In addition, the proposed regulations stipulate that property that has been unused or vacant for at least five years should be treated as meeting the original use requirement when it is placed in service following such period of non-use.
Although QOZ business property must be acquired by purchase, under the proposed regulations, leased property also qualifies as long as the following general criteria are satisfied: First, leased tangible property must be acquired under a lease entered into after December 31, 2017. Second, as with owned tangible property, substantially all of the use of the leased tangible property must be in a qualified opportunity zone during substantially all of the period for which the business leases the property. There also is an anti-abuse provision designed to prevent the use of a lease to avoid the substantial improvement requirement for the purchase of real property.
To qualify as a QOZ business, 50 percent of its gross income must come from the active conduct of a trade or business in a QOZ. The updated regulation provides that a business meets the 50 percent threshold if it satisfies one of the following safe harbors: At least 50 percent of the services performed for the business by its employees and independent contractors are performed within a QOZ. This is determined based on (i) hours of services performed, (ii) amounts paid by the business for services performed. The tangible property of the business that is located in a QOZ and the management or operational functions of the business that are performed in a QOZ are each necessary to generate 50 percent of the business’s gross income. A QOZ business that does not meet one of these safe harbors may still meet the 50 percent threshold if it can show that at least 50 percent of the gross income of a trade or business is derived from the active conduct of a trade or business in a QOZ.
Reinvestment of Proceeds
The proposed regulations provide that a Qualified Opportunity Fund (QOF) has 12 months from the time of the sale or disposition of qualified opportunity zone property or the return of capital from investments in qualified opportunity zone stock or qualified opportunity zone partnership interests to reinvest the proceeds in other qualified opportunity zone property before the proceeds would not be considered qualified opportunity zone property with regards to the 90-percent asset test. This proposed rule gives substantial flexibility to taxpayers in satisfying the 90-percent asset test, which should encourage greater investment within QOFs compared to the baseline.
The proposed regulations also clarify what events cause the inclusion of deferred gain, that a QOF may not be a subsidiary member of a consolidated group, and how to determine the length of holding periods in a qualifying investment. These proposed regulations provide greater certainty to taxpayers regarding how to structure investments in order to comply with the statutory requirements of the opportunity zone incentive.
Opportunity Zones provide three main benefits: They allow investors to defer tax on capital gains timely invested into a QOF until no later than December 31, 2026; Investors who hold the QOF investment for five or seven years upon the expiration of the deferral period can receive a 10 percent or 15 percent reduction on their deferred capital gains tax bill; and investors who sell the QOF investment after holding the investment for at least 10 years can receive the added benefit of paying no tax on any post-acquisition realized appreciation in the QOF investment.
Public hearings on the new regulations will be held in July where comments will be considered.
This is a general summary of the proposed regulations. If you are interested in creating a Qualified Opportunity Fund, want to directly invest in one, own property in a Qualified Opportunity Zone and want to determine how to take advantage of the new regulations, or you just have a question about how to participate in one, contact Stevan Pardo at (786) 800-3316 or email firstname.lastname@example.org.