Treasury issued final Opportunity Zone Regulations on December 19, 2019 (“Final Regulations”).  These Final Regulations update the first two rounds of Proposed Regulations (issued on October 29, 2018 and April 17, 2019).¹ The Final Regulations clarified some key issues in connection with investing in and forming Qualified Opportunity Funds (“QOF”) and the QOF’s investments in Qualified Opportunity Zone Businesses (“QOZB”).² Practitioners, commentators and investor groups pushed on many of the topics covered in the Proposed Regulations, and most of the issues covered were resolved very favorably in the Final Regulations. That said, there was at least one unwelcome surprise in the preamble to the final Regulations. A summary of the key issues and observations is below.

Some Key Points:

• Treasury expressed strong reservations in the preamble on allowing opportunity zone benefits where a property owner sells its property to a QOZB or QOF and reinvests the proceeds from the sale back into the relevant QOF. Treasury stated that these transactions would be re-characterized as contributions of property by sellers in exchange for QOF interests, thereby precluding the seller from receiving opportunity zone benefits, and disqualifying the property as a qualifying asset (because it was not purchased).  This is true regardless of whether the property seller is a related party under the opportunity zone rules.  In other words, it appears that whether the seller ends up with less than 20% of the capital or profits interest in the buyer is totally irrelevant; 

• Proposed rules on investment of gains from the sale of section 1231 property (real/depreciable property used in a trade or business) are eliminated – investors can invest the gross amount of gain from the sale of 1231 property (though investors relying on the proposed rules for investments made during the 180 day period beginning on December 31, 2019 are protected);

• The Final Regulations add a third 180-day investment period for capital gains from property sales by flow-through entities.  Now, qualified gains from partnership and S corporations can be invested in the 180 days beginning on the date of the sale, the 180 days beginning on the last day of the entity’s tax year, and during the 180 day period beginning on the due date (without regard to extensions) of the entity’s tax return.

• The Final Regulations clarify that each payment on an installment sale is a separate eligible gain in the year received (regardless of when the underlying sale occurred, even if prior to 2018);

• Investors who hold QOF investments for 10 years can realize OZ benefits by excluding all gain from the sale of QOF interests, QOZB interests, and, critically, from assets held by QOZB partnerships and S corporations (except inventory sold in the ordinary course of business);

• The working capital safe harbor may be expanded to up to 62 months if there is more than one qualifying investment relating to the same overall safe harbor plan;

• “Original Use” of vacant property is expanded to include property that was vacant for one year prior to the designation of its location as an eligible opportunity zone census tract or for property that has been continuously vacant for 3 years;

• “Substantial improvement” test now allows aggregation of tangible personal property, and even buildings, in some circumstances; 

• Allows one 6 month “cure” period if a QOF fails a testing date;

• Makes clear that gains from interim sales of assets when an investment in a QOF is held for less  than 10 years must be recognized by investors (although eligible capital gains derived on or before December 31, 2026 may be deferred by making a qualifying investment in a qualified opportunity fund);

• “Clarification that (i) transfers by gift or in a divorce are inclusion events and (ii) transfers upon death are not inclusion events (related rules are adopted for beneficiaries and estates); and

• Allows QOFs to merge in certain circumstances;

Explanations and Observations

I.  Investing Qualified Gains

• Transactions Involving Sales of Property and Reinvestment of Gains in Buyer Will NOT Receive Opportunity Zone Benefits. The preamble to the Final Regulations states:

…an eligible taxpayer’s gain from a sale to or an exchange of property with an unrelated QOF (acquiring QOF), as part of a plan that includes the investment of the consideration received by the eligible taxpayer back into the acquiring QOF [or QOZB], is not eligible gain to the eligible taxpayer….

The preamble indicates that Treasury will treat such transactions as contributions of property by the seller to the QOF in exchange for an interest in the QOF, followed by a contribution by the QOF of the property to the QOZB.  Moreover, it apparently does not matter at all whether the seller ends up with less than 20% of the capital or profits interest in the buyer, making hash of the related party rules.  Moreover, Treasury’s view means that not only would the investor’s investment be ineligible for opportunity zone benefits (it would be treated as a tax –free contribution under Section 721 of the Code), but, even more importantly, the property could not ever be qualified opportunity zone business property because it was not acquired by the QOZB by “purchase.”  

Observations:  Although the language is a bit ambiguous – does the investor have to reinvest all of “the consideration” for the investment to be disqualified? – until the situation is clarified QOFs should not accept reinvestments of gains from the sale of the property acquired by the QOF (or QOZB). Also, Treasury’s view is based on general tax principals rather than a specific opportunity zone regulation, and so in theory every opportunity zone investment from the start of the program that involves a sale of property and reinvestment of the gain by the seller is at risk.  Finally, although the language in the preamble is limited solely to situations where the seller reinvests “the consideration received….back into the acquiring QOF [or QOZB]” any investment by a property seller into the buyer structure carries at least some risk of being re-characterized as a tax free contribution of property under section 721 of the Code.

