October 23, 2018
IRS guidance addresses many, though not all, questions about Opportunity Zones
On October 19, 2018, the IRS released proposed regulations (REG-115420-18) and a revenue ruling (Revenue Ruling 2018-29) providing guidance on Section 1400Z-1 qualified opportunity zones (Opportunity Zones) and the related Section 1400Z-2 tax treatment. The proposed regulations describe and clarify the types of gains that may be deferred by investors in a Qualified Opportunity Fund (QOF), the time by which gain must be invested in a QOF, and procedures for electing to defer specified gains. In addition, the proposed regulations include rules related to QOF self-certification, valuation of QOF assets, and Qualified Opportunity Zone Businesses.
Revenue Ruling 2018-29 provides guidance on applying the "original use" requirement in Section 1400Z-2(d)(2)(D)(i)(II) and the "substantial improvement" requirement in Sections 1400Z-2(d)(2)(D)(i)(II) and 1400Z-2(d)(2)(D)(ii) to real property.
Finally, New Form 8996, Qualified Opportunity Fund, and Instructions for Form 8996 were also released. A QOF files this form with its first tax return to certify its formation as a QOF and then with subsequent tax returns to demonstrate its compliance with the "90% Asset Test" described in Section 1400Z-2(d)(1).
The Tax Cuts and Jobs Act amended the Code to add Sections 1400Z-1 and 1400Z-2, which contain provisions related to Opportunity Zones. Section 1400Z-1 includes definitional and procedural rules for designating Opportunity Zones. Section 1400Z-2 allows taxpayers to elect to receive certain Federal income tax benefits to the extent that those taxpayers timely invest eligible gains into Opportunity Zones through a QOF.
These new provisions were designed to spur investment in designated distressed communities throughout the country by granting investors preferential tax treatment. The investments must be made through QOFs, which are investment vehicles that must have at least 90% of fund assets invested in Opportunity Zones.
The preferential tax treatment offered under Section 1400Z-2 is threefold: (1) investors can defer tax on capital gains timely invested into a QOF until no later than December 31, 2026; (2) investors that held the QOF investment for five or seven years upon the expiration of the deferral period can receive a 10% or 15% reduction on their deferred capital gains tax bill; and (3) investors that sell the QOF investment (not the underlying assets) after holding the investment for at least 10 years can receive the added benefit of paying no tax on any post-acquisition realized appreciation in the QOF investment.
Types of investors and gains eligible for deferral
The proposed regulations clarify that only capital gains are eligible for deferral under Section 1400Z-2(a)(1). The gain must be gain that would be recognized no later than December 31, 2026, if deferral under Section 1400Z-2(a)(1) were not permitted. Additionally, the gain must not arise from a sale or exchange with a related person as defined in Section 1400Z-2(e)(2). For this purpose, the general 50% standard of common ownership for "related" status is reduced to 20%.
To receive tax benefits under Section 1400Z-2, the taxpayer must invest eligible gain into a QOF in exchange for an equity interest (including preferred stock or a partnership interest with special allocations).
Taxpayers eligible to elect gain deferral under Section 1400Z-2 are those that recognize capital gain for federal income tax purposes. These include individuals, C corporations, partnerships, regulated investment companies (RICs), real estate investment trusts (REITs), and certain other pass-through entities. Foreign individuals and foreign corporations subject to tax on capital gains in the US are not specifically excluded from the regime. The proposed regulations include special rules for partnerships and other pass-through entities, and for taxpayers to whom these entities pass through income and other tax items.
Section 1256 gains on certain financial contracts
The proposed regulations also include special rules for when taxpayer's "mark to market" their position in Section 1256 contracts. Such contracts potentially produce significant capital gain (or loss) at the contract level on an aggregate basis due to requirements to mark these contracts to market annually. The "mark to market" causes the taxpayer to account for any not-yet recognized appreciation or depreciation in the position, which is treated as 60% long-term capital gain or loss and 40% short-term capital gain or loss (to the extent the gain or loss is capital). To minimize tax compliance and administrative burdens, the proposed regulations allow deferral under Section 1400Z-2(a)(1) only for a taxpayer's net capital gain from Section 1256 contracts in the tax year even though technically the gains may be much greater on a gross basis. The proposed regulations also provide that the 180-day period for investing net capital gain from Section 1256 contracts in a QOF begins on the last day of the tax year.
