Novogradac Asks IRS to Address Issues With Final O-Zone Regs

February 18, 2020

Office of Associate Chief Counsel (Income Tax and Accounting)
Attention: Julie Hanlon-Bolton, Kyle Griffin, and Robin Tuczak
Internal Revenue Service (IRS)
1111 Constitution Avenue, NW
Washington, D.C. 20224

CC:PA:LPD:PR
(TD 9889)
Room 5203
Internal Revenue Service
P.O. Box 7604
Ben Franklin Station
Washington, D.C. 20044

Re: Comments on TD 9889: Investing in Qualified Opportunity Funds

Dear Ms. Hanlon-Bolton, Mr. Griffin, and Ms. Tuczak:

On behalf of the members of the Novogradac Opportunity Zones Working Group (the “OZ Working Group”), we comment on the final regulations provided in TD 9889: Investing in Qualified Opportunity Funds (the “Regulations”).

We applaud the extraordinary efforts of the Department of Treasury (Treasury) and the IRS in issuing the Regulations before the end of 2019. We are encouraged by the development of the Regulations, and appreciate the time, thought, and care that went into drafting them.

In the attached memorandum we identify a few issues arising under the Regulations and recommend solutions that can be addressed by either a technical correction to the Regulations or supplemental guidance from Treasury or the IRS.

The OZ Working Group includes various participants in community development finance: investors; lenders; for-profit and nonprofit developers; community development financial institutions; trade organizations; and other related professionals. Our comments represent collective input from these stakeholders as to how to make OZ incentives more impactful to low-income communities.

Our sincere thanks for your consideration of our comments. We are available to provide additional insight and background regarding our comments, and welcome the opportunity to do so, should you wish.

Very truly yours,

Novogradac & Company LLP

By Michael J. Novogradac, Managing Partner

By John S. Sciarretti, Partner

Opportunity Zones Working Group
Dover, OH

CC:
Michael Novey, Office of Tax Policy, Treasury
John Moriarty, Associate Chief Counsel

Attachments:

Comments on TD 9889: Investing in Qualified Opportunity Funds (Guidance Under §1400Z-2)

Novogradac OZ Working Group:
Final Regulations Issues and Recommendations

---

Table of Contents

I. General Considerations

II. QOF Considerations

III. QOZB Considerations

IV. QOZBP Considerations

---

I. General Considerations

A. All-or-none application of the final or proposed regulations

Issues

Whether taxpayers can choose to apply some, but not all, sections of the final and/or proposed regulations.

Whether every taxpayer that is party to the same transaction must apply the same regulations during the transition period.

Discussion

The final regulations are effective on March 13, 2020 and are generally applicable to taxable years beginning after that date. However, taxpayers can choose early application of the final regulations if applied in a consistent manner for all such taxable years. Taxpayers may also choose to rely on proposed regulations for taxable years beginning after December 21, 2017 and on or before March 13, 2020 (the “early application period”), but only if relied upon in a consistent manner for all such taxable years.¹ Taxpayers do not appear to have the option to rely on the proposed regulations published October 29, 2018, unless they also incorporate the May 1, 2019, updates to the proposed regulations. Taxpayers also have the option to not apply the final or proposed regulations and to make reasonable and good faith interpretations of the OZ statute.

While the language in the final regulations provides that consistent application is necessary, it is unclear whether taxpayers can pick and choose to apply some sections of the final and/or proposed regulations during the early application period without applying them in their entirety. It is also unclear whether all taxpayers that are party to the same transaction must choose to apply the same regulations during the early application period. For example, if a taxpayer chooses to apply final regulations during the early application period with respect to an eligible investment in a qualified opportunity fund (“QOF”), does this require the QOF to also rely on final regulations in their entirety during the early application period? If a QOF chooses to apply final regulations during the early application period with respect to a qualifying investment in a qualified opportunity zone business (“QOZB”), does an unrelated QOF, also investing in the same QOZB, need to apply final regulations during the early application period?

