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Opportunity Zones: what the second round of regs has to fix

Five days after Treasury's public hearing, the operating-business half of §1400Z-2 still waits on rules sponsors have been modeling around for three months

The Editors
Staff, Incorporator.org
10 min read Updated
Contents 6 sections
  1. Where the record stands as of February 19
  2. The five rules the second round needs to finish
  3. What Treasury heard that we did not expect
  4. How sponsors are pricing the gap
  5. A dateline observation, honestly
  6. Sources

reasury held its public hearing on the first round of Opportunity Zone proposed regulations five days ago, and the second round has not yet dropped. For anyone sponsoring a Qualified Opportunity Fund that holds an operating business rather than a single piece of real estate, the next regulatory package is the one that determines whether the fund is financeable at all.

The first round, REG-115420-18, handled the investor side of §1400Z-2 and the cleanest real-estate case. What is waiting in the queue is the rulebook for everything else.

Where the record stands as of February 19

Treasury and the IRS published REG-115420-18 in the Federal Register on October 19, 2018, with comments due by December 28, 2018. A public hearing was originally calendared for January 10, 2019. The partial government shutdown (December 22, 2018 through January 25, 2019) forced a postponement, and Treasury rescheduled the hearing for February 14 via a notice in the Federal Register on February 1, 2019.

The February 14 hearing filled the IRS Auditorium to capacity. Twenty-three speaker slots ran in ten-minute increments, and Treasury came in with more than 150 written comments already docketed. The stenographic transcript is now on file at Tax Notes and in the rule's public docket.

What Treasury heard in the room tracks closely with what the comment letters asked for, and with what the deal bar has been flagging since the first round posted. The second-round proposed regs are the document that will either clear these questions or leave them open into the summer.

The five rules the second round needs to finish

A reader who has not been living inside §1400Z-2 should know what the structural gaps are. The statute defines a QOF at §1400Z-2(d)(1) and a Qualified Opportunity Zone Business at §1400Z-2(d)(3). It cross-references §1397C for parts of the QOZ Business definition and bolts on its own 90% asset test at the fund level. The first round of regs filled in enough of the investor-side plumbing (the 180-day window, the self-certification on Form 8996, the gain types that qualify) that real-estate money is moving. The operating-business plumbing remains half-written in five places.

The working-capital safe harbor. Proposed §1.1400Z-2(d)-1(d)(5)(iv) set out the outline: cash held by a QOZ Business, pursuant to a written plan for the acquisition, construction, or substantial improvement of tangible property in a zone, and deployed in substantial compliance with that plan within 31 months, counts as a reasonable amount of working capital for purposes of §1397C(e)(1). The mechanics were described at a high level. What comment letters asked Treasury to clarify is whether the safe harbor covers serial deployments (a construction draw schedule that extends a second 31-month window), whether a refinancing resets the clock, and whether operating cash (payroll, leases, inventory) is treated the same as capex cash. The first-round text reads most naturally as a real-estate safe harbor; the industry wants it broadened for operating businesses that will never buy a building.

The "substantially all" thresholds. §1400Z-2(d)(3)(A)(i) requires a QOZ Business to hold "substantially all" of its tangible property as QOZ Business Property. The phrase appears again inside the definition of QOZ Business Property at §1400Z-2(d)(2)(D)(i)(III), which requires that during "substantially all" of the QOF's or subsidiary's holding period, "substantially all" of the use of the property is in a zone. The statute uses the phrase three times and defines it zero times. The first round took a first cut at 70% for the entity-level test, paired with the fund-level 90%, which puts the effective through-fund floor at 63% of tangible property sitting in a zone. Treasury did not set a number for the holding-period and use-within-zone meanings of the same phrase. Whether those come in at 70%, 80%, 90%, or some blended formulation is one of the harder open questions, because the same statutory words have at least three different jobs.

The 50% gross-income test. The cross-reference at §1400Z-2(d)(3)(A)(ii) picks up §1397C(b)(2), which requires that at least 50% of a QOZ Business's gross income be derived from the active conduct of a trade or business in the zone. The statute imports the rule; the statute does not tell a software company with engineers in a zone and customers in 47 other states how to apply it. The first round of regs did not resolve this, and it is the single question the operating-business bar asked most persistently. Several witnesses on February 14 pressed Treasury for a safe harbor keyed to where services are performed rather than where customers sit, which would make the test workable for knowledge-work businesses where revenue geography bears no relationship to where value is created. Treasury has not yet signaled which side of that question it will land on.

Original use and substantial improvement for buildings. Rev. Rul. 2018-29, issued the same week as the first round, told sponsors that for a building on land within a zone, the substantial-improvement test under §1400Z-2(d)(2)(D)(ii) is measured against the basis of the building only, not the land. That unlocked urban infill. It did not answer what "original use" means for a vacant or abandoned structure that has been sitting empty for years. Does a building that was vacated in 2006 have its "original use" with the next buyer? Does the vacancy clock need to run through the first zone designation in June 2018? Witnesses at the hearing asked Treasury to set a clean rule (a specified vacancy period, say, or a "previously placed in service" test), because vacant-property acquisitions are the largest single category of proposed real-estate deals and no one wants to close without knowing whether the property clears the test.

