On January 13, 2020, the Treasury Department and the Internal Revenue Service published final regulations (the Final Regulations) regarding Qualified Opportunity Zones (QOZs) and Qualified Opportunity Funds formed to invest in QOZs (QOFs). The first set of proposed regulations, released on October 19, 2018, contained helpful guidance but left numerous lingering issues and unanswered questions. A second set of proposed regulations, released on April 17, 2019 (together with the first set of proposed regulations, the Proposed Regulations), provided relief to QOFs and their investors and clarified the manner in which QOFs may be structured. The Final Regulations largely adopt the Proposed Regulations; most of the changes and additions made by the Final Regulations are clarifying in nature. A few of the changes, however, are significantly favorable to investors, which reflects the government's continuing commitment to facilitate broad investment in QOFs by eligible investors. This note provides a detailed analysis of the most important clarifications and changes made by the Final Regulations, specifically focusing on those changes that will make it easier for investment vehicles to qualify as QOFs and for investors to make qualifying investments in QOFs.
Part ITax Benefits Derived from Investing in QOFs
Overview of Tax Benefits
A qualifying investment in a QOF is an equity interest in a QOF that has been acquired for cash (or property, subject to certain limitations) with respect to which the investor has made an election to defer eligible capital gain that would otherwise be recognized no more than 180 days before the day the interest in the QOF was acquired. An eligible investor may obtain three types of federal income tax benefits as a result of its qualifying investment in a QOF:
a temporary deferral of any eligible gains invested into a QOF so long as such gains are invested within the 180-day investment period and the investor makes the gain-deferral election; if the investor holds its qualifying investment for at least 5 years, the tax basis of the qualifying investment is increased on the fifth anniversary of the investment by 10 percent of the amount of gain initially invested in the qualifying investment, and if the investor holds its qualifying investment for at least 7 years, the tax basis of the qualifying investment is increased on the seventh anniversary of the investment by an additional 5 percent of the amount of such gain; however, these basis increases apply only if the relevant anniversary occurs before December 31, 2026 and only to the extent the deferred gain has not already been recognized. Thus, for qualifying investments made in 2020 or 2021, only a 10 percent basis increase (and not a 15 percent increase) will be available; and if the investor holds its qualifying investment for 10 years or more, the investor may elect for the basis of such qualifying investment to be equal to its fair market value on the date such interest is sold or exchanged (the FMV Basis Election) and thus generally will not recognize gain on the sale of its qualifying investment 10 years or more after it acquired such interest. Sale of Interests in a QOF Partnership does not Trigger Depreciation Recapture or Other Ordinary Income Items
The Final Regulations clarify that, if an investor in a QOF that is taxed as a partnership (i.e., a QOF partnership) makes the FMV Basis Election upon its sale of QOF interests after 10 years:
the investor's basis in its qualifying investment in the QOF is adjusted immediately before the investor sells or exchanges such interest so that its basis equals the greater of (1) the investor's allocable share of the non-recourse debt of the QOF partnership and (2) the sum of the fair market value of such interest and the investor's share of the QOF partnership's liabilities under section 752, and the bases of the QOF partnership's assets, and the assets of any partnership in which the QOF partnership holds an interest, are also adjusted, solely with respect to such investor, in a manner similar to the adjustments that would have been made to the QOF partnership's assets if the investor had purchased the interest for cash equal to fair market value at the effective time of the FMV Basis Election and such partnerships had a valid section 754 election in effect. The effect of these rules is to eliminate any gain upon the investor's sale or exchange of a qualifying investment after a 10-year holding period, regardless of whether the investor has used net losses allocated by the QOF partnership and whether the investor has received substantial leveraged distributions from the QOF partnership. Under the Proposed Regulations, it was unclear whether the IRS might interpret the rules to require the inclusion by the investor of ordinary income with respect to depreciation that had been taken by a partnership in which the QOF partnership held an interest.
