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Individual Addresses Errors in Opportunity Zone Regs

APR. 8, 2020

Individual Addresses Errors in Opportunity Zone Regs

DATED APR. 8, 2020
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April 8, 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: T.D. 9889, Investing in Qualified Opportunity Funds

Dear Mr. Griffin,

This letter is a comment to T.D. 9889, Investing in Qualified Opportunity Funds, 85 Fed. Reg. 1866 (Jan. 13, 2020), which contains final regulations for qualified opportunity fund (QOF) investments under section 1400Z-2 of the Code. Although T.D. 9889 was corrected in some places by 85 Fed. Reg. 19082 (April 6, 2020), this comment addresses six errors and omissions that remain in the final regulations, which may be clarified by a second set of corrections. This comment is being submitted in my personal capacity.

This comment does not cover substantive tax issues that have been discussed by substantially all qualified opportunity zone tax practitioners since late 2018 and may have been raised by recent comments, such as (i) whether cash and other intangible property (covered under the working capital safe harbor) are transubstantiated into tangible property for purposes of the 70% tangible property test,1 or (ii) whether the circular flow of cash doctrine applies to a seller of tangible property to a QOF or qualified opportunity zone business if the seller also owns 20% or less of the interests in the QOF or qualified opportunity zone business.2

1. Effective Dates

The April 6, 2020 corrections modified Treas. Reg. § 1.1400Z(a)-1(g)(2) to provide that eligible gains recognized before December 22, 2017 can be deferred with a QOF investment. This change is welcomed by many taxpayers and is consistent with the IRS FAQ available at https://www.irs.gov/newsroom/opportunity-zones-frequently-asked-questions, which states:

Q. I sold some stock on December 15, 2017, and, during the required 180-day period, I invested the amount of the gain in a Qualified Opportunity Fund. Can I elect to defer tax on that gain?

A. Yes. You make the election on your 2017 return. Attach Form 8949, reporting Information about the sale of your stock. Precise instructions on how to use that form to elect deferral of the gain will be forthcoming shortly.

However, the corrections also modified Treas. Reg. § 1.1400Z(a)-1(g)(2)(ii) in a confusing fashion that does not clarify whether a taxpayer may rely on only one section of the final regulations in 2017 through 2020 or whether the taxpayer must apply all sections of the final regulations in 2017 through 2020. When the uncorrected final regulations were issued, its preamble and the text of Treas. Reg. § 1.1400Z(a)-1(g)(2) indicated that a taxpayer must apply “the section 1400Z-2 regulations,” which is all of the final regulations. Although some commentators have previously stated that a taxpayer may rely on only one section of the final regulations in 2017 through 2020, Treasury and the Internal Revenue Service confirmed a month ago that the final regulations are all or nothing.3 The corrected final regulations suggest a reversal of that position, which should be clarified with some additional explanation in order to reduce taxpayer confusion.4

2. Definition of Inventory

Treas. Reg. § 1.1400Z2(c)-1(b)(2)(ii) provides that for purposes of the 10 year gain exclusion rule, the excluded “gains and losses include all gains and losses other than gains or losses from the sale or exchange of any item of inventory, as defined in section 1221(a)(1), in the ordinary course of business.”

Treas. Reg. § 1.1400Z2(d)-2(b)(ii) provides that any “inventory (including raw materials) of a trade or business” produced by QOF or QOZB in 2018 or later is deemed to satisfy the purchase requirement and the original use or substantial improvement requirement. Alternatively, Treas. Reg. § 1.1400Z2(d)-1(b)(2)(iii) provides that “all inventory (including raw materials) of the trade or business” may be excluded from both the numerator and denominator of the QOF's 90% asset test or the QOZB's 70% tangible property test.

The final regulations should clarify whether inventory is also defined by reference to section 1221(a)(1) for purposes of Treas. Reg. § 1.1400Z2(d)-2(b)(ii) and Treas. Reg. § 1.11400Z2(d)-1(b)(2)(iii).

