April 24, 2019
IRS proposes additional Opportunity Zone regulations
The IRS released a second set of proposed regulations (REG-120186-18) on April 17, 2019 (the April 2019 Proposed Regulations), detailing the requirements that Opportunity Zone (OZ) investors must meet to defer the taxation of capital gains invested in a qualified opportunity fund (QOF). Additionally, the April 2019 Proposed Regulations address the requirements for QOFs and for QOF investments into qualified opportunity zone businesses (QOZB).
The April 2019 Proposed Regulations address issues left open by the first set of proposed regulations (REG-115420-18) issued on October 19, 2018 (the October 2018 Proposed Regulations). These issues include:
This Alert provides a general overview of the April 2019 Proposed Regulations. Subsequent detailed Tax Alerts will offer a deeper dive into certain aspects of the regulations, including how they apply in the context of partnerships, real estate, private equity funds, asset management funds, family offices and individuals. A webcast on the April 2019 Proposed Regulations will be held Friday, April 26. To register for the webcast, please click here.
IRC Sections 1400Z-1 and 1400Z-2
The Tax Cuts and Jobs Act added IRC Sections 1400Z-1 and 1400Z-2, which contain provisions related to Opportunity Zones. IRC Section 1400Z-1 includes definitional and procedural rules for designating Opportunity Zones. IRC 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 IRC 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 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.
October 2018 Proposed Regulations
The October 2018 Proposed Regulations described and clarified the types of gains that investors in a QOF could defer, the time by which the gain must be invested in a QOF, and procedures for electing to defer specified gains. They also provided rules on QOF self-certification, valuation of QOF assets, and QOZBs. For additional information on the October 2018 Proposed Regulations, see Tax Alert 2018-2119.
April 2019 Proposed Regulations
Definitions around the requirements for QOZBs and QOZB property
The April 2019 Proposed Regulations provided several definitions and clarifications around the requirements for a QOZB and QOZ business property.
Clarifying "substantially all" requirements
IRC Section 1400Z-2(d)(2) treats tangible property as QOZB property if substantially all of the property's use occurs in an OZ for substantially all of the period that the QOF holds the property. IRC Section 1400Z-2(d)(2) also requires a corporation or partnership to qualify as a QOZB for substantially all of the period that a QOF holds qualified OZ stock or partnership interests in that entity.
The October 2018 Proposed Regulations defined "substantially all" as 70% but did so solely in the context of requiring "substantially all" of a QOZB's owned or leased property to be QOZB property. Those Proposed Regulations were silent as to how substantially all is defined for "use" by a QOF and for holding period purposes. The April 2019 Proposed Regulations define "use" in the context of a QOF as 70% and define "substantially all" for holding period purposes as 90%. Accordingly, the October 2018 and April 2019 Proposed Regulations together provide the following:
Defining active conduct of a trade or business and the 50% gross income test
IRC Section 1400Z-2(d)(3) requires a QOZB to derive at least 50% of its total gross income from the active conduct of a trade or business within an OZ. Commenters on the October 2018 Proposed Regulations questioned whether the term "active conduct of a trade or business" had the same meaning under IRC Section 1400Z-2 as it does in IRC Section 162. Others questioned whether leasing real property would qualify as an active trade or business if the business "has limited leasing activity."
The April 2019 Proposed Regulations would adopt the definition of "trade or business" in IRC Section 162 for purposes of IRC Section 1400Z-2. They would also clarify that "the ownership and operation (including leasing) of real property used in a trade or business" is active conduct in the context of IRC Section 1400Z-2(d)(3), so long as the trade or business is not "merely entering into a triple-net-lease."
To assist businesses in determining if they have satisfied the 50% gross income requirement, the April 2019 Proposed Regulations provide three safe harbors and a facts-and-circumstances test. The safe harbors consist of the following:
If a business meets one of these safe harbors, the 50% gross income test is satisfied.
