With the publishing of the second set of proposed opportunity zone regulations, there are some misconceptions and even myths associated with the Opportunity Zone (OZ) incentive circulating in the industry. Here are the facts.
1. DOES LAND-BANKING OR JUST BUILDING A HOT DOG STAND ON LAND WORK AS AN OZ INVESTMENT STRATEGY?
No. The second set of regulations indicates that land must be used in a trade or business of a qualified opportunity fund (QOF) or qualified opportunity zone business (QOZB). As a result, land held solely for appreciation, such as the case of land-banking, would fail this test and not be qualified OZ property. Unimproved land in an OZ is not required to be substantially improved for it to be qualified property. However, there must be a plan at the time of purchase to improve the land by more than an insubstantial amount within 30 months. To meet this requirement, some stakeholders have suggested that investors could just build the proverbial hot dog stand on an otherwise unimproved 40-acre land parcel. While the math may seemingly work, the actual purpose for the improvements would appear to be to achieve an “inappropriate tax result.” The second set of regulations do establish general anti-abuse rules. The Commissioner can now recast a transaction (or series of transactions) for federal tax purposes as appropriate to achieve tax results that are consistent with the purpose of the OZ incentive. Clearly, the potential tax repercussions of trying to game the incentive may not be worth the risk.
2. IS THERE A “GOLDEN SEAL OF APPROVAL” FOR A BUSINESS TO BE RECOGNIZED AS A QOZB?
No. There is no third-party approval process to establish that a business is a QOZB. Instead, QOFs must adhere to the numerous rules outlined in the legislation and regulations. These rules require that QOFs self-certify whether at least 90 percent of their assets are invested in Qualified Opportunity Zone Property, which includes an equity interest in a partnership or corporation that is a QOZB. Since there is no actual “golden seal of approval,” QOF investors should exercise caution and use careful diligence when determining whether a QOF is investing in a QOZB. In general, a business must qualify as a QOZB both when the QOF acquires its equity interest in the QOZB and during substantially all, at least 90%, of the QOF’s holding period of that interest. The QOZB must be organized as a either a corporation or partnership (including a multi-member LLC) for federal income tax purposes in one of the 50 states, Washington DC, or a U.S. possession. The QOF must invest in the QOZB by contributing cash directly in exchange for stock or a partnership interest. It can also contribute property, such as land that was purchased after 2017.
In order for the QOF business to qualify as a QOZB, it must engage in an active “trade or business” utilizing owned or leased tangible property within the OZ. A trade or business is typically an activity that is carried on with continuity and regularity with profit being the primary purpose. Almost any type of active trade or business potentially can qualify, with the exception of “sin businesses.” The QOZB’s tangible assets must generally meet an original use test or a substantially improved test. In each taxable year, at least 50 percent of the gross income of the QOZB must come from the active conduct of the trade or business located in the OZ. To meet the 50 percent test, the QOZB must satisfy one of three safe harbors (based on performance of services, amounts paid for services, or the location of management, property and operations) or a facts and circumstance review, as outlined in the second set of regulations. There are additional standards for the use of any intangible property and nonqualified financial property (including working capital) held by the QOZB.
3. THE FEDERAL GOVERNMENT PICKED THE OPPORTUNITY ZONES, RIGHT?
No. As outlined in section 1400-Z(1) in the Tax Cut and Jobs Act, the “chief executive officer” (Governor) of the “State” (which includes all 50 states, U.S. territories, and Washington DC) nominated eligible low-income and contiguous census tracts to be OZs. Data from the 2011-2015 American Community Survey was used to identify eligible tracts. Twenty-five percent of a state’s low-income census tracts could be nominated (or 25 if the state has less than 100 qualifying census tracts.) No more than 5% of contiguous census tracts, with less stringent income restrictions, could be nominated. Still, these contiguous OZs had income restrictions requiring that the median family income of the tract does not exceed 125% of the median family income of the low-income community (adjacent tract). Once the tracts were nominated, Treasury certified and designated those tracts as OZs.
By definition, OZ census tracts have a higher poverty rate than the national average. According to Treasury, nearly 35 million Americans live in the over 8,700 communities designated as OZs and these designated census tracts had an average poverty rate of over 32 percent, compared with a rate of 17 percent for the average U.S. census tract.
4. THE ENTIRE BUILDING ALWAYS NEEDS TO BE IN THE OZ, CORRECT?
Not for certain purposes. According to the second set of regulations, the IRS’s treatment of real property that straddles OZs and non-OZs is similar to Empowerment Zones. If the square footage of real property located in the OZ is substantial as compared to the amount of contiguous real property outside of the OZ, then all the real property outside the of the OZ will be treated as inside the OZ. Real property located in the OZ is considered substantial if the unadjusted cost of the real property inside the OZ is greater than the unadjusted cost of the real property outside the OZ.
