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The IRS has added four new frequently asked questions (FAQs) to its Opportunity Zones FAQs: two new FAQs addressing whether investors can adjust their basis to fair market value, and two FAQs explaining the Qualified Opportunity Zone Business (QOZB) 50% gross income test.

Background

Qualified Opportunity Funds (QOFs) are specially created investment vehicles that must have at least 90% of fund assets invested in Qualified Opportunity Zones, which were created by Tax Cuts and Jobs Act (TCJA) to spur investment in distressed communities. QOFs can meet the 90% investment requirement by either directly investing in qualifying tangible property located in a Qualified Opportunity Zone or by investing in a QOZB. Preferential tax treatment is available for certain investors in QOFs under IRC Section 1400Z-2, which allows investors to: (1) defer tax on capital gains timely invested into a QOF until no later than December 31, 2026; (2) receive a 10% or 15% reduction on their deferred capital gains tax bill if they held the QOF investment for five or seven years upon the expiration of the deferral period; and (3) receive the added benefit of paying no tax on any post-acquisition realized appreciation in the QOF investment if they sell the QOF investment after holding it for at least 10 years.

The IRS issued proposed regulations on investing in QOFs in October 2018 (see Tax Alert 2018-2119) and followed with a second set of proposed regulations in April 2019 (see Tax Alert 2019-0823). The April 2019 proposed regulations addressed additional issues not covered by the October 2018 proposed regulations, including how to satisfy the "50% gross income test," which requires a QOZB to derive at least 50% of its total gross income from the active conduct of a trade or business within a Qualified Opportunity Zone (IRC Section 1400Z-2(d)(3)). Specifically, among other provisions, the April 2019 proposed regulations included a definition of "trade or business" for purposes of the 50% gross income test and certain related guidance, as well as safe harbors for satisfying the test.

Investor adjusting basis to fair market value

Investor selling or exchanging investment in a QOF after holding it for at least 10 years can adjust the basis to fair market value if the investment was made in connection with a proper deferral election

In the answers to the new FAQs, the IRS states that an investor that sells or exchanges an investment in a QOF after holding the investment for at least 10 years may adjust the basis to fair market value, but only if the investor made the investment in connection with a proper deferral election. Furthermore, that election must have remained in effect until that sale or exchange after 10+ years. The IRS also clarifies that such election does not cease to be effective solely because, on December 31, 2026, the law requires the investor to include in income the gain that was deferred under the election.

No basis adjustment to fair market value for ordinary, not capital, gain invested in QOF

The IRS separately addresses the case of an investor that had ordinary gain from the sale of property in 2018, invested that gain with 180 days of the sale in a QOF, and subsequently sold that investment 10+ years later. The IRS stated that such investors cannot adjust their basis to fair market value. Because such gain was not capital gain, the IRS explained, the investor cannot elect to defer it. Because the investment in the QOF wasn't made in connection with a proper deferral election, the basis adjustment to fair market value is not available for the investment.

50% gross income test

Explanation of the 50% gross income test

The IRS explains that a QOZB must earn at least 50% of its gross income from business activities within a Qualified Opportunity Zone for each tax year. The IRS adds that the April 2019 proposed regulations included three safe harbors that a business may use to meet this test: (1) hours-of-services-received test, (2) amounts-paid-for-services test, and (3) necessary-tangible-property-and-business-functions test.

Not necessary to meet all three safe harbors to satisfy 50% gross income test

The IRS specifies that it is sufficient to satisfy one safe harbor for the 50% gross income test. It includes two independent examples of satisfying the test through one of the safe harbors. As one example, a business satisfies the test via the hours-of-services-received safe harbor when 50% or more of all the hours of services that the business receives and uses were performed in one or more Qualified Opportunity Zones. In the second example, a business again satisfies the 50% gross income test via the hours-of-services-received safe harbor, but the example in this instance illustrates that the business can aggregate hours spent in multiple Qualified Opportunity Zones in which the business operates in calculating the safe harbor.

Implications

These new FAQs expound on provisions contained in the October 2018 and April 2019 proposed regulations. Although the guidance may not differ from what many practitioners are currently advising, the FAQs may nonetheless provide QOF investors with increased clarity and confidence in (1) understanding whether they are eligible for the preferential tax treatment associated with a QOF investment and (2) projecting what that preferential tax treatment may look like over a possible 10-or-more year investment period. Additionally, QOFs and their investors may now have a better understanding of the 50% gross income test for QOZBs and what may be required to comply. In addition to the three safe harbors mentioned in the FAQ, we note that the April 2019 proposed regulations also provide that a QOZB may satisfy the 50% gross income test if "all of the facts and circumstances" show that it derives at least 50% of its gross income from the active conduct of a trade or business in a Qualified Opportunity Zone.

At this time the comment periods for the October 2018 and April 2019 proposed regulations have closed. We expect that the IRS will continue providing guidance in the form of additional FAQs, new QOF or QOZB reporting requirements, additional proposed regulations, and/or finalization of all or part of the October 2018 and April 2019 proposed regulations.

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