INSIGHT: The Second Set of Proposed Opportunity Zone Regulations: Where Are We Now?

On April 17, 2019, the Treasury Department issued a highly anticipated second set of proposed regulations on opportunity zones (the “2019 proposed regulations”). The opportunity zone (OZ) program has received significant national attention as an ambitious and generous tax incentive aimed at driving investment into the nation’s most distressed communities.

This part of the series addresses the regulations regarding when a taxpayer must include in income gains previously deferred by investment in a qualified opportunity fund (QOF) and investment holding periods.

What circumstances are treated as “inclusion events”—events that require a taxpayer to include in income gains that were previously deferred?

The 2019 proposed regulations provide a long list of “inclusion events” and a significant amount of guidance related to the various tax consequences of inclusion events. Inclusion events are relevant only until the taxpayer has included in income all of the gain deferred through investment in a QOF. Thus, after Dec. 31, 2026, the guidance regarding inclusion events is no longer relevant.

The general rule is that a taxpayer recognizes the gain it has deferred through investment in a QOF on the earlier of the date of an inclusion event or Dec. 31, 2026. Generally, an event is an inclusion event only if and to the extent that a taxpayer transfers all or part of its qualifying investment and that transfer reduces the taxpayer’s equity interest in the QOF. However, subject to additional rules and exceptions, a taxpayer’s receipt of a distribution from a QOF can be an inclusion event regardless of whether the taxpayer’s ownership interest in the QOF is reduced.

Inclusion Events:

sale or exchange of all or a portion of a qualifying investment to the extent that there is a reduction in the taxpayer’s equity interest in the qualifying investment; note that a taxpayer’s transfer of its qualifying investment to an entity that is disregarded as separate from the taxpayer for federal income tax purposes is not an inclusion event because the transfer is disregarded for federal income tax purposes;

subject to exceptions, the receipt of property (including cash) in a distribution (regardless of whether the taxpayer’s equity interest is reduced);

termination or liquidation of the QOF;

liquidation of QOF owner (QOF shareholder or partner)(with special rules for tax code Section 336 and 337 distributions);

claim of worthlessness;

gifting a QOF qualifying investment (although there are special rules for transfers to grantor trusts); and

any transaction that has the effect of reducing either (1) the amount of remaining deferred gain of one or more direct or indirect partners, or (2) the amount of gain that would be recognized by those partners on a fully taxable disposition of the qualifying investment that gave rise to the inclusion event to the extent that such amount would reduce that gain to an amount less than the remaining deferred gain (this rule is referred to as the “remaining deferred gain reduction rule”).

A transfer of a QOF qualifying investment by reason of death is generally not an inclusion event. In addition, a contribution of a qualifying investment in a QOF to a grantor trust where the owner of the qualifying investment is the deemed owner of the trust under the grantor trust rules, is not an inclusion event. However, a change in grantor trust status is an inclusion event unless it is a termination of grantor trust status by reason of the death of the owner.

Subject to the remaining deferred gain reduction rule, a tax code Section 721 contribution of a qualifying investment in a QOF partnership is generally not an inclusion event as long as the transfer does not cause a termination of the QOF partnership or the direct or indirect owner of the QOF. The inclusion rules will apply, however, to any part of the transaction to which Section 721(a) does not apply. In addition, again subject to the remaining deferred gain reduction rule, a tax code Section 708(b)(2)(A) merger or consolidation of a partnership that holds a qualifying investment, or of a partnership that holds an interest in such partnership, in a Section 708(b)(2)(A) transaction, is generally not an inclusion event. However, the general inclusion rules will apply to any part of the transaction that is otherwise treated as a sale or exchange.

Subject to the remaining deferred gain reduction rule, an actual or deemed partnership distribution allocable to a qualifying investment is only an inclusion event to the extent that the distributed property has a fair market value in excess of the partner’s basis in the qualifying investment. This should allow distributions of operating cash flow in many circumstances (due to the allocation of income that will increase investors’ bases).

Notwithstanding any of the regulatory guidance on inclusion events, the regulations provide the Commissioner with the ability to publish guidance providing that a type of transaction is or is not an inclusion event.

There are additional rules in the regulations regarding inclusion events that are related to S corporations and C corporations that are not analyzed in this article.

If an inclusion event occurs, what is the amount of gain included in gross income?

