On December 19, 2019, the U.S. Treasury Department and the IRS released the long-awaited final regulations for the Qualified Opportunity Zone (QOZ) regime. The final regulations confirm much of the guidance provided in the two earlier sets of proposed regulations and answer many questions, but important issues remain open.
THE TOP 11 DEVELOPMENTS IN THE FINAL REGULATIONS
1. Gross Section 1231 Gain: Gross section 1231 gain (from the sale of real property or depreciable property used in a trade or business and held for more than one year) may be invested in a qualified opportunity fund (QOF), without regard to gross section 1231 losses, and the 180-day investment period generally begins on the sale date.
2. Pass-Through Gain: For eligible gain allocated from a partnership, at the partner's election, the 180day investment period may begin on (a) the sale date, (b) the last day of the partnership's taxable year or (c) the unextended due date of the partnership's tax return (generally, the following March 15). Similar rules apply to S corporations, estates and non-grantor trusts. For a RIC or REIT capital gain dividend, at the shareholder's election, the 180-day investment period may begin on (i) the payment date or (ii) the last day of the shareholder's taxable year.
3. Asset Sale Exit: If, after 10 years, a QOF partnership or QOF S corporation directly or indirectly sells assets (other than sales of inventory held in the ordinary course of business), the resulting gain is taxfree to a qualifying investor. To avoid certain adverse tax consequences, the net sales proceeds should be entirely distributed to the investor within 90 days of the sale.
4. 62-Month Safe Harbor: A qualified opportunity zone business (QOZB) may use multiple 31-month working capital safe harbors, up to a total of 62 months, which provides helpful flexibility for projects with long start-up or development periods.
5. Feeder Vehicles; Carried Interest: An investor may contribute its QOF interest to an upper-tier partnership (UTP) without triggering deferred gain. The UTP may issue a profits interest to a service provider, which may result in tax-free gain to the service provider after 10 years from the investor's QOF investment.
6. 2021 Effective Date; No Grandfathering: The final regulations are generally effective for 2021 and later. A taxpayer may elect to apply the final regulations (instead of the prior proposed regulations) to pre-2021 years, but only if the taxpayer applies all of the final regulations for all of such years. The lack of a grandfathering provision may prevent the prior proposed regulations from applying to tax positions relating to QOF or QOZB compliance that have ongoing relevance in 2021 or later.
7. Investment by Property Seller in the QOF: The preamble confirms that existing common law doctrines may apply to QOZ transactions. For example, if a seller of property invests sale proceeds in the QOF buyer, or in the QOF that owns the QOZB buyer, existing "step transaction" principles may recast the transaction as an in-kind contribution depending on the facts and circumstances, which may eliminate the seller's QOZ tax benefits and disqualify the property with respect to the buyer.
8. Ground Leases: All leased real estate (including, apparently, unimproved land) is non-qualifying property if the lessee QOF or QOZB has a fixed-price purchase option, regardless of whether the lessor is related or unrelated to the lessee.
9. Vacant or Polluted Property: The "original use" requirement is automatically met by real property that (a) has been vacant (less than 20% used) for an uninterrupted period of at least 3 years, or at least one year ever since the area's QOZ designation, until its purchase by a QOF or QOZB, or (b) is in a brownfield site and is remediated by the QOF or QOZB, even if the property has been previously placed in service.
10. Excluded Businesses: Although a QOF may directly own and operate (or lease property to) a golf course, country club, massage parlor, hot tub facility, suntan facility, gambling facility or liquor store, a QOZB cannot do so, subject to a 5% de minimis threshold.
11. Non-U.S. Investors: For a non-U.S. investor, only gain that is otherwise subject to U.S. federal income tax (e.g., FIRPTA gain or other ECI gain that is not exempt under a treaty) may constitute eligible gain.
BRIEF INTRODUCTION TO THE QOZ REGIME
In 2017, Congress created a new tax incentive program to promote investments in certain low-income communities and adjacent census tracts (qualified opportunity zones, or QOZs). Three tax benefits are generally available for a taxpayer who timely invests eligible gain into a qualified opportunity fund (QOF):
1. deferral of the eligible gain until December 31, 2026, or upon an earlier inclusion event;
2. permanent exclusion of some of the eligible gain, subject to 5- and 7-year holding periods, which generally results in a 15% exclusion for eligible gain invested in a QOF in 2018 and 2019 or a 10% exclusion for eligible gain invested in 2020 or 2021; and
3. permanent exclusion of all gain from the QOF investment itself, subject to a 10-year holding period.
To qualify as a QOF, an investment vehicle must generally be the original user of or substantially improve tangible property located in a QOZ, whether directly or (more commonly) indirectly through a subsidiary known as a qualified opportunity zone business (QOZB). The property must be acquired by purchase from an unrelated person or by lease, be used in a business in a QOZ and constitute a minimum percentage of the QOF's assets or the QOZB's tangible assets.