In addition, section 1221(a)(1) refers to both inventory and “property held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business.” Condo developments and other real property held for sale to customers in the ordinary course of business, for example, are generally not inventory. For comparison, section 751(d) has used more general language since the Internal Revenue Code of 1954 and provides that “inventory items” includes “property of the partnership of the kind described in section 1221(a)(1)”, not just inventory described in section 1221(a)(1).

The final regulations should clarify whether the Treas. Reg. § 1.1400Z2(c)-1(b)(2)(ii) reference to inventory as defined in section 1221(a)(1) was intended to also encompass property held primarily for sale to customers in the ordinary course of business. A QOF partnership may have ordinary income from the sale of condo units after 10 years.

If the concept of inventory in Treas. Reg. § 1.1400Z2(c)-1(b)(2)(ii) is expanded to include property held primarily for sale to customers in the ordinary course of business, the final regulations should clarify whether property held primarily for sale to customers in the ordinary course of business is consistently also inventory that can be deemed a qualifying asset or excluded from the asset tests, under Treas. Reg. § 1.1400Z2(d)-2(b)(ii) and Treas. Reg. § 1.1400Z2(d)-1(b)(2)(iii), respectively.

In addition, the final regulations should clarify whether a QOF partner's ordinary income gain under section 751 on the sale or other disposition of a partnership asset, to the extent attributable to the partnership's “inventory items” as defined in section 751(d), can be gain from inventory in the ordinary course of business that is subject to the Treas. Reg. § 1.1400Z2(c)-1(b)(2)(ii) exception to the 10 year gain exclusion. For example, a QOF sells an interest in a QOZB that owns inventory items.

Lastly, Treas. Reg. § 1.1400Z2(c)-1(e) provides for an exclusion after 10 years of a QOF REIT's capital gain dividends, to the extent that the capital gain dividends are attributable to the QOF REIT's long-term capital gain from the disposition of qualified opportunity zone property, i.e., qualified opportunity zone business stock, qualified opportunity zone partnership interests, or qualified opportunity zone business property held directly by the QOF REIT as defined in section 1400Z-2(d)(2)(A). Consistent with the changes made in the final regulations to the 10 year gain exclusion rule for QOF partnerships and QOF S corporations in Treas. Reg. § 1.1400Z2(c)-1(b), the 10 year gain exclusion for QOF REITs in Treas. Reg. § 1.1400Z2(c)-1(e) should be modified to (i) apply to gain from the disposition of property by a QOZB, not just from the disposition of qualified opportunity zone property by the QOF REIT, (ii) apply to all gains or losses (not only capital gains or losses) other than from the sale or exchange of any item of inventory, as defined in section 1221(a)(1), in the ordinary course of business and that is not subject to the prohibited transaction safe harbors in section 857(b)(6)(C) or section 857(b)(6)(D), and (iii) provide that section 265 or any similar provisions do not apply to disallow any deductions otherwise allowable under subtitle A for amounts paid or incurred by a taxpayer that are allocable to any QOF REIT capital gain dividend excluded from gross income under Treas. Reg. § 1.1400Z2(c)-1(e).

3. Unexplained Change to Lease with Option to Purchase

Prop. Treas. Reg. § 1.1400Z2(d)-1(d)(2)(i)(E) provided:

In the case of real property (other than unimproved land) that is leased by the entity, if, at the time the lease is entered into, there was a plan, intent, or expectation for the real property to be purchased by the entity for an amount of consideration other than the fair market value of the real property determined at the time of the purchase without regard to any prior lease payments, the leased real property is not qualified opportunity zone business property at any time.

Prop. Treas. Reg. § 1.1400Z2(d)-1(c)(4)(i)(E) had an identical rule for a QOF lessee.

In contrast, the final Treas. Reg. § 1.1400Z2(d)-2(c)(4) provides:

Plan, intent, or expectation for purchases not for fair market value. In the case of real property that is leased by an eligible entity, if, at the time the lease is entered into, there was a plan, intent, or expectation for the real property to be purchased by the eligible entity for an amount of consideration other than the fair market value of the real property determined at the time of the purchase without regard to any prior lease payments, the leased real property is not qualified opportunity zone business property.