• Gross Section 1231 Gains Can Be Invested During 180 Day Period Beginning on Date of Sale.  The Proposed Regulations provided that only net Section 1231³  gains could be invested, and then only during the 180 day period beginning on the last day of the taxable year (December 31 for calendar year taxpayers), because only at that time would an investor be able to know whether or not there was net Section 1231 gains.  This resulted in a sometimes lengthy window between recognition of the Section 1231 gain and the ability to invest such gain in a QOF and a requirement to manage Section 1231 losses to make sure there were net Section 1231 gains at the end of the year.

The Final Regulations eliminate all differences between Section 1231 gains and other eligible gains.  That is, gain from each sale of 1231 property can be invested without regard to other sales of 1231 property, and on a gross basis, without taking into account any other Section 1231 gains or losses.  The general tax treatment of net Section 1231 gains or losses is now done without including the invested Section 1231 gains, which will now be accounted for in 2026 (or in the year of disposition of the QOF interest, if earlier). 

The Final Regulations also confirm that gross Section 1231 gains can be invested directly by partnerships and S corporations that sell the property.  There had been concern that Treasury would only permit the investors in flow through entities (and not the flow through entity itself) to invest Section 1231 gains because, arguably, that was where the netting for Section 1231 gains occurred. 

Observation:  Investors and sponsors were concerned that subsequent Section 1231 losses could eliminate Section 1231 gains, and “initial funding loan” mechanisms where being used to bridge the gap between sale date and the day you could invest the gains as equity into a QOF.  The Final Regulations eliminate the need for this complex structuring.  The Final Regulations also grandfather 2019 investments of Section 1231 gains under the proposed rules.

• Beginning of the 180 Day Window for Flow-Through (Schedule K-1) Gains. The Proposed Regulations provided that if certain flow through entities, such as partnerships, S corporations, and certain non-grantor trusts (entities for which the investors receive a Schedule K-1 with the investor’s allocation of the entities’ tax items) did not invest any capital gains directly, then the investors could elect to invest the capital gains themselves, with the 180 day window beginning on either (i) the 180 day window beginning on the date of the capital gain event or (ii) the 180 day period beginning on the last day of the flow through entities taxable year.  This provided partners (especially passive partners), who may not otherwise realize a sale had occurred an opportunity to invest.

  The final Regulations added an additional option for investors with gains from flow-through entities.  In addition to the two options listed above, the final regulations allow investors to invest gains from pass-through entities during the 180 day window beginning on the due date for the pass-through entity’s tax return, without extensions (generally March 15th for calendar year flow through entities).  

Observation:  This additional window acknowledges that many investors wouldn’t learn about a capital gain event until the receipt of the Schedule K-1, and this provides the investors additional time upon learning upon the capital gain event.  Investors should consider adding provisions to operating agreements providing that the manager of the partnership or other flow-through entity will notify the investors of capital gain events, at a minimum by the unextended due date of the entity’s tax return.  It also can extend the investment period to as much as 21 months after the original sale.

• Beginning of the 180 Day Window for Installment Sale Gains. The final Regulations provide that eligible capital gains include gains recognized under the installment method (provided such gains otherwise qualify as eligible gains). Taxpayers can treat the first day of the 180 day window for investing such gain as either the date a payment on the installment method is received or the last day of the taxable year such installment gain is recognized.  

Observation: The Regulations specifically provide that gains realized after January 1, 2018 from a pre-2018 installment sale are eligible gains for opportunity zone investment.  When a capital asset is sold on the installment method, taxpayers should consider whether to opt out of the installment method entirely in order to make a full OZ investment in the year of the sale (for example, if the taxpayer has a current OZ opportunity) or if it would be more beneficial to recognize the gain over time to allow many smaller OZ investments over time.

II.  10-Year Exit

• Even More Favorable Resolution to Sales of QOZB Assets vs. OZ Fund Interests. The Proposed Regulations allowed QOFs organized as partnerships, S corporations and REITs to sell their assets (e.g., interests in QOZBs) and, assuming that the investor has held the investment in the QOF for more than 10 years, the investor would pay no capital gains tax. A QOZB does this by making an election to exclude all gains recognized during the taxable year from income, except for income from sales of inventory in the ordinary course of business.  

