Florida Firm Raises 4 Issues With Proposed QOF Regs

June 7, 2019

Ms. Julie Hanlon-Bolton
CC:PA:LPD:PR (REG-120186-18),
Room 5203, Internal Revenue Service,
PO Box 7604, Ben Franklin Station
Washington, DC 20044

Dear Ms. Hanlon-Bolton:

Below are four comments on the proposed QOF regulations that, during our preparation for a recent panel discussion, you suggested that I submit for IRS consideration:

Newly Built QOZ Real Estate Purchased Directly from Developer

It would be helpful if an illustration to Prop. Reg. sec. 1.1400Z2(d)-1(c)(7)(i) was inserted to confirm that a condominium, townhouse, single family house, or other building or interest in a building, which was newly built on vacant land by a developer within a QOZ, and which was held for sale by that developer to customers in the ordinary course of business until its sale to a QOF or QOZB, was not "used" by the developer, and thus need not be substantially improved by the QOF or QOZB purchaser from that developer in order to be QOZBP. Such favorable original user treatment of the purchasing QOF and QOZB would be consistent with the IRS position, treating the buyer, not the builder, of manufactured property, as the original user, in Treas. Reg. sec. 1.168(k)-1(b)(3)(v) Example (2), Rev. Rul. 69-272, 1969-1 C.B. 23, and Ltr. Rul. 200502004. See also Ltr. Rul. 8349023.

Besides favorably promoting QOZ economic activity by condominium and other dealer-developers, and thereby creating construction and maintenance jobs and rental housing stock within QOZs, such a rule could attract capital from middle class investors at low transaction costs. For example, a single investor could form a QOF or QOZB that would buy one or more condominiums in a QOZ for rental.¹

Conversion of Personal Residences to Business Use

There is an ambiguity in Prop. Reg. sec. 1.1400Z2(d)-1(c)(7)(i), which states "the original use of tangible property in a qualified opportunity zone commences on the date any person first places the property in service in the qualified opportunity zone for purposes of depreciation," as to whether only prior depreciable use is considered. Prior "original use" triggers the necessity for substantial rehabilitation to qualify as QOZBP. Prop. Reg. sec. 1.1400Z2(d)-1(c)(7)(i) should clarify whether placement in service for non-depreciable use, such as an owner-occupied home, triggers a prior placement in service, and thus requires substantial rehabilitation.

It appears, based on analogous wording in CCA 201211011, that it was intended that prior placement in service for non-depreciable use triggers the substantial rehabilitation requirement. CCA 201211011 states that for "'placed in service' . . . for purposes of depreciation . . . see. Rev. Rul. 84-23, 1984-1 C.B. 38." Rev. Rul. 84-23 held that a building purchased and used as an owner-occupied house, and then converted to depreciable rental use four years later, was placed in service when first used as an owner-occupied house four years earlier.

Policy considerations point in different directions. Conversion of an owner-occupied house into a professional office, store, restaurant, or even a rental property, could be viewed as enhancing the economic activity within a QOZ, even with no substantial rehabilitation.

On the other hand, there is no evident policy reason to waive the substantial rehabilitation requirement. Moreover, since Rev. Rul. 2018-29 considers pre-2018, pre-QOF-designation, years in determining whether a building is used property, it may be difficult to establish with certainty that there has never been any pre-acquisition disqualifying depreciable use. For example, the city of St. Augustine, Florida was founded in 1565.² Depreciation has existed in the Internal Revenue Code since 1909.³ If a QOF was to buy a very old house in St. Augustine in 2020, would the QOF have to prove no disqualifying depreciable use since 1565? Since 1909? Or would the 5 year window for non-use be sufficient?

Section 1231 Gains

Prop. Reg. sec. 1.1400Z2(a)-1(b)(2)(iii) (2019) introduced for the first time the concept that Section 1231 gains recognized during calendar year 2018 could not support purchase of an eligible interest in a QOF between January 1, 2018 and December 30, 2018. Many, perhaps most, QOFs funded during 2018, particularly real estate QOFs, had already issued what their investors thought were eligible interests. They relied on the statutory language of Sec. 1400Z-2(a)(1)(A), which required the eligible interest in a QOF to be funded by reference to gains from a sale or exchange within the 180 preceding days.

Section 1400Z-2 is designed to attract capital to QOFs. Retroactively disqualifying from eligible interest characterization perhaps most designated QOF eligible interests issued in 2018, through a novel construction of the 2018 date of sale or exchange of every Sec. 1231 asset, to produce a Sec. 1231 gain as of December 31, 2018, is poor tax policy, whatever the theoretical merits of that statutory construction. At least for purported eligible interests issued before the May 1, 2019 proposed regulations were published, regulations should allow Sec. 1231 gains (perhaps reduced by any other cumulative net Sec. 1231 losses in that year) recognized within the preceding 180 days to be the basis of funding an eligible interest in a QOF.

Adjusted Basis for Purchased Tangible Personal Property

The Preamble to the 2019 Proposed Regulations states: "Additional comments are requested regarding the application of the substantial improvement requirement with respect to tangible personal property acquired by purchase." However, Prop. Reg. sec. 1.1400Z2(d)-1(c)(8), (d)(4) determine "substantial improvement of purchased tangible personal property by reference to adjusted basis. Because of immediate expensing of purchased tangible personal property, as a practical matter, the See. 1011 and Sec. 1016 adjusted basis of purchased tangible personal property is typically zero. This as a practical matter may eliminate the "substantial improvement" test for used tangible personal property and make aggregation irrelevant. Treasury needs to consider the possibility of using the pre-depreciation cost basis or other more suitable measure to determine substantial improvement before moving to the issue of aggregation.

Very Truly Yours,

Alan S. Lederman
Gunster
Fort Lauderdale, FL

Cc:
Mr. Michael Novey