These rules apply for purposes of the 50% gross income, the level of nonqualified financial property, and the substantial use of intangibles tests. However, this rule does not apply for purposes of determining if real estate is qualified OZ property.
5. SETTING UP A QOF AND A QOZB ARE SIMPLE DO-IT-YOURSELF CHORES, RIGHT?
No. Clearly, 74 pages of the first set of regulations and 169 pages of the second set of regulations (and a revenue ruling) have shown that setting up QOFs and QOZBs are not simple do-it-yourself documents — far from it.
Before investors, fund sponsors, developers and entrepreneurs embark on implementing the OZ incentive, they should seek knowledgeable counsel to discuss their particular facts and circumstances to ensure they meet all the rules in order to avoid making irrevocable decisions that could inadvertently prevent the use of OZ benefits. Examples of factors to consider include timing of investments, meeting the 90% QOF investment threshold, timelines for substantial improvements and working capital safe harbors, various “substantial” thresholds, entity formation and exit strategies. This is particularly critical if a QOF is raising capital from outside investors with any sort of fiduciary standards, including friends and family.
6. CAN SOMEONE MAKE THEIR GOLF COURSE A QOZB?
No. The legislation expressly prohibits businesses described in section 144(c)(6)(B) from becoming QOZBs. The restrictions extend to any “private or commercial golf course, country club, massage parlor, hot tub facility, suntan facility, racetrack or other facility used for gambling, or any store the principal business of which is the sale of alcoholic beverages for consumption off premises.” Investors should consider whether the business complies with existing state and federal laws before utilizing the OZ incentive.
7. MUST THE QOF BUY THE PROPERTY FOR THE OZ INCENTIVE TO WORK?
No. Leased property may be qualified OZ property as long as it meets certain requirements, including that the property must be acquired pursuant to a lease entered into after Dec. 31, 2017, and substantially all of the use of the leased property must be in an OZ during substantially all of the lease period. Further, the terms of the lease must reflect a common, arms-length transaction in the local market.
Qualified leases may be between related parties. If the lease is between related parties, the second set of regulations have provided the following additional tests to prevent abuse: There can’t be a prepayment to the lessor for a greater than 12-month period, and an option to acquire the leased property can’t be at less than fair market value. An additional requirement applies if the leased property is tangible personal property.
The second set of regulations now give a significant benefit to leaseholders. Since leased property can’t typically be placed in service for depreciation or amortization purposes, the “original use” requirement does not apply as it does with most purchased property. As a result, there is also no requirement that the leased property be substantially improved. These new leasing rules allow the flexibility needed by companies that want to grow and expand or when a pre-Jan. 1, 2018 owner wants to participate in the OZ.
8. IS IT POSSIBLE TO HAVE “ORIGINAL USE” WITH THE PURCHASE OF A BUILDING CURRENTLY UNDER CONSTRUCTION OR A VACANT BUILDING?
It depends. Tangible property owned by a QOF or a QOZB must meet either the original use or substantial improvement test. Quite simply, original use now begins on the date the property is first placed in service in the OZ for purposes of depreciation or amortization. This means that a building under construction that is acquired by the QOF or QOZB can satisfy the original use requirement. There is now further guidance for vacant buildings. When a building has been vacant for an uninterrupted period of at least five years, the purchased building can satisfy the original use requirement. Note that such a transaction could be subject to the general anti-abuse rule established under the second set of regulations, which permits the IRS to disqualify a QOF or a transaction if it is perceived to be abusive. Questions still remain, for example, if the QOF or QOZB buys a building that is 95 percent completed by the seller, is that still considered to be construction in progress?
9. MAY DIFFERENT LOTS BE AGGREGATED TO MEET THE SUBSTANTIAL IMPROVEMENT TEST?
No. Under the second set of regulations, the substantial improvement test is measured on an asset by asset basis. This may make it more challenging if different lots are purchased for one project and not all the lots need to be improved but are needed to make the project successful. However, if a building is being renovated on one of the lots and additional lots are required to expand the project, then this will be treated as one project. Therefore, the substantial improvement test would be met by including not just the renovations to the existing property but also the expansion of improvements that are tied to the existing property. Treasury has requested comments on this issue.
10. SINCE THE SECOND SET OF REGULATIONS ARE NOT FINAL AND ARE STILL SUBJECT TO COMMENT, CAN THEY BE RELIED UPON?
Yes. Treasury has stated that taxpayers may rely on them as they proceed with OZ investments, projects and businesses as long as they generally comply with all of the terms of the proposed regulations.