The Treasury Department and Internal Revenue Service (IRS) have released final regulations intended to clarify key questions regarding investing in qualified opportunity funds (QOFs). The Agencies had previously released draft regulations for public comment in late 2018 as well as April 2019.
The final regulations focus heavily on accounting issues relating to Qualified Opportunity Funds. In particular, the regulations set up a detailed set of rules for when certain transactions trigger an “inclusion event,” which is a transaction that may terminate an investors qualifying investment. NAHB strongly recommends its members operating a QOF consult with a tax professional prior to making any type of distribution or other transaction to ensure such action does not inadvertently trigger an inclusion event.
To help clarify what opportunity zones and QOFs are and how the associated tax benefits work, NAHB has answered a list of the most frequently asked questions on the subject. This has been updated to reflect the final regulations.
- What are opportunity zones and QOFs, and how do the tax benefits work?
- How will a taxpayer self-certify a QOF and complete annual reporting requirements?
- Can pre-existing entities qualify as a QOF?
- What type of income is eligible for deferral?
- How does a taxpayer elect to defer capital gains invested in a QOF?
- How are QOF investments treated after the opportunity zones expire in 2028?
- What is a qualified opportunity zone business? What are the original use and substantial improvement requirements?
- What does “substantially all” mean?
- How is land value factored into substantial improvements?
- What is the capital safe harbor?
- What is the 50% gross income requirement?
- Can a QOF sell an investment and reinvest the proceeds in a new investment, without losing the tax benefits? What about tax consequences for investors?
- Can I buy land and hold it as a qualifying investment?
- Does leased tangible property qualify or only property owned outright?
- Can I lease tangible property from a related party, such as another business entity I own?
- How is vacant property treated? What is vacant property?
- I own land that straddles an opportunity zone — some of it is in the zone, some not. Does it qualify?
- What are the compliance implications for opportunity funds under federal and state securities laws?
- Are there any special rules for section 42 Low-Income Housing Tax Credit properties?
- What are the special rules for brownfield sites?
- When are the final regulations effective?
NAHB urges all taxpayers to consult with a tax and/or investment advisor prior to making any investment/financial decisions.
The following information is strictly for informational purposes and highlights only certain aspects of the proposed regulation.
What are opportunity zones and QOFs, and how do the tax benefits work?
Opportunity zones are a new investment tool created as part of the Tax Cuts and Jobs Act of 2017. It seeks to encourage economic growth in designated distressed communities (i.e., qualified opportunity zones.)
Investments into an opportunity zone flow through a qualified opportunity fund. QOFs can take the form of a corporation or partnership.
The law provides two tax incentives for investments made in an opportunity zone. First, it allows taxpayers to defer federal taxes owed on any capital gains invested in a QOF. Over time, investors may be eligible to reduce federal taxes owed on the deferred capital gains. Second, the law excludes from gross income the post-acquisition gains on investments in QOFs that are held for at least 10 years.
How will a taxpayer self-certify a QOF and complete annual reporting requirements?
In general, any taxpayer that is a corporation or partnership may self-certify as a QOF. Taxpayers will use Form 8996, Qualified Opportunity Fund, for both the initial self-certification and the annual reporting of compliance with the 90% asset test.
The IRS has indicated that additional revisions to Form 8996 are forthcoming for tax years 2019 and beyond.
Can pre-existing entities qualify as a QOF?
The final regulations states that “there is no legal barrier to a pre-existing eligible entity qualifying as a QOF or qualified opportunity zone business,” but the pre-existing entity must satisfy all of the applicable requirements of the statute and regulations.
What type of income is eligible for deferral?
The final regulations specify that ordinary gains are not eligible but that “both long-term capital gain and short-term capital gain may be determined to be eligible gain.” With regard to recapture income, the final regulations note that “consistent with section 64, any gain required to be treated as ordinary income under subtitle A, such as section 1245 recapture income, is not eligible gain.”
In addition, the gain to be deferred must be a gain that would be recognized not later than Dec. 31, 2026, which is the final date under the law for the deferral of a gain. The regulations would also prohibit the deferral of any gain that arises from a sale or exchange with a related person as defined in section 1400Z-2(e)(2).
