Treasury and the IRS recently issued highly-anticipated proposed regulations and an accompanying Revenue Ruling providing additional guidance on the implementation of the Qualified Opportunity Zone provisions of the Tax Cuts and Jobs Act (the "TCJA"). Further guidance is anticipated later this year. This client alert presents, in question and answer format, a review of various aspects of the Qualified Opportunity Zone proposed regulations, including implications for investors and sponsors. 

GENERAL OPPORTUNITY ZONE MATTERS

What are Qualified Opportunity Zones?

  • The Tax Cuts and Jobs Act created a capital gains deferral and partial exemption for taxpayers who make long-term investments in economically depressed areas designated as “Opportunity Zones”.
  • The Opportunity Zone provisions are designed to encourage direct investment (and accompanying employment and economic stimulus) in a wide range of businesses (other than certain “sin” businesses) in economically depressed areas.
  • Opportunity Zones are designated low-income community population census tracts within the 50 states and the District of Columbia, and U.S. possessions.
  • State governors nominated low-income communities and contiguous tracts for designation as Qualified Opportunity Zones.
  • Without further Congressional action, the QOZ designations will expire on December 31, 2028.

Where are the QOZs Located?

  • Treasury has designated QOZs in each of the 50 states, the District of Columbia, and many U.S. territories.
  • A list and map of all QOZs that have been designated can be found at https://www.cdfifund.gov/Pages/Opportunity-Zones.aspx.
  • The designation period has ended and the QOZ designations are not subject to further change.

INVESTOR RELATED MATTERS

What Tax Incentives are Available to Investors?

  • Temporary Deferral: eligible gains rolled into qualified opportunity funds (“QOFs”) are deferred until the earlier of December 31, 2026 or the date on which the investment in the QOF is transferred.
  • Elimination of up to 15% of deferred gain subject to tax: eligible gains invested in a QOF get a basis increase of 10% of the deferred gain after 5 years and 5% of the deferred gain after 7 years, for a total potential 15% increase in basis.
    • In order to reap the maximum tax benefit available with respect to deferred gain, taxpayers must invest deferred gain into a QOF by December 31, 2019.
  • Exclusion of gain on post-acquisition appreciation: if an investment in a QOF is held for at least 10 years, the taxpayer recognizes no gain on the post-acquisition appreciation in its QOF interest.
    • Importantly, the QOZ rules appear to require that taxpayers sell their interests in a QOF to benefit from the exclusion of post-acquisition appreciation.
      • This could cause commercial issues as buyers generally strongly prefer purchasing assets instead of purchasing entities.
      • In addition, for QOFs in corporate form, the requirement of an entity sale raises the issue of the inability of the buyer to obtain a basis step-up in the assets without paying tax on a liquidation of the corporation.
        • In such cases, corporate QOFs would be well advised, to the extent possible, to consider utilizing the REIT form as a REIT could be liquidated post-sale without triggering tax due to the availability of the dividends-paid deduction upon liquidation, while also providing the buyer with a fair market value tax basis step-up in the assets upon liquidation.

Who is Eligible to Defer Gains by Investing in QOFs?

  • Any person that is otherwise subject to U.S. federal income taxation on the gain, including individuals, C-Corps., RICs, REITs, partnerships, S-Corps, trusts and estates, as well as Non-U.S. persons that are subject to U.S. federal income taxation and non-super tax-exempts that are taxable on UBTI.

What Types of Gains are Eligible to be Rolled into a QOF?

  • Capital gains (long term or short term (including gains characterized as short term under the new carried interest provisions of the TCJA)) from actual or deemed sales or exchanges of any property of the taxpayer with unrelated parties, or any other gain that is required to be included in capital gain, are eligible for deferral.
    • This excludes depreciation recapture which is recharacterized as ordinary income (i.e., Section 1245 gains attributable to personal property).
      • Also excluded are gains on positions that are part of “offsetting position transactions,” such as straddles.
    • Gains eligible for deferral include:
      • Section 1231 gains (property used in a trade or business, which is treated as capital gain by Section 1231).
      • Unrecaptured Section 1250 gains (although Section 1250 gains are taxed at a higher rate (25%) than typical capital gains, they are nonetheless capital gains).
      • Capital gain net income from Section 1256 contracts.
      • Capital gain dividends received from REITs and RICs.
      • Undistributed capital gains from REITs or RICs required to be included in a shareholder’s long-term capital gain under Code sections 852(b)(3)(D) or 857(b)(3)(D).

