As part of the legislation known as the Tax Cuts and Jobs Act, (1) Congress enacted two companion provisions designed to encourage investment and economic growth in certain low-income communities. First, Sec. 1400Z-1 paved the way for more than 8,700 such low-income communities and qualifying contiguous census tracts to be designated as qualified opportunity zones (QOZs). In turn, Sec. 1400Z-2 offers three federal income tax incentives to a taxpayer who invests in a business located within one of these zones: (1) the temporary deferral of capital gains, to the extent the gains are reinvested into a qualified opportunity fund (QOF); (2) the partial exclusion of previously deferred gains when certain holding period requirements in a QOF are met; and (3) the permanent exclusion of post-acquisition gains from the sale of an investment in a QOF held longer than 10 years.
In the May issue of The Tax Adviser (Nitti, "Opportunities Beckon in New Qualified Opportunity Zones," 50 The Tax Adviser 356 (May 2019), available at tinyurl.com/y3fxw49z), the author of this update article examined the requirements for qualifying for these tax benefits, as provided by Sec. 1400Z-2 and proposed regulations that were published in October 2018 (the "October proposed regulations"). (2) The conclusion of that article identified key questions that were raised by the October proposed regulations that, until addressed and answered by the IRS, would threaten to slow investment into QOZs.
On April 17, 2019, the IRS published a second round of proposed regulations under Sec. 1400Z-2 (the "April proposed regulations"). (3) The April proposed regulations provided taxpayer-friendly responses to the questions raised by the October proposed regulations; as a result, taxpayers may finally move forward with opportunity zone investments with the level of certainty and confidence they have sought.
For the full background on the various requirements and benefits of a QOZ investment, please read the May article in its entirety before continuing with this article. This discussion focuses solely on the questions raised by the October proposed regulations that were subsequently addressed by the April proposed regulations.
Sec. 1400Z-2 and the associated proposed regulations contain a number of critical terms that are often abbreviated. See the sidebar, "Glossary of Key Terms and Abbreviations," for these terms and their abbreviations, which are used throughout this article.
The April proposed regulations provided much-needed clarity by addressing the following questions raised by the October proposed regulations.
Sec. 1231 gains as 'eligible gains'
The October proposed regulations made clear that gain from the sale of a Sec. 1231 asset is eligible gain that may be deferred upon reinvestment into a QOF because it is "treated as capital gain." (4) Sec. 1231 requires a netting process, however; only net Sec. 1231 gains, after reduction for Sec. 1231 losses, are treated as capital gain. This netting process posed a problem in several ways.
Example 1: An individual sells a Sec. 1231 asset for a gain of $1 million on Jan. 2, 2019. The 180-day window for reinvestment (see definition of QOF in the sidebar, "Glossary of Key Terms and Abbreviations") would seem to begin on that date. On Dec. 5, 2019, the same individual sells a second Sec. 1231 asset, this time recognizing a loss of $1.2 million. The taxpayer has no net Sec. 1231 gain for the year, but that was revealed to be the case only after the 180-day window related to the Jan. 2 sale had expired. How could the individual have reinvested the Sec. 1231 gain of $1 million within 180 days of Jan. 2, 2019, when it would not be clear whether the individual has a net Sec. 1231 gain for the year until Dec. 31, 2019?
The April proposed regulations direcdy address this question, providing that a taxpayer may not reinvest Sec. 1231 gain until the netting process has completed. Because this process is not complete until the end of the taxpayer's tax year, the 180-day period begins on the last day of the tax year. (5)
Thus, in the case of the individual taxpayer discussed above, the individual would not be permitted before the end of 2019 to reinvest the $1 million of gain recognized on Jan. 2, 2019, because the netting process is not yet complete. And because, when that process is complete, the individual's Sec. 1231 gains and losses for the year result in a net loss, there is no eligible gain that may be deferred. If, instead, the Sec. 1231 loss on Dec. 5,2019, were only $600,000, the individual would have $400,000 of net Sec. 1231 gain eligible to be reinvested into a QOF, with the 180-day period beginning on Dec. 31,2019.