Treatment of leased property
The April 2019 Proposed Regulations would treat leased tangible property as QOZB property if two conditions are satisfied: (1) the QOF or QOZB enters into the lease acquiring the tangible property after December 31, 2017; and (2) substantially all (70%) of the property's use occurs in an OZ for substantially all (90%) of the period that the business leases the property. Additionally, the April 2019 regulations require all leases to have "market rate" terms (i.e., negotiated at arm's length, as determined under IRC Section 482). If the lease is between related parties, then the April 2019 Proposed Regulations add two additional requirements:
If the QOF or QOZB falls under the requirement to purchase tangible property, the value of the property it purchases must be equal to or more than the leased tangible personal property's value. Additionally, the QOF or QOZB must purchase the property by the earlier of the end of the lease term or 30 months from when the QOF or QOZB received possession of the leased property.
The April 2019 Proposed Regulations provide an "anti-abuse rule," which would prohibit leased real property from qualifying as QOZB property if the QOF or QOZB already had a "plan, intent or expectation," to purchase the property for below fair market value. The rule is designed to prevent taxpayers from attempting to "circumvent the substantial improvement requirement for purchases of real property" by instead entering a lease.
How to apply the working capital safe harbor to operating businesses
In response to comments received to the October 2018 Proposed Regulations, the April 2019 Proposed Regulations made two changes to the working capital safe harbor. First, they add that "the development of a trade or business" in an OZ is an allowable planned use for working capital. Second, they provide relief when the safe harbor's 31-month period is exceeded if the delay is attributable to waiting for "governmental action," provided the application was completed during the 31-month period.
The April 2019 Proposed Regulations did not change the requirement that development must occur through a QOZB, as opposed to a QOF directly developing a project, in order to utilize the 31-month safe harbor.
Transactions that can subject deferred gain to immediate taxation
Under IRC Section 1400Z-2(b)(1), a QOF investor's deferred gain is not subject to tax until the earlier of (1) the date the investor sells or exchanges the qualifying investment, or (2) December 31, 2026. The April 2019 Proposed Regulations would clarify that deferred gain becomes subject to tax to the extent a transaction "reduces a taxpayer's equity interest in the qualifying investment" for Federal income tax purposes. Similarly, deferred gain can become subject to tax to the extent a QOF gives an investor property (e.g., money, securities) "that is treated as a distribution for Federal income tax purposes."
To illustrate these principles, the April 2019 Proposed Regulations provide a non-exhaustive list of transactions that will subject deferred gain to immediate taxation (i.e.,an inclusion event). The list includes sales of a qualifying investment in QOF partnership or corporation, sales of interests in an S corporation or partnership that is a QOF investor, gifts of qualifying investments, and certain distributions of qualifying QOF partnership interests or stock.
Arguably, the regulations addressed the two most frequently asked questions about potential inclusion events: whether distributions from a QOF partnership or QOF S corporation will result in an inclusion event, and whether dividend distributions from a QOF corporation under IRC Section 301(c)(1) and 301(c)(2) (dividends from earnings and profits and dividends that constitute a return of capital) are inclusion events.
So long as the distribution did not exceed the partner's or shareholder's basis in the QOF, the April 2019 Proposed Regulations would not treat distributions from a QOF partnership or a QOF S corporation as an inclusion event. Similarly, dividend distributions from a QOF corporation under IRC Section 301(c)(1) and 301(c)(2) would not be treated as inclusion events, but dividends under IRC Section 301(c)(3) (dividends in excess of basis) would be.
When deferred gain becomes subject to tax, the April 2019 Proposed Regulations would generally require the QOF investor to include the lesser of two amounts in income, minus the investor's basis. The first amount equals the fair market value of the investment (or portion of the investment) that the investor disposed of. The second amount equals "[a]n amount which bears the same proportion to the remaining deferred gain as" the first amount bears to the "fair market value of the total qualifying investment immediately before the inclusion event."
The April 2019 Proposed Regulations include special rules for partnerships and S corporations to determine the amount of deferred gain subject to tax, as well as their basis. Special rules also apply to certain QOF distributions.
How to treat a QOF's sale of assets
The April 2019 Proposed Regulations also address what happens when a QOF sells an asset. This Alert describes those provisions in two parts: provisions for when the sale takes place before completion of the 10-year holding period under IRC Section 1400Z-2(c), and provisions for when the sale takes place after completion of the 10-year holding period under IRC Section 1400Z-2(c).
