On April 17, 2019, the Department of Treasury issued the second set of proposed regulations regarding the Qualified Opportunity (QO) Zone Program. This long-awaited guidance further clarifies how to comply with the program and how to make it over some of the hurdles associated with structuring related transactions.
While there is much more detail in the proposed regulations, which we will delve into in future posts, below addresses the top questions we have received from clients to date.
>> Read more about round one of the proposed regulations in “10 Key Questions — Answered — About Qualified Opportunity Zones.”
To be considered a QO Zone business, “substantially all” of the tangible property the business owns or leases must be QO Zone business property. One of the requirements for business property to be considered QO Zone business property is that during substantially all of the QO Zone Fund’s holding period of the property, substantially all of the use of such property was in a QO Zone. If a QO Zone Fund owned a partnership interest or stock, the partnership or corporation needs to be a QO Zone business during substantially all of the QO Zone Fund’s holding period of the partnership interest or stock.
Until now, substantially all was not defined. The new set of proposed regulations define substantially all as 70% or more for the use of property in a QO Zone and 90% or more for the holding period test.
This is an important definition for investors to understand because QO Zone Funds that fail the 90% test are subject to a harsh penalty that quickly erodes the benefits of the program.
Treasury could find no authority for the QO Zone Fund to avoid recognition of the gain from the sale or disposition of the qualifying investment. This means taxpayers will be taxed on the gain from the sale of the asset but the original deferred gain and holding period of the QO Zone Fund interest are unaffected.
The proposed regulations provide a 12-month exception to the 90% test (penalty) for proceeds received by a QO Zone Fund from the sale or disposition of QO Zone business property, QO Zone stock and QO Zone partnership interests — provided the proceeds are held continuously in cash, cash equivalents or debt instruments with a term of 18 months or less. Accordingly, the QO Zone Fund has 12 months from the date of distribution, sale or disposition to avoid the penalty. After the initial six-month 90% testing date, the subsequent testing dates are June 30 and December 31. So, if the 12-month period falls outside of a testing date, the QO Zone Fund would have until the next testing date to redeploy the proceeds into another qualifying investment.
If the fair market value of the distribution does not exceed the partner’s tax basis in its qualifying QO Zone Fund partnership interest, it is not an inclusion event and does not impact the deferred gain. Alternatively, if the fair market value of the distribution does exceed the partner’s tax basis, it would be an inclusion event and reduce the deferred gain.
Another option to avoid the inclusion event would be to have the QO Zone Fund reinvest the refinance proceeds into other QO Zone business property.
Assuming the other requirements of Section 1400Z-2(d)(3)(A)(ii) are met, the proposed regulations provide three safe harbors to determine whether a sufficient amount of income is derived in a QO Zone for the purposes of meeting the 50% gross receipts test. The gross receipts test requires:
If the business can meet one of these tests, it can be considered a QO Zone business. However, the proposed regulations also include a facts and circumstances test that allows a business to qualify even if any of the three safe harbors are not met.
Certain leased property may be considered QO Zone business property. The leased property must be:
The leased property does not have to meet the original use test. Leased property is also not required to be leased by an unrelated party. The lease terms must be a market rate lease.
This provision provides building owners located in a QO Zone who either recently renovated their building, or where renovation isn’t necessary, to have another bite at the apple for this program. It provides an incentive for businesses to relocate their businesses into a QO Zone to obtain the benefit of the program. Time will tell whether landlords can use this incentive to structure 10-year leases.
If the lessor and lessee are related, there are two additional hurdles a QO Zone Fund must overcome for the lease to be considered QO Zone business property:
Whether or not the gain will qualify will be based on the answers to the following questions:
Regarding timing, the proposed regulations clarify the 180-day period for Section 1231 gain begins on the last day of the tax year. This is important to note because investors cannot make a qualified investment into a QO Zone Fund until they have experienced a capital gain. This rule may make it administratively difficult for large QO Zone Funds to line up investor capital because investors in Section 1231 gain will need to wait until the end of the year to invest.
No. The proposed regulations clarify that investments in QO Zone Funds must be in cash or property, not services. A carried interest is considered a mixed-funds investment and not eligible the benefits of the program.
This second round of regulations offer more clarity to the QO Zone Program, helping investors, businesses and ultimately communities reap the benefits.
Contact Dave Sobochan at firstname.lastname@example.org, Adam Hill at email@example.com or Angel Rice at firstname.lastname@example.org to discuss this topic further.
Cohen & Company is not rendering legal, accounting or other professional advice. Information contained in this post is considered accurate as of the date of publishing. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts, circumstances and current law.
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