Who is a Related Party for Purposes of the QOZ Rules?

  • The related party rules of Code Sections 267(b) and 707(b)(1) apply, substituting 20% for 50%. In other words, where there is 20% common ownership, parties will generally be related.
  • As noted above, capital gains from sales or exchanges with related parties are not eligible to be rolled into a QOF.

What is the Time Period for Rolling Gains into a QOF?

  • Taxpayers have 180 days from the recognition of the gain to roll their gains into a QOF.
    • The 180-day period runs from the date that the gain was realized.
    • For capital gain dividends from a REIT or a RIC, the 180-day period begins to run on the date that the capital gain dividend is received.
      • It is unclear how the 180-day period with respect to capital gain dividends will be practically applied, as REITs and RICs have the ability to designate dividends paid during the taxable year as capital gain dividends within 30 days after the close of the taxable year. Thus, a REIT or RIC shareholder may not be aware that it has received a capital gain dividend until well after 180 days from the date the distribution was received.
    • For capital gains passed through a partnership to a partner, a partner has until 180 days from the end of the partnership’s taxable year to reinvest in a QOF.
      • If a partner knows of both the date of the partnership’s gain and the partnership‘s decision not to elect deferral at the partnership level, the partner may choose (but is not required) to begin its 180-day period on the same date as the date of the beginning of the partnership’s 180-day period.

How Does a Taxpayer Elect Deferral?

  • Taxpayers must make a deferral election on IRS Form 8949, which will be attached to their original federal income tax return for the year that the deferred gain otherwise would have been recognized.
    • Although not specifically addressed in guidance issued to date, it is anticipated that the election cannot be made on an amended return.

Must All of a Taxpayer’s Gain be Rolled into a QOF?

  • No. Taxpayers may invest all or merely a portion of their capital gain in a QOF.

What Happens if the Taxpayer Invests Non-Gain Cash in a QOF?

  • Taxpayers may invest cash that is not attributable to a capital gain into a QOF, but that cash is treated as a separate investment in the QOF from the cash attributable to the capital gain; the investment from the capital gain cash qualifies for the tax incentives of the QOZ program, whereas the investment from the non-capital gain cash does not.

Can Partnerships and Other Pass-Through Entities Defer Gain?

  • Yes. A partnership may choose to defer gain at the partnership level by reinvesting gain dollars in QOZ property, a QOZ business, or a QOF.
    • In such cases, it is unclear what happens if a partner disposes of its partnership interest prior to the partnership disposing of its interest in the QOF.
  • If the partnership chooses not to defer, the partners may defer the gain passed through to them on schedule K-1.
    • In this case the partner’s 180-day period to reinvest generally begins on the last day of the partnership’s taxable year.
      • However, a partner may elect to begin its 180-day period at the same time as the partnership’s 180-day period.
      • Investors should consider negotiating for notification provisions in partnership agreements and sponsors should expect that investors will request information reporting on potentially deferrable gains.
    • In considering the appropriate level at which to make the deferral election (i.e., at the partner vs. partnership level), consideration should be given to the related party rules. Specifically, a sale may constitute a related party sale to a partner, but not the partnership, or vice versa.
    • Consideration will need to be given as to how to report to partners on the K-1 or otherwise the amount that is eligible for deferral.
    • Consideration will also need to be given to the timing of reporting. Many partnerships currently do not deliver K-1s to their partners on a schedule that would allow the partners to elect deferral in time to meet the 180-day deadline.
  • Gains under Code Section 1231 would appear to need to be deferred at the partner, and not the partnership level, because the treatment of 1231 gains as capital is determined at the partner level.

What Type of Interests in a QOF Qualify for the Deferral Benefit?

  • Investments in QOFs must be equity interests, which includes preferred stock or a partnership interest with special allocations.
    • As a result, a partner may receive the full benefit of gain deferral in respect of a partnership interest, even if its share of the appreciation in partnership assets does not match its proportionate share of partnership capital.
  • Importantly, debt instruments are not eligible interests.
  • The exclusion of debt interests from eligibility places additional importance on traditional debt-equity analysis with respect to hybrid instruments such as debt-like preferred.

How do the QOZ Rules Surrounding an Interest in a QOF Intersect with the General Carried Interest Rules?

