The Land of OZ

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Opportunity Zone Regulations Part Two: The Devil’s Details

The second set of proposed regulations (the “Proposed Regulations”) released by the IRS with respect to the Opportunity Zone (OZones) program on April 16, 2019 is extremely helpful, generally taxpayer friendly and provides investors with sufficient guidance to close transactions without waiting for a third round of regulations. Treasury has stated that they will likely not issue a third round of guidance. Others have provided summaries of the second set of OZone regulations, so we focus here on several issues raised by the regulations and hopefully, provide some guidance for resolution.

  1. Investment Flexibility

The Proposed Regulations provide that cash invested in a Qualified Opportunity Fund (QOF) will not be included in the QOF’s assets for compliance testing purposes for the initial six-month period after receipt, ensuring that a QOF will not have less than six months to invest a capital contribution in Qualified Opportunity Zone Business Property (QOZBP). This six-month safe harbor provides QOFs with time to resolve closing issues and may permit more flexibility to make multiple installments from the QOF to a Qualified Opportunity Zone Business (QOZB) as the QOZB meets investment criteria.

  1. Distributions from QOZBS

The second tranche of OZone regulations continued the development of a principle introduced in the initial OZone Regulation: To the greatest extent possible, “normal” tax rules apply to OZone investments. So, an OZone investor who has not been taxed on the gain invested in a QOF has a zero basis in the QOF. When any distribution is made in excess of the basis that an investor has in the QOF, the gain would be recognized in the distribution and the original gain would be accelerated from the 2026 recognition date.

The positive effect: If the QOF invested in a partnership (QOZPS) that is operating the QOZB, and the QOZPS borrowed non-recourse debt to operate the property, the QOZPS allocates basis to the limited partner QOF, and that basis is included in the basis of the OZone investor in the QOF. Under normal partnership tax rules, a distribution not in excess of basis is not subject to tax. In the land of OZone, the same rules apply and the distribution of loan proceeds, not in excess of basis, will not be subject to federal income tax.

But now the detail devil smiles. Normal “disguised sale” rules, included in 1.707-3 are also applicable. So, if the QOZPS distributes debt-financed cash within two years of the investment, the distribution is presumed to be a “disguised sale,” subject to tax, as well as an “inclusion event,” which accelerates the 2026 tax on the original gain. Investors must plan around the “disguised sale” rules if they want to refinance at the QOZPS level to fund the payment of 2026 tax, or if, as in normal business partnership investing, they want to receive a return of their investment at stabilization.

A number of non-taxable transfers are not inclusion events, including the contribution of a QOF interest to a partnership and transfers of QOF interests pursuant to a corporate reorganization. A transfer of an interest at death is not an inclusion event (including the transfer by the decedent to his estate and a transfer by a decedent’s estate to a beneficiary), but sales by either the estate or a beneficiary will not qualify for exclusion of gain even if the beneficiary holds the interest for more than ten years. A transfer of an interest to a disregarded LLC or to a grantor trust does not constitute an inclusion event, unless the LLC later becomes a regarded entity or the grantor trust loses its grantor status. Inclusion events may be partial, such as a transfer of 50 percent of the taxpayer’s interest in a QOF, or may be a total recognition.

  1. Operating Businesses

The Proposed Regulations provide three safe harbor tests to determine if an operating business is actively conducted within a QOZ, any one of which can be satisfied. The first is that 50 percent or more of the total hours of the QOZB employees and independent contractors are performed in the QOZ. The second safe harbor

requires at least 50 percent of the “value” of employee and independent contractor hours to be performed within the QOZ (measured by the compensation paid with respect to the services performed). The third safe harbor is satisfied when the management of the enterprise is located within a QOZ and substantially all the property of the enterprise is local in the QOZ. If none of the safe harbors apply, the taxpayer can use a facts and circumstances analysis to determine if the income sourcing test is met. The flexibility provided by these safe harbors should result in most operating businesses satisfying the income sourcing test.

While these safe harbors will make it easy for most operating businesses to comply with the OZone rules, taxpayers must still be careful when their business model utilizes a substantial number of independent contractors. It will be difficult if not impossible for taxpayers to obtain accurate information from independent contractors.

Businesses that develop software must also be careful. Software that is developed in the OZone and then sold presents an easy case, but software that is licensed may be more difficult since the income would not be “active.” Still, if the software developers work in the OZone, and continue their development efforts, management is located in the OZone and the assets of the company are located in the OZone, the software development company should meet the third safe harbor.