As an overall limitation, the total amount of gain included in gross income on the date of an inclusion event is limited to the remaining amount of deferred gain reduced by any increase in basis made under tax code Section 1400Z-2(b)(2)(B)(iii)(the 10 percent step-up in basis after five years) or Section 1400Z-2(b)(2)(B)(iv)(the 5 percent step-up in basis after seven years).

Subject to the overall limitation, the determination of the amount of gain included in gross income when an inclusion event occurs is dependent upon the type of inclusion event.

Certain Enumerated Inclusion Events:

If there is an inclusion event due to any of the following:

a distribution by a QOF partnership in excess of a partner’s basis,

application of the remaining deferred gain reduction rule,

a distribution by a QOF C corporation,

a dividend-equivalent redemption,

a qualifying tax code Section 381 transaction,

a tax code Section 355 transaction,

a recapitalization, or

a tax code Section 1036 transaction.

the amount of deferred gain included in gross income is equal to the lesser of (1) the remaining deferred gain, or (2) the amount that gave rise to the inclusion event. The “amount that gave rise to the inclusion” is dependent upon the type of inclusion event and, in most cases, is specifically defined in the regulations (e.g., on a partnership distribution that is an inclusion event, this amount would be the amount of the distribution that exceeds the distributee partner’s basis).

Example: On Jan. 15, 2019, Taxpayer A realizes $500,000 of capital gain that it can defer through investment in a QOF. On June 1, 2019, A invests the $500,000 into a QOF partnership in exchange for a qualifying investment. On August 1, 2022, the QOF borrows $200,000 on a recourse basis and the liability is allocated entirely to partners other than A. On Dec. 1, 2022, the QOF distributes $100,000 in cash to A. The $100,000 distribution to A is an inclusion event because it exceeds A’s basis in its qualifying investment (which is zero). The amount of the deferred gain that A recognizes is $100,000 (the lesser of the $500,000 of remaining deferred gain and the $100,000 amount that gave rise to the inclusion event). Note that under the basis ordering rules, A will increase its basis in its QOF interest by the $100,000 of included gain before A determines the other tax consequences of the event. Thus, A recognizes no gain under tax code Section 731 in this example. After the distribution, A’s basis is zero (increased by $100,000 due to the inclusion of deferred gain in income and decreased by $100,000 due to the distribution).

Other Inclusion Events:

For other inclusion events, subject to the overall limitation, the amount of remaining deferred gain included in gross income is determined as follows (unless the special rule applicable to a QOF partnership or S corporation applies):

(1) Multiply the fair market value (on the date of the inclusion event) of the taxpayer’s entire qualifying investment in the QOF by the percentage of the taxpayer’s qualifying investment that was disposed of in the inclusion event = the fair market value of the portion of the qualifying investment that was disposed of in the inclusion event (x);

(2) Determine the ratio of x/y where “y” is the fair market value of the total qualifying investment immediately prior to the inclusion event;

(3) Multiply that ratio (x/y) by the remaining deferred gain, which gives you an amount that bears the same proportion to the remaining deferred gain as the fair market value of the portion of the qualifying investment that was disposed of bears to the fair market value of the total qualifying investment;

(4) Take the lesser of the amount determined under (3) and “y” (the fair market value of the total qualifying investment); and

(5) Determine the excess, if any, of the amount determined under (4) over the taxpayer’s basis in the portion of the qualifying investment disposed of in the inclusion event = amount of deferred gain included in gross income.

In a QOF partnership or S corporation, this computation is done differently. In that context, the deferred gain included in gross income is determined as follows:

(1) Determine the remaining deferred gain (taking into consideration any basis adjustments that have been made under tax code Section 1400Z-2(b)(2)(B)(iii) (five-year step-up) or (iv) (seven-year step-up));

(2) Multiple the amount determined in (1) by the percentage of the qualifying investment that gave rise to the inclusion event; and

(3) Compare the amount determined in (2) to the gain that would be recognized on a fully taxable disposition of the qualifying investment that gave rise to the inclusion event; the lesser amount is the deferred gain included in gross income.

