Individuals Identify Opportunity Zone Issues Needing Guidance

a. Evidence of the Planned Activity. Section 1400Z-2(d)(2)(B)(iii) and (C)(iii) requires that “during substantially all of the qualified opportunity zone fund's holding period for the such stock/interest, such corporation/partnership qualified as a qualified opportunity zone business.” Accordingly, if a corporation or partnership acquires property with a plan to undertake new construction or to make additions to basis over any 30-month period after acquisition, is the property a “qualified opportunity zone business” while it is awaiting construction or rehabilitation? Does the rehabilitation have to be “in place”, with actual tenants or use while the rehabilitation is going on?

Our recommendation is that if a taxpayer has reasonable written evidence of a plan to meet the additions to basis requirement within 30 months of acquisition (or perhaps longer, e.g., five years, because the statutes refers to “any” 30-month period), then there shall be a presumption that the business is a qualified opportunity zone business unless subsequent facts make clear that this presumption was not warranted.

b. Additions to Basis with Respect to Such Property. The statute refers to “additions to basis with respect to such property,” indicating that the additional work need not be a rehabilitation. Is it sufficient if a Fund buys a housing development and also constructs an adjacent and appropriately sized community center or playground that passes the basis requirements? The second building or improvement would seem to be “with respect to” the first. We recommend that the basis in new construction and improvements be applied to pass the 30-month test if the Fund can reasonably demonstrate that these items are with respect to the used property. Another alternative might be to apply the “substantially related and subordinate” rules that apply to tax-exempt bond transactions.

c. Reasonable Working Capital. While new construction, rehabilitation or “with respect to” construction is pending, are the funds which will pay for the “new construction/rehabilitation/construction with respect to” exempt from the “nonqualified financial property” (“NQFP”) rules of Section 1397C(b)(8)? Failure to have such an exemption would cause most investments in Qualified Opportunity Zone Stock or Qualified Opportunity Zone Partnership Interests that invest in construction projects to have more than 5% NQFP. Thus the entire investment would fail to be Qualified Opportunity Zone Property and cause a catastrophic failure of the 90% penalty test.

We recommend that such funds be considered reasonable “working capital” (and therefore, not nonqualified financial property) if used to pay for the costs of a reasonable and diligently undertaken project that meets requirements like those we have suggested for the 30-month rule, as described above. We would be pleased to provide you with an illustration of similar rules that apply to new markets tax credit transactions. Similarly, for QO Funds that invest directly in Qualified Opportunity Zone Business Property, where the new construction, rehabilitation or “with respect to” construction is pending, we recommend that such funds be considered reasonable working capital using a 30-month rule and therefore not negatively impact the 90% test during the 30-month period. We note that Section 1400Z-2(f)(3) provides that no penalty for failing to meet the 90% test shall be imposed where there is reasonable cause for such failure. Combined with the regulatory authority provided to the Service under Section 1400Z-2(d)(4), we believe the Service has the authority to promulgate regulations providing for reasonable working capital.

a. How does averaging work? The averaging requirement raises many questions. First, does the fund just determine its percentages on the two dates? We note that the 6-month reference appears to only apply to the “first” such date, or is it supposed to be the earliest possible 6-month period each year of the QO Fund's existence? What is being averaged? The fair market value of the assets? Their basis? Their original basis at the time of their acquisition by the fund? Our suggestion is that a fund determine its percentage of QOZ property six-months after formation, and the last day of the taxable year, and that this average must equal or exceed 90 percent to avoid the penalty of subsection (f).

