By: Jerald David August, Chair, International Taxation and Wealth Planning Practice Group
The Tax Cuts and Jobs Act, P.L. No. 115-97, §13923, added new Sections 1400Z-1 (Qualified Opportunity Zones) and 1400Z-2 (Gains Invested in Qualified Opportunity Zones (“QOZs”), to the Internal Revenue Code (“Code”) under the Tax Cuts and Jobs Act. The new tax deferral provision has received much attention from taxpayers realizing large capital gains. The QOZ provision permits the temporary deferral of gain recognition for realized capital gains which are reinvested in a qualified opportunity fund (QOF). A qualified opportunity zone is one that is designated in a certain low-income community as defined in Section 45D(e). The designation of a particular census tract as a QOZ remains in effect beginning with the date of designation and ending at the end of the tenth calendar year beginning on or after the date of designation. There is a process by which state governors submit nominations for a limited number of QOZs to the Treasury for designation. If the number of low-income communities in a particular state is less than 100, the governor may designate up to 25 tracts and if more , then the designation must be for up to 25% of the number of low-income communities in the state.
The deferral in the recognition of the realized capital gain applies under Section 1400Z where the taxpayer timely makes a reinvestment for the amount of the gain in a QOF. This is required under a 180 day rule after the date of the closing of the sale or exchange resulting in the capital gain when such gain is first realized for Federal income tax purposes. A taxpayer is permitted, under the proposed regulations discussed below, to make several elections to defer gain with respect to the same sale provided the qualifying investment or investments are made within the 180 day required term.
A QOF is an investment corporation or partnership whose purpose is to invest in a QOZ (other than another qualified opportunity fund) that holds at least 90% in the value, as defined, of its assets in QOZ property. Qualified opportunity zone property includes: any qualified opportunity zone stock, any qualified opportunity zone partnership interest, and any qualified opportunity zone business property.
Where a QOF fails to meet the 90% QOZ investment requirement, and subject to a reasonable cause relief rule, the investment fund is required to pay a monthly penalty of the excess value over 90% of the value of the QOF’s assets multiplied by the statutory underpayment rate on tax deficiencies under Section 6211. Where the QOF is a partnership, the penalty is taken into account at the partner level based on each partner’s distributive share of the penalty base plus the addition for interest.
The maximum amount of the deferred gain allowed under Section 1400Z, as mentioned, is equal to the amount invested in a QOF by the taxpayer during the 180-day period beginning on the date of sale of the gain asset to which the deferral pertains. For amounts of the capital gains that exceed the maximum deferral amount, the capital gains must be recognized and included in gross income in the year of sale.
The taxpayer’s basis of her “tax deferred gain” investment in a Q0F immediately after its acquisition is zero. If the investment is held by the taxpayer for at least five years, the basis is increased by 10% of the deferred gain. Where the QOF investment is held for seven years or more, the basis in the QOZ investment is increased by an additional 5% of the deferred gain. See Section 1400Z-2. Where the qualified investment is held until at least December 31, 2026, the deferred gain is required to be included in gross income. As a result, the basis in the QOF investment increases by the remaining 85% of the deferred gain. Only taxpayers who essentially rollover capital gains of non-zone assets to QOZ funds or assets before December 31, 2026, are eligible to benefit.
The second tax benefit or windfall under the QOZ rules in Section 1400Z-2 is that the taxpayer is permitted to exclude from gross income the post-acquisition capital gains on investments in QOZ funds that are held for at least 10 years. Specifically, in the case of the sale or exchange of an investment in a QOF held for more than 10 years, at the election of the taxpayer, the basis of such investment in the hands of the taxpayer, is its fair market value of the investment at the date of such sale or exchange. See Section 1400Z-2(c). The maximum amount of the deferred gain is equal to the amount invested in a qualified opportunity Taxpayers can continue to recognize losses associated with investments in QOZ funds as provided under current law.
The Treasury or its delegate, the Internal Revenue Service, is required to report annually to Congress on the opportunity zone incentives beginning 5 years after enactment of the TCJA on the investment levels of the QOFs, and the impacts on the particular census tracts that are designated.
Notice of Proposed Rulemaking (NOPRM 2018) Under the Qualified Opportunity Zone Rules
In NOPRM 2018 (REG-115420-18; 83 F.R. 54279-54296) the Service issued guidance setting forth general rules with respect to qualifying and reporting gains for income tax deferral and additional details under Section 1400Z-2 The Preamble to NOPRM 2018 describes the rules promulgated with respect to a number of important areas which are highlighted in the first part of this post. The second portion of this post will address the changes and additional guidance provided in the more recent set of proposed regulations under Section 1400Z.
Gains Eligible For Deferral.
Section 1400Z-2(a)(1) provides that gain subject to deferral is with respect to gain from the sale or exchange of property held by the taxpayer to an unrelated person to the extent such gain does not exceed the aggregate amount invested by the taxpayer in a QOF within 180 days of the date of the sale or exchange in question. No mention is made as to whether both short term and long term capital gains apply, whether (and the extent to which) long term capital gain resulting from the Section 1231 hodge-pot applies, and whether ordinary income gains are eligible as well, such as gain from the sale of a building that results in Section 1245 or Section 1250 recapture. The NOPRM 2018 simply provides that based on the legislative history the deferral only applies to “capital gains”.
Moreover, the gain deferred under Section 1400Z-2(a)(1) must be gain that would be recognized no later than December 31, 2026 in accordance with Section 1400Z-2(a)(2)(B)(expiration of deferred gain not previously included in gross income). The gain must not be sourced from a related person as defined under Section 1400Z-2(e)(2) which relies upon the constructive ownership rules under Sections 267(b)(1) and 707(b)(1) but substituting 20% in lieu of 50%.
Taxpayers Eligible to Elect Gain Deferral
The NOPRM 2018 acknowledges that only taxpayers that recognize capital gains are eligible for the gain deferral election under Section 1400Z-2. This includes, individuals, C corporations, RICs, REITS, partnerships, other forms of pass through entities, common trust funds per Section 584, qualified settlement funds, and disputed ownership funds described in Treas. Reg. §1.468B. Special rules apply for pass through entities. In particular, flow through entities as well as its members or partners can invest in a QOF and defer recognition of eligible gain. Additional guidance in this area will be forthcoming. .
Investments in Qualified Opportunity Zone
The NORPM 2018 requires that a QOF investment must be characterized, for federal income tax purposes, as an equity interest in the QOF, which includes preferred stock or a partnership interest with special allocations. A debt instrument does not qualify.  The equity interest held by the taxpayer from the QOF can be pledged as collateral for a loan, including a purchase-money financing. Deemed contributions of money under the liability allocation rules under Section 752(a) do not constitute an investment in a QOF.
