Final Opportunity Zone Regulations Provide Some Much-Needed Clarity

Section 1400Z-2, added by Public Law 115-97 (the Tax Cuts and Jobs Act), provides tax incentives for investors to make equity investments in qualified opportunity funds (QOFs) that will in turn invest in qualified opportunity zone business property (QOZ Business Property), either directly or indirectly through qualified opportunity zone businesses (QOZ Businesses) operating in qualified opportunity zones (QOZs).

On December 19, the Department of the Treasury (Treasury) and the Internal Revenue Service (IRS) released the final regulations governing the tax benefits from investing in qualified opportunity zones (QOZs). The package is 544 pages and finalizes two different sets of proposed regulations—one issued on October 29, 2018 (October 2018 proposed regulations) and the other issued on May 1, 2019 (May 2019 proposed regulations). More than 300 comments were filed in response to the two sets of proposed regulations.

The final regulations largely finalize the rules contained in the proposed regulations and also add several new rules, many of which are taxpayer-favorable rules that had been requested by commenters. Among the new rules contained in the final regulations are rules providing: (1) "gross" 1231 gains are gains eligible for investment upon the recognition of such gains; (2) expansion of additional events involving QOF interests that are inclusion events; (3) clarification on the amount of an investor's basis in its interest in a QOF; (4) at exit, exclusion from gain for all sales of assets by a QOF or QOZ business, including hot assets but excluding inventory; (5) aggregation of the basis of assets for the substantial improvement requirement; (6) reduction of the number of years of vacancy required for property to qualify as original use; (7) expansion of the real property straddles rule to the 70% use test; (8) clarification that the working capital safe harbor can apply up to 62 months and covered tangible property qualifies as QOZ business property; (9) examples of activities that are and are not subject to the anti-abuse rule; and (10) rules providing for including QOFs in a consolidated group.

I. Provisions Relating to Initial Investment in a QOF

A. Eligible Gains

The final regulations made a number of changes affecting which gains are eligible for deferral under the QOZ rules.

1. Section 1231 Gains

   Section 1231 gains arise when a taxpayer sells or exchanges "section 1231 property," which generally means depreciable or real property that is used in a taxpayer's trade or business and held for more than one year. Under general tax rules, a taxpayer calculates net section 1231 gain or loss at the end of the year. If there is a net section 1231 gain, all of such gains or losses are taxed at capital gains rates; if there is a net section 1231 loss, all of such gains or losses are taxed at ordinary rates.

   Under the May 2019 proposed regulations, only net section 1231 gain was treated as eligible gain under the QOZ rules. As a result, a taxpayer's 180-day period for investment into a QOF did not begin until the end of the year when the amount of net section 1231 gain could be determined.

   Several commenters requested that the final regulations permit a taxpayer with section 1231 gains to elect a 180-day period starting from the date of the underlying sale or exchange, rather than the end of the year. Commenters also requested that a taxpayer with net section 1231 gains for a given year be permitted to treat all section 1231 gains as eligible gains for that year.

   The final regulations adopt a taxpayer-favorable "gross approach" to section 1231 gains whereby eligible gains include the gross amount of eligible section 1231 gains unreduced by section 1231 losses. Furthermore, eligible section 1231 gains are not limited to the net section 1231 gains for a taxable year. As a result, it is not necessary for an investor to wait until the end of the taxable year to determine whether any eligible section 1231 gains are eligible gains, so the final regulations start the 180-day period on the date of the sale or exchange that gives rise to the eligible section 1231 gain.

2. Gains from Sales to, or Exchanges of Property with, a QOF or QOZ Business

   In general, to qualify for QOZ tax benefits, an investor must invest an eligible gain into a QOF, which requires a capital gain from the sale to an unrelated party. In addition, to qualify as QOZ Business Property, the property must be acquired by the QOF or QOZ Business by purchase from an unrelated party. As a result, neither property that is purchased by a QOF from a related party, nor property that is contributed to a QOF in a transfer under section 351 or 721 may qualify as QOZ Business Property. Commenters requested Treasury and the IRS to clarify the treatment of transactions in which a taxpayer sells property to, or exchanges property with, a QOF or a QOZ Business and then contributes the proceeds of such sale or exchange to the QOF.