Example:
On Jan. 15, 2019, Taxpayer A realizes $500,000 of capital gain that it can defer through investment in a QOF. On June 1, 2019, A invests the $500,000 into a QOF partnership in exchange for a qualifying investment. On August 1, 2020, the QOF borrows $200,000 on a nonrecourse basis. A’s allocable share of the debt is $100,000. On July 15, 2024, A sells 50 percent of its qualifying investment in the QOF for $400,000 cash. At the time of the sale, the fair market value of the QOF’s property is $1.8 million. Assume that there are no other inclusion events, distributions, allocations, or changes in the amount or allocation of outstanding debt. At the time of the sale, A has held the qualifying interest for over five years and, therefore, there is a 10 percent increase in the basis of the interest. A’s basis in its entire interest immediately prior to the sale is, therefore, $150,000 (original zero basis plus $100,000 liability share plus $50,000 five-year step-up in basis). The sale of 50 percent of A’s interest requires A to recognize $225,000 of previously deferred gain (the lesser of $225,000 (remaining deferred gain ($450,000) x the percentage of the qualifying investment that A sold (50 percent)) or $325,000 (the gain A would recognize on a fully taxable disposition of 50 percent of A’s interest ($400,000 minus $75,000 basis)). A also recognizes $100,000 of gain with respect to the appreciation in the interest sold.

The amount of gain recognized on Dec. 31, 2026, is equal to the excess of (1) the lesser of (a) the remaining deferred gain, and (b) the fair market value of the qualifying investment held on Dec. 31, 2026 over (2) the taxpayer’s basis in the qualifying investment on Dec. 31, 2026.

Does a partner in a QOF partnership receive a basis increase equal to its allocable share of liabilities?

Under Subchapter K, tax code Section 752(a) treats any increase in a partner’s share of partnership liabilities as a contribution of cash by the partner to the partnership. Generally, a partner increases its basis in its partnership interest in an amount equal to its allocable share of partnership liabilities. The 2018 proposed regulations provided that deemed contributions of cash to a QOF taxed as a partnership that occur when the QOF incurs debt do not create a separate interest in the fund (to which the opportunity zone tax benefits would not have attached). However, those regulations did not specifically address whether that meant that a partner in a QOF is allowed to increase its basis in a qualifying investment by the amount of its allocable share of partnership liabilities. The provisions and the examples in the 2019 proposed regulations make it clear that this basis increase is allowed.

If an investor has a mixed-funds investment in a QOF partnership, does the investor have two separate bases?

Yes. A partner that holds both a qualifying investment and a non-qualifying investment in a QOF partnership is treated as holding two separate interests in the partnership and the basis of each interest is computed separately. Thus, all tax code Section 704(b) allocations of income, gain, loss and deduction, all tax code Section 752 allocations of debt, as well as distributions, that a QOF partnership makes with respect to a partner who owns both a qualifying and non-qualifying investment are treated as if they are made to two separate interests based on the allocation percentages of the interests. The allocation percentages are determined based on the relative capital contributions attributable to each investment. If either or both of the partner’s interests are increased (e.g, the partner makes an additional contribution to the QOF), the partner’s interests are valued immediately prior to the event and the allocation percentages are adjusted accordingly.

What are the rules applicable to debt-financed distributions by a QOF partnership?

This may be the question most often asked by potential investors in QOFs that are investing in real estate development—can the investors receive a tax-free debt-financed distribution without triggering gain and/or jeopardizing the OZ tax benefits? Normally, under Subchapter K, a partner is able to receive a debt-financed distribution tax-free to the extent of that partner’s adjusted basis in the partnership. A liability allocation increases basis and a subsequent distribution of proceeds from the borrowing is tax-free to the extent of the partner’s adjusted basis.

Under the proposed 2019 regulations, a debt-financed distribution is generally allowed. There is an example in the regulations of a QOF that borrows money on a nonrecourse basis three years after investors make their qualifying investments in the QOF; in that example, the debt is allocated to the investors in accordance with the rules under tax code Section 752(a) and the QOF distributes a portion of the proceeds from the borrowing to one of the investors. In the example, the distribution is not an inclusion event (does not trigger inclusion of previously deferred gain) and there is no gain recognized on the distribution because the investor has sufficient basis to absorb the distribution. The investor’s basis in its QOF interest is reduced by the amount of the distribution.

However, there are two very important exceptions to the general rule that a debt-financed distribution from a QOF partnership does not affect the availability of OZ benefits:

(1) There is a provision that treats any distribution from a QOF partnership to a QOF investor holding a qualifying investment that has remaining deferred gain as an inclusion event if and to the extent that the distribution exceeds the distributee partner’s tax basis. Note that if the investor holds a mixed-funds investment, only the portion allocable to the qualifying investment is subject to this rule. The general tax code Section 731 distribution rules will apply to the remainder of the distribution. Note also that, as discussed in the inclusion event sections above, this rule applies to any distribution from the QOF, not just a debt-financed distribution.

