The final regulations on Opportunity Zones adopted several suggestions from taxpayers, including more flexible rules on gains from the sale of business property.
“The final regulations allow a taxpayer to invest the entire amount of gains from such sales without regard to losses and change the beginning of the investment period from the end of the year to the date of the sale of each asset,” according to a December 19 Treasury release issued along with the final rules (T.D. 9889).
The Opportunity Zone program, created by the Tax Cuts and Jobs Act, allows for the deferral, reduction, and in some cases, elimination of capital gains tax by investing in qualified opportunity funds.
The treatment of section 1231 gains was one of the biggest complaints among practitioners. The second set of proposed regulations (REG-120186-18) only permitted the investment of net gains and required the 180-day investment period to begin on the last day of the investor’s tax year. The first set of proposed regs (REG-115420-18) from October 2018 is also included in the final regs.
The changes to section 1231 gains in the final rules should make the process of investing those gains less complicated, a senior Treasury official said during a press call.
Cleaner Rules
Another major win for investors is that gains can be excluded from tax when property is sold at the subsidiary Opportunity Zone business level rather than requiring it to be sold at the fund level.
“However, the amount of gain from such a QOF’s or its [Opportunity Zone business’s] asset sales that an investor in the QOF may elect to exclude each year will reduce the amount of the investor’s interest in the QOF that remains a qualifying investment,” the Treasury statement said.
Investors and practitioners argued that the proposed rule requiring an interest to be sold at the fund level didn’t reflect the realities of business practices. The new approach will allow gains to flow up from the subsidiary to investors, which should be well received by taxpayers, the Treasury official said.
“The final regulations address many of the areas we thought needed clarity or a change in guidance,” Michael J. Novogradac of Novogradac & Co. LLP told Tax Notes. Novogradac said there’s a lot to consider in the 544-page reg package, but so far, he’s pleased with the many positive changes, including the treatment of corporations filing consolidated returns, changes to the vacant property rule, and the treatment of sales of business assets.
John W. Lettieri of the Economic Innovation Group, which was involved in developing the Opportunity Zone program, also praised the changes in the regs. He said the changes to section 1231 gains would unlock capital and help to achieve Congress’s purpose.
Lettieri also said that by allowing a more sensible unwinding of funds than the proposed regulations had permitted, the final regs will make it easier to create multi-asset funds and provide for cleaner exits from funds. “It’s a much cleaner standard,” he said.
Triple Net Leases
Triple net leases were another area in which practitioners had concerns. Under the proposed regs, leasing real property is considered the active conduct of a trade or business, but the regs add that “merely entering into a triple-net-lease with respect to real property owned by a taxpayer is not the active conduct of a trade or business by such taxpayer.” An official acknowledged in October at an American Bar Association event that the IRS was hoping to provide more clarity in the final rules.
The final regs confirm the earlier view, but the IRS agreed that in some cases, a taxpayer that utilizes a triple net lease as part of its business could be treated as conducting an active trade or business.
“Accordingly, the final regulations provide an example in which a lessor leases a three-story mixed-use building to three tenants, each of which rents a single floor,” the regs state. “In that example, (i) the lessor leases one floor of the building under a triple-net-lease, but leases the remaining two floors under leases that do not constitute triple-net-leases, and (ii) the employees of the lessor meaningfully participate in the management and operations of those two floors.”
Under that example, the lessor would be treated as engaged in an active trade or business with respect to the entire building for the purposes of section 1400Z-2(d)(3)(A).
Other Changes
The final rules also provide clarification about what kinds of gains can be invested and when, including addressing concerns about the timing of Schedules K-1.
The regs allow for some aggregation of property for purposes of the substantial improvement test and also reduce the vacancy requirement from five years to three years, and in some cases, as little as one year.
The leasing rules also received several changes, including that leases between unrelated parties are presumed to be at market rate. The regs also provide clarifications on the working capital safe harbor and attempt to clarify when intangible property is considered used in an Opportunity Zone.
Consolidated groups can also elect to treat a lower-tier opportunity fund C corporation as a member of the group in specific circumstances under the final rules.