Application of the 180 Day Investment In QOF Rule
Under Section 1400Z-2(a)(1)(A), a taxpayer attempting to qualify under the non-taxable rollover rule, must generally invest in a QOF within 180 days of the closing of the relevant sale or exchange which the NOPRM 2018 clarified begins with the date on which the gain would be recognized for Federal income tax purposes, without regard to the deferral available under Section 1400Z-2. Examples are provided for gains from capital gain dividend distributions and gains from the sale of exchange trade stock.
What about the taxable sale of an investment in a QOF? Can the reinvestment gain be reinvested in another QOF and result in two layers of deferred gains? The Preamble to the NOPRM 2018 provides that a later sale or exchange of a QOF allows that taxpayer to make a qualifying new investment in a QOF under Section 1400Z-2(a)(2) which will continue the deferral of the prior realized gain. Deferring an inclusion, however, is permitted only where the taxpayer sells her entire initial investment in the QOF since Section 1400Z-2(a)(2)(A) prohibits the making of a deferral election under Section 1400Z-2(a)(1) with respect to a sale or exchange if an election previously made with respect to the same sale or exchange remains in effect. (emphasis supplied). A new 180 day reinvestment rule applies to rollover gain realized from the taxable disposition of the entire QOF held by the taxpayer.
Impact on Tax Attributes After Realization of Gain Caused By Termination of Deferral
The NOPRM 2018 provides that the tax attributes, e.g., characterization, of the deferred gain is preserved and taken into account when the gain is finally recognized. Rules are provided as well for basis in separately blocks for purchased stock on which gain is deferred under Section 1400Z-2(a)(1)(B). Where, for example, a taxpayer disposes of less than all of its interests in a QOF, the QOF interests disposed of must be identified using a first-in, first-out (FIFO) method or, in certain instances, under a pro-rata method in order to determine the character and any other attributes, of the gain recognized.
Gains of Partnerships and Other Pass-Through Entities
Under the NOPRM 2018, a partnership is permitted to elect deferral under Section 1400Z-2 and, where the partnership does not so elect, the proposed regulations permit each partner to make the election. Where the partnership makes the qualifying investment in a QOF, Prop. Reg. §1.1400Z-2(a)-1(c)(1) no part of the deferred gain is required to be included in the distributive shares of taxable income the partners under Section 702, and the gain does not result in an increased in partnership basis under Section 705(a)(1).
On the other hand, Prop. Reg. §1.1400Z-2(a)-1(c)(2) set forth rules where a partnership does not elect to defer capital gain. In such case, the partnership level capital gain is includible in each partner’s distributive share of gross income, with characterization intact, and further results in a corresponding basis increase under Section 705(a)(1). Each partner allocated its share of the capital gain, may elect deferral under the QOZ rules. Consistent with the “first day” includible in gross income approach in starting the 180 day rule, where the partner is making the QOF election, each partner’s 180-day period to elect and make a qualifying investment in a QOF 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 the gain is not deferred. The proposed regulations, however, provide an alternative for situations in which the partner knows (or receives information) regarding both the date of the partnership’s gain and the partnership’s decision not to elect deferral under section 1400Z-2. In that case, the partner may choose to begin its own 180-day period on the same date as the start of the partnership’s 180-day period. The NOPRM 2018 announces that rules analogous to those provided for partnerships and partners will apply to other pass through entities such as trusts or estates, beneficiaries thereof, and with respect to S corporations and their shareholders.
Section 1400Z-2(c) Election for Investments Held At Least 10 Years
Where a taxpayer that holds a QOF investment for at least ten years, Section 1400Z-2(c), provides that each such taxpayer may elect to increase the basis of the investment to its fair market value of the investment on the date that the investment is sold or exchanged. Such basis step-up election under Section 1400Z-2(c) is available only for gains realized for QOF investments previously made in under Section 1400Z-2(a). It is possible for a taxpayer to invest in a QOF in part with gains for which a deferral election under section 1400Z-2(a) is made and in part with other funds (for which no section 1400Z-2(a) deferral election is made or for which no such election is available). Section 1400Z-2(e) requires that these two types of QOF investments be treated as separate investments, since they receive different treatment for Federal income tax purposes.
QOF Investments and the 10-Year Zone Designation Period
Section 1400Z-2(c), as just described, permits a taxpayer to elect to increase the basis in its investment in a QOF provided the taxpayer holds the investment for at least ten years from the date of the original investment in the QOF. However, under Section 1400Z-1(f), the designations of all QOZs now in existence will expire on December 31, 2028. The loss of QOZ designation raises the question on gain deferral elections still in effect when the designation expires. Consider, for example, whether the investors may still make basis step-up elections for QOF investments from 2019 and later.
Section 1400Z-2 does not contain a specific statutory on this issue. However, under the D.C. enterprise zone provision in Section 1400B(b)(5), a taxpayer is still allowed to satisfy the requisite holding period despite the termination of the designation of a zone. Citing the legislative history to the QOZ rules, the proposed regulations permit taxpayers to make the basis step-up election under Section 1400Z-2(c) even after a QOZ designation expires. The ability to make this election is retained under the NOPRM 2018 and is further preserved until December 31, 2047, which is 20½ years after the latest date that an eligible taxpayer may properly make an investment that is part of an election to defer gain under Section 1400Z-2(a). Because the latest gain subject to deferral ends on December 31, 2026, the last day of the 180-day period for deferring gain would be in late June 2027. A taxpayer deferring such a gain would achieve a 10-year holding period in a QOF investment by holding such interest until the end of June 2037. Thus, this proposed rule 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 described in section 1400Z-2(c), plus another 10 years. An open question whether the regulations should provide for a presumed basis step-up election immediately before the ability to elect a step-up upon disposition expires? If a basis step-up without disposition is allowed, the NOPRM 2018 does not seem to answer how QOF investment is to be valued at the time of the step-up.
Rules for a Qualified Opportunity Fund
Certification of an Entity as a QOF
Section 1400Z-2(e)(4) allows for legislative regulations on the certification of QOFs under Section 1400Z-2. The NOPRM 2018, in general, permits any taxpayer that is a corporation or partnership for tax purposes to self-certify as a QOF, provided that the entity self-certifying is statutorily eligible. The proposed regulations permit the Commissioner to determine the time, form, and manner of the self-certification in IRS forms and instructions or in guidance published in the Internal Revenue Bulletin. Presumably Form 8996, Qualified Opportunity Fund, will both for initial self-certification and for annual reporting of compliance with the 90% Asset Test in Section 1400Z-2(d)(1) and filed with the taxpayer’s Federal income (or informational) return annually. See https://www.irs.gov/forms-pubs/about-form-8996.
