The Tax Cuts and Jobs Act created new U.S. federal income tax incentives for taxpayers that make certain investments in qualified opportunity zones ("QOZs") through qualified opportunity funds ("QOFs"). The law provides three main tax incentives to encourage investment in QOZs:
- deferring the inclusion in gross income for eligible gains to the extent that corresponding amounts are reinvested in a QOF within 180 days;
- excluding from gross income 10% of such deferred gains if the QOF interest is held for at least 5 years and 15% of such deferred gains if the QOF interest is held for at least 7 years; and
- excluding from gross income the post-acquisition gains on investments in QOFs that are held for at least 10 years (the "QOF Investment Gain Permanent Exclusion").
An initial set of proposed regulations addressing QOFs was issued by the IRS on October 29, 2018, which can be found here. The IRS has recently issued a second set of proposed regulations (REG-120186-18) (the "New Proposed Regulations") that can be found here. This client alert contains a summary of the highlights of the New Proposed Regulations. A more detailed discussion of these New Proposed Regulations can be found here, and our client alert that discussed the first set of proposed regulations can be found here.
1. Gains Eligible for Deferral
The New Proposed Regulations clarify that Section 1231 gains (generally, gains from the sale of tangible property used in a trade or business) in excess of Section 1231 losses for a taxable year qualify as gains eligible for deferral and partial exclusion. The New Proposed Regulations also indicate that Section 1231 gains are deemed to arise on the last day of the taxable year in which they are generated for purposes of determining when the 180-day period for investment begins.
2. Expansion of QOF Investment Gain Permanent Exclusion
Under the QOZ rules, a taxpayer that holds a QOF investment for at least 10 years may elect to increase the basis of the investment to its fair market value when the investment is sold, which effectively allows the taxpayer to exclude all post-investment appreciation in the QOF investment from gross income. However, it wasn't clear how or if this rule applied to an investor's share of gain from the sale of assets by a QOF formed as a partnership.
The New Proposed Regulations expand the QOF Investment Gain Permanent Exclusion so that it applies to certain eligible gains allocable to a partner or shareholder from a QOF partnership or QOF S corporation. If a QOF partnership or QOF S corporation disposes of "QOZ property" (defined below) after the taxpayer has held its qualifying investment in the QOF for at least 10 years, the taxpayer may make an election to exclude from gross income some or all of the taxpayer's allocable share of the capital gain arising from such disposition. In other words, a QOF partnership or QOF S corporation can sell the underlying QOZ property and, as long as the taxpayer has held its qualifying investment in such QOF partnership or QOF S corporation for at least 10 years, then such taxpayer will benefit from the exclusion.
3. Rules Regarding Qualifying Investment in a QOF
The New Proposed Regulations clarify that qualifying investments in a QOF include purchases of equity interests in a QOF from existing owners of the QOF and transfers of property other than cash to a QOF in exchange for equity interests in the QOF (in addition to transfers of cash to a QOF in exchange for equity interests in the QOF).
On the other hand, the New Proposed Regulations provide that a partnership interest issued in exchange for services (such as a carried interest) is not a qualifying investment, even if all of the partnership's investments are qualifying investments.
4. Added Clarity and Flexibility Regarding Requirements for Qualification as a QOF
To qualify as a QOF, an entity must hold at least 90% of its assets (the "90% QOF Asset Test") in "QOZ business property" and equity interests in corporations, partnerships and LLCs engaged (or being formed to engage) in "QOZ businesses" (QOZ business property and such equity interests, "QOZ property").
A QOZ business is a business meeting the following requirements: (i) 70% of the tangible property owned or leased with respect to the business is QOZ business property ("70% QOZ Business Asset Test"); (ii) at least 50% of its total gross income is derived from the active conduct of a trade or business within a QOZ ("50% QOZ Source Income Test"); (iii) at least 40% of its intangible property is used in the active conduct of a trade or business in a QOZ; (iv) less than 5% of the average unadjusted basis of its assets consists of "nonqualified financial property" such as cash, debt instruments, and equity interests, subject to an important "working capital safe harbor" exception; and (v) it is not engaged in certain listed "leisure" activities.
The New Proposed Regulations have added needed clarification and flexibility in meeting the foregoing tests, much of which is geared towards businesses other than commercial real estate development and leasing. In particular, the New Proposed Regulations include additional guidance with respect to the 90% QOF Asset Test, 50% QOZ Source Income Test, "working capital safe harbor" and "QOZ business property" requirements.
5. Deferred Gain Inclusion Events
The New Proposed Regulations provide additional guidance as to when gain that was deferred under the QOZ rules must be included in the taxpayer's income (an "Inclusion Event"). Although the New Proposed Regulations broadly define what constitutes an Inclusion Event, they provide several useful exceptions that specifically are not Inclusion Events, including (i) a contribution to a partnership that is tax-free under Section 721, (ii) Section 708(b)(2)(A) partnership mergers or consolidations, (iii) the transfer by a taxpayer to a trust that is treated as a grantor trust of which the taxpayer is the deemed owner, (iv) transfers to a disregarded entity by the sole owner of the disregarded entity, (v) transfers by reason of death, and (vi) certain specified Section 381 non-taxable transactions.
Additionally, the New Proposed Regulations provide that a distribution of money or other property by a QOF partnership or QOF S corporation generally does not constitute an Inclusion Event with respect to the distributee except to the extent that the amount of money and fair market value of other property received in the distribution exceeds the distributee's tax basis in the portion of the QOF partnership or QOF S corporation interest which is a qualifying investment. Thus, a QOF partnership generally can borrow money and distribute the proceeds of such borrowing to a partner to the extent of such partner's allocable share of the loan without causing an Inclusion Event.
If you have any questions, or otherwise would like further information on this topic, please do not hesitate to contact us.
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