The Treasury released the final opportunity zone regulations on December 19, 2019, giving investors a little time to digest the 544 pages in case they wanted to make any last-minute moves prior to year-end.
The final regulations combine the first two sets of regulations released in October 2018 and April 2019, as well as provide additional insight on many topics previously debated between investors, service professionals and others interested in this program.
The finalized regulations make it easier for investor participation, provide favorable rules for deal structuring and will hopefully help increase the amount of operating businesses taking advantage of the program in communities of need. Due to the extensive amount of details in the final regulations, it would be impossible to summarize it all in one article, but we will touch on highlights in the details below.
Working capital safe harbor
The final regulations clarify that Qualified Opportunity Zone Businesses (QOZBs) may string together subsequent or overlapping working capital safe harbors to span for a maximum of 62 months, providing some relief for the timing requirements of new developments.
To qualify for a maximum 62-month safe harbor period, a start-up business must receive multiple cash infusions during its start-up phase. Regardless of the number of subsequent cash infusions, the 62-month working capital safe harbor cannot extend past the 62-month period beginning on the date of the first cash infusion covered by the safe harbor.
Additionally, if a governmental permitting delay has caused the delay of a project covered by the 31-month working capital safe harbor, and no other action could be taken to improve the tangible property or complete the project during the permitting process, then the 31-month working capital safe harbor will be tolled for duration equal to the permitting delay.
Substantial improvement test—aggregation allowed
The Treasury and IRS made taxpayers alter their approach to the substantial improvement test by allowing for asset aggregation instead of requiring an asset-by-asset approach in certain situations.
The final regulations allow for asset aggregation when determining whether a non-original-use asset (such as a preexisting building) has been substantially improved by a Qualified Opportunity Fund (QOF) or QOZB. They can take into account purchased original-use assets that otherwise would qualify as Qualified Opportunity Zone Business Property (QOZBP) if the assets are used in the same trade or business and it improves the functionality of the non-original-use assets in the same or contiguous QOZ.
The regulations use an example of a hotel trying to meet the substantial improvement requirement. They allow for the costs of newly purchased assets such as mattresses, linens, furniture, electronic equipment and other tangible property to be included in the basis of substantial improvements for testing purposes.
It’s also important to note that all non-original use purchased property is still required to be improved by more than an insubstantial amount, so physical improvements would still need to be made to the hotel.
The final regulations also allow for certain buildings to be aggregated. The examples include building groups located entirely within a parcel of land described in a single deed, as well as groups spanning continuous parcels of land described in separate deeds.
In order to be treated as a single property for testing purposes with contiguous parcels of land in separate deeds, the buildings must be part of a business that meet all of the following requirements: be operated exclusively by the QOF or QOZB, share facilities or share significant centralized business elements, and be operated in coordination with, or reliance upon, one or more of the trades or businesses.
The final regulations confirm that a debt-financed distribution to QOF investors is generally allowable and will not be considered an inclusion event as long as the distribution is made after two years and it does not exceed the investor’s basis in the QOF.
The regulations define an inclusion event as an event that results in the inclusion of gain under the opportunity zone regulations, and one generally occurs when a taxpayer reduces their equity interest in a qualifying investment. The ability to complete a debt-financed distribution can be a useful tool for QOFs, but funds should work closely with their tax advisors to make sure they don’t get tripped up by these rules and end up with an unfavorable result.
Exit strategy simplified
The Treasury simplified the exit strategy for owners of QOF partnership interests and S Corporation stock. The final regulations allow for the sale of assets at both the QOF and QOZB level to qualify for non-gain recognition if it meets the 10-year holding period in the QOF. Assets can be sold at either level and do not need to be sold all at once, which gives a lot more flexibility to multi-asset funds. The regulations also allow for investors to do partial dispositions of their QOZB interests.
Additionally, the final regulations now allow for gain arising from the sale or exchange of a qualifying opportunity zone interest (inclusion event) to be reinvested into a different QOF within the 180-day investment period beginning on the date of the inclusion event.
§1231 Gains—IRS and Treasury change their perspective
The final regulations made favorable changes to the §1231 guidance.
