02 May 2019 April 2019 proposed regulations on Opportunity Zones provide generally welcome guidance to QOF partnerships and their investors In a second set of proposed regulations (REG-120186-18) released April 17, 2019, (the April 2019 Proposed Regulations), the IRS further elucidates the prerequisites needed for investors to qualify for Opportunity Zone (OZ) tax benefits. The general market consensus is that this guidance will encourage many investors to proceed with their investments in qualified opportunity funds (QOFs) OZFs and spur their creation. Certain questions, however, still remain.1 This Alert focuses on certain highlights of the April 2019 Proposed Regulations applicable to QOFs classified as partnerships for US federal income tax purposes (QOF partnerships) and their investors. As this Alert is targeted, it assumes that the reader has a general understanding of the OZ rules. If a general overview of the OZ rules would be helpful, please see Tax Alert 2018-2119.{link} For a more detailed summary of the April 2019 Proposed Regulations, please see Tax Alert 2019-0823. As part of the Tax Cuts and Jobs Act (the TCJA), Congress added IRC Sections 1400Z-1 and 1400Z-2, which establish the OZ regime. This regime was created in the hopes of stimulating economic development and job creation in economically stagnated areas in the United States. To attract investment in OZ, the regime provides taxpayers the ability to either defer or eliminate US federal income tax on capital gains invested in OZ, provided that certain requirements are met. Specifically, investments in OZ offer investors three tax benefits: (i) deferral of capital gains that are reinvested in a QOF within 180 days after the recognition of such gains (qualified gain) until the earlier of the date of disposition of the QOF interest or December 31, 2026; (ii) a permanent exclusion of 10%-15% of such qualified gain, depending upon the holding period (5 or 7 years); and (iii) a permanent exclusion of all gain, other than qualified gain, realized on a qualifying investment in a QOF held for at least 10 years, in addition to (i) and (ii). To obtain such benefits, an investor acquires an equity interest in a QOF, which must be a partnership or corporation for US federal income tax purposes. The QOF must satisfy several requirements. Of note, the QOF must invest 90% of its funds in qualified opportunity zone property (QOZP). QOZP includes both (i) interests in a qualified opportunity zone business (QOZB) and (ii) qualified opportunity zone business property (QOZBP). Interests in a QOZB may be either QOZ stock or QOZ partnership interests. The IRS issued a preliminary set of proposed regulations (REG-115420-18) on October 19, 2018 (the October 2018 Proposed Regulations), which left unaddressed many important aspects of the rules. The April 2019 Proposed Regulations address many of these open partnership issues. In general, a QOF investor's deferred qualified gain is not subject to tax until the earlier of (i) the date the investor sells or exchanges the qualifying investment or (ii) December 31, 2026. The April 2019 Proposed Regulations would clarify that deferred qualified gain becomes subject to tax to the extent an "inclusion event" occurs. An inclusion event is generally a transaction (i) that "reduces a taxpayer's equity interest in the qualifying investment" for federal income tax purposes or (ii) for which the investor receives a distribution of property from a QOF for federal income tax purposes. The April 2019 Proposed Regulations provide a non-exclusive list of inclusion events. Before the issuance of the April 2019 Proposed Regulations, commentators were concerned that an inclusion event could occur when a QOF partnership distributes property to its partners. Under the April 2019 Proposed Regulations, however, distributions from a QOF partnership would not result in an inclusion event, so long as the distribution did not cause the distributee partner to recognize gain under the partnership tax rules. The rules would generally permit QOF partnerships to make debt-financed distributions without causing an inclusion event so long as (i) the distribution would not otherwise result in gain recognition under the general partnership tax rules (e.g., IRC Section 731(a)(1) gain) and (ii) the distribution is not subject to the disguised sale rules of IRC Section 707. For example, in Year 1, Partners A and B could each put $50 of qualified gain into a QOF partnership, construct a building using the $100, and borrow $60 for a permanent mortgage. Partners A and B would have a $0 basis in their initial $50 investment under IRC Section 1400Z-2(b)(2)(B)'s special zero basis rule. (IRC Section 1400Z-2(b)(2)(B) provides that a taxpayer's initial basis in a qualifying investment is generally zero, thereby preserving the inherent gain deferred under the OZ rules.) The partners would each receive $30 of debt basis under IRC Section 752. In Year 3, each partner could receive a distribution of $30 without having an inclusion event. To the extent that $40 