This past April, the U.S. Treasury released a second set of proposed regulations relating to the qual­ified opportunity zone program. These proposed regulations address a wide range of is­sues affecting owners of real property located in “qualified opportunity zones” who want to develop their property using capital furnished by qualified opportunity zone pro­gram investors.

From the per­spective of those owners, the most impor­tant issues addressed by this second set of proposed regula­tions relate to the cir­cum­stances under which (1) unimproved land or a vacant structure acquired by pur­chase or real property acquired under lease that is used in trade or bus­iness in a qualified op­portunity zone will be treated as “quali­fied oppor­tunity zone business pro­perty;” and (2) the ownership and operation of real property is deemed conducting an active trade or business.

What follows is an ex­plana­tion of the significance of quali­fied oppor­tunity zone business pro­perty status within the relevant sta­tu­tory framework, a brief description of the proposed regulations relating to when real proper­ty will be treated as quali­fied oppor­tunity zone business pro­perty and a real life example of how these proposed regulations have made it easier for real property owners to raise capital from qualified opportu­nity zone investors.

Significance of Business Property Status

The qualified op­por­tunity zone program provides significant tax benefits to a taxpayer who has realized a capital gain and makes a timely investment of some or all of that gain in a “qualified opportunity zone fund” (i.e., an investment vehicle that, a­mong other things, holds at least 90 percent of its assets in qua­li­fied op­por­tunity zone pro­perty). Most investment vehicles seeking qualified opportunity zone fund status satisfy this 90 percent of assets test by acquiring equity interests in entities that are and are expected to remain “qualified op­portunity zone bus­i­nesses.” An entity is a qualified opportunity zone business if, among other things, it con­­ducts an active trade or business within a qualified opportunity zone and at least 70 per­cent of the pro­perty owned or leased by that trade or business is qua­li­fied op­por­tunity zone business pro­perty.

Real property owned by an entity is qualified opportunity zone business pro­perty for pur­poses of the 70 percent of assets test if, a­mong other things, (1) it is used in a trade or bus­iness within a qualified opportunity zone, (2) it is pur­chased from an unrelated seller after Dec. 31, 2017, and (3) its original use com­mences with its purchase by the entity or it is sub­­­­stan­­­tially improved by the entity following its pur­chase. (For purposes of the relevant statutory framework, entities generally are treated as “related” if the same persons own (or are considered to own un­der certain rules of constructive ownership) more than 20 percent of the capital or profits of each entity.)

The proposed regulations provide two methods for determining the asset values for pur­poses of the 90 per­cent and 70 percent of assets tests. If a taxpayer has an applicable fin­an­cial statement (i.e., files a GAAP compliant financial statement with the SEC or other federal a­gency (other than the IRS) or provides a GAAP compliant audited fin­an­cial statement to its credi­tors or equity holders), it may value its owned or leased property as reported on that state­ment or it may elect to use an alternative method under which the value of owned property is e­qual to its unad­justed cost basis and the value of leased property is equal to the present value of the pay­ments to be made under the related lease. Taxpayers that do not have applicable financial state­ments are required to value their assets using the alternative method described above.

Property Acquired by Purchase

Unimproved Land. The proposed regulations make clear that unimproved land does not need to be sub­stan­tially improved following purchase in order to be treated as qual­ified op­por­tu­nity zone bus­i­ness property. However, to be treated as qualified opportunity zone business pro­perty, the unim­proved land must be purchased with the inten­t to improve it by “more than an in­sub­stantial a­mount” within 30 months following its purchase and it actually is so im­proved or oth­­­erwise en­hanced in value following purchase.

Vacant Structures. The proposed regulations include a special rule relating to vacant struc­tures, which provides that a vacant, previously used structure will satisfy the original use requirement if, at the time of purchase, it has been unused or vacant for an uninterrupted period of at least five years.

Property Acquired Under Lease

The proposed regulations provide that leased property does not need to satisfy the ori­gi­nal use/substantial improvement requirement in order to be treated as qualified op­por­tunity zone bus­i­ness property, provided it is leased from an unrelated lessor under a “market rate lease” entered into af­ter De­c. 31, 2017. How­ever, in the event the lessor and the lessee are related, the leased property will not be treated as qualified op­portunity zone business pro­perty (1) if the lessee makes a pre­pay­ment to the lessor (or to a person related to the lessor) re­lating to a period of use of the property that exceeds 12 months, or (2) if at the time the lease was entered into, there is a plan, intent or ex­pec­tation for the real property to be purchased by the les­see for an a­mount other than fair market value (deter­mined at the time of purchase without re­gard to pri­or lease payments).

The proposed regulations also provide that improvements an entity makes to leased pro­­­perty satisfy the “original use” requirement for the amount of the cost of such improvements (unreduced by subsequent depreciation).

Operating Real Property as an Active Trade or Business

The proposed regulations make clear that owning and operating (including lea­sing) real property constitutes actively conducting a trade or business, but that merely leasing property under a triple-net-lease is not.

The following example illustrates how the proposed regulations have enabled the owner of real property to access previously inaccessible qualified investment zone investment capital to fund a hotel devel­op­ment project in a qualified opportunity zone:

Individuals A and B own lim­ited liability com­pany X, which in 2010 purchased a mixed-use building lo­cated in a qualified opportunity zone. A and B want to convert the building into a hotel u­s­ing funds fur­nished by qual­ified op­portunity zone pro­gram inves­tors but wish to retain a 40 percent in­terest in the hotel.

The building is not currently qualified business op­por­tunity zone business property because it did not satisfy the “purchased after Dec. 31, 2017” requirement. A and B formed lim­ited lia­bility com­pany Y, to be owned 40 percent by them and 60 per­cent by oppor­tunity zone program investors, and then had X sell the building to Y. Prior to issuance of the second set of proposed regulations, this strategy would not have resulted in the building being treated as qualified business opportunity zone business pro­perty—while it would have satisfied the “purchased after De­c. 31, 2017” require­ment, it would not have qualified in the hands of Y, because it would have been pur­chased from X, a re­lated party.

Under the second set of proposed regula­tions, A and B are able to satisfy the “related party” rules, by having X lease the buil­ding to Y for a term of 50 years under a “market rate lease,” there­by transforming the building into qualified opportunity zone busi­ness property.

Barry A. Klingman, head of Warshaw Burstein's tax department, has had more than 40 years of experience in all areas of taxation.