   The preamble to the final regulations provides some guidance on this kind of transaction. The preamble notes that generally applicable federal income tax principles may require, depending on the circumstances, that this kind of transaction be recharacterized, for tax purposes, as a contribution of the property to the QOF (potentially followed by a further contribution by the QOF to the QOZ Business). If the transaction is recharacterized in this way, then the investor generally would not be treated as investing an eligible gain, and the property generally would not be QOZ Business Property in the hands of the QOF or QOZ Business.

   Because the preamble frames its analysis in terms of generally applicable federal income tax principles, such as the step transaction doctrine and circular cash flow principles, the application of these rules requires a careful analysis that takes into account all of the relevant facts and circumstances. Depending on the facts and circumstances, some sales of property to a QOF or QOZ Business followed by a contribution to the QOF may or may not be recharacterized as a contribution of property.

3. Offsetting-Positions Transactions and Straddles

   The October 2018 proposed regulations included rules limiting the ability of taxpayers to treat gains from certain "offsetting-positions transactions" as eligible gains under the QOZ rules. Under the proposed regulations, these rules applied to a broader set of transactions than the existing tax rules regarding so-called "straddles." Based on concerns from commenters, the final regulations do not include the provisions that applied to offsetting-positions transactions that are not straddles and made a number of other changes to streamline and reduce the burden of these rules.

   B. 180-Day Investment Period

   The final regulations include a number of changes and clarifications relating to the 180-day investment period. First, as described above, the final regulations provide that the 180-day investment period for eligible section 1231 gains begins on the date of the underlying sale or exchange, rather than the end of the year.

   Many investors with section 1231 gains relied on the delayed 180-day period for section 1231 gains that was included in the proposed regulations. Under the final regulations, these investors may find that the 180-day period for these gains has now expired. However, as described below, the final regulations provide that the rules contained therein are applicable for tax years beginning 60 days after the date the final regulations are published in the Federal Register. For dates prior to that time, taxpayers may choose to either rely on the final regulations or the proposed regulations, but taxpayers must choose to apply either the final or proposed regulations for each section of the regulations and cannot apply parts of both the final and proposed regulations for a particular section.

   Second, the final regulations provide that the 180-day period for real estate investment trust (REIT) and regulated investment company (RIC) capital gain dividends generally begins at the close of the shareholder's taxable year in which the capital gain dividend would otherwise be recognized. This rule is intended to facilitate the ability of RIC and REIT shareholders to make qualifying investments in QOFs even when they do not have the same taxable year as the RIC or REIT.

   Third, the final regulations provide additional flexibility for qualified investment of capital gains recognized in an installment sale by allowing taxpayers to elect to choose the 180-day investment period to begin on either: (i) the date a payment under the installment sale is received, or (ii) the last day of the year the eligible gain under the installment method would otherwise be recognized.

   Fourth, the final regulations modify the election for choosing a 180-day investment period for a partner's distributive share of eligible gains earned by a partnership. Under the proposed regulations, partners could elect to either use the same 180-day period as the partnership or to use the 180-day period beginning on the last day of the taxpayer's taxable year. Under the final regulations, the second option is changed to the 180-day period beginning on the due date for the partnership's tax return, without extensions. This change should provide partners with additional time to receive Schedules K-1, which provide partners with necessary information about the amount of their distributive share of eligible gain.

   C. Investments By Non-US Investors

   The final regulations contain a number of new rules regarding the treatment of investments into a QOF by non-US investors. The final regulations clarify that deferral of a gain generally is available only for capital gain that would otherwise be subject to US federal income tax but for the making of a valid deferral election. As a result, in order to make a qualifying investment, a non-US investor must have an eligible gain that...