January 10, 2020 Final regulations on Opportunity Zones retain same approach as proposed regulations with a few big changes The IRS released eagerly-awaited final regulations (TD 9889, Final Regulations) on qualified Opportunity Zones (OZs). The Final Regulations address what types of gains may be invested and when, when gains may be excluded from tax, how qualified opportunity funds (QOFs) and qualified opportunity zone businesses (QOZBs) can invest in QOZs, how C corporations can invest in OZs, and new rules for QOF C corporations, among other topics. The biggest changes include:
The final regulations are effective 60 days after publication in the Federal Register (publication in the Federal Register is scheduled for January 13, 2020, making the final regulations effective on March 14, 2020). For calendar-year taxpayers, this means that, the final regulations must be applied for the 2021 tax year and thereafter. In prior years, taxpayers could choose to apply the proposed regulations or the final regulations as long as they applied either set of regulations consistently for all those tax years. If a taxpayer chooses to apply the proposed regulations, it must apply the Final Regulations for IRC Section 1400Z-2(c) instead of Proposed Treas. Reg. Section 1.1400Z2(c)-1, which addresses the disposal of OZ investments after at least 10 years. Background The Tax Cuts and Jobs Act (TCJA) created OZs by adding IRC Section 1400Z-1 and IRC Section 1400Z-2 to encourage investment in economically-distressed areas by giving tax incentives to taxpayers who invest and hold onto investments in OZs through QOFs. IRC Section 1400Z-1 allows certain areas to be designated as OZs. IRC Section 1400Z-2 provides benefits for investment in QOFs. A QOF is a corporation or partnership that holds at least 90% of its assets in OZ property. Investors in QOFs must make an IRC Section 1400Z-2(a) election to defer eligible gain. The investment interest must be an equity interest and may include preferred stock or a partnership interest with allocations. In general, the investment must have been made within 180 days after the deferred gain was realized. Investors can generally defer tax on eligible gains invested in a QOF until the earlier of the date on which the investment in a QOF is sold or exchanged, or December 31, 2026. If the QOF investment is held for longer than five years by the end of the deferral period, 10% of the deferred gain is excluded; a 15% exclusion applies if the investment is held for more than seven years by the end of the deferral period. If the investment is held for at least 10 years, the investor is eligible for a basis increase equal to the QOF investment's fair market value on the date that the QOF investment is sold or exchanged, thus excluding 100% of the gain that would have been realized from disposing of the appreciated QOF. Additionally, taxpayers invested in QOF partnership, S corporations, RICs, or REITs for at least 10 years may be eligible to exclude gain from the sale of the QOF's underlying assets. 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 May 2019 (see Tax Alert 2019-0823) (referred to collectively as Proposed Regulations). In the Final Regulations, the IRS addressed the comments received in response to the 2018 and 2019 proposed regulations while retaining the basic approach. A discussion of the biggest changes in the Final Regulations follows. Eligible gain Only capital gains are eligible for deferral under IRC Section 1400Z-2(a)(1). Under the Proposed Regulations, only capital gain net income from IRC Section 1231 property was eligible for a qualified OZ investment and the 180-day investment period began on the last day of the investor's tax year. The Final Regulations change this rule so that the gross amount of eligible IRC Section 1231 gains, unreduced by IRC Section 1231 losses, is eligible for investment. The IRC Section 1231 gain must still exceed any amount treated as ordinary income under IRC Sections 1245 or 1250. As a result, it is not necessary for investors to wait until the end of the tax year to determine eligible gains, so the 180-day investment period under the Final Regulations begins on the sale date of each property. For partners receiving a distributive share of gain from partnerships, the 180-day investment period clock under the Proposed Regulations began either on the last day of the partnership tax year or on the date the partnership realized the gain. Under the Final Regulations, partners have the option to start the 180-day investment period on the due date of the partnership's tax return (not including extensions). This rule applies to partners, S corporation shareholders, and owners of certain other pass-through entities. This will alleviate the problem that can occur when owners of flow-through entities do not timely have the necessary information on the federal income tax consequences of entity transactions due to the timing of Schedule K-1 filings. The Final Regulations also address RIC and REIT shareholders with eligible gain. Under the Proposed Regulations, the 180-day investment period for such gain began on the day on which the dividend was paid. The Final Regulations give RIC and REIT shareholders the additional option to begin the 180-day investment period on the last day of the shareholder's tax year. Substantial improvement Tangible property held by a QOF or QOZB must either be originally used or be "substantially improved" by the QOF or QOZB to constitute qualified opportunity zone business property (QOZBP). For determining whether property meets the substantial improvement requirements, the Proposed Regulations asked for comments on the proposed asset-by-asset approach, as compared to asset aggregation and similar approaches. The Final Regulations apply an "asset aggregation" approach for determining whether a non-original use asset (such as a pre-existing building) has been substantially improved. Under this approach, QOFs and QOZBs can take into account purchased original-use assets that otherwise would qualify as QOZBP if the purchased assets are (1) located in the same qualified