The QOZ regime is extremely complex. The remainder of this Memorandum focuses on the changes and other new guidance made in the final regulations. For additional discussion of the QOZ regime and the prior proposed regulations, please see our October 22, 2018 Memorandum and our April 22, 2019 Memorandum.
INVESTMENTS IN QOFS
Eligible Gain: Section 1231
Gain from the sale of "section 1231 property," which generally includes real property and depreciable personal property used in a trade or business and held for more than one year, is not automatically capital gain. Instead, a taxpayer must generally aggregate all of its section 1231 gains and losses for a taxable year, including its share of such gains or losses recognized by a partnership, S corporation or other pass-through entity. The net section 1231 gain is generally long-term capital gain, and the net section 1231 loss is generally an ordinary loss, except that net section 1231 gain may be recharacterized as ordinary income under a recapture rule in certain circumstances.
Under the prior proposed regulations, only a taxpayer's net section 1231 gain for a year was eligible gain that could be invested in a QOF. Because the section 1231 netting occurs at the individual or corporate taxpayer level, the application of this rule to section 1231 gain recognized by pass-through entities was uncertain.
The final regulations treat gross section 1231 gain as eligible gain, subject to other applicable requirements. This rule gives affected taxpayers greater certainty as to their eligible gain and permits taxpayers with items of gross section 1231 gain and gross section 1231 loss to defer the gain and thereby free up the loss to apply against ordinary income in the same year. The final regulations also clarify that, under certain circumstances, the section 1231 recapture rule may treat the deferred section 1231 gain as ordinary income on December 31, 2026, or an earlier inclusion event, even if the gain would not have been so recharacterized when originally recognized if no QOF investment were made. As discussed below, the final regulations make a corresponding change to the timing of the 180-day investment period for such gains.
Eligible Gain: Non-U.S. and Tax-Exempt Investors
The final regulations provide that only gain that is otherwise subject to U.S. federal income tax is eligible gain. Therefore, for a non-U.S. investor, only FIRPTA gain (i.e., gain from the sale of U.S. real property interests) and other gain that is effectively connected with the conduct of a U.S. trade or business (ECI) (or that is otherwise subject to U.S. federal income tax) may constitute eligible gain, provided that such gain is not otherwise exempt from U.S. federal income tax under a U.S. income tax treaty (e.g., gain that constitutes business profits but is not attributable to the taxpayer's U.S. permanent establishment). As a result, a non-U.S. investor's gains that are not subject to U.S. federal income tax (e.g., gain from the sale of securities, except for certain individuals with a minimum presence in the United States) are not eligible gain. Likewise, for a tax-exempt investor, only gain that constitutes unrelated business taxable income (UBTI), such as gain from the sale of debt-financed property, may constitute eligible gain. There is no guidance as to whether a non-U.S. or tax-exempt investor that chooses to rely on the prior proposed regulations for pre-2021 years may treat pre-2021 gain that is not subject to U.S. federal income tax as eligible gain.
A partnership is permitted to invest its eligible gain into a QOF without regard to the foreign or tax-exempt status of its partners. However, the final regulations include an anti-abuse rule targeting partnerships formed or availed of with a significant purpose to avoid the above rules (e.g., a non-U.S. person contributing securities to a partnership and causing the partnership to sell the securities and make the QOF investment).
Eligible Gain: Offsetting-Positions Transactions & Section 1256 Contracts
Under the prior proposed regulations, gain arising from a position that was part of an "offsetting-positions transaction" (defined broadly as a transaction in which a taxpayer has substantially diminished its risk of loss associated with one position by holding one or more additional positions, including positions with respect to property that is not actively traded) was not eligible to be deferred.
The final regulations abandon the blanket disqualification of "offsetting-positions transactions" and instead disqualify only gain from a position that was part of a section 1092 straddle (which applies only to actively traded personal property), subject to certain exceptions. The exclusion applies only if the gain arose from a position that was part of a section 1092 straddle during the current year or during a prior year if a loss from any position in the prior-year section 1092 straddle is carried over to the current year. In addition, the final regulations liberalize the treatment of "section 1256 contracts" (i.e., regulated futures contracts, foreign currency contracts, nonequity options, dealer equity options and dealer securities future contracts), in particular disqualifying only the portion of the net gain arising from "section 1256 contracts" attributable to such contracts that were part of section 1092 straddles (and, unlike the prior proposed regulations, not disqualifying all such net gain). As in the prior proposed regulations, subject to the above, only net section 1256 gain in a taxable year is eligible gain.
180-Day Investment Period
To qualify for tax benefits under the QOZ regime, eligible gain must be invested in a QOF during a 180day investment period generally beginning on the date the gain is realized.
Under the prior proposed regulations, when a partnership recognizes eligible gain, a partner may choose to use two different investment periods. The final regulations add a third investment period option (#3 below):
- The 180-day period beginning on the date on which the gain is realized,
- The 180-day period beginning on the last day of the partnership's taxable year in which the gain is realized or
- The 180-day period beginning on the due date (without extensions) of the partnership's tax return for the year in which the gain is realized (generally, the following March 15).