Further, "if, at any time during the [tax] year, any of the taxpayer's [Section] 1256 contracts was part of an offsetting positions transaction … and any other position in that transaction was not a [Section] 1256 contract, then no gain from any [Section] 1256 contract is an eligible gain with respect to that taxpayer in that [tax] year."
Additionally, the proposed regulations provide that "any capital gain from a position that is or has been part of an offsetting-positions transaction (other than an offsetting-positions transaction in which all of the positions are [Section] 1256 contracts) is not eligible for deferral under Section 1400Z-2." The proposed regulations define an "offsetting-positions transaction" as "a transaction in which a taxpayer has substantially diminished [its] risk of loss from holding one position with respect to personal property by holding one or more other positions with respect to personal property" (and the regulations make clear that this definition includes straddles).
For example, a taxpayer could have an S&P500 index futures contract with an offsetting short against an S&P 500 exchange traded fund. In that case, it is likely the taxpayer has an offsetting position under the proposed regulations and any gain on the 1256 contract would not be eligible for deferral. That said, if the taxpayer had entered into a Section 1256 and another contract offsetting the risk of the former that was also a Section 1256 contract, the capital gain deferral would be permitted.
Gains of partnerships and other pass-through entities
The proposed regulations allow a partnership to elect to defer all or part of a capital gain to the extent that it makes an eligible investment in a QOF. To the extent that a partnership does not elect to defer capital gain, the capital gain is included in the distributive shares of the partners' income under Section 702 and is subject to the Section 705(a)(1) basis rules. If all or any portion of a partner's distributive share satisfies all of the rules for eligibility under Section 1400Z-2(a)(1), then the partner generally may elect its own deferral with respect to its distributive share.
The partner's 180-day period generally begins on the last day of the partnership's tax year, because that is the day on which the partner would be required to recognize the gain if the gain were not deferred. If, however, the partner knows both the date of the partnership's gain and the partnership's decision not to elect deferral under Section 1400Z-2, the partner may choose to begin its own 180-day period on the same date as the start of the partnership's 180-day period.
Special rules for deferral election
Section 1400Z-2(a)(1)(A) requires a taxpayer to generally invest in a QOF during the 180-day period beginning on the date of the sale or exchange giving rise to the gain. The proposed regulations provide a special rule for scenarios in which Federal tax rules deem an amount to be a gain from a sale or exchange of a capital asset, but do not provide a date for the deemed sale or exchange. In that scenario, except as otherwise provided in the proposed regulations, the first day of the 180-day period is the date on which the gain would be recognized for Federal income tax purposes without regard to the deferral available under Section 1400Z-2.
The proposed rules also address confusion regarding whether Section 1400Z-2(a)(2)(A) bars a taxpayer from making multiple elections within 180 days for various parts of the gain from a single sale or exchange of property held by the taxpayer. The statute states that no election may be made under Section 1400Z-2(a)(1) with respect to a sale or exchange if an election previously made with respect to that sale or exchange is in effect. To clarify, the proposed regulations state that, for a taxpayer that made an election under Section 1400Z-2(a) for some, but not all, of an eligible gain, the term "eligible gain" includes the portion of that eligible gain for which no election has been made.
The proposed regulations state that deferral elections must be made in the time and manner to be provided in forthcoming IRS guidance. The IRS expects that deferral elections will be made on Form 8949, which must be attached to the taxpayer's Federal income tax returns for the tax year in which the gain would have been recognized if it had not been deferred. The IRS anticipates releasing form instructions to this effect "very shortly."
