Second Round of Opportunity Zone Regulations Issued

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In October the IRS issued the first set of proposed regulations under the Tax Cuts and Jobs Act's Opportunity Zone program (LMC TCJA Alert #25). Last week, a second round of regulations were issued. Many commentators view the new rules as friendly toward businesses operating in an Opportunity Zone, easing concern that most investments would be steered toward real estate development.

 

Opportunity Zones were designed to spur investment in distressed communities throughout the US through tax benefits. Over 8,700 communities across all 50 states, the District of Columbia and five US territories have been designated as Qualified Opportunity Zones (QOZs). Taxpayers participating in funds that invest in these areas can receive multiple tax benefits (LMC TCJA Alert #8).

 

The new regulations provide that a business located in a qualified QOZ may qualify for benefits if it meets one of the following tests demonstrating substantial activity in the zone: 

 

  • At least 50% of the hours spent by employees and independent contractors are within the QOZ (the location of customers is not relevant)
  • At least 50% of the amount paid by a business to employees and independent contractors are for services performed within the QOZ (a taxpayer may also have employees outside the zone)
  • The tangible property located in a QOZ and the management or operational functions performed in the QOZ are each necessary for the generation of at least 50% of the gross income of the business
  • A business that does not qualify for these "safe harbors" may still qualify if facts and circumstances demonstrate that at least 50% of its gross income is derived from the QOZ 

 

The proposed regulations address the "original use" and "substantially improved" tests in the law - the requirements that either a business's property was never before used in that QOZ or that the taxpayer double its original investment with additional improvements over 30 months. The rules provide that property that has never before been eligible for depreciation is considered original use, even if was partially completed before the business purchased it. Further, property in a QOZ that has been vacant for at least five years receives a fresh start as original use, so the next taxpayer that places it in service for depreciation purposes qualifies for the test.

 

A key Opportunity Zone benefit provides permanent exclusion of capital gains earned on a fund held for at least 10 years. The new proposed regulations allow some flexibility to an investor who retains his overall interest in the passthrough fund in which he invested when the fund itself sells off some of its QOZ assets after 10 years. The investor's share of capital gain from that sale is excluded from tax.

 

The regulations provide that a fund that sells some of its QOZ property may reinvest the proceeds in another QOZ property within 12 months. The reinvested property will continue to count toward the 90% of assets that the fund is required to hold in QOZ property, preserving the deferral of the gain that investors originally contributed to the fund. However, if assets sold were not held in the fund for 10 years, gain on their sale will pass through to investors on their Schedules K-1 and be subject to tax.

 

Contact your LM Cohen professional if you have questions about the new Opportunity Zone proposed regulations. All our prior Tax Cuts and Jobs Act Alerts are available on the Updates page of our website.

 

 

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