Similar 180-day periods apply to shareholders of S corporations and beneficiaries of estates and nongrantor trusts.
The prior proposed regulations provided that a RIC (mutual fund) or REIT shareholder may invest a capital gain dividend during the 180-day period that began on the date the dividend is received, even if the RIC or REIT did not designate the dividend as a capital gain dividend until later. The final regulations add a second elective 180-day investment period that generally begins on the last day of the shareholder's taxable year.
Because the prior proposed regulations limited eligible gain from the sale of section 1231 property to the taxpayer's net section 1231 gain for its taxable year, the 180-day period for such net gain began on the last day of the taxable year. As discussed above, the final regulations permit gross section 1231 gains to be eligible gains, and accordingly, the 180-day period for section 1231 gain, like that for capital gain, generally begins on the date on which the gain is realized (but in the case of section 1231 gains allocated from a partnership or other pass-through entity, a partner or other owner may elect to begin its 180-day period on a later date as described above).
The change to the section 1231 gain investment timing presents a potential trap for the unwary. For example, suppose a taxpayer realized a section 1231 gain in May 2019 (and no section 1231 loss in 2019) and invested the gain in a QOF on December 31, 2019, which was the first day of the 180-day investment period under the rule in the prior proposed regulations, albeit after the 180-day period beginning on the date of realization. An election by the taxpayer to apply the final regulations to pre-2021 years would cause the taxpayer's QOF investment to be non-qualifying because it did not occur within the 180-day investment period beginning on the section 1231 gain realization date.
The final regulations confirm that installment sale gains may be eligible gains, even if the applicable installment sale occurred before the enactment of the QOZ regime on December 22, 2017. Taxpayers may elect to start the 180-day investment period on the date an installment sale payment is received or on the last day of the taxable year in which the installment gain is recognized. A portion of the installment sale price may be interest under the imputed or unstated interest rules, and the deferral of installment sale gains with a QOF investment does not also defer the interest inclusions.
Investment by Property Seller in the QOF
In some cases, the seller of a property to a QOF (or a QOZB) may also wish to invest in the QOF. The final regulations (and the preamble) confirm that this type of taxable "rollover" transaction may be challenged in two ways.
First, as discussed in the preamble, if the sale proceeds (or presumably any portion of it) are returned to the QOF as part of a plan, the IRS may recast the transaction as a partially or wholly in-kind contribution of the property to the QOF (or the QOZB) under existing the common law "step transaction" and "circular cash flow" doctrines. In that case, the seller may not recognize eligible gain in the deemed contribution, and the property may fail the "purchase" requirement and therefore constitute non-qualifying property.
Second, the final regulations confirm that if the seller becomes related to the buyer as a result of the seller's planned subsequent investment in the QOF, the sale and purchase may be treated as occurring between related persons. In that case, the seller would not recognize eligible gain, and the property would fail the "purchase" requirement and therefore would constitute non-qualifying property.
Accordingly, if a QOF (or a QOZB) purchases property from a potential QOF investor, the QOF and the potential investor should carefully consider the structure of the sale and the investment in light of the above.
A QOF investor generally recognizes its deferred gain (less any portion excluded as a result of the 5- or 7-year holding period rule) on December 31, 2026, or at certain earlier "inclusion events," such as a sale of the QOF interest, certain transfers of interests in the QOF investor and certain taxable distributions from the QOF.
Feeder Funds and Other Entity Transactions
An investor with eligible gain generally must invest directly in a QOF and cannot contribute its cash or other property to another entity that then invests in the QOF. However, the prior proposed regulations permitted an investor to contribute its QOF interest to a partnership in a tax-free transaction without causing an inclusion event. The final regulations confirm this result with an example in which the subsequent partnership contribution occurs two years after the QOF investment, which should provide some comfort for an investor who contributes its QOF interest to a partnership in a similar time frame. If the partnership contribution occurs within two years after the QOF investment or is pursuant to a plan, the investor should consider the risk that the QOF investment may be subject to challenge under existing common law "step transaction" or other doctrines.
The final regulations confirm that certain inclusion events may trigger the deferred gain but nevertheless allow the investor to continue to qualify for gain exclusion after 10 years. These inclusion events include a distribution by a QOF partnership (including an LLC taxed as a partnership) to a partner of cash or property with a fair market value in excess of the partner's tax basis and certain return-of-capital distributions by a QOF corporation to a shareholder in excess of the shareholder's basis in its QOF interest.
The prior proposed regulations provided that an investor may reinvest gain arising from an inclusion event into a new QOF investment (and therefore defer gain again) only if the inclusion event was the complete disposition of the entire original QOF investment. The final regulations remove the requirement of a complete disposition and permit an investor to reinvest gain arising from a partial disposition of the investor's QOF interest. It is not clear whether gain arising from other inclusion events (e.g., distributions by QOF partnerships or QOF corporations discussed above) is eligible to be reinvested into a new QOF investment.