  The final regulations expand on this by (1) permitting any sale of assets at any level, including a QOZB selling its assets, and (2) allowing exclusion of all gain by investors who have held their QOF interests for at least 10 years, including any gain arising from recapture.  The only exception to this benefit is for inventory sold in the ordinary course of business.  Note that any reinvestment of such proceeds (with the gain excluded) is treated is a non-OZ investment (“fresh equity”) and that portion of an investor’s investment does not get further OZ benefits.  This ability to exclude gains when a QOF or QOZB sell assets does not apply to investors in QOF organized as C corporations.

Observation:  This change will allow fund sponsors to organize more traditional multi-asset investment funds without having to worry about finding a buyer willing to acquire the equity interests in the QOZB.  This also eliminates the distinction between selling a QOF interest, where all gain was excluded, and sales of QOF assets, where only capital gains were excluded from tax, but not ordinary income, from things like hot assets or recapture. Note also that the Final Regulations do not modify the tax treatment of sales of assets within the QOF investor’s 10-year holding period.  These are still taxable transactions (although such gains may potentially be deferred by being reinvested into a QOF).

III.  QOF and QOZB Testing and Qualifying Property

• Self-Constructed Property is “Purchased” for Opportunity Zone Purposes.  The Final Regulations confirm what many had assumed, that self-constructed property intended to be used in the trade or business is a qualified asset.  The materials used for the construction of the property must themselves be qualified opportunity zone business property.  The Final Regulations further state that such property is considered “acquired” when significant work of a physical nature begins, and provides a safe harbor when 10% of the total expected construction cost is expended.  The FAQ accompanying the final regulations states that, for purposes of the 70% test, self-constructed property is valued at the “purchase price as of the date when significant work of a significant nature begins.”

Observation: The meaning of the term “purchase price” is unclear, but clearly includes costs incurred by a testing date.

• Expansion of the Working Capital Safe Harbor.  The Final Regulations expand the working capital safe harbor for start-up businesses where there are multiple contributions of capital to a QOZB, and therefore more than one working capital safe harbor plan document.  To qualify, each subsequent cash infusion must be covered by an additional working capital safe harbor and the working capital plan for the additional cash infusions must “form an integral part of the plan covered by the initial working capital safe harbor period.” The 62 months is a maximum period regardless of number of cash infusions.  Moreover, the additional infusions must not be de minimis – basically designed solely to obtain the additional period.  The Final Regulations further provide that, during the working capital safe harbor period:

1) NQFP in excess of 5% limit will not cause business to fail to qualify a QOZB;

2) gross income earned will be counted towards the 50% gross income requirement; 

3) tangible property purchased, leased, or improved by a business with cash covered; by working capital safe harbor will count for 70% standard; and

4) intangible property will count toward 40%.

Observation:  As discussed below, although property being improved with cash subject to the working capital safe harbor (and property that is expected to be substantially improved within the requisite 30-month period) is counted for purposes of the 70% test, the Final Regulations do not provide specific guidance on how such property is valued.  Based on rules for self-constructed property, it appears that valuation is based on the actual costs incurred in constructing and improving the property.     

• Modifications to the Original Use Test.  The Final Regulations modify the rules for when vacant property can meet the original use test.  Vacant property will now meet the original use test if it was vacant for at least one year at the time the opportunity zone containing the property was designated and has remained vacant since such time, or, if the property does not meet this test, if it has been vacant for three years beginning with the date the relevant opportunity zone was designated.  

  The Final Regulations define “vacant” to mean “significantly unused,” which means that more that than 80% of the building or land, as measured by square footage of usable space, is not being used. 

  In addition, so-called “brownfield” sites will automatically meet the original use test and the original use test will be met for land and structures.  Finally, real property (land and structures) purchased from local government will meet the original use test if held by government pursuant to an involuntary transfer (abandonment, bankruptcy, etc.).

• Modifications to the Substantial Improvement Test.  The most important change from the proposed regulations is that the Final Regulations provide an opportunity to aggregate property and even buildings for purposes of the substantial improvement test.  Previously, commentators were concerned that each piece of tangible property had to be separately considered, no matter how small, and that administrative problems with the test might discourage investors from investing in operating businesses.  The Final Regulations provide some relief, and also allow some aggregation of buildings so that integrated real estate projects can more easily qualify.  

  First, a QOZB can include the cost of purchased “original use” assets that otherwise qualify as qualified opportunity zone business property in determining whether a property has been substantially improved if the purchased assets (i) are used in the same trade or business in the opportunity zone (or a contiguous opportunity zone as the non-original use asset and (ii) the purchased assets improve the functionality of the non-original use asset.  The Final Regulations provide an example whereby a hotel can include the cost of linens, furniture, etc. used in the hotel in determining whether the hotel building has been substantially improved.  If this approach is used, the purchased property is not treated as original use property but instead, its basis is added to the non-original use property for purposes of the 70% test.  The non-original use property must still be improved by a non-insubstantial amount.