Before completion of the 10-year holding period under 1400Z-2(c)
IRC Section 1400Z-2(e)(4)(B) authorizes Treasury to issue regulations providing QOFs with "a reasonable period of time to reinvest the return of capital from investments in qualified [OZ] stock and qualified [OZ] partnership interests, and to reinvest proceeds received from the sale or disposition of qualified [OZ] property."
The April 2019 Proposed Regulations give QOFs one year to reinvest "some or all of the proceeds" from the "return of capital or the sale or disposition" of: (1) QOZB property, (2) qualified OZ stock, and (3) qualified OZ partnership interests. The one-year reinvestment period begins on the date of sale, distribution or disposition of the tangible property, stock, or partnership interest. The QOF must continuously hold the proceeds in cash, cash equivalents, or certain debt instruments until the proceeds are reinvested. The April 2019 Propose Regulations provide relief for when the 12-month reinvestment period is exceeded due to delays with "governmental action" on an application that was completed during the 12-month period.
While the April 2019 Proposed Regulations would clarify that the sale or disposition of qualified OZ property by a QOF does not affect an investor's holding period in a QOF, they were unable to satisfy the many commenters that wanted a rule stating gains would not be taxed if the proceeds were reinvested. As such, any gain from the sale of a QOF/QOZB investment/asset would be subject to tax under the regular taxation rules.
After the completion of the 10-year hold period under 1400Z-2(c)
The April 2019 Proposed Regulations would allow the holder of a direct qualifying QOF partnership interest or qualifying stock of a QOF S corporation to elect "to exclude from gross income some or all of the capital gain" from the QOF's disposition of qualified OZ property as reported on Schedule K-1. The Proposed Regulations detail the mechanics for effectuating that election, specifying that partners or shareholders could increase their basis by such amount. The April 2019 Proposed Regulations would also allow (i) QOF Real Estate Investment Trusts (REITs) to "designate special capital gain dividends, not to exceed the QOF REIT's long-term gains on sales of qualified OZ property," and (ii) QOF REIT investors that held the REIT stock for at least 10 years to treat the capital gain dividend as arising from the sale or exchange of the QOF and apply a 0% tax rate to those dividends. Interestingly, the Proposed Regulations provide no similar election to holders of stock in a QOF C corporation that is not a QOF REIT.
The meaning of "original use"
IRC Section 1400Z-2 requires the "original use" of tangible property acquired by a QOF or QOZB to occur in an OZ and commence with the QOF or QOZB. Alternatively, QOFs or QOZBs must substantially improve used property for it to be QOZB property.
The April 2019 Proposed Regulations define "original use" as beginning on the date that acquired tangible property is first placed in service in the OZ for depreciation or amortization purposes. If the property is leased instead of owned, then original use occurs when the property is first used in the OZ "in a manner that would allow depreciation or amortization" if the user owned the property. As such, a QOF or QOZB could not claim OZ benefits for acquired tangible property that was previously located in the OZ and depreciated or amortized by another taxpayer. A QOF or QOZB could, however, claim OZ benefits for acquired tangible property that was already in the OZ, but not previously depreciated or amortized, or that was previously depreciated or amortized, but not located in the OZ. Additionally, the original use requirement would be satisfied if a QOF or QOZB acquired a building or other structure that had been vacant for at least five continuous years.
Qualifying OZ investments into a QOF
Contributions of property to a QOF
The April 2019 Proposed Regulations would clarify that a taxpayer can make an investment into a QOF that is eligible for OZ tax benefits "by transferring property other than cash to a QOF," so long as there is not a distribution that results in treatment of the transfer as a disguised sale. Cash contributions to a QOF in exchange for a QOF interest may also be "disregarded" if there is a distribution that results in the transaction being deemed a disguised sale.
