20 Ozone Things to Know for 2020 (Part 1)
Two months have elapsed since Treasury and IRS issued the Final Regulations on Opportunity Zones. The effective date is March 13, 2020. During these two months, the Sullivan Ozone Practice Group has hosted gatherings for our clients and/or interested potential investors. Last week, over 125 interested parties attended our most recent Tax Briefing panel. We have narrowed our analysis down to our top 20 things to know for 2020. We will share our thoughts in two phases.
Opportunity Zones have been the hottest topic in real estate over the past two years and truly was one of the hidden gems emanating from the Tax Cuts and Jobs Act of 2017. This broad legislation benefits not only the communities situated in areas designated as “opportunity zones,” but also many stakeholders, including (i) real estate developers seeking equity investments for developments in these areas, (ii) sponsors, syndicators and private equity groups looking to create specific funds with the goal of investing in businesses and real estate in designated zones, and (iii) individual taxpayers with gain or the ability to create gain looking to defer and reduce the tax paid on such gain by making qualifying investments in qualified opportunity funds.
This new federal program is a community reinvestment tool designed to use tax incentives to drive long-term investments to rural and low-income urban communities throughout the nation. The backbone of the law is centered around the ability of taxpayers to defer, reduce and eliminate realized and future capital gain taxes.
In an effort to provide clarity to the law, the IRS has issued multiple rounds of proposed regulations and FAQs and invited industry comment. The real estate industry and tax professionals both identified problems and suggested solutions in the hundreds of their sequential submissions to Treasury and the IRS. The culmination of these joint efforts led to the issuance of the “final” regulations.
Briefly, the final regulations confirm many of the numerical tests and thresholds announced in the previously-published proposed regulations (first issued in October 2018 and, following a comment period, revised and re-issued in May 2019) and then supplement those to provide further clarity and/or to answer questions raised during the public comment periods. The final regulations are intended to make these “rules easier to follow and understand.”
Two additional general observations should be made. First, the final regulations do not appear to eliminate any previously proposed rules which were favorable to investors. Second, proffered regulations which would force investors to report expansive details of their investments, while the subject of pending Congressional action, were not adopted and are not incorporated in the final regulations.
It is an elusive task to rank in order of importance the most pressing answers coming out of the final regulations, but we must start somewhere. Our “top 10” appear below and will be followed in the next couple weeks with 10 more subjects.
1. Are Section 1231 gains still subject to a “netting” rule to be calculated at the end of a tax year?
In response to the overwhelming number of comments received by Treasury and IRS and in keeping with the goal allowing investment capital to flow into opportunity zones as soon as possible, the previously proposed “netting” rule was abandoned.
Gross Section 1231 gain is eligible for investment without a “netting” of losses. Section 1231 gains are not reduced by Section 1231 losses for purposes of determining what amount of gain is eligible for qualifying investment. Clarity on this rule alone should allow capital to be invested faster and with more certainty.
To quote Treasury, “(U)nlike the net approach of the proposed regulations, the final regulations adopt a gross approach to eligible Section 1231 gains without regard to any Section 1231 losses . . . accordingly, the term “capital gain net income” . . . is no longer applicable . . .”
In another rule applicable to Section 1231 gain, and owing in large measure to the elimination of the “netting” rule, the 180 days during which a taxpayer must invest eligible gain to obtain the tax deferral (and other benefits) begins on the date the taxpayer otherwise would have recognized that gain or, in other words, the date of a sale or exchange.
2. Can a Qualified Opportunity Zone Business (QOZB) sell its underlying property/asset and have the investors in a Qualified Opportunity Fund (QOF) which owns the QOZB exclude the appreciated gain from income (i.e. secure the beneficial tax treatment) after the 10-year hold?
This was a much-needed clarification on how to exit an investment and realize the ultimate tax benefit provided by the law – the elimination from income of any new gain. The final regulations now align with generally followed commercial real estate practices. A QOZB can sell its underlying property and its ultimate owners (the taxpayers, who, through their ownership in a QOF, have owned such asset for more than 10 years) can elect to exclude any gain from such sale from their income.
