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January 31, 2020

Treasury Department and IRS Issue Final Regulations on Investing in Qualified Opportunity Zones

The Treasury Department and the IRS in December 2019 issued final regulations (the “Final Regulations”) addressing investments in qualified opportunity funds (“QOFs”). The Final Regulations retain the general structure of the proposed regulations that were issued on October 28, 2018 and May 1, 2019, but make significant modifications that in many cases provide those managing or investing in a QOF or a qualified opportunity zone business (a “QOZ Business”) with greater flexibility than was available under the proposed regulations. For information regarding the general aspects of the qualified opportunity zone (“Opportunity Zone”) regime, please see our Opportunity Zones practice page.

The Final Regulations generally apply to taxable years beginning after March 13, 2020. However, for taxable years to which the Opportunity Zone provisions are applicable and that begin on or before March 12, 2020, taxpayers may choose either to apply the Final Regulations in their entirety or the proposed regulations in their entirety. Highlights of a number of important points in the Final Regulations are set forth below.


Deferral of gains via investment in QOF

The Final Regulations include a number of provisions that clarify the treatment and eligibility of certain types of gain under the program, including those listed below.
  • Deferral of gain by Non-U.S. Persons and U.S. Tax-Exempt Entities. The Final Regulations permit non-U.S. persons (who are not generally subject to U.S. federal income tax) to defer capital gains that are treated as effectively connected with the conduct of a trade or business in the United States, and permit U.S. tax-exempt entities to defer capital gains that are treated as unrelated business taxable income. Accordingly, non-U.S. investors and tax-exempt investors that have realized U.S. capital gains that would be subject to U.S. tax absent an effective gain deferral may wish to explore the possibility of a deferral through investment in a QOF.
  • Deferral of gain from inclusion events. Taxpayers may defer gains from QOF inclusion events (i.e., from transactions that would otherwise require the inclusion of previously deferred gains). Any gain arising from such an inclusion event is eligible for deferral if invested in a different QOF within 180 days. However, the Treasury specifically declined to allow investors to tack their holding period for the second QOF investment onto the holding period for the first QOF investment which had been reinvested. As a result, the clock resets on the new investment, and such further deferred gain is treated as a new investment in a QOF for purposes of the investor’s deferral and holding period.
  • Deferral of gross Section 1231 gains. The Final Regulations adopt a gross gain approach to eligible Section 1231 gains (that is, gross Section 1231 gains may be deferred via an investment in a QOF without netting against Section 1231 losses). The 180-day period for investing eligible Section 1231 gains generally begins on the date of the sale or exchange that gives rise to the Section 1231 gain.
  • Deferral elections by investors in pass-through entities. The Final Regulations provide additional time to make an eligible investment in a QOF for taxpayers that receive capital gains from partnerships, S corporations, or non-grantor trusts by permitting such taxpayers to elect to begin the 180-day investment period on the due date of such entity’s tax return for the year in which the capital gain arose (without regard to extensions for return filing).
  • Deferral of capital gains from installment sales. Taxpayers with otherwise eligible capital gains from installment sales are permitted by the Final Regulations to elect one of two options with respect to the 180-day investment period for such gains. Taxpayers may elect either to (1) begin the 180-day period on the date an installment payment is received or (2) begin such period on the last day of the tax year in which the eligible installment sale gain would otherwise be recognized.


Exclusion of gain for investments held for 10 years

The Final Regulations provide some additional clarifications and flexibility in structuring and disposing of Opportunity Zone investments. Notably, the Final Regulations permit investors in QOFs that hold investments through subsidiary QOZ Businesses structured as partnerships to exclude gains after 10 years upon disposition of the underlying property or the QOZ Business.

Based on the revised guidance, a qualifying investor may elect to step up its basis in any property owned directly or indirectly through one or more partnerships by a QOF that is a partnership or an S corporation upon the sale of such property after the 10-year holding period has elapsed, thereby excluding such gain from federal income tax. This exclusion applies to capital gains and to ordinary gains, but not including gains from the sale of inventory property in the ordinary course of business. These rules notably make it possible for QOZ Businesses structured as partnerships to sell their assets directly without jeopardizing the 10-year gain exclusion, and should facilitate the use of multi-asset QOFs that hold a portfolio of distinct real estate assets, operating businesses and other eligible property. In order to avail oneself of this rule, investors must make an election in the relevant tax years for which they are excluding gain, and any such gains will be deemed to be distributed to partners on the last day of the QOF’s relevant tax year.

In addition, the Treasury has clarified that, in the event of a valid election by the taxpayer, the tax basis of an interest in a QOF partnership that is sold or exchanged after being held for 10 years or longer would be adjusted to an amount equal to its net fair market value plus the partner’s share of partnership debt relating to that interest. In the case of a QOF S corporation, the basis would be adjusted to an amount equal to the fair market value of the shares immediately prior to the sale or exchange.