Any taxpayer that is a corporation or partnership for Federal income tax purposes can self-certify as a QOF, provided that the self-certifying entity is statutorily eligible to do so. The IRS will set forth the time and manner for self-certification in forthcoming guidance. It expects that taxpayers will use Form 8996, Qualified Opportunity Fund, both for initial self-certification and for annual reporting of compliance with the 90% Asset Test described in Section 1400Z-2(d)(1). The IRS released Form 8996 in draft form concurrently with the release of the proposed regulations.
Additionally, using a pre-existing entity as a QOF is not prohibited, provided that the pre-existing entity satisfies the requirements under Section 1400Z-2(d). Additionally, neither stock in a pre-existing corporation nor a partnership interest in a pre-existing partnership is prohibited from qualifying as Opportunity Zone Property, so long as the pre-existing entity satisfies the requirements under Section 1400Z-2(d).
The proposed regulations also conveyed that an eligible interest in a QOF is not impaired by the taxpayer's use of the interest as collateral for a loan.
Additionally, the proposed regulations clarify that deemed contributions under Section 752(a) do not create an investment in a QOF and do not result in "mixed fund" treatment under Section 1400Z-2(e)(1). Such deemed contributions typically increase a partner's basis in its partnership interest as a result of assuming liabilities.
Finally, the proposed regulations clarify that a QOF must be created or organized in one of the 50 States, the District of Columbia, or a US possession. Further, if an entity is organized in a US possession, as opposed to the 50 states or DC, the QOF must operate in the possession in which it is organized.
90% Asset Test
Section 1400Z-2(d)(1) requires a QOF to hold 90% of its assets in Opportunity Zone Property. To determine whether it meets the 90% Asset Test, a QOF must average the percentage of its assets in Opportunity Zone property at six months and at the end of the QOF's fiscal year.
The proposed regulations allow a QOF both to identify the tax year in which the entity becomes a QOF and to choose the first month in that year in which it will be treated as a QOF. For an entity that chooses to become a QOF in a month other than the first month of its first tax year, the proposed regulations provide guidance on how to apply the 90% Asset Test in the entity's first year as a QOF.
Regarding the valuation method for applying the 90% Asset Test, the proposed regulations require the QOF to use the asset values that are reported on the QOF's applicable financial statement for the tax year, or, if the QOF does not have an applicable financial statement, the cost of the QOF's assets.
In response to requests to give QOFs longer than the six months provided under Section 1400Z-2(d)(1) to invest in qualifying assets, the proposed regulations provide a working capital safe harbor for QOF investments in Qualified Opportunity Zone Businesses that acquire, construct or rehabilitate tangible business property. The safe harbor allows Qualified Opportunity Zone Businesses to apply the definition of "working capital" provided in Section 1397C(e)(1) to financial property held by the business for up to 31 months, if: (1) a written plan exists that identifies the financial property as property held for the acquisition, construction or substantial improvement of tangible property in an Opportunity Zone, (2) a written schedule consistent with the ordinary business operations of the business states that the property will be used within 31 months, and (3) the business substantially complies with the schedule.
Under Section 1400Z-2(d)(3)(A)(i), an entity will qualify as a Qualified Opportunity Zone Business if it satisfies the "substantially all" requirement, among other things. The proposed regulations specify that an entity satisfies the "substantially all" requirement if at least 70% of its owned or leased tangible property is Qualified Opportunity Zone Business Property (as defined Section 1400Z-2(d)(3)(A)(i)).
Consistent with the statute, the proposed regulations reiterate that, so long as a proper deferral election was made under Section 1400Z-2(a) upon investing gain in a QOF and so long as the QOF investment is held for at least 10 years, then the taxpayer may make a Section 1400Z-2(c) election to step up basis in the QOF investment to fair market value upon sale or exchange. The preamble to the proposed regulations note that commentators have questioned how the expiration of Opportunity Zone designations in 2028 under Section 1400Z-1(f) will affect the ability to make a Section 1400Z-2(c) election when a taxpayer with a QOF investment has its 10-year investment anniversary after 2028. In response to this concern, the proposed regulations permit taxpayers to make the basis step-up election under Section 1400Z-2(c) after an Opportunity Zone designation expires. Specifically, even though the Opportunity Zone designations will have expired, a taxpayer can make the Section 1400Z-2(c) election until December 31, 2047.
