Opportunity (Zones) Unlocked
The highly-anticipated second round of IRS guidance concerning tax benefits under the new Qualified Opportunity Zone (QOZ) program was published April 17. It clarifies many of the terms established under previous proposed regulations and seeks comments on remaining questions. The new guidance also loosens the criteria used to determine qualifying investments. But the real game changer concerns leased property used by a taxpayer within the QOZ program.
Before discussing the changes for leased property, let’s address the new criteria for qualifying investments. Prior to this guidance, taxpayers who held property in a QOZ before passage of the TCJA were essentially locked out of receiving the benefit of the QOZ program with respect to the pre-existing property. For instance, these taxpayers may have investable gains from other sources that they would like to reinvest into a business integrated with the pre-existing property. The property must be transferred to a QOZ Fund before the taxpayer can benefit from the QOZ program, and the prior law did not seem to provide a mechanism to accomplish this transfer.
The new guidance resolves this issue by providing that a qualifying investment can consist of cash or other property. Hence, a taxpayer can take advantage of the benefits under the QOZ program with respect to investable gains from other sources by contributing pre-existing QOZ property to a QOZ Fund. In this case, the new guidance requires the taxpayer to bifurcate its investment into the QOZ Fund, where one portion is a qualifying investment and the other portion is a non-qualifying investment. The qualifying portion generally is equal to the taxpayer’s adjusted tax basis in the contributed property. The non-qualifying portion is the excess of the property’s fair value over the taxpayer’s adjusted tax basis (essentially the built-in gain), which is not eligible for QOZ program benefits.
Special rules apply when the property contributed has a fair value that is less than the taxpayer’s adjusted tax basis in such property. In any case, the ability of the investor to treat a property contribution as a qualifying investment should not overshadow the ramifications this will have on the QOZ Fund. The QOZ Fund must acquire its qualified property by purchase, and a contribution of property by an investor does not satisfy this criteria. The QOZ Fund must therefore acquire other qualified property by purchase in amounts sufficient to satisfy a 70% test with respect to all of the QOZ Fund’s property, which now includes the non-qualifying contributed property.
Regarding a potential sale of property to a QOZ Fund, the new guidance provides that any gain recognized on the sale of property to a QOZ Fund is not eligible for benefits under the QOZ program, but the transfer itself counts as a qualifying investment to the extent it is received in a taxable exchange for equity in the QOZ Fund.
The new guidance provides another pathway for these taxpayers to benefit from the QOZ program. Assume a taxpayer holds QOZ property and also has capital gain proceeds from other sources he wants to invest in a QOZ Fund. The QOZ Fund can lease the pre-existing QOZ property from the taxpayer, and subsequently use the taxpayer’s invested proceeds to purchase other QOZ property. The benefits under the QOZ program allow the taxpayer to defer the taxation of reinvested capital gains until the earlier of when the taxpayer’s QOZ investment is sold or Dec. 31, 2026. And if the taxpayer holds the investment in the QOZ Fund for at least five years, 10% of this gain is permanently excluded from taxation. This permanent gain exclusion is increased to 15% if the interest in the QOZ Fund is held for at least seven years. Additionally, if the taxpayer in this situation held the investment in the QOZ Fund for 10 or more years, all of the post-acquisition gain in the QOZ Fund is permanently excluded from taxation.
But before these taxpayers go rushing to draft and sign leases or to create funds that implement this strategy, there are some important caveats. First, the lease must have been entered into after Dec. 31, 2017. Second, the lease must be at fair market value (arm’s-length). Third, substantially all of any tangible property leased by the QOZ Fund must be used in the QOZ during substantially all of the period the QOZ business leases the property. As a brief aside, the new guidance clarifies that “substantially all” requires 70% of any tangible property be used (e.g., leased) by the QOZ Fund in the QOZ and requires that property be qualified during 90% of the period the QOZ business leases the property.
Additionally, there are specific anti-abuse provisions that apply to leases between related parties (such as between a taxpayer and a QOZ Fund in which the taxpayer is an investor). Under these anti-abuse provisions, there cannot be a prepayment to the lessor for a period of use that exceeds 12 months. Further, if the original use of the leased property did not commence with the QOZ Fund, then the QOZ Fund must also purchase QOZ property that is equivalent in value to the value of the leased property during the 30-month period beginning with the inception of the lease. For this purpose, “original use” begins on the day the lessee places property into service or first uses it in a manner that would allow for depreciation if the lessee was the property owner.
A lessee can also claim original use if the property was unused or vacant for an uninterrupted period of at least five years. Property can also meet the original-use requirement if it was not previously used in the QOZ. For example, if a piece of manufacturing equipment was used outside the QOZ and then moved into the QOZ pursuant to the QOZ Fund’s lease, then its original use would be the date it was placed into service inside the QOZ.
As a part of this discussion, it is important to note that these principles apply similarly to purchased property, as well.
Finally, there is an additional anti-abuse rule for leased real property. This rule prevents taxpayers and QOZ Funds from directly using a lease to avoid the substantial improvement requirement for real property. Under this provision, property will never be QOZ business property if, at the time the lease was entered into, “there was a plan, intent, or expectation for the real property to be purchased by the [QOZ Fund] for an amount of consideration other than the fair market value of the real property.” In other words, a planned purchase cannot be turned into a lease just because this guidance provides a more favorable result.
This new guidance may provide a way for taxpayers who were previously unable to take advantage of the QOZ program to get into the game. However, there are specific anti-abuse provisions and general rules for leases that apply.
The tax reform commonly known as the Tax Cuts and Jobs Act (TCJA) created a unique yet somewhat complex opportunity for investments in low-income communities. Should you have questions or require additional information about the QOZ program, don’t hesitate to reach out to Bill Smith (301.961.1943, firstname.lastname@example.org), Managing Director, CBIZ National Tax Office, or contact your local CBIZ MHM tax professional.