On April 17, 2019 the U.S. Treasury released its newest and most highly anticipated proposed Regulations covering Opportunity Zones. Many investors, as well as legal, accounting, and financial professionals, sought clarification on a cadre of issues related to Opportunity Zones operations and specific definitions including:
- Timing and amount of the deferred gain that is included in income
- Treatment of leased property used by a quality opportunity business
- Qualified Opportunity Zone (“QOZ”) business gross receipts testing
- The “reasonable period” test for a Qualified Opportunity Fund (“QOF”) to reinvest proceeds from a qualified asset sale penalty-free
Timing and amount of the deferred gain that is included in income
The proposed regulations state that a gain deferred with an equity investment in a QOF will be recognized when they are sold or exchanged by December 31, 2026, whichever came first. While the timing related to the end of tax year 2026 is straightforward, the proposed regulations more clearly define sold or exchange in relation to this timing matter. The intent being to inhibit investors from decreasing their investment level. Distributions of cash and other defined properties are now also gain triggering events.
There are different definitions for various entities and as to how an inclusion event is calculated. Transfers by gift will generally be considered inclusion events with the exception of gifts to grantor trusts, since the granter reports the income earned from those trusts. Contrary to the gift rule, most transfers caused by death to an estate and then subsequently to individual beneficiaries or to trusts are not considered inclusion events. When the deferred gain of property received upon death prior to December 31, 2026 is included in income on the earlier of a disposition or December 31, 2026, the income will be treated as income in respect of a decedent. Distributions in excess of basis will also trigger gain recognition.
Treatment of leased property used by quality opportunity business
In order to meet the substantially all“70% asset” test, a QOF can include QOZ business property. The property must be tangible, its original use in line with QOZ business where it is being used, or the QOF business must substantially improve the property. Additionally, substantially all the assets businesses use must take place within QOZ. The proposed regulations remove the substantial improvement requirement for leased tangible property, as most taxpayers do not have basis in leased property. Further, leased property does not carry the requirement to originate from an unrelated lessor. Opposingly, the sale of tangible property must be from an unrelated party in order to qualify for deferral. The proposed regulations also address certain aspects of lease terms. The lease in place must be at market value. It should be noted that if lessee and lessor are related, the property will not qualify for treatment as QOF property if the lease terms allow for a prepayment of fees in excess of 12 months. Leased real property is also addressed. If the lease for real property is entered into and at the time there is an expectation that the real property will be sold to the QOF for any amount other than fair market value, the real property will be excluded from the definition of QOF business property. These sections give example to the Treasury’s effort to reduce benefits relayed to related parties via preferential terms of lease arrangements.
Qualified Opportunity Zone (“QOZ”) business gross receipts testing
One of the more highly anticipated sections of the proposed regulations involves gross receipts testing. To meet the qualified business entity definition any entity must derive half of its gross income from the active trade or business within the QOZ. We have been provided with three safe harbor tests, the first of which is based on service hours. If 50% of the service hours performed by employees or independent contractors falls within the QOZ, then the test is passed. The second test is the same 50% threshold, but here the metrics being measured are the amounts being paid to employees or independent contractors operating within the QOZ. If this test is met, then the business meets the 50% gross receipts test. The third safe harbor test states that if the tangible property and the management and operational functions of the business needed to generate 50% of the gross receipts are located within the zone, then the 50% gross receipts test has been met. This last safe harbor test is especially important for potential QOZ business opportunities such as manufacturing. Before the issuance of this batch of regulations, there was concern that if a manufacturing operation located within a zone created a product, and then shipped those products to customers outside of a zone, those receipts may not be eligible for the test. The third safe harbor clearly addresses this concern and give thresholds to test the ratio of the QOZ assets to total assets in service. Lastly, there is a facts and circumstances test allotted to address uncommon conditions business arrangements where more than 50% of receipts are derived from a QOZ.
The “reasonable period” test for a Qualified Opportunity Fund (“QOF”) to reinvest proceeds from a qualified asset sale penalty-free
Prior to these proposed regulations, many taxpayers wanted to know what the definition of a reasonable amount of time meant in the context of reinvesting proceeds stemming from a QOF investment sale, as well the treatment of a potential gain from that sale. The proceeds from such a sale will continue to qualify for the substantially all assets, or 90% test so long as they are reinvested within 12 months of the date of the sale. Furthermore, during that 12-month grace period, the proceeds must remain rather liquid. The proceeds can only be held in liquid forms, such as cash, equivalents, or debt termed at 18 months or less. This doesn’t allow for Opportunity Funds to use proceeds from QOF investment sales for any lengthy period for any assets outside of very liquid assets. This regulation aims to be a preventative measure put in place to halt the removal of funds from bona fide QOF investments for alternative, “non-qualified” investments.
While we wait for the Treasury to finalize these proposed regulations the general consensus to these provisions is largely taxpayer friendly among many investors, both individuals and institutions. The Treasury used its ability in interpreting the legislation to make the law more able to be utilized by operating entities. The benefits of a real estate based QOZ investment were more clearly defined in previously issued rounds of regulations. Those more clearly defined benefits have led to more REIT, or real estate-focused, investment products being brought to market. Now operating entities have had additional clarity provided as to the specific advantages they are afforded by these new Regs. This could very well catalyze the infusion of capital raised by private equity and venture capital earmarked for the creation of their own respective fund meant to invest in QOZ businesses. General prudence and due diligence should still be administered when making investments in any QOFs. The overall quality of the underlying assets of the investment must have merit primarily as a sound investment, regardless of tax-benefits.