The preamble to the final regulations does not explain why the clause “(other than improved land)” was removed in the final regulations. As a result, a QOF or QOZB lessee of unimproved land can no longer have a fixed price purchase option once the QOF or QOZB is subject to the final regulations, even if the lease was entered into before the effective date of the final regulations.

The preamble to the proposed regulations explained that this anti-abuse rule was necessary to “prevent the use of leases to circumvent the substantial improvement requirement for purchases of real property (other than unimproved land).” 84 Fed. Reg. 18657 (May 1, 2018). In the proposed regulations, the anti-abuse rule did not apply to unimproved land because unimproved land was not subject to the substantial improvement requirement in the first place.

Given that unimproved land continues to not be subject to the substantial improvement requirement, under Treas. Reg. § 1.1400Z2(d)-2(b)(4)(iv)(B), the final regulations should either conform to the proposed regulations and exclude unimproved land or provide a more detailed explanation as to why the provision was changed. A discussion of the merits of the three alternatives (no regulation, proposed regulation, or final regulation) would be helpful under Executive Orders 13711, 13563, and 12866.

4. More than an Insubstantial Amount

Treas. Reg. § 1.1400Z2(d)-2(b)(4)(iv)(B) provides that unimproved land is not subject to the substantial improvement requirement:

Unimproved land. Unimproved land that is within a qualified opportunity zone and acquired by purchase in accordance with section 1400Z-2(d)(2)(D)(i)(I) is not required to be substantially improved within the meaning of section 1400Z-2(d)(2)(D)(i)(II) and (d)(2)(D)(ii)

Treas. Reg. § 1.1400Z2(d)-2(b)(4)(iv)(C) then provides an exception:

Exception for insubstantially improved land. Notwithstanding paragraph (b)(4)(iv)(B) of this section, if the land is unimproved or minimally improved and the eligible entity purchases the land with an expectation or an intention to not improve the land by more than an insubstantial amount within 30 months after the date of purchase, paragraph (b)(4)(iv)(B) of this section does not apply with respect to such land and such land is not considered qualified opportunity zone business property unless it is substantially improved within the meaning of sections 1400Z-2(d)(2)(D)(i)(II) and (d)(2)(D)(ii).

The final regulations should clarify what is considered “more than an insubstantial amount” in Treas. Reg. § 1.1400Z2(d)-2(b)(4)(iv)(C), similar to how the final regulations provided the definition of “substantially all” as 70% in Treas. Reg. § 1.1400Z2(d)-2(d)(4) and the definition of “substantially all” as 90% in Treas. Reg. § 1.1400Z2(d)-2(d)(3).

Generally in the context of other Code provisions, Treasury and the IRS have relied on more qualitative factors in determining what is substantial and what is insubstantial. In response to one commenter's request that Treasury and the IRS clarify what is considered “substantially all” for section 965(h)(3) purposes,5 the preamble to the final regulations under section 965 responded that “[t]he phrase 'substantially all' is used in various Code provisions and in regulations, and often is determined based on all of the facts and circumstances. Consistent with this general approach, the Treasury Department and the IRS decline to provide a bright-line definition of 'substantially all' in the final regulations.”6

In the QOF context, however, Treasury and the IRS have decided to depart from the general approach, to no longer base the determination on all of the facts and circumstances, and to add two bright-line definitions for “substantially all,” for which there should be definitions for what is “insubstantial” as well in order to maintain consistency.

Substantially all

90%

Treas. Reg. § 1.1400Z2(d)-2(d)(3), Treas. Reg. § 1.103-8(a)(1)(i), Treas. Reg. § 1.731-2(c)(3)(i)

Substantially all

85%

Treas. Reg. § 1.1394-1(l), Treas. Reg. § 1.45D-1(c)(5), Treas. Reg. § 1.72(e)-1T, Treas. Reg. § 53.4942(b)-1

Substantially all

80%

Treas. Reg. § 301.7701(i)-1(c)(2), Prop. Treas. Reg. § 1.250(b)-5(c)(5)

Substantially all

70%

Treas. Reg. § 1.1400Z2(d)-2(d)(4), Treas. Reg. § 301.6111-3(b)(3)(i)(D), Rev. Proc. 77-37, 1977-2 C.B. 568

Substantial portion

40%

Treas. Reg. § 1.1400Z2(d)-1(d)(3)(ii)(A)

Insubstantial

15%

Treas. Reg. § 53.4943-7(d)(2)(iii)

Insubstantial

?