For an S corporation that owns QOF investments, the final regulations eliminate a rule in the prior proposed regulations that a 25% or more change in the S corporation's stock ownership was an inclusion event for all of the S corporation's QOF investments. As a result, the S corporation's shareholders generally do not cause an inclusion event when they sell or dispose of any amount of their S corporation stock.
A gift for income tax purposes, which includes certain charitable contributions and certain transfers to one's spouse or former spouse incident to a divorce, is an inclusion event. The final regulations confirm that the gift recipient is not entitled to any QOZ tax benefits in respect of the gifted interest.
The final regulations confirm that a transfer by a taxpayer to a grantor trust (including an intentionally defective grantor trust) of which the taxpayer is the sole grantor is generally disregarded for income tax purposes (whether the transfer takes the legal form of a gift, sale or other structure) and is not an inclusion event, which may facilitate estate tax planning for QOF investors.
In contrast, death is not an inclusion event: the heirs obtain the QOF interest with no basis step-up, recognize the deferred gains (subject to partial exclusion under the 5- and 7-year holding period requirements) in 2026 or an earlier inclusion event, as the decedent would have, and can obtain the same 10-year gain exclusion tax benefit, as the decedent would have. The final regulations do not provide specific guidance on the treatment of charitable bequests of QOF interests, including how (if at all) the charity would be taxed on a subsequent inclusion event.
Treatment of Certain QOF Partnership Distributions Within Two Years of Investment
The final regulations continue to provide that modified disguised sale rules apply to QOF partnership investments. Under these rules, which involve a large body of authorities that are beyond the scope of this discussion, a distribution of cash or other property (generally excluding operating cash flow and certain preferred distributions) to a QOF investor within two years of its QOF investment is presumed to be part of a disguised sale, and disqualifies the initial QOF investment to the extent of the distribution. If a distribution is recharacterized as part of a modified disguised sale, a portion of the initial QOF investment corresponding to the distribution is disqualified, which may result in tax, interest and penalties to the investor and may reduce the investor's QOZ tax benefits on its QOF investment.
In response to commenters' requests, the final regulations add a new example in which an investor contributes cash to an "overfunded" QOF partnership and the QOF returns some cash to the investor in the same year at a time when the investor has zero basis in its QOF interest. The example states, without explanation, that the distribution is not recharacterized under the modified disguised sale rules discussed above. (It is not apparent how the contribution and distribution in the same year can overcome the twoyear presumption under the modified disguised sale rules.) The example concludes that the distribution is an inclusion event for the investor, which would result in tax, but not interest and penalties, for the investor. As discussed in "Feeder Funds and Other Entity Transactions" above, it is not clear whether gain arising from an inclusion event resulting from a QOF partnership distribution is eligible to be invested into a new QOF investment.
Potential to Merge Existing QOFs
The more favorable rules for multi-asset QOFs, described below, may encourage some existing singleasset QOFs to merge. The prior proposed regulations generally permitted QOF corporations to merge with each other without resulting in an inclusion event. The final regulations continue this treatment and further generally permit QOF partnerships to merge with each other without causing an inclusion event. Any merger of QOF partnerships should be carefully reviewed because it is irreversible. Divisions of QOF partnerships are inclusion events, although certain tax-free spin-offs of QOF corporations are not inclusion events.
10-YEAR GAIN EXCLUSION
QOF Partnerships and QOF S Corporations
Under the statute, a qualifying investor may sell its interest in a QOF partnership or QOF S corporation after 10 years and pay no federal income tax on its gain, including with respect to depreciation recapture and other ordinary income gain items. The prior proposed regulations extended the 10-year gain exclusion rule to capital gain recognized by a QOF partnership or QOF S corporation (but not by a QOZB) on the sale of its qualifying property and allocated to a qualifying investor who has held its QOF interest for at least 10 years.
The final regulations further extend the 10-year gain exclusion rule to all gains and losses arising from the sale of property (other than inventory held in the ordinary course of business) owned directly, or indirectly through one or more partnerships (including QOZB partnerships), by a QOF partnership or QOF S corporation, and allocated to a qualifying investor. This gain exclusion treatment is elective by the investor, and the investor may make different elections for different QOFs for different years (thereby selectively excluding gains and including losses from different QOFs or from the same QOF for different
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years), although an election applies to all of the allocable applicable gains and losses from a QOF for the year.
The expanded 10-year gain exclusion rule in the final regulations makes it possible for QOZB partnerships to sell their assets directly. For QOFs that conduct real estate businesses through such QOZBs, this means that the QOZBs can sell the real estate directly, which better aligns with commercial practice and encourages the use of multi-asset QOFs that may own different real estate projects to be sold eventually to different buyers.
To eliminate future QOZ benefits attributable to the reinvestment of proceeds from a property sale with respect to which an investor excluded gain, the final regulations introduce a complex deemed distribution and recontribution mechanic solely for determining an investor's qualifying and non-qualifying interest in a QOF generally after the sale. The effect of this mechanic is that if the QOF does not distribute all of the net proceeds from a property sale within 90 days, a portion of an investor's QOF interest does not qualify for the 10-year gain exclusion rule going forward.
