Dear Mr. Dinwiddie:
The Milken Institute (the Institute)1 appreciates the opportunity to comment on the Internal Revenue Service’s request for comment regarding the proposed Opportunity Zones regulations.2
The Institute is a nonprofit, nonpartisan think tank determined to increase global prosperity by advancing collaborative solutions that widen access to capital, create jobs, and improve health. The Institute’s Center for Financial Markets (CFM)3 promotes financial market understanding and works to expand access to capital, strengthen and deepen financial markets, and develop innovative financial solutions to the most pressing global challenges.
More than 50 million Americans live in economically distressed communities, and between 2000 and 2015 more than half of these communities experienced a decline in both jobs and businesses.4 As part of the 2017 Tax Cuts and Jobs Act, more than 8,700 distressed communities, representing 34.7 million people and 11.8% of all U.S. census tracts, have been designated as Opportunity Zones (OZs or the Zones). By providing tax incentives to investors, the Opportunity Zones Initiative has the potential to create jobs and improve lives in these communities, and to contribute to economic growth and prosperity for the U.S. more broadly.
While we are encouraged by this potentially powerful economic development tool, we are also cognizant that various clarifications are needed to maximize positive impact. As a result, in August 2018 the Milken Institute formed a working group of legal and tax accounting experts to analyze the legislation and identify critical issues. Creating a fact pattern consistent with industry best practices, the working group traced a hypothetical Opportunity Zone investment from the point of realizing a gain to the point of disposing of a Qualified Opportunity Zone Fund (QOF) investment in the future. This “vignette” highlights common issues that most market participants would grapple with, such as forming a QOF and acquiring and improving Qualified Opportunity Zone Property. For your convenience, we are attaching the resulting analysis of critical issues to this letter.
Fortunately, recent proposed regulations clarified many of the critical issues; however, additional clarifications are needed as highlighted in the vignette. These additional clarifications will enable regulators, policymakers, and investors to more effectively support underserved communities, and ultimately realize the promise of this legislation.
Seventeen key takeaways of our comments are:
1. The proposed regulations provide that deferred capital gain will have the same tax attributes in the year of inclusion that it would have had if the gain were not deferred. Our understanding is that the gain will be taxed at whatever the applicable tax rate is for capital gain at the time of inclusion. For example, if short-term capital gain is invested into a QOF in 2019 and deferral for that gain ends in 2026, the capital gain will still be treated as short-term, but at whatever applicable rate that is in 2026. The taxpayer will not have "locked in" a specific applicable 2019 Federal tax rate by investing into a QOF. We recommend that the regulations provide clarity on this point.
2. The proposed regulations provide guidance around when the 180-day period for investment begins in a variety of contexts. There are two additional situations in which we recommend the regulations specifically address the timing for the beginning of the 180-day period. First, we recommend that the regulations address installment sales, and if each installment payment should have its own 180-day window beginning on the date that payment is received. Second, we recommend that the regulations address IRC section 1231 gains, and if the 180-day window begins on the last day of the taxable year, at which point a taxpayer would be able to calculate the amount of gain that will be treated as capital versus ordinary income.
3. The proposed regulations provide that in a scenario where a partnership (or other pass-through entity) sells a capital asset, either the partnership or the partners may be the "taxpayer" that invests the capital gain into a QOF. In the case of a partner investing its distributive share of capital gain, the proposed regulations provide that the partner may begin the 180-day period for investment on the last day of the partnership's tax year or on the day of the partnership's sale of the capital asset. In order to better enable partners receiving late notice to make Opportunity Zone investments, we recommend that the final regulations allow for a partner's 180-day window to begin upon receiving notice of the distributive share of capital gain. Additionally, we believe there is ambiguity around whether partners can invest their distributive share of the partnership's gross capital gain just like other taxpayers, or if partners are limited deferring net gain because the net number is typically reported on a K-1. We recommend the regulations clarify that partners are permitted to invest gross gain amounts, regardless of when the partner begins the 180-day window for investment.
