The IRS recently issued proposed regulations to address gains that may be deferred when taxpayers invest in a qualified opportunity fund (QOF). This is a great opportunity for clients to defer capital gains from sale of stocks and to spur investment in designated opportunity zones.
The proposed regulations also withdraw and replace placeholder provisions in an earlier set of proposed regulations. These concern:
- The definition of “substantially all”
- Transactions that can trigger includible gain
- The timing and amount of deferred gain that is included
- The treatment of leased property used in the qualified opportunity zone (QOZ) business
- The use of QOZ business property in the QOZ
- The sourcing of income to the QOZ business
- The reasonable period for a QOF to reinvest proceeds from the sale of qualifying assets
In addition, within a few months the IRS expects to address administrative rules for a QOP that fails maintain the required 90 percent investment standard, as we well information reporting requirements.
Finally, the IRS expects to revise Form 8996, Qualified Opportunity Fund, for 2019 tax years and subsequent years. These revisions may require additional information, including the employer identification number (EIN) for the QOF business, and the amounts invested by QOFs and QOF businesses in particular QOZs.
Substantially All” for QOZ Business
The 2018 regs provided that a trade or business satisfies the “substantially all” test for a QOZ business if at least 70 percent of its tangible property is qualified opportunity zone business property. The new proposed regs generally extend this 70-percent threshold to the “substantially all” tests for use. However, in the holding period context, the “substantially all” threshold is 90 percent.
Original Use of Purchased Tangible Property
The proposed regulations generally provide that the “original use” of tangible property acquired by purchase by any person commences on the date when that person or a prior person:
- first places the property in service in the qualified opportunity zone for purposes of depreciation or amortization; or
- first uses the property in the qualified opportunity zone in a manner that would allow depreciation or amortization if that person were the property’s owner.
Used tangible property will satisfy the original use requirement with respect to a QOZ so long as the property has not been previously used (that is, has not previously been used within that QOZ in a manner that would have allowed it to depreciated or amortized) by any taxpayer
In addition, a building or other structure that has been vacant for at least five years before being purchased by a QOF or QOZ business satisfies the original use requirement. Improvements made by a lessee to leased property satisfy the original use requirement and are considered purchased property for the amount of the unadjusted cost basis of the improvements.
Land can be treated as QOZ business property only if it is used in a trade or business of a QOF or QOZ business. The holding of land for investment does not give rise to a trade or business, and the land cannot be QOZ business property. Anti-abuse rules determine whether unimproved land can be qualifying property. However, other purchased real property generally must be substantially improved, as determined on an asset-by-asset basis.
Leased Tangible Property in QOZ
Leased tangible property may be QOZ property if:
- the lease is entered into after 2017, and
- substantially all of the property’s use is in a QOZ during substantially all of the lease period.
However, the first-use requirement does not apply to leased tangible property. The leased property can generally also be acquired from a related person, though several conditions apply. The proposed regs also provide methods for valuing the leased property.
The proposed regs:
- provide that in determining whether a substantial portion of intangible property of a QOZ is used in the active conduct of a trade or business, a substantial portion is at least 40 percent;
- address real property that straddles a QOZ;
- provide three safe harbors and a facts-and-circumstances test for determining whether a corporation or partnership derives at least 50 percent of its gross income from the active conduct of a qualified business;
- defined “trade or business” by reference to Code Sec. 162, except that the ownership and operation (including leasing) of real property used in a trade or business can also be the active conduct of a trade or business; and
- provide a safe harbor for working capital.
Other QOZ, QOF and QOZ Business Rules
The proposed regs also address:
- Section 1231 gains
- relief with resect to the 90 percent asset test, including relief for newly contributed assets and QOF reinvestments
- the amount of an investment for purposes of the deferral election
- inclusion events, the timing on basis adjustments, includible amounts, and special rules for partnerships and S corporations
- gifts and bequests
- exceptions for disregarded transfers and some non-recognition transactions
- distributions and contributions
- consolidated return provisions
- holding periods and tacking rules
- anti-abuse rules
- special rules for Indian tribes and tribally leased property.