The previous two articles (published December 19th and January 7th) discussed some important issues that the U.S. Treasury resolved in its proposed regulations issued on October 19, 2018.1 I promised in the last column that my next one would discuss important unanswered questions where additional Treasury guidance would be welcome if not essential.
Capital gains invested in opportunity zones are required to remain at risk for 10 years.
Traditionally, real estate investors can extract invested capital and even profits tax-free in properly structured financing transactions before the ultimate sale of the property.
Will qualified opportunity funds (QOFs) or qualified opportunity zone businesses (QOZBs) be allowed to refinance their portfolio properties before expiration of the 10-year period and distribute the proceeds to investors without jeopardizing opportunity zone benefits?
If investors in effect extract all or part of their equity investments when the project refinances or obtains additional financing, the IRS may argue that the investors have withdrawn their investments or converted their equity investments to debt.
Thus, the IRS could deny investors Opportunity Zone benefits and try to tax the invested deferred capital gains at that time.
It does not seem to make sense to allow investors to do this individually but deny the same opportunity to the fund itself, especially since financing of hard assets, not equity interests, is the norm in the real estate world.
Active Conduct Of Trade Or Business: Sales Outside The Zone The proposed regulations mandate that at least 50% of the gross income of a QOZB must derive from the active conduct of a trade or business “in the qualified Opportunity Zone.” The proposed regulations added the words within quotation marks; although perhaps intended to clarify an ambiguity, the language created or exacerbated others, including these— What about sales of goods or services to customers outside the zone?
If Treasury follows international tax “source of income” rules, which may be analogous, performing services from an office in the Opportunity Zone should qualify, regardless of where customers are physically located.
Based on this rule, if adopted by final Opportunity Zone regulations, sales of goods outside the zone that are manufactured inside the zone should qualify, especially if no sales activities occur outside the zone (or, possibly, if they are undertaken on a commission basis by distributors).
But what if some sales activities do occur outside the Opportunity Zone?
The same international tax rules indicate that soliciting orders, advertising, and even broadcasting radio advertisements into an area can constitute conducting business in that area.
Once again, the issue is whether a miserly approach will inhibit the inflow of operating businesses into the Opportunity Zones or result in a premature exit once it appears that the business has trapped itself in an iron cage (hats off to Max Weber).
Interim Gain Issue: Sale By Fund Before 10 Years Followed By Qualified Reinvestment Of Sale Proceeds The statute and current regulations allow an investor to sell its complete interest in a QOZF and reinvest the proceeds in another qualified investment within 180 days without recognizing gain (although it is not clear whether the investors’ 10-year holding period restarts).
However, neither the statute nor the proposed regulations indicate whether a fund or QOZB can, in a similar vein, sell Opportunity Zone business property (or whether a fund can sell the stock or membership interest in a QOZB), and reinvest the proceeds without paying tax on any gain.
The statute and proposed regulations do state that a fund should have a reasonable time to reinvest the proceeds without violating the 90% asset test but are silent on this “interim gain” issue.
Generally, Will We Be Burdened By Having To Sell Equity Interests, Not The Real Estate Or Other Assets Themselves To Qualify For Various Benefits?
The statute provides that the 10-year exemption from tax is only realized when an investor sells the investment in the QOF, and not when the QOF sells its property or investment in a QOZB.
Since it does not serve a legitimate policy purpose but undermines the legislative goals, perhaps the Treasury will eliminate this artificial distinction.
But as of this writing, on the 18th day of the government shutdown, the hallways and offices of the U.S. Treasury are dark and the pencils are down.
1 This article assumes readers’ knowledge of the basic Opportunity Zone statutory provisions.
Dan Flanigan is managing partner of the New York office of POLSINELLI.
Flanigan and POLSINELLI have provided the above material for informational purposes only.
Originally Published on January 22, 2019 at 01:05PM
Article published originally via “opportunity zones” – Google News https://nyrej.com/the-wizard-of-oz-that-s-opportunity-zones-dorothy-still-has-some-questions-by-dan-flanigan