(2) There is a provision that requires the QOF partnership to analyze any distribution to determine whether the tax code Section 707 disguised sale rules would treat the contribution of cash or other property to the QOF in exchange for the qualifying investment and the subsequent distribution as a disguised sale. In making this determination, (a) any cash contributed is treated as non-cash, and (b) in the case of a debt-financed distribution, the partner’s share of liabilities is zero. If, applying these rules, the distribution would be a disguised sale under Section 707, then to the extent there would have been a disguised sale, the original transfer of the deferred gain to the QOF partnership is not treated as an investment for which a deferral election could be made. Again, this rule applies to any distribution from the QOF, not just a debt-financed distribution.

Comment: A QOF partnership must carefully examine any distributions it makes to an investor within the first two years of an investor’s otherwise qualifying investment in the QOF. A distribution after this two-year time period that is in excess of an investor’s basis will also be problematic under (1) above in that it is considered an inclusion event (triggering recognition of a portion of the original deferred gain) to the extent it exceeds the distributee’s basis and is made while the distributee still has remaining deferred gain. However, distributions within 2 years, if treated as Section 707 disguised sales under the rule described in (2) above, will actually change the character of the investor’s original investment from a qualifying investment to a non-qualifying investment. It is important to note that when analyzing whether the Section 707 rules apply, a cash contribution is treated as a non-cash contribution—so even if an investor has not contributed property other than cash to the QOF and even if the investor is receiving cash in the distribution, the disguised sale rules can apply to re-characterize the investment for OZ purposes.

How do you determine the holding period of a QOF investment?

The holding period for a QOF investment is extremely important because the OZ tax benefits are dependent upon an investor holding a qualifying investment for five, seven, and 10 years. If a taxpayer receives a qualifying investment in a QOF in exchange for property, the taxpayer’s holding period for the qualifying investment is determined without regard to the taxpayer’s holding period in the property that was transferred to the QOF.

If a taxpayer receives a qualifying investment in a QOF as a gift that was not an inclusion event (i.e., a contribution to a grantor trust) or by reason of the prior owner’s death, the taxpayer’s holding period for the qualifying investment includes the time that the donor or deceased owner held the interest. In other words, the holding period tacks.

There are additional holding period rules in the regulations relevant to C corporations that are not discussed in this article.

How do the basis adjustment rules apply in the context of a tiered arrangement?

The 2019 proposed regulations provide that in the context of a tiered arrangement (e.g., a situation in which a QOF investor is itself a partnership), the five, seven, and 10 year basis step-ups are allocated to the owners of the QOF and to the owners of any partnerships that directly or indirectly (solely through one or more partnerships) own the QOF interest. The adjustments will track to the owners’ interests based on their shares of the remaining deferred gain to which the adjustments relate.

If, after an investor holds an interest in a QOF partnership or S corporation for at least 10 years, the QOF sells qualified opportunity zone property, is the taxpayer able to elect to exclude from income its share of the gain from the sale?

Yes. The 2019 proposed regulations provide that if a taxpayer has held a qualifying investment in a QOF partnership or S corporation for at least 10 years and the QOF disposes of qualified opportunity zone property after that 10 year holding period, the taxpayer can elect to exclude from gross income its share of the capital gain arising from the disposition that is reported on the K-1 and is attributable to the qualifying investment. The taxpayer makes the election for the taxable year in which the capital gain recognized by the QOF partnership or S corporation would otherwise be included in the taxpayer’s gross income in whatever manner is prescribed in forms and instructions.

Comment: This is a very impactful and much-needed provision that goes a long way toward solving the issue that existed with respect to exit strategy out of a QOF partnership or S corporation. The statute provides for a basis step-up to fair market value on the “sale or exchange” of a fund interest after the investor has held the interest for at least 10 years. The issue is that if a fund that is a pass-through sells assets and distributes the proceeds, that is not a “sale or exchange” of the fund interest for tax purposes. Forcing the sale of the fund interest versus a sale of the assets is not economically feasible in many situations.

Comment: It is important to note a couple of things about this provision. First of all, it only applies to a fund’s sale of “qualified opportunity zone property.” Up to 10 percent of a fund’s assets can consist of non-QOZP. If a fund sells an asset that is not QOZP, the exclusion election is not available. Second, the exclusion is available only with respect to capital gain that arises from the sale of an asset—not ordinary income. Third, this provision is in a section of the regulations that is not effective until final regulations are issued; thus, taxpayers cannot rely on this provision prior to that time.

