Opportunity Zones: Second Set Of Proposed Regulations Provide Clarity

On Wednesday, April 17, 2019, the Treasury Department and the Internal Revenue Service issued a broad, investment-friendly second set of Proposed Regulations (the “Proposed Regulations”) regarding “Qualified Opportunity Zones” (“QOZs”) and “Qualified Opportunity Funds” formed to invest in QOZs (“QOFs”). The first set of Proposed Regulations (the “Prior Proposed Regulations”), issued on October 19, 2018, contained helpful guidance but left numerous lingering issues and unanswered questions.1 The Proposed Regulations expand and modify the Prior Proposed Regulations in numerous ways that provide relief to QOFs and their investors and clarify the manner in which QOFs may be structured. The changes reflected in the Proposed Regulations are in most cases very favorable to investors and appear to reflect a desire by the government 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 Proposed 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 I - Effect of the Proposed Regulations on Tax 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:2

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 in an inclusion event (described below); 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 Proposed 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 fair market value of such interest plus the investor's share of the QOF partnership's liabilities under section 752, and the bases of the QOF partnership's assets 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 the partnership 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. These rules also avoid the creation of offsetting capital losses and ordinary income items under the technical partnership tax rules. (The consequences of an investor's election to eliminate certain capital gains of a QOF partnership or QOF REIT that are realized after the investor has held a qualifying investment for at least 10 years are discussed below.)

Carried Interests Issued by a QOF Do Not Qualify for QOZ Benefits

Where a person receives an interest in a QOF in exchange for services rendered to the QOF or to an entity in which the QOF holds any direct or indirect equity interest, the Proposed Regulations provide that the portion of such person's QOF interest received in exchange for such services is not treated as a qualifying investment. Thus, a profits interest in a QOF that is acquired for such services (a “carried interest”) is not eligible for QOZ benefits. Furthermore, a capital interest acquired in exchange for such services is also ineligible for QOZ benefits. Thus, generally speaking, only the investment of eligible gain gives rise to QOZ benefits. We note, however, that a fund manager may be allowed to benefit from an FMV Basis Election made by an upper-tier partnership in which the fund manager owns a carried interest, to the extent that such partnership holds qualifying investments in a QOF for more than 10 years and, through such election, eliminates gain that is allocable to the fund manager.

QOF Interests Acquired for Cash or Property from Their Current Holder Qualify for QOZ Benefits

If an investor acquires an equity interest in a QOF on or before December 31, 2026, in a secondary market transaction (that is, for cash or property from another investor in the QOF rather than from the QOF directly), such interest may be a qualifying investment if the investor has recent, eligible gain that can be deferred at that time.

Partnership Refinancing Distributions Generally Tax-Free After Two Years

Prior to the Proposed Regulations, it was unclear whether a QOF partnership could distribute debt proceeds to its owners without triggering the recognition of gain by such investors. The Proposed Regulations clarify that a distribution of cash by a QOF partnership to its investors generally does not trigger gain to the extent the distribution does not exceed the investors' bases in the QOF (including taking into account any increase in their bases attributable to the QOF's debt).

However, any distribution of cash or property will disqualify an investor's original transfer to the QOF partnership from beneficial QOZ treatment to the extent the overall transaction would be recharacterized as a disguised sale if the cash contributed to the QOF partnership had been non-cash property and the exception from disguised sale treatment for certain debt-financed distributions were ignored. Ordinarily, disguised sale treatment would be presumed for distributions made within two years of the contribution, and no disguised sale treatment would be presumed for distributions made more than two years after the contribution. Thus, it appears that distributions by a QOF partnership to its partners that are (i) made more than two years after the investors' contributions to the QOF, and (ii) do not exceed the investors' bases in their QOF interests generally would not trigger gain or otherwise disqualify the investors' interests. Nevertheless, consideration should be given as to whether the facts and circumstances of any such distribution (e.g., where the distribution is certain to be made) could disqualify the investors' qualifying investment even where such distribution is made more than two years after the investors' contributions.

A refinancing distribution by a QOF corporation (including a QOF REIT) generally will be taxable to a shareholder in the QOF to the extent the distribution exceeds the shareholder's basis in its shares of the QOF. However, because a shareholder's basis in its shares is not increased by its share of the QOF corporation's debt, and the shareholder's basis in its qualifying QOF shares is zero until increased by the QOZ rules upon the fifth and seventh anniversaries of investment and on December 31, 2026, a QOF REIT (or other QOF corporation) may have less flexibility to make tax-free distributions of refinancing proceeds than a comparable QOF partnership.

Investors in QOF Partnerships and REITs Who Have a Holding Period in Excess of 10 Years Now Allowed to Benefit from the 10-Year Gain Elimination Provision Even Where QOF Sells Underlying Properties

Prior to the issuance of the Proposed Regulations, one of the most challenging structuring issues facing QOFs related to the fact that, under the statute and the Prior Proposed Regulations, the ability of QOF investors to eliminate gain after their 10-year holding period appeared to be available only upon a sale of interests...