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The Bottom Line is where Klatzkin’s advisors provide analysis and insight into key developments in taxation, accounting, and other issues and how they affect businesses and individual taxpayers.

Final Opportunity Zone Guidance Provides Clarity for Commercial Real Estate Investors

By JOHN BLAKE, CPA

February 5, 2020

The Qualified Opportunity Zone (QOZ) program was written into law at the end of 2017, and these past two years, the IRS has worked to make sense of it. In October 2018, they released their first round of proposed regulations, and six months later, in April of 2019, they released their second. However, these regulations were not made final until this past December when the IRS published Treasury Decision 9889 (TD 9889). For almost two years, taxpayers had no formal guidance to follow if they chose to invest in opportunity zones, but TD 9889 filled that void. Investors now have a good idea of how the law works and can comfortably move forward with their QOZ investment decisions.

What is in the Final Regulation?

The final regulation formalized many of the provisions included in the proposed guidelines, but TD 9889 focuses heavily on qualified opportunity fund (QOF) compliance. QOFs are the backbone of this tax incentive program. They are the intermediary vehicles between taxpayers and QOZ investment, which means that taxpayers who hope to convert capital gain into the qualifying property must invest in a QOF.

Real estate investors should not trust just any QOF with their investment. They should ensure their chosen fund is complying with the law and meets all the requirements of a QOF. The final regulation provides compliance guidance for QOFs and tells investors what they should be looking for. Here are just some of the provisions in the final regulation.

What Qualifies as QOZ Property?

For a fund to qualify as a QOF, 90% of their assets must be considered “QOZ property.” QOZ property can be any one of the following:

  • QOZ Partnership Interests – The QOF purchases an interest in a domestic partnership that is regarded as a “QOZ business” (a term we will define later), they have purchased QOZ partnership interest.
  • QOZ Stock – The QOF purchases stock and uses that investment to support their activities in the opportunity zone, they have purchased QOZ stock.
  • QOZ Business Property – The QOF owns a subsidiary that is considered a “QOZ business,” the subsidiary’s tangible property is considered QOZ business property.

What Qualifies as a QOZ Business?

QOZ businesses are trades or businesses in which at least 70% of all the business’s tangible property is QOZ business property. This includes both owned and leased property. When calculating the leases used within and without the QOZ, leases between unrelated parties are assumed to be at market rate, and that short-term leases automatically qualify as being within the opportunity zone.

The 70% test is also a use test, which means that mobile property must be used in the QOZ at least 70% of the time. If the mobile property is used within multiple QOZs, the aggregate amount of time used in any QOZ can help satisfy this test.

What Qualifies as a QOZ Business Property?

QOFs that invest in QOZ businesses are permitted to purchase a business already operating within the opportunity zone, but with one catch: the business’s existing tangible property cannot count toward the 70% use test. This encourages QOFs to provide additional funding to expand that business’s operations within the opportunity zone. To count a QOZ business’s existing property toward the 70% test, they must make “substantial improvement” to the property.

Revenue Ruling 2018-29 (a binding document released by the IRS in mid-2018) explained how to determine if a building has been substantially improved, but the final regulations went a bit further. Assets used to improve a structure can count toward the substantial improvement test if they improve the functionality of the building, are held in the same (or contiguous) opportunity zone, and are actively used in the business. Buildings that straddle QOZ and non-QOZ tracts can count as QOZ business property if the amount of property (as measured by square footage or unadjusted basis) located within a QOZ is higher than the amount located outside the QOZ tract.

So Much More to Learn

The terms we’ve defined today is just the tip of the iceberg. The 544-page document also discusses:

  • How to value self-constructed property and how self-constructed property can qualify for the 90% and 70% asset tests
  • How QOFs can voluntarily decertify themselves
  • How inherited QOF interests are treated
  • How and when the basis is adjusted after the investment has been held for 10 years
  • How inventory is treated in the 90% and 70% asset tests
  • When the 180-day clock begins ticking for gains passed through from a partnership

If you have been considering QOZ investment, now is the time to act. To receive the 10% step-up in basis, you must invest before December 31, 2021. QOZ investment will not work for all taxpayers, but it can be a good option for many. If you have any questions about any part of QOZ’s, Klatzkin can help. For additional information, call us at 609-890-9189 or click here to contact us. We look forward to speaking with you soon.

About the Author

John focuses on helping with the tax needs of real estate, technology and manufacturing, distribution, and wholesale companies. He works with management and business owners to review their business plan, tax planning process, identify additional saving opportunities, and ensure compliance and reporting deadlines are met. Also, John helps educate clients about the new opportunities available...

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