The IRS and Department of the Treasury released the long-awaited second tranche of regulations for Opportunity Zones in mid-April. The first round of regulations, released in October 2018, began to provide some clarity for investors and those working in communities targeted by the Opportunity Zone provision. The initial regulations included guidance for real estate transactions but left many questions unanswered about how to use Opportunity Fund investments to operate a business.
Operating a Business in an Opportunity Zone
This second round of regulations provides additional clarity for operating a business in an Opportunity Zone, particularly when it comes to starting a new business venture. The first round of regulations required 50 percent of the gross income of a business be generated within the Opportunity Zone. This raised concerns that Opportunity Zone businesses would be limited in their growth and in the type of goods and services they could provide. If 50 percent of sales had to take place in an Opportunity Zone, then this provision might prevent businesses from selling their goods and services to a wider market. The second round of regulations addresses those concerns and provides several “safe harbor” tests for a business to determine whether 50 percent of its total gross income comes from within an Opportunity Zone.
The regulations will allow a business to meet that threshold if over 50 percent of its services, based on total hours of its employees and independent contractors, takes place inside an Opportunity Zone; if 50 percent of its services, based on the amount paid for those services takes place within the zone; or if the tangible property of a business and the management and operational functions of the business take place within the zone. The regulations also provide for a general facts and circumstances test where it is apparent that 50 percent of the gross income is derived from conduct in the zone.
Treatment of Unimproved Land
Another key issue addressed in the second round of regulations is the treatment of unimproved land. This round of regulation provides further guidance that unimproved land without a building on the property must be used in trade or business. This is designed to prevent Opportunity Funds from simply engaging in land speculation to gain tax benefits without contributing capital into the targeted community. Although this will prevent the land from simply being held vacant or unimproved, there is no threshold for the business use, potentially allowing someone to use a very small portion of the land in a minimally impactful commercial activity to meet the threshold of using the parcel in a trade or business.
For parcels that do contain a building, Treasury and the IRS indicated in the first round that the value of the land would not be counted when determining whether the Opportunity Fund investment resulted in a substantial improvement to the property, only the value of the building itself. Since the regulations require that an investment result either in an original use or a substantial improvement, the first round of regulations did not fully address all of the options for investment. This tranche of regulations provides additional clarity regarding whether the business activity supported by the Opportunity Fund investment meets the criteria for original use. The regulations state that if the Opportunity Fund or taxpayer is the first person to place the property in service for depreciation or amortization, it would meet the original use qualification.
The regulations also state that if a property has been vacant for five years, then any use would be an original use. This continues to create a barrier for Opportunity Funds to invest in pre-existing businesses in Opportunity Zones since the business would either need to meet the original use or the substantially improved threshold, but it could help draw investment toward long abandoned property.
How Long Must Investors Hold onto Assets in an Opportunity Zone?
The most recent regulations also provide clarity to investors for how long they must hold on to individual assets in an Opportunity Zone. In order to receive the maximum tax benefit, an investor must keep their money in an Opportunity Fund for at least ten years; however, there were questions regarding whether those Funds could then buy and sell a variety of Opportunity Zone assets or if they would need to remain with a single project for a full ten years. The regulations clarify that Opportunity Funds may buy and sell different assets over the ten-year period, provided that the money is reinvested in a new qualified Opportunity Zone investment within 12 months and that the proceeds are held as cash, cash equivalents, or a debt instrument with a term of 18 months or less.
These sales will not trigger an investor’s deferred capital gains, but Treasury felt it did not have the authority or any precedent to exempt interim gains from being recognized by the investor and is continuing to request comments on the best way to handle interim gains. The confirmation that investors can buy and sell assets within Opportunity Zones throughout the ten years of the investment means that deals will continue to be made throughout the life of the Opportunity Zone provision.
Additional Questions Answered by the New Regulations
The second round of regulations answer several other questions, including how leased property is treated, what activities would trigger the deferred gains during the life of an Opportunity Fund, how an investor can simply sell specific assets at the end of the ten year period without having to sell their entire equity interest in an Opportunity Fund, and provides for additional grace periods for initial investments and reinvestments once funds have been received by an Opportunity Fund.
What the New Regulations Don’t Cover
Although the latest regulations are extensive, they do not address all of the outstanding issues with the implementation of Opportunity Zones or many of the CDFI field’s concerns with the provision and its impact on communities. The regulations do not provide significant clarity to the substantial improvement test, instead requiring investors to follow an asset-by-asset test, which could prove cumbersome for small businesses. Additionally, these regulations do not speak to the reporting, data collection, and transparency requirements that OFN has been advocating for, although Treasury did simultaneously release a separate Request for Information. Treasury is soliciting public comments (due July 1, 2019) on these regulations. OFN is preparing comments and participating in a public hearing on July 9 to highlight our concerns and present our recommendations for improvement.