Part II: Changes/Updates for Real Estate Investments
This blog post is the second in our series regarding the second round of proposed rules that were recently released by the IRS. Read part one here. Our blog will focus specifically on the proposed rules as they related to investments in real estate. So if you are still considering a Qualified Opportunity Zone investment in real estate, this blog is for you.
- Real property straddling a Qualified Opportunity Zone (QOZ) – If a substantial portion (measured by the cost of real property in the QOZ versus outside of the QOZ ) of the real property is situated within a QOZ, then all of the real property is considered to be in the QOZ.
- 1231 Gains – Capital gains from the sale of real estate are eligible for QOZ deferral. §1231 gains and losses are netted at year-end to overall gain or loss to determine if the §1231 gains are capital gains. For this reason, the proposed rules indicate that the 180-day clock for reinvestment of net §1231 gains starts ticking at the end of the taxable year.
- Original use requirement for tangible property – As you may remember, the OZ legislation requires Qualified Opportunity Zone Businesses (QOZB) or Qualified Opportunity Zone Fund (QOF) to purchase Qualified Opportunity Zone Business Property (QOZBP) whose original use begins in an OZ or is substantially improved by the QOZB. For purposes of real property, substantial improvement meant to spend an amount equal to the purchase price of the building. In other words, the land was excluded from the measurement of substantial improvement.
This second round of proposed rules provides further clarification that the purchase of unimproved land in a QOZ after 12/31/17, is not subject to the substantial improvement requirement even though it would not meet the original use requirement. However, there is also specific guidance that land held for investment, will not qualify as trade or business and will not qualify as QOZBP.
The other significant guidance in this area of original use is related to vacant structures. Previously it seemed that real property that existed in QOZs before 12/31/17 will never meet the original use requirement, and will always be subject to the substantial improvement requirement. However, with the recently released second round of proposed rules, Treasury added an exception for structures that have been vacant for at least five years before being purchased by a Qualified Opportunity Zone Fund (QOF) or QOZB. If the purchased structure has been vacant for five years before purchase, the property will meet the original use requirement, and substantial improvement will not be required.
- Working Capital Safe Harbors – Related to the Substantial Improvement requirement, the working capital safe harbors were introduced with the previous round of proposed legislation. The working capital safe harbor allows the QOF or QOZB to maintain cash on hand for 31-months for use in substantially improving the property. The second round guidance provides some additional flexibility by allowing a QOF or QOZB to exceed the 31-month window if the delay is due to waiting for government action.
- Active conduct of a trade or business – Rental real estate always seems to have to jump through extra hoops when it comes to being seen as a trade or business. While the earliest examples of QOZs include rental real estate, the QOZ legislation proves to be no different. The ownership and operation, including leasing, of real property can be considered the active conduct of trade or business. Nonetheless, beware of the triple-net-lease as the guidance goes on to indicate that entering into a triple-net-lease is not considered the active conduct of a trade or business.
The second round of proposed guidance for Opportunity Zone Investments was released in April 2019, covering topics ranging from additional definitions of the commonly used OZ phrase “substantially all”; transactions that could trigger the inclusion of gain and reinvestment; and guidance for start-ups and operating businesses.
Our first blog post covered the highlights centered around start-ups and operating businesses. Stay tuned for our third blog on transactions that could trigger gain as well as the potential for reinvestment and continued deferral of those gains.