Gain Deferral Using Qualified Opportunity Zone Investment Strategies

This Legal Update provides an overview of the "Qualified Opportunity Zone" rules.1 These rules provide for generous deferrals of recognized capital gains, potentially some capital gains exemptions and potentially tax-free returns on the Qualified Opportunity Zone investment itself. We first provide a discussion on the background and legislative intent behind the rules. We then provide a discussion on key concepts within the Qualified Opportunity Zones program, the tax incentives associated with Qualified Opportunity Zone investments and address some of the unresolved issues surrounding the program. We are seeing offering of investments in funds that invest in Qualified Opportunity Zones already springing up.

The Qualified Opportunity Zone rules are complex but provide a fair amount of flexibility. Therefore, we urge investors to not exclude Qualified Opportunity Zone business plans based on the nature of the assets involved, but rather to consult a tax advisor regarding the application of the rules to their particular facts.

Background

In December 2017, the Qualified Opportunity Zone rules were enacted as part of "Tax Cuts and Jobs Act" (a.k.a., the 2017 tax reform legislation).2 The opportunity zones program is the first new federal community development tax program since the Clinton administration. On a high level, these new provisions establish a new community development program to promote long-term investments in low-income communities nationwide and drive long-term capital to underserved communities. The Qualified Opportunity Zones program affords a tax incentive to investors to reinvest their gains into funds that invest in Qualified Opportunity Zones.

What is a Qualified Opportunity Fund?

"Qualified Opportunity Funds" are investment vehicles that hold at least 90 percent of their assets in "Qualified Opportunity Zone Property" and deploy capital in Qualified Opportunity Zones.3 A Qualified Opportunity Fund must meet certain requirements and make certain tax filings.4

The Qualified Opportunity Fund must be organized as a "corporation" or "partnership."5 (It is unclear as to whether an opportunity fund may be organized as a limited liability company.) Qualified Opportunity Zone Property includes three items: (1) newly issued stock, (2) newly- issued partnership interests and (3) business property. Qualified Opportunity Zone Partnership Interests and Stock are equity interests in certain businesses that operate in Qualified Opportunity Zones. We explore these rules in more detail below.

Qualified Opportunity Zones

The zones were selected by the US Department of the Treasury (Treasury) after nomination by governors. A Qualified Opportunity Zone is defined as "a population census tract that is a low-income community that is designated as a qualified opportunity zone." Importantly, on June 21, 2018, the US Internal Revenue Service (IRS) published a list of all Qualified Opportunity Zones in the United States and Puerto Rico.6 The list of Qualified Opportunity Zones can be found at https://www.cdfifund.gov/Pages/Opportunity-Zones.aspx.

Qualified Opportunity Zone Partnership Interests and Stock

A qualified opportunity zone partnership interest is any capital or profits interest in a domestic partnership. In this case, the rules envision tiered structures: the Qualified Opportunity Zone Fund (which may be a partnership) will acquire an interest in another partnership that itself is engaged in the qualified opportunity zone business. Importantly, however, a Qualified Opportunity Zone Fund may not invest in another Qualified Opportunity Fund.7 The interest must be acquired by the Qualified Opportunity Fund (i) solely in exchange for cash and (ii) after December 31, 2017. Additionally, when the interest is acquired, the partnership must have been a qualified opportunity zone business (discussed below), or be a new partnership formed for purposes of being engaged in a qualified opportunity zone business. Lastly, during substantially all of the Qualified Opportunity Fund's holding period of the interest, the lower-tier partnership must be engaged in a qualified opportunity zone business.

The requirements for qualified opportunity zone stock are the same as a qualified opportunity zone partnership. Likewise, the stock must be issued by a domestic corporation (as opposed to a domestic partnership).

Qualified Opportunity Zone Business Property

"Qualified Opportunity Zone Business Property" is defined as tangible property used in a trade or business of the Qualified Opportunity Fund. Qualified Opportunity Zone Property must be acquired by the Qualified Opportunity Fund from unrelated parties, in a transaction that is not a carryover basis transaction,8 and the acquisition must occur after December 31, 2017.

Importantly, either (i) "the original use" of the property must commence with the Qualified Opportunity Fund or (ii) the Qualified Opportunity Fund must "substantially improve" the property. Lastly, during "substantially all" of the Qualified Opportunity Fund's holding period of the property, the use of the Qualified Opportunity Zone Property must be in a Qualified Opportunity Zone. The term "substantially all" appears multiple times in the statutory language but is not defined in the statute or the legislative history.

The term "original use" is not defined in statute, but regulations and case law provide guidance on how the term will likely be interpreted. We expect original use to mean "the first use to which the property is put, whether or not such use corresponds to the use of such property by the taxpayer."9

For the additional requirement for used property (i.e., property the original use of which does not begin with the Qualified Opportunity Fund), "substantial improvement" is considered to occur only if, during the 30-month period after the date of the acquisition of the property, additions to the basis with respect to such property in the hands of the Qualified Opportunity Fund exceed an amount equal to the adjusted basis of such property at the beginning of such 30-month period in the hands of the Qualified Opportunity Fund.10 This rule allows real estate developers to purchase used real estate and significantly improve the property without having to meet the original use requirement.11

Qualified Opportunity Zone Business

A partnership interest or stock acquired by a Qualified Opportunity Fund must be a stake in a corporation or partnership that meets three sets of requirements (a "Qualified Opportunity Zone Business").12 It is important to note that the rules do not require Qualified...