Investors in QOF Partnerships Who Have a Holding Period in Excess of 10 Years now Generally Allowed to Benefit from the Gain Elimination Provision where QOF or QOZB (or Other Lower-Tier Partnership) Sells Underlying Assets
The Final Regulations expand the reach of the 10-year gain elimination provision by providing that when a QOF partnership (directly or indirectly through a partnership in which the QOF partnership holds an interest) recognizes gain from the sale of any property (other than inventory sold in the ordinary course of business), any investor in the QOF partnership who has held a qualifying investment in such QOF partnership for more than 10 years can make an election to eliminate the gain attributable to the investor's qualifying investment. In order to benefit from such gain elimination, the property that is sold does not need to be qualified opportunity zone property (QOZP), the gain that is recognized does not need to be capital gain, and, if a lower-tier partnership sells the property and allocates gain to the QOF partnership, the lower-tier partnership does not need to qualify as a qualified opportunity zone business (QOZB). The investor's election to exclude such gain applies to all of the gains and losses (other than from dispositions of inventory in the ordinary course of business) allocable to the investor from the QOF partnership (including gains and losses of lower-tier partnerships) during the year to which the election relates. To the extent the QOF partnership directly or indirectly reinvests or retains the electing investor's share of the net proceeds from any such sale during such year, that portion of the investor's investment in the QOF partnership will become a non-qualifying investment (and thus ineligible for the benefits of the QOZ regime). Specifically, the QOF partnership is treated as distributing to the electing investor its share of net proceeds from the asset sales on the last day of the QOF's taxable year. Immediately after the deemed distribution, the electing investor is treated as recontributing the amount received in exchange for a non-qualifying investment. The QOF partnership is treated as retaining or reinvesting the electing investor's share of the net proceeds, except to the extent it makes an actual distribution of sales proceeds to the investor within 90 days of the asset sale.
The Final Regulations are more taxpayer-favorable than the Proposed Regulations insofar as the Proposed Regulations only allowed investors to exclude capital gain from the disposition of QOZ property by the QOF partnership. As a result, under the Final Regulations, a direct disposition by the investor of its qualifying investment in the QOF partnership after 10 years generally would not be more advantageous to the investor than a sale by the QOF of the assets it holds directly and indirectly. A fund platform composed of multiple side-by-side QOF partnerships, however, still allows the investors in the platform to recognize losses recognized in respect of one or more of the QOFs while electing to eliminate gains recognized in respect of one or more other QOFs, which will not be possible in the case of multi-asset QOF partnerships to the extent gains and losses are recognized by the QOF during the same taxable year.
A similar election is available to shareholders of a QOF REIT with respect to capital gain dividends of the REIT attributable to long-term capital gain recognized by the REIT on any sale or exchange of QOZ property after the 10-year holding period for the shareholder has been achieved. The Final Regulations provide that electing shareholders exclude from income any capital gain dividend to which the election applies, which generally will allow the shareholders to avoid state and local income tax on the dividend in states that have conformed their income tax laws to federal law in respect of QOF investments (or conform to federal income tax law generally); the Proposed Regulations had required electing shareholders to include the dividend as income to which a zero percent rate of federal tax applied. Because a QOF REIT can pass through this benefit only with respect to gross items of long-term capital gain the REIT recognized on any sale or exchange of QOZP, it remains unclear whether capital gains recognized by a partnership in which the REIT has invested are eligible. Furthermore, ordinary income recapture recognized by a REIT will, outside the context of a liquidation of the REIT, give rise to REIT ordinary dividends that cannot be eliminated from the investor's income. The Final Regulations apply the same rules to QOF RIC capital gain dividends as to QOF REIT capital gain dividends.
Events that Trigger Inclusion of Deferred Gain
The statute provides that the amount of gain that is deferred with respect to a qualifying investment generally must be included in the investor's income in the taxable year that includes the earlier of (A) the date on which the...