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 eligible gains to the extent that corresponding amounts are reinvested in a QOF within 180 days,
- excluding from gross income 10 percent of such deferred gains if the QOF interest is held for at least 5 years and 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 first set of proposed regulations (83 FR 54279) (the "Prior Proposed Regulations") issued on October 19, 2018, by the U.S. Treasury and the Internal Revenue Service (the "IRS"), which provided 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 IRS has recently issued a second set of proposed regulations (REG-120186-18) (the "New Proposed Regulations") that can be found here. The New Proposed Regulations both address different aspects of investments in QOZs and QOFs than the Prior Proposed Regulations and update the Prior Proposed Regulations.
The New Proposed Regulations are proposed to be effective when finalized but may be relied on immediately by taxpayers so long as the New Proposed Regulations are applied in their entirety and in a consistent manner.
1. Gains Eligible for Deferral
The Prior Proposed Regulations provided that only capital gains (and not gains characterized as ordinary income, such as gains that are re-characterized as depreciation recapture income) are eligible for deferral under the QOZ rules. 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 are treated as capital gains for these purposes and therefore are also eligible for deferral. 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 Rule Excluding Post-Acquisition Gains in QOF Partnerships and QOF S Corporations 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 Prior Proposed Regulations did not address whether or how this rule applied in cases where a QOF partnership or QOF S corporation disposed of assets.
The New Proposed Regulations expand the post-acquisition gain exclusion rule to exclude 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 capital gain (including separately stated capital gain) arising from such disposition. Such exclusion is limited to the capital gain reported on Schedule K-1 of the QOF partnership or QOF S corporation that is attributable to the qualifying investment. 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 receive the full benefit of the exclusion.
However, many QOFs may own assets indirectly through underlying partnerships. Neither the Prior Proposed Regulations nor the New Proposed Regulations specify whether the gain from the sale of assets by such a lower-tier partnership is eligible for the exclusion.
3. Rules Regarding Qualifying Investment in a QOF
The New Proposed Regulations clarify that qualifying investments 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 the case of a purchase of an equity interest by a taxpayer from an existing owner of a QOF, the amount of the qualifying investment equals the amount of cash and the fair market value of other property paid for the equity interest (or, if less, the amount of the taxpayer's gains which are eligible for deferral).
In the case of a transfer of property other than cash by a taxpayer to a QOF in exchange for an equity interest in the QOF, the amount of the qualifying investment equals the lesser of the "net" fair market value of such property (i.e., net of debt to which the property is subject or which is otherwise assumed by the QOF in the transfer) and the taxpayer's "net" adjusted tax basis in such property (or, if less, the amount of the taxpayer's gains which are eligible for deferral).
4. Requirements for Qualification as a QOF--Added Flexibility With Respect to 90 Percent Asset Test
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 and is generally required to be a domestic entity.
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 6-month period of the QOF's tax year and (2) the last day of its tax year. The Prior Proposed Regulations provided that the first 6-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, which gives taxpayers some flexibility in establishing the initial 6-month measurement period so as to better ensure compliance with the 90 percent test. The New Proposed Regulations expand this flexibility by allowing a QOF to apply the 90 percent test without taking into account any investments received by the QOF in the preceding 6 months (i.e., new capital) if such capital is held as cash, cash equivalents or debt instruments with a term of 18 months or less.
The New Proposed Regulations also provide that proceeds received by a QOF from the sale or disposition of QOZ property are treated as QOZ property for purposes of the 90 percent test as long as the QOF reinvests such proceeds in QOZ property during the 12-month period beginning on the date of such sale or disposition of such property so long as, prior to such reinvestment, such proceeds are continuously held in cash, cash equivalents or debt instruments with a term of 18 months or less.
5. 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 (a "QOZ partnership interest"); and
- "QOZ business property" (defined below) 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 after 2017, 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 (or, in the case of a new entity, such entity must be organized for purposes of becoming a QOZ business), and during 90 percent 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.