The treatment of 1231 gain
The October 2018 Proposed Regulations clarified that only capital gains are eligible for deferral under IRC Section 1400Z-2(a)(1). Numerous commenters, however, have noted that IRC Section 1231 gain represents a unique fact pattern; when a partnership has 1231 gain, the question of whether the gain is capital or ordinary is not determined until it is allocated to the ultimate taxpayer and then it is only capital gain to the extent that the gain exceeds IRC Section 1231 losses. To address this fact pattern, the April 2019 Proposed Regulations would treat only "capital gain net income from [IRC Section] 1231 property" as eligible gain for purposes of IRC Section 1400Z-2. Additionally, the 180-day period for investing eligible 1231 gain into a QOF begins on the last day of the tax year.
The treatment of carried interests on QOFs
IRC Section 1400Z-2(e)(1) treats only the portion of a QOF investment that is made with eligible capital gain as a qualifying investment and eligible for OZ tax benefits. Per the April 2019 Proposed Regulations, a contribution of "services" to a QOF in exchange for ownership cannot be a qualifying investment. The Preamble to the April 2019 Proposed Regulations explains that a carried interest is effectively a partner receiving a partnership interest in exchange for services provided. As such, it is not eligible for the various benefits afforded to qualifying investments under IRC Section 1400Z-2 and would be treated as a mixed fund investment.
The treatment upon a sale of a QOF interest/shares to another party
The April 2019 Proposed Regulations would also permit a taxpayer that acquires a direct investment in a QOF from the QOF's direct owner, rather than from the QOF itself, to make an IRC Section 1400Z-2(a) election in the amount of the purchase price.
Harmonization of IRC Section 1400Z rules with different entity structures
A major portion of the April 2019 Proposed Regulations would clarify how the IRC Section 1400Z-2 rules interact with different entity structures. Because these rules are dense and extremely technical, this Alert highlights only the key issues. Additional technical analyses will be provided in future Tax Alerts, as previously noted.
The April 2019 Proposed Regulations would clarify that the "five- and seven-year" basis increases under IRC Section 1400Z-2(b)(2)(B)(iii) and (iv) apply for all purposes, including affecting the availability of IRC Section 704(d) suspended losses.
Additionally, the IRC Section 1400Z-2(c) basis adjustment is calculated as if the adjustment were made to the partnership assets.
In the event of mixed investments into a QOF, the April 2019 Proposed Regulations would treat the mixed investment as two separate investments with two separate capital accounts and outside basis for purposes of IRC Section 1400Z-2, even though subchapter K principles provide for a unitary basis and capital account.
The April 2019 Proposed Regulations would not treat a QOF recapitalization, as defined under IRC Section 368(a)(1)(E), as an inclusion event, provided that the QOF shareholders do not receive boot.
The April 2019 Proposed Regulations also do not consider QOF stock to be stock for purposes of corporate affiliation under IRC Section 1504. This effectively means that ownership of stock in a QOF corporation would not result in an IRC Section 1504 affiliation, so a QOF corporation could not be a subsidiary member of a US Federal consolidated group. The QOF corporation could, however, be the common parent of its own US Federal consolidated group. The Preamble accompanying the April 2019 Proposed Regulations focuses on the consolidated return intercompany transaction rules (Reg. Section 1.1502-13), investment adjustment rules (Reg. Section 1.1502-32), and excess loss account rules (Reg. Section 1.1501-19), as requiring complicated modifications to properly interact with IRC Section 1400Z-2. Rather than attempting to draft the required harmonizing rules, the IRS drafted the April 2019 Proposed Regulations to preclude a QOF corporation from being a consolidated group subsidiary.
Additionally, the April 2019 Proposed Regulations would apply IRC Section 1400Z-2 separately to each member of a consolidated group. This means that the actual consolidated group member that triggered the gain would have to invest in the QOF directly (i.e., the consolidated group would not be treated as a single entity for this purpose).
The April 2019 Proposed Regulations would clarify that the rules for liquidating and reorganizing QOF C corporations and QOF C corporation shareholders also apply in the S corporation context. If an S corporation were the OZ investor in a QOF and converted to a C corporation, the conversion would not be an inclusion event. Conversely, if a C corporation became an S corporation, the conversion also would not be an inclusion event.