were distributed to a partner, the partner would have a $10 inclusion event. Implications: Investors in a QOF partnership may generally monetize an amount equal to their tax basis in the partnership, including basis attributable to an allocation of liabilities, without an inclusion event. This is a welcome acknowledgement from the government that Section 731's favorable tax rules apply to a qualifying investment and allows investors to qualify for the QOF tax benefits while extracting debt proceeds. This clarification that a partner's basis may be increased by virtue of the partner's Section 752 debt allocation also permits loss allocations under "normal" Subchapter K principles. However, a QOF partnership ought to closely scrutinize any distributions it makes to an investor within the first two years of the investor's otherwise qualifying investment in the QOF — if such transfers are recharacterized as a disguised sale, the character of the investor's original investment may be converted from a qualifying investment to a non-qualifying investment. The April 2019 Proposed Regulations favorably address sales of assets by a QOF (or a QOZB). To the extent that the 10-year holding period is not yet met for the asset sold, the QOF has one year to reinvest some or all of the proceeds in QOZP. The one-year reinvestment period would begin on the date of sale, distribution or disposition of the property, stock or interest. During the reinvestment period, the QOF must continuously hold the proceeds in cash, cash equivalents, and certain debt instruments. Any gain realized by the QOF from the sale of a QOF investment/asset would be subject to tax under the regular rules of taxation. Finally, because the portion of the April 2019 Proposed Regulations addressing asset sales is not effective until final regulations are issued, taxpayers cannot rely on this provision until then. Implications:The 12-month window for reinvestment is a welcome clarification and allows QOFs operational flexibility. However, investors in a QOF partnership may recognize gain to the extent that the QOF partnership sells QOZP and does not reinvest the proceeds in a tax-free manner (e.g., in an IRC Section 1031 exchange to the extent applicable). Moreover, while this reinvestment window provides for operational flexibility, the use of this provision may decrease the amount of gain for which permanent exclusion is available. This is because when a QOF sells QOZP and reinvests the proceeds in a new asset, the investor's holding period in the QOZP remains unchanged, such that the newly acquired asset has a shorter time in which to appreciate in value (assuming the investor plans to dispose of its qualifying investment upon reaching a 10-year holding period). In addition, the April 2019 Proposed Regulations would clarify that the sale or disposition of QOZP by a QOF does not affect an investor's holding period in the QOF, assuming that the fund continues to qualify as a QOF. Implications:The fact that the sale or disposition of QOZP by a QOF does not impact an investor's holding period in the QOF is expected to enable investors to more easily satisfy the 10-year holding period required to permanently eliminate capital gain. When a QOF partnership interest is held for at least 10 years, the holder may elect to exclude some or all of the capital gains from the sale of QOZP by the QOF partnership. The holder may increase its basis in its QOF partnership interest to the extent of any capital gain from the QOF's disposition of QOZP as reported on a Schedule K-1. However, the April 2019 Proposed Regulations would only allow an election for capital gains and not ordinary income (e.g., from depreciation recapture) resulting from the sale of QOZP by a QOF partnership. Implications: This favorable rule is expected to pave the way for the formation of large, multi-asset QOFs and to permit retail investors to participate, subject to the possible adverse recapture rules that seemingly apply upon asset sales, as discussed later. 4. Investors could transfer non-cash property to a QOF partnership in exchange for a qualifying investment A taxpayer could make a qualifying investment in a QOF partnership by transferring property other than cash to the QOF partnership in exchange for an eligible QOF interest. This rule would apply regardless of whether the transfer is a recognition or nonrecognition event. Thus, eligible transfers include not only IRC Section 721(a) contributions, but also partnership contributions that are subject to tax. Proposed Regulation Section 1400Z2-(1)(b)(10)(i)(B)(2)would apply separately to each piece of property contributed to the QOF. Thus, if a taxpayer had qualified gain and contributed built-in gain property in exchange for a QOF interest equal to the fair market value of the contributed property, the taxpayer would have a "mixed-funds" investment — a qualifying investment and a non-qualifying investment. Proposed Regulation Section 1400Z2-(1)(b)(10)(i)(A) calculates the amount of a taxpayer's qualifying investment. Under the provision, the