  • If the general partner of a QOF rolls over eligible gains in order to acquire its GP capital interest in the QOF, under a plain reading of the rules and the fact that the QOZ rules do not generally change the application of subchapter K, the GP should be able to enjoy the tax benefits of the QOZ program with respect to both its capital and carried interest.
  • The proposed regulations are silent on this point, however. Thus, it is possible that, if addressed in future guidance, Treasury and the IRS could choose to bifurcate the carried interest and the capital interest into two different investments, with only the capital interest enjoying the benefits of the QOZ program.
  • In any event, sponsors should not be any worse off than they are currently with respect to the taxation of carried interest, regardless of any action by Treasury or the IRS on this point.

By When Must Investments in QOFs be Made?

  • Absent further congressional action, taxpayers must invest gains realized prior to December 31, 2026, provided that for sales made in the month of December 2026, a taxpayer will have until June 29, 2027 to reinvest the gain in a QOF in order to benefit from the exclusion of gain on post-acquisition appreciation available with a 10-year minimum hold (taxpayers will then have until December 31, 2047 to sell their QOF interests).
    • As previously noted, in order to benefit from the elimination of up to 15% of the deferred gain required to be recognized by December 31, 2026, a taxpayer must invest deferred gain into a QOF by December 31, 2019 (in order to realize the benefit of the full 15% gain elimination) or by December 31, 2021 (in order to realize the benefit of 10% gain elimination).
    • To the extent investments are made after December 31, 2021, the recognition of deferred gain will still be delayed until December 31, 2026 (unless triggered earlier by a transfer), but the sole benefit to the taxpayer in respect of the deferred gain will be time value of money, and there will be no elimination of any portion of the deferred gain.

What Happens to the Tax Attributes of the Deferred Gain Rolled into a QOF?

  • The tax attributes of the deferred gain are preserved in their entirety through the deferral period and are picked up at the time that the gain is recognized. For example, if a short-term capital gain is deferred, it will continue to be a short-term capital gain when recognized later.

When Must Deferred Gain be Recognized?

  • Deferred gain is recognized on the earlier of the date of the transfer of the taxpayer’s interest in the QOF or December 31, 2026.

What Ordering Rules Apply to the Recognition of Deferred Gain?

  • Taxpayers disposing of less than all of their fungible interests in a QOF are required to identify the QOF interests sold on a first-in-first-out (“FIFO”) basis.
  • If the FIFO method is not applicable (for example, if the interests in the QOF held by a taxpayer are not fungible), the QOF interests sold are identified on a pro rata basis.

Can the QOF Gain Deferral Be Combined with Other Tax Code Provisions To Extend Deferral Past December 31, 2026?

  • No. Once the election is made to roll gains into a QOF, taxpayers are unable, through Section 1031 or otherwise, to extend deferral on the original deferred gain past December 31, 2026.

May Gains From the Sale or Exchange of QOF Interests Themselves Be Further Deferred Prior to December 31, 2026?

  • Yes. If a taxpayer acquires an interest in a QOF and later triggers deferred gain via a transfer of the interest, the taxpayer may make a new investment in a QOF (within 180 days) and is eligible to defer the inclusion of the deferred gain, so long as the initial QOF investment has been disposed of in its entirety. However, the latest date at which the deferred gain may be recognized continues to be December 31, 2026.
  • Additionally, although not specifically addressed by the proposed regulations, it appears that triggering and reinvesting deferred gain restarts the 10-year clock for a fair market value basis step-up on post-acquisition appreciation.

By When Must Taxpayers Exclude Gain on Post-Acquisition Appreciation?

  • Taxpayers are entitled to exclude gain attributable to post-acquisition appreciation from the sale of QOF interests at any time on or before December 31, 2047. Consequently, a taxpayer must sell its interest in a QOF on or before December 31, 2047 to enjoy an exclusion of post-acquisition appreciation (assuming that the taxpayer has held the interest for at least 10 years).

Do Tax Incentives Run with the Interests in QOFs?

  • No. A purchaser of interests in a QOF from the original taxpayer does not achieve tax benefits, even if the purchase is made with capital gain funds.

How do the QOZ Rules Interact with the Partnership Tax Rules?

  • The QOZ rules generally do not impact the regular application of Subchapter K to QOFs taxed as partnerships.
  • The QOZ rules provide that a deemed contribution by a partner to a partnership as a result of an increase in a partner’s share of liabilities under Code Section 752(a) principles is not treated as a separate investment into a QOF.
    • The guidance to date is silent as to the impact of a decrease in liabilities under Code Section 752(b), and in particular whether a deemed cash distribution under Section 752(b) resulting from such a decrease in liabilities would be an event that triggers deferred gain.
  • When a QOF partnership borrows to fund investment, the QOZ rules appear to allow the entire gain attributable to the partnership interest (i.e., economic gain attributable to both invested equity and partnership debt) to benefit from the exclusion of post-acquisition appreciation.
  • The proposed regulations do not address whether debt-financed distributions will trigger recognition of deferred gain. However, in the absence of guidance to the contrary, debt-financed distributions that are not treated as disguised sales under existing Subchapter K rules should be permissible.