Solely for IRC Section 1400Z-2 purposes, the April 2019 Proposed Regulations would also deem a QOF investment to be "disposed of" if an S corporation (i) were the OZ investor in a QOF and (ii) had a greater-than-25% change in ownership. As such, the S corporation would have an inclusion event with respect to its remaining gain and the investment would no longer qualify for the five- and seven-year basis step-ups or the 10-year exclusion.
Estates and trusts
The April 2019 Proposed Regulations would not treat "a transfer of a qualifying investment by reason of the taxpayer's death" as an inclusion event. Such transfer does not restart the holding period for the QOF investment for purpose of the 5- and 7-year basis step-ups or the 10-year exclusion (i.e., the beneficiary would be deemed to have held the QOF investment for a period including the time that it was held by the decedent).
Additionally, a transfer of a qualifying investment by gift to a trust that is treated as a grantor trust would not be an inclusion event if the taxpayer were deemed the owner. Transfers of QOF interests by gift, to a trust that is not a grantor trust or otherwise, however, would be considered inclusion events.
The Department of Treasury and the IRS should be commended for the breadth and depth of the issues addressed in this set of Proposed Regulations. The April 2019 Proposed Regulations cover nearly all the issues that we were contemplating and some that were not on our radar. The Proposed Regulations would significantly change the way the OZ program is implemented and should generally be viewed as taxpayer/program friendly.
Clarification of QOZB and QOZB property requirements
The clarifications around the requirements for qualification of QOZBs and QOZB property should allow investments that were previously stalled due to lack of clarity to move forward.
The three safe harbors for determining if 50% of a business's gross income comes from active conduct in an OZ provide a variety of approaches that work for different types of businesses. They also allow businesses to rely on a facts-and-circumstances test for situations that may have not been contemplated. The uncertainty around the treatment of leased property was causing many transactions to be paused. The rules would allow for related-party leases, subject to certain qualifications, which is a reasonable result considering the lessor will not get the tax OZ benefits but the lessee will get OZ benefits for its investment and the OZ will get the benefit of economic activity.
Transactions that may subject deferred gain to immediate taxation
The rules around what constitutes an inclusion event are particularly generous. The general view before the release of these regulations was that any return of capital would be considered an inclusion event. Under these rules, QOF investors can receive their entire basis back before an inclusion event occurs. This is particularly valuable in the real estate sector, as it allows for debt-financed distributions. For example, Partners A and B could each put $50 of eligible gain into a QOF partnership, use that $100 to build a building and then borrow $60 for a permanent mortgage. While Partners A and B would have a $0 basis in their initial $50 investment under IRC Section 1400Z-2(b)(2)(B), they would each receive $30 of debt basis under IRC Section 752 (as laid out in the October 2018 Proposed Regulations) and could therefore take a distribution of $30 each without suffering an inclusion event.
How to treat a QOF's sale of assets
The fact that income from the sale of any QOZBs or QOZB property would be subject to tax may affect some QOF business plans. The provision allowing a 12-month window for reinvestment, however, is favorable and may better enable taxpayers to hold investments for at least 10 years.
Furthermore, any disappointment in the way the regulations handle the sale of QOZBs or QOZB property before achieving a 10-year hold is arguably offset by the fact that the regulations would allow for the sale of assets (rather than a QOF interest) to get the IRC Section 1400Z-2(c) 10-year exclusion benefit if the QOF were a partnership, S corporation or REIT. This would fundamentally change the program by making multi-asset QOFs much easier to execute. This allowance for tax benefits related to the sale of a QOFs underlying assets should allow large QOFs to form and should allow for retail investors to participate. Additionally, there was prior concern that a new 10-year holding period would commence for investors upon a QOF's sale of assets. Under the Preamble to the April 2019 Proposed Regulations, however, this reset of the 10-year holding period is no longer an issue, as the sale of assets would not affect an investor's holding period of a QOF interest.
Qualifying OZ investments into a QOF
The rules around IRC Section 1231 mean that partnerships cannot roll over their 1231 gain and such gain would have to be passed through to the investor, which would be required to use the last day of the tax year as the date of gain (i.e., an investor could not elect to use the partnership's date of sale as the beginning of the 180-day period for investment as partners can with other types of transactions). This provision also puts pressure on investors to collect all of their K-1 information quickly so they can make a timely determination as to the tax treatment of any 1231 gain that they generate or were allocated.
