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Fort Worth
Tuesday, April 20, 2021

Commentary: New guidance for investment in qualified opportunity zones (Part II)

Since the first guidance regarding investment in Qualified Opportunity Zones (QOZ) was issued by the U.S. Treasury Department in October 2018, 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. Part I of this series (published in the June 3-9 issue) discussed portions of the New Regulations relevant to investors, and this article (Part II) discusses provisions of the New Regulations related to assets and operations of a Qualified Opportunity Fund (QOF) and its subsidiaries.

• 90% Asset Test. A QOF must meet an asset test each 6 months in order to qualify as a QOF, but a number of ordinary events can cause a QOF to fail in any testing period. The New Regulations provide that new contributions in the 6-month test period are disregarded if held in cash or short-term debt instrument. The New Regulations also modified the permitted method of valuing assets for purposes of the test to provide greater flexibility; in addition to the prior “applicable financial statement” method, alternate methods for both owned and leased property are proposed.

The statute requires that QOFs have a reasonable period of time to reinvest proceeds of the sale of QOZ property (including equity in qualifying subsidiaries) without failing the asset test. The New Regulations define that “reasonable period” to be 12 months beginning on the date of disposition, and state that if during such period the proceeds are held in cash or short-term debt instruments, then they will be considered to be QOZ property. Treasury requested comment on whether QOF subsidiaries should have an analogous rule, so this currently applies only to a QOF itself.

• Substantially All. The QOZ statute uses “substantially all” in numerous places without defining it. The Initial Regulations defined the term for purposes of being a QOZ business to require that at least 70% of property leased or owned be QOZ business property. The New Regulations now propose to use 70% in the context of the use of property within a QOZ and 90% in the context of holding periods (i.e., the qualification of a subsidiary equity under the QOZ rules while owned by a QOF or the qualification as QOZ business property while owned by a QOF).

• Trade or Business. While the Initial Regulations provided reasonable initial guidance to investment (and particularly real estate investment), the QOZ statute also provides for deferral if investment proceeds are used to start a trade or business in a QOZ. The New Regulations decline to provide a specific definition of a “trade or business” but instead default to the extensive history under Code Section 162. Other specifics included in the New Regulations regarding qualifying as a QOZ business will be discussed in Part III of this series

The New Regulations do provide examples of what does not qualify. The introduction to the New Regulations states that merely holding land for investment and not as part of a trade or business is not itself a trade or business and the land cannot be a QOZ business property. The intent of the QOZ statute is to require new capital investment or increased economic output of property, and so merely purchasing property without an intent to improve it, or to only minimally improve it, is not a qualifying use; an example given in the introduction to the New Regulations is purchasing a tract of land for the purpose of growing crops on it.

• Original Use. An issue that sparked significant comment is the requirement that property have “original use” by a QOF. The New Regulations define it as the date that such property is first placed in service in a QOZ that starts or would permit depreciation or amortization of that property; if this event occurs by a prior owner of the property, then that property would not satisfy the “original use” requirement by a QOF. The New Regulations also address “original use” as applied to an existing building acquired by a QOF, and propose that it must have been vacant for at least 5 years prior to being acquired by the QOF in order to satisfy this requirement.

• Substantial Improvement. Defined as increasing the tax basis of property by an amount at least equal to its initial basis, the New Regulations provide that the requirement for “substantial improvement” will be determined on an asset-by-asset basis; however, Treasury requested comments on how an aggregate approach might be implemented. Treasury also requested comment regarding non-realty (e.g., equipment) that cannot be “substantially improved.”

• Intangible Property. The QOZ rules incorporate certain parts of Code Section 1397C, which defines “enterprise zones” to require that 50% of gross income be derived from active conduct of a business, that a substantial portion of any intangible property be used in the active conduct of a trade or business, and that less than 5% of the tax bases of the property of such entity be attributable to nonqualified financial property. The New Regulations define a “substantial portion” of intangible property to be at least 40%; neither the New Regulations nor Code Section 1397C, however, define what constitutes such intangible property, and a discussion of such matter is outside the scope of this article, but the applicability of other Code Section 1397C concepts will be discussed in Part III of this series.

• Multiple Zones. Where a QOZ business straddles census zones, at least 50% of total gross revenue must come from within the QOZ portion.

• Anti-Abuse Rules. The QOZ statute authorized Treasury to issue rules to prevent abuse under the QOZ regime. The New Regulations propose as a general anti-abuse rule that the IRS may recharacterize a transaction, based on the facts and circumstances, if a “significant purpose” of the transaction is to achieve a tax result that is inconsistent with the QOZ statute. Treasury also reserved for the future possible other anti-abuse provisions and requested comments on rules for matters such as “land-banking” or other acquisition of unimproved land for inappropriate purposes under the statute.

The provisions of the New Regulations regarding leased property and qualifying trade or business activities will be addressed in Part III of this series.

Sean Bryan is a tax partner at Kelly Hart & Hallman LLP.

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