At a high level, §1231 gain is gain from the disposition of property that is used in a trade or business, including real property such as rental real estate. In general, §1231 gains and losses are netted to determine if they should be capital (net gains) or ordinary (net losses) in character. Under general tax principles, this determination doesn’t occur until the last day of the tax year.
The proposed regulations maintained that, due to the nature of how this gain operates, net §1231 gains could not be invested into a qualified opportunity fund (QOF) until the last day of the tax year. These rules had made it harder for investors with §1231 gains to participate.
In the final regulations, the Treasury and the IRS have determined that a “gross approach” should be taken, no longer requiring investors to wait until the end of the year. Allowing the 180-day period of investment to begin on the date of the sale, exchange or other disposition should accelerate capital infusion into QOZs. However, it is important to note that gains characterized as ordinary income (such as §1245 or §1250 depreciation recapture) are not eligible to be a qualifying investment.
Investment period for gains from flow-through entities
The Treasury decided to provide more flexibility to investors by providing partners of a partnership, shareholders of an S corporation and beneficiaries of decedents’ estates and non-grantor trusts with the option to treat the 180-day period of capital gains flowing through to them as commencing upon the due date of the entity’s tax return, not including any extensions.
The regulations also generally allow the time period for capital gains from flow-through entities to begin on the date the gain is triggered or on the last day of the entity’s tax year.
The final regulations allow an eligible taxpayer to elect to choose the 180-day period for their gain reinvestment to begin on either 1) the date a payment under the installment sale is received or 2) the last day of the taxable year the eligible gain under the installment method would be recognized. Additionally, the regulations confirm the installment sale can occur prior to December 2017 as long as the capital gain is recognized after that time.
Vacant property—qualification for original use
The final regulations relaxed the rules for vacant property and reduced the previously proposed five-year vacancy requirement for property to meet the original use requirement. There now is a special one-year vacancy requirement for property that was vacant for an uninterrupted period prior to the date of publication of the QOZ designation and remained vacant until purchased.
With respect to property not vacant as of the time of the QOZ designation, the regulations require the property to be vacant continuously for at least three years. The three-year vacancy period for property that was not vacant at the time of the QOZ designation will more effectively facilitate investment in the QOZ. Real property is considered vacant if the property is significantly unused, defined as more than 80% of the building or land is not being used.
Option to disregard recently contributed property in asset test
The final regulations provide a six-month grace period for recently contributed property to a QOF to be invested in qualifying property. This makes sense, as QOFs may not have enough time to invest recently contributed capital prior to the asset testing period.
Property contributed to QOF
Property that is contributed to a QOF cannot be QOZBP because QOZBP must be purchased by a QOF.
The final regulations reiterate that land does not need to meet the original use or substantial improvement requirement to be treated as QOZBP as long as it is used in a trade or business and meets all other requirements, including that it should be improved by more than an insubstantial amount.
The regulations do not give a specific threshold for insubstantial improvements because it is highly fact dependent. However, it tells us that improvements such as an irrigation system for a farming business would be considered more than an insubstantial amount.
The regulations also implement an anti-abuse rule that says if a significant purpose of the acquisition of land is for speculative investment purposes, the transaction can be recharacterized so that the taxpayer may not receive the benefits of a qualifying QOZ investment. There is an example of a taxpayer that builds a small structure and runs a parking lot business on an otherwise empty lot that is recharacterized as nonqualifying under the anti-abuse rule.
Death of QOF owner
When a QOF interest is transferred due to the death of an owner, the beneficiary that receives the qualifying investment does not get to adjust the basis to fair market value at the time of death. The final regulations provide that the tax on the decedent’s deferred gain is the liability of the person in receipt of that interest from the decedent at the time of an inclusion event.
Opportunity zone regulations: What’s next for you?
We’ve already seen a significant uptick in opportunity zone investments since the release of the final regulations. Because the facts and circumstances of every investor are different, the summary above should not be considered legal or tax advice and should not be solely relied upon in making decisions on opportunity zone properties, businesses and funds. Please seek out our assistance directly before moving forward with any opportunity zone investments.
Be on the lookout for additional guidance and commentary from Wipfli regarding the finalized regulations over the next several weeks.