The proposed regulations also address the tax attributes of deferred gain that must be included in a taxpayer's income upon the expiration of the deferral period under Section 1400Z-2(a)(1)(B) and 1400Z-2(b). The proposed regulations specify that all tax attributes are preserved through the deferral period and are taken into account when the deferred gain is included. When a taxpayer disposes of a portion of its fungible interests in a QOF and cannot readily determine the tax attributes of the gain being recognized, the proposed regulations provide that the taxpayer should apply the first-in, first-out (FIFO) method to determine the tax attributes of the disposed interest. To the extent that FIFO does not provide a complete answer in terms of tax attributes upon disposition of a partial QOF interest, then the taxpayer should apply a pro-rata method to determine the attributes of the gain recognized. For example, if a taxpayer invests $300 of short-term capital gain in 2018 into a QOF and in 2019 the taxpayer invests $200 of long-term capital gain into the same QOF, then the taxpayer must apply the FIFO method when it subsequently sells only 60% of its interest in the QOF in order to determine the attributes of the gain that it must include in income.
Additionally, the proposed regulations clarify that an investor disposing of its entire QOF interest may defer that gain by properly making a new QOF investment.
The regulations are proposed to be effective on or after the date that final regulations are published. Taxpayers may, however, generally rely on various sections of the proposed regulations until the final regulations are issued, provided the taxpayer applies the rules in the relevant section in their entirety and in a consistent manner. This invitation to rely on the proposed regulations should encourage taxpayers to proceed with their plans to invest.
Additional forthcoming proposed regulations
The IRS plans to issue additional proposed regulations in the near future, which it expects will incorporate the guidance in Revenue Ruling 2018-29 (described in the next section). In addition, the IRS expects that the second round of proposed regulations will address other issues under Section 1400Z-2 not addressed in the current proposed regulations, including:
Revenue Ruling 2018-29
Revenue Ruling 2018-29 addresses the treatment of land under Section 1400Z-2(d)(2)(D)(i) when a QOF acquires a building located on land within an Opportunity Zone. The IRS concluded that "substantial improvement" to the building is measured by the QOF's additions to the building's adjusted basis, not the adjusted basis of both the building and the land.
A QOF purchased Property X, located in an Opportunity Zone, for $800x in September 2018. Property X consists of a factory building erected before 2018 and the land on which the factory was built. Of the $800x, 60% ($480x) is attributable to the land and 40% ($320x) is attributable to the building. Within 24 months of purchasing Property X, the QOF invests an additional $400x to convert the building into residential rental property.
Law and analysis
Section 1400Z-2(d)(1) defines a QOF as any investment vehicle that is organized as a corporation or partnership for purposes of investing in Opportunity Zone Property and holds at least 90% of its assets in Opportunity Zone Property. Section 1400Z-2(d)(2)(A) defines Opportunity Zone Property as property that is: (1) Opportunity Zone Stock, (2) Opportunity Zone Partnership Interest, or (3) Opportunity Zone Business Property. Opportunity Zone Business Property is tangible property used in a QOF's trade or business if: (1) the QOF purchases the tangible property after December 31, 2017; (2) the original use of the tangible property begins with the QOF or the QOF substantially improves the tangible property; and (3) during substantially all of the QOF's holding period for the tangible property, substantially all of the property's use is in an Opportunity Zone.
Section 1400Z-2(d)(2)(D)(ii) treats tangible property used in a QOF's trade or business as substantially improved if, during any 30-month period beginning after the tangible property's acquisition, additions to the basis of the tangible property exceed the tangible property's adjusted basis at the beginning of the 30-month period.
Addressing the treatment of land, the IRS clarified that "land can never have its original use in a QOZ commencing with a QOF" because land is permanent. Therefore, Section 1400Z-2(d)(2)(D)(ii) applies to the factory building on Property X, but not the land.