For example, if the fund was a calendar year taxpayer formed on March 1, and it had 80 percent of its assets in QOZ property on September 1 (i.e., 6 months later), and 100 percent on December 31 (i.e., the end of the year), then the average would be 90 percent, and the test would be passed. We do not have a good suggestion for valuation. In the spirit of using “any reasonable method,” perhaps computations should be made using “unadjusted basis” (recognizing that adjusted basis could yield nonsensical results on account of bonus depreciation), unless and until the taxpayer elects to obtain an appraisal and use that.

b. How is the first 6-month period measured? If an investment closes on June 27 for a calendar year fund, does the 6-month period end on June 30, or December 27? And if it is the latter, does the fund apply the test on both December 27 and again on December 31, just 4 days later? We recommend that (i) for the first time, the test should be first performed on the date that is six months after the entity is formed and at the end of the tax year that immediately follows that date, and (ii) in subsequent years, the test should be performed on the date that is six months from the start of the tax year, and the final day of such taxable year. For example, a calendar year fund formed on October 1, 2018 would measure compliance on April 1, 2019 and December 31, 2019, and then on June 30 and December 31 of each year thereafter.

a. Active Business. The guidance should confirm that leasing activities, particularly the leasing of residential real estate constitutes a QOZ business. As you know, Section 1400Z-2 points the reader to certain subsections of 1397C for additional definitions. While the pointers do not send the reader to the subsections of Section 1397C that limit potential leasing (including residential and certain personal property leasing) activities, investors are concerned that the IRS might apply such rules.

For example, many Code sections send the reader to the related party rules of Section 267(b), and tax practitioners generally apply the rules of section 267(c) as well, even though they are not incorporated by the original pointer. The lack of guidance on this point is preventing those who often invest in Section 42-eligible housing developments from investing their gains in Opportunity Zones, seeming to frustrate the purpose of the section. It would be sufficient for guidance to note that, of the provisions in Section 1397C, only those specifically identified in Section 1400Z-2 (i.e., paragraphs (2), (4), and (8) of section 1397C(b)) apply.

b. “Non-permitted businesses”. Section 1400Z-2 refers to Section 144(c)(6)(B) for a list of businesses that are not permitted for Opportunity Zone businesses. Section 1397C has the same reference to Section 144(c)(6)(B), plus it adds many farming businesses to the excluded list. For the same reasons as discussed in the preceding paragraph, it might be helpful for the IRS to say that only the list in Section 144(c)(6)(B) is prohibited, or to observe that “farming businesses are a permitted investment.”

c. References to “Substantially all.” As we have discussed, the Code provision includes the phrase “substantially all” five times, and we recommend that the IRS publish guidance defining this term for purposes of section 1400Z-2. Where the reference is to time, we recommend that the phrase be applied with a combination of a percentage, along with an initial phase-in and exceptions for reasonable cause.

d. Separate funds of non-gains money. It is possible to read 1400Z-2 to provide that separate funds that make use of only non-gains money can qualify for the benefits of the post-10-year basis step-up of subsection (c). That seems inconsistent with the implication of subsection (e), but that subsection actually addresses joint funds of both gain and non-gain money, while subsection (c), read by itself, simply states that benefit is available without referring to the source of the investment. The IRS could settle this question by issuing guidance on this point.

e. Taxing the Operation and Distributions of the Opportunity Zone Business. We are anticipating that when an Opportunity Fund owns a partnership interest or corporate stock or Opportunity Zone Business Property, this investment will generally be taxed in the ordinary way. For example, if a partnership in which the fund invests generates income, the Opportunity Fund will get a K-1, and report its share of the income; if such a partnership borrows money and makes a distribution to its partners, including the Opportunity Fund, this will be taxed or not under the usual rules that apply to distributions to partners (e.g., a distribution in excess of basis generally results in capital gain to the partner). Similarly, if the corporation in which the fund owns stock generates corporate level income, it will be subject to the applicable tax rules for corporations; if it makes a distribution to its stockholders, including the Opportunity Fund, this distribution will be subject to the normal tax rules that apply to distributions to stockholders. We see people making various assertions about alternate tax treatments for these items that goes beyond the specific deferrals and non-taxability that appears in Section 1400Z-2, and it may be useful for the IRS to clarify this tax treatment or identify those situations where a special rule might apply.

f. Any Reasonable Method. Several of the questions we and others have raised might be best addressed by the IRS adopting an “any reasonable method” or “any reasonable method, consistently applied” standard. The IRS has used this standard many times; for example, a brief review of the Treasury Regulations indicates that this phrase appears 119 times.