  1. The Getaway

Another positive development in the Proposed Regulations is the establishment of rules facilitating multiple investments by a single QOF. When a QOF sells an asset after the ten-year holding period, the basis step-up to fair market value applies not only to the equity interests held by the QOF investors, but also to the assets held by the QOF. As a result, the QOF can sell its interest in a QOZPS or a QOZ corporation without recognizing gain on the sale. If the QOF sells a portion of its assets, one of three QOZPS it owns, for example, and distributes the proceeds, the QOF investor can elect to exclude his portion of the gain on the percentage of the total assets sold. Accordingly, while a purchaser interested in the QOZB assets would be forced to buy the equity interests of the QOZPS, one step of the two-step removal from the assets that the purchaser wants to acquire has been eliminated.

Now the devil chuckles. If the QOZPS sell assets, normal gain recognition rules apply. That includes normal “hot asset” rules, such as a depreciation recapture, which converts capital gain into ordinary income. Also, with no step-up that includes the full amount of debt, as provided in the regulations, depreciation deductions that have reduced basis would generate gain, including real estate straight-line depreciation. How can we ditch the Devil? A potential solution in many of these transactions could be for the investor member in the QOF to sell its interest in the QOZPS to the managing member. The managing member would make an election to step-up the basis of the assets in the QOZPS, and following the step-up in basis, sell the assets to a third party purchaser.

  1. Substantial Improvement

While many of the new regulations are taxpayer friendly, there are also some disappointing provisions in the Proposed Regulations. First, the regulations apply the “substantial improvement” test under an asset-by-asset method, not on an aggregate method. This approach makes compliance substantially more difficult. For example, if a QOZPS purchases a parcel of land containing three buildings, then the purchase price must be allocated among the three buildings and the rehabilitation of each of the three buildings must be substantial. The asset-by-asset approach is difficult where some of the purchased assets are in good shape and don’t require rehabilitation. Assets that are not substantially rehabilitated are “bad assets” for the “substantially all” test. If those assets exceed 30 percent of the aggregate basis of the assets, the QOZB will fail qualification.

How can this result be avoided? Perhaps the assets that don’t require rehabilitation could be purchased by a separate entity and operated separately. Perhaps the assets could be purchased by another entity and leased to the QOZB with pricing and lease terms that would reduce the bad assets calculation to an amount less than 30 percent. In the case of leased tangible personal property, used property will not constitute “bad” property if the QOZB purchases new property in an amount that exceeds the value of the used assets that are leased.

  1. Triple Net Leases

While leasing real estate is generally an active business for OZone purposes, “merely” triple net leasing is NOT an active business and does not qualify. Here, the focus should be on the word “merely.” So, if the QOZB is developing a site and leasing to a tenant, such as Target, Walmart, CVS, Walgreens and others who insist upon utilizing a triple net lease, the QOZB can avoid “merely” by developing a portion of the site and leasing that portion on other than a triple-net basis. Likewise, many QOZB can retain some significant expense to avoid triple-net status. The word “merely” telegraphs that the magnitude of the active rental activity does not need to be “substantial” in comparison to the amount of the triple-net activity. Taxpayers should consult their advisors to define “merely” in any specific situation.

With the exception of the Devil’s details described above, the second tranche of OZone regulations has established a user-friendly set of rules that will permit most OZone business venturers to qualify under the OZone rules. With that, OZone investment should accelerate rapidly. Let’s hope the OZone program fulfills its potential to assist designated communities left behind in the economic recovery to join the progress that many other communities have enjoyed since the recession.

Disclaimer: This is for general information and is not intended to be and should not be taken as legal advice for any particular matter. It is not intended to and does not create any attorney-client relationship. The opinions expressed and any legal positions asserted in the article are those of the author and do not necessarily reflect the opinions or positions of Miles & Stockbridge, its other lawyers or the National Housing & Rehabilitation Association.

Story Contacts:
Jerry Breed
[email protected]

Corenia Riley Burlingame
[email protected]

Jerry Breed focuses his practice on tax planning and the structuring of low-income housing tax credit, historic rehabilitation tax credit, new markets tax credit and renewable energy transactions. Mr. Breed has closed many low-income housing, historic rehabilitation, new markets tax credit and renewable energy transactions that permit his clients to maximize tax benefits and investment returns, all within the framework of the client's business goals. He has substantial experience in the taxation of community development and new markets credit investments. Mr. Breed also has represented clients with respect to audits of tax credit investments. Clients of Mr. Breed include syndicators and investors in low-income housing, historic rehabilitation, new markets tax credit and renewable energy transactions as well as developers of these credit projects. In the New Markets Tax Credits area, Mr. Breed represents the owners of qualified active low-income community businesses and community development entities. Mr. Breed also represents state housing authorities that allocate low-income housing tax credits. Frequently, these federal credits include state credits and other federal, state and local subsidies. Mr. Breed has given presentations at numerous seminars and conferences on the low-income housing, historic rehabilitation, new markets tax credits and renewable energy credits including presentations on partnership taxation, and real estate tax issues. He also is author of a number of articles on tax credits and other federal income tax matters.