Meeting the Substantial Improvement Requirement in Opportunity Zones

The new and final round of guidance on opportunity zones was released in December, and many opportunity zone investors are still understanding the impact. While the 500-page document highlighted many aspects of the rules and regulations regarding opportunity zones, guidance related to the substantial improvement rule was one of the most significant changes.

“The proposed regulations had an asset by asset test as to the substantial improvement rule,” Phil Jelsma, a partner and chair of the tax practice team at Crosbie Gliner Schiffman Southard & Swanson, tells GlobeSt.com. “Generally, with respect to property that has previously been depreciated, the taxpayer must double its tax basis or costs during the first 30 months of ownership to satisfy a ‘substantial improvement’ test.  Raw land or ground up’ development does not need to meet this rule but generally any property with existing structures that have been depreciated would be subject to the substantial improvement test.”

The final regulations impact the rule in a few ways, and could help investors of opportunity zone assets avoid the substantial improvement test. “First, the final regulations allow aggregation of multiple assets,” says Jelsma. “If the buildings are on contiguous parcels or located on a single parcel and transferred in a single Grant Deed, they can be aggregated as if they were a single parcel. Although all the buildings must receive some rehabilitation, they do not each need to meet the ‘substantial improvement’ test.”

In addition, the guidance includes a second rule to address contiguous parcels. “The second rule deals with contiguous parcels or parcels in contiguous Opportunity Zones which are not described in a single Grant Deed and they can be aggregated if used in the same trade or business and the investment improves the functionality of the assets,” says Jelsma. “The first test combines two or more assets in the same or contiguous parcels while the second test deals with property used in the same trade or business which can be located in contiguous Opportunity Zones.”

The guidance also reduces the vacancy requirement of a substantial improvement, also helping investors to prevent a substantial improvement test. “The final regulations also reduce the amount of time that a property has to be vacant in order to avoid substantial improvement test,” says Jelsma. “Under the proposed regulations, a property had to be vacant for at least five years.  If ‘vacant,’ the property did not need to meet the substantial improvement test. Under the final regulations, a property is considered vacant if less than 20% is used and it met this vacancy test during the 1-year period prior to the Opportunity Zone being designated.  If the property cannot satisfy this test, then it must be vacant less than 20% used for three years.”

Finally, the final regulations also allow Qualified Opportunity Zone Businesses to have two consecutive 31 month capital safe harbors or up to 62 month to establish a trade or business, according to Jelsma. “These working capital plans are important because these businesses may not have more than 5% of their assets in ‘nonqualified financial property’ like cash or bank accounts,” he says. “The proposed regulations created a 31 month safe harbor for working capital spent in accordance with a written schedule or plan.  The final regulations allow 2 consecutive 31-month periods if there are multiple cash investments and payment is part of an integral plan.”