The new, widely anticipated Treasury and Internal Revenue Service (IRS) guidance on implementing Qualified Opportunity Zone (QOZ) and Qualified Opportunity Fund (QOF) investments addresses stakeholder feedback, “substantially improving” clarity and flexibility on several key topics, including the 50% test, purchase and improvement of real estate assets, working capital safe harbor, and reinvestment of QOF assets. The Administration is complementing its apparent goal of encouraging QOZ investment with a coordinated policy push through the interagency White House Opportunity and Revitalization Council. We expect that these measures, taken together, will catalyze continued investment in QOZ real estate and prompt renewed attention on leveraging QOZ provisions for operating companies.
It’s a big day today for people excitedly scouring lengthy government documents! The giant whooshing sound you heard yesterday was the nationwide Opportunity Zone community collectively exhaling after the Internal Revenue Service released its second round of preliminary implementation guidance. Following up on the October 19, 2018 release of initial guidance and a February 14, 2019 public feedback hearing, this release was the long-awaited next step in establishing a regulatory framework for Opportunity Zones and Opportunity Funds in advance of the December 31, 2019 investment deadline for full statutory tax benefits.
The rollout was timed to match a White House ceremony highlighting the White House Opportunity and Revitalization Council, an interagency working group charged with coordinating policies across the executive branch to support QOZ investment and development. The “WORC”, as the Administration dubs it, is to be chaired by Scott Turner, a businessman and former NFL player. The public relations rollout continued through the day with an afternoon speech by Ben Carson, Secretary of Housing and Urban Development (HUD) to the Council of Development Finance Agencies (CDFA). Carson’s speech highlighted a complementary policy push, centered on five key points:
We will certainly keep you posted on executive branch policy developments. With respect to the guidance itself, we noted in our February briefing that the public feedback at the Valentine’s Day hearing largely centered on four topics: asset eligibility guidelines, investment criteria, timing requirements, and community development and mission metrics. We describe in turn the elements of the new document that, in our view, are most salient from our perspective of federal public policy and real estate finance.
Generally, the IRS will deem “qualified opportunity zone business property” to meet the “original use” requirement of the legislation if no other taxpayer has taken depreciation or amortization on that property within that QOZ. It appears, therefore, that used equipment bought from third parties outside one’s own zone will qualify as “original use.” The exception for land remains intact.
With respect to buildings, the IRS proposes a five-year vacancy requirement. That is, a building that has been vacant for at least five years can be purchased by a qualified opportunity zone business or fund and be deemed “original use.” The proposed IRS regulations appear intended to hold a line against land banking, which is pointedly characterized as “abuse” in the document. Holding of land, in itself, does not constitute a trade or business in the eyes of the IRS, and that land will not be deemed “qualified opportunity zone business property.” For real estate assets, the general rule remains that anything not new construction (or vacant for at least five years) will not be “original use”, and therefore require “substantial improvement” at least equal to the cost basis of the asset (less the amount attributable to land).
An interesting passage in the new document is that “[the] Treasury Department and the IRS are also studying the circumstances under which tangible property that has not been purchased but has been overwhelmingly improved” may satisfy the original use requirement. The federal government solicits further feedback on this question. This may open the door to QOF investment in federal tribal lands, as well as innovative forms of cooperation between property owners and long-term tenants.
The new guidance does remain silent on some topics that have previously been raised. For example, the EPA wrote to Treasury on December 18, 2018 advocating that environmental remediation costs for brownfield sites be included in “substantial improvement”, but yesterday’s document does not address that question.
Broad sentiment in the QOZ community to date has been that there is a clearer path to real estate investment in QOZs than for operating businesses. This view seems to have been reflected in a January 24, 2019 letter from 16 Members of Congress. Perhaps in consideration of this imperative, the new document places considerable emphasis upon the guidance relevant to operating companies. A key portion of the relevant statute stipulates that a QOZ business “must derive at least 50% of its total gross income from the active conduct of a business within a qualified opportunity zone.” Until now, this criterion has been the object of widespread confusion and criticism in both written comments and the Valentine’s Day hearing. The IRS has addressed this by providing three safe harbors, plus an additional facts and circumstances test to determine whether businesses qualify. Meeting any single one of these tests will place a business in the clear.
Another key takeaway from the new guidance is that the IRS will permit turnover of individual assets within a QOF, as long as investors remain within their fund for the required 10 years. The passage, a Hemingway-esque model of clarity in a document otherwise littered with language that only a tax lawyer could love, is worth quoting at length:
“Congress tied these tax incentives to the longevity of an investor’s stake in a QOF, not to a QOF’s stake in any specific portfolio investment. Further, Congress expressly recognized that many QOFs would experience investment “churn” over the lifespan of the QOF and anticipated this by providing the Secretary the regulatory latitude for permitting QOFs a reasonable time to reinvest capital. Consistent with this regulatory authority, the Treasury Department and the IRS clarify that sales or dispositions of assets by a QOF do not impact in any way investors’ holding periods in their qualifying investments or trigger the inclusion of any deferred gain reflected in such qualifying investments so long as they do not sell or otherwise dispose of their qualifying investment…”
The document addresses in-kind investments in QOFs, which are to be valued at the lesser of (a) the taxpayer’s adjusted basis in its equity received; or (b) the fair market value thereof. It also enumerates in detail the events that trigger inclusion of deferred income (i.e. realized taxpayer gain) and adjustments to basis.
Perhaps most germane to both real estate businesses and operating companies are key modifications to the 31-month safe harbor period for working capital. Previously, it specifically covered the acquisition, construction, and/or substantial improvement of tangible property (e.g. renovating an apartment building). Now, however:
Alongside the working capital safe harbor, the IRS will also offer QOF reinvestment relief from application of the 90% asset test if failure to meet the 12-month deadline can be attributed to governmental delays on completed applications. For example, if a planned rollover of sale proceeds from one QOZ shopping center to another is held up by occupancy permitting on the new asset, the QOF will not be penalized for it.
Finally, the IRS now defines “substantially all” not only in terms of 70% for the proportion of QOZ tangible property, but at 90% for the “holding period” component of the governing statute.
While the guidance did not address community development and mission metrics for QOZ investments, the Treasury Department and the IRS did release a separate companion document “to seek public input on the development of public information collection and tracking related to investment” in QOFs. Commenters at the Valentine’s Day hearing placed this question near the top of the list of subjects they raised. The letter from Members of Congress also prominently raises this topic, although the governing legislation is notably silent on this requirement.
While we hope you find these notes valuable background, please note that they do not constitute tax, legal, or accounting advice for any individual reader. While we can start to discern the outlines of the playing field as the fog of first light continues to lift, we will rely on the excellent professionals with whom we work to mark that field’s bounds and referee the plays we call.