Commencement Notice of a QOF
The proposed regulations allow a QOF both to identify the taxable year in which the entity becomes a QOF and select the first month in that year to be treated as a QOF. If an eligible entity fails to specify the first month it is a QOF, then the first month of its initial taxable year as a QOF is treated as the first month that the eligible entity is a QOF. A deferral election under Section 1400Z-2(a) may only be made for investments in a QOF that has already started its effective date period.
Becoming a QOF in a Month Other Than the First Month of the Taxable Year
Under the 90% Asset Test set forth in Section 1400Z-2(d)(1), with respect to an entity’s first year as a QOF, where the entity chooses to become a QOF beginning with a month other than the first month of its first taxable year. The phrase “first 6-month period of the taxable year of the fund” means the first 6-month period composed entirely of months which are within the taxable year and during which the entity is a QOF. For example, if a calendar-year entity that was created in February chooses April as its first month as a QOF, then the 90% Asset Test testing dates for the QOF are the end of September and the end of December. Where a calendar-year QOF chooses a month after June as its first month as a QOF, then the only testing date for the taxable year is the last day of the QOF’s taxable year. Regardless of when an entity becomes a QOF, the last day of the taxable year is a testing date.
The NOPRM 2018 provides that Section 1400Z-2(f)(1) does not apply before the first month in which the entity qualifies as a QOF. Additional regulations will address, among other issues, the applicability of the Section 1400Z-2(f)(1) penalty and decertification of a QOF.
Section 1400Z-2(e)(4)(B) authorizes regulations to ensure that a QOF has “a reasonable period of time to reinvest the return of capital from investments in QOZ stock and QOZ partnership interests, and to reinvest proceeds received from the sale or disposition of Q0Z business property.” For example, where a QOF shortly before a testing date sells QOZ property, that QOF is to be granted a reasonable amount of time to again comply under the 90% Asset Test. Additional regulations will provide guidance on such reinvestments by QOFs. Many stakeholders have requested guidance not only on the length of a “reasonable period of time to reinvest” but also on the Federal income tax treatment of any gains that the QOF reinvests during such a period.
Pre-Existing Entities Qualifying as a QOF or Issuer of QOZ Stock Or Partnership Interest
The NORPM 2018 noted that the Treasury and the IRS received questions and comments on whether, after 2017, a QOF may acquire an equity interest in a pre-existing operating partnership or corporation. The proposed regulations clarify that a pre-existing entity may qualify as a QOF or as a subsidiary entity operating a qualified opportunity business, provided that the pre-existing entity satisfies the requirements under Section 1400Z-2(d). Section 1400Z-2(d)(1), as mentioned, requires that a QOF must test semi-annually whether its assets consist on average of at least 90% QOZ property. For purposes of these semi-annual tests, Section 1400Z-2(d)(2) requires that a tangible asset can be QOZ business property by an entity that has self-certified as a QOF or an operating subsidiary entity only if it acquired the asset after 2017 by purchase.
Valuation Method for Applying the 90-Percent Asset Test
Under the 90% Asset Test of a QOF under Section 1400Z-2(d)(1), the proposed regulations require the QOF to use the asset values that are reported on the QOF’s applicable financial statement for the taxable year, as defined in Treas. Reg. § 1.475(a)-4(h). If a QOF does not have an applicable financial statement, the proposed regulations require the QOF to use the cost of its assets. Additional methods are still under consideration.
Under the 90% Asset Test provision, 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. The 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 a period of up to 31 months, provided 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. Recordkeeping is require.
The NOPRM 2018 fortunately recognized that a broad definition of “working capital” was needed. Indeed, Section 1400Z-2(d)(iii) anticipates situations in which a QOF or operating subsidiary may need up to 30 months after acquiring a tangible asset in which to improve the asset substantially.Additional comments on the “working capital” exception were requested beyond the acquisition, construction, or rehabilitation of tangible business property to the development of business operations in the opportunity zone.
Qualified Opportunity Zone Business
Under Section 1400Z-2(d)(1), a QOF is any investment vehicle organized as a corporation or partnership for the purpose of investing in QOZ property (other than another QOF). As mentioned, a QOF must hold at least 90% of its assets in QOZ property. Compliance with the 90% Asset Test is based on the average of the percentage of the qualified opportunity zone property held in the QOF as measured on the last day of the first 6-month period of the taxable year of the QOF and on the last day of the taxable year of the QOF. Again, the computation is driven by financial statement positions of value which will generally will be set at “cost”. The government is still considering other valuation methods, such as tax adjusted basis.
Under Section 1400Z-2(d)(2)(A), QOZ property includes QOZ business property. QOZ property may also include certain equity interests in an operating subsidiary entity (either a corporation or a partnership) that qualifies as a QOZ business by satisfying certain requirements pursuant to Section 1400Z-2(d)(2)(B) and (C). Where a QOF operates a trade or business directly and does not hold any equity in a QOZ business, at least 90% of the QOF’s assets must be QOZ property.
The definition of qualified opportunity zone business property requires property to be used in a QOZ and also requires new capital to be employed in a QOZ. Under Section 1400Z-2(d)(2)(D)(i), QOZ business property means tangible property used in a trade or business of a QOF, but only if (1) the property was acquired by purchase after December 31, 2017; (2) the original use of the property in the QOZ commences with the QOF, or the QOF substantially improves the property; and (3) during substantially all of the QOF’s holding period for the property, substantially all of the use of the property was in a QOZ.
Under Sections 1400Z-2(d)(2)(B)(i) and (C), to qualify as a QOZ business, an entity must be a QOZ business both (a) when the QOF acquires its equity interest in the entity and (b) during substantially all of the QOF’s holding period for that interest. The manner by which the QOF acquires the pertinent equity interest must meet certain requirements. Under Section 1400Z-2(d)(3)(A), for a trade or business to qualify as a QOZ business, it must (among other requirements) be one in which substantially all of the tangible property owned or leased by the taxpayer is QOZ business property.
Where an entity qualifies as a QOZ business, the value, i.e., applicable financial reporting amount, of the QOF’s entire interest in the entity counts toward the QOF’s satisfying the 90% Asset Test. Therefore, where a QOF operates a trade or business (or multiple trades or businesses) through one or more entities, the QOF can satisfy the 90 % Asset Test if each of the entities qualifies as a QOZ business. The minimum amount of qualified opportunity zone business property owned or leased by a business for it to qualify as a QOZ business is controlled by Section 1400Z-2(d)(3)(A)(i).
In determining whether an entity is a QOZ business, the NOPRM 2018 sets forth a threshold rule to determine whether a trade or business satisfies the “substantially all” requirement in Section 1400Z-2(d)(3)(A)(i). Where 70% or more of the tangible property owned or leased by a trade or business is QOZ business property (per Section 1400Z-2(d)(3)(A)(i)), the trade or business satisfies the substantially all requirement in Section 1400Z-2(d)(3)(A)(i). The 70% threshold provided in the NOPRM 2018 is intended to apply only to the term “substantially all” as it is used in Section 1400Z-2(d)(3)(A)(i) and in several other places in Section 1400Z-2. See, e.g., Sections 1400Z-2(d)(3)(A)(i), 1400Z-2(d)(2)(D)(i)(III), 1400Z-2(d)(2)(B)(ii)(III) and 1400Z-2(d)(2)(C)(iii).
