The IRS just issued more proposed regulations under §1400Z-2 of the Internal Revenue Code, dealing with investments in qualified opportunity zones and qualified opportunity funds. Some highlights:
- In general, a QOF must spend at least as much to rehabilitate a building as it paid for the building itself. But this rule doesn’t apply to a building that’s been vacant for five years. This presents an enormous incentive to acquire and rehabilitate vacant properties (that are located in QOZs).
- The tax benefits associated with QOFs are available only to an “active trade or business.” The new regulations provide that (1) the ownership and operation (including leasing) of real estate can qualify as an “active trade or business,” for these purposes, but (2) a triple-net lease of real estate is not an “active trade or business.”
- To qualify for tax benefits, a corporation or partnership must derive at least 50% of its gross income from the active conduct of a business within a QOZ. The new regulations provide three safe harbors and a facts-and-circumstances test to make this 50% calculation.
- In general, at least 90% of the assets of a QOF must be in the form of “qualified opportunity zone property.” The new regulations allow the QOF to ignore investments made by investors in the QOF during the preceding six months in making this calculation, as long as the new investments are held in cash, cash equivalents, or certain short-term debt instruments This rule will make it far easier for QOFs to satisfy the 90% test while continuing to raise capital.
- Similarly, if a QOZ sells assets and reinvests the proceeds in other assets, then the proceeds of the sale will be treated as “qualified opportunity zone property” for purposes of the 90% test, as long as they are held in cash, cash equivalents, or certain short-term debt instruments and reinvested within 12 months. Of course, any gain recognized by the QOZ from the sale will be taxed to investors.
- The new regulations provide that an investment in a QOF may be made with cash or other property, but not by performing services for the QOF.
- The new regulations provide alternative approaches to valuing the assets of a QOF, both for making the 90% calculation and for determining whether substantially all of the QOFs assets are in a QOZ.
- A “qualified opportunity zone business” must own “qualified opportunity zone property,” and “qualified opportunity zone property” does not include property purchased from a related party. But under the new regulations, it can include property leased from a related party, under certain circumstances.
- By investing in a QOF, a taxpayer can defer recognizing capital gains for tax purposes until 12/31/2026. But if an “inclusion event” occurs before 12/31/2026, the taxpayer must recognize the capital gain at that time. Selling the interest in the QOF is an obvious example of an “inclusion event.” The new regulations provide many more, less obvious examples, like giving the interest in the QOF to a charity, or receiving a distribution from the QOF that exceeds the taxpayer’s basis.
- After holding a QOF for 10 years, a taxpayer may exclude all capital gains from the appreciation of the interest in the QOF. The new regulations provide that the taxpayer doesn’t have to sell her interest in the QOF to benefit from the exclusion; the exclusion also applies if the QOF sells its assets and distributes the gains.
- A ”qualified opportunity zone business” means a trade or business in which substantially all of the tangible property is “qualified opportunity zone business property.” The new regulations clarify that in this instance, “substantially all” means 70%.
- “Qualified opportunity zone business property” means tangible property used in the trade or business of the QOF if, during substantially all of the QOF’s holding period for such property, substantially all of the use of the property was in a QOZ. Believe it or not, the new regulations provide that the first instance of “substantially all” in that sentence means 90% and the second instance means 70%.
The new regulations illustrate why tax lawyers so look forward to new tax legislation, and are so popular at cocktail parties.
Questions? Let me know.
2 thoughts on “More IRS Regulations On Qualified Opportunity Zones”
Thank you, Mr. Roderick, for the update! I wish there were more tax lawyers at cocktail parties I attend — I have so many questions! Does after tax funds also get the capital gains exclusion after holding a QOF for 10 years? For example, I have $90K of capital gains to invest in a QOF but the fund has a $100K investment minimum. I add $10K of after tax money to make the minimum requirement. How is this $10K treated?
Be careful what you wish for!
The $10,000 doesn’t get any special tax treatment. It’s treated as an entirely separate investment for QOZ purposes.