Recommendation

We recommend the IRS confirm, in the form of a frequently asked question (FAQ), that a section-by-section application of the final regulations, proposed regulations or reasonable and good faith interpretation of the OZ statute is permissible.

We also recommend that the IRS confirm that the rules apply on a taxpayer basis, so that each investor in a QOF, each QOF and each QOZB can determine separately how to apply a section-by-section application of the final regulations, proposed regulations or reasonable and good faith interpretation of the OZ statute.

II. QOF Considerations

A. Gains from sales or exchanges with QOFs or QOZBs

Issue

To what extent, if at all, an investor can sell property to a QOF or QOZB, contribute cash equal to the gain on the sale to the QOF, and treat the gain as “eligible gain” and the QOF or QOZB treat the purchase as a purchase from an unrelated party.

Discussion

Qualified opportunity zone business property (“QOZBP”) does not include property that is purchased by a QOF or QOZB from a related party, or property that is contributed to a QOF or QOZB in a tax-free transfer under sections 351 or 721. Commentators requested guidance as to what extent, if at all, an investor could sell property to a QOF or QOZB, contribute cash equal to the gain on the sale to the QOF followed by an investment in a QOZB in an indirect structure, and treat the gain as “eligible gain” and the QOF or QOZB treat the purchase as a purchase from an unrelated party.

The preamble to the Regulations warns that if the transaction described above were successfully challenged under the step transaction doctrine and circular cash flow principles, the transaction would be treated for Federal income tax purposes as a transfer of property to the purchasing QOF for an interest therein or, if applicable, as a transfer of property to a QOF for an interest therein followed by a transfer of such property by the QOF to the purchasing QOZB. In either case, the investor would not be treated as investing eligible gain in the QOF, and the property would not be QOZBP.² There is confusion as to whether this could be the result regardless of whether the taxpayer became related to the QOF following its investment in the QOF because the preamble discussion does not address whether the taxpayer became related. Although the preamble discussion does make reference to an example in the anti-abuse section of the Regulations whereby the taxpayer does become related following its investment.³ This example implies that the transaction was not valid only because of the unitary plan to become related.

We wouldn't expect the Regulations to adopt an absolute standard where no property sales can occur between a taxpayer and a QOF or its QOZB followed by investment of cash from that gain in the QOF regardless of whether or not the investor became related. Both the step transaction doctrine and circular cash flow principles are generally not applied if a step has independent economic significance, is not a sham, and was undertaken for a valid business purpose. Property sales can occur between a taxpayer and a QOF or its QOZB with valid business purpose and independent economic significance that is different from the taxpayer's following investment in the QOF. For example, consider a sale by a taxpayer of non-zero basis property to a QOZB where only the gain dollars (not the total purchase price) are invested by the taxpayer in an unrelated QOF interest following the sale. Would this partial investment also be ineligible? Would only part of the asset be treated as contributed to the QOZB or would the total asset be treated as contributed with a deemed distribution of the proceeds not invested in the QOF?

Recommendation

Given that the step transaction and circular cash flow principles are generally not applied if a transaction has independent economic significance, we recommend that IRS and Treasury confirm through a technical correction to the preamble that an investor can sell property to a QOF or QOZB, contribute an amount equal to the gain on the sale to the QOF, which may or may not be followed by an investment of that amount by the QOF in a QOZB, and treat the gain as “eligible gain” and the QOF or QOZB purchase as a purchase from an unrelated party so long as the selling partner is not a related party after contributing gain to the QOF and each transaction is treated as a separate transaction and not a component of an overall plan to make a cash contribution of the sales proceeds to the QOF under the step transaction doctrine and circular cash flow principles.

B. Option to disregard recently contributed property

Issue

Whether QOFs choosing to disregard recently contributed property can also exclude earnings on temporarily invested contributions and capitalized costs associated with the organization and start-up of the QOF.

