Final Regulations on Opportunity Zones
January 16, 2020
The Opportunity Zone (OZ) program generated quite a lot of hype and questions since its enactment as part of the Tax Cuts and Jobs Act. After two rounds of proposed regulations, the Treasury Department issued final OZ regulations on December 19, 2019. These regulations clarify the two rounds of proposed regulations, and also include some new rules. Key takeaways from the final regulations are discussed below:
The final regulations reversed course on the eligibility of 1231 gains (gains from the sale of business property) for OZ deferral. 1231 gains are netted with losses to determine if the net is a capital gain or an ordinary loss. In the proposed regulations, this netting process was required to determine if a taxpayer had gain eligible for OZ deferral — only a net gain was eligible for deferral and investment into a Qualified Opportunity Fund (QOF). The final regulations changed course and consider an investor’s gross 1231 gain to be eligible for deferral and investment into a QOF. The netting process is no longer required to calculate the amount eligible for deferral.
Timing of Investment of Eligible Gains
- 1231 Gains — Because the final regulations adopted the gross concept to 1231 gains, investors do not need to wait until the end of the year for the 180-day clock to begin. Rather, the 180-day investment window will begin on the date of sale or exchange of 1231 property.
- Installment Sale Gains — For taxpayers with capital gain from installment sales, the regulations provide the option to start the 180-day investment window when each payment is received, or the last day of the tax year. Additionally, installment payments resulting from a pre-2018 sale are eligible as long as the payment is received by 2026.
- Gains from Pass-through Entities — The proposed regulations treated the 180-day investment window for eligible gains from pass-through entities to start on the last day of the tax year; alternatively, the investor had the ability to make an election and start the 180-day window on the date of sale by the pass-through entity. The final regulations add a third option to start the 180-day investment window on the due date of the pass-through entity’s tax return, not including extensions.
The May 2019 proposed regulations provided an asset-by-asset test to meet the substantial improvement requirement. The final regulations reversed course and allow for aggregation, as long as certain requirements are met. Buildings located entirely within a land parcel can be aggregated into a single property. Multiple buildings on adjoining land parcels can be aggregated if certain requirements are met. Additionally, the final regulations specify that original use assets can be characterized as a non-original use substantial improvement.
Working Capital Safe Harbor
One of the many benefits of using a Qualified Opportunity Zone Business (QOZB) within a QOF is the working capital safeharbor. The safeharbor was expanded under the final regulations. If the Qualified Opportunity Zone (QOZ) is in a federally declared disaster area, the safe harbor is extended by an additional 24 months. Additionally, start-up businesses have an extended safeharbor of 62 months.
Final regulations retain the provision that unimproved land that is only “minimally improved” by a QOF or QOZB will not qualify as OZ business property if the intent was not to improve the land by more than an insubstantial amount. If the intent is to make minimal improvements without substantially increasing the economic productivity of the land, then the transaction is inconsistent with the purposes of the OZ program, and the land will not be considered OZ property.
Vacant Properties and Brownfield Sites
The proposed regulations allowed that a vacant building would be considered to meet the original use test if it was vacant for five or more years. Under the final regulations, the vacancy period is reduced to continuous three years; if the property was vacant prior to the publishing of the designated Opportunity Zones, then the vacancy period is reduced to 1 year. A property is considered vacant if more than 80% of the building or land is not being used.
Additionally, brownfield sites located within an Opportunity Zone will be considered to be original use, though investment will need to be made to ensure that the site meets “basic safety standards for human health and environment.”
The proposed regulations indicated that the ownership and operation of real property can qualify as an active conduct of a trade or business, but that merely entering into a triple-net lease does not qualify as such, and is therefore ineligible for Opportunity Zone benefits. The final regulations indicate that in certain cases, businesses with triple-net leases can be treated as undergoing the active conduct of a trade or business. The example given shows a commercial building with three tenants each occupying a single floor — one with a triple-net lease and two without. Because the landlord or his employees “meaningfully participate in the management and operations” of the building, the active conduct of a trade or business standard is met.
Exclusion of Gain from Asset Sales
The final regulations state that all asset sale gains from property held at least ten years are eligible for a basis step-up, including depreciation recapture. The only exclusion is for inventory sold in the normal course of business. This applies to both QOF and QOZB asset sales.
The proposed regulations were submitted by the Treasury Department to the Federal Register for publication on January 13, 2020. The regulations become effective for tax years beginning on or after 60 days after publication in the Federal Register. For calendar-year taxpayers, that will mean the 2021 tax year. However, taxpayers have the prerogative to abide by either the final regulations or the proposed regulations, provided that the regulations are applied consistently and in their entirety.
The final regulations provide investors much more clarity and confidence about the Opportunity Zone program. Should you have any questions about how the regulations will impact an existing QOF or QOZB, or if you are interested in using the Opportunity Zone program, please reach out to our experts at Geffen Mesher.