The U.S. Treasury Department and IRS yesterday issued a version of proposed regulations as guidance providing additional details about investment in qualified opportunity zones.
The statutory opportunity zone regime—enacted as part of the December 2017 tax reform legislation (Pub. L. No. 115-97)—allows the deferral of all or part of a gain that would otherwise be includible in income if the gain is invested into a Qualified Opportunity Fund (“QOF”). The gain is deferred until the investment is sold or exchanged, or December 31, 2026, whichever is earlier. If the investment is held for at least 10 years, investors may be able to permanently exclude gain from the sale or exchange of an investment in a QOF.
While the opportunity zone statute and a prior round of proposed regulations provide an overall structure for the program and answer some basic questions, investors and those interested in developing zone-based businesses have been awaiting more detailed guidance. The proposed regulations released yesterday appear to answer many (though certainly not all) of the questions taxpayers have been asking, and provide some welcome flexibility to investors and businesses that want to take advantage of the opportunity zone incentives. Below are some highlights.
Qualified opportunity zone business (“QOZB”) property (“QOZBP”) is tangible property used in a trade or business of the QOF if the property was purchased after December 31, 2017. The proposed regulations permit tangible property acquired after December 31, 2017, under a market rate lease to qualify as “qualified opportunity zone business property” if during substantially all of the holding period of the property, substantially all of the use of the property was in a qualified opportunity zone.
A key part of the newly released proposed regulations clarifies the “substantially all” requirements for (1) the holding period, and (2) the use of the tangible business property as follows:
The guidance notes there are situations when deferred gains may become taxable if investors transfer their interest in a QOF. For example, if the transfer is done by gift, the deferred gain may become accelerated. However, inheritance by an heir is not a taxable transfer, nor is a transfer, upon death, of an ownership interest in a QOF to an estate or a revocable trust that becomes irrevocable upon death.
Section 1231 gains
Treasury and IRS have addressed the issues associated with treating section 1231 gains as capital gains. Specifically, the proposed regulations provide that the only gain arising from section 1231 property that is eligible for deferral is capital gain net income for a tax year. This net amount is determined by taking into account all the section 1231 gains and section 1231 losses for a tax year on all of the taxpayer’s section 1231 property. While not specifically addressed in the proposed regulations, it would appear that the reference to taxpayer implies that a partnership, or its partner may be treated as a taxpayer.
The 180-day period to reinvest into a QOF with respect to the capital gain net income from section 1231 property for a tax year begins on the last day of the tax year.
Tax rate to apply to deferred gain
Some commentators have argued that the deferred gain should be taxed at the end of the deferral period at the same rate in effect in the tax year in which the gain was originally recognized, arguing that the reference to section 1(h) (which specifies a tax rate) in the definition of eligible gains provides support for this position.
Treasury and IRS have not provided such a rule. Instead, the proposed regulations require that the taxpayer simply include the gain in income in the year in which the deferral period ends, which would appear to require that the taxpayer pay tax based on the prevailing tax rates in that year.
Treatment of land and leases of land and other property
The proposed regulations addressed many of the issues raised by commentators, such as how to treat the acquisition of raw land by purchase, by lease, and by contribution. One of the main issues is how the acquired interest in land will be treated for purposes of applying the 90% and 70% asset tests and the “substantial improvement” requirement.
The proposed regulations provide that unimproved land within a QOZ that is acquired by purchase is not required to be substantially improved.
The proposed regulations provide that leased property is QOZB property if:
Definition of “original use”
For purchased tangible property, the original use commences on the date any person first places the property in service in the QOZ for depreciation or amortization purposes (or first uses it in a manner that would allow depreciation or amortization if that person were the property’s owner). Thus for acquisitions of partially completed buildings, the original use would commence when the purchaser completed the building and placed the building into service for depreciation purposes.
Transfers of QOF interests in non-recognition transactions
The proposed regulations address the consequences of the QOF interest holder transferring its interest in a section 721(a) transaction, or receiving an interest pursuant to a partnership or corporate merger or other corporate nontaxable reorganization, but do not address distributing out the interest to one or more of its partners.
Treatment of carried/profits interests
QOZ benefits are available for those partners that contribute capital and get their return from that capital.
If a taxpayer receives an eligible interest in a QOF for services rendered to the QOF or to a person in which the QOF holds any direct or indirect equity interest, then the interest in the QOF that the taxpayer receives is not an eligible investment and will be treated as a mixed fund investment. While the proposed regulations provided some guidance on bifurcating the allocation percentage for each separate investment, exactly how the IRS is going to measure how much is from each is not clear.
Outstanding debt and distribution issues
Qualified opportunity zone business (“QOZB”) 50% of gross Income rule
The proposed regulations retain the requirement that the gross income be derived from the active conduct of the trade or business in the opportunity zone.
However, the proposed regulations provide three safe harbors and a facts-and-circumstances test for determining whether sufficient income is derived from a trade or business in a QOZ for purposes of the 50% test. The safe harbors are:
Qualifying real estate related businesses: The ownership and operation (including leasing) of real property is the active conduct of a trade or business. However, merely entering into a triple net lease of property is not the active conduct of a trade or business for QOZB purposes.
Multi-asset partnership or S corporation QOFs
The proposed regulations provide that if a taxpayer has held a qualifying investment in a QOF partnership or S corporation for at least 10 years, and the QOF partnership disposes of QOZ property after such 10-year period, the taxpayer may make an election to exclude from gross income some or all of the capital gain arising from such disposition reported on Schedule K-1 and attributable to the qualifying investment.
Sales of QOZ property during 10-year holding period
The proposed regulations provide for a 12-month period for a QOF to reinvest the proceeds from a sale or disposition of QOZ property into other QOZ property without the proceeds becoming being treated as non-QOZ property, provided the proceeds are held as short-term investments (e.g., working capital). Delays in reinvesting due to waiting for governmental action is not taken into account.
On the eligible gain point, the proposed regulations do not specifically address whether eligible gains can flow through tiers to the ultimate taxpayer or be used anywhere along the line by an upper-tier partnership. It may be that the IRS thought it was clear enough from the first set of proposed regulations.
See the discussion above for tiering up investments in QOFs through section 721 (non-recognition) transactions.
The proposed regulations provide a nonexclusive list of 11 inclusion events for a taxpayer’s qualifying investment to be included in the taxpayer’s income. Examples include:
Other key provisions
KPMG tax professionals are still reviewing and analyzing the proposed regulations and intend on issuing a more detailed special report about these regulations in the coming days.
For more information, contact a KPMG tax professional:
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Orla O'Connor | +1 415 963 7511 | firstname.lastname@example.org
Richard Blumenreich | +1 202 533 3032 | email@example.com
Tom West | +1 202 533 3212 | firstname.lastname@example.org
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