Treas. Reg. § 1.1400Z2(d)-2(b)(4)(iv)(C)

Furthermore, it is not clear that Treas. Reg. § 1.1400Z2(d)-2(b)(4)(iv)(B) applies to minimally improved land, as opposed to unimproved land, even though such application is implied by the exception for minimally improved land in Treas. Reg. § 1.1400Z2(d)-2(b)(4)(iv)(C). The final regulations should clarify that Treas. Reg. § 1.1400Z2(d)-2(b)(4)(iv)(B) applies to both unimproved land and minimally improved land, in order for the Treas. Reg. § 1.1400Z2(d)-2(b)(4)(iv)(C) exception to make more sense.

5. Straddling Real Property

Treas. Reg. § 1.1400Z2(d)-1(d)(3)(ix) provides that certain real property that straddles a qualified opportunity zone is deemed to be entirely in the qualified opportunity zone for purposes of the section 1400Z-2(d)(3)(A)(ii) requirements on gross income, etc. The final regulations added Treas. Reg. § 1.1400Z2(d)-2(d)(4)(vii), which provides that the same real property that straddles a qualified opportunity zone is also deemed to be entirely in the qualified opportunity zone in order to satisfy the section 1400Z-2(d)(2)(D)(i)(III) requirements of 90% holding period and 70% use in a qualified opportunity zone.

Sections 1400Z-2(d)(2)(D)(i)(II) has an additional requirement for qualified opportunity zone business property, which is that the original use of such property in the qualified opportunity zone commences with the QOF, or the QOF substantially improves the property.

The final regulations should provide that real property that straddles a qualified opportunity zone is deemed to be entirely in the qualified opportunity zone for purposes of the original use requirement. Such treatment would be consistent with the deemed treatment of the real property that straddles a qualified opportunity zone as entirely in the qualified opportunity zone for all other purposes, and parallels the deemed treatment of inventory as satisfying the original use requirement (discussed above). If a QOZB's land parcel is 60% in a qualified opportunity zone and 40% outside the zone, and the ground-up construction on the land is also considered to be 60% in the zone and 40% outside the zone, the QOZB may fail the 70% tangible property test and fail to benefit from any of the special rules for real property that straddles a qualified opportunity zone.

6. Notice Requirement for S Corporations

Treas. Reg. § 1.1400Z2(b)-1(h)(4) was omitted in the published version of the final regulations at 85 Fed. Reg. 1974 (Jan. 13, 2020). Treas. Reg. § 1.1400Z2(b)-1(h)(4) is supposed to provide notification rules for S corporations: “(4) S corporations. Similar rules to those in paragraphs (h)(1) and (h)(3) of this section apply to S corporations as appropriate.”

The omission seems to be unintentional. The preamble to the final regulations refers to the missing Treas. Reg. § 1.1400Z-2(b)-1(h)(4) three times in 85 Fed. Reg. 1950 (Jan. 13, 2020).

I would be pleased to discuss these comments if you believe it would be helpful.

Sincerely,

Libin Zhang

FOOTNOTES

1 See Libin Zhang, Qualified Opportunity Zones and Select Partnership Issues, 34 Tax Management Real Estate Journal No. 11 (Nov. 11, 2018).

2 See Bradley T. Borden and Alan S. Lederman, Property Contribution and Basis Issues in Pass-Through Opportunity Funds, 34 Tax Management Real Estate Journal No. 12 (Dec. 5, 2018).

3 See Lydia O'Neal, Opportunity Zone Rules Application Is “All or Nothing”: Official, Bloomberg Daily Tax Report (March 6, 2020).

4 See Lydia O'Neal, Opportunity Zone Tax Rule Corrections Add Clarity — And Confusion, Bloomberg Daily Tax Report (April 2, 2020).

5 Libin Zhang, Comments on Proposed Regulations under Section 965, at 25 (September 18, 2018).

6 84 Fed. Reg. 1861 (Feb. 5, 2019).

END FOOTNOTES

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