The Tax Cuts and Jobs Act (P.L. 115-97), signed into law on December 22, 2017, created new U.S. federal income tax1 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 some gains to the extent that corresponding amounts are reinvested in a QOF,
- excluding from gross income up to 15 percent 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.
Our previous client alert (which can be found here) discussed the tax incentives that may be available for investments in QOZs (using QOFs) and several uncertainties that existed pending further guidance from the U.S. Treasury and the Internal Revenue Service ("IRS").
The IRS has recently issued proposed regulations (REG-115420-18) (the "Proposed Regulations") that can be found here. The Proposed Regulations provide guidance regarding investments in QOZs and QOFs, clarifying which gains qualify for deferral, which taxpayers and investments are eligible, and the parameters for QOFs.
The Proposed Regulations generally take a taxpayer-friendly approach to implementing the QOZ rules. The Proposed Regulations are proposed to be effective on or after the date that they are finalized but may be relied on immediately by taxpayers in certain circumstances.
1. Gains Eligible for Deferral
It is unclear from the statute itself whether gains that are characterized as ordinary income are eligible for benefits under the QOZ program. The Proposed Regulations provide that, based on the legislative history as well as the text and structure of the statute, only capital gains are eligible for deferral. Thus, in situations where a sale or other taxable disposition gives rise to both capital gain and ordinary income (such as a sale of property where part of the gain is re-characterized as depreciation recapture income), only the capital gain component may be deferred by investment in a QOF. The proposed regulations also provide (i) that portions of the capital gain from the disposition of a single investment may be invested in different/separate QOFs (e.g., if $100 of capital gain is generated from a sale of an investment, $40 of that gain could be invested in QOF 1 and $60 of that gain could be invested in QOF 2) and (ii) rules permitting gain from the disposition of an interest in a QOF to be further deferred through a qualifying investment in another QOF.
2. Electing Taxpayers
The Proposed Regulations provide that any taxpayer that recognizes capital gain for tax purposes is eligible to defer gain under the QOZ program, including individuals, corporations, partnerships, and some other passthrough entities.
The Proposed Regulations include special rules for partnerships and other passthrough entities (e.g., S corporations) and for taxpayers to whom these entities pass through income and other tax items. Under those rules, a partnership can elect deferral with respect to eligible gains and, to the extent that the partnership does not so elect, a partner of the partnership may elect deferral with respect to the partner's distributive share of the partnership's eligible gain. Thus, partners in a partnership generally can effectively elect on a partner-by-partner basis whether to defer their respective shares of partnership-level gain by investing in a QOF. Moreover, the rules provide additional flexibility for partners in a partnership by permitting a partner to invest its distributive share of gain within 180 days of the date the gain is generated or within 180 days of the last day of the partnership's tax year in which the gain is generated.
3. Eligible Interests in a QOF
The Proposed Regulations provide that an eligible interest in a QOF must be equity for tax purposes. Eligible QOF interests include preferred stock in a corporation and a partnership interest with special allocations. Debt instruments are not eligible QOF interests, although the Proposed Regulations would permit a taxpayer to pledge interests in a QOF.
4. How to Elect Deferral
The preamble to the Proposed Regulations states that the IRS currently anticipates that taxpayers will make deferral elections on a revised Form 8949 (relating to the reporting of gains from the sale or other disposition of capital assets), which will be attached to their tax returns for the taxable year in which the eligible gain would have been recognized if it had not been deferred.
5. Exclusion for Post-Acquisition Gains in QOFs Held for at Least 10 Years
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 or exchanged if a proper deferral election is made for the investment. This basis step-up election effectively allows the taxpayer to exclude all post-investment appreciation in the QOF interest from gross income.
The Proposed Regulations allow taxpayers to make the basis step-up election even after all QOZ designations now in existence expire on December 31, 2028. The Proposed Regulations preserve the ability to make the basis step-up election until December 31, 2047. Thus, for example, if a taxpayer made a qualifying QOZ investment on December 31, 2018, then sold that QOF investment on December 31, 2047, the taxpayer generally could elect to exclude from income all 29 years of post-investment appreciation in the QOF investment.
6. Requirements for Qualification as a QOF
A QOF is defined in Section 1400Z-2 as any investment vehicle organized as a corporation or partnership for the purpose of investing in "QOZ property" (defined below). The Proposed Regulations provide that only domestic entities (and, subject to certain limitations, possession entities) are eligible to be QOFs.
To qualify as a QOF, the entity must hold at least 90 percent of its assets in QOZ property, determined for each taxable year by generally averaging the QOF's percentage of QOZ property assets on (1) the last day of the first six-month period of the QOF's tax year and (2) the last day of its tax year. The Proposed Regulations provide that the first six-month period of the QOF's first taxable year begins on the first day of the particular month in which the eligible entity first elects to be treated as a QOF in its self-certification as described in "How to Self-Certify as a QOF" below. This rule gives taxpayers some flexibility in establishing the initial six-month measurement period so as to better ensure compliance with the 90 percent test. The Proposed Regulations also provide that, for purposes of applying the 90-percent asset test, the QOF's assets generally must be valued at the values reported on the QOF's applicable financial statement or, if the QOF does not have an applicable financial statement, at cost.
7. Requirements for QOZ Property
Section 1400Z-2 broadly identifies three types of QOZ property:
- Stock held by a QOF in a lower-tier domestic corporation invested in a QOZ ("QOZ stock");
- Partnership interests held by a QOF in a lower-tier domestic partnership invested in a QOZ ("QOZ partnership interest"); and
- QOZ business property directly held by a QOF.
