By Alex Flachsbart, Opportunity Alabama

 Guidance Issued. On Wednesday, April 17th, Treasury released the latest round of guidance on the Opportunity Zones program. It answers many of the big issues we were tracking, especially for active businesses, where we now have a much clearer pathway towards qualification and investment. The summary below is not meant to be all-encompassing or comprehensive, nor is it meant to be tax or accounting advice. Instead, it is meant to provide you with the information you need to ask the right questions and start getting engaged in the Opportunity Zones ecosystem we’re building across Alabama!

 Setting the Table. Whether a project is a real estate deal or an actual operating company, it must meet the same set of six tests, which are grouped into two buckets. Key clarifications made by Treasury are bolded, then explained at length below.

After the new round of regulations, the rules read as follows:

  • 70% of the business’ tangible property must: (1) be acquired by purchase after 2017 from an unrelated party, (2) spend 70% or more of its time in the zone, and (3) be “original use” property or be substantially improved. The treatment of leased (rather than “purchased”) property and a number of lingering issues around original use and substantial improvement are addressed below.
  • In addition, the business must (4) get 50% of its revenue from “active conduct” in the zone (described at length below), (5) use 40% or more of its intangible property in the zone, and (6) spend down working capital raised within 31 months. Until Wednesday, Point (4) was the big issue for operating companies, but – thanks to Treasury guidance – we now have a much clearer path towards qualifying operating companies for Opportunity Fund investment.

Qualifying a Business – The Framework, Explained

Operating Companies – The “Active Conduct” Test. Under the prior round of regulations, operating companies (from startups to manufacturers) could not qualify as Opportunity Zone businesses unless they could prove that at least 50% of their gross income came from the “active conduct” of their business within an Opportunity Zone. In this round, Treasury clarified what this means.

As long as 50% of the services performed by your business are performed in the zone, your business should satisfy the 50% gross income requirement. You can measure whether 50% or more of your services were performed in the zone by looking at (1) percent of employee / contractor hours spent in the zone, (2) percentage of salary / contractor payments allocable to the zone, or (3) whether the tangible property and management functions of the business in the zone generate 50% or more of business revenue. Note that none of these tests require you to look at where your customers are located.

A few other clarifications should be very helpful to active businesses as well.

  • Active businesses now have the same 31-month “safe harbor” for spending down working capital raised from an Opportunity Fund that real estate projects enjoy.
  • Businesses can have tangible property (like trucks) that move around consistently, as long as that movable property is located in a zone at least 70% of the time – and goods or inventory in transit are ignored for purposes of this test.

Original Use and Substantial Improvement
. For any business or real estate company that owns assets, those assets must be either “original use” or “substantially improved.” (For businesses / real estate projects that lease assets, see below). There was some confusion about what these terms meant and how they apply. Treasury clarified that “original use” means property that has never before been depreciated in an OZ – opening the door to Opportunity Funds acquiring newly constructed property without taking on construction risk or existing businesses moving into OZs and reforming with new investors.

A few helpful clarifications around what does and does not need to be substantially improved:

  • Property that has not been depreciated before is original use and does not need to be substantially improved.
  • Land is a unique asset because it has been occupied since time immemorial. Treasury formally recognized this and exempted land from the original use / substantial improvement requirement altogether. However, this does not allow OZ equity raises for land-banking – the land acquired must still be used in the active conduct of a trade or business.
  • Buildings that are vacant for five years or longer before their OZ acquisition and development count as original use and do not need to be substantially improved. This is a huge win for those looking to redevelop substantially blighted areas – but clarification is still needed on what degree of proof must be shown that a building was, in fact, vacant.
  • Leased property does not need to be substantially improved, as explained below.

This basically leaves (a) owned existing buildings and (b) other owned existing assets already placed into service by a business – like machinery or equipment – that would need to be substantially improved if acquired (directly or indirectly) by an Opportunity Fund. Unfortunately, the regulations suggest that those improvements need to be made on an asset-by-asset basis – dealing a major blow to existing businesses, who will have some difficulty doubling the cost basis of every asset they own.

Leased Property
. One of the major problems (for real estate and operating companies) with the statute revolves around the uncertainty it created on how leased property should be treated. Treasury provided a comprehensive framework for leased property in the regulations, clarifying that leased property will count as qualified OZ business property if it was (1) acquired after December 31, 2017 and (2) spends 70% or more of its time in an OZ. Critically, there is no original use or substantial improvement requirement for leased property – but only if the lease is structured as a “market rate lease” for federal tax purposes. Treasury also provided a much simpler method for valuing leased property for purposes of calculating the required asset tests under the statute (tying to financial statement value or by performing a “present value” calculation). These new rules around leasing open up some intriguing possibilities, but also present some challenges in certain instances, especially where leases are not for fair market value.

Other Helpful Clarifications. A few other clarifications that could be helpful, especially in the real estate context:

  • Government-induced delays in permitting or entitlement can create an extension of the 31-month safe harbor for spending down an Opportunity Fund raise.
  • Companies in the business of leasing property can be qualified OZ investments. However, a company that exists solely to triple net lease a piece of property or a development to a third party may have substantial difficulty qualifying.

Running a Fund.
A few major fund issues some of you have been tracking:

  • Under the new guidance, funds have at least 6 but no more than 12 months to deploy capital from whenever it actually hits the fund, eliminating the timing concerns around the June 30 / December 31 testing dates. This provides some additional flexibility from the prior round, in which managers were worried about raising capital immediately before the fixed testing dates.
  • While further analysis is needed, Treasury appears to have created a mechanism to help partners in qualified Opportunity Funds avoid having to pay at least some depreciation recapture at sale.
  • Debt-financed distributions appear to be permitted, but only if done carefully and in strict compliance with partnership tax principles.
  • Treasury created a defined process for winding down a multi-asset fund that is far more straightforward than the previous process.
  • Treasury clarified that a qualified opportunity zone business (whether it’s an operating company or real estate) needs to remain qualified for 90% of the holding period or more, opening the door to the possibility that a business could be non-qualified for a period of time and still be a good asset for a fund.

However, the biggest question of all – whether interim gains from sales during the 10+ year holding period would be taxable events for fund LPs – was not addressed in this round. Instead, Treasury clarified that if sales do occur, funds have 12 months to reinvest the proceeds into new investments (but that, in doing so, LPs will still have to pay capital gains tax on those interim gain events).

Given the refusal by Treasury to provide clarity on this issue, some fund managers are already looking at alternative solutions. Some have proposed allowing partners to take distributions from interim gains and reinvest those distributions into a new QOF managed by the same fund manager – albeit with a new holding period. Regardless of the solution, however, the interim gains issue remains the single biggest unresolved question in the OZ space after the latest round of regulations.

Next Steps
. Over the next several months, Opportunity Alabama will be criss-crossing the state doing seminars on the latest round of OZ guidance and continuing to build a pipeline of investable projects. Email us at [email protected] with the subject line “Travel Schedule” if you’d like to get the itinerary or schedule a talk near you.