Discussion

QOFs choosing to disregard recently contributed property and having no other qualified investments are likely to fail the 90-percent test due to: (1) the deposit of earnings on permitted temporarily invested contributions; and, (2) capitalized costs associated with the organization and start-up of the QOF. The preamble to the Regulations provides that organizational and start-up costs do not result in QOF assets cognizable for Federal income tax purposes and therefore are not taken into account for purposes of the 90-percent standard.⁴

Recommendation

We recommend that IRS and Treasury provide an FAQ and additional Form 8996 instructions confirming that QOFs are also permitted to exclude from the numerator and denominator: (1) the deposit of earnings on permitted temporarily invested contributions during the period that begins not more than 6 months before the test from which the contribution is being excluded; and, (2) capitalized costs associated with the organization and start-up of the QOF that occurred not more than 6 months before the test from which they are being excluded. The FAQ and Instructions should also provide an exception for situations where all of a QOF's assets are permitted to be excluded, resulting in a fraction that is undefined.

C. Valuing QOZB interests

Issue

Whether a QOF investment in a QOZB is a “purchase” qualifying for the alternative valuation method.

Discussion

The preamble to the Regulations provides that the alternative valuation method may be used to value only assets owned by a QOF that are acquired by purchase or constructed for fair market value. In such instances, the QOF's unadjusted cost basis of the asset is generally determined under section 1012 or section 1013 (with regard to inventory). Otherwise, the value of each asset owned by a QOF that is not purchased or constructed for fair market value equals the asset's fair market value.⁵ There is confusion whether the acquisition of qualified opportunity zone stock or a qualified opportunity zone partnership interest, which by definition would need to be at original issue, is considered an acquisition by purchase that can be valued under the alternative valuation method. If it is not considered an acquisition by purchase, then the fair market value needs to be determined on the last day of the first six month period and on the last day of the taxable year. This would be costly and burdensome for QOFs.

We note that under IRC Section 1045 — Rollover of gain from qualified small business stock, acquisition of original-issue small business stock is considered a purchase, the unadjusted basis of which in the hands of the taxpayer before deferral adjustments is its cost within the meaning of section 1012.⁶ By analogy, a QOF investment in a QOZB partnership or corporation should be considered a purchase for purpose of using the alternative valuation method.

Recommendation

We recommend that IRS and Treasury confirm that the acquisition of qualified opportunity zone stock or a qualified opportunity zone partnership interest, which by definition would need to be at original issue, is considered an acquisition by purchase that can be valued under the alternative valuation method.

III. QOZB Considerations

A. “Infusion of working capital assets”

Issue

Whether the phrase “infusion of working capital assets” includes contributions from debt and non-QOF equity.

Discussion

To qualify for multiple 31-month safe harbors (with a maximum of 62 months for the first safe harbor), a business must receive multiple non-de minimis cash infusions during each 31-month safe harbor period. Upon receipt of a subsequent cash infusion, a business can extend the original 31-month safe harbor period that covered the initial cash infusion and receive the benefit of an additional 31-month period, for a total of 62 months provided certain requirements are met. Neither the Regulations nor the preamble define what is included in the phrase “infusions of working capital assets.” As a result, there is some confusion as to whether QOZBs can source subsequent infusions of working capital through debt or non-QOF equity and still qualify for the extended safe harbor.

We note that one of the purposes of the safe harbor is to allow QOZBs to hold cash needed to develop the business. Such cash will not always come from QOF equity contributions. The operational needs of QOZBs dictate the need for the safe harbor to apply to all cash infused into a QOZB, not just that from QOF equity.