4. Although the proposed regulations address questions around who is the "taxpayer" in the context of a partnership with capital gain, they do not address questions around who is the "taxpayer" in the context of a corporation with capital gain. We believe that guidance for the corporate context would be an appropriate addition to this set of regulations. We recommend that the regulations address whether any entity within a consolidated group can be the "taxpayer" that invests into a QOF when there is eligible capital gain within the consolidated group. We suggest that the regulations provide that any member of the consolidated group can invest the capital gain.
5. Taxpayers could benefit from additional clarity on Limited Liability Company (LLC) usage relating to the formation and structuring of the QOF and Qualified Opportunity Zone Business (QOZB) entities. Although the IRS FAQ website provides that a QOF can be a LLC, this is not included in the proposed regulations. To avoid confusion, we recommend this language be included on both the website and the finalized regulations. Additionally, we recommend that the regulations clarify that QOZBs can be a LLC, and that QOF and QOZB entities must be regarded entities for Federal tax purposes.
6. Draft Form 8996 for QOF certification provides for the taxpayer to list the first month in which the fund chooses to be a QOF and the proposed regulations provide for how to determine the 90% asset test measurement period for a QOF that is formed in a month that is not the first month of the taxable year. We recommend that the regulations provide additional guidance, perhaps in the form of an example, regarding how to calculate the first measurement date. For example, if a calendar year taxpayer forms a QOF on February 15 and contributes eligible capital gain on February 16, the QOF would list "February" as the first month in which it chooses to be a QOF. Would the first measurement date for that QOF be July 1st, July 31st, August 1st, August 15th, August 16th, August 31st, or something else?
7. It is our understanding that encouraging investments in existing projects and businesses that have already been in these communities would be consistent with the legislative intent of the Opportunity Zone initiative. In order to enable investors to better evaluate the tradeoffs between forming a new entity versus acquiring interest in an existing entity (i.e. QOF, QOZB, QOZP), investors need additional clarifications on the definition of “original use,” and IRS should ensure investments in existing entities are not unduly discouraged.
8. Additionally, Revenue Ruling 2018-29 states that the original use of land in an Opportunity Zone cannot commence with a QOF, but also says that the QOF does need to substantially improve land. This has raised questions around whether unimproved land in an Opportunity Zone can be Qualified Opportunity Zone Property. We recommend that the regulations address this ambiguity and clarified that unimproved land can indeed be Qualified Opportunity Zone Property. For example, if a QOF with $100,000 spends $90,000 to acquire land in an Opportunity Zone (value of land is $90,000 as reported on the QOF's financial statement), then the QOF has complied with the requirement that it most hold at least 90 percent of its assets in Qualified Opportunity Zone Property.
9. To encourage investments in job-creating operating companies, investors need more clarifications on the QOZB income test, and a definition of “active conduct” that favors such investments. Investments in OZ operating companies should create market leaders that generate economic growth within the Zones, but also attract income from regional, national, and international activities. As such, IRS should restore the original language in IRS Code section 1397C(b)(2) that is cross-referenced in 1400Z-2, which would only require that at least 50 percent of an Opportunity Zone Business’s total gross income come from the active conduct of its trade or business, rather than add an extra burden that income be sourced from within the Opportunity Zone.
10. To ensure Opportunity Zone residents reap more than employment benefits, investors need incentives to prioritize working with local stakeholders. Local business leaders, that have resided in an Opportunity Zone historically, are best placed to ensure local residents benefit from the initiative. IRS should consider a safe harbor for “related persons” that were residents of OZs prior to December 2017, and maintain that residency, by restoring “50 percent” rather than “20 percent” each place it occurs in the proposed regulations.
11. The proposed regulations prohibit a qualified investment from having more than 5% of its assets being in nonqualified financial assets. To ensure that QOF investments are appropriately capitalized with both debt and equity, and that capital is recycled within the Zones, Community Development Financial Institutions (“CDFIs”) should be included in the definition of QOZB, irrespective of the 5% nonqualified financial asset test.
12. The proposed regulations clarified that a QOF cannot invest in a “sin business”, which is defined as “a private or commercial golf course, country club, massage parlor, hot tub facility, suntan facility, racetrack or other facility used for gambling, or any store the principal business of which is the sale of alcoholic beverages for consumption off premises.” Given that a significant number of residents of Opportunity Zones suffer from mass incarceration, providing tax benefits to enterprises (i.e. private prisons) that profit from these activities would be in direct conflict with the spirit of the Opportunity Zone statutes. As such, we recommend expanding the definition of “sin businesses” and exclude QOF investments in private prisons.