What Happens if I Sell or Monetize my QOF Interest?

  • If the QOF is sold or transferred in any manner (even on a tax-deferred basis) to a different taxpayer (including a related taxpayer), the deferred gain is accelerated.
  • However, the proposed regulations explicitly permit taxpayers to borrow against their QOF interests and pledge the interests as collateral to secure the borrowing.
    • This method of obtaining cash can replicate a cash-out refinance that might have been conducted at the partnership level in a traditional real estate partnership.

QUALIFIED OPPORTUNITY FUND MATTERS

What is a QOF?

  • A QOF is defined as a partnership or corporation organized to invest in qualified opportunity zone property.

How does a QOF Become Certified?

  • QOFs can self-certify by filing IRS Form 8966 attached to their federal income tax return for the taxable year for which the QOF election is being made.
  • QOFs have the ability to indicate the first month and year they wish to qualify as a QOF.
    • Any investments made prior to the month with respect to which the QOF elects to begin its QOF status are not eligible for tax benefits.
  • QOFs must continue filing the Form 8966 annually and must certify compliance with the 90% Test (defined below).

What Kind of Entity is Eligible to be a QOF?

  • Any domestic entity that is treated as a corporation or a partnership for federal income tax purposes can qualify as a QOF, including:
    • Limited partnerships.
    • Limited liability companies taxed as partnerships or corporations.
  • The IRS also noted in the preamble to the proposed regulations that entities must be created or organized in one of the 50 states, the District of Columbia, or a U.S. possession to be eligible to be a QOF.

Can a Pre-Existing Entity Qualify as a QOF?

  • Yes, provided it can meet the requirements discussed below, with the caveat that any property acquired prior to the QOF designation will not be QOZ Property.

What Testing Requirements Apply to a QOF?

  • 90% Test. A QOF must hold at least 90% of its assets in QOZ property (the “90% Test”).
  • The test is applied by measuring the average of the percentage of QOZ property in the QOF on two testing dates, the last day of the first six-month period of the QOF’s taxable year and the last day of the QOF’s taxable year.
  • QOFs that choose to begin their QOF qualification other than on January 1 of a given year will have their first testing period 6 months after their first QOF month, and again at year end.

How are Values Determined for Purposes of the 90% Test?

  • A QOF must use asset values as reported on its applicable financial statements (as defined in Treasury Regulations Section 1.475(a)-4(h) (i.e., financial statements required to be filed with the SEC, another federal agency other than the IRS, or certificated audited financial statements) to determine compliance with the 90% Test.
  • If a QOF does not have applicable financial statements, it must use the unadjusted cost basis of its assets.

What Happens if a QOF Fails the 90% Test?

  • If a QOF fails the 90% Test in any month, the QOF must pay a penalty equal to the shortfall in its 90% Test multiplied by the underpayment rate provided for in Code Section 6621(a)(2) (currently approximately 5%).
  • Forthcoming additional guidance will address potential decertification of QOFs that fail the 90% Test.

What Qualifies as QOZ Property?

  • QOZ property includes:
    • QOZ trade or business property; and
    • QOZ partnership interests or corporate stock (a “QOZ Entity”)
      • A QOZ partnership interest is a partnership capital or profits interest that:
        • is acquired by the QOF after December 31, 2017 solely in exchange for cash;
        • at the time the interest was acquired the partnership was a QOZ business or was being organized for purposes of being a QOZ business; and
        • during substantially all of the QOF’s holding period of such interest, the partnership qualifies as a QOZ business.
      • QOZ stock is stock in a domestic corporation provided that:
      • the stock is acquired by the QOF after December 31, 2017 at original issuance solely in exchange for cash;
        • QOZ stock may be issued through an underwriter.
      • at the time the stock was issued, the corporation was a QOZ business or was being organized for the purposes of being in a QOZ business; and
      • during substantially all of the QOF’s holding period in the stock, the corporation qualified as a QOZ business.

What is QOZ Business Property?

