On Friday, October 19, 2018, the U.S. Treasury and IRS issued proposed regulations providing guidance on investments in qualified opportunity zones relating to the types of gains that may be deferred when a taxpayer invests in a Qualified Opportunity Fund (QOF); the time period when amounts must be invested in a QOF; and how to defer specified gains. The proposed regulations also provide guidance on self-certification as a QOF, valuation of QOF assets and qualified opportunity zone businesses. This alert provides a summary of the proposed regulations.
Congress enacted the qualified opportunity zone legislation as a temporary provision to encourage private sector investment in certain lower-income communities designated as qualified opportunity zones. Under the legislation, taxpayers may elect to defer recognition of gain to the extent of amounts invested in a QOF, provided that corresponding amounts are invested during the 180-day period beginning on the date the gain would have been recognized by the taxpayer, absent the election. The deferred gain is included in income on the earlier of the date the investment in the QOF is sold or exchanged, or December 31, 2026.
For investments in a QOF held longer than five years, taxpayers may exclude 10 percent of the deferred gain, and for investments in a QOF held longer than seven years, taxpayers may exclude a total of 15 percent of the deferred gain. In addition, for investments in a QOF held longer than 10 years, the post-acquisition gain on the qualifying investment in the QOF may also be excluded from income. A QOF must hold at least 90 percent of its assets in qualified opportunity zone property.
Among the items addressed by the proposed regulations are:
- Gains Eligible for Deferral. The proposed regulations clarify that only capital gains arising from sales or exchanges with unrelated parties (as defined for purposes of Section 1400Z-2) are eligible for deferral under Section 1400Z-2(a)(1) of the Code. Eligible gains include capital gains from an actual, or deemed, sale or exchange, or any other taxable event that causes capital gain required to be included in a taxpayer’s taxable income. The regulations require that the gain to be deferred must be gain that would be recognized absent the deferral provided under Section 1400Z-2(a)(1). In addition, the gain must not arise from a sale or exchange with a related person as defined in Section 1400Z-2(e)(2). Therefore, it appears that gains treated as ordinary income such as depreciation recapture and gain from the sale or exchange of inventory or other non-capital assets will not qualify as eligible gains for purposes of Section 1400Z-2.
- Types of Taxpayers Eligible to Elect Gain Deferral.. The proposed regulations provide that only taxpayers that recognize capital gain are eligible to elect deferral under Section 1400Z-2 of the Code; these include individuals, C corporations, partnerships and certain pass-through entities. The proposed regulations also include special rules for partnerships and other pass-through entities and for the taxpayers to whom these entities pass-through income and other tax items. Under the proposed regulations, pass-through entities can invest in a QOF and their owners can defer recognition of eligible gain.
- Investments in a QOF. The proposed regulations clarify that an eligible interest in the QOF received by the taxpayer must be an equity interest in the QOF, including preferred stock or a partnership interest with special allocations. An eligible interest cannot be a debt instrument; however, the eligible interest received can be pledged as collateral for loans.
- 180-Day Rule for Deferring Gain by Investing in a QOF. In order to be able to defer gain, taxpayers must invest in a QOF within 180 days from the date of the sale or exchange giving rise to the gain to be deferred. For deemed capital gains, the proposed regulations provide that the first day of the 180-day period is the date on which the gain would be recognized for federal income tax purposes. In addition, if a taxpayer acquires an original interest in a QOF and a later sale or exchange of that interest triggers inclusion of deferred gain, and the taxpayer makes a qualifying new investment in a QOF, the proposed regulations allow the taxpayer to make an election to defer the inclusion of the previously deferred gain. This deferral is only permitted if the taxpayer has disposed of the entire initial investment without which the taxpayer could not have made the previous deferral election under Section 1400Z-2 of the Code.
Important Clarification for Partners of Partnerships. The proposed regulations provide that, if a partnership does not elect to defer partnership capital gain under Section 1400Z-2 of the Code, a partner may elect to defer the partner’s allocable share of such capital gain. The partner’s 180-day period with respect to the partner’s allocable share of such capital gain generally begins on the last day of the partnership’s taxable year, because that is the day on which the partner would be required to recognize the gain if not deferred. This treatment could provide important additional time for partners to elect capital gain deferral under Section1400Z-2 for their allocable share of partnership capital gain, assuming that the partnership does not itself elect such deferral with respect to its capital gain.
- Attributes of Included Income When Gain Deferral Ends. The proposed regulations provide that all of the deferred gain’s tax attributes are preserved through the deferral period and are taken into account when the gain is ultimately included in income. In other words, the nature and character of the gain at the time it is deferred will be the nature and character of the gain at the time such deferral ends.
- Gain Not Already Subject to an Election. To address confusion concerning whether a taxpayer can make multiple elections within 180-day for various parts of the capital gain from a single sale or exchange of property held by the taxpayer, the proposed regulations clarify that in the case of a taxpayer who has made an election with respect to some but not all of the an eligible gain, the term “eligible gain” includes the portion of that eligible gain as to which no election has been made.
