Tax Alert: IRS Releases Proposed Regulations on Qualified Opportunity FundsBy Alan M. Blecher | October 23, 2018
The IRS has issued proposed regulations relating to the deferral of gain under Code Section 1400Z-2, for investments in qualified opportunity funds (QOFs). Enacted late last year, the QOF provisions, while enticing, left many questions unanswered. Investors and their advisors thus eagerly awaited these proposed regulations, highlights of which are discussed below.
Section 1400Z-2 allows eligible taxpayers to elect to eliminate the recognition of up to 15% of capital gains that are reinvested in a QOF within 180 days after the sale or exchange that results in the gain. Depending on when the capital gain is realized and the QOF investment made, 85% of the gain may be deferred until December 31, 2026 if the QOF investment is still held at that time. If the QOF investment is held for at least 10 years, the taxpayer may make a basis step-up election which eliminates taxable gain on any post-investment appreciation in the value of the QOF investment.
The proposed regulations clarify that a QOF must be an entity classified as a corporation or partnership for federal income tax purposes. This includes a limited liability company (LLC), alleviating earlier concerns. A QOF must be organized for the purpose of investing in qualified opportunity zone (QOZ) property (other than another QOF) and must hold at least 90% of its assets in QOZ property. All QOZs have now been identified. Apparently, a QOF must invest in property either directly or through a first- tier investment entity. The use of more than one level of tax regarded entities in the ownership structure above a QOF to hold operating assets could potentially disqualify the QOF.
Only Capital Gains Are Eligible for Deferral
The proposed regulations clarify that only capital gains (including, apparently, short-term capital gains) are eligible for the deferral provisions. The text of the Code section utilizes the phrase “gain,” which had led some to believe that ordinary gain, in addition to capital gain, would qualify. However, relying on the statute’s legislative history, the proposed regulations provide that a gain is eligible for deferral only if it is treated as a capital gain for federal income tax purposes. Eligible gains, therefore, generally include capital gain from an actual, or deemed, sale or exchange, or any other gain that is required to be included in a taxpayer’s computation of capital gain. The gain must not arise from a sale or exchange with a related person, and it must be gain that would be recognized, if the deferral were not permitted, not later than December 31, 2026. For this purpose, the definition of related person encompasses a more than 20% common ownership threshold, rather than the more than 50% test that is utilized elsewhere in the Code.
A taxpayer may make multiple elections within the 180-day period for different parts of gain from a single transaction. If a taxpayer acquires an interest in a QOF and makes the gain deferral election, and subsequently sells its QOF interest, the taxpayer may further defer the recognition of the gain originally deferred (and, presumably, any subsequent appreciation in the original QOF interest), by investing said gain in a QOF within the 180-day period and making the deferral election regarding the new QOF investment. The continued deferral of the originally deferred gain in this situation is permitted only if the taxpayer has disposed of its entire initial investment without which the taxpayer could not have made the previous deferral election.
The only gain arising from section 1256 contracts that is eligible for the gain deferral is capital gain net income for the year. The 180- day period here begins on the last day of the tax year. Gain from section 1256 contracts that are part of an offsetting-positions transaction in which any of the other positions are not also section 1256 contracts is not eligible for the deferral. Capital gain from a position that is or has been part of an offsetting-positions transaction (except where all positions are section 1256 contracts) is not eligible. Offsetting-position transactions are specifically defined and include most straddles.
Types of Taxpayers Eligible to Elect Gain Deferral
Taxpayers eligible to elect gain deferral are those that recognize capital gain for federal income tax purposes, including individuals; C corporations (including RICs and REITs); partnerships; S corporations; trusts and estates, common trust funds, qualified settlement funds, and certain other entities.
If a partnership has eligible gain and does not elect to defer some, or all, of this gain, then a partner may make the election with respect to its distributive share of the gain which the partnership did not defer. The 180- day period with respect to the partner generally begins on the last day of the partnership’s taxable year. The partner may elect to treat the partner’s own 180- day period as being the same as the partnership’s 180- day period (the date the eligible gain is realized by the partnership). Analogous rules apply in the case of S corporations, trust and estates and their shareholders or beneficiaries, as the case may be.