A QOZ business is a business meeting the following requirements: (i) "substantially all" (at least 70 percent, as provided in the Prior Proposed Regulations) of the tangible property owned or leased with respect to the business is QOZ business property; (ii) at least 50 percent of its total gross income is derived from the active conduct of a trade or business within a QOZ; (iii) a substantial portion of its intangible property is used in the active conduct of a trade or business in a QOZ; (iv) less than 5 percent of the average unadjusted basis of its assets consists of "nonqualified financial property" such as cash, debt instruments, and equity interests (subject to a working capital safe harbor); and (v) it is not engaged in certain listed "leisure" activities.
The New Proposed Regulations provide substantial clarity as to what constitutes a QOZ business. Most significantly, they provide three alternative safe harbor tests with respect to the 50 percent gross income requirement, in addition to a general facts and circumstances test.
The first safe harbor applies if at least 50 percent of the services performed for such business by its employees, independent contractors, and employees of independent contractors (collectively, the "service providers"), based on number of hours spent performing the services, are performed within the QOZ. The second safe harbor applies if at least 50 percent of the services performed for such business by the service providers, based on compensation paid by the business to such service providers, are performed within the QOZ. The third safe harbor applies if at least 50 percent of the gross income of the business is derived from both the tangible property of the business that is located in the QOZ and the management or operational functions performed for the business in the QOZ. Satisfying any of the safe harbors causes the business to meet the 50 percent gross income requirement.
The New Proposed Regulations also provide that a business will meet the "substantial portion of its intangible property" requirement if at least 40 percent of its intangible property is used in the QOZ business.
Additionally, the New Proposed Regulations expand the working capital safe harbor by providing that (i) the written designation for planned use of working capital now includes the development of a trade or business in the QOZ as well as the acquisition, construction, and/or substantial improvement of tangible property, (ii) exceeding the 31-month period does not violate the safe harbor if the delay is attributable to waiting for government action the application for which is completed during the 31-month period and (iii) a business may benefit from multiple overlapping or sequential applications of the working capital safe harbor. This latter change permits a QOF to have a new 31-month period apply to follow-on investments in the QOF, so long as such follow-on investments otherwise meet the working capital safe harbor requirements.
With respect to the "active conduct" of a trade or business requirement, the New Proposed Regulations provide that the leasing of real property is the active conduct of a trade or business, unless the leasing activity is merely entering into a triple-net lease with respect to real property owned by the taxpayer. The New Proposed Regulations further indicate that the holding of land for investment is not considered to give rise to a trade or business.
b. QOZ Business Property
QOZ business property generally is tangible property used in a trade or business by the QOF or QOZ business that is acquired by the QOF or QOZ business by purchase (not including a purchase from a related person or through a like-kind exchange) or lease after 2017. Either the original use of any such owned property in the QOZ must commence with the QOF or QOZ business, or the QOF or QOZ business must substantially improve the property. During substantially all of the QOF's or QOZ business's holding period for owned tangible property, substantially all of the use of such property must be in a QOZ. The New Proposed Regulations provide detailed guidance regarding the requirements for leased property, as well as additional guidance regarding inventory and the "original use in the QOZ" and "substantially all of the QOF's or QOZ business's holding period" requirements. Each of these is discussed below.
The New Proposed Regulations generally provide that the "original use" of tangible property acquired by purchase commences on the date when any person first places the property in service (as determined for depreciation or amortization purposes) in the QOZ (or first uses such property in a manner that would allow depreciation or amortization if that person were the property's owner).
Yet the New Proposed Regulations provide a couple of taxpayer-favorable exceptions. If property has been unused or vacant for an uninterrupted period of at least 5 years, original use in the QOZ commences on the date after that period when any person first so uses or places the property in service in the QOZ. Used tangible property satisfies the original use requirement if the property has not been previously so used or placed in service in the particular QOZ. Thus, used tangible property would satisfy the original use requirement if the property has not previously been used within that QOZ in a manner that would have allowed it to be depreciated or amortized by any taxpayer.
The IRS had previously released guidance (Revenue Ruling 2018-29) concluding that the original use requirement does not apply to land, whether it is improved or unimproved, due to its permanence. Unimproved land is not required to be substantially improved, and land upon which a building is located need not be separately substantially improved (but, rather, only the building itself need be substantially improved, determined by reference to the cost of the adjusted basis of the building itself). As a result, in order to qualify as QOZ business property, land simply needs to be located within the QOZ and used in a trade or business.
