On April 17, 2019, the IRS and the Treasury Department released proposed regulations (“Proposed Regulations”) regarding new tax incentives for investments in qualified opportunity zones (“QOZs”) and qualified opportunity funds (“QOFs”). The Proposed Regulations build upon the initial guidance from the first round of regulations released in October 2018 (“Initial Regulations”) to provide additional clarity regarding the use of QOZs and QOFs. Below is a summary of key updates addressed in the Proposed Regulations.
QOF Eligibility
“Original use” and “substantial improvement”
The Proposed Regulations require that, for direct investments in tangible property in a QOZ (“QOZ Property”) by a QOF, either the original use of such property must commence with the QOF or the QOF must make substantial improvements to the property. Original use of QOZ Property acquired by purchase commences on the date when the property is first placed in services in the QOZ for purposes of depreciation or amortization (or first used in a manner that would allow depreciation or amortization). Therefore, QOZ Property that is depreciated or amortized by a taxpayer other than a QOF or a QOZ business (“QOZ Business”) cannot satisfy the original use requirement. However, a taxpayer other than a QOF or a QOZ Business that has not yet depreciated or amortized QOZ Property would satisfy the requirement. Used QOZ Property may not have been previously used (in a manner that would have allowed it to depreciate or amortize) by any taxpayer. A QOF or a QOZ Business can also meet the “original use” requirement by purchasing a building or other structure that has been vacant for at least five years.
After receiving comments on the “substantial improvement” requirement, the IRS now recognizes that, in certain instances, some QOZ Property is not capable of being substantially improved. The IRS is contemplating the possibility of applying an aggregate standard for determining compliance with this requirement, potentially allowing QOZ Property to be grouped by location in the same QOZs.
QOZ Business Requirements
“Substantially all”
To qualify as a QOZ Business, a business must be located in a QOZ for substantially all of the business’s holding period of that property. The IRS has clarified that “substantially all” of the holding period is 90%. A QOZ Business must also use a “substantial portion” of its intangible property in the business. The IRS has clarified that “substantial portion” of intangible property is 40%.
50% of Gross Income
A QOZ Business must also derive at least 50% of its total gross income from the business. The IRS issued three safe harbors and a “facts and circumstances” test for meeting the 50% requirement. Businesses need to only meet one of these safe harbors to qualify: (i) at least 50% of the hours of services performed for the business by its employees and independent contractors are performed within the QOZ; (ii) at least 50% of the services performed for the business must be performed within the QOZ, based on amounts paid by the business for the services; or (iii) the tangible property of the business in a QOZ and the management and operational functions performed for the business are each necessary to generate 50% of the gross net income. Additionally, under the “facts and circumstances” test, if a taxpayer does not meet those safe harbors, such taxpayer can meet the requirement if, based on the facts and circumstances, at least 50% of the gross income is derived from the active conduct of the business. While the parameters of “facts and circumstances” are not yet defined, the IRS and the Treasury Department are soliciting comments on the safe harbor tests for further clarification.
How the Disposition of Underlying Investments Affects Tax Incentives and QOF Eligibility
A taxpayer’s basis in a QOF interest automatically increases after 5, 7, and 10 years of holding the interest. In a multi-asset QOF, because the tax incentives are tied to the investor’s QOF interest and not to the underlying assets of the QOF, the sale or disposition of a portion of the QOF’s assets would generally not impact investors’ eligibility for capital gains deferral and exclusion incentives. However, once an investor disposes of all or a portion of a QOF interest, such investor will recognize all or a portion of his or her deferred gains (“Inclusion Event”). The Proposed Regulations provide a nonexclusive list of eleven Inclusion Events.
While the disposition of underlying assets may not trigger the recognition of an investor’s deferred gains, the gain received from the sale of depreciable QOZ Property (“Depreciation Recapture”) cannot be deferred or excluded and the investor must report it as income. Even if the QOF reinvests those sale proceeds in new QOZ assets, the gain from the sale of a particular asset is still recognized as taxable income.
One issue identified after the Initial Regulations were released was whether an entity could lose its QOF status if it did not hold 90% of its assets in QOZ Property, particularly after the disposition of some of its assets. The IRS has clarified that failure to satisfy the 90% test does not by itself cause an entity to lose its QOF status. A new QOF has the ability to delay the start of its status as a QOF, allowing it to deploy new capital before the QOF is tested. Additionally, the test can exclude any investments received in the preceding 6 months. If a QOF wants to sell a portion or all of its assets and reinvest in new QOZ assets, it may reinvest within 12 months of the date of sale without violating the 90% test or applicable holding period requirements.
Debt-Financed Distributions
The Proposed Regulations provide that an investor’s initial basis in a QOF is zero. Generally, with a basis of zero, any distributions made to an investor would be taxable income. However, the Proposed Regulations affirm that, consistent with partnership tax rules, an investor’s allocable share of QOF partnership liabilities is included in the investor’s tax basis, thereby allowing the QOF to make tax-free debt-financed distributions. A QOF partnership can make debt-financed distributions to the extent of the investor’s tax basis in the QOF without triggering an Inclusion Event. However, an investor may not be eligible for QOZ tax benefits if the distributions are treated as a “disguised sale” under existing partnership tax rules.
Regulation A+
The vast majority of exempt securities offerings are issued under Regulation D due to the flexibility and cost-effectiveness of the exemption. However, Regulation D offerings are “restricted securities” and generally not available on the secondary market. Because there are neither eligibility requirements for who can invest in a QOF nor transferability restrictions of QOF interests under the current rules, issuers of securities in QOFs may want to consider the option of relying upon the Regulation A+ (“Reg A+”) registration exemption. Reg A+ allows the issuance of securities of up to $20 million or $50 million in a 12-month period to the general public to invest in startup and emerging companies without registering with the SEC. Therefore, similar to the trend of real estate investment trusts (“REITs”) turning to Reg A+ as an available securities exemption, we think Reg A+ could gain traction as a desirable exemption for QOFs.
The IRS and the Treasury Department requested comments on the Proposed Regulations, which can be found on the IRS website. If you have any questions regarding this alert or QOFs in general, please contact Kevin Cott at kcott@colefrieman.com or by phone at 770.674.8481.