The preamble provides the following response to a commentator's request to provide a new safe harbor to cover debt-financed work-in-progress projects:

“The Treasury Department and the IRS appreciate the commenter's recommendation and are sympathetic to the commenter's concern regarding the existing business practice of using debt to finance construction. However, section 1397C(e) clearly treats as NQFP any debt with a term greater than 18 months. Based on the text of section 1397C(e), the final regulations do not adopt the commenter's request to provide a special safe harbor for debt-financed construction projects.”⁷

This response has created confusion because debt covered under section 1397C(e) addresses monies lent, not monies borrowed, which is the focus of commenter's request.

Recommendation

Because it is very common for QOZBs to receive and hold cash from multiple sources including debt and non-QOF equity, cash which is intended to be used to finance construction and other purchases, we recommend that the IRS confirm through an FAQ or a technical correction to the preamble that the phrase “infusion of working capital assets” includes contributions from debt and non-QOF equity.

B. Treatment of working capital assets as QOZBP

Issue

Whether cash and cash equivalents (including debt instruments with a term of 18 months or less), held as reasonable working capital and expected to be spent on QOZBP pursuant to the written plan, can be treated as QOZBP during the safe harbor period.

Discussion

The preamble does not appear to be consistent with the Regulations regarding the treatment of cash or cash equivalents held as reasonable working capital for purposes of the 70-percent tangible property standard.

The preamble suggests in a couple of places that cash and cash equivalents held as reasonable working capital and expected to be spent on QOZBP pursuant to the written plan can be treated as QOZBP during the safe harbor period.⁸

Conversely, one interpretation of the Regulations is that cash and cash equivalents held as reasonable working capital are not treated as QOZBP until they are spent on tangible property pursuant to the written plan.⁹

Allowing cash and cash equivalents, held as reasonable working capital and expected to be spent on QOZBP pursuant to the written plan, to be treated as QOZBP will increase the number of businesses that qualify for qualified opportunity zone (“QOZ”) financing. This is especially so in the case of existing QOZBs that have a temporary imbalance of nonqualified tangible property (due to legacy assets purchased before 2018) until working capital assets are spent on qualified tangible property during the safe harbor period pursuant to their written plan. For example, assume P, an existing business looking to expand, already holds $250 of tangible property that is not QOZBP because the property was purchased before 2018, and P holds no other tangible property. During 2020, P receives $750 of working capital from a QOF for expansion purposes that P expects to spend on QOZBP pursuant to a written plan during the following 31 months. If the cash reserved for the purchase of QOZBP and held by the QOZB can be treated as QOZBP, then P is expected to continuously satisfy the 70-percent tangible property standard over the working capital safe harbor period. Otherwise, P will not comply with the standard and therefore not qualify as a QOZB until at least $600 is spent on QOZBP. This will make it difficult for both existing businesses looking to meaningfully expand and current owners of real estate developing impactful projects to use this incentive.

Recommendation

Treasury and IRS should correct Treas. Reg. §1.1400Z2(d)-1(d)(3)(viii) for consistency with the preamble to confirm that cash held as reasonable working capital and expected to be spent on QOZBP pursuant to the written plan is treated as QOZBP as follows:

Treas. Reg. §1.1400Z2(d)-1(d)(3)(viii): “. . . if the tangible property referred to in paragraph (d)(3)(v)(A) is expected to satisfy the requirements of section 1400Z-2(d)(2)(D)(i) as a result of the planned expenditure of those working capital assets, then working capital assets designated to be spent on tangible property purchased, leased, or improved by the trade or business, pursuant to the written plan for the expenditure of the working capital assets and the associated expenditures, is are treated as qualified opportunity zone business property . . .”

IV. QOZBP Considerations

A. Treatment of non-original use property during the substantial improvement period

Issue

Whether non-original use property undergoing substantial improvement is deemed QOZBP for a QOZB during the substantial improvement period.

Discussion

The preamble provides that unimproved property is deemed QOZBP during the substantial improvement period for both QOFs and QOZBs.¹⁰ The Regulations only refer to QOFs in this respect.¹¹

Recommendation

We recommend the following technical correction to the Regulations to clarify that unimproved property is deemed QOZBP during the substantial improvement period for both QOFs and QOZBs.