Substantial Use in a QOZ
As indicated above, during substantially all of the QOF's or QOZ business's holding period for owned tangible property, substantially all of the use of such property must be in a QOZ. The New Proposed Regulations provide a bright-line rule that, during 90 percent or more of the QOF's or QOZ business's holding period for QOZ business property, at least 70 percent of the use of such property must be in a QOZ.
The New Proposed Regulations clarify that, with respect to contiguous real property, if the portion of such real property located within the QOZ is substantial in comparison to the portion of such real property outside of the QOZ (based on square footage), then all of such real property is deemed to be located within the QOZ. The preamble to the New Proposed Regulations provides that the portion of real property located within the QOZ should be considered "substantial" if the unadjusted cost of the real property located within the QOZ exceeds that of the real property outside of the QOZ.
The New Proposed Regulations confirm that leased tangible property meeting certain requirements will qualify as QOZ business property for purposes of satisfying the 90 percent test applicable to QOFs and the substantially all (i.e., 70 percent) requirement applicable to QOZ businesses. Unlike owned property (other than land), the original use of the leased property does not have to commence with the QOF, nor does the QOF have to substantially improve the property.
But the New Proposed Regulations impose several other requirements. For any leased property, the terms of the lease of the QOZ business property must be market (that is, reflect common, arm’s-length market practice in the locale that includes the QOZ) at the time that the lease is entered into.
If the QOF or QOZ business is related to the lessor, the New Proposed Regulations impose two additional requirements. First, the QOF or QOZ business cannot make any prepayment in connection with a lease relating to a period of use of the property that exceeds 12 months. Second, if the leased property is tangible personal property and the QOF or QOZ business would not satisfy the original use requirement described above if it were to purchase (rather than lease) such property, then (i) the QOF or QOZ business must acquire ownership of tangible property that is QOZ business property, with a value that is at least equal to that of such leased property, during the "relevant testing period" and (ii) there must be substantial overlap of the QOZs in which the owner of the property so acquired uses it and the QOZs in which that person uses the leased property. The "relevant testing period" is the period that begins on the date that the QOF receives possession of the leased property and ends 30 months thereafter or, if earlier, on the last day of the lease. "Substantial overlap" has not been defined for this purpose.
Leased tangible property may be valued using either an applicable financial statement valuation method or an alternative valuation method (which is essentially the sum of the present values of each payment due under the lease, determined using a discount rate equal to the applicable federal rate under Section 1274(d)(1)). The QOF may select the applicable financial statement valuation method if it actually has an applicable financial statement (generally, a financial statement that is required to be filed with a federal agency (other than the IRS) or a certified audited financial statement) that (i) is prepared according to GAAP and (ii) requires recognition of the lease of tangible property. The QOF must apply the selected method consistently to value all leased tangible property with respect to the taxable year.
The New Proposed Regulations provide a safe harbor for testing how inventory affects the "substantially all" requirement for tangible property used in a QOZ. Inventory, including raw materials, does not fail to be used in a QOZ because it is in transit (i) from a facility in a QOZ to customers located outside the QOZ or (ii) from a vendor to a facility located in a QOZ.
6. Special Rules for Qualifying Investments in Partnerships
The New Proposed Regulations provide special rules for the treatment of qualifying investments in partnerships.
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. A contribution of property to a QOF with a "net" fair market value (i.e., net of debt to which the property is subject or which is otherwise assumed by the QOF in the transfer) in excess of the contributing taxpayer's "net" adjusted tax basis in the property, or the contribution of cash and property in excess of the taxpayer's gain that is eligible for benefits under the QOZ rules, results in "excess investment."
Any such excess investment in, or the service component of the interest in, the QOF partnership is not a qualifying investment and, thus, is not eligible for any benefits under the QOZ rules.