13. The proposed regulations define the Working Capital Safe Harbor for QOZBs within the context of expenses on “the acquisition, construction, and/or substantial improvement of tangible property.” Many operating companies, especially in services industries, undergo an initial period of operating losses not associated with tangible property. It is our understanding that enabling job creating economic growth is what was intended in the Opportunity Zone legislation, and as such, should be prioritized, even if no improvement in tangible property is made. Therefore, we recommend the definition of the Working Capital Safe Harbor be expanded to include “operating losses” to ensure QOF investments in high growth operating companies are encouraged.
14. The proposed regulations provide a 31-month time period for the Working Capital Safe Harbor for QOZBs, as long as there is a written working capital plan with a designation and schedule. However, there is limited clarity on what qualifies as such. We recommend that the regulations provide additional guidance around the level of detail that must be included in the written designation and schedule, as well as what it means to be “substantially consistent” with the plan. For example, clarifications are needed on if the regulations require more than a written statement that the QOZB will be held for “the acquisition of and improvement of real estate in Texas”, or if it requires details on the specific parcel of real estate and the development plan, (scope, budget, and timing) for that parcel. If the plan relates to other tangible property, such as equipment, perhaps the plan would need to identify the type of equipment and the opportunity zone in which the equipment will be used. In terms of demonstrating substantial consistence with the plan and schedule, we recommend that additional guidance be provided in terms of what substantial consistence requires. Perhaps a percentage threshold of capital that must be spent in alignment with the plan and schedule. For example, has a QOZB “substantially complied” if 60% of its capital was spent as specified in the schedule?
15. The proposed regulations provide for how to calculate the percentage of tangible property owned or leased by a QOZB. Our understanding based on this provision and others is that tangible property leased to a QOZB counts as Qualified Opportunity Zone Property. However, we understand that there is some confusion among taxpayers on this point. We recommend a clarification in the regulations, explicitly clarifying that property leased to a QOZB can be Qualified Opportunity Zone Property. We further recommend that the regulations provide clarity around whether the lease must be entered into after December 31, 2017 and must be with an unrelated party in order for the leased property to count as Qualified Opportunity Zone Property. Additionally, we recommend that the regulations address whether property leased into the QOZB is subject to the substantial improvement requirement and if so, how would substantial improvement be measured? Our suggestion is that if the lease is treated as a valid lease for tax purposes, then the Opportunity Zone Business will have zero basis in the building and the building will not be subject to the substantial improvement requirement. However, if the lease is treated as a purchase for tax purposes, then the Opportunity Zone Business will be treated as having acquired the property and the leased building will be subject to the substantial improvement requirement.
16. The proposed regulations provide clarity on the 10-year hold for the purposes of taxpayers securing the Opportunity Zone tax benefits, however, there is confusion on how QOFs can maintain compliance during that 10-year period. To create alignment between QOFs and taxpayers related to the 10-year hold period, IRS should allow QOFs to roll over gains from interim sales in qualifying investments into other qualifying investments without triggering a taxable event (i.e. similar to the ability of taxpayers to rollover gains from one QOF to another within a six month period, as stated in the proposed regulations).
17. To fulfill the purpose and determine the impact of the Opportunity Zones Initiative, implementation standards and metrics are needed, but they must not be overly burdensome to collect. IRS should include a request for information on planned job creation resulting from a QOF investment on self-certification Form 8996.
A more comprehensive list of suggested clarifications that merit attention have been identified and detailed in the attached presentation.
The Milken Institute appreciates the opportunity to comment on this request for comment regarding the Opportunity Zones proposed regulations. Please let us know if we can provide any additional information, and we would be pleased to continue this discussion in person.
Center for Financial Markets
Center for Financial Markets
1 Available at: http://www.milkeninstitute.org/
2 Available at: https://www.irs.gov/newsroom/treasury-irs-issue-proposed-regulations-on-new-opportunity-zone-tax-incentive
3 Available at: http://www.milkeninstitute.org/centers/markets
4 Available at: https://eig.org/dci