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Interview: Final Opportunity Zone Rules: A Deep Dive

Posted on Feb. 3, 2020

Tony Nitti, a tax partner at RubinBrown LLP, discusses the final rules on Opportunity Zones and his observations of the program in action with Tax Notes senior legal reporter Stephanie Cumings.

Read the podcast transcript below. This post has been edited for length and clarity.

David Stewart: Welcome to the podcast. I'm David Stewart, editor in chief of Tax Notes Today International. This week: zeroing in on Opportunity Zones. In late December the IRS and Treasury released the final Opportunity Zone regulations, which spanned hundreds of pages. Here to discuss the new rules and what they mean for tax practitioners is Tax Notes Today senior legal reporter Stephanie Cumings. Stephanie, welcome back.

Stephanie Cumings: Thanks for having me.  

David Stewart: Who did you talk to?

Stephanie Cumings: I was very fortunate to be joined by phone by Tony Nitti, a partner at RubinBrown. Tony has over 20 years of tax and accounting experience. There's a very good chance you already know who he is. He's a frequent speaker at events and webinars, and he's a well-known contributor to Forbes.

David Stewart: What did you talk about?

Stephanie Cumings: We discussed the final regulations on the Opportunity Zone program. For those who don't know, the Opportunity Zone program was a provision of the Tax Cuts and Jobs Act that lets taxpayers defer, reduce, and in some cases eliminate capital gains tax by making long-term investments in designated low-income areas. The regs are very long and complicated, and Tony walks us through some of the key changes and clarifications. We also discuss Tony's observations of the program in action because, for all of its benefits and attempts to make the program taxpayer-friendly, it seems like a lot of people have hesitated to make investments because the rules are so complex. 

David Stewart: Alright, let's go to that interview.

Stephanie Cumings: Tony, thank you so much for joining us on the podcast today. There's been a lot of talk about Opportunity Zones since the TCJA was enacted, but it seems like more people are talking about Opportunity Zones than investing in them. One of the common explanations for that was that people were waiting for more guidance. Now that the final regulations are out, do you think this is the year that people finally stop talking about Opportunity Zones and start investing in them?

Tony Nitti: Stephanie, first of all, thank you for having me. That's going to be interesting to see. The feeling I've gotten after the first couple weeks of practitioners and taxpayers trying to absorb the final regulations is that we may have come full circle.

When the TCJA passed, Opportunity Zones were eight pages buried in a much larger bill that warranted attention for a number of different reasons. Nothing was going on with Opportunity Zones until we got some regulations. We got proposed regulations, then we got another round of proposed regulations. Now we've got these final regulations.

While the final regulations are helpful, they're causing a lot of confusion. They're so much bigger and so much lengthier than the proposed regs. I feel that some people are in a "deer in headlights" mode where they don't want to move in any direction because they're not quite sure how the final regulations interpret what it is they're trying to accomplish. Every step of the way with the O-Zones, we think this is a step that's going to spur people to really move forward with their investment. This most recent round is just so all-encompassing and so involved, it's got a number of people scared.

I can say that from experience because just in the last couple weeks, that's been the subject matter of most of the phone calls I've gotten from people around the country. "Hey, I thought I felt comfortable with what I was going to do under the proposed regs. Now I'm really not so comfortable under the final regulations." It'll take some time. It's only been a couple of weeks, but I am getting that sense of people being a little bit paralyzed by the breadth of the final regulations.

Stephanie Cumings: Let's dive into some of the specifics in the final regs. There were some changes in clarifications around gains that are eligible to invest, including section 1231 gains. Can you tell us how the rules changed for section 1231 gains from the proposed regs to the final regs?

Tony Nitti: These are definitely taxpayer-friendly changes. The only issue is the effective date of the final regulations. They're not effective for most taxpayers until their 2021 calendar year. You can rely on those regulations in the current year or even in 2019. But you have to be consistent. We're going to see how that could create some confusion with the treatment of section 1231 gains.

First things first, it's just a unique type of transaction within the tax law where if you sell a rental property, for example, you're not guaranteed capital gain because it's not technically a capital asset.

Instead, depreciable property held in a trade or business for more than a year is treated as what's called a section 1231 asset. With section 1231 what you do is you take all your gains and losses during the year, you net them together, and the result is a bit of a chameleon. If it's a net gain, it's treated as capital gain. If it's a net loss, it's an ordinary loss. The reason that's important in the O-Zone space is because you can only invest gain treated as capital gain into one of these Opportunity Funds and into an Opportunity Zone.