An eligible interest in a QOF is an equity interest issued by the QOF, including preferred stock or a partnership interest with special allocations. Thus, debt instruments do not qualify. The proposed regulations clarify that a there is no prohibition to using a pre-existing entity as a QOF, providing that the pre-existing entity satisfies the requirements for a QOF.
The statute contemplates that a taxpayer may make an investment with “mixed use funds” that is, an investment only a portion of which consists of gain to which a deferral election is in effect. For example, a taxpayer can invest eligible gain into a QOF and elect the deferral, and also invest funds for which no deferral election is either made or available. In such a case, the taxpayer’s investment in the QOF is treated as two separate investments, consisting of one investment that only includes amounts for which the election applies, and a separate investment, consisting of other amounts. The special provisions of section 1400Z-2 apply only to the former. It is anticipated that many QOFs will be classified as a partnership for federal income tax purposes. The proposed regulations provide that if the partnership borrows money, any resultant adjustment to the partner’s basis in its partnership interest under section 752(a) is ignored when determining if the portion of the partner’s investment is either subject to the deferral election or not.
As the treatment of debt in the QOF/partnership context is unclear, the conservative approach at this time is to plan for the possibility of recapture of losses claimed against debt basis, upon disposition. Among the areas of uncertainty is if there is a different result depending where in the structure the debt is. The Treasury Department is seeking comments as to whether not treating the section 752(a) deemed contribution as creating a separate investment may be considered abusive.
Treatment of Land and Buildings
To facilitate the rehabilitation of vacant buildings in QOZs, for purposes of determining whether a building is substantially improved, the basis of the underlying land is not considered. Revenue Ruling 2018-29, issued in tandem with the proposed regulations, provides similarly.
Working Capital and the 90% Asset Test
In response to comments that it may take longer than six months to develop a new business or construct or rehabilitate real estate, the proposed regulations provide a working capital safe harbor for QOF investments in QOZ businesses that acquire, construct or rehabilitate tangible business property, which includes both real property and other tangible property used in a business operating in an opportunity zone. This safe harbor allows QOZ businesses to apply the definition of working capital provided in section 1397C(e)(1) to property held by the business for up to 31 months. This safe harbor applies if there is a written plan that identifies the financial property 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. Taxpayers would be required to retain any written plan in their records.
The ”70/30” Test
In determining whether an entity is a QOZ business, the proposed regulations provide that if at least 70% of the tangible property owned or leased by the entity is QOZ business property, then the business will satisfy the requirement in the statute that “substantially all” of its tangible property consist of QOZ business property.
Timing of the Basis Step Up Election
As stated above, a taxpayer is permitted to elect to increase the basis in its investment in a QOF if the investment is held for at least 10 years from the date of the original investment in the QOF. However, the statue provides that the designations of all QOZs now in existence will expire on December 31, 2028. Among the issues thus implicated is whether investors may still make basis step-up elections for QOF investments made in 2019 and later.
The proposed regulations address this concern by permitting taxpayers to make the basis step-up election after a QOZ designation expires. An election may be made under the proposed regulations until December 31, 2047. Since the latest gain subject to deferral would be at the end of 2026, the last day of the 180-day period for that gain would be in late June 2027. A taxpayer deferring such a gain would achieve a 10-year holding period in late June 2037. Thus, the proposed regulation would permit an investor in a QOF that makes an investment as late as the end of June 2027 to hold the investment in the QOF for the entire 10 year holding period, plus another 10 years.
Marks Paneth will keep you informed as more guidance on the Qualified Opportunity Fund program is released. If you have any questions, please contact a member of our Real Estate Group.
About Alan M. Blecher
Alan M. Blecher, JD, is a Principal at Marks Paneth LLP. Mr. Blecher has considerable experience serving high-income and high-net-worth individuals and their closely held businesses. He focuses especially on partnerships, limited liability companies and S corporations. He has been in public accounting since 1985 and has been involved in tax planning for numerous transactions. These include transactions involving public debt offerings, sales of family businesses and restructurings of distressed entities, among others. Mr. Blecher... READ MORE +