The Treasury Department and IRS have issued two sets of proposed regulations intended to clarify key questions regarding investing in qualified opportunity funds (QOFs). The first set of proposed regulations was issued in late 2018, and the second set was issued in April 2019. In some cases, the 2019 proposed regulations amend the late-2018 draft regulations.
Public comments on the April 2019 proposed regulations will be accepted until July 1.
These proposed regulations may be changed before the agencies finalize them. Additional guidance is expected in the coming months to address the administrative rules applicable to a QOF that fails to maintain the required minimum investment standards as well as information reporting requirements for eligible taxpayers.
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. These questions include:
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.
The deferral of federal taxes owed on the initial investment ends on Dec. 31, 2026.
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.
In the April 2019 proposed regulation, the IRS indicated that additional revisions to Form 8996 are forthcoming for tax years 2019 and beyond.
Can pre-existing entities qualify as a QOF?
The late-2018 proposed regulations would not prohibit “using a pre-existing entity as a QOF or as a subsidiary entity operating as a qualified opportunity business, provided that the pre-existing entity satisfies the requirements under section 1400Z-2(d).”
What type of income is eligible for deferral?
The late-2018 proposed regulations specify that ordinary gains are not eligible and that “only capital gains are eligible for deferral and potential exclusion under section 1400Z-2.” 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. These proposed 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 late-2018 proposed regulations would “permit taxpayers to make the basis step-up election under section 1400Z-2(c) after a qualified opportunity zone designation expires.”
Taxpayers would be able to preserve this election until Dec. 31, 2047. The late-2018 proposed regulation would also allow a taxpayer who “makes an investment as late as the end of June 2027 to hold the investment in a QOF for the entire 10-year holding period described in section 1400Z-2(c), plus another 10 years.”
What is a qualified opportunity zone business, and 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 percent 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.” The proposed regulations would allow the “substantially all” requirement to be met when “at least 70 percent of the tangible property owned or leased by a trade or business is qualified opportunity zone business property (as defined section 1400Z-2(d)(3)(A)(i).”
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.” The late-2018 proposed regulations would allow the “substantially all” requirement to be met when “at least 70% of the tangible property owned or leased by a trade or business is qualified opportunity zone business property (as defined section 1400Z-2(d)(3)(A)(i).”
The late-2018 proposed regulations note that the 70% requirement will give “QOFs an incentive to invest in a qualified opportunity zone business rather than owning qualified opportunity zone business property directly.” These proposed regulations highlight an example of how the 70% requirement might alter QOF investment behavior:
For example, consider a QOF with $10 million in assets that plans to invest 100% of its assets in real property. If it held the property directly, then at least $9 million (90%) of the property must be located within an opportunity zone to satisfy the 90% asset test for the QOF. If instead, it invests in a subsidiary that holds real property, then only $7 million (70%) of the property must be located within an opportunity zone. In addition, if the QOF only invested $9 million into the subsidiary, which then held 70% of its property within an opportunity zone, the investors in the QOF could receive the statutory tax benefits while investing only $6.3 million (63%) of its assets within a qualified opportunity zone.
The April 2019 proposed regulations seek to further clarify other instances of the statute that reference “substantially all.” In general, these regulations distinguish between references to “substantially all.” with regard to invested dollars, and generally holds these to a 90% threshold, and investments in tangible property, which generally has a lower “substantially all” threshold of 70%.
For example, the QOF is allowed to invest in qualified opportunity zone property in several different means, including qualified opportunity zone stock or partnership interest. Part of the definition of such stock or partnership interest is that “during substantially all of the qualified fund’s holding period for such stock [interest], such corporation qualified as a qualified opportunity zone business.” The April 2019 proposed regulations would define “substantially all” in this case as 90%.
For references in the statute within the definitions of qualified opportunity zone business property and qualified opportunity zone business to “substantially all” of the tangible property, the proposed regulations set the “substantially all” threshold at 70%.
The April 2019 proposed regulations note that with these definitions of “substantially all,” a QOF could satisfy all standards with as little as 40% of the tangible property used within a qualified opportunity zone:
This could occur if 90% of QOF assets are invested in a qualified opportunity zone business, in which 70% of tangible assets of that business are qualified opportunity zone property; and if, in addition, the qualified opportunity zone business property is only 70% in use within a qualified opportunity zone, and for 90% of the holding period for such property. Multiplying these shares together (0.9x0.7x0.7x0.9=0.4) generates the result that a QOF could satisfy the requirements of Section 1400Z-2 under the proposed regulations with just 40% of its assets effectively in use within a qualified opportunity zone.
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.
In NAHB’s comments to the late-2018 proposed regulations, we raised concerns regarding delays that might extend a project’s completion beyond 31 months, particularly delays due to governmental approvals. In response, the April 2019 proposed regulations clarify 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.
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 April 2019 proposed regulations seek to clarify how that requirement is satisfied by providing three safe harbors. Businesses only need to meet one of these safe harbors to qualify.
- 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
- 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
- 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.
However, for investors into a QOF, the April 2019 proposed regulations appear to create new complexities if investments are sold and reinvested by a QOF. The proposed regulations 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).
Although the proposed regulations state that “Congress tied these tax incentives to the longevity of an investor’s stake in a QOF, not to a QOF’s state in any specific investment portfolio,” 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.
NAHB believes this runs counter to the legislative intent of the statute, which clearly provides investors with a second tax incentive, on investments held at least 10 years, which adjusts the basis of the investment to reflect its market value at the time of sale, thereby negating any capital gains tax liability. NAHB will provide comments back to the IRS on this subject.
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.
The late-2018 proposed regulations seek to further clarify how to calculate the original basis of the property by excluding the cost of the underlying land: “for purposes of this requirement, the basis attributable to land on which such a building sits is not taken into account in determining whether the building has been substantially improved.” Additional taxpayer guidance can also be found in IRS Revenue Ruling 2018-29.
Can I buy land and hold it as a qualifying investment?
In general, the April 2019 proposed 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 proposed 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, according to the April 2019 proposed 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 April 2019 proposed 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.
Second, when leasing from a related party, the proposed 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 proposed 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.
Is tangible personal property a qualifying investment? What about used property (e.g., used construction equipment)?
Under the statute, real property and tangible personal property placed in use with a qualified opportunity zone must either have “original use” within the qualified opportunity zone or be substantially improved. In general, the April 2019 proposed regulations would define “original use” of personal tangible property as property that has not been previously depreciated or amortized before its use within the qualified opportunity zone. In addition, when placed in use, the property must be depreciated or amortized by the QOF or qualified opportunity zone business.
With regards to used tangible property (other than land), used tangible property will satisfy the original-use requirement with respect to a qualified opportunity zone so long as the property has not been previously used (that is, has not previously been used within that opportunity zone in a manner that would have allowed it to depreciated or amortized) by any taxpayer.
How is vacant property treated?
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).
Following the release of the late-2018 proposed regulations, NAHB recommended that vacant property not be treated as an existing structure subject to the substantial improvement requirements, but rather be subject to the original-use requirements. Investments that are considered “original use” require no specified additional minimum improvement.
In the April 2019 proposed regulations, the Treasury Department and IRS are proposing that where a building or other structure has been 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.
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 borrow 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. 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.
How can I submit comments to the Treasury and IRS?
Taxpayers may submit comments electronically via the Federal Rulemaking Portal at www.regulations.gov, referencing IRS REG-115420-18. All comments are due by July 1, 2019.
The comment period has closed for the late-2018 proposed regulations.
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.