When the owner of a local manufacturer operating in Central New York for more than 60 years sold the company to a national operator on Jan. 7, 2020, he realized over $2 million in capital gains that will be taxed in 2020 at 20 percent. The family business has long supported workforce-training programs and economic development in the neighborhoods where its facilities are located. Using $1 million of the gain to purchase a partnership interest in a Qualified Opportunity Fund formed to invest in a mixed-use project in a local Opportunity Zone will give the owner the best of both worlds — he can defer and reduce a portion of the capital-gains tax and continue to spur economic activity in the community.
By investing within 180 days, the owner will not have to pay the capital-gains tax on $1 million until Dec. 31, 2026, unless he sells his partnership interest in the local fund. If he holds the fund investment for five years, the tax will be calculated on $900,000 rather than $1 million, resulting in a reduction of the capital-gains tax. If he holds the partnership interest for at least 10 years, the gain on his sale of the partnership interest will be tax-free.
The Opportunity Zones (OZ) program seeks to attract equity investment from investors with U.S. taxable capital gains to spur economic activity in businesses located in designated OZs throughout the United States. Investors can defer and reduce federal capital-gains tax by investing in a Qualified Opportunity Fund, which invests, directly or indirectly, in tangible property located in an OZ and used in a trade or business. Central New York has 21 OZs located in Onondaga, Oswego, Cortland, and Cayuga counties.
After two sets of proposed regulations and much delay, the U.S. Treasury Department published the final regulations in the Federal Register on Jan. 13, 2020. This article discusses changes and clarification in the final regulations that make investment in real-estate projects easier.
Background: A Qualified Opportunity Fund is organized as a corporation or a partnership for the purpose of investing at least 90 percent of its assets in qualified opportunity zone stock or qualified opportunity zone partnership interests of a qualified opportunity zone business (qualified business) or directly in qualified opportunity zone business property. The tax benefits a taxpayer may realize by investing in a Qualified Opportunity Fund increase the longer the taxpayer holds the fund investment.
Qualified OZ Business: A Qualified Opportunity Fund may make an indirect investment in a corporation or partnership that satisfies several conditions including that at least 70 percent of the tangible property owned or leased by the entity is Qualified OZ Business Property (as discussed below); 50 percent or more of the qualified business’s gross income is derived from the active conduct of a trade or business in an OZ; and except as discussed below, that trade or business is not operating a private or commercial golf course, country club, massage parlor, hot tub facility, suntan facility, racetrack or other facility used for gambling, or any store the principal business of which is the sale of alcoholic beverages for consumption off-premises.
Qualified OZ Business Property is tangible property located in an OZ acquired by purchase from an unrelated party or leased, after Dec. 31, 2017. One of the requirements to be a Qualified OZ Business Property is that either the original use of the tangible property commences with the qualified business or the qualified business substantially improves the tangible property. The final regulations address several concerns with how a qualified business acquiring a vacant building could satisfy the original use test.
Recognizing that renovation and reuse of vacant buildings are an important tool to spur economic activity in an OZ, the U.S. Treasury Department and Internal Revenue Service eased the original use requirement applicable to vacant buildings.
The proposed regulations called for a building to have been unused or vacant for an uninterrupted period of at least 5 years prior to eligible use by a qualified business. The final regulations reduce the 5-year vacancy requirement to a 1-year vacancy requirement, if the property was vacant for at least 1-year prior to the OZ designation and remains vacant through the date of purchase. For other vacant property, the proposed 5-year vacancy requirement is reduced to 3 years. In addition, property involuntarily transferred to local government (e.g., tax taking, abandonment or condemnation for blight) can be treated as original use property when purchased by a qualified business from the local government.
Similarly, the final regulations respond to suggestions from the U.S. Environmental Protection Agency and make OZ investments in brownfield sites possible. A qualified business that cleans up a brownfield site to improve its safety and compliance with environmental standards will be able to treat both the land and structures in a brownfields site redevelopment as original use property. In addition, the lengthy development process for a brownfield site will benefit from the working capital safe harbor.
A qualified business measures compliance on the same dates as each fund investing in the business measures the 90 percent investment standard, on both the last day of the first six months and the last day of the taxable year. For construction or renovation projects and startup of business operations that require more than 6 months to begin generating gross income and satisfy the tests, a working capital safe harbor provides a 31-month period for start-up including when appropriate the acquisition, construction and/or substantial improvement of tangible property, and the final regulations allow up to 31 additional months. To be eligible for the safe harbor, the qualified business must (1) have a written plan that identifies the working capital assets and a written schedule consistent with the ordinary startup of a trade or business showing that the working capital assets will be used within 31 months, and (2) use the working capital assets in a manner substantially consistent with the written schedule.
Now a qualified business may engage in de minimis amount of prohibited business, adding some flexibility for certain businesses, such as hotel or shopping center operators. The final regulations permit less than 5 percent of gross income to be derived from operation of prohibited businesses and lease of a de minimis amount (less than 5 percent) of property to prohibited businesses. The statute allows a Qualified Opportunity Fund directly investing in Qualified OZ Business Property to operate that property for any prohibited business.
The final regulations add finality and clarity that investors and businesses have needed to fully embrace the OZ program. Now is the time to invest in the Central New York community.
Jean Everett is a member of the OZ Team at Bousquet Holstein PLLC. She works from the law firm’s New York City, Syracuse, and Ithaca offices. Contact her at email@example.com.