In a long-awaited act, the Treasury has released its second set of proposed opportunity zone regulations. While opportunity zones have gotten a lot of attention for their exciting potential benefits, the lack of substantive guidance has prevented many investors and developers from fully moving forward. However, these proposed regulations answer many lingering questions and provide greater clarity. Below we summarize what you need to know about the key updates.
Because the facts and circumstances of every investor are different, the summary below should not be considered legal or tax advice and should not be solely relied upon in making decisions on opportunity zone properties, businesses and funds. Please seek out our assistance directly before moving forward with any opportunity zone investments.
Be on the lookout for additional guidance and commentary regarding the second tranche of proposed regulations from Wipfli over the next several weeks.
Just now hearing about opportunity zones? We previously covered opportunity zones basics — from what they are to how they enable tax benefits to what qualifies as a Qualified Opportunity Fund (QOF).
Summary of the Key Updates to the Proposed Opportunity Zone Regulations
Exit Strategy — A taxpayer that is the holder of a qualifying QOF partnership interest or S corporation stock may elect to exclude from gross income the capital gain from the disposition of qualified opportunity zone property reported on Schedule K-1 of such entity, provided the disposition occurs after the taxpayer’s 10-year holding period.
Debt-Financed Distributions — The proposed regulations include an example with a debt-financed distribution and indicates it should be allowable as long as the distribution does not exceed the investor’s basis in the QOF.
Carried Interest — The proposed regulations clarified that an investment into a QOF may be made with cash or property, but an interest received in exchange for services would not qualify for the QOF tax benefits. A service provider’s interest will be able to be tracked between its interest in capital gains invested and the performance of services.
§1231 Gains — Because the capital gain income from §1231 property is determinable only as of the last day of the taxable year, these proposed regulations stipulate that the 180-day period allowing you to invest such capital gain income from §1231 property in a QOF begins on the last day of the taxable year.
Leased Property — The lease must have been entered after December 31, 2017, and be a “market rate” lease to be considered qualified opportunity zone business property. There is no original use or substantial improvement requirement for leased property. When the lessor and lessee are related, there may be further restrictions. There is also further guidance on how to value a lease for asset test purposes and when there are prepayments.
Substantial Improvement Asset by Asset — The proposed regulations indicate substantial improvements must be made on an asset-by-asset basis in order to be Qualified Opportunity Zone Business Property (QOZBP).
Tangible Property & Original Use Definition — Original use of the tangible property begins on the placed in-service date for purposes of depreciation or amortization. If the tangible property was previously depreciated or amortized within the Qualified Opportunity Zone (QOZ), then it needs to be substantially improved to be considered QOZBP.
Vacant Property — If property has been unused or vacant for an uninterrupted period of at least five years, original use in the zone commences on the date after that period when any person first uses or places the property in service in the QOZ.
Triple Net Leases — Merely entering into a triple net lease with respect to real property owned by a taxpayer is not the active conduct of a trade or business by such taxpayer for QOZ purposes.
Property Adjacent to a QOZ — If the amount of real property based on square footage located within the QOZ is substantial as compared to the amount of real property based on square footage outside of the QOZ, and the real property outside of the QOZ is contiguous to part or all of the real property located inside the QOZ, then all of the property is deemed to be located within a QOZ.
50% Gross Income Test Clarified — The proposed regulations set forth three safe-harbors to meet the 50% of its total gross income in the opportunity zone requirement. The QOF must meet one of the three safe-harbors.
- Safe harbor #1: 50% of the services performed for the business by its employees and independent contractors (and employees of independent contractors) are performed in the QOZ, based on amounts paid for the services performed.
- Safe harbor #2: 50% of the services performed (based on hours) for such business by its employees and independent contractors (and employees of independent contractors) are performed within the QOZ.
- Safe harbor #3: 50% of the gross income requirement is met if (1) the tangible property of the business that is in a QOZ and (2) the management or operational functions performed for the business in the QOZ are each necessary to generate 50% of the gross income of the trade or business.
Working Capital Safe Harbor — The working capital safe harbor for a written plan now includes the development of a trade or business in the QOZ as well as acquisition, construction and/or substantial improvement of tangible property.
31-Month Working Capital Safe Harbor Exceptions — Exceeding the 31-month period does not violate the safe harbor if the delay is attributable to waiting for government action, the application for which is completed during the 31-month period.
Events Triggering Gain Inclusion — The IRS set out several different events that would require inclusion of gain, including gifts, donations and transfers of interest. However, transfers due to death will not trigger gain if the interest is transferred appropriately.
With this new, additional guidance, now is a great time to move forward. The Treasury released these proposed regulations to help people pursue QOZ opportunities. While there is a 60-day commentary period and more changes may be coming, the foundation is finally settling.
At Wipfli, we’re committed to educating clients about opportunity zones and helping them start seeing the benefits. We assist clients and prospects determining if their investment qualifies under the opportunity zone rules, structuring their QOF appropriately, working through the complexities of their specific situation, as well as providing general tax, attestation, accounting and other services. Contact us to get started.