The proposed regs said, "If you have $1 million of section 1231 gain on January 2, 2020, you can't be sure whether that gain is going to be capital until you figured out what other section 1231 gains and losses you have during the year and net them all together. If you end up with an $800,000 loss on December 5, 2020, at the end of the year, your netting is going to reveal only $200,000 of section 1231 gain."

The proposed regs said you could in that situation invest the net section 1231 gain of $200,000. You could only do it starting the last day of the tax year, because that's the first day the netting is complete and you know the results. That meant somebody with $1 million of gain in January had to just sit there and wait until the end of the year. Even if there were no other losses coming, they couldn't make their investment until December 31 of that year because that's when the netting was complete. Obviously, a lot of people were not fans of that treatment.

The final regulations went wildly in the other direction. They say, "Despite what we know about general tax principles, for our purposes, every section 1231 gain and loss is going to stand on its own. If you have $1 million of section 1231 gain on January 3, 2020, there could be more than $1 million of section 1231 losses coming to you later in the year. It doesn't matter. Starting on that January 5 date, when you recognize the $1 million in section 1231 gain, knock yourself out. You can invest it immediately into an Opportunity Zone and start your 180-day clock on the date of sale." If you do that, and later in the year you have a loss from a section 1231 asset, it doesn't matter. That section 1231 loss stands on its own, and the result is you'll have a net loss for the year, and you still got to invest the full $1 million of gain. 

When you put those examples together, you could see why it's caused some problems for 2019. Someone might have had a gain on January 5 of $1 million, and then in December had a loss of $800,000. Their net section 1231 gain is $200,000. If they want to rely on the proposed regs, they're stuck putting in $200,000 of gain, and they can't do it till December 31. If they wanted to try to rely on the final regs and contribute the full $1 million of gain, the problem is the ship has already sailed. The 180-day period began back on January 5 on the date of sale.

For 2019, some people are going to realize they just can't have their cake and eat it, too. They're either going to have to deal with the proposed regs and contribute on a net basis starting the last day of the year, or hope that their gain was late enough in the year so that they haven't lost their 180-day period yet.

Stephanie Cumings: There were also some clarifications about installment sales. Could you tell us a little bit about that?

Tony Nitti: This is the question I was getting all over the place when I taught on Opportunity Zones. It says, "You can only invest gain that's recognized on a sale after 2017." People are saying, "What about if I sell something in 2015, 2016, or 2017, and I'm collecting installment payments in 2018, 2019, or 2020? Can I take those gains even though they originated from a sale before 2018 and contribute them?"

I thought, logically, of course you could, because for tax purposes under section 453, those gains aren't treated as being recognized until you received payment. But we didn't have any clarification. Final regs made it clear that when you have an installment sale, even if it originated before 2018, every year when those cash payments are received and you recognize your proportionate share of gain, every one of those payments that gives rise to gain is eligible for its own deferral by contributing it into an Opportunity Zone. That provided some much needed clarity people were waiting on.

Stephanie Cumings: There was some interesting language in the preamble about circular cash flows and the step transaction doctrine. When it comes to transferring property to a fund, this was maybe not taxpayer friendly. Could you talk a little bit about that section of the preamble?

Tony Nitti: This kind of sucker-punched some people a little bit because we knew you couldn't defer gain on the sale of property to a related QOF. Related parties for those purposes is defined as a 20 percent relationship-ownership stake. You couldn't sell land for $500,000 to a fund. Then immediately invest that amount in the fund if you were going to own more than 20 percent of the fund because you'd be related parties and it would kill it for everybody. Not only would you not have eligible gain to defer, but the land wouldn't be a qualified property fund because it was acquired from a related party.

What the final regs did is take things a step further. Let's say, you have land that you sell for $1 million and you sell it to a fund. Then you immediately take that $1 million and invest it into the fund. You don't own 20 percent, so you're not related. There's nothing that prohibits you from doing it under the related party rules.

The problem is the final regs should say, "Look at this logically. You started out with land. The partnership, or the QOF, whatever it is, your Qualified Opportunity Fund started out with $1 million. The fund gave you the $1 million for the land. Then you turn around, put the $1 million back in the fund, and the fund still has the $1 million it had from the beginning." It says, "Under step transaction principles, we'll combine all those steps together." Since you didn't end up with the cash that the fund did, it's really treated as if you contributed the property into the fund.

There's a number of problems there. Number one, you wouldn't have eligible gain to defer. Number two, that property is never going to be qualifying property for the fund because it was acquired via contribution instead of purchase.

We got some clarity there, but it's caused so much confusion among taxpayers. What if we sold land for $1 million? We had $800,000 of basis in the land, so we only end up with $200,000 of gain. Then, rather than putting the full $1 million of proceeds back into the fund, we only put $200,000. Has there still been a circular movement of that cash? I mean, we got $1 million out. We only put $200,000 back in. The answer? Probably no.