  • QOZ business property is tangible property used in a trade or business of the QOF, provided that it must meet all of the following requirements:
    • The property is acquired by the QOF from an unrelated person after December 31, 2017;
      • As noted earlier, 20% common ownership will generally trigger the related party definition.
      • The related party rules may complicate the ability of typical real estate joint venture structures in which a property owner and developer form a JV to develop property to qualify as QOFs.
    • The original use of the property in the QOZ commences with the QOF; or the QOF “substantially improves” the property;
      • Substantial improvement results if the costs of improvements during the 30-month time period from the date of purchase are greater than the QOF’s purchase price of the property. In other words, the investment must be doubled.
      • In the case of land and buildings, additions to the basis in the building only need exceed the adjusted basis in the building at the beginning of the 30-month period. Importantly, the cost of land is not included in the taxpayer’s basis for purposes of determining substantial improvement.
    • During substantially all of the QOF’s holding period in the QOZ business property, substantially all of the use of the QOZ business property is in the QOZ.

What is a QOZ business?

  • A QOZ business is a trade or business which meets all of the following requirements:
    • Substantially all of the tangible property owned or leased by the taxpayer is QOZ business property;
      • For this purpose only, “substantially all” means at least 70%.
      • If a QOF owns more than one QOZ Entity, each entity must satisfy the 70% test.
    • A working capital safe harbor is available for QOZ Entities, which allows funds to be placed in a working capital account (i.e., cash, cash equivalents, and debt instruments with maturities of 18 months or shorter) for up to 31 months if certain recordkeeping requirements are met.
      • Importantly, the working capital safe harbor is only available at the QOZ Entity level and not at the QOF level.
    • A minimum of 50% of the total gross income of the entity is derived from the active conduct of such trade or business;
      • An active trade or business for this purpose has not been defined by Treasury and the IRS.
    • A substantial portion of any intangible property of the QOZ Entity must be used in the active conduct of such trade or business;
    • Less than 5% of the average aggregate unadjusted basis of the property of the QOZ Entity is attributable to nonqualified financial property (generally debt, stock, partnership interests, options, futures contracts, forward contracts, notional principal contracts, annuities, and similar types of property);
      • The working capital safe harbor described above also applies to compliance with this requirement.
    • The business is not one of a list of enumerated “sin” business, including a private or commercial golf course, country club, massage parlor, hot tub facility, suntan facility, racetrack or other gambling facility, or liquor store.

CURRENT STATE OF GUIDANCE

Can Taxpayers Rely on the Recently Issued Proposed Regulations?

  • Yes. Although the recently issued regulations are in proposed form only, the regulations provide that taxpayers may rely upon them currently so long as they are applied consistently and in their entirety.

What Open Questions Remain to be Addressed by Treasury and the IRS?

  • There remain open questions to be addressed by future regulations. These questions include but are not limited to:
    • What is the definition of “active trade or business” as used in the definition of QOZ business?
    • What penalties and potential disqualification (and potential savings clauses) might apply to QOFs that fail to qualify?
    • What is the meaning of “substantially all” as used in the statute (other than in the context of a QOZ business, in which case the standard is 70%)?
    • Outside of the land context, what is the meaning of the term “original use” as it relates to the requirement that the original use of property must commence with the QOF in a situation in which the “substantial improvement” requirement is not satisfied?
    • Will the working capital safe harbor rules be expanded?
    • What happens to a partner’s outside tax basis in its partnership interest if a partnership makes the deferral election and subsequently receives a basis step-up under the QOZ rules?
    • What transactions may trigger inclusion of deferred gain under the QOZ rules (and in particular, will reductions in allocated portions of partnership liabilities under Code Section 752(b) trigger inclusion of deferred gain)?
    • Would it be appropriate to allow a QOF to sell its assets and allow interest holders to elect to treat the asset sale as a sale of their interest in a QOF (so as to qualify for the exclusion on post-acquisition appreciation)?
    • What will be a reasonable period of time to reinvest proceeds in new QOZ property if a QOF sells existing QOZ property?
    • Will additional rules surrounding the “substantial improvement” requirement for tangible property be advisable?
    • What form will the administrative rules surrounding situations where a QOF fails the 90% Test take?
    • What information reporting requirements will be applicable to QOZs?
    • Are any exceptions to the 180-day requirement for rolling gains into a QOF warranted?
    • Will alternatives to the FIFO and pro rata methods be available in cases in which taxpayers dispose of less than all of their QOF interests?
    • Is it appropriate to allow for issuances of QOZ partnership interests through underwriters, as is explicitly allowed for QOZ stock under the proposed regulations?