Several Taxpayer friendly provisions added
The long awaited final Qualified Opportunity Zone (QOZ) regulations were released Dec. 19, 2019, along with a short FAQ document from the IRS that addresses some of the major changes.
The final regulations combine the two previously released proposed regulations (see our coverage here and here), clarify the proposed regulations as necessary, and provide additional rules based on the public comments and additional analysis. The writers of the final regulations did several things to make these regulations easier to understand. They also split the proposed regulations 1.1400Z2 (d)-1 into two sections, combined some duplicative rules, and added additional terms for easier reading and comprehension. Some highlights of the new rules are discussed below:
Timing of eligible gains
The final regulations establish that eligible section 1231 gains may include the gross gain without regard to section1231 losses, and that the 180-day window to invest begins on the date of the sale or exchange giving rise to the section 1231 gain. This is in stark contrast to the proposed regulations, which required that the 180-day window to invest would begin the last day of the year, and that section 1231 gains would have to be netted against section 1231 losses from the tax year before being invested.
Section 1231 gain generally refers to gain from the sale or exchange of business property, giving these rules wide application. The regulations discuss various scenarios that are particular to section 1231 gain, and prescribe rules to address these scenarios. This includes a rule that limits qualified section 1231 gain to the extent that it exceeds any amount with respect to the section 1231(b) property that is treated as ordinary income under section 1245 or section 1250.
Installment Sales, RIC/REIT Dividends, and Partnership Investment Timing
The final regulations add flexibility with a number of timing options for the 180-day investment period. For eligible gains from installment sales, the taxpayer has the option to either invest when payments are received or the last day of the taxable year the eligible gain under the installment method would have been recognized but for deferral. They also create an option that allows the 180 day-period for partners of a partnership, shareholders of an S corporation, and beneficiaries of decedents’ estates and non-grantor trusts to invest eligible gain in a Qualified Opportunity Fund (QOF) to begin on the applicable entity’s tax return due date (not including any extensions). This is a significant change from requiring the 180-day period to begin at the end of the entity’s tax year, and allows much greater flexibility. A similar rule was created for RIC/REIT dividends, which allows the shareholder’s 180-day investment period to begin either when the shareholder receives a capital gains dividend or the close of the shareholder’s tax year.
Working Capital Safe Harbor
One of the most important rules for a QOZ business (QOZB) is the working capital safe harbor. From the proposed regulations, a taxpayer was essentially allowed to treat working capital assets held by a business as reasonable in amount and as qualified property for a period of up to 31 months if certain conditions were met. The final regulations expand on these protections, and generally allow greater flexibility for working capital within a QOZB with the following additions:
- A working capital safe harbor for start-ups is created to allow 62 months instead of 31 months;
- The safe harbor adds an additional 24 months if the QOZ is in a Federal disaster area;
- A rule was created that after a maximum of 62 months, any funds remaining in the safe harbor cannot be considered good assets for the 70% tangible property standard;
- Allows tangible property such as equipment and buildings that is being improved to qualify as being used in the QOZB’s trade or business
The second round of proposed regulations released in May of 2019 provided that substantial improvement is tested on an asset-by-asset basis. The final regulations provide favorable guidance surrounding this asset-by asset improvement requirement by allowing for multiple assets to be aggregated into a single property.
The final regulations outline that buildings located entirely within a parcel of land can be aggregated into a single property. Further, multiple buildings located within adjoining parcels of land can be treated as a single property if:
- The buildings are operated exclusively by the QOF or the QOZB
- The buildings share facilities or significant centralized business elements, and
- The buildings are operated in coordination with or reliance upon one or more trades or businesses.
The final regulations create a new rule that allows tangible property purchased, leased, or improved by a trade or business that is undergoing the substantial improvement process (but has not yet been placed in service) to qualify as qualified opportunity zone business property for the 30-month substantial improvement period as long as the entity reasonably expects that the property will be substantially improved and used in the trade or business in a QOZ by the end of the 30-month period.