  Second, in some circumstances the Final Regulations allow a QOZB to aggregate the cost of buildings and treat them as a single asset for purposes of the substantial improvement test.  The Final Regulations provide that two or more buildings can be aggregated and treated as single asset if they are on single deed or, if on multiple deeds, if they are contiguous.  Such buildings constitute an “eligible building group.”  The eligible building group must (a) be operated exclusively by the QOF or QOZB; (b) the buildings in the group must share significant centralized business elements, such as personnel, accounting, legal, manufacturing; and (c) the buildings in the group must be operated in coordination with, or reliance upon, one or more trades or businesses.  

Observation:  The new aggregation rules provide a pathway for operating businesses and real estate projects to more easily meet the substantial improvement test.

• Qualification of Property During Substantial Improvement and Working Capital Periods.  The Final Regulations provide that property that is in the process of being substantially improved (and is reasonably expected to be substantially improved within the 30-month period) or that is the subject of a working capital safe harbor is counted as qualified opportunity zone business property during the improvement period and working capital period, as the case may be.  However the Final Regulations do not provide guidance on what value is counted for purposes of the 70% test.  

  The Final Regulations also confirm that, while land does not need to meet either the substantial improvement or original use tests, it must meet all other requirements, such as being purchased after December 31, 2017 from an unrelated party.  In addition, to discourage “land banking,” the Final Regulations provide that unimproved land must be improved by “more than an insubstantial amount.”  The Final Regulations do not provide a specific percentage but do give examples of qualified improvements.  These include an irrigation system put in for a farming business or grading land in connection with a construction business as having more than an insubstantial amount of improvement.

• Treatment of Inventory.  The Final Regulations allow a QOF or QOZB to choose, on an annual basis, to include or exclude inventory in calculation of 90% test (for QOFs) or the 70% tangible property test (for QOZBs), so long as the choice is applied consistently with respect to the semi-annual tests in each period.  If included, inventory produced by an eligible entity after December 31, 2017 meets the original use test.  The Final Regulations confirm that inventory in transit from a vendor to a facility in an opportunity zone or from the facility to customers are considered used in an opportunity zone, even while in transit or temporarily warehoused outside of an opportunity zone for up to 30 days.

Observation:  Including Inventory in the asset test calculation should help make it easier for operating businesses to qualify, as most company’s inventory will have turned over and therefore will generally have been acquired after 2017, and if located or assembled in an opportunity zone should qualify as a “good asset” for asset test purposes.  One issue to consider is whether custom inventory prepared for a QOZB outside of an opportunity zone will be considered in connection with the requirement that 50% of a QOZB’s revenue come from the active conduct of a trade or business in an opportunity zone.

• Cure Period. The Final Regulations provide that a QOF (or QOZB) can elect to apply a six-month cure period should it fail a 90% test on a testing date.  During this cure period, any QOZB that does not meet its 70% asset test will nevertheless be treated as qualified opportunity zone property.  However, if the QOZB fails the test at the end of the sixth month cure period, and if the QOF fails its 90% test (counting the QOZB as a non-qualified asset), then the QOF will be subject to a penalty that treats the QOF as not qualifying for the entire cure period.   

• Other Issues. There are a great number of other clarifications in the 544 pages of Final Regulations, including the following:

• 50% gross income test.  The Final Regulations provide that:
  The 50 percent gross income can be earned from any opportunity zone.  
  A QOZB must maintain adequate records and implement sound processes to track the hours worked by and amounts paid to employees and independent contractors.  

  Guaranteed payments paid to partners in a partnership for services are counted (but not other payments to such partners).

  The Final Regulations imply that amounts paid to accountants, lawyers and other service providers are counted in the 50% test

• Real property straddling an opportunity zone. The test:

  Includes both a square footage and unadjusted cost test
  The property can be separated by a road, railway, stream, etc.
  Property is not contiguous if there is only a common corner 

• Spousal transfers are inclusion events

• For purposes of the 70% and 90% tests, assets not purchased, such as contributed property or, possibly, QOZB interests owned by a QOF, are valued at their fair market value as of the testing date.

• There is a safe harbor for the 40% intangible property test, but it is quite opaque.     

¹ Polsinelli’s summary of the proposed regulations can be found here and here. 

² This summary assumes familiarity with general opportunity zone requirements.  General summary of opportunity zones can be found here.

³ Section 1231 gains are, generally, gain from depreciable property and real property used in a trade or business held for more than 1 year.