Regulation Resolution? 26 OZ Issues We're Watching (Part 2)

Published by John Sciarretti and Michael J. Novogradac on Monday, October 14, 2019 - 12:00AM

The Treasury Department is widely expected to release updated opportunity zones (OZ) regulations in the near future–with the regulations first going to the Office of Information and Regulatory Affairs, perhaps this month, for clearance before being released to the public 30-plus days later.

Our previous blog post addressed several investor, qualified opportunity fund (QOF) and affordable housing issues that the next round of OZ regulations need to clarify or change. This post addresses 15 qualified OZ business property and qualified OZ business issues that also need clarity or change.

When the regulations are released to the public, we will be reviewing them with an eye to how they address the issues mentioned in this and the prior blog.

Treasury’s first tranche of proposed regulations was issued nearly a year ago and the second tranche was issued in April. Since then, the Novogradac Opportunity Zones Working Group (OZ Working Group) has submitted letters to Treasury on areas that need additional clarity or changes. The OZ Working Group also submitted letters on corporate consolidated return rules and challenges for affordable housing, issues addressed in the previous blog post.

As you review these 15 issues, as well as the 11 raised in the previous blog post, we encourage you to weigh in with your thoughts. Email us at [email protected] but also consider becoming a member of the OZ Working Group. Definitely make it a priority to attend the Novogradac 2019 Fall Opportunity Zones Conference, Oct. 24-25, in Chicago, where these issues will be the focus of much discussion and keynote speaker Daniel Kowalski, counselor to the Treasury Secretary, will likely touch on many of these issues.

Here are issues that should be addressed by the Treasury regulations:

Qualified Opportunity Zone Business Property

1. Substantial Improvement Test–Asset-by-Asset v Aggregate Application of Test

The proposed regulations call for an asset-by-asset application of the substantial improvement test, but the phrasing in Internal Revenue Code (IRC) Section 1400Z-2 suggests that a business can meet the substantial improvement test on an aggregate basis. To facilitate the qualification of an existing business as a qualified OZ business, Treasury should provide that the substantial improvement test may be met by a QOF or a qualified OZ business on an aggregate basis at the election of the taxpayer–where the acquisition of tangible property over any 30-month period exceeds the aggregate adjusted basis of existing tangible property held by the QOF or qualified OZ business at the beginning of a 30-month period.

2. Improvements to Non-Qualifying Property

The regulations should clarify that improvements made to nonqualified OZ property (either because it was purchased on or before Dec. 31, 2017; purchased from a related party; or lacks substantial improvements) satisfy original-use requirements as purchased property similar to lessee improvements and are treated as separate property.

3. Substantially All of the Usage of QOF Tangible Property

The proposed regulations appear to contain a test to determine if a QOF trade or business meets a tangible property use test, as opposed to determining if property used by a QOF in a trade or business satisfies the use requirement. Treasury should remove the QOF trade-or-business tangible property use test and clarify that a QOF determines whether substantially all (70 percent) of the use of tangible property was in an OZ on an asset-by-asset basis.

4. Vacant Property

The proposed regulations require a property to be unused or vacant for an uninterrupted period of five years to be considered original use in an OZ, which is definitionally too narrow and temporally too long. The terms “unused” and “vacant” should be changed to “substantially unused” and “substantially vacant.” Treasury should also shorten the five-year period to one year for property in an OZ that was substantially vacant or substantially unused before the designation of the tract as an OZ and two years for property in a tract that becomes substantially unused or substantially vacant after the designation of the tract as an OZ.

5. Unimproved Land

The proposed regulations provide that original use and substantial improvement requirements don’t apply to unimproved land and that land is generally eligible to be qualified OZ business property if it’s used in a trade or business and meets other requirements. However, such guidance isn’t applicable if the land is unimproved or “minimally improved” and the land was purchased with an expectation, intention or view to not be improved by, “more than an insubstantial amount” within the 30-month period. Updated regulations should provide that unimproved land doesn’t need to be improved by “more than an insubstantial amount” if the land is integral to the trade or business of the QOF or qualified OZ business and if the QOF or qualified OZ business reasonably expects the land to generate economic activity that wasn’t expected before its purchase and use. It also would be helpful for Treasury to create a safe harbor that provides that capital improvements of at least 20 percent of the cost basis of land are deemed “more than an insubstantial amount.”

6. Original Use–Demolition of Existing Property

In updated regulations, Treasury should clarify that structures in an OZ that will be demolished pursuant to the development of a trade or business should be treated as qualified OZ business property during the period before demolition.

7. Self-Constructed Property

The regulations should clearly provide that self-constructed property (property manufactured, built or produced by a taxpayer for its trade or business) is considered “acquired by purchase.”

8. Related Party Fees

Regulations should clarify that reasonable capitalized fees paid to a related party with respect to the development or redevelopment of tangible property are considered an addition to adjusted basis for purposes of measuring the substantial improvement of property and don’t cause the property to fail to qualify as qualified OZ business property. Also, the regulations should clarify that those fees qualify as qualified OZ business property to the extent that the tangible property for which the fees are paid is qualified OZ business property.

