OZ Reporting Requirements in Spotlight with Second Tranche of Regulations Released

Published by Michael Novogradac on Monday, June 3, 2019
Journal cover thumb June 2019

The April 17 release of the second tranche of proposed Treasury guidance for the opportunity zones (OZ) incentive provided clarity for investors. 

Specifically, the 169-page document provided guidance on several gating issues that had stalled many OZ investors, fund managers and businesses, particularly in relation to operating businesses. The proposed regulations also provided added tax clarity for the start-up, operation and wind-down phases of qualified opportunity funds (QOFs).

Now the OZ community prepares for the next steps, which may (or may not) involve a third tranche of regulatory guidance, but will almost certainly will involve some level of subregulatory guidance on reporting requirements. The only real question is whether such reporting requirements will come from Treasury, federal legislation or a combination of the two.

The coming months will be just as important in the OZ world as the past few months have been. This column will first briefly review what came out of the second tranche of guidance before turning to a discussion of what lies ahead. (Two posts at www.novoco.com/blog provide a deeper explanation and analysis of the guidance than is possible in this space).

Big-Picture View of OZ Guidance

Treasury’s proposed guidance covered issues that affect a wide range of stakeholders in the OZ incentive, broken down here by the biggest issues in several overarching categories.

Operating businesses: Regulations provided guidance on how to comply with the 50 percent of gross income rule from the first tranche of regulations. The proposed regulations provide three safe harbors–businesses qualify if 50 percent of services (based on hours worked) are performed within the OZ, 50 percent of the services (based on amount paid) are performed in the OZ or if the tangible property and operational functions of a business in the OZ are each necessary to generate 50 percent of the gross income. The proposed regulations also provide a general facts and circumstances test in the event a business does not satisfy one of the safe harbors.

The guidance also provided clarity for businesses on how to treat leased property, explained that a “substantial portion of intangible property is used” means 40 percent or more, noted that the “substantial improvement of property” requirement is determined on an asset by asset basis, and defined how to address inventory that is in transit.

Investors: Guidance specified that services don’t qualify as “investments” in a QOF, that the 180-day window to invest Section 1231 net gains begins on the final day of the taxable year and provided a list of events that cause the inclusion of deferred gain.

Fund operations: Treasury’s proposed regulations included the definition of “substantially all” for “use in the OZ” (70 percent), “tangible property owned or leased” (70 percent) and the measurement of a tangible property as qualified OZ property or interest in a OZ partnership or OZ stock during a holding period (90 percent).

The guidance also clarified that 12 months is a “reasonable time” to reinvest proceeds from the return of capital from or sale or disposition of qualified OZ property for purposes of the 90 percent test and provided guidance on the exit approach during a wind-down period.

Fund Exits: The proposed regulations allow investors in a partnership and S Corporation QOF to exclude capital gains allocated to them from the sale of qualified OZ property if they hold the interest for at least 10 years.

Real estate: The proposed regulations provided guidance that “original use” of tangible property begins when the property is placed in service for purposes of depreciation or amortization. Guidance also said that a building qualifies for original use if it’s been vacant five years and that the 31-month safe harbor to hold funds can be extended if the delay is attributable to waiting for government action. Guidance also said that “merely” entering into a triple-net-lease of real property is not the active conduct of a trade or business.

Corporations: The proposed regulations say that a qualified opportunity fund cannot be a member of a consolidated group of corporations and the member of a consolidated group of corporations that has capital gains must be the entity that invests in a qualified opportunity fund to qualify for gain deferral.

Feedback Crucial

Treasury asked for comments on the regulations. The department simultaneously issued a request for methods to assess relevant aspects of investments by QOFs. While the requests are related, they address separate issues.

Comments on proposed regulations are always important, but stakeholders in the OZ incentive should be particularly motivated to comment on the second tranche of regulations. The first tranche received about 150 comment letters and resulted in an overflow crowd at the Valentine’s Day hearing to discuss the comments–a turnout that resulted in Treasury scheduling this tranche’s hearing, July 9, at a bigger venue.

During the Novogradac 2019 Opportunity Zones Spring Conference, Dan Kowalski, counselor to the Treasury secretary, and others–including Shay Hawkins, then-legislative assistant to Sen. Tim Scott, R-S.C., an original sponsor of the OZ legislation–urged as much feedback as possible on the guidance. Hawkins urged OZ stakeholders to focus on a few issues that are particularly important, although he didn’t suggest which ones they should be.

Feedback is crucial. The early days of the OZ incentive will set the tone for the future, so it’s imperative that those involved make their voices heard. Several issues from the first tranche were addressed in the second tranche, a good indication that Treasury listened to feedback.  The Novogradac Opportunity Zones Working Group submitted comments on the first tranche of regulations, and testified at the public hearing, and will do both again for the second round.

Treasury will accept comments for 60 days through July 1.

For those involved, the guidance’s preamble said that taxpayers and QOFs can generally rely on most of the proposed regulations, assuming they apply the regulations consistently and in their entirety.

Reporting Requirements

No reporting requirements were included in the guidance, but Treasury and the IRS requested detailed comments about prospective methods for assessing relevant aspects of investments by QOFs. The questions include the composition of investments by asset class, identifying OZs that have received QOF investments and the impacts and outcomes of QOF investments. The deadline for those comments is July 1.

There will be an updated Qualified Opportunity Fund Form 8996, which will require additional information.

Treasury has come under criticism from some corners over the lack of a specific requirement for an objective and tangible local public benefit in order to qualify for the OZ incentives. That noted, there is widespread agreement on the need for reporting, with the minimum including the location, purpose, amount of financial commitment and some measurement of community impact for investments. Some stakeholders want significantly more reporting, using the new markets tax credit mandated reporting as a starting point. 

There has been a consistent call for some sort of measurement for OZs since the incentive became law. Sens. Scott and Cory Booker, D-N.J., and Reps. Ron Kind, D-Wis., and Mike Kelly, R-Pa., have introduced legislation that would institute reporting standards that were part of the Investing in Opportunity Act, the legislation from which the OZ incentive was taken. The standards were left out of the final provisions during tax reform in late 2017, but Scott, Booker, Kind and Kelly want them back in and they have plenty of company.

A group of Democratic members of Congress issued a letter to Treasury and IRS officials the day the second tranche of proposed regulations were issued, calling for guidelines.

Here’s a point on which nearly everyone agrees: For the OZ incentive to have maximum desired impact, it’s urgent for there to be data with which success can be measured and adjustments can be built.

Third Tranche and Finalized Guidance

In addition to the reporting standards legislation, Sen. Scott was preparing to introduce legislation that would allow investors to receive the seven-year step-up for OZ investments made by the end of 2020, rather than 2019 as in the current law.

Treasury indicated that a third tranche of guidance may not be needed, although at the Novogradac 2019 Opportunity Zones Spring Conference in Denver, Kowalski , said a third tranche “may or may not” come–leaving open the option.

Another outstanding question is whether Treasury will update and re-propose the regulations based on the amount of feedback it gets from stakeholders or finalize the regulations.

The U.S. Department of Housing and Urban Development issued a request for information on OZs and the White House Opportunity and Revitalization Council implementation plan, with a deadline of June 17. OZ stakeholders should weigh in with their viewpoints.

April’s release of regulations and the clarifications–particularly for real estate financing and for unwinding QOFs–will likely lead to more investment in opportunity zones.