Regulation Resolution? 26 OZ Issues We’re Watching (Part 1)

Published by John Sciarretti, Michael Novogradac on Monday, October 7, 2019 - 12:00am

Treasury is expected to release updated opportunity zones (OZ) regulations in the coming weeks, and we expect that the updated regulations will merge the first two tranches of regulations into one and provide more clarity on many remaining issues, as well as some outright changes. Before their release, however, Treasury must first send the updated regulations to the Office of Information and Regulatory Affairs (OIRA) for their review and comment, after which, the regulations can be released.

If the past is a guide, OIRA will take 30 plus days to review and comment. If the updated regulations are submitted to OIRA within the next couple of weeks, the public release may come before Thanksgiving. It is widely anticipated that the updated regulations will largely be final regulations, though some portions of the updated regulations may be released in proposed form, so the public has an opportunity to comment on the new guidance.

Since the second tranche of proposed regulations were released April 17th, the Novogradac Opportunity Zones Working Group (OZ Working Group) submitted a detailed letter that weighed in on many areas that need additional clarity or changes, and submitted separate letters on corporate consolidated return rules and challenges facing affordable housing.

The OZ Working Group’s letters to Treasury include 26 issues that need greater clarity or changes in the updated regulations. This post will address 11 of those issues, specifically those concerning investors, qualified opportunity funds (QOFs) and affordable housing investments in OZs. A subsequent blog post will address the other 15 issues, those related to OZ business property and OZ businesses. For a more detailed description of the issues, analysis, and recommendations provided to Treasury, please review the letters linked to above. When the updated regulations are released to the public, we will be reviewing those regulations with an eye to how they address these 26 issues.

As you review these 11 issues (and the 15 issues in the subsequent blog), we encourage you to weigh in with your thoughts and ideas. Share them by emailing [email protected], by becoming a member of the OZ Working Group and/or joining us in Chicago at our OZ Conference. How OZ funds, investors and businesses are dealing with these 26 issues will be discussed–along with many other real-world topics of interest to a broad range of OZ stakeholders–at the Novogradac 2019 Fall Opportunity Zones Conference, Oct. 24-25 in Chicago.

Here is a look at key investor and QOF issues for the updated regulations:

Investor Issues

1. Corporate consolidated return rules.

Corporations with one or more subsidiaries are generally treated as a consolidated group and generally file a consolidated return. While a corporation may be a member of a consolidated group, the proposed regulations provide that a corporation that generates capital gains is the only corporation that can invest those gains in a QOF and make a deferral election. The effect of this rule is that capital gains generated by many corporate consolidated groups won’t be invested in OZs. Why? Because the corporation within a consolidated group that generates capital gains is often not, for regulatory or other reasons, able to make an equity investment in a QOF. Updated regulations should allow any member of a consolidated group to make investments in a QOF of the capital gains of any other member of the consolidated group.

The proposed regulations also forbid a QOF from being a member of a consolidated group. QOFs should be allowed to be part of a corporate consolidated group.

2. Section 1231 Gains.

Regulations specify that the 180 day period within which a taxpayer can invest IRC Section 1231 gains in a QOF doesn’t begin until the end of the taxable year. This rule was proposed because the end of the taxable year is when a taxpayer can determine whether they have net Section 1231 gains, such that they have capital gains eligible for a deferral election with respect to an investment in a QOF. A better solution is to allow taxpayers the option to invest Section 1231 gains within 180 days from when they’re generated, or the end of the taxable year,. This suggestion comes with the understanding that if the taxpayer has net Section 1231 losses for the taxable year, or insufficient capital gains to support the full amount of the investment, all or a portion of the investment would be considered a mixed fund, and not eligible for OZ benefits.

Also, Treasury should allow the investment of gross Section 1231 gains to the extent that there are net gains for the taxable year.

3. 10-year Sale of Interest in a QOF Partnership.

Treasury should clarify in updated regulations whether a QOF partnership has to adjust partnership assets to fair market value (FMV) when a partner sells an interest after 10 years. The regulations are unclear whether or not the QOF partnership has to adjust the basis to FMV.

4. 10-year Gain Exclusion Provision for Partnerships and S Corporations.