Accordingly, it is expected that QOF partnerships and QOF S corporations will seek to distribute all of the net proceeds from a property sale within 90 days. The distribution may be difficult to achieve with deferred payment sales, such as those involving escrow arrangements and seller notes payable after 90 days. Furthermore, although "net proceeds" is generally reduced by the property's secured acquisition indebtedness, it may not exclude other indebtedness that is paid down with the sale (e.g., pursuant to a mandatory prepayment requirement in a credit document). In such a situation, the QOF may not have sufficient available cash on hand to satisfy the 90-day net proceeds distribution requirement and may need to borrow the necessary funds.
Consistent with the discussion above, under the statute, a qualifying investor may sell its interest in a QOF REIT after 10 years and pay no federal income tax on its gain. The prior proposed regulations extended the 10-year gain exclusion rule to capital gain dividends paid by the QOF REIT attributable to sales of qualifying property by the QOF REIT (but not by a QOZB), which was implemented via a 0% federal income tax rate on the dividend. However, the dividend may have nonetheless been subject to the 3.8% additional Medicare tax on net investment income (NII) and state or local income tax.
Under the final regulations, the capital gain dividend is excluded from gross income, which should prevent the dividend from being subject to the NII tax and may mitigate state or local income tax on the dividend in conforming jurisdictions. However, the final regulations continue to limit the 10-year gain exclusion rule to net capital gain from the sales of qualifying property by the QOF REIT (but not by a QOZB). The final regulations also extend this 10-year gain exclusion rule to QOFs that are RICs.
REIT Investments into QOFs
Although the final regulations are generally favorable for taxpayers, they did confirm an issue that applies to REIT investments in QOFs, which may have the effect of turning certain QOF gain exclusion benefits into tax deferral (i.e., timing) benefits for REIT shareholders and recharacterizing capital gain as ordinary income.
For example, suppose a REIT recognized $100 million of eligible gain in 2019, which it invests in a QOF. The REIT defers the $100 million of capital gain to 2026, when the REIT will recognize $85 million of its deferred gain (assuming no prior inclusion event and that the REIT's QOF investment has not
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depreciated) and must generally pay an $85 million dividend in order to avoid corporate-level income tax. After 10 years, in 2029, when the REIT's QOF investment is valued at $300 million, the REIT can sell its QOF investment without any taxable gain at the REIT level.
The final regulations confirm that the REIT's earnings and profits (E&P) is increased by the $200 million of tax-free gain when the REIT sells its QOF investment. The REIT's E&P is also increased in 2024 by the $10 million (10%) basis increase and in 2026 by the $5 million (5%) basis increase. As a result, if the REIT makes a distribution to its shareholders in excess of the REIT's taxable income, the excess distribution is a dividend taxable as ordinary income to the shareholders to the extent of the $215 million excess E&P. The E&P rule has the effect of recharacterizing and potentially accelerating income arising from the distribution of amounts attributable to the REIT's gain excluded under the QOZ regime.
A REIT that has realized eligible gain may consider paying a capital gain dividend to its shareholders, who can each decide separately whether to invest such capital gain dividend in a QOF, rather than directly investing the eligible gain in a QOF, although in certain circumstances the amount of the capital gain dividend may be less than the amount of the REIT's eligible gain.
QOF AND QOZB COMPLIANCE
A QOF must meet a 90% asset test, under which at least 90% of its assets must constitute qualifying property (including certain interests in a QOZB), tested generally every 6 months. A QOZB must meet various income and asset requirements, including that at least 70% of its tangible assets constitute qualifying property.
62-Month Safe Harbor
Cash is not a qualifying asset for a QOF's 90% asset test. In addition, a QOZB cannot have more than 5% of its assets (based on unadjusted tax basis) consist of cash, debt, stocks, partnership interests and other nonqualified financial property. Notwithstanding this limitation, the prior proposed regulations permitted a QOZB to hold working capital (i.e., cash, cash equivalents and short-term debt) for the development of a trade or business in a QOZ, including the acquisition, construction or substantial improvement of tangible property in the QOZ, provided that, among other requirements, the working capital was spent in accordance with a written schedule within 31 months of receipt (which may be extended by certain government-related delays). The prior proposed regulations left open many questions relating to the status of the QOZB's tangible property during this 31-month safe harbor period.
The final regulations extend and clarify the working capital safe harbor, providing that tangible property may benefit from multiple overlapping or sequential application of the working capital safe harbor, for a maximum of 62 months, provided that (a) each infusion of working capital independently complies with the 31-month working capital safe harbor, (b) the subsequent infusions of working capital form an "integral part" of the plan covered by the initial 31-month working capital safe harbor and (c) each overlapping or sequential application must include a "substantial amount" of working capital. It is unclear what amount of working capital satisfies the "substantial amount" requirement. The 31-month period to use the working capital may be further extended by up to 24 months in the event of a federally declared disaster with respect to the QOZ.