The QOZ rules refer to an interest in a partnership that is in part not a qualifying investment as a "mixed-funds investment." Pursuant to the New Proposed Regulations, the partner holding a mixed-funds investment is treated as owning two partnership interests for purposes of the QOZ rules. Partnership items affect the qualifying and non-qualifying portions of such investment proportionally, based on the relative allocation percentages of each interest, and in the case of a profits interest issued for services, the allocation percentage attributable to the profits interest will be the highest percentage interest in residual profits attributable to such interest.
7. 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"). Subject to certain exceptions, an Inclusion Event generally results (i) from a transfer of a qualifying investment in a QOF to the extent the transfer reduces the taxpayer's equity interest in the qualifying investment, (ii) from certain types of distributions from a QOF, (iii) if the QOF terminates, liquidates, or otherwise ceases to exist (e.g., a QOF that is a partnership becomes a disregarded entity), and (iv) from a claim of worthlessness by the taxpayer with respect to a qualifying investment in a QOF.
The New Proposed Regulations also specifically identify the following as Inclusion Events: (i) a taxable disposition of all or any part of a qualifying investment in a QOF partnership or a QOF corporation, (ii) a taxable disposition of interests in an S corporation which itself is a direct investor in a QOF partnership or a QOF corporation if, immediately after such disposition, there has been a change in the ownership of such S corporation of more than 25 percent, (iii) generally, any taxable transfer by a partner of all or a portion of its interest in a partnership that directly or indirectly holds a qualifying investment in a QOF, (iv) a transfer of a qualifying investment by gift, (v) taxable liquidating distributions and, in most cases, redemption distributions, with respect to QOF stock, (vi) any actual or deemed distribution by a partnership of cash or other property with a fair market value in excess of the partner's basis in its qualifying QOF partnership interest and (vii) certain non-recognition transactions, such as a tax-free liquidation of a QOF corporation or a tax-free Section 351 contribution of QOF stock to a corporation, if such transaction results in a change in the taxpayer's interest in the qualifying investment.
The New Proposed Regulations also provide that certain transfers of interests in a QOF 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, including a transfer of the qualifying investment to the deceased owner's estate, a distribution by the estate to a beneficiary, or the termination of grantor trust status as the result of the death of the owner, and (vi) certain specified Section 381 non-taxable transactions.
The New Proposed Regulations provide that a distribution of money or other property by a QOF partnership or QOF S corporation constitutes an Inclusion Event with respect to the distributee only to the extent that the amount of money and fair market value of other property received in the distribution exceeds the distributee's basis in the portion of the QOF partnership or QOF S corporation interest which is a qualifying investment. In the case of a QOF partnership, the distributee partner's basis in the portion of its partnership interest which is a qualifying investment includes the portion of partnership debt allocable to the distributee partner which is attributable to such 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.
The New Proposed Regulations provide that, in general, other than with respect to partnerships, an Inclusion Event causes the taxpayer to include in gross income an amount equal to (i) the lesser of (A) the fair market value of the portion of the qualifying investment disposed of in the Inclusion Event and (B) the amount that bears the same ratio to the remaining deferred gain as the amount in clause (A) bears to the total fair market value of the qualifying investment in the QOF immediately before the Inclusion Event, minus (ii) the taxpayer's basis in the qualifying investment. For certain Inclusion Events involving distributions on QOF stock, a simplified rule provides for the inclusion in gross income of the amount of such distribution to the extent of remaining deferred gain.
With respect to partnerships, the amount included in gross income due to an Inclusion Event is equal to the lesser of (i) the remaining deferred gain in the qualifying investment (less any increases in basis provided by the QOZ rules as a result of satisfying the 5-year or 7-year holding period requirements), multiplied by the percentage of the qualifying investment that gave rise to the Inclusion Event and (ii) the total gain that would result from a fully taxable sale of such portion of the qualifying investment that gave rise to the Inclusion Event for its fair market value.
8. Basis in Qualifying Investment
An electing taxpayer's initial basis in a qualified investment in a QOF is zero. This basis is automatically increased by 10 percent of the amount of the deferred gain after the investment has been held for 5 years and by 15 percent of the amount of the deferred gain after the investment has been held for 7 years. The New Proposed Regulations clarify that the basis is increased by the amount of deferred gain recognized, immediately after the deferred capital gain is taken into income, upon the earlier of December 31, 2026, or an Inclusion Event.