Section 1400Z-2(e) Investments from Mixed Funds
Where only a portion of a taxpayer’s investment in a QOF is subject to the deferral election under Section 1400Z-2(a), Section 1400Z-2(e)(1) requires the investment to be treated as two separate investments, which receive different treatment for Federal income tax purposes one under a gain deferral election under Section 1400Z-2(a) and the other which is not so elected. . Pursuant to Section 1400Z-2(e)(1)(B), the proposed regulations reiterate that a taxpayer may make the election to step-up basis in an investment in a QOF that was held for 10 years or more only if a proper deferral election under Section 1400Z-2(a) was made for the investment.
Question surfaced during the comment period whether Section 752(a) could result in investments with mixed funds for purposes of Section 1400Z-2(e)(1). The proposed regulations clarify that deemed contributions of money under Section 752(a) do not constitute an investment in a QOF; therefore, a deemed contribution under Section 752(a) does not result in the partner having a separate investment under Section 1400Z-2(e)(1). Further guidance in this area is expected.
Proposed Effective Date Under NOPRM 2018.
The NOPRM 2018 states that the general effective date will apply to the regulations when issued in final form and published in the Federal Registry. However there were exceptions: (i) an eligible taxpayer may rely on Prop. Reg. §1.1400Z-2(a)-1 with respect to eligible gains that would be recognized before the final regulations’ date of applicability, but only if the taxpayer applies the rules in their entirety and in a consistent manner; (ii) a taxpayer may further rely on the rules in Prop. Reg. § 1.1400Z-2(c)-1 with respect to dispositions of investment interests in QOFs in situations where the investment was made in connection with an election under Section 1400Z-2(a) that relates to the deferral of a gain such that the first day of 180-day period for the gain was before the final regulations’ date of applicability. This reliance is dependent on the taxpayer’s applying the rules of Section= 1.1400Z-2(c)-1 in their entirety and in a consistent manner; (iii) a QOF may rely on Prop. Reg. § 1.1400Z-2(d)-1 with respect to taxable years that begin before the final regulations’ date of applicability, but only if the QOF applies the rules in their entirety and in a consistent manner; and (iv) a taxpayer may rely on Prop. Reg. §1.1400Z-2(e)-1 for investments and deemed contributions of money occurring prior to the final regulations being issued again provided the taxpayer applies the rules in their entirety and in a consistent manner.
Notice of Proposed Rulemaking (NOPRM 2019) Under the Qualified Opportunity Zone Rules
The second tranche of proposed regulations, which also partially withdrew part of the NOPRM 2018 [REG-115420-18], were issued in May, 2019. REG-120186-18; 2019-21 IRB 1193. The focus of the NOPRM 2019 was also Section 1.1400Z-2, special rules for capital gains invested in opportunity zones. The NOPRM revised the “substantially all” definitions, rules identifying transactions that may trigger the inclusion of gain that a taxpayer has elected to defer; the timing and amount of deferred gain that is included; the treatment of leased property used by a QOZ business (or QOZB); the use of QOZB property in the qualified Opportunity Zone; the sourcing of gross income to the QOZB; and the “reasonable period” for a QOF to reinvest proceeds from the sale of qualifying assets without paying a penalty.
Qualified Opportunity Zone Business Property (NOPRM 2019)
Definition of Substantially All: Sections 1400Z-2(d)(2) and (d)(3)
The NOPRM 2018 clarified the “substantially all” test sets forth a floor or threshold requirement of 70% of “value”in determining whether a trade or business is a QOZB. The NOPRM 2019 continues the application of the 70% standard used in NOPRM 2018 in testing the use of QOZB property in a QOZ, per Section 1400Z-2(d)(2)(D)(i)(III), under the “substantially all” test which uses a 70% threshold. As to owned versus leased tangible property, the NOPRM 2019 proposed regulations provide identical requirements in determining whether a QOF or QOZB has used “substantially all” of such tangible property within the “QOZ”. Whether such tangible property is owned or leased, these proposed regulations propose that the substantially all requirement regarding “use” is satisfied if at least 70% of the use of such tangible property is in a QOZ.
As the use of the phrase “substantially all” in both the trade or business and QOF tests, which possibility was acknowledged in the NOPRM 2018, the NOPRM 2019 provide that “substantially all” as used in the holding period context in Sections 1400Z-2(d)(2)(B)(i)(III), 1400Z-2(d)(2)(C)(iii), and 1400Z-2(d)(2)(D)(i)(III) is defined at the threshold level of 90% of “value” (not 70%). The Treasury and IRS announced that using a threshold lower than 90% in the holding period context would reduce the amount of investment in QOZs to less than what Congress intended in enacting Section 1400Z-2.
Original Use of Tangible Property Acquired by Purchase
Comments were received on the requirement that tangible property must be acquired by purchase and have its “original use” in a QOZ commencing with a QOF or QOZB, or be substantially improved, in order to qualify for the tax deferral. One area of uncertainty was whether “original use” could include property that was previously placed in service in the QOF for one use, but now placed in service for a different use, and still qualify? Another related question was whether property already used in a QOZ be placed in service in the same QOZ by purchase effectuated by an unrelated taxpayer?
The NOPRM 2019 responded by setting forth the “original use” of tangible property acquired by purchase by any person commences on the date when that person or a prior person first places the property in service in the QOZ for purposes of depreciation or amortization (or first uses the property in the QOZ in a manner that would allow depreciation or amortization if that person were the property’s owner). Accordingly, tangible property located in the QOZ depreciated or amortized by a taxpayer other than the QOF or QOZB does not qualify under Section 1400Z-2(d)(2)(D)(i)(II). On the other hand, tangible property (other than land) located in the QOZ but not yet depreciated/amortized by a taxpayer other than the QOF or QOZB can satisfy the “original use” requirement of Section 1400Z-2(d)(2)(D)(i)(II). Used property can qualify, as long as it has not previously been used within that QOZ in a manner that would have allowed it to depreciated or amortized) by any taxpayer. Special rules in the NOPRM 2019 apply the “original use” requirement for assets acquired in certain transactions described in various parts of the Code, including spin-offs under Section 355 or attribute rules contained in Section 381. See Prop. Reg. §1.1400Z-2(b)-1(d)(2).