amount of the qualifying investment equals the lesser of (i) the taxpayer's basis in the QOF investment without regard to the special zero basis rule in IRC Section 1400Z-2(b)(2)(B) or (ii) the fair market value of the eligible interest received, both determined immediately after the contribution. Proposed Regulation Section 1400Z2-(1)(b)(10)(i)(B) calculates the non-qualifying investment portion. Implications: There appears to be an error in Proposed Regulation Section 1400Z2-(1)(b)(10)(i)(B). Consistent with the calculation provided in Example 1, the amount of the non-qualifying investment should likely be equal to the excess of the fair market value of the eligible interest (rather than the amount of the qualifying interest) over the taxpayer's adjusted basis in the interest without regard to the special zero basis rule. A partner that holds both a qualifying investment and a non-qualifying investment in a QOF partnership would be treated as holding two separate interests in the partnership and the basis of each partnership interest would be computed separately, exclusively for purposes of the OZ rules (e.g., not for purposes of Subchapter K). Thus, all allocations of income, gain, loss, and deduction, all allocations of debt, as well as distributions, that a mixed-funds partnership makes would be treated as if they were made to two separate interests based upon the allocation percentages of the interests. These allocation percentages are determined based on the relative capital contributions attributable to each of the qualifying and non-qualifying interests. If either or both of the partner's interests were increased (e.g., the partner made an additional contribution to the QOF partnership), the partner's interests would be valued immediately before the event and allocation percentages would be adjusted accordingly. The following example from the April 2019 Proposed Regulations illustrates how this would work: Assume that Partner A contributes $200 to a QOF partnership; 50% of the capital contribution (or $100) relates to qualified gain; and $20 of partnership debt is allocable to Partner A under IRC Section 752. Partner A's outside basis in the partnership for OZ purposes is $120 (qualifying investment tax basis ($0 per IRC Section 1400Z-2(b)(2)(B)(i)) + non-qualifying investment tax basis ($100) + Partner A's share of liabilities ($20)). For purposes of the OZ rules, Partner A has two separate interests in the partnership and the basis of each interest is computed separately. Partner A's outside basis in the qualifying investment is $10 (qualifying investment tax basis ($0 per IRC Section 1400Z-2(b)(2)(B)(i)) + Partner A's share of liabilities attributable to the qualifying investment ($10 = 50% * $20). Partner A's outside basis in the non-qualifying investment is $110. Only a distribution of money over $120 would cause Partner A to recognize gain under IRC Section 731. However, the OZ rules would add complexity. Consider a distribution of $40. For purposes of the OZ rules, such a distribution would be divided between the two investments and would constitute an inclusion event. Specifically, Partner A would recognize gain under the OZ rules in the amount of $10 (the excess of the $20 distribution attributable to the qualifying investment over the $10 basis in such qualifying interest). Implications:This construct takes the novel approach of bifurcating a partnership interest held by a single taxpayer for purposes of the OZ rules. Said differently, while Subchapter K treats the partnership interest as a single interest (e.g., with a unitary basis), the single partnership interest would be treated as two distinct interests for purposes of the OZ rules (e.g., the basis of each of the qualifying interest and non-qualifying interest is determined under the OZ rules). Certain taxpayers may be well advised to consider using a combination of debt and equity (as opposed to creating a mixed-funds investment) as a result of the allocation percentage mechanism. Moreover, the treatment of mixed-funds investments is expected to result in additional administrative burdens on QOFs partnerships and require the careful tracking of partners' qualifying and non-qualifying interests. If a taxpayer acquired an eligible investment (e.g., a qualifying interest or non-qualifying interest in a QOF partnership) from a direct owner of the QOF, the taxpayer could elect to defer gains in the amount equal to the purchase price. Thus, a taxpayer could acquire a qualifying interest in the QOF partnership from a party other the QOF partnership. Implications: This provision in the April 2019 Proposed Regulations provides for liquidity of QOF interests and enables interests in QOF partnerships to be traded privately and publicly. This change from the October 2018 Proposed Regulations is very helpful from a market perspective. Notably, the fact that the seller of the QOF interest may have held a non-qualifying interest (e.g., received its interest in the QOF in exchange for services) appears to be irrelevant. In such an instance, the purchaser appears to be eligible to receive OZ tax benefits. 