How does a taxpayer elect to defer capital gains invested in a QOF?
Taxpayers will make deferral elections on Form 8949, Sales and Other Dispositions of Capital Assets, which will be attached to their federal income tax returns for the taxable years in which the gain would have been recognized if it had not been deferred.
How are QOF investments treated after the opportunity zones expire in 2028?
A major source of uncertainty is the effect of the expiration of all designed opportunity zones on Dec. 31, 2028. Under the statute, a taxpayer who holds an investment in a QOF for at least 10 years receives a stepped-up basis that excludes from gross-income the post-acquisition gains on QOF investments. Because the opportunity zones themselves only exist for 10 years, questions have been raised whether meeting the 10-year investment window requires investments to be made prior to the end of 2018.
The final regulations would permit taxpayers to make the basis step-up election under section 1400Z-2(c) after a qualified opportunity zone designation expires. Under the final regulations, “the ability to make an election under section 1400Z-2(c) for investments held for at least 10 years is not impaired solely because, under section 1400Z-1(f), the designation of one or more qualified opportunity zones ceases to be in effect.”
Taxpayers would be able to preserve this election until Dec. 31, 2047.
What is a qualified opportunity zone business, and
Qualified opportunity zone business property is the tangible property used in a trade or business of the QOF. Section 1400Z-2(d)(2)(D) of the statute provides that tangible property will be treated as a qualified opportunity zone business property if it meets three requirements.
- The QOF must have acquired the property after Dec. 31, 2017 from an unrelated person.
- During substantially all of the QOF’s holding period, substantially all of the tangible property has been in the QOZ. (See the FAQ on Substantially All.)
- The original use of the tangible property must begin with the QOF or the QOF must substantially improve the tangible property.
The original use and substantial improvement requirements are key features to any opportunity zone investment. In essence, the statute differentiates between a new investment where no investment existed before (original use commences with the QOF) and existing tangible property that requires an additional investment to qualify (substantial improvement). For example, a newly constructed building may qualify as original use, but purchasing an existing building will generally require the QOF to substantially improve it.
A property is considered substantially improved when, within 30 months of acquisition, its additional basis is increased so as to exceed its purchase price (in the case of real property, the basis to be doubled excludes the value of the land).
The regulations define “original use” of tangible property as property that has not been previously depreciated or amortized before its use within the qualified opportunity zone.
What does “substantially all” mean?
Under the statute, a QOF is any investment vehicle organized as a corporation or partnership. A QOF must hold at least 90% of its assets in qualified opportunity zone property, which includes qualified opportunity zone business property. Qualified opportunity zone business property “may also include certain equity interests in an operating subsidiary entity (either a corporation or partnership) that qualifies as a qualified opportunity zone business…”
For a trade or business to qualify as a qualified opportunity zone business, “it must (among other requirements) be one in which substantially all of the tangible property owned or leased by the taxpayer is qualified opportunity zone property.” Both the terms “qualified opportunity zone property” and “qualified opportunity zone business” incorporate several “substantially all” requirements. In general, the final regulations conform with the definitions of “substantially all” that were proposed in the draft regulations. The final regulations continue to differentiate between “substantially all” requirements for holding periods versus a “use” context.
For example, with regard to holding qualified opportunity zone stock, qualified opportunity zone partnership interests, and qualified opportunity zone property, the regulations define “substantially all” as “90% of the total holding period of the QOF.”
In the “use” context, such as tangible property used in a trade or business, “substantially all” is defined as “70% of the total use of such tangible property” must occur within the QOZ.
How is land value factored into substantial improvements?
Under the statute, within 30 months of acquisition of existing property, the QOF must substantially improve the property. The additional basis of property must “exceed an amount equal to the adjusted basis of such property” when acquired.
IRS Revenue Ruling 2018-29 and the final regulations clarify that “land that is purchased and located within a qualified opportunity zone is not subject to either the original use requirement under section 1400Z-2(d)(2)(D)(i)(II) or the substantial improvement requirement under sections 1400Z-2(d)(2)(D)(i)(II) and 1400Z-2(d)(2)(D)(ii).”
