Trending publication

04.22.2019 | Legal Advisory

The Tax Cuts and Jobs Act of 2017 (“TCJA”) established a program to provide preferential tax treatment for new investments made after December 31, 2017 in certain tracts of land in economically-distressed communities, known as Opportunity Zones. The tax incentives include a temporary deferral from inclusion in gross income from capital gains reinvested in a qualified opportunity fund, an increase in tax basis of the reinvested gains by 10 percent if the investment is held for at least five years and by an additional five percent if the investment is held for at least seven years, as well as a permanent exclusion from gross income of capital gains accrued after the investment in the opportunity fund from the sale or exchange of the investment in the opportunity fund if the investment is held for at least 10 years.

On October 29, 2018 the Department of the Treasury (“Treasury Department”) and the Internal Revenue Service (“IRS”) published a long-awaited notice of proposed rulemaking providing guidance with respect to investments in qualified opportunity funds (the “2018 Proposed Regulations”), and issued Rev. Rul. 2018-29, but still left many unanswered questions. A second set of proposed regulations was eagerly awaited and finally published by the Treasury Department and the IRS on April 17, 2019, which provides further guidance (the “2019 Proposed Regulations”). This advisory focuses on the aspects of the 2019 Proposed Regulations that we anticipate will be most meaningful to taxpayers seeking to establish or invest in a Qualified Opportunity Zone Fund.

1. Guidance on meaning of “Substantially All” and “Substantial Portion”

The Internal Revenue Code (“IRC”) provides that a trade or business is a qualified opportunity zone business if substantially all of the tangible property owned or leased by the business is qualified opportunity zone business property; however, the IRC does not define “substantially all” for purposes of this test.^[1] The 2018 Proposed Regulations clarified that the threshold to determine whether a trade or business satisfies the substantially all test such that it is a qualified opportunity zone business is 70 percent.

The “substantially all” test is also used to determine if property is qualified opportunity zone property.^[2] To qualify as qualified opportunity zone property, during substantially all of the qualified opportunity fund’s holding period of such property, substantially all of the use of such property must have been in a qualified opportunity zone.^[3] The 2018 Proposed Regulations did not provide guidance on the threshold to satisfy the “substantially all” test in this context. The 2019 Proposed Regulations provide that with respect to determining if property is qualified opportunity zone property, the term “substantially all” is defined as 90 percent. As such, in order for property to be qualified opportunity zone business property, the property must have been used in a qualified opportunity zone for at least 90 percent of the qualified opportunity fund’s holding period.

The 2019 Proposed Regulations clarify that inventory of a trade or business does not fail to be used in a qualified zone solely because the inventory is in transit from the qualified zone to a customer or from a vendor to a facility located in the qualified zone.

2. Guidance on “Original Use” – Including Guidance on Land

The original use of tangible property in a qualified opportunity zone must commence with the qualified opportunity fund or the qualified opportunity fund must substantially improve the property in order for such tangible property to be qualified opportunity zone business property.^[4] The 2019 Proposed Regulations provide guidance on the definition of “original use,” explaining that original use of tangible property acquired by a taxpayer commences on the date that person or a prior person first places the property in service in the qualified opportunity zone for purposes of depreciation or amortization. For purposes of determining whether property has been substantially improved by the qualified opportunity fund, the 2019 Proposed Regulations clarify that the determination will be made on an asset-by-asset basis.

The 2019 Proposed Regulations further explain that land may be treated as qualified opportunity zone business property if it is used in a trade or business of a qualified opportunity fund or qualified opportunity zone business. However, the requirement that original use of the property in the qualified opportunity zone commence with the qualified opportunity fund or be substantially improved is not applicable to land. The 2019 Proposed Regulations explain that land can be treated as qualified opportunity zone business property only if it is used in a trade or business of a qualified opportunity fund or qualified opportunity zone business, and explain that the holding of land for investment does not give rise to a trade or business.

3. Guidance on Leased Property

In general, qualified opportunity zone business property is tangible property used in a trade or business of a qualified opportunity fund if such property was acquired by such fund by purchase after December 31, 2017, the original use of such property in the qualified opportunity zone commenced with the qualified opportunity fund or the qualified opportunity fund substantially improved the property, and during substantially all of the qualified opportunity fund’s holding period for such property, substantially all of the use of such property was in a qualified opportunity zone.^[5] However, the requirements are different with respect to tangible property leased by a qualified opportunity zone business.

The 2019 Proposed Regulations explain that leased tangible property may be treated as qualified opportunity zone business property if the leased tangible property is acquired under a lease entered into after December 31, 2017, and substantially all of the use of the leased tangible property is in a qualified opportunity zone during substantially all of the period for which the business leases the property. Notably, the 2019 Proposed Regulations do not impose an original use requirement with respect to leased tangible property.

For purposes of valuing leased tangible property for the 90 percent asset test and 70 percent substantially all test, the 2019 Proposed Regulations provide two methodologies. Under the first methodology, the applicable financial statement valuation method, the value of leased tangible property is the value of such property as reported on the applicable financial statement for the respective reporting period. Under the second methodology, the alternative valuation method, the value of the tangible property is calculated as the sum of the present values of the payments to be made under the lease for such property.