opportunity zone (or a contiguous qualified opportunity zone) as the non-original use property, (2) used in the same trade or business as the non-original use property, and (3) improve the functionality of the non-original use property. If a QOF or QOZB chooses to substantially improve purchased non-original use real property using the aggregate approach, the non-original use real property must be improved by more than an insubstantial amount. In addition, if a QOF or QOZB chooses to use this approach, the purchased original-use assets that otherwise would be QOZBP will not be treated as original-use property; instead, the basis of that purchased property will be taken into account in determining whether the additions to the basis of the non-original use property satisfy the substantial use requirement. The Final Regulations also say that buildings on the same parcel of land can be treated as a single property. In addition, a QOF or QOZB can treat buildings on contiguous parcels of land as a single property if the buildings (1) are part of one or more trades or businesses operated solely by the QOF or QOZB, (2) share facilities or significant centralized business elements, and (3) are operated in coordination with, or reliance upon, one or more of the trades or businesses. Additions to the basis of the buildings can be aggregated for purposes of substantial improvement so long as the total additions equal 100% of the basis of the group of buildings. Exiting OZ investments The Final Regulations permit taxpayers invested in QOF partnerships or QOF S corporations for at least 10 years to exclude gains from the sale of QOF property, including sales of interest in QOZBs that are disposed of at different times, from income. The Final Regulations expand on the benefit described in the Proposed Regulations, which only provided for the exclusion of capital gain from a sale directly by the QOF, meaning only the capital gain was tax-free and asset sales by QOZBs received no tax benefits. The Final Regulations also permit shareholders invested in QOF RICs and QOF REITs for at least 10 years to exclude capital gain dividends identified with a date from income. This differs from the Proposed Regulations, which would have required shareholders to apply a 0% tax rate to the capital gain dividends rather than an exclusion. The Final Regulations retain the "special amount includible rule" in Prop. Treas. Reg. Section 1.1400Z2(b)-1(e)(4). For inclusion events involving partnerships and S corporations, the rule defines the amount includible as the percentage of the qualifying QOF partnership or QOF S corporation disposed of, multiplied by the lesser of (1) the remaining deferred gain less the five-year and seven-year basis adjustments; or (2) the gain that the partner or shareholder would recognize if the interest were sold in a fully taxable transaction for its then-fair market value. Consolidated returns Under the Proposed Regulations, IRC Section 1400Z-2 applied separately to each member of a consolidated group so the same member had to both sell the capital asset giving rise to eligible gain and timely invest the proceeds in a qualifying investment. The Final Regulations affirm this general rule but also allow an election to treat the investment by one member as a qualifying investment by another member, so the first member is treated as making an investment in the QOF and immediately selling the qualifying investment to the second member for fair market value. The election is available when:
The Proposed Regulations did not treat stock in a QOF C corporation as stock for purposes of an affiliated group filing a consolidated return (under IRC Section 1504), meaning the QOF C corporation was not a member of the consolidated group. The Final Regulations permit (but do not require) the consolidation of subsidiary QOF C corporations with its investor parent, subject to certain conditions:
For a consolidated QOF C corporation, the final regulations include a rule under which an investor member must take its ELA into account under Treas. Reg. Section 1.150219 before its basis in the QOF member stock is adjusted to fair market value under IRC Section 1400Z-2(c). According to the Preamble, this rule is needed to "effectuate and harmonize" the ELA (negative basis) rules under Treas. Reg. Section 1.1502-19 and IRC Section 1400Z-2. The Final Regulations provide a transition path for subsidiary QOF C corporations that met the IRC Section 1504 requirements (except for Treas. Reg. Section 1.1504-3(b)(1)) as of the publication of the second set of Proposed Regulations. As described previously, the Final Regulations permit subsidiary QOF C corporations to be part of a consolidated group. Accordingly, subsidiary QOF C corporations that existed as of May 2019 can elect to retain QOF status and to also remain a member of the consolidated group. Alternatively, a consolidated group can elect to treat the C corporation as (1) always having been a QOF partnership, (2) never having been a member of the consolidated group, or (3) never having certified as a QOF. If no election is made within the prescribed time, then the subsidiary QOF C corporation is treated as deconsolidating. For QOF C corporations that are not consolidated, the Final Regulations state that QOF stock is not treated as stock only when determining eligibility of affiliated groups to join in filing a consolidated return under IRC Section 1501. Therefore, this rule will not affect the availability of the "dividends received deduction" or any other provision that cross-references affiliation status under IRC Section 1504 other than consolidated group membership. Working capital safe harbor The Proposed Regulations provided a working capital safe harbor for QOZBs developing a trade or business in an OZ, which may include acquiring, constructing, or rehabilitating tangible business property. The safe harbor allowed QOZBs to apply the definition of "reasonable amounts of working capital" in IRC Section 1397C(e)(1) to cash, cash equivalents, or debt instruments that have a term of 18 months or less and are held by the business for up to 31 months, if: (1) a written plan exists identifying the financial property as property held for the development of a trade or business, including the acquisition, construction, or substantial improvement of tangible property in an OZ; (2) a written schedule consistent with the business's ordinary business operations states that the property will be used within 31 months; and (3) the business substantially complies with the written plan and schedule. The Proposed Regulations stated that a QOZB could benefit from multiple overlapping or sequential applications of the working capital safe harbor. The Final Regulations refined this working capital safe harbor by creating a safe harbor for start-ups. During the maximum 62-month covered period, the following apply:
Other changes and clarifications There were numerous other updates or clarifications provided in the Final Regulations, including the following:
Implications Overall, the final regulations are considered by many to be taxpayer friendly. Much of the content should make it easier for investors to invest in QOFs and for QOFs to deploy capital into QOZBs in the targeted communities. That said, taxpayers that have already entered into transactions will want to pay close attention to the transition rules, as there are significant differences between the Proposed Regulations and the Final Regulations. We expect that the IRS will continue issuing guidance in the form of additional FAQs, new QOF or QOZB reporting requirements, and more. Eligible gain Taxpayers with IRC Section 1231 gain who contributed to QOFs during the 180-day window for IRC Section 1231 gain in the Proposed Regulations, instead of the new 180-day window in the Final Regulations, must rely on the Proposed Regulations consistently for all tax years until the 2021 tax year if they want to make a deferral election for their contributed gain. For example, a taxpayer that sold IRC Section 1231 property in January 2019 likely waited until December 31, 2019, before investing in a QOF because the Proposed Regulations required the taxpayer to calculate capital gain net income (instead of gross) from IRC Section 1231 property and invest within 180 days from the last day of the taxpayer's tax year. Under the Final Regulations, that taxpayer invested outside of the permitted 180-day investment window for IRC Section 1231 gain, which would have begun in January 2019 when the taxpayer sold the IRC Section 1231 property. Thus, the taxpayer must rely on the Proposed Regulations until the 2021 tax year in order to make a deferral election for the invested IRC Section 1231 gain. This reliance requirement may preclude the taxpayer from taking advantage of beneficial provisions in the Final Regulations until 2021. Substantial improvement Under the Final Regulations, taxpayers that choose to substantially improve purchased non-original use property can opt to add the basis of property that would otherwise qualify as QOZBP in aggregate to determine satisfaction of the substantial improvement requirement for a single non-original use property. The asset-by-asset approach in the Proposed Regulations raised confusion as to how to determine each asset basis and the minimum unit for each determination. The asset-aggregation approach provides a more plausible option for investors and developers that intend to manufacture, construct, and produce non-original use properties in OZs and substantially improve them. Exiting OZ investments The Final Regulations clarify that the disposition of QOF partnership or QOF S corporation assets, including both the QOZB interests and properties sold by QOZBs, are eligible for the 10-year exclusion benefit. Taxpayers are now eligible for the 10-year exclusion benefit through asset disposition, rather than the previous restriction under which the 10-year exclusion benefit was only available upon the disposition of QOF interests. This provision largely enhances the flexibility of exit options for QOF partnerships and QOF S Corporations. The Final Regulations also allow a shareholder of QOF RICs and QOF REITs to exclude capital gain dividends identified with a date from its taxable income for the tax year if the shareholder held the qualifying investment for at least 10 years. Unlike applying a 0% tax rate to the qualifying capital gain dividends, as in the Proposed Regulations, excluding the dividend from taxable income eliminates complexity and uncertainty in determining eligible gain for applicable city, local and state tax purposes. Consolidated returns The Final Regulations reversed the position in the Proposed Regulations that a wholly-owned QOF could not be part of the same consolidated group as the investor company. This counteracts the negative impact introduced by the Proposed Regulations when the taxpayer entered into transactions with a wholly-owned QOF part of the consolidated group. The Final Regulations allow subsidiaries of QOF C Corporations to consolidate in certain fact patterns, although it does not require them to do so. To accommodate the reversed position, the Final Regulations give transition relief for pre-existing QOF subsidiaries to elect to be reclassified as a QOF partnership, a QOF C corporation that is not a member of the consolidated group, or a member of the consolidated group that is not a QOF. In addition, the Final Regulations allow any member of a consolidated group to invest eligible gain generated by any other member of the consolidated group. This change is important when dealing with regulated industries such as banks, insurance companies, or utilities, among others. The new rule will potentially encourage more investments into OZ from those regulated industries. Working capital safe harbor The Final Regulations provide a working capital safe harbor of 62 months for start-up businesses, in addition to the 31-month working capital safe harbor in the Proposed Regulations. This addition provides leniency for operating businesses that struggle to fit the specific business fact pattern into the short working capital safe harbor. ———————————————
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