Treas. Reg. §1.1400Z2(d)-2(b)(4)(ii): “For purposes of the 90-percent investment standard and the 70-percent tangible property standard under section 1400Z-2(d)(1), tangible property purchased, leased, or improved by a trade or business that is undergoing the substantial improvement process but has not yet been placed in service by the eligible entity or used in the eligible entity's trade or business is treated as satisfying the requirements of section 1400Z-2(d)(2)(D)(i) and paragraph (b)(2) of this section for the 30-month substantial improvement period. . . .”

B. Additions to non-qualified property

Issue

Whether additions made to non-qualified tangible property used in a QOZ satisfy the original use requirement as purchased property.

Discussion

The preamble to the Regulations provides that the Regulations do not adopt a commenter's recommendation that improvements made to non-qualified property used in a QOZ satisfies the original-use requirement as purchased property, even though this treatment is expressly provided for in the Regulations for leasehold improvements. Treasury's reason hinges on additional administrative burdens that would arise for taxpayers and the IRS from tracking such improvements to non-qualified property.¹²

Similar to leasehold improvements, a taxpayer generally must separately track and capitalize direct and allocable indirect amounts paid to improve a unit of property owned by the taxpayer.¹³ Accordingly, there is no additional administrative burden from tracking these improvements. Treasury and IRS should provide that tangible property improvements made to non-qualified property are not disqualified from constituting QOZBP similar to the rules provided for leasehold improvements and other self-constructed property.

Recommendation

We recommend that IRS and Treasury make a correction to the preamble and/or publish an FAQ confirming that additions made to non-qualified tangible property used in a QOZ satisfy the original use requirement as purchased property.

C. Treatment of related party additions to basis

Issue

Whether reasonable capitalized fees paid to a related party are treated as: (1) a qualified addition to the basis of QOZBP; (2) a non-qualified addition to basis of QOZBP; or, (3) disqualifying the entire property.

Discussion

It is common in real estate development for an affiliate of the owner of a real estate project to also be the developer and/or general contractor for that project. Payments by a project owner to an affiliated general contractor are primarily used by the general contractor to pay unrelated subcontractors for property and services provided to the general contractor for the benefit of the project owner. A portion of the payments are also retained by the general contractor for reasonable profit, overhead and general requirements of the general contractor. An affiliated general contractor will often be related to the project owner within the meaning of section 179(d)(2) as modified by section 1400Z-2(e)(2).

Neither the Regulations nor the preamble specifies the treatment of reasonable capitalized fees paid to a related party. Guidance under section 179 suggests that a proportional approach to qualification is permitted based upon a regulatory example where a purchase by husband and wife from husband's father only taints the share of property purchased by husband.¹⁴ Similarly, under Go-Zone incentive guidance, special bonus depreciation was allowed proportionally when a real property was used for both a prohibited activity and a non-prohibited activity.¹⁵

In addition, the Regulations should include a safe harbor where self-constructed property is treated as purchased from an unrelated party in its entirety as long as related party fees, and profit, overhead and general requirements of a related general contractor do not exceed 20 percent of the unadjusted cost basis of the property. Such a rule is similar to the bonus depreciation rules where property that contains used parts will not be treated as reconditioned or rebuilt if the cost of the used parts is not more than 20 percent of the total cost of the property, whether acquired or self-constructed.¹⁶

Recommendation

We recommend that IRS and Treasury provide a safe harbor permitting self-constructed property to be treated as purchased from an unrelated party in its entirety as long as related party fees and profit, overhead and general requirements of a related general contractor do not exceed 20 percent of the unadjusted cost basis of the property. In the event that related party fees and profit, overhead, and general requirements of the general contractor exceed 20 percent, the entire amount of related party expenditures capitalized should be considered non-qualified additions to basis.