7. Transfers of QOF partnership interests in nonrecognition transfers would receive favorable treatment Investors in a QOF partnership could transfer their QOF partnership interests in nonrecognition transaction without losing OZ tax benefits, either via an IRC Section 721(a) contribution to another partnership or a partnership merger transaction. However, any gain would need to be traced back to that particular partner. Implications: This provision is helpful in that it provides a certain degree of flexibility to QOZ investors and appropriately allows certain partnership restructurings to occur without an inclusion event. However, the favorable treatment would be limited to the transactions previously described. Moreover, as the list of inclusion events in the April 2019 Proposed Regulations is non-exclusive, taxpayers should approach non-recognition transactions with caution. Furthermore, the rule requiring the tracing of gain is expected to result in additional administrative burdens on QOFs partnerships. QOF Real Estate Investment Trusts (REITs) could designate special capital gain dividends, not to exceed the QOF REIT's long-term gains on sales of QOZP as arising from the sale or exchange of a qualifying investment. A 0% tax rate would apply to such capital gain dividends. Implications: This rule is similar — but not identical — to the rule applicable to QOF partnership interests held for at least 10 years. In the partnership context, the partner could elect to exclude some or all of the capital gains from the sale of QOZP by the QOF partnership. In the REIT context, the gain would be included but taxed at a 0% rate. While the federal income tax liability would be the same, there may be state tax implications, as it remains unclear how states will treat REIT capital gains dividends subject to a 0% tax rate under the OZ rules. Only capital gains would be eligible for deferral under the OZ rules. The April 2019 Proposed Regulations would treat only gain arising from IRC Section 1231 property that is eligible for deferral under the OZ rules as capital gain net income for a tax year. This net amount is determined by taking into account the capital gains and losses for a tax year on all the taxpayer's IRC Section 1231 property. Implications: Determining net capital gain would eliminate the ability to reinvest IRC Section 1231 gains on a gain-by-gain basis, and impose netting as provided in IRC Section 1231 in determining whether there is IRC Section 1231 gain (which is treated as capital gain). It remains unclear whether the determination is to be made at the ultimate taxpayer level or the partnership level. The April 2019 Proposed Regulations state that the 180-day period for any capital gain net income from IRC Section 1231 property for a tax year would begin on the last day of the tax year. Unlike with non-1231 gains, there is no ability to elect to use the date of sale for purposes of determining the 180-day period. Implications: When a QOF partnership realizes IRC Section 1231 gain at the beginning of a tax year, the taxpayer will not know if the gain is eligible until the end of the tax year and may only invest such gain in a manner that is tax favorable under the OZ rules the following year. While this rule takes into account practical considerations, it appears to delay investments into QOFs and QOZP. The April 2019 Proposed Regulations address the treatment of carried interests in a QOF partnership. A carried interest, in effect, results when a partner receives a partnership interest in exchange for services. Carried interests would not be eligible for the various benefits afforded qualifying OZ investments. The portion of an interest in a QOF partnership that is a carried interest would be treated as a non-qualifying investment and the rules for mixed-funds investments, discussed previously, would apply. Implications:Funds sponsors and other partners that receive interests for services would be subject to "normal" taxation in accordance with the rules of Subchapter K and IRC Section 1061. The OZ regime provides taxpayers the ability to defer certain capital gains and eliminate other capital gains, provided that certain requirements are met. While some issues remain open, the April 2019 Proposed Regulations, alongside the October 2018 Proposed Regulations, generally provide investors and funds with the necessary framework to successfully structure their investments to meet the OZ requirements and obtain the attendant tax benefits. It is worth stressing that these regulations create significant complexities, especially in the partnership context. Satisfying the OZ qualifications to obtain tax benefits will require careful planning and analysis.
1 The IRS is currently accepting comments on the April 2019 Proposed Regulations, which taxpayers are encouraged to submit. The comment period ends 60 days after the date of publication of the April 2019 Proposed Regulations in the Federal Register. Document ID: 2019-0856 | |||||||||||||||