Vacant structures or other property other than land purchased after 2017 but previously placed in service within the QOZ may be disregarded under the “original use” requirement if the structure or other property has not been utilized or has been abandoned for a minimum period of time. After comments were received on this issue under enterprise zone, and other tax incentive provisions for investing in low income communities, the NOPRM 2019 sets forth that where a building or other structure has been vacant for at least five years prior to being purchased by a QOF or QOZB, the purchased building or structure will satisfy the original use requirement. This seems to be too long a required period and the Treasury asked for additional comments.
As to improvements made on leased property, the proposed regulations provide that improvements made by a lessee to leased property satisfy the original use requirement and are considered purchased property for the amount of the unadjusted cost basis of such improvements as determined in accordance with section 1012.
As provided in Rev. Rul. 2018-29, 2018 I.R.B 45, and the NOPRM 2019, if land that is within a QOZ is purchased the requirement under Section 1400Z-2(d)(2)(D)(i)(II) that the original use of tangible property in the QOZ commence with a QOF is not applicable to the land, whether the land is improved or unimproved. Likewise, unimproved land that is within a QOZ and acquired by purchase in accordance with Section 1400Z-2(d)(2)(D)(i)(I) is not required to be substantially improved within the meaning of Sections 1400Z-2(d)(2)(D)(i)(II) and (d)(2)(D)(ii). In reviewing comments with respect to purchase of vacant land within a QOZ, the NOPRM 2019 provides that land can be QOZB property for purposes of Section 1400Z-2 only if used in a trade or business of a QOF or QOZB. The NOPRM 2019 explained that the Section 162(a) standard for carrying on a trade or business is be applied under Section 1400Z-2. In contrast, the holding of land for investment, per se, does not give rise to a trade or business and such land could not be QOZB, at least that is the position taken in the rule-making. Obviously, the applicable standard requires that all facts and circumstances have to be taken into account in making this determination.
The Preamble states, in this regard, that in some instances the holding of “land is a crucial business asset for numerous types of operating trades or businesses aside from real estate development….”. Therefore were the regulations to impose a requirement on all types of trades or businesses to substantially improve (per Sections 1400Z-2(d)(2)(D)(i)(II) and (d)(2)(D)(ii)) land that is used by them may encourage noneconomic, tax-motivated business decisions, or otherwise effectively prevent many businesses from benefitting under the opportunity zone rules. After stating the need for flexibility but without promoting tax abuse type trategies in this area, the NOPRM 2019 states that where a significant purpose for acquiring unimproved land was to achieve that inappropriate tax result, the general anti-abuse rule set forth in Prop. Reg. §1.1400Z2(f)-1(c) would treat the acquisition of the unimproved land as an acquisition of non-qualifying property. Additional comments were requested under Section 1400Z-2(e)(4)(c), in addition to the general anti-abuse rule, to address “land banking” by QOFs or QOZBs, and on other possible rules that could be adopted to prevent abuse in this area.
It is important to recognize that where real property, other than land, is acquired by purchase per Section 1400Z-2(d)(2)(D)(i)(I) and had been placed in service in the QOZ by a person other than the QOF or QOZB (or first used in a manner that would allow depreciation or amortization if that person were the property’s owner), it must be substantially improved to be become QOZB property. See Section 1400Z-2(d)(2)(D)(ii).
Safe Harbor for Testing Use of Inventory in Transit
Section 1400Z-2(d)(2)(D)(i)(III) provides that QOZB property means tangible property used in a trade or business of the QOF if, during substantially all of the QOF’s holding period for such property, substantially all of the use of such property was in a QOZ. How the rules apply to inventory was the subject of comments and in this regard whether inventory in transit on the last day of the taxable year of a QOF would be counted against the QOF when determining whether the QOF has met the 90% Asset Test in Section 1400Z-2(d)(1). In response, the NOPRM 2019 clarify that inventory of a trade or business does not fail to be used in a QOZ solely because the inventory is in transit from a vendor to a facility of the trade or business in a QOZ, or from a facility of the trade or business that is in a QOZ to customers of the trade or business that are not located in a QOZ. Issues on warehousing of inventory and other applicable rules matters for which additional comments were solicited by the Treasury and IRS.
Treatment of Leased Tangible Property in NOPRM 2019
Section 1400Z-2(d)(3)(A)(i) provides that a QOZB is a trade or business where, inter alia, substantially all (in this context 70% or more) of the tangible property owned or leased by the taxpayer is QOZB property per Section 1400Z-2(d)(2)(D), determined by substituting “qualified opportunity fund” with “qualified opportunity zone business” each place that such term appears.
Therefore, for purposes of Section 1400Z-2(d)(2)(D)(i), QOZB property is tangible property that: (i) was acquired by the trade or business by purchase (per Section 179(d)(2)) after December 31, 2017; (ii) the original use of such property in the QOZ commences with the QOZB, or the QOZB substantially improves the property; and (iii) for substantially all of the QOZB’s holding period of the tangible property, substantially all of the use of such property is in the QOZ.
Many comments were received that the requirement by purchase rule would discourage needed investment in the opportunity zones simply because the property was “leased” instead of being “purchased”. In response, the Treasury and the Service, in NOPRM 2019, permit leased tangible property meeting certain criteria to be treated as QOZB property for the 90% test under Section 1400Z-2(d)(1) and under the “substantially all” requirement under Section 1400Z-2(d)(3)(A)(i). In order to qualify: (i) the leased tangible property must be acquired under a lease entered into after December 31, 2017; and (ii) substantially all of the use of the leased tangible property must be in a QOZ during substantially all of the period for which the business leases the property.
It is noteworthy that the NOPRM 2019 does not impose an “original use” requirement with respect to leased tangible property. There were several reasons set forth in the Preamble to the NOPRM 2019 for making this distinction, including that the lessee generally is not treated as the owner of property and is not entitled to depreciate the property and for the added reason that the original use of tangible property in many instances already is effectuated by the lessor. In addition to removing the “original use” for QOZB property leased in a QOZ, the proposed regulations do not impose a requirement for a lessee to “substantially improve” leased tangible property Section 1400Z-2(d)(2)(D)(ii). However, in order to maintain greater parity between decisions to lease or own tangible property, while also limiting abuse, the proposed regulations provide one limitation as an alternative to imposing a related person rule or a substantial improvement rule and two further limitations that apply when the lessor and lessee are related.
First, the NOPRM 2019 requires in all cases, that the lease under which a QOF or qualified opportunity zone business acquires rights with respect to any leased tangible property must be a “market rate lease.” For this purpose, whether a lease is market rate (that is, whether the terms of the lease reflect common, arms-length market practice in the locale that includes the qualified opportunity zone) is determined under the regulations under Section 482. This limitation operates to ensure that all of the terms of the lease are market rate.