Because the factory building existed in the Opportunity Zone before the QOF's purchase, the building's original use did not commence with the QOF. Thus, under Section 1400Z-2(d)(2)(D)(ii), the QOF must substantially improve the factory building during any 30-month period beginning after the QOF acquired Property X. The QOF's additions to the factory building's basis ($400x) exceeded the QOF's adjusted basis in the building at the beginning of the 30-month period ($320x), therefore the requirement is satisfied.
Substantial improvement to the building is not measured by additions to the adjusted basis of the building and the land. The IRS also concluded that "measuring a substantial improvement to the building by additions to the QOF's adjusted basis of the building does not require the QOF to separately substantially improve the land upon which the building is located."
Overall, the proposed regulations were taxpayer favorable. However, the IRS left a number of important issues to be addressed in future regulations (expected to be released in the "near future"). The major issues addressed in the current set of proposed regulations and their implications are discussed below.
Type of gain that can be deferred and deferral process
The proposed regulations define eligible gain as gain that is: A) treated as a capital gain for Federal income tax purposes; B) would be recognized before January 1, 2027 (ignoring deferral under Section 1400Z-2) and; C) does not arise from a related-party transaction. Further, the proposed regulations define capital gain by referring to the capital asset definitions in Section 1221 instead of the capital gains rates. To the extent a Code section causes a partial recharacterization of the capital gain to ordinary income (e.g., as a result of depreciation recapture), the benefit may be reduced. Partial gain recharacterization may also occur with the sale of a controlled foreign corporation (CFC) by US shareholders. Under Section 1248, any gain attributable to CFC earnings not yet subject to US tax may be treated as ordinary dividend income in lieu of capital gain.
Also in the cross-border space, foreign individual and corporate investors may find significant opportunities from capital gains generated by the disposition of real property in the US or partnership investments that generate effectively connected income. There is no statutory prohibition against, or policy rationale for, excluding this taxpayer group from the QOF regime. There are some additional important procedural matters for this sub-group that should be addressed in forthcoming guidance, including the manner in which withholding certificates may be obtained to prevent the upfront application of withholding on gross proceeds.
In summary, the definition of eligible gain is broader than many people anticipated and should allow for more gains to be invested in QOFs and more economic benefit to designated Opportunity Zones than previously anticipated. Taxpayers that may have initially thought they did not have eligible gain should reevaluate that conclusion. Similarly, taxpayers need to consider whether they should put into place a process to immediately identify eligible gains to enable them to achieve deferral through an investment in a QOF within the 180-day window.
The proposed regulations also answered a frequently asked question regarding whether the "taxpayer" under Section 1400Z-2(a)(1) would be the partnership or the individual partners when a partnership has sold or exchanged a capital asset. The proposed regulations effectively define the "taxpayer" as both, stating that the partnership can make the election and roll eligible gain into a QOF or the partnership can include the gain in the distributive shares of the partners, who would then be able to make the election. This clarification provided in the proposed regulations is very important; as many funds generate gains in a large fund structure, it would be impractical for a fund manager to get all of the partners to agree on how much eligible gain to reinvest and which QOF should receive that investment.
When a partnership elects to defer capital gain recognition and timely invests in a QOF, that gain is not included in the distributive shares to the partners. When the partnership ultimately does recognize the capital gain upon expiration of the deferral period, that deferred gain will be included in the distributive shares of the partners in that partnership at that time. This may result in shifting the burden of capital gain from earlier-in-time partners to later-in-time partners.