Qualification of QOFs and QOZ Businesses

The Final Regulations include a number of important clarifications on the various aspects affecting the eligibility of qualified opportunity zone business property under the Opportunity Zone regime, as further described below.
  • Working Capital Safe Harbor. The Final Regulations expand upon the initial 31-month working capital safe harbor included in the proposed regulations by providing that tangible assets of a QOZ Business may potentially qualify for two consecutive 31-month working capital safe harbor periods. Rather than allowing 62 months during which the working capital safe harbor may apply, the Final Regulations contemplate two consecutive separate periods, with a requirement for additional working capital and plans that take into account the additional amounts.
  • “Substantial Improvement” with multiple assets. In determining whether property has been “substantially improved,” the Final Regulations provide a number of rules that permit certain assets to be considered in the aggregate rather than on a strict asset-by-asset basis. In general terms, properties may contribute toward qualification under the substantial improvement requirement if such properties are in the same Opportunity Zone, are used in the same trade or business, and one such property improves the functionality of the other. In addition, the Treasury has clarified that property which is in the process of being substantially improved will qualify as an eligible asset where the QOF or QOZ Business “reasonably expects” such substantial improvement to occur.
  • “Use” of Tangible and Intangible Property. Under the Opportunity Zone statute, a QOZ Business must use substantially all of its tangible property in a trade or business, which the Treasury previously clarified means 70% of the entity’s tangible assets. The Final Regulations provide further clarity on what is considered “use” of property in a trade or business, providing that use will be established where the property (1) is located within the geographic borders of the Opportunity Zone and (2) is used in connection with the ordinary conduct of the trade or business in the performance of an activity that contributes to the generation of gross income. The Final Regulations also provide similar clarity on intangible property used in a trade or business, providing that use is established where (1) the use is normal, usual, or customary in the conduct of the trade or business; and (2) used in connection with the ordinary conduct of the trade or business in the performance of an activity that contributes to the generation of gross income. Note, however, that the Final Regulations provide that materials and supplies that are used to manufacture, produce or construct property in the Opportunity Zone must themselves be qualifying property and thus must be acquired from an unrelated person.
  • Treatment of Land. The preamble to the Final Regulations clarifies that land generally is not required to meet the original use or substantial improvement tests, and that therefore (subject to certain exceptions, including an anti-abuse rule discussed below) land in a Opportunity Zone is qualifying property if it is acquired from an unrelated person in 2018 or after and is used in a trade or business. In order for this rule to apply, however, the QOF or QOZ Business must acquire the land with an expectation or intention to improve such land by “more than an insubstantial amount” within 30 months. This is a qualitative analysis, and the Treasury declined to assign a percentage test to what constitutes an “insubstantial amount” for these purposes.
  • Use of Land in a Business. The Treasury confirmed that certain types of property used in land-based businesses, such as easements, land and agricultural leases, timber deeds and water rights, if leased or otherwise purchased in accordance with the statutory requirements, would be eligible assets. In addition, the Treasury confirmed that expenditures to improve land and any naturally occurring structures located thereon may be taken into account for purposes of demonstrating compliance with the “more than an insubstantial amount” anti-abuse rule.
  • Leases. The Final Regulations provide a rebuttable presumption with respect to leased property whereby the terms of the lease are market rate terms if the lease is between unrelated parties. In addition, the Final Regulations retain but clarify the proposed rule that merely entering into a triple-net lease with respect to real property does not qualify as the active conduct of a trade or business for purposes of the Opportunity Zone regime. In two contrasting examples, the Final Regulations illustrate that while merely triple-net leasing an entire building will not constitute the active conduct of a trade or business (even if the landlord maintains an office with personnel on site at the building), triple-net leasing a portion of a building and leasing other portions of the building to other tenants that do not assume responsibility for all costs relating to their leased space, when the landlord’s employees manage and operate the spaces leased by those other tenants, can qualify as the active conduct of a trade or business. While these examples provide helpful clarification, they still leave certain important questions unanswered.
  • Vacant Property. The length of time that purchased property is required to be vacant in order to be considered “original use” property was reduced from five years. Under the Final Regulations, property that was vacant for one year before the designation of the Opportunity Zone in which it is located is eligible to be treated as original use property. Property that became vacant after the Opportunity Zone in which it is located was designated must be vacant for three years in order to be eligible to be treated as original use property. The definition of “vacant” for these purposes generally requires that less than 80% of the property’s usable space actually be in use.

For further information about this Alert, please contact:
Paul Marino, Partner 212.573.8158 or pmarino@sadis.com
Seth Lebowitz, Partner 212.573.8152 or slebowitz@sadis.com
Richard Shamos, Counsel 212.573.8027 or rshamos@sadis.com

Please feel free to discuss any aspect of this Alert with your regular Sadis & Goldberg contact.