Second, if the lessor and lessee are related, the proposed regulations do not permit leased tangible property to be treated as qualified opportunity zone business property if, in connection with the lease, a QOF or qualified opportunity zone business at any time makes a prepayment to the lessor (or a person related to the lessor within the meaning of Section 1400Z-2(e)(2)) relating to a period of use of the leased tangible property that exceeds 12 months. This requirement operates to prevent inappropriate allocations of investment capital to prepayments of rent, as well as other payments exchanged for the use of the leased property.
Third, also applicable when the lessor and lessee are related, the proposed regulations do not permit leased tangible personal property to be treated as QOZB property unless the lessee becomes the owner of tangible property that is qualified opportunity zone business property and that has a value not less than the value of the leased personal property. This acquisition of this property must occur during a period that begins on the date that the lessee receives possession of the property under the lease and ends on the earlier of the last day of the lease or the end of the 30-month period beginning on the date that the lessee receives possession of the property under the lease. There must be substantial overlap of zone(s) in which the owner of the property so acquired uses it and the zone(s) in which that person uses the leased property.
Finally, the NOPRM 2019 sets forth an anti-abuse rule to prevent the use of leases to circumvent the substantial improvement requirement for purchases of real property (other than unimproved land). In the case of real property (other than unimproved land) that is leased by a QOF, if, at the time the lease is entered into, there was a plan, intent, or expectation for the real property to be purchased by the QOF for an amount of consideration other than the fair market value of the real property determined at the time of the purchase without regard to any prior lease payments, the leased real property is not qualified opportunity zone business property at any time.
The Treasury Department and the IRS request comments on all aspects of the proposed treatment of leased tangible property.
Valuation of Leased Tangible Property
For purposes of the 90% Asset Test and the 70% substantially all requirements, the NOPRM 2019 provides that the annual value of leased tangible property may be determined under a financial statement valuation method or an alternative valuation method. A QOF or QOZB, as applicable, may select the applicable financial statement valuation method if they actually have an applicable financial statement (within the meaning of §1.475(a)-4(h)). Once a QOF or QOZB a valuation method, it must be consistently applied.
Qualified Opportunity Zone Businesses
Real Property Straddling a Qualified Opportunity Zone
Section 1400Z-2(d)(3)(A)(ii) incorporates the requirements of Sections 1397C(b)(2), (4), and (8) related to Empowerment Zones. Commenters suggested that the proposed regulations adopt a rule that is similar to the rule used for empowerment zones under Section 1397C(f). Section 1397C(f) provides that if the amount of real property based on square footage located within the QOZ is substantial as compared to the amount of real property based on square footage outside of the zone, and the real property outside of the zone is contiguous to part or all of the real property located inside the zone, then all of the property would be deemed to be located within a qualified zone.
The NOPRM 2019 provides that in satisfying the requirements of Section 1400Z-2(d)(3)(A)(ii), Section 1397C(f) applies in the determination of whether a qualified opportunity zone is the location of services, tangible property, or business functions (substituting “qualified opportunity zone” for “empowerment zone”). Real property located within the qualified opportunity zone is considered substantial if the unadjusted cost of the real property inside a qualified opportunity zone is greater than the unadjusted cost of real property outside of the qualified opportunity zone.
50 Percent of Gross Income of a Qualified Opportunity Zone Business
Section 1397C(b)(2) provides that to be a “qualified business entity” (in addition to other requirements found in section 1397C(b)) with respect to any taxable year, a corporation or partnership must derive at least 50% of its total gross income “from the active conduct of such business.” The phrase such business refers to “a qualified business within an empowerment zone.” For purposes of application to Section 1400Z-2, the NOPRM 2019 references in Section 1397C to “an empowerment zone” are treated as meaning a qualified opportunity zone. Thus, the corporation or partnership must derive at least 50% of its total gross income from the active conduct of a business within a qualified opportunity zone.
There are three safe harbors plus a residual “facts and circumstances” test set forth in the new proposed regulations in determining whether sufficient income is derived from a trade or business in a QOZ under the 50% total gross income test. The first safe harbor requires that at least 50% of the services performed (based on hours) for such business by its employees and independent contractors (and employees of independent contractors) are performed within the qualified opportunity zone. The second safe harbor is based payments made by the trade or business for services performed in the QOZ by employees and independent contractors (and employees of independent contractors). Under this test, if 50% or more of the services performed for the business by its employees and independent contractors (and employees of independent contractors) are performed in the QOZ, based on amounts paid for the services performed, the business meets the 50% gross income test in Section 1397C(b)(2) will be made.
The third safe harbor is a two part or conjunctive test relating to tangible property and management or operational functions performed in a QOZ. The proposed regulations, in NOPRM 2019, provide that a trade or business may satisfy the 50% gross income requirement where: (i) the tangible property of the business is in a QOZ; and (ii) the management or operational functions performed for the business in the QOZ are each necessary to generate 50% of the gross income of the trade or business. .
Under the residual test, a taxpayer not meeting one of three safe habour tests may still satisfy the 50% requirement based on a facts and circumstances test if, based on all the facts and circumstances, at least 50% of the gross income of a trade or business is derived from the active conduct of a trade or business in the QOZ.
Use of Intangibles
As set forth in NOPRM 2018 and Section 1400Z-2(d)(3), a QOZB must satisfy Section 1397C(b)(4). Section 1397C(b)(4) requires that, with respect to any taxable year, a substantial portion of the intangible property of a qualified business entity must be used in the active conduct of a trade or business in the qualified opportunity zone, but Section 1397C does not provide a definition of “substantial portion.” The NOPRM 2019 provides that, for purposes of determining whether a substantial portion of intangible property of a QOZ is used in the active conduct of a trade or business, the term substantial portion means at least 40%.
Working Capital Safe Harbor
In response to comments received after the issuance of NOPRM 2018, the NOPRM 2019 make two changes to the safe harbor for working capital. First, the written designation for planned use of working capital now includes the development of a trade or business in the qualified opportunity zone as well as acquisition, construction, and/or substantial improvement of tangible property. Second, 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.
Special Rule for Section 1231 Gains
In NOPRM 2018, proposed regulations stated that only capital gains are eligible for deferral under Section 1400Z-2(a)(1). Section 1231(a)(1) provides that, if the section 1231 gains for any taxable year exceed the Section 1231 losses, such gain shall be treated as long-term capital gain. The NOPRM 2019 provides that only Section 1231 gains, constitute eligible gain for purposes of Section 1400Z-2. In further responding to a technical issue that the determination of capital gain, such as Section 1231 capital gain, may not be determinable until the last day of the taxpayer year, the NOPRM 2019 provides that the 180 day period for investing capital gain income from Section 1231 property in a QOF begins on the last day of the taxable year.
Relief with Respect to the 90-Percent Asset Test
With Respect to Newly Contributed Assets
The proposed regulations, therefore, allow a QOF to apply the 90% asset test without taking into account any investments received in the preceding 6 months. The QOF’s ability to do this, however, is dependent on those new assets being held in cash, cash equivalents, or debt instruments with term 18 months or less.