Comment: It is unclear how an investor would apply this exclusion election if the investor has obtained its qualifying investment over time. The 2018 proposed regulations provided that in certain circumstances, an investor that holds QOF partnership interests with identical rights acquired over time will be able to use the FIFO method when and if the investor sells all or a part of its QOF interest. The 2018 proposed regulations allow the use of the FIFO method to determine three specific issues: (1) whether the investment was one to which the deferral election applied; (2) the attributes of the gain subject to a deferral election at the time the gain is included in income; and (3) the extent, if any, of an increase in basis under tax code Section 1400Z-2(b)(2)(B) (which are the increases at five years and at seven years, but not the basis step-up election at 10 years). Based on the way in which the 2018 proposed regulations were written, it does not appear that a taxpayer is able to use the FIFO method when it comes to determining the 10-year holding period necessary for the basis step-up to fair market value in Section 1400Z-2(c), which means that if an investor has made fungible investments (separate investments with indistinguishable property rights) in a QOF partnership over time and sells less than all of its interest prior to the end of the 10-year period beginning on the date of the last investment, the investor will not fully qualify for the gain exclusion.

With respect to the new gain exclusion election in the 2019 proposed regulations discussed in this section, the language in the regulations refers to “a taxpayer [that] has held a qualifying investment … in a QOF partnership or QOF S corporation for at least 10 years.”

Even if the FIFO method provided in the 2018 proposed regulations applied, it does not really solve the issue because the interest itself is not being sold—the QOF is selling an asset and passing through the gain to the investor who is making the exclusion election. Perhaps the way to approach this is to compute the percentage of the investor’s qualifying investment that has been held for at least 10 years and apply that percentage to the relevant Schedule K-1 capital gain to determine the portion that is eligible for exclusion. There is nothing in the regulations, however, that requires an investor to do this. There is arguably some ambiguity in the reference to a taxpayer that has “held a qualifying investment” for at least 10 years. Does “a” refer to the investment in its entirety or to any portion of the investment? A literal interpretation would lead to the conclusion that as long as an investor has held any part of its qualifying investment for at least 10 years, it has held “a” qualifying investment for that period. Thus, if this provision is issued in final form as currently written, regardless of whether the investor has held the entire qualifying investment for 10 years, the investor may be able to elect to exclude any and all capital gain reported on a K-1 that is attributable to the QOF’s sale of QOZP.

In the context of a QOF partnership, is the basis step-up election available after a 10-year hold a step-up to gross fair market value (including liability relief)?

Yes. The 2019 proposed regulations specifically provide that with respect to the election to step-up basis to fair market value upon a sale or exchange of a QOF partnership interest that has been held for at least 10 years, the basis increase includes debt.

Is there depreciation recapture on a sale or exchange of an interest in a QOF partnership to which the taxpayer has applied the fair market value step-up election? In other words, does tax code Section 751(a) apply?

No. The 2019 proposed regulations provide that immediately prior to the sale or exchange of a QOF partnership interest for which a tax code Section 1400Z-2(c) election is being made (step-up in basis to fair market value), the bases of the QOF assets are also adjusted, in a manner similar to a tax code Section 743(b) adjustment. This basis adjustment to the QOF assets will eliminate the ordinary income issue with respect to tax code Section 751 hot assets, including depreciation recapture.

Comment: Although this provision solves the tax code Section 751 ordinary income/capital loss issue when an investor sells or exchanges a QOF interest, it does not appear to solve the issue when the QOF sells QOZP (including an interest in a qualified opportunity zone business (QOZB)). As discussed above, if a QOF partnership sells an asset after an investor has held the QOF interest for at least 10 years, that investor can elect to exclude its share of the capital gain from the sale. However, that exclusion provision specifically applies only to capital gain and there is no provision that would eliminate ordinary income on a sale by the QOF of an interest in a QOZB (which could have depreciation recapture or unrealized receivables, etc…).

This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.

Lisa is the Co-Chair of Buchanan, Ingersoll & Rooney’s Tax Section and the Co-Chair of its Opportunity Zones Practice Group. Her tax practice focuses on business tax planning with particular emphasis on pass-through taxation and real estate transactions.

The author wishes to thank Bruce Booken, co-chair of the Tax Section at Buchanan, Ingersoll & Rooney, for his review and insightful comments with respect to this article.

For a copy of the entire article as it appears in the Tax Management Memorandum, click here:

INSIGHT: The Second Set of Proposed Opportunity Zone Regulations: Where Are We Now?—Part 2