Last July, I wrote a blog post on opportunity zones and the importance to investors and professionals of forthcoming guidance from the IRS. The first chapter of that guidance was issued in October 2018, and was the subject of my second blog post. Last month the IRS issued additional guidance in the form of more proposed regulations. The latest guidance is generally favorable to real estate investors, and reflects continuing efforts by the Government to promote the purposes and intent of the Opportunity Zone legislation. In this post, I will briefly discuss my top picks related to real estate from the important answers we received in this second round of guidance.
- If a Qualified Opportunity Fund (QOF) sells its assets after the investors’ ten-year holding period, the investors will receive all or almost all of the same benefits they would have received if they had sold their interests in the QOF. Without this most recent guidance, the investors would have to sell their interests in the QOF to avoid tax on their investment’s appreciation. However, if a QOF’s opportunity zone property is an interest in a Qualified Opportunity Zone Business (QOZB) rather than, for example, direct ownership of real estate, it must sell its QOZB interest to achieve favorable results. If the QOZB sells the real estate for more than its basis, that will be a taxable event. There are remaining benefits with respect to particular types of recapture income that can be achieved by an investor selling its interest in a QOF rather than having the QOF sell its assets.
- The guidance is quite favorable with respect to the subject of leasing. I mention two significant points here. Except for engaging solely in triple net leasing, leasing real property will be treated as the active conduct of a trade or business by a landlord QOZB, with the result that the ownership of an interest in the QOZB will count toward the 90% test applied to QOFs. A tenant QOZB may lease real estate (even from a related party, subject to certain limitations) and use the real estate in a business to satisfy applicable tests.
- Distributions to an investor will not trigger tax on previously deferred gains, subject to some important limitations. The distributions must not exceed an investor’s basis in its investment and the distributions must not run afoul of what are commonly referred to as the “disguised sales rules.” As a practical matter, this means that distributions that do not exceed taxable income from operations and distributions from most refinancing transactions that occur more than two years after the investor's investment will not trigger tax on previously deferred gains.
- Death bequests of QOF interests will not trigger inclusion of deferred gains as taxable income, and the holding period clocks (five, seven, and 10 year periods) will not restart. However, lifetime gifts of QOF interests will trigger such inclusion. I leave it to the reader to decide which is preferable.
- The guidance from the IRS also liberalizes a key test. Under previous guidance, a QOF had to pass the opportunity zone property ownership tests on the sooner of (a) six months from the investment or (b) the end of its tax year. This meant that if an investment was made one day before the end of the QOF’s tax year, there would only be one day to comply with the test. The new guidance allows the QOF to ignore investments received during the previous six months if they are held in cash or cash equivalents.
As with previous guidance, the IRS requests comments on several of the issues it has addressed and anticipates more guidance in the coming months. So stay tuned for the next exciting installment of this blog.I would like to thank Michael Lortz, CPA at Geffen Mesher, for his helpful brainstorming of QOF issues with me. Any errors in this post are mine not his.