The 2019 Proposed Regulations do not require the leased tangible property to be acquired from an unrelated lessor. The 2019 Proposed Regulations provide that the lease must be market rate. Additionally, if the lessor and lessee are related parties, the qualified opportunity zone business or qualified opportunity fund may not make a prepayment to the lessor for a period of use exceeding 12 months. Finally, if the lessor and lessee are related parties, leased tangible property may not be treated as qualified opportunity zone business property unless the lessee becomes the owner of tangible property that is qualified opportunity zone business property that has a value of at least the value of the leased personal property. Note that the 2019 Proposed Regulations provide an anti-abuse rule to prevent taxpayers from circumventing the substantial improvement requirement through the use of leases.

4. 50 Percent of Gross Income From Qualified Opportunity Zone Safe Harbors

The 2018 Proposed Regulations imposed a gross income requirement, requiring that for each taxable year at least 50 percent of the gross income of a qualified opportunity zone business is derived from the active conduct of a trade or business within the qualified opportunity zone. In response to concerns about how sales outside a qualified opportunity zone would be treated, the 2019 Proposed Regulations provided three safe harbors to satisfy the 50 percent gross income requirement. The 50 percent gross income requirement is satisfied if 50 percent of the services performed by employees and independent contractors of a business, based on the number of hours worked or the amounts paid, are performed in the qualified opportunity zone. A trade or business may satisfy the 50 percent gross income requirement based on a conjunctive test if the tangible property of the business located in the qualified opportunity zone and the management or operational functions performed for the business in the qualified opportunity zone are each necessary to generate 50 percent of the gross income of the trade or business.

5. 90 Percent of Assets in Qualified Opportunity Zone Property - Working Capital Safe Harbor

An investment vehicle that is organized as a partnership or corporation must hold at least 90 percent of its assets in qualified opportunity zone property in order to be a qualified opportunity fund. The 2018 Proposed Regulations provided for a working capital safe harbor under which qualified opportunity fund investments in qualified opportunity zone businesses may hold cash, cash equivalents, or debt instruments with a term of 18 months or less for a period of up to 31 months if there is a written plan that identifies the cash or cash equivalent is being held for the acquisition, construction, or substantial improvement of tangible property in the opportunity zone, there is a written schedule, and the business complies with the written schedule.

The 2019 Proposed Regulations updated the 31 month safe harbor to say that the written plan may identify the cash or cash equivalent for the development of a trade or business in the qualified opportunity zone in addition to for the acquisition, construction, or substantial improvement of tangible property. The 2019 Proposed Regulations make it clear that a business may benefit from multiple overlapping or sequential applications of the working capital safe harbor, provided each application independently satisfies the safe harbor requirements. Furthermore, the 2019 Proposed Regulations explain that the 31 months provided for in the safe harbor may be exceeded if the delays are attributable to government approvals.

The 2019 Proposed Regulations provide for a six month grace period for new qualified opportunity funds, allowing new qualified opportunity funds to delay the start of their status as a qualified opportunity fund, thereby delaying the start of the 90 percent asset test. Additionally, pursuant to the 2019 Proposed Regulations, an existing qualified opportunity fund that receives new capital may apply the 90 percent asset test without taking into account investments received in the preceding six months.

6. Reasonable Period of Time to Reinvest

Qualified opportunity funds are granted a reasonable period of time to reinvest proceeds from the sale or disposition of qualified opportunity zone business property, qualified opportunity zone stock, and qualified opportunity zone partnership interests in order to remain compliant with the 90 percent asset test. The 2019 Proposed Regulations provide guidance on how long constitutes a reasonable length of time. Per the 2019 Proposed Regulations, a qualified opportunity fund has 12 months from the date of disposition, sale, or distribution of such property to reinvest the proceeds. Additionally, in order for the reinvested proceeds to be counted as qualified opportunity zone business property from the date of the disposition, sale, or distribution until the date of reinvestment in other qualified opportunity zone property, the proceeds must be continuously held in cash, cash equivalents, or debt instruments with a term of 18 months or less until the reinvestment.

The 2019 Proposed Regulations provide clarity and flexibility to investors and further encourage investments in opportunity zones. The 2019 Proposed Regulations make it clear that in addition to real estate developers, startup businesses may benefit from making investments in opportunity zones. Overall, the initial response to the 2019 Proposed Regulations has been very positive, with experts predicting that there will be an increase in capital investments into opportunity zones in the coming months.

Please see our prior advisory, “Finding Opportunities in Qualified Opportunity Zones," for additional information. Learn more about these developments by contacting Melissa Sampson McMorrow or a member of our Tax Department at 617.439.2000.

This advisory is for information purposes only and should not be construed as legal advice on any specific facts or circumstances. Under the rules of the Supreme Judicial Court of Massachusetts, this material may be considered as advertising.

[1] IRC § 1400Z-2(d)(3)(A)(i).

[2] IRC § 1400Z-2(d)(2)

[3] IRC § 1440Z-2(d)(2)(D)(i)(III).

[4] IRC § 1400Z-2(d)(2)(D)(i)(II).

[5] IRC § 1400Z-2(d)(2)(D)(i).