If a partnership or S corporation recognizes a Sec. 1231 gain that it intends to reinvest and defer at the entity level, presumably, the partnership or S corporation would be treated as a "taxpayer" for these purposes. Thus, the partnership or S corporation would determine its own net Sec. 1231 gain at the end of its tax year and have 180 days from the last day of the year to invest any net gain amount into a QOF.
Operating a QOF or QOZB Trade-or-business requirement
QOZBP must be "used in a trade or business" of a QOF or QOZB." (6) Sec. 1400Z-2 and the October proposed regulations, however, did not address this critical question: What is a "trade or business" for purposes of Sec. 1400Z-2?
The April proposed regulations addressed the trade-or-business requirement by stating that whether it is conducted direcdy by a QOF (7) or through a subsidiary QOZB, (8) the term "trade or business" means a trade or business within the meaning of Sec. 162. In general, an activity qualifies as a Sec. 162 trade or business if the of business property (including leased property) arises with, or its substantial improvement is performed by, a QOZB or a QOF. taxpayer is involved in the activity "with continuity and regularity" (and not merely sporadically), and the taxpayer's primary purpose for engaging in the activity is for income or profit. As a result, whether an activity constitutes a Sec. 162 trade or business is generally a factual determination. (9)
While reaching the standard of a Sec. 162 trade or business has at times proved problematic for rental activities, the April proposed regulations clarified that, for purposes of meeting the definition of a QOZB, the ownership and operation (including leasing) of real property is the active conduct of a trade or business. Merely entering into a triple-net lease with respect to real property owned by a taxpayer, however, is not the active conduct of a trade or business by a taxpayer. (10) The IRS recently defined a triple-net lease (for purposes of Sec. 199A) as any "lease agreement that requires the tenant or lessee to pay taxes, fees, and insurance, and to be responsible for maintenance activities for a property in addition to rent and utilities." (11)
Thus, if a QOF or QOZB constructs or renovates a building that is then rented, for example, to Walmart on a triple-net basis, the proposed regulations default to the conclusion that the building is not used in a trade or business and should not count toward the 90% or 70% test (see the definitions of QOF and QOZB in the sidebar, "Glossary of Key Terms and Abbreviations"). This treatment echoes a previous conclusion by the IRS that holding property rented on a triple-net basis is an investment rather than a Sec. 162 trade or business. (12)
In summary, the April proposed regulations generally take a forgiving approach whereby all rental activities--other than properties rented on a triple-net basis--will satisfy the trade-or-business requirement. As a result, a QOF or QOZB should structure any lease arrangement to avoid its being classified as a triple-net lease.
Challenges in investing in an operating business
The October proposed regulations provided taxpayers enough guidance to move forward with constructing or improving real estate in a QOZ. The 30-month substantial-improvement rule, the 31-month working-capital safe harbor, and the 70% and 90% asset tests combined to provide a framework within which a QOF or QOZB could enter into a construction or rehabilitation project with a degree of certainty as to how those projects would comply with the requirements of Sec. 1400Z-2. (13)
Glossary of key terms and abbreviations
QOF: Qualified opportunity fund. A taxpayer may defer "eligible gain" by investing some or all of the gain amount into a QOF within 180 days of the sale giving rise to the eligible gain. A QOF is any investment vehicle that is organized as a corporation or a partnership for the purpose of investing in qualified opportunity zone property (other than another QOF). In general, a QOF must hold at least 90% of its assets as qualified opportunity zone property (QOZP; see below) or face a penalty (the "90% test"; see Sec. 1400Z-2(f)(l)).
QOZ: Qualified opportunity zone. Sec. 1400Z-1 allows for the designation of certain low-income community population tracts as QOZs. In addition, other census tracts with a median family income not exceeding 125% of that of a contiguous low-income community maybe designated as QOZs. These designations were made in 2018 and will remain in effect until Dec. 31,2028. A fisting of these zones can be found in Notice 2018-48.
QOZP: Qualified opportunity zone property. A QOF must conduct a trade or business within a QOZ, either directly--by holding qualified opportunity business property (QOZBP; see below)--or indirectly, by holding QOZ stock or a QOZ partnership interest (Sec...