Furthermore, the final regulations clarify a rule in the prior proposed regulations that if tangible property is expected to constitute qualifying property as a result of the planned expenditure of working capital covered by the extended 62-month safe harbor (e.g., the tangible property is expected to be used in the QOZB's trade or business and to satisfy the "original use" or "substantial improvement" requirement, if
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applicable), then the tangible property purchased, leased or improved by the QOZB pursuant to its working capital plan (e.g., building materials and partially constructed structures) is qualifying property during the 62-month safe harbor period.
The extended working capital period enables QOFs and QOZBs to enjoy a longer lead-time (up to 32 months) before commencing a 30-month substantial improvement period, which can give taxpayers flexibility to have existing leases expire and to obtain permits and other governmental approvals.
The statute imposes three separate "trade or business" requirements on a QOZB: (1) the QOZB must conduct a trade or business, (2) qualifying property must be used in the trade or business and (3) at least 50% of the QOZB's gross income must be derived from the active conduct of the trade or business. The prior proposed regulations provided that a rental real estate business satisfies all these requirements, but that merely entering into a triple-net lease with respect to real property did not constitute the active conduct of a trade or business.
The final regulations retain this rule but also include two examples that clarify the treatment of triple-net leases. In one example, a QOZB leases an entire office building to a tenant that assumes responsibility for all costs relating to the building (e.g., taxes, insurance and maintenance) in addition to paying rent. The example concludes that the lease is a triple-net lease and accordingly QOZB is not engaged in the active conduct of a trade or business with respect to the building, even if the QOZB maintains an office in the building with staff members to address issues arising from the lease.
In a second example, a QOZB leases a three-story mixed-use building to unrelated tenants. One of the tenants assumes responsibility for all costs relating to that tenant's leased space (e.g., taxes, insurance and maintenance) in addition to paying rent. The other tenants do not assume such responsibility, and the QOZB's employees manage and operate those tenants' leased space. Furthermore, the QOZB maintains an office in the building, which its employees regularly use to carry out their duties, including to address issues arising from all three leases. The example concludes that the QOZB is engaged in the active conduct of a trade or business with respect to the entire building.
Although these examples provide helpful guidance, they raise additional questions, including (a) whether there is a maximum portion of a rental building that may be triple-net leased before the leasing of the entire building ceases to be a trade or business, (b) what costs relating to the leased property may be passed to the tenant before a lease constitutes a triple-net lease and (c) whether a QOZB may manage and operate leased property through a property management company (whether or not affiliated with the QOZB) instead of its own employees.
The statute prohibits a QOZB from operating an excluded business, i.e., a 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.
The final regulations confirm that a QOF may directly operate an excluded business. In addition, the final regulations prohibit a QOZB from leasing property to a tenant that operates an excluded business. However, under a pair of de minimis rules, a QOZB is permitted to derive up to 5% of its gross income from the operation of excluded businesses and to lease up to 5% its property (determined by net rentable square feet in the case of real property and by value in the case of all other tangible property) to excluded
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businesses. A QOZB that is in the leasing business should consider including covenants in its leases to prevent any tenant from conducting an excluded business.
At least 40% of the QOZB's intangible property must be used in the active conduct of a trade or business in one or more QOZs. The final regulations clarify that intangible property is generally used in such a trade or business if (i) the use is normal, usual or customary in the conduct of the trade or business and (ii) the intangible property is used in the performance of an activity of the trade or business that contributes to the generation of gross income for the trade or business. The exact parameters of the twoprong test can be highly complex and fact-specific for some businesses. The preamble to the final regulations confirms that an intellectual property holding company, which predominantly develops or holds intangible property for sale or license, may qualify as a QOZB.
Active Conduct of a Trade or Business
The QOZB must generally ensure that at least 50% of its gross income is derived in the active conduct of a trade or business in one or more QOZs, which can be met if the QOZB's employees and independent contractors generally provide more than half of their services in the QOZs based on either hours or compensation. The final regulations provide that independent contractors' hours are counted only if spent for the QOZB, and therefore the test does not include the independent contractors' time spent for other parties.
The 50% gross income test can also be met if the QOZB's intangible property located in the QOZs, and its management or operational functions performed in the QOZs, are necessary for the generation of at least 50% of the QOZB's gross income. A QOZB that is headquartered in a QOZ may benefit from this business functions test, although the final regulations do not provide additional guidance on the application of this test.
Potential to Merge Existing QOZBs
The more favorable rules for multi-asset QOZBs, described above, may encourage a QOF with multiple QOZBs to merge its QOZBs. The final regulations permit QOZB partnerships to merge with each other and QOZB corporations (including REITs) to merge with each other or undertake certain other acquisitive reorganizations. Any merger of QOZBs should be carefully reviewed because it is irreversible, as divisions of QOZB partnerships and spin-offs of QOZB corporations are generally not permitted.