The proposed regulations also provide that partners receiving a distributive share of eligible gain start the 180-day period for investment into a QOF on the last day of the partnership's tax year, unless the partner opts to begin the 180-day period on the day of the partnership's sale or exchange of the capital asset. For example, if a partnership sold a capital asset on January 1, 2018, the partnership would have until July 1, 2018, to roll the gain into a QOF and elect deferral. If the partnership did not elect to roll over all of the gain, then the partners would receive a distributive share of the gain that was not rolled over and the partners would have a 180-day window starting on December 31, 2018 (assuming a calendar tax year) to invest their share of the gain into a QOF and elect to defer including that gain in income. This provision in the proposed regulations is favorable in many ways, particularly in terms of timing for taxpayers invested in partnerships selling capital assets. Partnerships might, however, need to contend with a new demand from partners for completed tax returns or Schedules K-1 sooner than typical to allow partners to satisfy the investment requirement within the 180-day window. Presumably a partner that invests within the 180-day window beginning on the last day of the partnership's tax year will do so in reliance on information provided in the Schedule K-1, which reports a partner's share of any net capital gain.
Deployment of QOF assets
The proposed regulations provide guidance addressing many issues around QOFs, the 90% Asset Test, and Opportunity Zone Property. Most notably, the proposed regulations provide that an existing entity can become a QOF. Many commentators had speculated that a QOF would need to be a new "clean" entity. Upon filing the self-certification form, however, an existing entity can indicate the first month that it was a QOF. All contributions before that date would not be eligible for the benefits under Section 1400Z-2 and would result in a "mixed fund" as defined under Section 1400Z-2(e)(1).
The first testing date for the 90% Asset Test would be six months after the date the QOF selected on its self-certification form. The last date of the tax year, however, is always a test date. This means that a new calendar-year QOF that "starts" in December would only have one month to pass the 90% Asset Test, whereas a QOF that "started" in June would have a full six months to pass the test. As such, it may be prudent for those whose 180-day investment window extends into the following calendar year to delay "starting" their QOF until the new calendar year.
The proposed regulations also provide that, for the purpose of applying the 90% Asset Test, a QOF should use the asset values reported on its applicable financial statements and, in lieu of applicable financial statements, the cost of the QOF assets. The reference to a defined set of widely used financial statements should align with general taxpayer preferences to rely on their books and alleviate taxpayer concerns about performing ongoing valuations solely for tax purposes. For a QOF without applicable financial statements, the regulations do not specify how to determine the "cost of the assets." In lieu of forthcoming regulations stating otherwise, a taxpayer will presumably rely on the unadjusted basis of the assets in the QOF for purposes of the 90% Asset Test.
When Opportunity Zones were first created through the Tax Cuts and Jobs Act, one of the main areas of concern was how a QOF could possibly pass the 90% Asset Test in a real estate development or rehabilitation context given that very few projects can be completed within six months. The proposed regulations address this concern by providing a very generous working capital safe harbor for Operating Zone Businesses, including businesses that own and operate real estate. Under the Operating Zone Business working capital safe harbor, cash that meets the definition of working capital is ignored for purposes of the nonqualified financial property requirement. The definition of working capital is taxpayer favorable, with the Operating Zone Business needing a written plan and a written schedule that it substantially follows. The proposed regulations provide an example of a business that falls within the safe harbor where the business plans to complete a project, but has not even obtained control of the land on which it planned to build.
For projects that are expected to take longer than 31 months, taxpayers could begin the project in an entity and wait to certify that entity as a QOF until the taxpayer was comfortable with meeting the working capital definition.
Noticeably missing from the this set of proposed regulations is any guidance as to what happens if the QOF is ultimately unable to execute on the written plan and written schedule for the money held as working capital. For example, what happens if, after buying the land, the QOF is unable to obtain the necessary entitlements? While the IRS has indicated that future regulations will address what types of conduct could lead to penalties or potential decertification of a QOF, it is unclear how many taxpayers will be willing to move forward without knowing the downside risk.
The proposed regulations also address the treatment of land as Opportunity Zone Property, addressing an issue of great interest to many tax professionals. Given that land inherently cannot be new and has a separate basis from assets built on it, tax professionals have questioned how land could satisfy the substantial improvement requirement. Some had speculated that the IRS might look at land and a building on the land as having a combined basis. Revenue Ruling 2018-29, however, provided an even more favorable answer, which is that the land does not have to be substantially improved. The Revenue Ruling specified that, if land and building are purchased together, only the building must be substantially improved. This may allow some smaller projects that could not have previously satisfied the substantial rehabilitation requirement to proceed.