QOF managers will likely be disappointed by the language in the Preamble to the April 2019 Proposed Regulations around carried interest. Their view that the carried interest would have been eligible for QOZ benefits is a logical one. To the extent that a QOF is 100% qualified, then the issuance of a carried interest over time effectively shifts gain that would otherwise be excluded from tax to gain that is taxable to the carried interest partner. Previously, a taxpayer had to timely invest qualified gain proceeds into a QOF to get OZ benefits. With the April 2019 Proposed Regulations, taxpayers with eligible gain can buy an investor's interest in a QOF and defer the gain and, if holding period requirements are met, receive the benefits of the five- and seven-year step ups and the 10-year exclusion. One interesting consideration is how the market will develop around this, as the new QOF purchaser will have new time frames to satisfy in meeting the holding period benchmarks. How will a QOF approach an asset sale if the original investors have reached the 10-year mark and secondary investors have not?
Harmonization of IRC Section 1400Z rules with different entity structures
The rule that the IRC Section 1400Z-2(c) basis adjustment is calculated as if the adjustment were made to the partnership assets is important; it would prevent investors from getting whipsawed under the hot asset rules for partnerships, which would have resulted in ordinary income related to depreciation recapture and an offsetting capital loss that QOF partners may or may not have been able to utilize efficiently. This would also increase the value of cost segregation reports for real estate investments. Rather than having depreciation be simply a timing difference, any depreciation that could be brought into the holding period would be a permanent benefit. In the realm of QOF REITs, we are interested to see how state income taxes will be impacted due to the fact that the Proposed Regulations tax the capital gains dividends under 1400Z-2(c) using a 0% tax rate rather than excluding the income.
Taxpayers will likely be disappointed with the IRS's decision not to harmonize IRC Section 1400Z-2 with the consolidated return regulations. While harmonizing the rules would certainly be complex, the inability to include a wholly-owned QOF corporation as a subsidiary in a consolidated group likely caught many taxpayers off guard. This would limit the ability to utilize a QOF corporation's deductions like depreciation unless the QOF corporation is generating significant income (either on its own, or through a consolidated group with respect to which it is the common parent), which seems unlikely as many of the relevant investments will be new activities. The Preamble accompanying the April 2019 Proposed Regulations acknowledges that the approach in the Proposed Regulations reflects a decision to minimize administrative burdens, rather than anything required by either IRC Section 1400Z-2 or the referenced consolidated return regulations. The Preamble acknowledges that a different approach could still be adopted, and it solicits comments on permitting a QOF corporation to be a consolidated group subsidiary. Even if the proposed approach is ultimately adopted when the Regulations are finalized, it would apply prospectively to years beginning on or after publication of final regulations; there is no indication that the proposed approach would apply in prior periods. For taxpayers applying a different approach in prior periods, the complexities described in the Preamble should be addressed.
Similarly, the requirement for eligible gain to be rolled over separately by the consolidated group member that triggered the gain (i.e., a consolidated group is not treated as a single entity for this purpose) would likely result in less gain being available to roll over than otherwise would be the case due to non-tax regulatory and other issues. For example, an entity that serves as a regulated utility generally would be unable to use roll over gain into investments in unregulated activities. Although the Proposed Regulations would apply prospectively, there is not clear authority under current law for applying a different approach in prior periods.
The Proposed Regulations offer another large change to the OZ program by clarifying the treatment of a transfer by death. Previously, some were concerned that a transfer by death would be an inclusion event, which could affect the availability of the 10-year exclusion. This is particularly important to the amount of capital available to be invested in QOFs, as a large part of the investor pool is high net worth individuals who consider estate planning to be part of any investment with a 10+ year horizon.
Finally, we note that the Preamble to the Proposed Regulations point out many areas where the Department of Treasury and the IRS are looking for comments as they work towards finalizing these Regulations. The comment period ends 60 days after the date of publication of the Proposed Regulations in the Federal Register.