Partnership Seeks Clarification of O-Zone Regs

December 28, 2018

Internal Revenue Service
CC:PA:LPD:PR (REG-115420-18)
Room 5203
P.O. Box 7604
Ben Franklin Station
Washington, DC 20044

RE: Comments to the Proposed Regulations under Section 1400Z-2 (Qualified Opportunity Zones)

Dear Sir or Madam:

We commend Treasury and the Internal Revenue Service for the thoughtful proposed regulations issued pursuant to Section 1400Z-2 of the Internal Revenue Code. These proposed regulations, together with Rev. Rul. 2018-29, provide taxpayers with much-needed guidance to begin forming and investing in qualified opportunity funds (“QOFs”) to foster economic growth in qualified opportunity zones (“QOZs”).

We would like to offer the following comments, which are relevant to a number of our clients, in furtherance of the goal of using Section 1400Z-2 to foster economic growth:

Each of these comments is outlined in more detail below

1. The QOF should be permitted to own qualified opportunity zone property through a multi-tiered structure.

Many businesses operate through multi-tiered partnership structures for a variety of business reasons. To accommodate these business exigencies, the final regulations should confirm that QOFs have the flexibility to own qualified opportunity zone property indirectly through a multi-tiered holding structure in order to meet their business needs. It should not matter how many tiers there are in the structure, so long as the QOF holds the requisite 90% of its assets in qualified opportunity zone property and its subsidiaries satisfy the 70% test. To prevent potential abuse, the final regulations could require the 70% test to be satisfied on a cumulative basis for each chain of entities by looking through tiers of entities to the underlying assets of the lower-tiers.

2. “Original use” for new construction should commence when the property is placed in service.

Section 1400Z-2(d)(2)(D) defines qualified opportunity zone business property to mean, inter alia, tangible property acquired by the QOF by purchase after December 31, 2017, where (x) the “original use” of the property in the QOZ commences with the QOF or (y) the QOF “substantially improves” the tangible property.

The Proposed Regulations request comments on possible approaches to defining the "original use” requirement.

For a newly-constructed building, we believe that "original use" should commence when the building is “placed in service”. Thus, for example, if a QOF acquires a building in mid-construction, the building under construction should count as a new, unused building for purposes of the Section 1400Z-2(d)(2) “original use” test.

Such a rule will better foster steady economic development in QOZs. Where necessary, it will enable QOFs to serve a stabilizing effect in the QOZ because it will encourage QOFs to take over, and turn around less successful, partially completed projects without having to satisfy the “substantial improvement” test. If QOFs cannot rely on satisfying the “original use” test in partially completed projects in QOZs, the pool of potential investors for partially completed projects in QOZs would be dramatically reduced, which will be detrimental to the QOZs.

If this rule is adopted, we would support another commentator's sensible call to establish a “bright line” rule that "original use" occurs when a completed structure has received its certificate of occupancy from the relevant local government agency. Such a rule would provide the kind of certainty that would be needed, and would be consistent with how the Internal Revenue Service has interpreted "original use" in other analogous areas, such as for purposes of the Section 42 low-income housing credit.

3. Land acquired before 2018 by pre-existing entities should not be counted as a disqualifying asset for QOF qualification purposes.

Section 1400Z-2 requires a QOF to hold at least 90% of its assets in qualified opportunity zone property, defined, inter alia, as tangible property acquired by the QOF by purchase after December 31, 2017. Under the proposed regulations, a QOF operating a trade or business directly must hold at least 90% of its assets in qualified opportunity zone property, whereas a QOF operating a trade or business indirectly through one or more entities can satisfy the 90% test if each such entity holds at least 70% of its assets as qualified opportunity zone business property.

The proposed regulations (Prop. Treas. Regs. § 1.1400Z-2(d)-1(a)(3)) state that a pre-existing entity can qualify as a QOF as long as the entity satisfies all the requirements of Section 1400Z-2, including the requirement that the qualified opportunity zone property “must be acquired after December 31, 2017.”

We believe it would be consistent with the intent of Section 1400Z-2 to interpret the statute to permit a pre-existing entity that acquired land (directly or indirectly) on or before December 31, 2017 to exclude the value of such land in determining whether it qualifies as a QOF under the 90% test and the 70% test.

This would be consistent with the statutory intent because the statute is designed to drive post-2017 economic growth through new (post 2017) investment in buildings, equipment and businesses in the QOZ. The land upon which this post 2017 construction, growth and development occur has always been there and does not itself represent the type of investment that the statute is designed to encourage.

We believe this is a logical extension of the holding in Rev. Rul. 2018-29 which disregards land for purposes of the “original use” requirement as well as the holding in Rev. Rul. 2018-29 and the proposed regulations which disregard the value of land for purposes of the “substantial improvement” test. The conclusions in the ruling and the proposed regulations on these points correctly disregard the land because the focus of the statute is encouraging the development of the building and the business it will house. The “substantial improvement,” “original use” and “acquired by purchase after December 31, 2017” requirements are all part of the Section 1400Z-2(d)(2)(D)(i) definition of "qualified opportunity zone business property." Excluding the value of pre-2018 acquired land for purposes of determining whether a pre-existing entity can qualify as a QOF fosters the same goal.

If the final regulations do not adopt this recommendation, then the owners of the pre-existing entity may be forced to sell their property located in a QOZ to unrelated persons. Alternatively, such owners may be able to ground lease their land to a new entity that they own which could qualify as a QOF under Section 1400Z-2 by building substantial improvements on the ground lease and by excluding the value of the land by virtue of the ground lease. It seems unnecessary to require the owners of such land to take such steps in order for the development of such land to qualify under the QOZ provisions.

To this end, the proposed regulations defining QOFs should be amended to provide that the mere ownership of land prior to January 1, 2018 does not disqualify an entity from qualifying as a QOF as follows:

1.1400Z-2(d)-1 Qualified Opportunity Funds

(b) Valuation of assets for purposes of the 90-percent asset test — (3) The value of land acquired prior to January 1, 2018 by preexisting entities. Land owned by a QOF prior to January 1, 2018 will not be taken into account for purposes of the 90-percent asset test in Section 1400Z-2(d)(1).

This amendment to the 90% test should apply for purposes of the 70% test as well through the cross-reference in Prop. Treas. Reg. § 1.1400Z-2(d)-1(d)(3)(ii)(B) that incorporates the same methodology for valuing assets under both tests.

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Again, we commend Treasury and the Internal Revenue Service for the thoughtful guidance provided to date on QOZs.

Sincerely,

William G. Cavanagh
Norton Rose Fulbright US LLP
New York, NY