Additional taxpayer guidance can be found in IRS Revenue Ruling 2018-29.
What is the capital safe harbor?
In general, a QOF has six months to invest cash held in qualifying assets. However, the agencies note that concerns have been raised in circumstances when construction or rehabilitation of real estate takes longer than six months. In response, the late-2018 proposed regulations would create a capital safe harbor for “QOF investments in qualified opportunity zone businesses that acquire, construct, or rehabilitate tangible business property, which includes both real property and other tangible property used in a business in an opportunity zone.” The safe harbor allows working capital to be held by the business for up to 31 months, “if there is a written plan that identifies the financial property as property held for the acquisition, construction, or substantial improvement of tangible property in the opportunity zone, there is a written schedule consistent with ordinary business operations of the business that the property will be used within 31 months, and the business substantially complies with the schedule.”
Taxpayers would be required to retain any written plan for their records.
NAHB requested the agencies provide additional flexibility for delays that arise during construction that might extend a project’s completion beyond 31 months — particularly delays due to governmental approvals. In response, the April 2019 proposed regulations further offered that the safe harbor is NOT violated if the delay is attributable to waiting for government action on an application that was completed during the 31-month safe harbor period.
Additionally, the April 2019 proposed regulations add an additional qualifying purpose to the safe harbor, namely working capital earmarked for the development of a trade or business. This is an addition to working capital intended for the acquisition, construction, and/or substantial improvement of property.
The final regulations have adopted all of the above noted provisions but with some clarifications and limitations. Specifically, the final regulation has clarified that the working capital safe harbor should be tolled — that is, the 31-month clock put on pause — “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.” Where this is the case, “then the 31-month working capital safe harbor will be tolled for a duration equal to the permitting delay.”
In addition, the final regulations allow for additional flexibility under certain circumstances. If the qualified opportunity zone business is located in a qualified opportunity zone within a federally declared disaster area, the qualified opportunity zone business may receive up to an additional 24 months to consume its working capital assets, as long as it otherwise complies with the requirements of the safe harbor. The final regulations also confirm that a single business may benefit from more than a single application of the safe harbor, providing that each application complies with the requirements of the safe harbor.
The final regulations also create a new 62-month working capital safe harbor for start-up businesses.
What is the 50% gross income requirement?
Under the statute, in order to be a qualified business entity, a corporation or partnership must derive at least 50% of its total gross income from the active conduct of such business. The final regulations clarify how that requirement is satisfied by providing multiple safe harbors. Businesses only need to meet one of these safe harbors to qualify.
- Hours Performed Test: If at least 50% of the services performed (based on hours) by its employees and independent contractors (and employees of independent contractors) are performed within the qualified opportunity zone
- Amounts Paid Test: If at least 50% of the services performed for the business by its employees and independent contractors (and employees of independent contractors) are performed in the qualified opportunity zone, based on amounts paid for the services performed. The final regulations clarify that guaranteed payments to partners in a partnership for service provided to the trade or business are also included in the amounts paid test.
- Business Functions Test: If (1) the tangible property of the business that is in the qualified opportunity zone, and (2) the management or operational functions for the business in the qualified opportunity zone are each necessary to generate 50% of the gross income of the trade or business
Taxpayers not meeting any of the safe harbors may meet the 50% requirement based on a facts and circumstances test.
Can a QOF sell an investment and reinvest the proceeds in a new investment, without losing the tax benefits? What about tax consequences for investors?
Under the statute, a QOF must invest 90% of its assets into qualifying opportunity zone property or a qualifying opportunity zone business. The statute also allows the regulators to ensure a QOF has a reasonable amount of time to reinvest the return of capital from investments sold. Questions have been raised if an investment is sold shortly prior to a testing date, how a QOF can bring itself into compliance with the 90% requirement.
The April 2019 proposed regulations would allow a QOF 12 months from the sale to reinvest proceeds. And for the sale proceeds to be counted as qualifying qualified opportunity zone business property, the proceeds must be continuously held in cash, cash equivalents or debt instruments with a term of 18 months or less.
