Given the initial excitement among tax practitioners about the possibilities for tax deferral and tax forgiveness with the new Qualified Opportunity Zone provisions in the Tax Cuts and Jobs Act, the response so far from the taxpayers has been somewhat muted. Many point to a lack of sufficient guidance with respect to the requirements for QOZs. An initial set of guidance was issued in October 2018. Now, a second set of guidance has been issued on April 17, 2019. Some continuing unaddressed issues point to a third set of guidance at some unidentified point in the future.
While the states have identified many QOZs that cover over 10 percent of the country, at most only a few hundred Qualified Opportunity Funds seem to have been formed, mostly in the real estate area, and are reported to have attracted around $25 billion in contributions. Real estate investors still have the choice between QOZs and the old like-kind exchanges, which, although somewhat complex in themselves, at least have more established rules at this point. Personal property, which no longer qualifies for like-kind exchange treatment, appears not to be a major focus of QOFs at this point, although there is some activity in the renewable energy area. Professional sports teams solved their loss of like-kind exchange treatment for player contracts by getting the Internal Revenue Service to provide them with an exemption.
There is also concern that the stated goal of the QOZ program — to promote development in disadvantaged communities — may miss the mark. Many of the QOZs cover areas that were probably ripe for development even without the QOZ provisions. Some of the reporting to Congress on achieving the goals of the QOZ program was dropped from the TCJA due to the requirements under which the act passed Congress. The number of QOFs which appear to have a philanthropic motivation is, not surprisingly, very low.
Timing is also very critical for the tax advantages of QOZs. To have the potential to achieve maximum benefits under the program, the potential 15 percent exclusion of tax on the contributed gain, contributions need to be made by Dec. 31, 2019, after which the potential exclusion falls to 10 percent. It is not clear how significantly that loss will be viewed by taxpayers after that date.
Still, this second set of proposed regulations do address a number of technical issues with QOZs and may result in a significant growth in contributions for the rest of the year in spite of some remaining unanswered questions. Except as noted, these proposed regulations may be relied upon currently.
Qualified Opportunity Zones
With respect to QOZs, the proposed regulations address:
- The meaning of “substantially all.” This is 90 percent for the holding period for QOZ property and 70 percent of use of QOZ business property within the QOZ. In meeting the 90 percent test, it can exclude capital contributions within the last six months.
- The meaning of “substantial improvement” to property. Invest an amount equal to the price paid at acquisition on an asset-by-asset basis. This is likely to be an easier standard for real estate than an operating business.
- The meaning of “original use.” This means when it is placed in service. For depreciation or amortization, unimproved land or a building vacant for five years can qualify.
- The meaning of active trade or business. Look to Code Sec. 162, but this can also include ownership and operation (including leasing) of real property, except for triple net leasing.
- Working capital safe harbor. The 50 percent test with three safe harbors and a facts and circumstances test: Safe Harbor 1 — 50 percent of services performed within the QOZ based on hours; Safe Harbor 2 — 50 percent of service performed within the QOZ based on amount paid; and Safe Harbor 3 — property and management activities within the QOZ produce at least 50 percent of gross income.
- Reinvestment rules: There is a one-year grace period.
- Intangibles rule: At least 40 percent used in active conduct of trade or business within the QOZ.
- Real property straddling QOZ. This is OK if contiguous and greater than 50 percent with the QOZ.
There are also rules for valuation and inventory in transit.
Transactions to look out for
Gain from the sale of property to a QOF in exchange for an equity interest in the QOF is not eligible for deferral. The same result holds for sale to another person in exchange for an equity interest. However, a QOF interest can be purchased from another investor.
Carried interests are not eligible for QOZ tax benefits. Code Section 1231 net gains can qualify. The IRS identifies 21 exclusion events for deferral of gain. Partnerships and S corps may be able to exclude gain from post-acquisitions appreciation on qualified property sold by a QOF, but C corps may not. They may have to recognize depreciation recapture. This provision in the proposed regulations may not be relied upon until regulations are finalized.
Other QOF rules
The valuation of property contributed is based on the lesser of the adjusted basis in equity received or the fair market value of equity received. Such transferred property will not qualify as QOZ property. Debt-financed distributions of property are permitted if two or more years after the date of the initial contribution to a QOF, unless treated as a disguised sale under Code Sec. 707.
Other issues addressed include timing of basis adjustments and holding period and tracking rules.
Anti-Abuse Rule and remaining issues
The proposed regulations include a general anti-abuse rule. The IRS still intends to address in future regulations what penalties are imposed when the 90 percent investment requirement is violated. It also expects to revise Form 8996, for 2019 and subsequent tax years, which changes may require additional information, such as an employer identification number for the QOF business and amounts invested by a QOF in particular QOZs.
Summary
The IRS has made an effort in this second set of proposed regulations to get into a great deal of detail to respond to taxpayer concerns about uncertainties with respect to how QOZs and QOFs will work in practice. It remains to be seen if this detail will be enough to get taxpayers involved in the program in line with initial expectations.Congress in also working on legislation to restore some of the requirements for the IRS to report the status of the program to Congress that were dropped from the original TCJA legislation, with a goal to make sure the QOZ program is achieving its goal of helping under-developed areas of the country.