One of the initial critiques of Section 1400Z-2 was that it often uses qualitative adjectives, such as the phrase "substantially all" five times, rather than quantifiable amounts to establish requirements. This ambiguity has led to confusion for some potential investors that wanted to apply the rules in absence of guidance. The proposed regulations have taken the highly unusual step of defining substantially all as 70%, but solely for purposes of Section 1400Z-2(d)(3)(A)(i), which addresses tangible property owned or leased by a Qualified Opportunity Zone Business. This leaves taxpayers without guidance on the applicable percentage for the remaining four "substantially all" references in the statute. Nonetheless, the 70% threshold for Qualified Opportunity Zone Businesses provides a lot of flexibility and should allow many businesses to benefit from the program. Of note, the 70% threshold is not measured on an entity basis but is measured "by the trade or business." This is presumably meant to prevent taxpayers from tucking smaller ineligible businesses under the umbrella of larger eligible businesses for the purpose garnering the benefits of Section 1400Z-2 on the otherwise ineligible activities.
One of the more technical items covered in the proposed regulations was that a partner's share of a partnership's liability (treated as a deemed contribution under Section 752(a)) is not treated as a contribution in the context of a QOF. This implies that the presence of debt on Opportunity Zone projects should not affect the tax benefits of a QOF investment under Section 1400Z-2. We expect that many QOFs will have debt and that such debt will give the QOF outside tax basis if the QOF is structured as a partnership.
Operating and exit issues
The last three items have significant implications for taxpayers and fall under the broad umbrella of operating and exit issues. These implications pertain to what happens after a QOF is created formed and capital is deployed into an Opportunity Zone.
The proposed regulations allow taxpayers to use a QOF as collateral without any consequences. This is extremely important for taxpayers that are looking to take money out of the QOF during the 10-year hold period, but don't want to redeem their interest in the QOF. For example, if a QOF invests in a building and the taxpayer wants to undertake a cash-out financing in Year 6, the cash distribution would be problematic as it would almost certainly be considered a redemption and would trigger recognition of part of the deferred gain and could possibly eliminate the availability of the exclusion for holding the QOF for 10 years on the redeemed portion. Based on the guidance in the proposed regulations, however, the taxpayer could instead use the QOF as collateral and borrow against the cash flow generated by the QOF to achieve a similar economic result.
The proposed regulations also explicitly allow for special allocations within a QOF. Many potential QOF managers were waiting to see how the IRS would address this question, hoping for the allowance of special allocations. The proposed regulations were not clear on how the special allocations will interact with the language in Section 1400Z-2(e)(1)(A), which states that "mixed funds" should be "treated as separate investments." While not clear, one could read those two items as indicating that a QOF could specially allocate items within the separate investments but not across the separate investments. Hopefully this will be addressed in future regulations.
The allowance for special allocations could, in theory, allow for items like a traditional fund carry. A traditional carry is effectuated by allocating gain upon the sale of assets within the fund. Given the rules for a QOF, such a sale of underlying assets would either need to be reinvested (under rules to be provided in future regulations) or would generate taxable income (the basis step-up is only on the sale of the QOF, not the sale of the underlying assets within the QOF). As such, the carry will need to be effectuated using a different mechanism, presumably something like an incentive management fee.
Finally, the proposed regulations address a concern of many taxpayers around Section 1400Z-1(f), which states that the Opportunity Zone designations expire at the end of 10 years. The proposed regulations preserve the ability for taxpayers to elect the Section 1400Z-2(c) tax benefit for QOF interests sold after at least 10 years by providing that the ability to make the election is preserved until December 31, 2047. If the taxpayer hasn't disposed of the QOF by December 31, 2047, then it may need to make an election at that time to step up its basis. Thus, a taxpayer could ultimately pay some amount of tax (the appreciation between 2047 and ultimate exit) on an investment that many people had thought would be "tax-free" if held for 10 years.