Each type of QOZ property has its own requirements, as described further below.
a. QOZ Stock and QOZ Partnership Interests
To qualify as QOZ stock or a QOZ partnership interest, the investment initially must be made in 2018 or later, directly from the issuer (or an underwriter, in the case of QOZ stock) and solely for cash. At the time of acquisition, the issuing entity must be a "QOZ business" (defined below) (or, in the case of a new entity, such entity must be organized for purposes of becoming a QOZ business), and during substantially all of the QOF's holding period for the QOZ stock or QOZ partnership interest, the relevant entity must continue to qualify as a QOZ business. "Substantially all" was not defined for this purpose in the Code or in the Proposed Regulations, but the preamble to the Proposed Regulations indicates that such a definition will be provided in future proposed regulations.
A QOZ business is a business in the designated QOZ (1) in which "substantially all" of the tangible property owned or leased by the taxpayer is "QOZ business property" (defined below); (2) which satisfies certain gross income and asset requirements relating to the extent of operations in the QOZ; and (3) which is not engaged in certain listed "leisure" activities (namely, private or commercial golf courses, country clubs, massage parlors, hot tub facilities, suntan facilities, racetracks or other facilities used for gambling, or any stores the principal business of which is the sale of alcoholic beverages for consumption off premises).
For this purpose, the Proposed Regulations provide a helpful bright-line rule that, if at least 70 percent of the tangible property owned or leased by a trade or business is QOZ business property, then the trade or business meets the "substantially all" requirement. The preamble to the Proposed Regulations expressly declined to apply this bright-line rule to the other uses of the phrase "substantially all" in the statute. The Proposed Regulations also provide an important working capital safe harbor for certain QOZ businesses. The safe harbor will allow QOZ businesses a grace period of up to 31 months to hold cash, cash equivalents and/or debt instruments with a term of 18 months or less for utilization in the acquisition, construction, or rehabilitation of tangible business property, which includes real property and other tangible property used in a business operating in a QOZ, if there is a written plan that identifies the cash, cash equivalents and/or debt instruments as property held for the acquisition, construction, or substantial improvement of tangible property in the opportunity zone, there is a written schedule consistent with the ordinary business operations of the business that the property will be used within 31-months, and the business substantially complies with the schedule. As drafted, this working capital safe harbor does not apply to cash held directly by the QOF.
b. QOZ Business Property
QOZ business property is tangible property used in a trade or business by the QOF which is acquired by the QOF by purchase (not including a purchase from a related person or through a like-kind exchange, but possibly including a lease) in 2018 or later. The original use of such property in the QOZ must commence with the QOF, or the QOF must substantially improve the property, and during substantially all of the QOF's holding period for such property, substantially all of the use of such property must be in a QOZ.2 Under the statute, "substantial improvement" generally requires capital expenditures over a 30 month period at least equal to the QOF's adjusted tax basis in the QOZ business property at the beginning of such period.
The Proposed Regulations address the substantial improvement requirement for a purchased building located in a QOZ. The requirement ignores the basis in the underlying land and instead looks solely to whether, during the relevant 30-month period, additions to the tax basis of the property in the hands of the QOF or QOZ business have exceeded an amount equal to the adjusted tax basis of the building at the beginning of such period. The underlying land need not be separately substantially improved. Simultaneously with the Proposed Regulations, the IRS released guidance (Revenue Ruling 2018-29) addressing the application to real property of the original use and substantial improvement requirements and concluding that the original use requirement does not apply to land due to its permanence.
8. How to Self-Certify as a QOF
The Proposed Regulations allow an eligible entity to self-certify as a QOF. The preamble to the Proposed Regulations provides that the IRS expects that taxpayers will use the new Form 8996, recently released in draft form, both for the initial self-certification and for annual reporting of compliance with the 90-percent asset test. The proposed regulations also indicate that the self-certification (i) must identify the first taxable year for which the eligible entity will be treated as a QOF and (ii) may designate a particular month in that first taxable year in which the eligible entity desires to first be treated as a QOF (which need not be the first month of such taxable year).
9. Further Proposed Regulations to Come
The preamble to the Proposed Regulations noted that additional proposed regulations are anticipated in the near future. The IRS intends for additional proposed regulations to address, among other issues: (1) the meaning of "substantially all" in each of the various places where it appears in Section 1400Z-2, as well as the interaction of those "substantially all" requirements in applying the QOF rules; (2) the transactions that may trigger the inclusion of gain that has been deferred under a Section 1400Z-2(a) election; (3) the "reasonable period" under Section 1400Z-2(e)(4)(B) for a QOF to reinvest proceeds from the sale of qualifying assets without paying a penalty; (4) administrative rules applicable under Section 1400Z-2(f) when a QOF fails to meet the 90-percent asset test; and (5) information-reporting requirements under Section 1400Z-2. The IRS also expects that additional proposed regulations will incorporate the guidance in Revenue Ruling 2018-29.
If you have any questions, or otherwise would like further information on this topic, please do not hesitate to contact us.
1 All "tax" references are to U.S. federal income tax, and all "Section" references are to the Internal Revenue Code of 1986, as amended (the "Code").
2 Once again, what rises to the level of "substantially all" has not yet been defined for this purpose and awaits further guidance.
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