Forming More Perfect Regulations
By Kaitlyn Snyder
8 min read
Figuring out Opportunity Zones
When asked about the December 19, 2019 final Opportunity Zone regulations, Jerome Breed, principal with Miles and Stockbridge P.C., said, “The IRS and Treasury did an excellent job with the final regulations. Of course, if I drafted the rules, I’d be happy with all of them.” John Gahan, partner with Sullivan and Worcester LLP, echoed the sentiment, “We as lawyers would never be completely happy with any set of rules. In our minds, we could always come up with improvements, because that’s what we’re trained to do. Having said that, functionally the regulations are now clear enough and flexible enough for investors.”
Now that investor demand for OZones has picked up following the release of the final regulations, here’s what our readers need to know.
Applicability
The final regulations are effective as of March 13, 2020. There was an uptick in investment following the release of the second set of proposed regulations on May 1, 2019, but experts anticipate that even more investors will enter the program now that there are final regulations.
Overall, the final regulations don’t substantially change much from the earlier proposals, but rather provide more clarity. Investors who operated in good faith under previously proposed rules will be safe, with the caveat that that they must uniformly adopt one set of regulations to play by; they can’t pick and choose pieces from whichever set of regulations they like better.
Investment as a Consolidated Group
The final regulations “permit corporate taxpayers filing consolidated returns to own a Qualified Opportunity Fund (QOF) that is a subsidiary member of the consolidated group.” That means, in theory, a financial institution could create a QOF to invest capital gains derived from one of the consolidated group members. To date, Gahan and Breed have seen investment mostly from family offices and developers of “one-off” projects but the final regulations could mean more OZone investing from traditional multifamily investors.
Vacancy Tests
The final regulations shortened the vacancy tests in two respects: It provides a one-year vacancy requirement for buildings that were vacant prior to and on the date of Qualified Opportunity Zone (QOZ) designation in the early spring of 2018. For properties that go vacant thereafter, the five-year vacancy period has been shortened to three years. “Property, including land and buildings, is considered to be in a state of vacancy if the property is ‘significantly unused.’ A building or land will be considered to be ‘significantly unused’ under the final regulations if more than 80 percent of the building or land, as measured by the square footage of useable space, is not being used.”
Substantial Improvement Test
The proposed regulations required “substantial improvement” of each individual asset or building on a property. The final regulations adopt an aggregate substantial improvement test, with a few important threshold requirements.
Improved Functionality. Each building on the property needs to have some amount of rehab done: a 100-to-zero percent investment split per building will not fly. The final regulations do not set a minimum amount that must be invested, but both Gahan and Breed are of the opinion that a minimum ten percent investment is a conservative safe starting point.
Aggregation. The aggregate substantial improvement test can be used for a single parcel or multiple parcels in a QOZ or adjacent QOZ, but cannot be used for two unrelated businesses. Two multifamily properties on different parcels can aggregate, but a multifamily property and a widget factory on the same parcel (or different parcels) cannot aggregate.
Activities and Expenses That Count as Substantial Improvements. The Department of the Treasury and the Internal Revenue Service (IRS) clarified that the following activities and expenses count towards the 70 percent substantial improvement test:
- Equipment installed in a building and used in a trade or business;
- Demolition costs;
- Reasonable capitalized fees for development;
- Required permits;
- Necessary infrastructure;
- Brownfield site assessment and remediation;
- Professional fees; and
- Necessary site preparation costs (including remediation and utility upgrades).
They further noted that “section 1400Z– 2(d)(2)(D)(ii) provides that any cost added to the basis of a property improved during the 30-month improvement period will be included in determining satisfaction of the substantial improvement requirement.”
Fair Market Value of Leased Property
In order to qualify as QOF property, the proposed regulations required the terms of a lease to be market-rate at the time the lease was entered into. Often, the land for affordable housing is leased by a state or local government at a significantly discounted rate. The final regulations offer an exception to the valuation method, which “provide[s] that, for purposes of satisfying the market-rate lease requirement, tangible property acquired by lease from a state or local government, or an Indian tribal government, is not considered tangible property acquired by lease from a related party.” This means that 100-year land leases for $1, and the like from state and local governments, are considered market-rate leases and thus eligible for all of the OZone benefits.