There's some ambiguity in the regs, but a lot of taxpayers are left to wonder how to interpret that circular transfer of the cash discussion. Whether there's going to be a tipping point where if you don't put too much of the cash back in, you're OK. But if you go $1 more than what's acceptable, it's all going to blow up. We just don't have that level of detail right now.

Stephanie Cumings: Under the rules, investors generally have 180 days to invest eligible gains in a fund, but there's some special rules for partnerships and S corps. Can you tell us about those?

Tony Nitti: Sure. These are largely born out of common sense. A partnership or S corp — first of all, let's make sure we understand they can be their own eligible entities and defer gain directly into a Qualified Opportunity Zone. A partnership or S corp can sell assets and just say, "Hey, we're going to make the decision at the entity level to defer this gain into a zone." All the partners and shareholders are stuck with that treatment.

Much more likely, however, what ends up happening is the partnership or S corp recognizes gain and says, "We're going to allocate that gain out to our owners and let each of them independently decide whether they want to defer." The problem that then arises is this 180-day window. What if the partnership sells its assets on January 5, 2020? You're a partner, but you aren't even going to know you necessarily have that gain until maybe you get a K-1 in February, March, or April of 2021. 

The final regulations basically say the default treatment when a partnership or S corporation allocates gain out to the owners, the 180-day period, regardless of when the partnership or S corp may have sold its assets, will begin on the last day of the partnership or S corp's tax years. Call it December 31, 2020, in our example. There are two elections that you can take to modify that. No. 1, maybe you're a partner or a shareholder, and you know the partnership or S corp sold the asset on January 5, 2020. You don't want to wait until the end of the year. You want to put your money in right away. You like this investment quite a bit. You can elect to start the 180-day period on that January 5, 2020 date as long as you have actual knowledge of what your gain amount is.

What the final regs did is say, "Take it to the other extreme." Maybe the partnership doesn't get you your K-1 until May or June of 2021. You can now elect to start the 180-day period on the unextended due date of the partnership or S corp's tax return. That would kick the period all the way back to beginning on March 15, 2021, which would buy another six months after that date. We have a lot of flexibility now. 

Stephanie Cumings: The program's biggest benefit comes at the end of 10 years, when certain gains can be excluded from taxation altogether. There were some major changes and clarifications in the final rules about how this works. Could you talk about that?

Tony Nitti: This has evolved over the regulations to become more and more taxpayerfriendly. The reason I say that is because originally the way the statute laid out your options, basically after 10 years, you had to sell your equity stake in the Qualified Opportunity Fund, and that could become tricky. Buyers typically don't want to buy equity. They want to buy assets, particularly in real estate deals, because they want to get a stepped-up fair market value basis and take depreciation deductions.

The regulations have certainly acknowledged that after 10 years, the big carrot that's being dangled here is tax-free gain. But if you can only get it upon a sale of equity, some people could be hamstrung. The proposed regulations said, "OK, a Qualified Opportunity Fund could, instead, sell its assets. But you could elect to exclude from those asset sales any kind of capital gain resulting from the sale only of Qualified Opportunity Zone business property." 

If you had some property outside the zone that wasn't qualifying, or if you had ordinary income depreciation recapture, which is very likely, you would end up paying tax on it if the QOF sold its assets versus if you were able to sell your equity.

The final regulations are much more friendly. They basically say,"The QOF sells its assets. Even if the QOZB subsidiary of a QOF sells its asset, you can elect to ignore and exclude all of the gain that flows through to you other than ordinary income, specifically from the sale of property held for sale to customers in the ordinary course of business." Or what we refer to as inventory. Now you'd be protected from depreciation recapture. You'd be protected if you sold non-qualifying assets. Upon asset sale, the only way you're going to get punished relative to an equity sale would be gain attributable to inventory. That's much more friendly than under previous rules.

Stephanie Cumings: The regs also provide that in order for property to be good property, for the purposes of the program, the original use of the property must have commenced with the fund or the fund must have substantially improved the property. The final rules made some changes about improving property. Can you talk about that?

Tony Nitti: This is where we're seeing some people almost paralyzed by how much new guidance there is. When you stop and take a step back— these requirements that to be qualified property— it either has to be property that's never before been placed in service in the zone, what we call the original use test, or be substantially improved makes sense. They want to encourage development and new investment into a zone that leaves the residents of that zone better than when the investors got there.