Gains of Partnerships and Other Pass-Through Entities
The proposed regulations provide that a partnership may elect to defer all or part of a capital gain to the extent that it makes an eligible investment in a QOF. Further, no part of the deferred gain is required to be included in the distributive shares of the partners under Section 702 of the Code and the gain is not subject to Section 705(a)(1). In an important development, if a partnership does not make an election to defer capital gain under Section 1400Z-2, and all or any portion of a partner’s distributive share satisfies all of the rules for eligibility under Section 1400Z-2 (including that the partnership sold or exchanged the asset generating the capital gain to a party unrelated to the partnership and partner electing deferral), then the partner may elect its own deferral with respect to the partner’s distributive share to the extent the partner makes an eligible investment in a QOF. The proposed regulations provide that rules analogous to the rules provided for partnerships and partners apply to other pass-through entities (including S corporations, decedent’s estates, and trusts) and to their shareholders and beneficiaries.
Election for Investments Held at Least 10 Years
A taxpayer that holds a QOF investment for at least 10 years may elect to increase the basis of the investment to the fair market value of the investment on the date the investment is sold or exchanged. The election to increase the basis in an investment in a QOF is only available if it is held for at least 10 years. Designations of all current qualified opportunity zones, however, will expire on December 31, 2028. Among the issue raised by this expiration is whether, after a qualified opportunity zone loses its designation, investors may still make a basis step-up election for QOF investments from 2019 and later. The proposed regulations confirm taxpayers are able to make a basis step-up election after a qualified opportunity zone designation expires. The ability to make the election is preserved until December 31, 2047, under the proposed regulations.
Qualified Opportunity Fund Rules
Section 1400Z-2(3)(4) of the Code allows the Secretary of the Treasury to prescribe regulations regarding the certification of QOFs. The proposed regulations permit a taxpayer that is a corporation or partnership for tax purposes to self-certify as a QOF. A deferral election may only be made for investments in a QOF. A proper deferral election may not be made for investments that are made in an entity before that entity is a QOF. Thus, if an investment is made prior to the date that the eligible entity elects QOF status, the investment cannot qualify for gain deferral and gain elimination under Section 1400Z-2.
The proposed regulations do provide that there is no prohibition on using a pre-existing entity as a QOF or as a subsidiary entity operating a qualified opportunity business, provided the pre-existing entity satisfies the requirements under Section 1400Z-2(d).
The proposed regulations provide that an eligible entity may elect QOF status for a month other than the first month of the eligible entity’s existence, so long as the eligible entity meets the 90% test and requirements for QOF qualification for each of the first six months after the date of the election. However, if the eligible entity elects QOF status for a month that is less than six months from the end of the eligible entity’s tax year, then the 90% test takes into account only the assets of the eligible entity on the last day of the eligible entity’s tax year.
The proposed regulations clarify that an eligible entity that has an applicable financial statement under Treas. Reg. 1.475(a)-4(h) must use the asset values from the applicable financial statement for purposes of testing under the 90% asset test. If the eligible entity does not have such an applicable financial statement, then the eligible entity must use the cost of the asset for purposes of testing under the 90% test.
Qualified Opportunity Zone Stock and Partnership Interests
The proposed regulations note that qualified opportunity zone property includes qualified opportunity zone stock and qualified opportunity zone partnership interests, provided:
(A) the stock or partnership interest is acquired by the QOF after December 31, 2017, at its original issue (directly or through an underwriter) solely in exchange for cash,
(B) as of the time the stock or partnership interest was issued, the corporation or partnership issuing the stock or partnership interest was a qualified opportunity zone business (or, in the case of a new corporation or partnership, the corporation or partnership was being organized for purposes of being such a qualified opportunity zone business), and
(C) during substantially all of the QOF’s holding period for the stock, the corporation or partnership qualifies as a qualified opportunity zone business.
The proposed regulations further clarify that stock acquired by a QOF is not treated as qualified opportunity zone stock if:
(A) at any time during the 4-year period beginning on the date 2 years before the issuance of the stock, the corporation issuing the stock purchased (directly or indirectly) any of its stock from the QOF or from a person related (within the meaning of section 267(b) or 707(b)) to the QOF; and
(B) at any time during the 2-year period beginning on the date 1 year before the issuance of the stock, the corporation made 1 or more redemptions of its stock with an aggregate value (as of the time of the respective purchases) exceeding 5 percent of the aggregate value of all of its stock as of the beginning of the 2-year period.
Substantial Improvement of QOZ Business Property that are Buildings
To qualify as qualified opportunity zone business property, the proposed regulations provide that the original use of the property must commence with the QOF’s use of the property in a qualified opportunity zone, or the QOF must substantially improve such property by additions to the property’s basis during a 30-month period that exceed the basis of the property at the beginning of the 30-month period. The proposed regulations clarify that the basis of land is not included in the basis of buildings for the substantial rehabilitation threshold, and that land on which a building is located does not need to be improved when testing whether the building has been substantially improved.