“Exits” with no tax on the appreciated gain now apply (again, after a 10-year hold), to:
- A QOF selling property it owns directly
- An investor who made a qualifying investment in a QOF selling that QOF interest
- By virtue of the above-described final regulation, sale of a QOZBP owned by a QOZB in which a QOF holds an interest.
3. Is the “substantial improvement” test for non-original use property still done on an asset-by-asset basis?
No; or at least not always.
In certain circumstances, the test may be done on an aggregate basis.
“. . . for purposes of applying the substantial improvement requirement, certain buildings located on the same or a contiguous parcel can have the improvements aggregated and treated as a single item of property...” The buildings must be part of an “eligible building group.”
In the context of operating businesses, a second aggregation approach applies when purchased original use assets (that would qualify as business property) are used in conjunction with non-original use assets in the same trade or business in the same (or a contiguous) zone and such assets “improve the functionality” of the non-original use assets (i.e. the property being improved). The improvement must be by more than an insubstantial amount.
It is important to note that not all circumstances permit use of the aggregation principle so guidance from accountants and lawyers is advisable to ensure the circumstances fit within rule.
There were a few other modifications made with respect to the “substantial improvement” requirement that the improvements be made over a 30-month period:
First, the tolling owing to government delay in acting on a permitting request remains in place, with some additional language suggesting the taxpayer must be making improvements not tied to the governmental approval. Other requests to extend the 30-month substantial improvement period were not adopted. Extensions for other “force majeure” events or events tied to the “reasonable control” of the taxpayer were not adopted.
Second, the final regulations provide that tangible property that is involved in the “substantial improvement” is treated as being used in a trade or business for satisfaction of the 30-month period. This means that property is “good” property for purposes of the 70 and 90 percent tests even before the improvements are completed. To apply this rule, the QOF or QOZB must reasonably expect that property will be substantially improved by the end of the 30-month period.
4. Were any substantive changes made to the “working capital safe harbor”?
Yes. Properly documented, the safe harbor for start-up businesses can cover 62 months. While there is some industry debate as to whether Treasury merely extended the original 31-month safe harbor to 62 months or clarified the originally proposed 31-month safe harbor, Treasury’s words are that they “created an additional 62-month safe harbor for start-up businesses.”
In addition, Treasury endorsed the use of multiple and/or overlapping “safe harbor” plans for incremental investments, but with a maximum aggregate “safe harbor” period capped at 62 months. When more than one plan is employed, each 31-month plan must satisfy the requirements of a qualifying plan independently and subsequent plans must be an integral part of the initial 31-month plan.
Technical rules were adopted governing how the “safe harbor” works in the context of constructing a property which qualifies for OZ benefits, and an additional 24-month extension (for a total of 55 months) was added for properties in federally-declared disaster areas.
5. How long does land or a building located with an OZ need to be vacant before qualifying as “original use” property? Other “Original Use” clarifications.
One year, if the land and/or building were vacant as of the date the census tract in which the property is located was designated an opportunity zone. For vacancies created thereafter, the threshold is three years. As to what constitutes being “vacant,” Treasury adopted a “significantly unused” test of 80% or more as measured by square footage of usable space.
In recognition that many opportunity zones contain vacant land and buildings that are municipally-owned and/or environmentally challenged, the final regulations provide two additional beneficial rules respecting “original use”:
- Reacting to the reality that local governments often acquire real property through involuntary transfer (for example, foreclosure following nonpayment of real estate taxes or general abandonment), an eligible entity that purchases such property from a local government can include all property comprising the real property (i.e. land plus buildings therein) as “original use” property.
- “Brownfield” sites are deemed “original use” property. Both the land and buildings thereon are exempt from the “substantial improvements” test provided the QOF or QOZB, within a reasonable period of time, makes investments into the site to improve safety and compliance with environmental laws/regulations.