As to reinvestments, Section 1400Z-2(e)(4)(B) authorizes the issuance of regulations providing that a QOF has “a reasonable period of time to reinvest the return of capital from investments in qualified opportunity zone stock and qualified opportunity zone partnership interests, and to reinvest proceeds received from the sale or disposition of qualified opportunity zone property.” The proposed regulations provide that proceeds received by the QOF from the sale or disposition of (i) qualified opportunity zone business property, (ii) qualified opportunity zone stock, and (iii) qualified opportunity zone partnership interests are treated as qualified opportunity zone property for purposes of the 90% investment requirement described in Sections 1400Z-1(d)(1) and (f), provided the QOF reinvests the proceeds received by the QOF from the distribution, sale, or disposition of such property during the 12-month period beginning on the date of such distribution, sale, or disposition. The one-year rule was designed to allow QOFs sufficient time in which to reinvest proceeds from qualified opportunity zone property. Further, in order for the reinvested proceeds to be counted as qualified opportunity zone business property, from the date of a distribution, sale, or disposition until the date proceeds are invested in other QOF property, the proceeds must be continuously held in cash, cash equivalents, and debt instruments with a term of 18 months or less. A QOF may reinvest proceeds from the sale of an investment into another type of qualifying investment. As an illustration, a QOF may reinvest proceeds from a sale of an investment in qualified opportunity stock into qualified opportunity zone business property.
Investment Churning Problems?
The legislative history to Section 1400Z recognized that many QOFs would experience investment “churn” over the lifespan of the QOF and anticipated the issuance of regulations to allow QOFs a reasonable time to reinvest capital. The Preamble to the NOPRM 2019 acknowledges that sales or dispositions of assets by a QOF do not impact in any way investors’ holding periods in their qualifying investments or trigger the inclusion of any deferred gain reflected in such qualifying investments so long as they do not sell or otherwise dispose of their qualifying investment for purposes of Section 1400Z-2(b). But there was a statement of concern. In this regard the Preamble provides that the Treasury and Service were unable to find precedent for the grant of authority in Section 1400Z-2(e)(4)(B) to permit QOFs a reasonable time to reinvest capital, etc. Comments on where Congress acknowledged its intent to grant rule-making authority but did not so specifically provide were requested.
“In this regard, the Treasury Department and the IRS are requesting commenters to provide prior examples of tax regulations that exempt realized gain from being recognized under sections 1001(c) or 61(a)(3) by a taxpayer (either a QOF or qualified opportunity zone business, or in the case of QOF partnerships or QOF S corporations, the investors that own qualifying investments in such QOFs) without an operative provision of subtitle A of the Code expressly providing for nonrecognition treatment; as well as to provide any comments on the possible burdens imposed if these organizations are required to reset the holding period for reinvested realized gains, including administrative burdens and the potential chilling effect on investment incentives that may result from these possible burdens, and whether specific organizational forms could be disproportionately burdened by this proposed policy.”
Perhaps a technical correction (retroactive of course) is what is required here.
Amount of an Investment for Purposes of Making a Deferral Election
A taxpayer may make an investment in a QOF by contributing cash or other property provided the transfer is not re-characterized as a transaction other than an investment in the QOF (as would be the case where a purported contribution to a partnership is treated as a disguised sale). The NOPRM 2019 provide special rules for determining the amount of an investment where a taxpayer transfers property other than cash to a QOF in a carryover basis transaction. In that case, the amount of the investment equals the lesser of the taxpayer’s adjusted basis in the equity received in the transaction (determined without regard to Section 1400Z-2(b)(2)(B)) or the fair market value of the equity received in the transaction (both as determined immediately after the transaction). In the case of a contribution to a partnership that is a QOF (QOF partnership), the basis in the equity to which Section 1400Z-2(b)(2)(B)(i) applies is calculated without regard to any liability that is allocated to the contributor under Section 752(a). These rules apply separately to each item of property contributed to a QOF, but the total amount of the investment for purposes of the election is limited to the amount of the gain described in Section 1400Z-2(a)(1).
Events That Cause Inclusion of Deferred Gain (Inclusion Events)
Section 1400Z-2(b)(1) provides that the amount of gain that is deferred if a taxpayer makes an equity investment in a QOF described in Section 1400Z-2(e)(1)(A)(i) (qualifying investment) is includible in the taxpayer’s gross income upon the earlier of: (i) the date on which the qualifying investment is sold or exchanged; or (ii) December 31, 2026. Section 1400Z-2(b)(1) does not directly address non-sale or exchange dispositions, such as gifts, bequests, devises, charitable contributions, and abandonments of qualifying investments. Conference Report provides that, under Section 1400Z-2(b)(1), the “deferred gain is recognized on the earlier of the date on which the [qualifying] investment is disposed of or December 31, 2026.” See Conference Report at 539.
The proposed regulations, in NOPRM 2019, follow the specific language in the Conference Report, and clarify that, subject to enumerated exceptions, an inclusion event results from a transfer of a qualifying investment in a transaction to the extent the transfer reduces the taxpayer’s equity interest in the qualifying investment for Federal income tax purposes. A transaction that does not reduce a taxpayer’s equity interest in the taxpayer’s qualifying investment is also an inclusion event under the proposed regulations to the extent the taxpayer receives property from a QOF in a transaction treated as a distribution for Federal income tax purposes. For this purpose, property generally is defined as money, securities, or any other property, other than stock (or rights to acquire stock) in the corporation that is a QOF (QOF corporation) that is making the distribution. Note, this language from the Preamble: “The Treasury Department and the IRS have determined that it is necessary to treat such transactions as inclusion events to prevent taxpayers from “cashing out” a qualifying investment in a QOF without including in gross income any amount of their deferred gain.”
Non-exclusive List of Inclusion Events Set Forth in NOPRM 2019. Based upon the guidance set forth in the Conference Report and the principles underlying the “inclusion event” concept described in the preceding paragraphs, the proposed regulations provide taxpayers with a nonexclusive list of inclusion events, which include:
(1) A taxable disposition of all or a part of a QOF partnership or stock interest;
(2) A taxable disposition of interests in an S corporation which itself is the direct investor in a QOF corporation or QOF partnership if, immediately after the disposition, the aggregate percentage of the S corporation interests owned by the S corporation shareholders at the time of its deferral election has changed by more than 25%. When the threshold is exceeded, any deferred gains recognized would be reported;
(3) In certain cases, a transfer by a partner of an interest in a partnership that itself directly or indirectly holds a qualifying investment;
(4) A transfer by gift of a qualifying investment;
(5) The distribution to a partner of a QOF partnership of property that has a value in excess of basis of the partner’s qualifying QOF partnership interest;
(6) A distribution of property with respect to qualifying QOF stock under Section 301 to the extent it is treated as gain from the sale or exchange of property under Section 301(c)(3);
(7) A distribution of property with respect to qualifying QOF stock under Section 1368 that is treated as gain from the sale or exchange of property under Sections 1368(b)(2) and (c);
(8) A redemption of qualifying QOF stock that is treated as an exchange of property for the redeemed qualifying QOF stock unde Section 302;
(9) A disposition of qualifying QOF stock in a transaction to which Section 304 applies;
(10) A liquidation of a QOF corporation in a transaction to which Section 331 applies; and
(11) Certain nonrecognition transactions, including: (i) a. A liquidation of a QOF corporation in a transaction under Section 332; (ii) the transfer of all or part of a taxpayer’s qualifying QOF stock in a section 351 transaction; (iii) an otherwise tax-free reorganization; (iv) certain acquisitive reorganizations; and (vii) other examples set forth in the NOPRM 2019.
