Opportunity Zones - first impressions from the second set of proposed regulations

The Tax Cuts and Jobs Act created various tax benefits for investors in designated qualified opportunity zones (QOZs). Through an investment vehicle called a qualified opportunity fund (QOF), a taxpayer can invest realized capital gains into a QOF in exchange for three tax benefits: (1) deferral of tax on invested gains until the earlier of 2026 or disposition of the QOF, (2) partial forgiveness of tax on invested gains if the QOF is held for at least five years, and (3) an exemption for all gain upon the sale of the QOF if held for at least 10 years. In October 2018, the Department of Treasury released a first set of proposed regulations related to investments in these QOZs.

The Treasury recently released a second set of proposed regulations, which expand upon and attempt to clarify the October 2018 proposed regulations as well as the original legislation. The new proposed regulations are 169 pages long and address a wide array of issues. In the coming weeks, Baker Tilly will release additional guidance on these regulations.

The most significant takeaways from the new proposed regulations are:

Safe harbor for 50 percent gross income test: To qualify as an opportunity zone business (QOZ business), a business must receive at least 50 percent of its gross income from the active conduct of a business in a QOZ. The regulations provide a facts and circumstances test and three safe harbors to determine whether sufficient income is derived from a business in a QOZ. The safe harbors are as follows:

1. at least 50 percent of the services based upon employee and independent contractor hours are performed in the QOZ;
2. at least 50 percent of the services performed based upon amounts paid for those services are performed in a QOZ; or
3. at least 50 percent of the gross income of the business derives from tangible property and management functions located in a QOZ.

Clarification of original use requirement: To qualify as qualified opportunity zone business property (QOZ business property), the property must be either substantially improved or originally used in a QOZ. Original use generally commences when the property is first placed in service within the QOZ for purposes of depreciation. Consequently, existing structures being depreciated will not qualify under the original use requirement. However, the new proposed regulations establish an exception for buildings that have been vacant for at least five years.