Generally, an investor has 180 days from the date of a transaction resulting in capital gain to reinvest the gain in a Qualified Opportunity Fund.
Since the first guidance regarding investment in Qualified Opportunity Zones (QOZs) was issued by the U.S. Treasury Department in October 2018, investors have shown immense interest in taking advantage of this opportunity to defer taxes on capital gains. In February 2019, Treasury held a public hearing to receive comments on the Initial Regulations, and, while considering those comments, released a second set of proposed regulations on April 17, 2019. This Part I discusses provisions of the New Regulations applicable to investors in a Qualified Opportunity Fund (QOF).
Form of investment
A pressing issue for investors at this time is how to invest. The statute requires the reinvestment of proceeds constituting gain from the sale of an asset (which the New Regulations make clear cannot be a sale to the QOF in which an interest in the QOF is acquired), which implies that a cash investment is required, but the New Regulations state that cash or other property may be transferred to a QOF. It is reasonable to assume that the proceeds from a sale must be used to acquire property that is then contributed to a QOF, but such a connection is not discussed. The New Regulations, for example, make reference to property held for 10 years that is then contributed to a QOF, but do not mention other statutory requirements (such as prohibiting acquisitions from related persons) that may be applicable. The New Regulations do provide that an “eligible interest” in a QOF may be obtained from a person other than the QOF via a transfer.
Section 1231 gain
Generally, an investor has 180 days from the date of a transaction resulting in capital gain to reinvest the gain in a QOF. The New Regulations provide that the 180-day period for gain from the sale of Section 1231 assets (property used in a trade or business, including equipment, machinery and real property) treated as capital gain net income begins on the last day of the taxable year.
The holding period of an interest in a QOF is relevant in determining the benefits of the deferral, and the New Regulations state that an investor’s holding period for its interest in a QOF for purposes of determining the 5-, 7- and 10-year tax benefits does not include the holding period for any property contributed to the QOF in exchange for such interest. Likewise, upon a sale of an interest in a QOF where the proceeds are reinvested in another QOF, the holding periods are not combined, but start anew. However, “tacking” of holding periods is permitted in certain corporate transactions, upon the death of the investor, and in certain other transactions where recognition of the deferred gain is not required.
Gain from asset sale
In order to maximize tax deferral, investors must be aware of events that trigger recognition of gain and thus payment of tax. Currently, the gain deferred into a QOF becomes taxable on Dec. 31, 2026, unless the interest in the QOF is sold. Unanswered in the statute and Initial Regulations is how the sale of assets by a QOF (particularly one that is a pass-through entity like a partnership) affects a QOF and the investors in a QOF; in the introduction to the Initial Regulations, Treasury acknowledged this deficiency and that practitioners and commentators requested guidance on the issue. While the New Regulations address the ability of a QOF to reinvest the proceeds from the sale of an asset (to be discussed in Part II of this series), Treasury stated in the introduction to the New Regulations that it does not have authority to issue regulations permitting either QOFs or investors in QOFs to avoid recognizing gain from the sale of assets by a QOF (other than with respect to an investment held for at least 10 years). This is a significant problem that apparently only Congress can fix, as it requires long-term holds by QOFs of assets in order to provide the desired tax-deferral; further, if a QOF needs to reinvest proceeds to continue to be a QOF, it cannot use the proceeds, or distribute the proceeds to investors, to pay tax on the sale.
While a sale of an interest in a QOF clearly results in the recognition of gain (both deferred and new), the New Regulations also set out other types of transfers that will, or that will not, require recognition of gain (many of which have specified exceptions), which primarily hinge on whether an investor’s interest in the QOZ is reduced. Specific transactions that will trigger gain recognition include liquidation of a corporate QOF and a gift of an interest in a QOF (including as a charitable contribution). Many transactions involving corporations (both as investors in a QOF and as a QOF) will trigger gain recognition, including certain distributions by corporate QOFs, distribution of an interest in a QOF in liquidation of a corporate investor in that QOF, and a contribution of an interest in a QOF to a corporation. Transactions that will not trigger gain recognition include the death of an individual investor and conveyance to a grantor trust. The trigger events apply to interests in partnerships that own interests in QOF, in effect looking through such partnership; however, neither a contribution to a partnership nor a merger of two partnerships will trigger gain recognition. The New Regulations also provide additional specific guidance on transactions related to S corporations that will trigger gain recognition, including changes of ownership greater than 25% and a conversion by an S corporation to a partnership or disregarded entity; however, a revocation of an S election is not a trigger event. Investors should note that the New Regulations address transfers of indirect, “upstream” interests in a manner similar to a direct interest in a QOF, and create requirements for investors to give notice of transfers to entities through which the investor directly or indirectly holds an interest in a QOF of deferral elections and for basis adjustments.
Corporate investors may want to include a QOF as part of a consolidated group of corporations. The New Regulations, however, state that the consolidated return framework is “incompatible” with the QOZ framework, and therefore a QOF C corporation may be a common parent of a consolidated group, but it may not be a subsidiary member of a consolidated group.
The New Regulations provide additional guidance for “mixed-fund investments,” which are investments in a QOF partnership by a single investor of both proceeds constituting deferred gain and other investment proceeds, as well as equity interests issued for services (e.g., a carried interest); note that this is the primary context where the contribution of property to a QOF in exchange for an interest in the QOF is discussed. Treasury proposes to require separate tracking of the deferred-gain investments from the other interests in a QOF for purposes of the QOZ rules, but otherwise to treat such interests in the standard unitary basis normally applied to partnership investments. The separate tracking includes rules for allocating basis and how distributions are attributed between the two investment interests, which Treasury acknowledges is a potentially complex approach.
Part II of this article will address issues more applicable to the operations of a QOF.
Sean Bryan is a tax partner at Kelly Hart & Hallman LLP.