On April 17, 2019, the U.S. Internal Revenue Service (IRS) and the Department of the Treasury (Treasury) issued a second set of proposed regulations (Regulations) on the new tax incentives for investments in qualified opportunity zones (OZ), which were enacted as part of the 2017 tax reform legislation known as the Tax Cuts and Jobs Act (Tax Act). Such incentives permit taxpayers to defer and reduce any capital gain they recognize provided that the amount of gain recognized is timely invested in certain funds that in turn invest in OZs. These incentives also exempt from tax all appreciation in the value of the taxpayer’s interests in such funds if they are held for at least 10 years. The Regulations supplement, and in certain places amend, the initial guidance released by the IRS and Treasury on October 23, 2018 (Initial Regulations). Please see the Sidley Update on such initial guidance for further background and information.
New Guidance Under the Regulations
The Regulations include important guidance, which supplements, and in places changes, the guidance provided by Treasury and the IRS in the Initial Regulations, for fund managers and investors wishing to invest in a qualified opportunity fund (QOF).
Rules Related to Tax Benefits
- Asset sales by QOF are also entitled to year-10 tax benefits. The Regulations allow investors to elect to exempt from tax capital gain recognized on the sale of assets by a QOF if the investor held its interests in the QOF for the 10-year requisite holding period. We note, however, that only capital gain is exempt, which leaves open the possibility of tax on depreciation recapture. We also note that the Regulations specify that taxpayers cannot rely on this portion of the Regulations until they become final. If the Regulations are finalized in their current form, this will facilitate the creation of multiple asset funds without the need for the use of real estate investment trusts or parallel QOF structures.
- Promote is not eligible for OZ tax benefits. The Regulations clarify that carried interest (i.e., a QOF interest received in exchange for services rendered to the QOF) is not an “investment” and therefore ineligible for OZ tax benefits. Where a single investor has both received a promote and invested cash in the QOF, the Regulations provide the investor with OZ tax benefits only with respect to the cash investment and appear to penalize such investor by dividing partnership allocations between the two parts of the partnership interests using the highest possible promote percentage interest.
- Partnership-level debt does not distort gain recognition and exclusion. The Regulations clarify that partnership-level debt allocated to a partner does not reduce the amount of the deferred gain required to be recognized on December 31, 2026, and does not reduce the tax benefits when an investor in a QOF sells its interest in the QOF after the 10-year requisite holding period.
Timing of Deferred Gain Recognition
- Debt-financed distributions. The Regulations confirm that an investor is not required to recognize gain on debt-financed distributions on its QOF interest to the extent that the amount of such distributions does not exceed its tax basis in the QOF interest. A special anti-abuse rule, however, would reduce the amount of qualified investments made by an investor in the QOF by amounts received as distributions from the QOF based on rules similar to the rules concerning disguised sales of property to a partnership. Importantly, the disguised sale rules include a rebuttable presumption that distributions made within two years of the contribution are disguised sales, unless the taxpayer can demonstrate that the distribution is dependent on the entrepreneurial risks of the partnership.
- Transfers of QOF interests to feeder fund. An investor may contribute its QOF interests to a feeder fund (or other partnership entity) without such transfer accelerating the recognition of the deferred gain. This will allow for the use of feeder fund structures, where a feeder fund holds interests in multiple QOFs.
- Transfers of QOF interests before end of 2026. The Regulations clarify that an owner of a QOF interest that transfers such interest by gift before December 31, 2026, results in an acceleration of the deferred gain. Transfers of QOF interests by reason of death and contributions to grantor trusts do not trigger the deferred gain. The Regulations further provide that certain nonrecognition transactions do not result in the acceleration of the deferred gain but do reset the holding period of the investor in the QOF.
Qualification as a QOF or Qualified Opportunity Zone Business (QOZB)
- QOF reinvestment rule. The Regulations specify that with respect to the penalties imposed on a QOF for failure to meet the 90% asset test, a QOF may dispose of qualified opportunity zone property it holds before the end of the 10-year requisite holding period so long as the QOF reinvests the proceeds in other qualified opportunity zone property within 12 months after the disposition. This rule is very limited as it does not exempt from tax the gain from the sale of such qualified opportunity zone property. Treasury and the IRS questioned whether granting such exemption would go beyond the scope of the regulatory authority granted by the OZ statutory framework.
- Valuation of assets for purposes of the 90% (at the QOF level) and 70% (at the QOZB level) asset tests. The Regulations modify the Initial Regulations by permitting the QOF and QOZB to elect, for purposes of valuing assets, whether to use (i) the value used in their generally accepted accounting principles financial statements or (ii) the unadjusted cost basis. This is a welcome relief from the requirement in the Initial Regulations that the QOF and the QOZB use the financial statements method (which takes into account cost recovery) under certain circumstances.