The final regulations also clarify that any cost added to the basis of the property during the 30-month improvement period will be included in determining if a property has been substantially improved. Further, certain expenses (such as “betterment” expenses under Treas. Reg. 1.263(a)-3(j)(1)(i)) are considered for purposes of substantial improvement, even if those expenses are properly capitalized to the land on which the property is located. Lastly, the final regulations allow for a Qualified Opportunity Fund or Qualified Opportunity Zone Businesses to use acquired original use assets that would have otherwise qualified as qualified opportunity zone business property, to count towards a non-original use assets substantial improvement. In order to do so, the purchased assets must be used in the same trade or business in the Qualified Opportunity Zone (or a contiguous Qualified Opportunity Zone) that the non-original use asset is used and it improves the functionality of the non-original use assets in the same Qualified Opportunity Zone (or a contiguous Qualified Opportunity Zone). The preamble uses the acquisition of a mattress, linens, furniture, and electronic equipment as an example of a purchased original use asset that can be treated as a substantial improvement to non-original use property.
Basis Adjustments for QOF Investments Held At Least Ten Years
One of the three primary benefits of the opportunity zone program is the ability to effectively exclude gains on the qualifying opportunity zone investment itself, if held for at least ten years. Section 1400Z-2 accomplishes this by providing that, immediately prior to the sale (or exchange) of a qualifying investment in a QOF, the basis of the investment is stepped up to its fair market value (presumably, the value it was sold for). The May 2019 proposed regulations extended this principle to sales of Qualified Opportunity Zone Business Property by a QOF, at the election of an investor who has held their QOF investment for at least ten years. However, this relief apparently only extended to capital gains, and not gains that are treated as ordinary income (for example, gains attributable to prior depreciation deductions).
The final regulations provide that all asset sale gains, except the sale of inventory in the ordinary course of business, are eligible for the basis step-up (and, therefore, the gain exclusion) for investments held at least ten years, regardless of their characterization (as ordinary or capital). In addition, the final regulations provide additional computational guidance for calculating the basis step-up for sales of partnership interests, including the use of a corresponding adjustment to the assets of the partnership which would also serve to eliminate potential ordinary gain under section 751(a).
The final regulations will be effective for tax years beginning on or after 60 days after they are published in the Federal Register. It is possible these regulations may not get published in the Federal Register by the end of the year, however, the Federal Register does not make substantive changes but only changes in presentation. For calendar year taxpayers, this means that they will not actually be effective until calendar year 2021. However, taxpayers may generally choose to rely on the final regulations in their entirety for years prior. Alternatively, taxpayers may instead choose to rely on the prior proposed regulations, in their entirely, until the first year for which the final regulations are effective. In either case, taxpayers must consistently apply the chosen regime for all applicable years in their entirety, in order to retain reliance protection.
In addition to the items highlighted above, the final regulations also contain updated guidance on the following:
- Procedures for a QOF to voluntarily decertify itself
- Relaxation of the rules on investing gains from straddle and straddle-like transactions, and related section 1256 contracts
- Clarification regarding the non-applicability of the basis step-up at death for qualifying investments
- Additional clarifications around various events that terminate a qualified investments and the related gain deferral (so-called inclusion events)
- A single-use six-month opportunity for QOZBs that fail various tests to cure such failures
- Clarification that restrictions on QOZBs holding certain financial property applies even to business in industries where this is a necessity (such as insurance)
- Additional guidance for corporate consolidated groups
- Self-constructed property now can be treated as acquired for the purposes of the QOF’s 90% and 70% asset tests, and is valued by the purchase price on the date when physical work of a significant nature begins
In addition, the IRS and Treasury have indicated they are continuing to study the interaction of the QOZ program with other existing credits and incentives, as well as the applicability of penalties for QOFs that fail their semi-annual tests. Additional guidance in these areas is expected.
The regulations are formally now waiting to be published by the Federal Register, which will likely not happen before year end. However, the Federal Register review will not include any substantive changes outside of formatting