For certain other transactions with respect to a qualifying investment in a QOF, including a distribution on QOF stock resulting in an Inclusion Event, or a distribution to a partner of property with a value in excess of the partner's basis in the qualifying QOF partnership interest, the basis adjustment is made before determining the tax consequences of the Inclusion Event with respect to the qualifying investment. Thus, for example, if a distribution on QOF stock constitutes an Inclusion Event resulting in the recognition of $100 of deferred gain under the QOZ rules, the basis of the QOF stock would be increased by $100 under the QOZ rules before determining the portion of such distribution that constitutes recovery of basis or gain from the deemed exchange of such QOF stock.
The New Proposed Regulations further clarify that, if a taxpayer makes an election to increase its basis in property held for 10 years to the fair market value of such property, such increase is made immediately before the taxpayer disposes of its qualifying investment. For dispositions of qualifying investments in a QOF partnership, the bases of the partnership's assets, including inventory and unrealized receivables, are also adjusted in the same manner as pursuant to a valid election under Section 754. This prevents the holder of such a qualifying investment from recognizing ordinary income (e.g., "hot asset" gain under Section 751(a)), and a corresponding amount of capital loss, as a result of the sale.
9. Application to Consolidated Groups
The New Proposed Regulations do not treat QOF stock as stock for purposes of Section 1504, which defines consolidated groups. Thus, a QOF C corporation cannot be a subsidiary member of a consolidated group (although it can be the common parent of a consolidated group).
The New Proposed Regulations also provide that (i) the QOZ rules apply separately to each member of a consolidated group and, in particular, a member of a consolidated group must independently satisfy the requirements with respect to eligible gain attributable to a sale to an unrelated party (e.g., the group member that generated the capital gain on which deferral is sought must also be the entity that invests in a QOF), (ii) upper-tier entities that own a QOF owner that is a member of a consolidated group increase their basis in the stock of the QOF owner by the amount of the special basis adjustments available for qualifying investments held for 5, 7 and 10 years and (iii) a modified version of the unified loss rule (the purpose of which is to prevent the duplication of a single economic loss) applies to a subsidiary in a consolidated group that owns a qualifying investment.
10. Holding Period of Qualifying Investment
The New Proposed Regulations generally provide that a QOF investor's holding period for its qualifying investment does not include the period during which the investor held property that was transferred to the QOF in exchange for the qualifying investment. However, a taxpayer is able to tack its holding period for qualifying QOF stock received in certain carryover basis transactions where the taxpayer's direct equity investment in the QOF continues.
11. QOF REIT Dividends
The New Proposed Regulations permit a REIT that qualifies as a QOF to distribute tax-free dividends, in respect of a qualifying investment in the QOF REIT that has been held for at least 10 years, to the extent of the QOF REIT's long-term capital gains from the sale of QOZ property.
12. General Anti-Abuse Rule
The New Proposed Regulations contain a broad anti-abuse rule providing that a transaction can be recast as appropriate if, based on all the facts and circumstances, a significant purpose of such transaction was to achieve a result that is inconsistent with the purposes of the QOZ rules.
13. Further Guidance to Come
The preamble to the New Proposed Regulations indicates that the IRS intends to issue guidance within a few months addressing administrative rules applicable to a QOF that fails to satisfy the 90 percent asset test and information reporting requirements for a taxpayer electing to defer eligible gain under the QOZ rules. It is unclear whether any further guidance, on those topics or otherwise, will be issued in the form of additional proposed regulations.
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.
ABOUT BAKER BOTTS L.L.P.
Baker Botts is an international law firm of approximately 725 lawyers practicing throughout a network of 13 offices around the globe. Based on our experience and knowledge of our clients' industries, we are recognized as a leading firm in the energy and technology sectors. Since 1840, we have provided creative and effective legal solutions for our clients while demonstrating an unrelenting commitment to excellence. For more information, please visit bakerbotts.com.