- Valuation of leased property. The Regulations clarify that QOFs and QOZBs using the unadjusted cost basis method to value their assets for purposes of the 90% and 70% asset tests are required to value leased property based on the present value of the lease payments (including all extensions if the rent is predefined) using the applicable federal rate.
- Grace period for QOF use of cash. Because cash, cash equivalents and debt instruments are not qualified opportunity zone property for purposes of the 90% asset test, the Regulations provide a much needed grace period allowing the QOF to disregard such cash items at the first testing date after the contribution, thus giving the QOF more time to invest such cash in qualified opportunity zone property before penalties are imposed.
- Active trade or business requirement. A QOZB is required to be engaged in the active conduct of a trade or business. The Regulations clarify that the ownership and operation (including leasing) of real property used in a trade or business is treated as an active conduct of a trade or business. On the other hand, merely entering into a triple-net lease with respect to real property does not meet this requirement. Similarly and according to the preamble to the Regulations, holding land for investment does not give rise to a trade or business.
- Working capital safe harbor. The Regulations expand the working capital safe harbor applicable to QOZBs to allow the use of funds for the development of a trade or business in the OZ (in addition to the use of funds for the acquisition, construction and/or improvement of tangible property as was the case under the Initial Regulations). The Regulations further add that delays caused by waiting for governmental action (assuming the requisite application is complete) do not violate the 31-month safe harbor period and clarify that a QOZB may apply the 31-month safe harbor separately with respect to each investment in the QOZB.
Rules Relating to Qualified Opportunity Zone Business Property
- “Substantially all” holding period test. For property to be treated as qualified opportunity zone business property, during substantially all of the holding period, substantially all of the use of such property must be in the OZ. The Regulations clarify that “substantially all” with respect to the holding period requirement means at least 90% and “substantially all” with respect to the use of property means at least 70% (e.g., during at least 90% of the holding period of a QOZB in the property, at least 70% of its use was in an OZ).
- Relaxed rules for qualification of leased property as qualified opportunity zone business property. The Regulations significantly relax the qualification rules for leased property. Under the Regulations, leased tangible property does not need to be substantially improved or originally used in the OZ and does not need to be leased from an unrelated party to be treated as qualified opportunity zone business property. To qualify, the lease (i) must be entered into after December 31, 2017, and (ii) the terms of the lease must be on market terms (common, arms-length market practice in the locale where the property is located). If the lease is between related parties, prepayments of more than a year are not permitted and certain other requirements must be met if the original use of leased tangible personal property in an OZ does not commence with the lessee. To prevent the use of leases to circumvent the substantial improvement requirement (and the related-party requirement), any plan, intent or expectation by the lessee at the beginning of the lease to acquire the property at less than its fair market value (as determined at the time of purchase) would disqualify the lease as qualified opportunity zone business property.
- Improvements on leased property qualify. The Regulations clarify that improvements made by the lessee on leased property satisfy the original use requirement as purchased property.
- Unimproved land does not need to be substantially improved. The Regulations provide that unimproved land does not need to be substantially improved to qualify as qualified opportunity zone business property, however, as explained above, the preamble clarifies that solely holding land for investment does not meet the trade or business requirement.
- Original use of acquired property. The Regulations clarify that the original use of tangible property in an OZ commences on the date that any person first places the property in service in an OZ for purposes of depreciation or amortization. However, original use for property that has been unused or vacant for an uninterrupted period of at least five years commences on the date when any person first uses or places the property in service in the OZ.
- Acquisitions from other QOF investors. An acquisition of QOF interests by a QOF investor from another qualifies as an eligible investment for OZ tax benefit purposes. This allows future secondary market investors to benefit from OZ tax benefits (assuming the QOF interests are acquired with qualified deferred capital gain realized before 2027).
- Consolidated return rules. A QOF that is a corporation is not permitted to be a subsidiary member of a consolidated group but may be the common parent of such group. The Regulations further provide that each member of a consolidated group is treated separately for OZ tax purposes, which requires the member that actually realized the capital gain, rather than its affiliates, to be the investor in the QOF.
- General anti-abuse rule. The Regulations include a general anti-abuse rule, which applies when a significant purpose of a transaction is to achieve a tax result that is inconsistent with the purposes the OZ framework. Under these circumstances, the IRS has the authority to recast the transaction (or series of transactions) as appropriate to achieve tax results consistent with such purposes. For example, the acquisition of agricultural land without an intent to invest more capital or increase economic activity with respect to the land would be considered abusive even though the land qualifies as qualified opportunity zone business property as a technical matter.