9. Real Property Straddling an OZ

Concerning property that straddles an OZ, Treasury should more clearly state that the rule for determining whether such property is qualified OZ business property applies for all purposes of the OZ rules, as opposed to a narrow subset of OZ rules. Treasury should also clarify some confusion around the method to measure whether a substantial amount of property is in the OZ, since the preamble to the proposed regulations includes language that conflicts with the actual language of the regulations. The phrasing in the regulations should be confirmed to control.

10. Inventory In-Transit

Treasury should allow taxpayers the option to exclude raw materials and finished inventory from the numerator and denominator of the 70 percent use of tangible property test and the 90 percent investment standard test for QOF direct investments in qualified OZ business property.

Qualified Opportunity Zone Business

11. A Qualified Opportunity Zone Business in the Zone

The proposed regulations describe a qualified OZ business by describing provisions that must be met in the qualified opportunity zone, which could be interpreted as meaning a business with interests in multiple OZs must satisfy various OZ requirements in a single OZ. Treasury should clarify that “the” opportunity zone means one or more OZs.

12. Grace Period for Businesses to Become Qualified

Treasury should provide that tangible property of a QOF or a qualified OZ business is not treated as failing to satisfy the use in a trade or business requirement solely because the tangible property is not in use in a trade or business before a reasonable start-up period, based upon facts and circumstances, as long as the QOF or qualified OZ business continues to develop the trade or business.

Treasury should also clarify that a qualified OZ business that uses a contribution of working capital within its applicable 31-month period–but has yet to use tangible property in a trade or business in the OZ by the end of the 31 month period–continues to receive the benefit of the working capital safe harbor and related safe harbors as long as it diligently and reasonably continues to develop the trade or business and uses the property in a trade or business in the OZ within a reasonable period of time.

Treasury should provide that if a qualified OZ business receives serial capital contributions under a common written plan, the qualified OZ business is not required to use 70 percent of its tangible property in the OZ within 31 months of the first capital contribution, rather, the qualified OZ business must use cash equal to the first capital contribution within 31 months, but is not required to use 70 percent of its tangible property in the OZ by the end of the 31-month period associated with the first capital contribution.

Treasury should also provide a cure period for previously qualified OZ businesses. Specifically, if a previously qualified OZ business becomes unqualified during a QOF’s holding period, the qualified OZ business should have 12 months from the time the failure to qualify is identified by the QOF, or reasonably should have been, to become a qualified OZ business. Under this cure period, a previously qualified OZ business would be treated as qualified if the business becomes re-qualified within 12 months. This is similar to the cure period provided under the new markets tax credit incentive for failure to satisfy the substantially all test.

13. Property that a QOF Leases

The updated regulations should provide that the requirement for property leases to be arms-length only applies to leasing arrangements between related parties. If the leases are between unrelated parties, they should be generally presumed to be arms-length terms. Absent such a rule, QOFs and qualified OZ businesses will suffer the unneeded compliance burden of documenting the arms-length nature of leases with unrelated parties. Such a rule would also more clearly allow governments, nonprofits and others to lease property on below-market terms necessary to attract specific types of new businesses and new developments.

14. Intangible Property

More guidance on the use of intangible property by qualified OZ businesses is needed.  Intangible property may be used directly by a trade or business to facilitate the provision of services or sale or lease of tangible property to customers (direct use intangible property). A trade or business may also sell or lease intangible property to customers (indirect use intangible property). Treasury should provide more guidance on the treatment of these two classes of intangible property.  For direct-use intangible property, a general rule should provide the meaning of the phrase “used in the active conduct of a trade or business” to mean the commercial use of intangible property for the management, development, manufacturing and sale or lease of goods and/or services to generate gross income. For indirect use intangible property, a safe harbor should provide that intangibles developed for sale or lease are “used in the active conduct of a trade or business” if a substantial amount (40 percent) of the services and property to develop the indirect use intangibles are conducted by the trade or business. Treasury should also provide objective standards for determining whether direct or indirect use intangible property is being used in the OZ.

15. Working Capital and Tangible Property Safe Harbor

Treasury regulations should clarify that certain nongovernmental delays–beyond a business’s control–will not preclude a business from qualifying for the working capital safe harbor, which now specifically mentions only government-caused delays. The qualification should be determined based on relevant facts and circumstances. The regulations should also clarify that if planned qualified OZ business property expenditures are included in the written schedule of planned expenditures, the expenditures can be treated as satisfying qualified OZ business property requirements for 31 months even though the planned expenditure of working capital assets is not complete - regardless of whether the qualified OZ business has sufficient working capital assets on-hand. Qualified OZ businesses should be permitted to call capital as needed without spoiling eligibility for the tangible property safe-harbor.


While Treasury has done a tremendous amount of work to issue the proposed guidance and fielded plenty of feedback from stakeholders, there is still work to do. We look forward to the release of the updated guidelines with the expectation that many or most of the issues raised will be addressed in a positive and constructive manner.

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