The Tax Cuts and Jobs Act (“TCJA”) provided the most comprehensive update to the tax code in over two decades. Of the many changes the TCJA provided, Sections 1400Z-1 and 1400Z-2 of the IRC are of the most heavily discussed and analyzed by taxpayers and tax practitioners. Collectively, these sections provide the opportunity for an eligible taxpayer to defer capital gains and obtain a step up in basis when properly investing in an opportunity zone.
To qualify for these tax benefits, a taxpayer must obtain capital gains that are eligible for deferral. For a gain to be eligible for deferral, it must be recognized through a sale or exchange with an unrelated person.1 After the sale, the taxpayer has 180 days to reinvest the gain into a Qualified Opportunity Fund (“QOF”).2
A QOF is an investment vehicle organized as a corporation or a partnership for the purpose of investing in Opportunity Zone Property (“OZP”). A QOF must hold at least 90% of its assets in OZP.3 The corporation or partnership self-certifies on its tax return that it is a QOF. To date, there is no legal prohibition for a preexisting entity self-certifying as a QOF. Once the QOF is formed, it must acquire OZP after December 31, 2017 by purchase in an arms-length transaction.4 OZP is property located in an economically distressed community that has been nominated for that designation by the state and confirmed by the Secretary of the U.S. Treasury.
After the QOF obtains OZP, it must substantially improve that property within 30 months, beginning after the date of acquisition of the tangible property.5 To substantially improve such tangible property, the additions to the basis of the property must exceed an amount equal to the adjusted basis.6 Alternatively, if the QOF obtains property for a new and original use, it does not have to substantially improve the property.7
The I.R.S. has requested commentary to help identify what parts of the foregoing process require clarification. Prior to identifying some of the issues that require clarification, it is important to note the policy behind the creation of opportunity zones. Opportunity zones were created to facilitate economic development in historically distressed areas by offering investors tax incentives. Additionally, the TCJA required pre-existing capital gains to be used to obtain the tax incentives. From this, we infer that the Federal government’s intention was to shift capital from appreciated assets to areas in which capital contributions would act as a catalyst for economic growth. With this background in mind, the next set of regulations must address a number of unresolved issues, but tax practitioners should also have an idea how the I.R.S. will clarify some of the issues.
Of the unresolved issues, the original use requirement needs clarification. Specifically, what happens if property acquired by a QOF, and located within a QOZ, was abandoned for a substantial period of time before the purchase? Would the original use of the property relate back to the last time the property was in use, or is any new use of the property considered the original use?
26 U.S.C (“IRC”) § 1394 establishes a similar procedural construct and applies to enterprise zones facility bonds. Based on IRC § 1397, an enterprise zone facility bond is a tax exempt private activity bond issue. The proceeds of an enterprise zone facility bond may be used by certain businesses in empowerment zones or enterprise communities. Empowerment zones and enterprise communities are highly distressed urban and rural communities. Taxpayers who purchase the enterprise zone bonds receive interest income that is tax exempt. More importantly, the issuer of the bond is required to place original use property in the empowerment zone.
To clarify the original use requirement in the enterprise zone context, the I.R.S. issued Treasury Regulation 1.1394-1(h). The regulation provides that if property is vacant for at least a one year period, use prior to that period is disregarded for purposes of determining original use. Moreover, de minimis incidental uses of property such as renting the side of a building for advertising are disregarded.
The policy behind enterprise facility bonds is similar to QOZ. Although the mechanism by which the economically distressed area receives capital is different, the overall goal of the program is the same: to provide capital to an economically distressed area and receive tax incentives for doing so. As a result, it would be logical for the I.R.S. to issue guidance adopting the rules as outlined above.
The I.R.S. should also contemplate and provide guidance on the original use of property located in an opportunity zone that was used for multiple different purposes before being sold to a QOF. For example, a building may have been used as a warehouse, a grocery store, a retail space, or other similar purposes within a short period of time before being purchased by a QOF. Based on these facts, it is difficult to determine the prior use of the property, and thus what would constitute original use of the property moving forward.