QUALIFYING PROPERTY OF A QOF OR QOZB
A QOF's or QOZB's qualifying property must generally (i) be acquired by purchase or lease in 2018 or later, (ii) if owned, be acquired from an unrelated party, (iii) be used in the QOF's or QOZB's business, (iv) if owned, meet either an "original use" test or a "substantial improvement" test and (v) be used in a QOZ for at least 70% of the time during at least 90% of the QOF's or QOZB's holding period of the property.
A newly constructed building, whether constructed or purchased by a QOF or QOZB, meets the original use test if the QOF or QOZB is the original user of the building. The prior proposed regulations provided that a previously used building may meet the original use test if it had been vacant for five years before being acquired by the QOF or QOZB. The final regulations shorten the required vacancy period to an uninterrupted period of three years, and further to only one year if the building has been vacant ever since
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its location was designated as a QOZ, up until the building's purchase by the QOF or QOZB. Property is considered "vacant" if 20% or less of its square footage of usable space is being used.
The original use requirement is also met automatically for real property (including the land and structures thereon) that is located in a brownfield site, if the QOF or QOZB makes investments within a reasonable period to ensure that the site meets basic safety standards for human health and the environment, or that is purchased from a local government which held the property as a result of an involuntary transfer, including through abandonment, bankruptcy, foreclosure or receivership.
A QOF or QOZB may acquire existing real property and meet the substantial improvement test, by more than doubling the adjusted tax basis of the building (but not the land) within a 30-month period after acquisition. The final regulations provide property aggregation rules that allow, but do not require, the substantial improvement determination to be made for multiple real properties, if they are described in a single deed or are otherwise closely related. The final regulations also clarify that the substantial improvement test for a building applies even if the value of the building is low relative to the value of the land, subject to the "minimally improved land" and anti-abuse rules discussed below.
The measurement of substantial improvement can also include new property that is used in the same business and improves the functionality of the property being improved, such as the purchase of new furniture and fixtures in a hotel renovation.
Status of Land for Original Use and Substantial Improvement Tests
The preamble to the final regulations clarifies that land generally does not need to meet the original use test or substantial improvement test, and therefore land is always qualifying property as long as it is acquired by the QOF or QOZB by purchase from an unrelated party in 2018 or later and is used in a trade or business. However, to benefit from this rule, the QOF or QOZB must acquire unimproved or minimally improved land with an expectation or an intention to improve the land by more than an insubstantial amount within 30 months.
In addition, anti-abuse rules apply if a significant purpose of a transaction (or a series of transactions) is to achieve a federal income tax result that is inconsistent with the stated purposes of the QOZ regime: to provide specified tax benefits to QOF investors to encourage the making of longer-term investments, through QOFs and QOZBs, of new capital in one or more QOZs and to increase the economic growth of such QOZs. The final regulations include an example of land acquired by a QOZB for speculative purposes, which the QOZB then paved and operated as a parking lot (adding a gate, a small structure for an attendant and two self-pay stations). The example concludes that the land was acquired to achieve a tax result that is inconsistent with the purposes of the QOZ regime, and consequently the land was not qualifying property. A second example, in which the QOZB made significant capital improvements to acquired agricultural land, concludes that the land was not acquired to achieve a tax result that is inconsistent with the purposes of the QOZ regime, and consequently the land may be qualifying property.
Qualifying property includes property leased by a QOF or QOZB in 2018 or later and used in its trade or business, even if the lessor is related to the QOF or QOZB. The lease must be market rate, although the final regulations provide a rebuttable presumption that leases between unrelated parties are market rate.
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The prior proposed regulations provided that leased real property (other than unimproved land) is nonqualifying property if, at the time the lease is entered into, there was a plan, intent or expectation for the real property to be purchased by the lessee for a price other than fair market value determined without regard to any prior rent payments. The prohibition applies regardless of whether the lessor is related or unrelated to the lessee. The final regulations extend this prohibition on fixed-price purchase options to leases of unimproved land, although this change is not discussed in the preamble.
No Repurchase Option for Real Property
Similar to the rule for leased real property discussed above, the final regulations provide that purchased real property is non-qualifying property if, at the time of the purchase, there was a plan, intent or expectation for the real property to be repurchased by the seller for a price other than fair market value. This would prevent property sales from including fixed-price repurchase options in favor of the seller.
A QOF or QOZB may acquire real property that straddles a QOZ boundary. The prior proposed regulations provided that real property is considered entirely within a QOZ if more than 50% of the property was in the QOZ based on square footage, although the preamble to the prior proposed regulations required that more than 50% of the real property was in the QOZ based on unadjusted cost. The final regulations resolve the discrepancy by providing that either square footage or unadjusted cost may be used for the 50% test in order to deem real property as entirely within a QOZ.
Furthermore, a QOZB is required to have only at least 70% of its tangible property consist of qualifying property in QOZs, and therefore it may have other real estate projects and other tangible assets entirely outside the QOZs, subject to the requirements that at least 50% of a QOZB's gross income is derived from the active conduct of a trade or business in one more QOZs and at least 40% of a QOZB's intangible property is used in the active conduct of a trade or business in one more QOZs.