For any income inclusion event, each would reduce or terminate the QOF investor’s direct (or, in the case of partnerships, indirect) qualifying investment for Federal income tax purposes or (in the case of distributions) would constitute a “cashing out” of the QOF investor’s qualifying investment. As a result, the QOF investor would recognize all, or a corresponding portion, of its deferred gain under Sections 1400Z-2(a)(1)(B) and (b).
Timing of Basis Adjustments
Under Section 1400Z-2(b)(2)(B)(i), an electing taxpayer’s initial basis in a qualifying investment is zero. Under Sections 1400Z-2(b)(2)(B)(iii) and (iv), a taxpayer’s basis in its qualifying investment is increased automatically after the investment has been held for five years by an amount equal to 10% of the amount of deferred gain, and then again after the investment has been held for seven years by an amount equal to an additional 5% of the amount of deferred gain. The proposed regulations clarify that such basis is basis for all purposes and, for example, losses suspended under Section 704(d) would be available to the extent of the basis step-up.
The proposed regulations clarify that basis adjustments under Section 1400Z-2(b)(2)(B)(ii), which reflect the recognition of deferred gain upon the earlier of December 31, 2026, or an inclusion event, are made immediately after the amount of deferred capital gain is taken into income. The NOPRM 2019 further clarifies that where the taxpayer makes an election under Section 1400Z-2(c), the basis adjustment under Section 1400Z-2(c) is made immediately before the taxpayer disposes of its QOF investment. For dispositions of qualifying QOF partnership interests, the bases of the QOF partnership’s assets are also adjusted with respect to the transferred qualifying QOF partnership interest, with such adjustments calculated in a manner similar to the adjustments that would have been made to the partnership’s assets if the partner had purchased the interest for cash immediately prior to the transaction and the partnership had a valid Section 754 election in effect.
Amount Includible With Respect to an Inclusion Event
The Preamble to the NOPRM 2019 provides, in general, that other than with respect to partnerships, if a taxpayer has an inclusion event with regard to its qualifying investment in a QOF, the taxpayer includes in gross income the lesser of two amounts, less the taxpayer’s basis. The first amount is the fair market value of the portion of the qualifying investment that is disposed of in the inclusion event. For purposes of this section, the FMV of that portion is determined by multiplying the FMV of the taxpayer’s entire qualifying investment in the QOF, valued as of the date of the inclusion event, by the percentage of the taxpayer’s qualifying investment that is represented by the portion disposed of in the inclusion event. The second amount is the amount that bears the same ratio to the remaining deferred gain as the first amount bears to the total FMV of the qualifying investment in the QOF immediately before the transaction. For inclusion events involving partnerships, the amount includible is equal to the percentage of the qualifying QOF partnership interest disposed of, multiplied by the lesser of: (i) the remaining deferred gain less any basis adjustments pursuant to Section 1400Z-2(b)(2)(B)(iii) and (iv) or (ii) the gain that would be recognized by the partner if the interest were sold in a fully taxable transaction for its then fair market value. With respect to inclusion events pertaining to a QOF shareholder that is an S corporation, where the S corporation has a change in ownership of more than 25%, there is an inclusion event with respect to all of the S corporation’s remaining deferred gain.
A special “dollar-for-dollar” rule applies in certain circumstances if a QOF owner receives property from a QOF that gives rise to an inclusion event. These circumstances include actual distributions with respect to qualifying QOF stock that do not reduce a taxpayer’s direct interest in qualifying QOF stock, stock redemptions to which Section 302(d) applies, and the receipt of boot in certain corporate reorganizations, as well as actual or deemed distributions with respect to qualifying QOF partnership interests.
It all sounds very complex doesn’t it? It is. The recapture events, “inclusion events”, are particularly in certain instances, a set of “gotcha’s” that the proposed regulations set out which may appear to many to take away the incentive to defer tax on capital gains, which was the incentive Congress decided would led to many investors making large investments in poor and low income communities in need of on-site community infusions of capital, employment and profits. The scope and extent of the “inclusion events” should be re-examined by the Treasury and the Service in the process of finalizing this regulations project.
It should also be noted that the discussion of the NOPRM 2019 is not complete.
Another post will be made shortly addressing the NORPM 2019’s treatment of partnership and S corporation provisions in general, special election for direct investors in QOF partnerships and QOF s corporations, transfers of property by gift or by reason of death, disregarded transfers and certain types of non-recognition transactions and Section 1400Z, distributions and contributions of involving QOF stock, consolidated return provisions and a few other “niceties”.
This post was intended to be published for informational purposes only and may not be relied upon by the reader or any other person as legal advice of Fox Rothschild LLP or the lawyer posting this information. Persons reading this post should consult with their own tax counsel or tax adviser in order to be advised on the subject of the deferral and exemption of capital gains with respect to Opportunity Zones enacted into law as part of the Tax Cuts and Jobs Act of 2017. Please feel free to contact, however, your lead attorney in Fox Rothschild LLP or Jerry August of Fox Rothschild LLP if you have a question or comment on this subject.
 In making such designation, the factors to be taken into account are: (i) designating areas which reinforce on-going state, local, or private economic development initiatives; (ii) performing successfully in geographically targeted development programs, i.e., the new markets tax credit, empowerment zones, and renewal communities; and (iii) have experienced business closures or relocations.
 The Service, concurrently with NOPRM 2018, issued a revenue ruling on the application to real property of the “original use” requirement under §1400Z-2(d)(2)(D)(i)(II) and the “substantial improvement” requirement in §1400Z-2(d)(2)(D)(i)(II) and §1400Z-2(d)(2)(D)(ii) with respect to a purchased building in a QOZ.
 See §1275(a)(1); Treas. Reg. §1.1275-1(d).
 The Service will provide guidance on the manner by which an eligible taxpayer elects to defer gain under §1400Z-2. See Form 8948, which is attached to the Federal income tax return for the year in which the gain would have been recognized.