Second Wave Of Opportunity Zone Guidance Addresses Many Key Issues, Leaves Open Questions For Future Guidance

Introduction

The Treasury Department and the Internal Revenue Service (the IRS) recently issued a second set of proposed regulations concerning the taxation of qualified opportunity zone funds (OZ funds) and their investors. In our previous client alerts "Opportunity Zone Funds Offer New Tax Incentive for Long-Term Investment in Low-Income Communities" and "New Guidance for Opportunity Zone Funds Clarifies Important Issues, Leaves Door Open to Additional Guidance," we outlined the basic rules of the opportunity zone (OZ) regime, described the first set of proposed OZ regulations and identified a number of issues that were left unresolved. Like the initial proposed regulations, the new proposed regulations provide thoughtful, pragmatic, policy-oriented guidance on key issues and can be expected to encourage the formation and capitalization of OZ funds by:

allowing investors to enjoy the tax exemption for gain on OZ fund investments held for 10 years (the OZ tax exemption) in cases where the OZ fund sells assets; providing a grace period to allow an OZ fund to deploy cash in a commercial manner following a capital raise; clarifying that an investor's outside basis in an OZ fund partnership interest is increased by the investor's share of the OZ fund partnership's debt, which is critically important for OZ fund partnerships focused on real estate; clarifying that an OZ fund can own and develop operating companies, including technology companies and service businesses; clarifying that an OZ fund can retain its status as such, notwithstanding certain unforeseen delays in the development of its property or the start-up of its business; providing rules pursuant to which an OZ fund or a qualified opportunity zone business (QOZB) (i.e., a corporation or partnership in which an OZ fund owns an interest) can lease its assets, including from related parties; clarifying the "substantial improvement" requirement; clarifying that certain real property leasing activities will satisfy the "active trade or business" requirement; providing safe harbors for the 50% income test applicable to QOZBs; clarifying that an OZ fund can reinvest asset sale proceeds in qualified opportunity zone property (QOZP); narrowing the types of events that will trigger an OZ investor's deferred gain; and clarifying that an investor can use OZ-eligible capital to acquire an OZ fund interest on the secondary market, which will increase the liquidity of OZ fund interests generally and provide OZ fund sponsors with the ability to warehouse OZ fund interests pending syndication to OZ fund investors. Although the regulations will become effective once finalized, a taxpayer may generally rely on them before then as long as the taxpayer applies the rules consistently and in their entirety. A taxpayer's ability to rely on the rules, however, does not extend to certain rules regarding the application of the OZ tax exemption to the disposition of an OZ fund interest. Although these rules will not become relevant until January 1, 2028 (at the earliest), they may be germane to structuring decisions made when the OZ fund is formed and acquires a QOZB, and the inability of taxpayers to rely on them is of concern.

Below is a summary of key provisions of the new proposed regulations and a discussion of important issues that remain unaddressed.

1. OZ Tax Exemption Available for Certain OZ Fund Asset Sales

   Perhaps the most powerful incentive provided by the OZ regime is the OZ tax exemption, which allows eligible investors to exclude gains realized on the sale of an OZ fund interest held for at least 10 years. The statute is unclear whether the exemption applies in circumstances other than the sale by an investor of its OZ fund interest. This caused concern particularly among investors in and sponsors of multi-asset OZ funds organized as partnerships or REITs, where, but for the requirements of the OZ regime, liquidity events would generally take the form of asset sales by the OZ fund or its subsidiaries. The new proposed regulations helpfully allow investors that satisfy the 10-year holding period to enjoy the OZ tax exemption on certain gains passed through to them when the OZ fund sells its assets.

   It is important to note, however, that, depending on the structure of the OZ fund and the level at which gain is recognized, similarly situated investors may experience disparate tax results, although it is not clear that these differences were intended. For example, it is clear under the new proposed regulations that an eligible investor that sells an OZ fund interest will not be subject to depreciation recapture with respect to assets held directly or indirectly by the OZ fund and that the investor can avail itself of the OZ tax exemption even if the OZ fund holds assets that are not QOZP. This is true regardless of whether the OZ fund is a partnership, an S corporation, or a REIT. Conversely, it would appear that, in the case of an OZ fund organized as a partnership or an S corporation, eligible investors will enjoy the OZ fund tax exemption only with respect to capital gains recognized by the OZ fund on the sale of QOZP and not with respect to gains characterized as ordinary income1 or gains recognized by the OZ fund on the sale of non-QOZP assets (such as intangibles and securities other than equity interests in a QOZB). The exemption also does not seem to apply to gains recognized on the sale of assets by a QOZB, whether or not such assets constitute QOZP. Accordingly, although the new proposed regulations expand the options for an OZ fund to exit an investment, these differences in income tax consequences may limit the ability of investors to avail themselves of these options.

   In the case of an OZ fund REIT, the OZ tax exemption seems to apply with respect to any capital gain dividends attributable to long-term capital gains, whether recognized at the OZ fund level or by a QOZB, although it is unclear whether the exemption is limited to capital gains recognized on the sale of QOZP. In addition, because the new proposed regulations specifically extend the OZ tax exemption only to REIT capital gain dividends, it seems dividends attributable to depreciation recapture would not be eligible for the exemption. As a consequence, some REIT OZ funds may find it prudent to structure a liquidity event as a sale of REIT assets followed by a series of liquidating distributions, rather than as a series of non-liquidating capital gain dividends. This is because the former structure entitles the OZ fund investor to the OZ tax exemption on all distributions made by the REIT in liquidation, including distributions in respect of non-QOZP assets and attributable to depreciation recapture.

2. 90% Asset Test Excludes Newly Raised Capital for Six Months, Potentially Extending Capital Deployment Period to as Long as 43 Months

   Under the statute, no more than 10% of an OZ fund's assets may consist of non-QOZP, including cash held as working capital, and a QOZB can hold only limited amounts of cash in excess of its reasonable working capital needs. These restrictions, together with the requirement that investors acquire their OZ fund interests within 180 days of a capital gain realization event, hindered the capital raising...