Originally published in Bloomberg Tax on July 23, 2020. Copyright ® 2020 The Bureau of National Affairs, Inc. 800-372-1033 www.bloombergindustry.com. Reproduced with permission.
Since its creation in 2017, the opportunity zone program has seen halting progress, initially because of lack of clarity around investment parameters and what constitutes qualified real property, and more recently because of the economic impact of the global pandemic. After the IRS issued final rules in December 2019, opportunity zone investment activity picked up significantly but abated again in early March when the full force of the coronavirus began to emerge.
Investment activity began to tick back up in mid-May. And with the IRS’s June 4 guidance for qualified opportunity zone funds (QOFs) and investors affected by the coronavirus, we expect that activity to continue: According to an Economic Innovation Group survey released on June 23, 56% of respondents, including investors and QOF managers and qualified opportunity zone businesses (QOZBs), say their level of engagement with opportunity zones “will remain undiminished and may even increase over the year ahead.”
The IRS’ most recent guidance confirmed investors’ beliefs about how the program would ultimately function. However, in keeping with tradition, this guidance, Notice 2020-39, leaves some questions unanswered:
As originally drafted, the opportunity zone program is scheduled to expire on Dec. 31, 2026. However, because of the initial lack of clarity, which made many potential investors hesitant to invest, many missed out on the 5% basis increase that expired at the end of 2019 and would have resulted in a total 15% exclusion of deferred capital gains by the end of 2026. If the program were extended to 2030, investors would regain that 5% basis increase, which could further spur investment.
As written, the opportunity zone program stipulates that taxpayers who see capital gains from the sale of assets have 180 days to redistribute the amount of the realized gain into a QOF. Notice 2020-39 provides that if a taxpayer’s last day to invest in a QOF would have fallen on or after April 1 and before Dec. 31, 2020, the taxpayer now has until Dec. 31, 2020, to invest that gain into a QOF.
Assuming an extension does not happen, industry groups separately are lobbying for a 15% step up in basis to take effect this year, effectively guaranteeing that if the program ends in 2026 rather than 2030, investors still receive the full tax benefits if they invest within the April 1 to Dec. 31 period.
Another elision of Notice 2020-39 is whether a business will still be deemed a QOZB given the impact that state and local stay-at-home mandates may have on the 50% gross income test. According to the final regulations, among the requirements to qualify as a QOZB is that 50% of total gross income must derive from business actively conducted within the QOZ. However, stay-at-home mandates may make meeting that standard difficult.
The final regulations outline criteria for meeting the 50% gross income test, including services performed in the QOZ based on hours or the amounts paid for services. Current and prospective investors should quantify the extent to which gross income was or may be generated outside the QOZ in the regular course of business.
Another requirement to qualify as a QOZB is for a substantial portion (40%) of the business’s intangible property to be used in the active conduct of the QOZB. The final rules in December provided that intangible property—anything from intellectual property to software—will be treated as such if the use of the intangible property is “normal, usual or customary in the conduct of the trade or business,” and the intangible property is used in the QOZ “in the performance of an activity of the trade or business that contributes to the generation of gross income for the trade or business.”
A company with multiple business lines or differing activities may have branch locations inside and outside a QOZ: for example, a manufacturing operation that has production activities inside a QOZ and a distribution warehouse outside the QOZ, perhaps even in another state. Investors have expressed uncertainty regarding how to determine or measure the location of the business’s intangible property.
With employees having worked remotely for months and potentially working remotely, at least in part, for the foreseeable future, QOZBs may fail to meet this standard. Businesses should keep a close eye on legislative and regulatory developments in the event that the IRS provides guidance that businesses will not be penalized for using intangible property outside a QOZ while working remotely.
The opportunity zone program was slow to get off the ground because of a lack of clarity around its parameters and mechanics, and the aforementioned lack of clarity could lead to renewed hesitation on the part of investors looking to participate in the program. For interested parties and for those already operating in opportunity zones, one possible remedy is for the IRS to release guidance stipulating that the loss of qualification may be remedied through a cure period.
In the final rules in December, in response to investors’ concerns that relief was unavailable to QOFs that discover that an entity in which they invested failed to qualify as a QOZB, the IRS provided for a six-month cure period for a non-qualifying trade or business if it is found to have caused the QOF to fail the 90% investment test. An analogous cure period could be instituted for businesses that lose QOZB status as a result of the coronavirus as well.
The current financial crisis has had a significant impact on low-income communities, which, judging from the 2008 financial crisis, may be the last to recover. QOZs, therefore, present an opportunity potentially to lift these areas more quickly out of distress and to begin to build lasting foundational change.
The struggle for the program can be found in its very composition: Opportunity zones are census tracts in distressed and low-income communities across the country that have been identified for preferential tax treatment. However, some of these tracts carry the potential for much higher returns than others: Property along the Gulf Coast that has been severely damaged by hurricanes but that could be cleaned up and used for resort properties, for example, has the potential for much greater returns than affordable housing investments in inner cities. Most investors weighing whether to invest in such a property versus affordable housing will naturally gravitate toward the investment more likely to yield higher returns. This makes it more difficult for the smaller percentage of QOFs and QOZBs that want to provide affordable housing to compete for capital.
Some opportunistic players may also end up leasing real estate in a QOZ without the requirement to improve it, grow a business, or offer jobs to the underserved in the area. To date, there are few examples of QOFs running their own businesses within QOZs.
The IRS and Treasury included broad anti-abuse language in the December rules and provided examples illustrating that land held for speculative purposes does not qualify for the program’s tax benefits—for example, the acquisition of land for and construction of a parking lot is considered speculative, not furthering the purposes of the program, and should not receive opportunity zone tax benefits.
The anti-abuse rules are highly conceptual, lacking necessary specificity, which may lead to varied, incorrect and perhaps abusive interpretations by QOZ business operators and the IRS.
Investors who are evaluating opportunity zones should ensure they are adhering to the intent and spirit of the program—to uplift distressed areas in need of revitalization and create new jobs and investment opportunities.
Though these questions remain outstanding, Notice 2020-39 provided relief for investors and QOFs by extending deadlines, lifting penalties, suspending requirements and correcting amendments to the final rules issued in December, including:
This relief presents planning and investment opportunities, which may be further compounded by the need for investors who sold stock in response to Covid-19 market volatility to find investments where they can allocate their capital gains. To reap the full tax benefits of the opportunity zone program, investors are required to meet a 10-year holding period, which before the coronavirus may have been a detractor. Now, however, given market uncertainty, that holding period may look more appetizing as investors may “leapfrog” this downswing in the market.
As a result, real estate projects and other businesses that investors may have dismissed previously—such as converting abandoned real estate into multi-use retail, shopping centers, and housing, or relocating an existing manufacturing facility from a high-cost real property tax area to a lower real property tax area in a QOZ—could now be within their suite of potential investment options. QOFs should be prepared to receive these funds.