The final regulations retain this 12-month reinvestment period with some modifications to allow for more flexibility in certain circumstances. First, if the QOF is waiting on government action (i.e. permit approval), the 12-month reinvestment period is tolled. Second, in the event of a delay due to a federally declared natural disaster, the reinvestment period may be expanded to 24 months. The Agencies note that a QOF must invest proceeds as original planned before the disaster: “For example, if a QOF is unable to invest in certain qualified opportunity zone business property because the property is located in a Federally declared disaster area, the QOF must invest the proceeds in a similar property located in that QOZ.”
Of note, the 12-month reinvestment period applies only to the QOF, not to a qualified opportunity zone business. The Agencies point out that “qualified opportunity zone businesses may avail themselves of the working capital safe harbor to enable proceeds to qualify as qualified opportunity zone business property.”
While the 12-month reinvestment period would clarify that the sale of assets by a QOF does not affect in any way investors’ holding periods in their qualifying investments or trigger the inclusion in their taxable income of any DEFERRED gain (i.e., the initial investment), the Treasury Department and IRS state they lack the legal authority to permit investors to avoid recognizing their gain on the investment when an asset is sold.
Can I buy land and hold it as a qualifying investment?
The final regulations would disallow as an eligible investment unimproved or minimally improved land if the taxpayer has an expectation, intention or view not to improve the land by more than an insubstantial amount within 30 months after the purchase. The holding of land for investment does not give rise to a trade or business, and such land could not be qualified opportunity zone business property.
These regulations do recognize that the degree to which it is necessary or useful for taxpayers seeking to grow their business to improve the land that their businesses depend on will vary, so no broad rules are proposed to differentiate between holding land for investment and land used for a legitimate business purpose. But the Treasury Department and IRS indicate they will be scrutinizing deals, and if they determine that a significant purpose for acquiring unimproved land was to achieve an inappropriate tax result, that investment will not qualify.
Does leased tangible property qualify or only property owned outright?
Yes, under the final regulations, leased tangible property would be considered qualifying opportunity zone business property, providing it meets the following requirements:
- The leased tangible property must be acquired under a lease entered into after Dec. 31, 2017, and
- Substantially all of the use of the leased tangible property must be in a qualified opportunity zone during substantially all of the period for which the business leases the property.
Unlike with owned tangible property, the regulations do not impose original use or substantial improvement requirements.
Can I lease tangible property from a related party, such as another business entity I own?
Yes, under the final regulations, tangible property may be leased from a related party but with some limitations.
First, the proposed regulations require in all cases that the lease is a market-rate lease. This rule applies regardless of whether the parties are related. However, “the final regulations provide that there will be a rebuttable presumption that, with regard to leases between unrelated parties, the terms of the lease were market rate (that is, the lease satisfies the market-rate lease requirement).” The final regulations also provide that leases between an unrelated party and a state, local or Indian tribal government satisfy the market-rate requirement.
Second, when leasing from a related party, the regulations prohibit a QOF or qualified opportunity zone business from making prepayments to the lessor or a person related to the lessor that exceeds 12 months.
Third, when leasing from a related party, the proposed regulations do NOT permit leased tangible PERSONAL property to be treated as qualified opportunity zone business property unless the lessee becomes the owner of tangible property that is qualified opportunity zone business property and that has value not less than the value of the leased personal property.
Finally, the regulations contain anti-abuse rules to prevent the use of leases to circumvent the substantial improvement requirement for the purchase of real property (other than land). Leased real property can be also be excluded as a qualifying investment if there was a plan, intention or expectation for the real property to be purchased by the QOF for an amount other than fair market value.
How is vacant property treated? What is vacant property?
In general, existing property is considered an eligible investment only if it is, within 30 months of acquisition, substantially improved. A substantial improvement requires additional investments into the property so as to double the basis of its initial acquisition cost (excluding the value of the land).
In the April 2019 proposed regulations, the Treasury Department and IRS proposed that where a building or other structure has been continuously vacant for at least five years prior to being purchased by a QOF or qualified opportunity zone business, the purchased building or structure will satisfy the original-use requirement. NAHB recommended in its comments that this vacancy period be reduced to three years. The final regulations accepted NAHB’s recommendation.
