Last week, Treasury issued a second round of proposed regulations regarding Opportunity Zones―offering investors more clarity as to whether their investments in designated Opportunity Zones will qualify for current capital gains tax deferral and future capital gains tax elimination.

This update discusses the background of the Opportunity Zone tax benefits and explains three important provisions in this new set of regulations.

These three provisions:
1. Explain how non-real estate businesses qualify as OZ businesses;
2. Expand the working capital safe harbor for OZ businesses; and
3. Allow the ownership and operation of real property to qualify as the active conduct of a trade or business in an OZ.

Background

The Tax Cuts and Jobs Act of 2017 included provisions that allow investors to invest capital gains in designated economically depressed areas, known as “Opportunity Zones,” and take advantage of multiple tax benefits as a result of this investment. The specific benefits include:

1. Temporary Deferral: The investor defers the tax on the capital gain invested in the Opportunity Zone (through an OZ Fund) until the earlier of a sale or exchange of the investment, or December 31, 2026.

2. Step-up in Basis After 5 and 7 Years: The investor realizes a 10% step up in basis of its investment if the investor holds the investment for at least 5 years prior to 2027—in other words, the investor will only pay tax on 90% of the deferred gain when that gain is taxed. The investor realizes an additional 5% step up in basis of its investment if the investor holds the investment for at least 7 years before 2027, meaning that the investor will only pay tax on 85% of the deferred gain when that gain is taxed.

3. No Tax on Post-Acquisition Appreciation: The investor may eliminate all tax on post-acquisition appreciation (that is, all gain above the initial deferred gain, which will be taxed as provided above) if the investor holds the investment for at least 10 years, and further disposes of the investment before 2048.

Investments must be made in “Qualified Opportunity Funds,” which generally are corporations, partnerships, or multi-member LLCs with a designated purpose of investing in business property in an Opportunity Zone.

This business property may be property used in a trade or business (“Qualified Opportunity Zone Business Property”), or it may be another entity that operates a trade or business (a “Qualified Opportunity Zone Business”).

Three Important Provisions in this New Round of Proposed Regulations

How Non-Real Estate Businesses Qualify as Qualified Opportunity Zone Businesses

This portion of the new proposed regulations provides answers to one of the biggest questions surrounding Opportunity Zones.

In order to qualify as a Qualified Opportunity Zone Business, the entity must derive at least 50% of its gross income from the active conduct of a trade or business in an Opportunity Zone.

A business which is based upon the real estate on which it sits (i.e., an apartment complex or a restaurant) should be able to determine if it complies with this rule easily: if the business sits on Opportunity Zone real estate, then it should be generating most, if not all, of its income from activities in an Opportunity Zone.

However, the statute and the first round of proposed regulations offered no guidance to a business that may have operations beyond the boundaries of its office building in an Opportunity Zone.

This second round of proposed regulations offers businesses 3 safe harbors to meet the 50% gross income test:

1. Safe Harbor 1 – 50% of the Service Hours Performed in the OZ
If at least half of the service hours performed by the business’ employees and independent contractors are performed within the Opportunity Zone, the business will meet the 50% income test.

2. Safe Harbor 2 – 50% of Compensation Paid to Workers in the OZ
If at least half of the compensation paid to the business’ employees and independent contractors is for services performed in the Opportunity Zone, the business will meet the 50% income test.

3. Safe Harbor 3 – Tangible Property and Management or Operational Functions
If the business’ tangible property in the Opportunity Zone and the management or operational functions performed in the Opportunity Zone are each necessary to generate 50% of the gross income of the trade or business, the business will meet the 50% income test.

In short, the proposed regulations clarify that businesses in a variety of industries may qualify as Qualified Opportunity Zone Businesses. Anyone thinking about opening a new business should consider whether it makes sense to locate the business in an Opportunity Zone. In addition, these favorable rules may increase the demand for all types of commercial real estate in Opportunity Zones.

The Second Set of Regulations Expands the Safe Harbor for Working Capital

The new proposed regulations also expand the safe harbor for working capital in three important ways.

The October 2018 proposed regulations allowed a Qualified Opportunity Zone Business a safe harbor for a reasonable amount of working capital — to avoid penalizing a business for holding cash, which does not qualify as Opportunity Zone Business Property, while it developed a project in the OZ. The first regulations required that (1) the capital be designated in a written plan for the acquisition, construction, and/or substantial improvement of tangible property in a zone and (2) the working capital be spent within 31 months.

1. More Flexibility for Use of Working Capital
The new regulations now allow a business to designate working capital in a written plan for the development of a trade or business in an Opportunity Zone, including the acquisition, construction, and/or substantial improvement of tangible property in a zone. This expanded safe harbor will allow an OZ business to spend capital on payroll, equipment, and other expenses as it sets up its business. It expands the safe harbor to OZ businesses and allows flexibility in how the capital can be used.

2. Governmental Delay Will Not Violate the Safe Harbor
The new regulations also state that if use of the capital assets is delayed by waiting for governmental action, for which the application is complete, that delay does not violate the safe harbor. This will be important for real estate developers or any other businesses that require governmental approval, such as rezoning or permits. So long as an application has been completed, a delay beyond 31-months because of government in action will not violate the safe harbor.

3. Single Business May Benefit from Multiple Safe Harbors
If a single business receives cash on multiple occasions, it may benefit from the working capital safe harbor each time it receives new cash for the development of the business, so long as it follows the other requirements of the safe harbor.

We believe this additional flexibility will give investors and developers more confidence that they will be able to develop their projects and stay within the time frames set forth in the regulations.

These Regulations Allow the Ownership and Operation of Real Property to Qualify as the Active Conduct of a Trade or Business

A number of clients have asked us whether the leasing of real property by a Qualified Opportunity Zone Business will amount to the active conduct of a trade or business. The new proposed regulations clarify that the ownership and operation (including leasing) of real property used in a trade or business is treated as the active conduct of a trade or business in an OZ. However, merely entering into a triple-net-lease with respect to real property owned by a taxpayer is not the active conduct of a trade or business by such taxpayer.

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