Since the first guidance regarding investment in Qualified Opportunity Zones (QOZs) was issued by the U.S. Treasury Department in October 2018 (“Initial Regulations”), investors have shown immense interest in taking advantage of this opportunity to defer taxes on capital gains. In February 2019 Treasury held a public hearing to receive comments on the proposed regulations, and while considering those comments, released a second set of proposed regulations on April 17, 2019 (New Regulations). Prior articles discussed portions of the New Regulations relevant to investors and operations of a Qualified Opportunity Fund (QOF), and this Part III addresses specific matters related to leased property and trade or business activities in a QOZ.
• Leased Property. The Initial Regulations did not provide significant guidance regarding leased property. The New Regulations attempt to provide greater parity among diverse business models, and specifically provides that leased property acquired after 2017 and that meets the substantial use tests will be treated as QOZ business property. To qualify as QOZ business property, the terms of the lease must be market terms in the locale of the property. Leased property acquired from related parties will constitute QOZ business property (unlike purchased property) if prepayments are limited to 12 months. The “original use” of leased property is defined the same as for purchased property (i.e., placed in service in a QOZ for purposes of depreciation). The New Regulations recognize that the original use requirement often cannot be applied to leased property, and therefore provide that improvements made to leased property satisfy the original use requirement and are considered as purchased property to the extent of the cost basis of such improvements.
If the original use of leased tangible personal property in a QOZ does not commence with the QOF, then the QOF must also purchase QOZ business property with a value not less than the value of the leased property within the period that begins upon possession of the leased property and ends on the earlier of the end of the lease or 30 months. The New Regulations provide that the value of leased property (including for purposes of meeting the 90% asset test for QOFs) is the present value of the lease payments, calculated at the beginning of the lease, and including all periods during which the lessee QOF may extend the lease at a pre-defined rent.
• Trade or Business Activities. The New Regulations decline to provide a specific definition of a “trade or business” but instead reference Code Section 162, although, as discussed in Part II of this article, Treasury provided some minimal parameters by disqualifying merely holding land for farming without other material investment. Treasury also requested comment on what constitutes the “active” conduct of a trade or business; the New Regulations do state that ownership and operation (including leasing) of real property is active conduct of a trade or business, but that entering into a triple-net lease of real property is not (although there has been push-back against this conclusion).
Portions of Code Section 1397C regarding Enterprise Zones are incorporated by statute into the QOZ rules. One of these is that at least 50% of gross income be derived from active conduct of a business within a QOZ. The New Regulations provide certain safe harbors in making this determination:
1.) Based upon the number of hours performed by employees and independent contractors; or
2.) Based upon the amounts paid for services performed in a QOZ by employees or independent contractors, or
3.) That the tangible property in the QOZ and the management functions performed in the QOZ are necessary to generate at least 50% of gross income of the trade or business.
Where the Initial Regulations set forth a safe harbor for working capital in meeting the test for use of assets within a QOZ, the New Regulations clarify that use of working capital for development of a trade or business in a QOZ falls within that safe harbor (as well as the acquisition, development and improvement of property within a QOZ), and that the 31-month period is not violated if delayed while waiting for government action. They further state that a business may benefit from overlapping applications of the safe harbor.
The New Regulations also provide a safe harbor for the use of tangible property within a QOZ for inventory, if it is in transit from a vendor to a trade or business in a QOZ, or from a trade or business in a QOZ to customers outside the QOZ.
• Future Guidance. The New Regulations provide a starting point for additional guidance on investment in QOZs, but the Treasury Department and IRS requested comment on almost every point in the New Regulations. While investors consider the implications of the existing proposed guidance, Treasury has scheduled a hearing on the New Regulations for July. The introduction to the New Regulations state that Treasury expects to address administrative rules for certain matters within “a few months” and intends to revise Form 8996 which QOFs must file annually, but it is unclear whether Treasury will release any further new regulations regarding QOZ investment once the Initial Regulations and New Regulations are finalized. Further, there are reports that Treasury may delay releasing a revised or final version of the Initial Regulations until it is able to do so with the New Regulations, which means sometime this autumn. In the meantime, investors will struggle with the existing guidance in order to maximize the period by which their gains may be deferred (particularly with respect to the 7-year benefit), which is rapidly shrinking, and the proposals by Treasury summarized above, together with the requests for comments by Treasury, will certainly generate significant commentary and comments, and the final form of both the Initial Regulations and the New Regulations may have material changes from their proposed forms. Because of the length of time it is taking for guidance to be issued, reports that Congress may enact legislation to change the holding period that permit the greatest tax deferral are most welcome.
Sean Bryan is a tax partner at Kelly Hart & Hallman LLP.