What you can't do in a fund is simply buy an existing rental property, maintain the status quo, and think you're going to get any of these benefits. That's not going to satisfy either of those tests. 

Substantial improvement requires that you double the basis of that property over a 30-month period. Let's say I buy a land and building for $1 million, with $400,000 allocated to the land and $600,000 allocated to the building. I have 30 months to spend another $600,001 improving the building, and that's a big ask.

From my experience that's a question you ask people to weed out who's really serious about investing in an O-Zone. You make clear to them that they have to either buy something or create something new or double the cost of something they buy. A lot of people shy away and say, "That's more than I have the appetite."

But meeting this substantial improvement test got a lot easier a couple of different ways under the final regulations. Number one, they recognize doubling the basis can be difficult.

Let's say you buy a hotel that you want to renovate. You spend $600,000 on the hotel. You have to spend another $600,000 renovating it. Instead of simply improving the hotel to the tune of $600,000, the final regs will allow you to count towards that substantial improvement requirement new assets that you purchased that helped facilitate the use of the hotel. Maybe you only spend $300,000 improving the hotel, the other $300,000 you spend on mattresses and gym equipment and furniture and fixtures for the hotel. You don't have to actually build out new walls and roofs. You could buy other assets that stand on their own as assets, but that will count towards a substantial improvement test. That is a big, big accommodation for a lot of taxpayers.

Another way things got easier under the substantial improvement test is if you own multiple buildings on one plot of land inside a zone. Let's say one of them you bought for $200,000 and the other one you bought for $300,000. You'd have the requirement that you improve them to the tune of half a million dollars over 30 months. But they would allow you to aggregate the buildings together. You wouldn't necessarily have to double the basis of each building specifically. You would need to double the basis of both buildings combined. If one building was in far worse shape than the other, you could spend a lot of money on the one building and that would count towards substantially improving the other building.

The final thing we got that's most noteworthy about the substantial improvement rules is about improving property. A lot of people worried about this. What if we buy that building for $600,000? Obviously it doesn't pass the original use test. We just have a $600,000 bad asset sitting on our books for purposes of satisfying the requirement that 90 percent of your assets be qualifying assets until it's improved.

The final regulations make clear that once you start substantially improving that $600,000 building, that building will count as qualifying property throughout that 30-month period. That's a huge sense of relief to a lot of taxpayers. Otherwise they thought they were going to be paying a penalty until the 30-month period was over.

But it's not all good news. There's one bit of bad news in the final regulations about substantial improvement. This took some people by surprise. They said, "If you substantially improved non-qualifying property, those substantial improvements don't do you any good. They don't count either."

If somebody had contributed an old building into the fund, then you spend a bunch of money improving that building. Because you're improving a building that can't qualify by that definition, as it wasn't acquired via purchase, all that time you spend improving is for naught because those costs are never going to count as eligible property. It leaves a bit of ambiguity. We know you can't substantially improve a disqualifying building and have it qualify.

But what if someone contributes land into a QOF? Again, contributed property is never qualifying property. But someone contributes land in, and then you construct a building on it. Is that going to be punished under that same set of rules? Or is that more forgiving?

My belief is that it will be more forgiving, because if you construct a building on raw land, you're not technically improving that land. You're creating new building. I think in that situation, the building would not be tainted just because the land was not a qualifying asset. Taxpayers are out there worried and wondering about it.

Stephanie Cumings: To go back to that original use requirement, there are also rules about vacant buildings and how long they have to be vacant. There were some changes in the final rules about that. 

Tony Nitti: Taxpayers always want to get the benefit of some of these incentive provisions while doing the least amount possible. If you are going to go into an Opportunity Zone and purchase a building that hasn't been open to the public for a number of years, you're going to say, "Wait a minute. If I slap some paint on it and get it back into service, I'm doing some good for the area. Why shouldn't that count?" By definition, it's not going to meet the original use test.

The proposed regs said, "If you want to hit the restart button on a building that's previously been placed in service, we'll allow you to treat a building as being newly placed in service if it sat vacant for five full years." That's kind of a big ask, because five years is a long time.

The final regulations give us some additional flexibility. They say, "Look at the date that this zone that you're in was designated as a zone. If a building was already vacant for one year on that date, then as long as it's still vacant when you acquire it, you can slap some paint on it, put it into service, and it'll satisfy the original use test. If it wasn't already vacant for a year on the date that the zone was designated, then you've got to sit back and wait for the building to be vacant for a total of three years before you can place it into service." But that's still better than five.

Stephanie Cumings: Obviously a lot of rules in these regulations. Are there any significant issues you think were left unresolved by the final regs? Or do you think it's just a matter of people digesting and understanding the rules that we have?