The final regulations confirm that the materials and supplies used in the manufacture, construction or production of property must be qualifying property, i.e., purchased from an unrelated person. Commenters had asked whether development fees may be paid to a related party and still be capitalized as a qualifying property, but the issue is not directly addressed in the final regulations.
Treatment of Inventory
The final regulations provide that inventory produced in 2018 or later is deemed to satisfy the "purchase" requirement and the "original use" / "substantial improvement" requirement, although it still needs to satisfy the use test: the inventory must be used in a QOZ at least 70% of the time (based on number of days between two consecutive semi-annual testing dates). The final regulations permit a QOF or QOZB to choose to either (i) exclude all inventory from both the numerator and the denominator of the 90% QOF asset test or the 70% QOZB tangible property test or (ii) include all inventory in both the numerator and the denominator of such tests.
CONSOLIDATED GROUP ISSUES
The prior proposed regulations had provided that each member of a consolidated group is a separate taxpayer for QOF purposes, so that capital gains recognized by one member could not be deferred with
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another member's QOF investment. Recognizing that some tax practitioners may have given tax advice to the contrary, the final regulations reverse course and generally allow consolidated groups to elect to be treated as a single taxpayer for QOF investment purposes. The ability to make the election has a specific effective date, however, and may not be practically useful for all affected consolidated groups.
The final regulations also clarify many other aspects of how the QOZ regime interacts with the consolidated group rules. For example, the investor and the QOF may be two corporations that are both members of a consolidated group, as long as the QOF is generally not owned directly or indirectly by any outside parties. Within a consolidated group, distributions that cause the investor to have (or to increase) a negative tax basis, or excess loss account, in the QOF stock are inclusion events. The investor may be allocated tax losses that generate an excess loss account in its QOF stock, which must be recaptured as taxable income upon a sale or disposition of the QOF stock, notwithstanding the 10-year gain exclusion rule. In contrast, tax losses allocated by a QOF partnership to its partners are generally not recaptured upon a sale or disposition of the QOF partnership after 10 years.
Complex rules apply to intercompany transactions and deconsolidations. Some QOF corporations have a limited time to convert into QOF partnerships for tax purposes, which may result in simpler tax compliance.
Regardless of whether the investor and the QOF are members of a consolidated group, the QOF's distributions of earnings may be eligible for a dividends received deduction of up to 100% for dividends between affiliated group members.
EFFECTIVE DATE AND GRANDFATHERING ISSUES
The final regulations are generally applicable for taxable years beginning after around March 13, 2020, which is 60 days after January 13, 2020, the date that the final regulations are scheduled to be published in the Federal Register. For a calendar year taxpayer, the final regulations will apply starting in 2021. For prior taxable years, a taxpayer may choose either (1) to apply all the final regulations or (2) to rely on all of the prior proposed regulations, in each case if applied in a consistent manner for all such prior years. A QOF investor, a QOF and a QOZB are different taxpayers, and apparently each may decide separately as to whether to apply the final regulations or to rely on the prior proposed regulations before 2021. In certain situations (such as those involving qualification as a QOZB), it is unclear what would happen if different choices were made by a QOF investor, a QOF and/or a QOZB.
The final regulations do not contain a grandfathering rule, which means that a tax position based on the prior proposed regulations may not continue to be valid in 2021 or later. For example, suppose that in June 2018 a QOZB leased more than 5% of its real property to an excluded business, and the QOZB and its QOF owners choose to rely on the prior proposed regulations for 2018 through 2020. Assuming that, under applicable law in the absence of the final regulations, the QOZB is not treated as an excluded business and that all other applicable QOZB requirements are met, the entity would be a valid QOZB for 2018 through 2020, but not necessarily in 2021 and later.
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The final regulations provide favorable guidance in many respects for QOFs and their investors, particularly with respect to the eligibility of section 1231 gains, the expanded working capital safe harbor for development projects and increased flexibility for exit structures. The final regulations leave some unresolved issues to be addressed by future guidance, including FIRPTA withholding for foreign investors (i.e., whether a foreign investor can defer the 15% withholding tax on FIRPTA gain if the investor timely invests the gain in a QOF) and involuntary decertification of a QOF (i.e., the circumstances under which the IRS may require a QOF to decertify and lose its QOF status, thereby triggering an inclusion event for the QOF's investors and preventing the investors from thereafter benefiting from the 10-year gain exclusion rule).
Colin S. Kelly
This memorandum is not intended to provide legal advice, and no legal or business decision should be based on its contents. If you have any questions about the contents of this memorandum, please call your regular Fried Frank contact or an attorney listed below:
Michael J. Alter
Cameron N. Cosby
Joseph E. Fox
Michelle B. Gold
Alan S. Kaden
Colin S. Kelly
David I. Shapiro
Richard A. Wolfe
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