We thought we knew what we wanted for Christmas (at least one of us had made strong hints about Burning Man tickets). But the best gifts are surprises, and this year was no exception. Just days before the big day, the US Internal Revenue Service (the "IRS") released its gift of 544 pages of final regulations (the "Final Regulations") addressing the formation and operation of qualified opportunity funds ("QOFs).2 The final regulations replace, but also synthesize and build on, two prior sets of proposed regulations.3 This Legal Update provides a selective overview of the nowfinalized rules.
The Final Regulations are generally applicable to 2020 and later tax years.4 For 2018 and 2019, taxpayers may choose to rely on either the Final Regulations or the prior proposed regulations but cannot cherry-pick provisions from both sets.5
I. Brief Background
The legislative history accompanying the enactment of the QOF rules states that the provisions are intended to benefit low income communities by encouraging investments in such communities.6 The IRS has promulgated a list of communities (by census tracks) that qualify as opportunity zones.7 A QOF that invests in one or more opportunity zones provides the tax benefits described below for its investors.
Broadly speaking, the QOF rules operate as follows. An eligible taxpayer invests an amount equal to the capital gain that the taxpayer desires to defer into a QOF within 180 days from the date of the actual or deemed recognition of the capital gain. The QOF must be a partnership or corporation. This rule prevents the taxpayers who recognized the gains to be deferred from making qualified opportunity zone investments directly. The QOF then must make an investment in qualified opportunity zone property. Qualified opportunity zone property may be qualified opportunity zone stock, qualified opportunity zone partnership interests or qualified opportunity business property.
Mechanically, the statute operates on two separate tracks. One track governs the deferred gain and the second track governs the investment in the QOF. If the QOF investment is made prior to 2022 and the taxpayer holds the QOF investment for at least five years, he reduces the amount of the deferred gain by 10%. If the investment is made before 2020, and the taxpayer holds the QOF interest for at least seven years, another 5% of the originally deferred gain is reduced and the tax on such additional 5% is forgiven. In 2026 (or earlier if the investment is disposed of or there is another "inclusion event"), the lesser of the deferred gain (adjusted for the prior increases in basis) and the excess of the fair market value of the QOF investment over the taxpayer's basis is then recognized and subject to tax at the then applicable tax rate.
Substantial tax benefits are available for the investment in the QOF itself as well. The taxpayer is initially deemed to have a zero tax basis in the QOF, despite having invested cash (or property). Then leveraging the rules for the deferred gain, the basis in the investment is increased by 10% after five years and by another 5% after seven years. The basis increase frees up losses deferred by the lack of basis in a QOF partnership interest (up to the amount of the increase).8 If the investor holds its QOF investment for at least 10 years, the taxpayer may elect, on the date of disposition, to increase his basis to the fair market value of the investment. This rule provides a tax-free return on gains recognized with respect to the QOF investment held at least 10 years. In all cases, however, the income earned by the QOF during its life is taxed to the investor (or the QOF itself if it is a corporation) under the regular tax rules; that is, the QOF rules do not impact current income from the QOF investment.
A description of the QOF rules is complicated by the fact that the statute and Final Regulations contemplate two-tier structures in which the investors invest in a QOF and the QOF then invests in a lower-tier partnership (or corporation). The interest held by the QOF in the lower-tier partnership is one category of "qualified opportunity zone property" ("QOZP"). The lower-tier partnership will be QOZP only if its assets and operations meet specified requirements discussed below.
II. Date of a QOF Investment
In general, a holding period of property begins on the day following the day of acquisition.9 The QOF provisions of the Code, however, provide that a taxpayer's holding period for a QOF investment begins on the date of the investment.10 The Final Regulations acknowledge and sanction this disparity.
The date on which a QOF investment is considered to be made is crucial for many taxpayers seeking to take advantage of gain reduction rules. As described below, in many cases, gains from partnerships and certain other investments pass-through to taxpayers on December 31 of the year. A taxpayer may not make a contribution to a QOF prior to the date on which she recognizes a capital gain. Also as noted above, if a taxpayer desires to take advantage of the seven-year 5% gain reduction rule, she must invest in a QOF no later than December 31, 2019 (December 31, 2021 for the 10% gain reduction). The Final Regulations accommodate these overlapping rules by allowing taxpayers to make an investment in 2019 (and 2021) by making the contribution to the QOF on December 31, 2019 (2021). By making the investment on the last day of the year, the contribution will not be made prior to the date on which the gain is treated as recognized, and it is still made prior to the cut-off date for the seven-year 5% gain reduction rule. In 2021, the same situation will arise for the 10% gain reduction rule.
III. Gain Eligible to Be Invested in a QOF
The big change in the Final Regulations is that they now provide that eligible gains that may be deferred include gains from the sale or exchange of property described in Code § 1231(b) not required to be characterized as ordinary income by Code §§ 1245 or 1250, regardless of whether Code § 1231(a) would determine those gains to be capital or ordinary in character.11 In contrast to the net approach of the proposed regulations, the Final Regulations allow gross Code § 1231 gains, without regard to any Code § 1231 losses, to be rolled into QOFs. In addition, under the Final Regulations, the character of eligible Code § 1231 gains, other than as gains arising from the sale or exchange of Code § 1231 property, is not determined until the taxable year such gains are taken into account in computing gross income pursuant to Code § 1231(a)(4). In a very taxpayer-favorable change, the Final Regulations provide that the 180-day period for investing an amount with respect to an eligible Code § 1231 begins on the date of the sale or exchange that gives rise to such gain instead of the last day of the tax year.12
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1 The authors are all tax lawyers with the law firm of Mayer Brown.
2 T.D. 9889 (December 19, 2019).
3 REG-115420-18 (Dec. 2018) and REG-120186-18 (Apr. 2019). For coverage of the prior proposed regulations please see https://www.mayerbrown.com/en/perspectivesevents/ publications/2018/10/just-released-irs-qualifiedopportunity- fund-guida and https://www.mayerbrown.com/en/perspectivesevents/ publications/2019/04/mayer-brown-analyzessecond- set-of-qualified-opportunity-fund-regulations.
4 See Treas. Reg. § 1.1400Z2(a)-1(g)(1).
5 Treas. Reg. § 1.1400Z2(a)-1(g)(2).
6 H.R. 115-__, 115th Cong., 1st Sess. 398 (2017). Commentators have raised questions as to whether the legislation is wellsuited to its purpose. See https://www.nytimes.com/2019/11/16/opinion/trump-taxopportunity- zones.html.
See also Treas. Reg. § 1.1400Z2(f)-1(c).
7 IRS Notice 2018-48.
8 Treas. Reg. § 1.1400Z2(b)-1(g)(4)(ii).
9 Rev. Rul. 70-598, 1970-2 CB 168.
10 Code § 1400Z-2(a)(1)(A).
11 Treas. Reg. § 1.1400Z2(a)-1(b)(11)(iii).
12 Treas. Reg. § 1.1400Z2(a)-1(b)(7).
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