Qualified Opportunity Zone Business
The proposed regulations clarify that a qualified opportunity zone business must satisfy the requirement that substantially all of its tangible property (owned or leased) be qualified opportunity zone business property. The regulations clarify that “substantially all” means at least seventy percent (70%). If the qualified opportunity zone business has an applicable financial statement under Treas. Reg. 1.475(a)-4(h) it must use the property values from the applicable financial statement for purposes of applying the 70% threshold. If the qualified opportunity zone business does not have such an applicable financial statement, then the business must use the cost of the property for purposes of applying the 70% threshold, assuming that there is only one QOF holder of a five percent (5%) or greater interest in the corporation or partnership operating the qualified opportunity zone business. If two or more QOF’s each own a 5% or greater interest in such corporation or partnership, then the values of the business property are determined by the method used by a QOF that results in the highest percentage of qualified opportunity zone business property for purposes of the 70% threshold.
Proposed Regulation Example:
Entity ZS is a corporation that has issued only one class of stock and that conducts a trade or business. Taxpayer X holds 94% of the ZS stock, and Taxpayer Y holds the remaining 6% of that stock. Both X and Y are Five Percent Zone Taxpayers.
ZS does not have an applicable financial statement, and, for that reason, a determination of whether ZS is conducting a qualified opportunity zone business may employ the Compliance Methodology of X or Y. X and Y use different Compliance Methodologies permitted under the proposed regulations for purposes of satisfying the 90-percent asset test.
Under X’s Compliance Methodology (based on X’s applicable financial statement), 65% of the tangible property owned or leased by ZS’s trade or business is qualified opportunity zone business property. Under Y’s Compliance Methodology (based on Y’s cost), 73% of the tangible property owned or leased by ZS’s trade or business is qualified opportunity zone business property.
Because Y’s Compliance Methodology would produce the higher percentage of qualified opportunity zone business property for ZS (73%), both X and Y may use Y’s Compliance Methodology to value ZS’s owned or leased tangible property.
Note: Although Section1400Z-2 of the Code applies the substantially all requirement in several other tests, the proposed regulations expressly note that the 70% standard only applies to the above test for qualified opportunity zone business property of a qualified opportunity zone business. The proposed regulations further note that the Service will provide guidance on the standard applicable to other “substantially all” tests under Section 1400Z-2 in the future.
No “Active” Business Guidance
The Service was expected to provide important guidance on how a qualified opportunity zone business satisfied the requirement that at least fifty percent (50%) of its annual gross income be derived from the active conduct of a trade or business within the qualified opportunity zone. The proposed regulations do not provide guidance on what constitutes an “active” trade or business for this purpose, although the Service indicated it plans to address such guidance in the future.
Reasonable Working Capital Safe Harbor
Section 1400Z-2 of the Code requires that not more than five percent (5%) of the aggregate unadjusted basis of property of a qualified opportunity zone business be nonqualified financial property. Nonqualified financial property does not include reasonable amounts of working capital. The proposed regulations clarify that such working capital may be held in cash, cash equivalents, or debt instruments with a term of 18 months or less. In addition, working capital is treated as reasonable in amount if the following three requirements are satisfied:
(A) Designated in writing. The working capital amounts are designated in writing for the acquisition, construction, and/or substantial improvement of tangible property in a qualified opportunity zone.
(B) Reasonable written schedule. There is a written schedule consistent with the ordinary start-up of a trade or business for the expenditure of the working capital assets. Under the schedule, the working capital assets must be spent within 31 months of the receipt by the business of the assets.
(C) Property consumption consistent. The working capital assets are actually used in a manner that is substantially consistent with the amounts designated in writing and the reasonable written schedule for the expenditure of the working capital assets.
Safe Harbors and Reasonable Working Capital
In addition, the proposed regulations provide a safe harbor for purposes of applying the test that at least 50% of the gross income of the qualified opportunity zone business be derived from the active conduct of a trade or business within the qualified opportunity zone. Under the safe harbor, if any gross income is derived from a reasonable amount of working capital, then such gross income is counted toward satisfaction of the 50% of gross income test. Further, the requirement that substantially all of the intangible property of the qualified opportunity zone business be used in the active trade or business is treated as satisfied during any period in which the qualified opportunity zone business is proceeding in a manner that is substantially consistent with paragraphs (A through (C) of the reasonable working capital safe harbor (amount designated in writing, reasonable written schedule, and property consumption consistent with such designated amount and schedule).
These proposed regulations will become effective when Treasury publishes final regulations adopting the proposed regulations. Taxpayers may rely on the proposed regulations until their promulgation as final regulations. In addition, further guidance concerning QOFs is expected from Treasury and the IRS and we will supplement this alert with further analysis of the proposed regulations and revenue ruling issued with the regulations.
For further information regarding QOFs and the proposed regulations, please don’t hesitate to contact any member of the Hirschler tax team.
 The Tax Cuts and Jobs Act of 2017 amended the Internal Revenue Code of 1986, as amended (the Code), to add new sections 1400Z-1 and 1400Z-2. Section 1400Z-1 provides procedural rules for designating qualified opportunity zones and related definitions. Section 1400Z-2 allows taxpayers to elect to defer certain gains to the extent that corresponding amounts are timely invested in a QOF.
Kristen M. Chatterton