Tony Nitti: No. I think the industry as a whole would tell you there's still some major things out there that are unclear, and some of them, the IRS concedes to. For example, we don't have an answer yet to what is probably the most important fundamental question of all of this. We know that to be eligible for those benefits, we have to meet the spirit of the law, which means the fund is investing in a business that's operated inside a zone. The way that's measured is by the fund's assets, or 90 percent of its assets held in qualifying property every six months. If they're not, you pay a penalty.

But what no one has said yet is when is enough enough? When have you failed the 90 percent test so much, so egregiously, that we blow up all of this and you don't get any of your benefits? That spooks taxpayers quite a bit because they're like, "Who's to say I can't just fail the 90 percent test every six months for 10 years, but still get my benefit after 10 years?"

The answer right now is we have no idea. No one has told us that. The IRS has acknowledged that. We don't know when they're going to tell us, but it seems like a fairly important thing to let us know about.

From a more practical perspective, though, there's still so much confusion about certain things in terms of what counts as qualifying assets and what doesn't. You buy an old building for $600,000 and start improving it. We know you've got to spend another $600,000 to improve it, and the regs say once you start improving it, that old building will count as a qualifying asset. But what about the cash that is sitting around? The other $600,000 that you're slowly but surely using to renovate the building. Does the cash count? Is it treated as qualifying property? Is it not? It's not perfectly clear in the regulations. 

A lot of people still have some fundamental questions about whether what they're doing is going to be OK. It's kind of a weird thing where we went from having no guidance to so much guidance that we're kind of back to still not understanding what to do about anything.

Stephanie Cumings: There have also been some criticisms of the program in the mainstream press and from other people about how maybe it won't help low-income communities the way it's intended to. I was wondering if you had any thoughts on that. Also if you think the IRS is really in a position to do anything about that through guidance?

Tony Nitti: I think the IRS has pretty much given orders to kind of stand down on this, and I joke about that. As Opportunity Zones evolved in the legislation, there were going to be requirements that a lot of this be tracked. This is not unique. Incentives like this, spurring people to invest in low-income areas, it's been done before. There's a lot of questions about whether it's ever been effective and whether the lives of the residents have actually been improved or if all of these things simply lead to gentrification.

There had been some requirements in the proposed legislation about tracking this because I think tax policy experts and economists are all very curious. But all of those tracking metrics were removed as part of the final legislation. 

We are already seeing a ton of criticism about the zones as far as where the zones were designated. The idea that these are all low-income areas is clearly not what's become the reality. There's no shortage of articles that have been published about specific areas, whether it's in Michigan or in Miami, where areas that probably did not need this type of investment were designated as Opportunity Zones for political reasons or whatever it may be. You've got questions on the front end. Are these really the most deserving areas that have been designated? You're going to have a lot of questions on the back end, which is what really happened after the life cycle. Was it something which a handful of people got very, very, very wealthy by doing what they were otherwise going to do, develop property in low-income areas? Or was this something where the incentive worked and enough people did something they wouldn't normally do and invested in these areas and created new opportunities, new businesses, and new housing.

People are very interested in tracking this. It's just something where the metrics required to do so aren't in place. I'm not sure if a decade from now we're going to be any wiser about whether these incentives really work.

Stephanie Cumings: I'm curious. Have you or do you plan to invest in a Qualified Opportunity Fund?

Tony Nitti: From a personal perspective? No. I'm still socking money away for the kid's college fund. There's no Opportunity Zone incentive coming down the pipe for me. Again, this is probably for a different class of taxpayer than I am currently residing in.

The more interesting discussion is my clients. They're so quick to say this doesn't work for me for one reason or another. I know from talking to people around the country that that has been the experience of many around the industry. That for all the attention given to Opportunity Zones, we're still trying to figure out where all of this is actually happening.

I've spoken to thousands of people at different conferences about Opportunity Zones and have yet to talk to anyone who says, "I've got a ton of clients doing this." Everybody's got one or two, and I've certainly got more than that. But by and large a lot of people learned about the incentive, explained it to their clients, and found that for whatever reason, location, the rules, 10-year holding period requirement. The clients just say, "You know, there's better uses of our money."

It's been fascinating for me because I've devoted tens of thousands of word in written and spoken forms to this incentive, but do not have clients clamoring to move forward with it.

Stephanie Cumings: It's incredibly complicated and a very interesting subject. I'm sure we're going to continue to talk about it for months and years to come. Tony, thank you so much for being on the podcast. We really appreciate it, and I know our listeners appreciate it.

Tony Nitti: Thank you for having me. I appreciate the opportunity to talk.

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