No Netting on Section 1231 Gains
Generally, Section 1231 gains and losses are netted to determine the character of the net gain/loss. However, this would cause investors to wait until the end of the year to invest in OZones, which was what the second set of proposed regulations required. Thankfully, the final regulations eliminated the “netting” requirement.
The final regulations permit the investment of Section 1231 gains, as they occur even if the taxpayer incurs net Section 1231 losses for a given year. The final regulations start the 180-day clock on Section 1231 gains on the date of the sale or exchange, as opposed to the end of the investor’s tax year, as provided in proposed regulations. According to Gahan, “This significant change adopted in the final regulations will allow money to go in faster if taxpayers don’t have to wait till the end of the year.”
Working Capital Safe Harbor
There is a 30-month working capital safe harbor for QOF’s substantially improving property. This safe harbor can be used by QOFs when there is a reasonable expectation that the property will be substantially improved within the QOZ as part of the trade or business of the QOF.
Triple-Net-Leases
The final regulations gave two examples of triple-net-leases, one that was allowable and one that was not. “The final regulations confirm that merely entering into a triple-net-lease with respect to real property owned by a taxpayer does not constitute the active conduct of a trade or business by such taxpayer.” Gahan believes that while the affirmation that a pure triple-net-lease is probably not acceptable is a positive step, at the same time, it will engender structuring craziness as developers try to determine what they can do safely and still have a “quasi-net-lease.”
Property Purchased Before 2018
The final regulations made clear that improvements made to a building acquired by the taxpayer prior to December 31, 2017 does not qualify as Opportunity Zone Business Property. This result accomplishes two purposes. First, it avoids the issues of allocating value and basis between the improvements and the acquire pre-2018 building, and secondly, encourages new investment that would not have been made but for the designation of the tract as an OZone. Breed noted that it may be possible to structure around this rule by leasing the property to an OZone Business, but such a transaction will require taxpayers to thread a narrow needle.
Force Majeure
The final regulations are notably silent on traditional “force majeure” provisions, which could allow for an extension of the 31-month working capital safe harbor period in the case of circumstances beyond the control of the developer. The final regulations allow for an extension equal to duration of the delay (up to 24 months) ONLY if a government permitting delay caused the delay of a project AND no other action could be taken to improve the tangible property or complete the project during the permitting process. While events beyond the control of the developer can be a tricky thing to define, industry standards were notably not included.
Addressing Ongoing Criticism
It is near impossible to mention OZones without also addressing the ever present criticism surrounding them. Breed argues that criticism that takes issue with tax benefits and investment returns flowing to wealthy individuals could be said for every tax credit program, since only those with significant amounts of taxable income are eligible to take advantage of the benefits.
The Inspector General of the U.S. Department of the Treasury launched an internal investigation on abuse in the OZone program and Congress has pending several ‘marker’ bills that are unlikely to advance including the Opportunity Zone Reform Act (H.R. 5042) sponsored by Democratic Representatives Jim Clyburn (SC), Alma Adams (NC) and William Lacy Clay (MO), as well as Senate Legislation to Establish Reporting Requirements (S. 2994).
In his article The Land of Oz: Measuring Results (Tax Credit Advisor, October 2018), Gahan argues for the importance of reporting requirements. Treasury and the IRS have yet to adopt any detailed reporting requirements beyond Form 8996. Gahan agrees that the form is a starting point but it fails to require the type of detailed reporting that would be helpful in measuring the effects and success of the program.
In conclusion, while there are still some outstanding concerns, on the whole, the final regulations achieved a critical objective of providing clarity to investors. As Breed argues, “We should be embracing every tool to get more investments in those designated parts of the country that have been left behind in the economic recovery of the last decade.” He suggests that in an attempt to improve what exists we don’t throw the baby out with the bathwater.