In addition, the final regulations provide a “special one-year vacancy requirement for property that was vacant prior to and on the date of publication of the QOZ designation notice that listed the designation of the QOZ in which the property is located, and through the date on which the property was purchased by an eligible entity.”
The final regulations define vacant property as real property that is “significantly unused.” More precisely, real property will be considered “significantly unused” if “more than 80% of the building or land, as measured by the square footage of useable space, is not being used.” In addition, property purchased by an eligible entity from a local government that the local government holds as the result of an involuntary transfer (i.e. abandonment, bankruptcy, foreclosure or receivership) may be treated as satisfying the original use requirement.
I own land that straddles an opportunity zone — some of it is in the zone, some not. Does it qualify?
The April 2019 proposed regulations recommended borrowed the same rules used for another place-based tax incentive, Empowerment Zones. The proposed regulations would allow straddling land to qualify if the amount of property within the qualified opportunity zone is substantial as compared to the amount of real property outside of the zone. Specifically, real property would qualify if the unadjusted cost of the real property inside a qualified opportunity zone is greater than the unadjusted cost of real property outside of the qualified opportunity zone (unadjusted cost test). In addition, all of the real property outside of the qualified opportunity zone must be contiguous to part or all of the real property inside the zone.
The final regulations retain the unadjusted cost test but also include a second option based on square footage. Under the square footage test, “if the amount of real property based on square footage located within the qualified opportunity zone is greater than the amount of real property based on square footage outside of the qualified opportunity zone, and the real property outside of the qualified opportunity zone is contiguous to part or all of the real property located inside the qualified opportunity zone, then all of the property is deemed to be located within a qualified opportunity zone.”
The final regulations also clarify issues related to when a property is “contiguous.” In this case, “the final regulations provide that parcels or tracts of land will be considered contiguous if they possess common boundaries, and would be contiguous but for the interposition of a road, street, railroad, stream or similar property.” The final regulations also exclude parcels of land that touch only at a common corner.
What are the compliance implications for opportunity funds under federal and state securities laws?
QOFs may be subject to state and federal securities law requirements, including registration requirements. The staffs at the Securities and Exchange Commission and the North American Securities Administrators Association have provided an overview of the compliance implications that should be considered.
In general, newly constructed buildings that have not yet been placed in service satisfy the original use requirement. Once the building is placed in service, it must be substantially improved.
Are there any special rules for section 42 Low-Income Housing Tax Credit properties?
The Treasury Department and IRS received several comments requesting clarification of certain interactions between opportunity zone investments and other tax incentives, including section 42. The Agencies noted they “continue to consider the combining of other tax incentives (including credits) with the benefits provided by section 1400Z-2” but have not included any special rules within these final regulations.
What are the special rules for brownfield sites?
Because remediation periods for brownfield sites may extend beyond the 30-month substantial improvement deadline, the Treasury Department and IRS “provide that all real property composing a brownfield site, including land and structures located thereon, will be treated as satisfying the original use requirement.” However, the final regulations require that the site be remediated to meet “basic safety standards for human health and environment” and such remediation efforts will be used to determine if the investment qualifies for this special rule.
When are the final regulations effective?
The final regulations are effective on March 13, 2020.
NAHB is providing this information for general information only. This information does not constitute the provision of legal advice, tax advice, accounting services, investment advice, or professional consulting of any kind nor should it be construed as such. The information provided herein should not be used as a substitute for consultation with professional tax, accounting, legal, or other competent advisers. Before making any decision or taking any action on this information, you should consult a qualified professional adviser to whom you have provided all of the facts applicable to your particular situation or question. None of this tax information is intended to be used nor can it be used by any taxpayer, for the purpose of avoiding penalties that may be imposed on the taxpayer. The information is provided “as is,” with no assurance or guarantee of completeness, accuracy, or timeliness of the information, and without warranty of any kind, express or implied, including but not limited to warranties of performance, merchantability, and fitness for a particular purpose.