Tax Alert: IRS Issues New Proposed Regulations on Qualified Opportunity FundsBy Alan M. Blecher | Abe Schlisselfeld | April 18, 2019
On April 17, 2019, the IRS released a second round of proposed regulations regarding investments in Qualified Opportunity Funds (QOFs). While the Qualified Opportunity Zones provision has garnered the attention of the real estate industry (as well as outside investors and fund managers) since its introduction in 2017, the lack of available guidance had many waiting to act on this potentially groundbreaking tax incentive program. These new regulations provide long-awaited clarity for investors seeking to take advantage of the opportunity zone tax benefits, addressing a number of the critical issues that remained after the first set of regulations was released in October 2018.
Upon initial analysis, these proposed regulations:
- Define the phrase “substantially all” regarding the use and holding period of tangible business property. At least 70% of the property must be used in a qualified opportunity zone. It must be qualified opportunity zone business property for at least 90% of the time it is held by a QOF or qualified opportunity zone business.
- Define the “original use” of tangible property acquired by purchase as commencing on the date the property is first placed in service in the qualified opportunity zone for purposes of depreciation or amortization. In other words, tangible property located in the zone that was depreciated or amortized by a taxpayer other than the QOF or qualified opportunity zone business does not satisfy the original use requirement. If a building or other structure has been vacant for at least 5 years prior to being purchased by a QOF, the purchased building will satisfy the original use requirement.
- Permit tangible property that is leased (under a market rate lease) to constitute qualified opportunity zone business property, provided that during substantially all of the holding period of the property, substantially all of the use of the property was in a qualified opportunity zone. Substantially all – (70%) of the tangible property owned or leased by the taxpayer must be qualified opportunity zone business property. There are two valuation methods for leased property – the applicable financial statement method and an alternative method based on the present value of the leased tangible property.
- Do not require leased property to be acquired from an unrelated lessor. However, if the lessor and lessee are related, leased tangible property does not qualify if, in connection with the lease, the QOF at any time makes a prepayment to the lessor or related party relating to a period of use that exceeds 12 months. When the lessor and lessee are related, the proposed regulations do not permit leased tangible personal property to qualify unless the lessee becomes the owner of tangible property that is qualified opportunity zone business property and that has a value at least equal to the value of the leased property. This acquisition must occur during a period that begins on the date the lessee receives possession of the property under the lease and ends on the earlier of the last day of the following 30-month period, or the last day of the lease. There is an anti-abuse rule to prevent the use of leases to circumvent the substantial improvement requirement for purchases of real property (other than unimproved land).
- Specify situations where deferred gains invested in QOFs may become taxable, such as a transfer by gift or distribution by a QOF organized as a partnership with a value in excess of the basis of the partner’s qualifying QOF partnership interest. A nonexclusive list of other “inclusion events” includes a sale of all or part of a qualifying investment in a QOF partnership or QOF corporation; a transfer by a partner of an interest in a partnership that itself directly or indirectly holds a qualifying investment; and various corporate liquidations, redemptions and reorganizations. However, inheritance by a surviving spouse is not a taxable transfer, nor is a transfer, upon death, of an interest in a QOF to an estate.
- Provide three safe harbors and a facts and circumstances test to determine if the 50% of gross income test is met. This test requires that at least 50% of total gross income must be derived from the active conduct of a business with a qualified opportunity zone. Only one of the three safe harbors needs to be met. The first two safe harbors are: (1) At least 50% of the services performed, based on hours; (2) At least 50% of services performed, based on compensation paid. The third safe harbor is satisfied if (i) the tangible property of the business that is in a qualified opportunity zone and (ii) the management or operational functions performed for the business in the qualified opportunity zone are each necessary to generate 50% of the gross income. If none of the safe harbors are met, the taxpayer must rely on the facts and circumstances
- Provide a “reasonable period” for a QOF to reinvest proceeds from the sale of qualifying assets without incurring a penalty. This period is 12 months. However, any gain recognized by the QOF still flows through to the investors.
- Clarify that a disposition of the underlying assets – as opposed to the disposition of the QOF interest by the investor – also qualifies for the exclusion of gain assuming that the investor has held its QOF investment for at least 10 years.
- Provide for the exclusion of cash and cash equivalents from the 90% asset test if received by the QOF within 6 months of the testing date.
- Clarify that a taxpayer’s Section 1231 gain qualifies for investment if its Section 1231 gains for the taxable year exceed its Section 1231 losses. Since this is only determinable at the end of the year, the 180-day period for investing such gain begins on the last day of the taxable year.
- Adopt the approach that a partner holding a “mixed-funds” investment will have a single basis and capital account for purposes of the partnership taxation rules, but not for the QOF rules. A mixed-funds investment is one in which a partner has contributed to a QOF property with a value in excess of its basis, or cash in excess of the partner’s eligible gain, or where a partner receives a partnership interest in exchange for services, such as a carried interest. The share of gain attributable to the excess investment and/or the service component of the partnership interest is not eligible for the various benefits afforded qualifying investments and is not subject to the inclusion rules discussed above. This is the case with respect to a carried interest, even if all of the partnership’s investments are qualifying investments. Under the proposed regulations, solely for the QOF rules, a mixed-funds partner will be treated as holding two interests, and all partnership items, such as income and debt allocations and property distributions, would affect the qualifying and non-qualifying interests proportionately, based on the relative allocation percentages.
These are just some of the highlights revealed in our initial analysis of the 169 pages of IRS guidance. The Real Estate Group at Marks Paneth continues to closely review this latest set of proposed regulations and looks forward to providing a more detailed summary in the days ahead.
About Alan M. Blecher
Alan M. Blecher, JD, is a Principal at Marks Paneth LLP. Mr. Blecher has considerable experience serving high-income and high-net-worth individuals and their closely held businesses. He focuses especially on partnerships, limited liability companies and S corporations. He has been in public accounting since 1985. He has been involved in tax planning for numerous transactions, such as those involving public debt offerings, sales of family businesses and restructurings of distressed entities, among others. Mr. Blecher... READ MORE +
About Abe Schlisselfeld
Abe Schlisselfeld, CPA, EA, is the Managing Partner of Marks Paneth LLP. In this capacity, he oversees the firm's operations, manages business development efforts and consults on key clients. He is chairman of the firm’s Executive Committee and plays a major role in developing strategy, setting policy and overseeing acquisitions. Prior to becoming Managing Partner in 2021, Mr. Schlisselfeld was the Partner-in-Charge of the firm’s Real Estate Group. In that role, he advised commercial and... READ MORE +