6. Do Triple Net Leases by Themselves Constitute the Active Conduct of a Trade or Business?
No. The Opportunity Zone legislation is premised on creating active and on-going economic activity. The IRS continues to reject the idea that transferring all of what are traditionally ownership responsibilities to a tenant will not allow the investor to meet the statutory requirements. Therefore, the basic rule is maintained that mere triple net leasing does not rise to the level of an active trade or business.
Instead, Treasury opted to provide two examples of arguably “triple net” lease arrangements to illustrate situations of compliance and non-compliance. Of course, the two examples focus on circumstances with predictable conclusions and hence little apparent guidance.
As such, triple net leasing situations will remain inherently a “facts and circumstances” test.
7. Were any of the “inclusion” event rules changed?
There were some changes but, in the main, the proposed rules were adopted.
Debt-financed distributions to a QOF investor generally are not an “inclusion” event, subject to some timing and basis rules. Rules respecting “disguised sales” must be observed.
A qualifying investment received by a beneficiary in a transfer by reason of death (an inheritance) continues to be a qualifying investment in the hands of the beneficiary. No election to include death as an “inclusion” event was permitted nor were regulations changed which permitted further deferral respecting the payment of the deferred tax – i.e. the liability for payment of the deferred tax is upon the recipient of the interest.
The existence/applicability of one “inclusion” event does not automatically terminate an eligible investment to the extent deferred gain remains after accounting for the inclusion event. An example is helpful – consider a $100,000 eligible investment which is subject to a $20,000 inclusion event. The remaining $80,000 of deferred gain can still receive the step-up in basis.
Gifts, on the other hand, remain “inclusion” events. “The Treasury Department and the IRS have concluded that (i) no authority exists to impose the donor’s deferred capital gain tax liability on the donee . . . and therefore (ii) the Federal income tax on the deferred gain must be collected from the donor at the time of the gift of the qualifying investment.”
Transfers between spouses or incident to a divorce remain “inclusion” events – the deferred gain is recognized and the interest in the QOF no longer is a qualifying investment.
8. Has there been any expansion of what information respecting QOFs or their investments needs to be reported to the IRS?
None beyond the previously published form. Reporting remains at the investor (QOF) level.
Form 8996, which includes the self-certification of a QOF’s compliance with the statute, must be filed annually. In that form, the QOF taxpayer certifies that the QOF’s organizing documents include purpose language that the entity is organized for the purpose of investing in a qualified opportunity zone property and a description of the qualified opportunity zone business the QOF expects to engage in.
While there have been calls for increased reporting, including measurement metrics, Treasury opted to steer clear of rules, which though helpful in directing money to the needed communities and/or in reducing possible abuses, could “likely present numerous obstacles for QOF investors and ultimately reduce, rather than increase, the total amount of investments in low-income communities.”
Treasury will allow QOFs to self-decertify. There are no current rules in place for involuntary decertification, although Treasury may address that down the road.
9. Are only capital gains eligible for qualifying investments?
Essentially, yes, although the specific wording of the regulation has been amended slightly.
“Treasury and the IRS have retained in the final regulation the general rule set forth in the proposed regulations that limits eligible gains to gains treated as capital gains for Federal income tax purposes.”
“Long-term capital gains and short-term capital gains are eligible gains for OZ purposes but gain required to be treated as ordinary income, such as Section 1245 recapture income, is not eligible gain.”
Much as owned tangible property must be acquired after December 31, 2017 to be treated as Qualified Opportunity Zone Business Property (QOZBP), leased property faces an analogous hurdle – for leased tangible property to qualify as QOZBP, the lease must be entered into on or after December 31, 2017.
Many were concerned with the requirements in the proposed regulations that the lease must be on market terms. In response, Treasury and IRS adopted a relaxed final rule – leases between unrelated parties receive the benefit of a rebuttable presumption that the terms of a lease are market rate. As a practical matter, this protects the IRS’s ability to penalize abusers with the result that most unrelated party leases are presumed compliant without complex rules respecting evidence of market rate terms.
Leases from a state or local government (or an Indian tribal government) do not need to be at “market” terms, thereby allowing local governments to lease property on investor favorable terms to encourage/incentivize investment.