In December of 2005, the Gulf Opportunity Zone Act (“Gulf Act”) was signed into law. The Gulf Act, which in many ways mirrors QOF and QOZ, provided tax benefits to assist individuals recovering from Hurricanes Katrina, Rita and Wilma. Of the many tax benefits the Gulf Act provided one was additional depreciation. Based on IRC § 1400N, property described in IRC § 168(k) was provided, an additional 50% first-year depreciation allowance under IRC § 167(a) if the property was placed into a designated Gulf Zone and it was the property’s original use.
Internal Revenue Bulletin 2007-17, Notice 2007-36, clarified the original use requirement as it applied to the Gulf Act and determined that reconditioned or rebuilt property did not satisfy the original use requirement if the property had been previously used within the Gulf Zone. Moreover, the U.S. Tax Court has also clarified the original use requirement as it relates to the Gulf Act. In Blakeney v. Commissioner of Internal Revenue Service, the taxpayer purchased a yacht and placed it into service for the first time in a Gulf Zone. As this was the first time the yacht was placed into service in that specific Gulf Zone, the I.R.S. accepted it as an original use, without analyzing the yacht’s prior use in any other area.8
Tax practitioners hypothesize that the I.R.S. will use a broad definition of original use to facilitate the greatest degree of economic growth. From this standpoint, only the last use of the property would be considered as outlined in the scenario above. Alternatively, a strict interpretation of the original use requirement would make it more difficult for QOF to operate in a QOZ because fewer entity choices would be available. Unfortunately for practitioners, it is likely the I.R.S., and the U.S. Tax Court, will adopt the strict interpretation of the original use requirement. As a result, all prior uses of the property within the QOZ will be taken into consideration when determining if the original use requirement is met.
Finally, further guidance is required to clarify the original use requirement when a QOF purchases only land, or land that has a structure which will be demolished. In Revenue Ruling 2018-29, the I.R.S. stated “given the permanence of land, land can never have its original use in a QOZ commencing with QOF.” Meaning, land must be substantially improved in order to qualify as QOZ property. In this context, what constitutes the substantial improvement of land? Upgrading the land itself such as razing or leveling would constitute substantial improvement. However, would vertical improvements to the land such as a building constitute an increase in basis to the land? From a policy perspective, allowing vertical improvement to substantially increase the basis of the property would facilitate economic prosperity. As a result, it would seem logical for the I.R.S. to conclude that vertical improvements could qualify as substantial improvements of the land itself.
In a similar scenario, what if an individual acquired OZP prior to December 31, 2017, and wanted to develop a building on the land now? Based on the statute, current land owners could not take advantage of the tax incentives because they were not acquired after December 31, 2017. In response, tax practitioners have conceptualized a leasing arrangement where owners of the land developed separate land and construction joint ventures with ground leases satisfying the statutes requirements. To date, regulations have not considered this planning technique. However, generally, for federal income tax purposes, a lease does not qualify as an acquisition unless certain conditions are met.
In conclusion, the process to obtain the tax benefits associated with IRC § 1400Z-1 and 1400Z-2 are complicated, and at times in need of clarification. However, the constructs from which these statutes are derived have been in existence for almost a decade, albeit on a much smaller scale. With just a quick glimpse into how the I.R.S. and the Courts have handled these issues in the past, we can help clients obtain significant tax benefits in the future, and less headache for tax practitioners in the present.
1 26 U.S.C § 1400Z-2(a)(1).
226 U.S.C § 1400Z-2(a)(1)(A).
326 U.S.C § 1400Z-2(d)(1).
426 U.S.C § 1400Z-2(d)(2)(D)(i)(I).
526 U.S.C § 1400Z-2(d)(2)(D)(ii).
726 U.S.C § 1400Z-2(d)(2)(D)(i)(II).
8Blakeney v. C.I.R., T.C. Memo 2012-289.R