Related-party rules. The statute bars a deferral election for gains realized from a sale to a related party, with "related" defined at §1400Z-2(e)(2) by reference to §§ 267(b) and 707(b)(1), substituting "20 percent" for "50 percent" wherever those thresholds appear. The first round of regs confirmed that substitution on the gain side. It did not fully work through the related-party questions on the asset side: whether a QOF can buy QOZ Business Property from a party who shares more than 20% common ownership with a QOF investor but not with the QOF itself, whether lease arrangements to related parties qualify (the statute implies yes in some circumstances, the regs did not say), and how common control inside a sponsor platform (a holdco, a QOF, a QOZ Business, and a management company) is characterized. These are not abstract questions. Sponsors running multiple zone deals routinely have overlapping equity between the fund and the property seller.

What Treasury heard that we did not expect

Three themes came through the February 14 testimony that were not front-and-center in the written comment file.

The first was reinvestment of interim gains. A QOF that sells a piece of QOZ Business Property in year five, with seven years left to run on the investor's ten-year clock, has a gain on the sale and cash to redeploy. The statute's basis step-up under §1400Z-2(c) is keyed to the sale of the QOF interest, not to the fund's asset sales, so an interim asset sale creates a mismatch: the fund has a taxable event and the investor has not yet hit the exclusion trigger. Several witnesses urged Treasury to allow a reinvestment window (six months, twelve months) during which a QOF could roll proceeds into new QOZ Business Property without interim recognition. The statutory text gives Treasury room; whether it uses that room is a drafting choice that will show up in the second round.

The second was inclusion of §1231 gain. Partnerships that invest in operating real estate recognize §1231 gain on dispositions, which nets to long-term capital at the partner level at year-end. The first round of regs indicated that the portion netting to capital qualifies, but did not walk through the timing. If a partner's 180 days runs from the last day of the partnership's taxable year, and §1231 netting happens at the partner level on the return filed months later, when exactly does the investor have to make the election. Comment letters asked Treasury to align the §1231 timing with the K-1 safe harbor already in the first round. That is a mechanical fix; it is also a fix that large investment funds need resolved before the end of their first tax filing season under the new program.

The third was investor-level reporting. Form 8996 covers the QOF. §1400Z-2(a)(1) requires the investor to elect on Form 8949. What the first round did not build out is the chain of reporting for a partner in a QOF partnership whose underlying investments are QOZ Business subsidiaries. Several witnesses argued for a simplified investor package (a supplemental schedule rather than a reconstruction of the asset-level tests), on the theory that ordinary investors cannot be expected to audit a 90% asset test from the outside. Treasury has not shown its hand here.

If you are coming to this topic cold, the broader context lives in our earlier pieces: the zone designations were locked in mid-2018 and fund-raising went live against an incomplete rulebook, as walked through in our September 2018 report on the designated map and the first-mover states; the first-round proposed regs filled in what they filled in, which we covered last month in our reading of REG-115420-18 and Rev. Rul. 2018-29.

How sponsors are pricing the gap

The practical question for anyone forming a fund this quarter is how to underwrite around the open items. Three patterns have settled in.

Real-estate sponsors are pushing forward. A single-asset substantial-improvement fund, organized as a partnership, with a written 31-month working-capital plan pointed at a specific property, and with the substantial-improvement test measured against a building-only basis per Rev. Rul. 2018-29, fits inside what the first round already says. Closings accelerated through November, December, and January despite the open items on the operating-business side, because none of those open items are binding on a plain-vanilla real-estate deal.

Operating-business sponsors are mostly still in fundraising. A fund that plans to hold a technology company, a manufacturer, or a multi-location services business cannot underwrite against the 50% gross-income test without knowing how Treasury will interpret it. Several sponsors have closed first rounds on soft commitments contingent on the second-round regs, with the expectation that subscriptions harden once the text publishes. If the second round arrives before the end of the first quarter, most of those soft commits convert. If it slips past mid-year, some number of them walk.

Mixed-use funds (a real-estate project with an operating-business tenant inside a zone) are the category that is hardest to price. The fund qualifies against the real-estate piece and fails or passes against the operating piece on rules that do not yet exist. Deal counsel is currently writing two-track plans that bifurcate the structure, with the operating business as a QOZ Business subsidiary and the real-estate leg inside the QOF directly. That adds complexity and legal cost, and it presumes the second round treats the two legs consistently. It may.

A dateline observation, honestly

Five days between a public hearing and a sitting agenda is not a lot of time to draft second-round regs. Treasury has telegraphed that the second round is in advanced stages; OMB review typically adds additional weeks to whatever the drafting calendar is. A realistic expectation is publication in the second half of the first quarter or the first half of the second quarter of 2019. Any sooner would be unusual. Any later would start to eat the seven-year step-up window, which, because of the §1400Z-2(b)(2)(B)(iv) 2026 recognition deadline, closes for new investments at the end of 2019.

That is the deadline that matters. The practical value of getting the operating-business rules finalized is measured in how much of 2019's capital can be committed with confidence against the seven-year step-up, and every week of delay compresses the window. The comment letters have been filed, the hearing has been held, and the second round is either close to publication or is waiting on a final political sign-off inside Treasury. From the outside we cannot tell which. From the outside, the deals waiting on it are visible enough.

Sources

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