When a QOF partnership or S corporation sells an interest in qualified OZ property that is a capital gain, it’s owners that have held their interest for ten years can elect to exclude the gain. A similar result doesn’t appear to be allowed if a partnership owned by a QOF partnership or S corporation sells property that generates a capital gain. Treasury should allow the gain exclusion rule to generally apply to all gains from the sale of property by a QOF of QOF property, as well as generally all gains allocable to a QOF by a qualified OZ business, so long as the investor has held their interest in the QOF for ten years.

5. 10-year Gain Exclusion for Real Estate Investment Trust (REIT).

Treasury regulations switched approaches and vocabulary–despite having the same goal–when addressing REIT capital gains. The regulations say that a REIT shareholder can apply “a zero-percent tax rate” to the capital gain dividend from the sale of OZ property after 10 years–phrasing that could lead to complications with state tax liability and the interaction with capital losses. The solution is simple: Treasury should state that REIT capital gains dividends are “excluded” from income, so long as the investor has held their interest for 10 years.

6. Effect of Inclusion Event on 10-year FMV Basis Election.

The final regulations should clarify that taxpayers have the right to adjust the basis to FMV for an interest in a QOF held at least 10 years, regardless of when an inclusion event occurred.

7. Transfer of Qualifying Interest by Reason of Death.

When the interest in a QOF is transferred to heirs because of death, the final regulations should clarify that the basis is the FMV less the remaining deferred gain, as opposed to adjusted basis in the hands of the decedent.

Qualified Opportunity Fund Issues

8. Debt Financed Distributions

The final regulations should confirm that a debt-financed distribution of cash to a QOF partnership investor is generally not an inclusion event if made after two years. Treasury should also provide some explicit examples of when a debt-financed distribution would be presumed a disguised sale and when it would not be.

9. Option to Disregard Recently Contributed Property to a QOF

For recently contributed property to a QOF, the proposed regulations properly provide a grace period to invest contributions in qualified OZ property. Unfortunately, the approach used has unintended adverse consequences. Treasury should provide that any property received by a QOF is treated as invested in qualified OZ property so long as such property is invested in qualified OZ property by the next testing date that is more than six months after the property is received. The proposed regulations currently provide that such property is excluded from the numerator and denominator of the 90 percent asset test.

10. Carried Interest

Many OZ fund sponsors provide services to a QOF and received an interest in the fund for those services, as well as make a financial contribution for which they elect to defer capital gain. The result is that the sponsor holds both a non-qualifying and a qualifying interest. If a fund sponsor sells their interest in the QOF ten years later, the selling price must be allocated between the qualifying and non-qualifying interest. The proposed regulations call for using the “highest share of residual profits” in determining the portion of sales proceeds allocated to the non-qualifying carried interest. This language is confusing and penalizes fund sponsors who choose to make a financial contribution to QOFs they sponsor. Treasury should instead allow fund sponsors to determine the value of their qualifying investment by comparing its value to the value of other interests in the fund held by investors who did not receive an interest in the fund for providing services.

Affordable Housing Issues

11. Affordable housing

There are several affordable housing issues that Treasury should address. With a severe shortage of affordable, decent, accessible housing in the nation, the OZ incentive can and should play a key role. However, the current proposed regulations are hindering that role. Here are a few suggestions for Treasury:

  • Treasury should allow QOFs and qualified OZ businesses to use an aggregate approach to measuring the substantial improvement test, as opposed to the current asset-by-asset requirement;
  • Treasury should change a proposed special gain inclusion rule that can result in investors in QOF partnerships having to recapture some or all of prior losses, as capital gain income, on Dec. 31, 2026;
  • Treasury should allow certain exclusions from the definition of non-qualified financial property for low-income housing tax credit (LIHTC) developments; and
  • Treasury should clarify that lease payments for the use of government property meet the arm’s-length market rate standard, even if they are nominal or reduced in amount.

Conclusion

The first tranche and second tranche of proposed regulations provided much needed clarity for participants in the OZ incentive, but the work is not complete. Parts of the proposed regulations still need additional clarity, and some areas need to be changed. When the updated regulations are released, we will be assessing how effectively Treasury has addressed the concerns of the OZ community broadly, and the OZ Working Group in particular.

In a subsequent blog post, the focus will shift to 10 issues regarding qualified OZ business property and five issues facing qualified OZ businesses.