The IRS has issued proposed regulations that provide guidance under Internal Revenue Code (IRC) Section 1400Z-2, as added by the Tax Cuts and Jobs Act, relating to gains that may be deferred as a result of a taxpayer’s investment in a qualified opportunity fund (QOF), as well as special rules for an investment in a QOF held by a taxpayer for at least 10 years. The regulations also update portions of previously proposed regulations to address various issues, including: the definition of “substantially all” in each of the various places it appears in IRC Section 1400Z-2; the transactions that may trigger the inclusion of gain that a taxpayer has elected to defer under IRC Section 1400Z-2; the timing and amount of the deferred gain that is included; the treatment of leased property used by a qualified opportunity business; the use of qualified opportunity zone business property in the qualified opportunity zone; and the “reasonable period” for a QOF to reinvest proceeds from the sale of qualifying assets without paying a penalty.
New proposed regulations: “substantially all”
The proposed regulations provide, consistent with the prior QOF regulations, that, in testing the use of qualified opportunity zone business property in a qualified opportunity zone, the term “substantially all” in the context of “use” is 70%. Whether such tangible property is owned or leased, the proposed regulations propose that the substantially all-requirement regarding “use” is satisfied if at least 70% of the use of such tangible property is in a qualified opportunity zone. However, the proposed regulations provide that the term “substantially all” as used in the holding period context in IRC Section 1400Z-2(d)(2)(B)(i)(III), IRC Section 1400Z-2(d)(2)(C)(iii), and IRC Section 1400Z-2(d)(2)(D)(i)(III) is defined as 90%.
Events causing inclusion of deferred gain (inclusion events)
IRC Section 1400Z-2(b)(1) provides that the amount of gain that is deferred if a taxpayer makes an equity investment in a QOF will be included in the taxpayer’s income in the tax year that includes the earlier of (A) the date on which the qualifying investment is sold or exchanged, or (B) December 31, 2026.
The proposed regulations clarify that, subject to enumerated exceptions, an inclusion event results from a transfer of a qualifying investment in a transaction to the extent the transfer reduces the taxpayer’s equity interest in the qualifying investment for federal income tax purposes.
To prevent taxpayers from “cashing out” a qualifying investment in a QOF without including in gross income any amount of their deferred gain, notwithstanding the above general principle, and except as otherwise provided in the proposed regulations, a transaction that does not reduce a taxpayer’s equity interest in the taxpayer’s qualifying investment is also an inclusion event under the proposed regulations to the extent the taxpayer receives property from a QOF in a transaction treated as a distribution for federal income tax purposes. For this purpose, property generally is defined as money, securities, or any other property, other than stock (or rights to acquire stock) in the corporation that is a QOF (QOF corporation) that is making the distribution. The proposed regulations provide a nonexclusive list of inclusion events.
In general, other than with respect to partnerships, if a taxpayer has an inclusion event with regard to its qualifying investment in a QOF, the taxpayer includes in gross income the lesser of two amounts, less the taxpayer’s basis, as follows:
- The fair market value of the portion of the qualifying investment that is disposed of in the inclusion event. The fair market value of that portion is determined by multiplying the fair market value of the taxpayer’s entire qualifying investment in the QOF, valued as of the date of the inclusion event, by the percentage of the taxpayer’s qualifying investment that is represented by the portion disposed of in the inclusion event.
- The amount that bears the same ratio to the remaining deferred gain as the first amount bears to the total fair market value of the qualifying investment in the QOF immediately before the transaction.
Qualified Opportunity Zone businesses
The proposed regulations provide that in satisfying the requirements of IRC Section 1400Z-2(d)(3)(A)(ii), IRC Section 1397C(f) (dealing with Empowerment Zones) applies in the determination of whether a qualified opportunity zone is the location of services, tangible property, or business functions (substituting “qualified opportunity zone” for “empowerment zone”). This is in response to concerns on the ability of a business that holding real property straddling multiple Census tracts, where not all of the tracts are designated as a qualified opportunity zone. Real property located within the qualified opportunity zone should be considered substantial if the unadjusted cost of the real property inside a qualified opportunity zone is greater than the unadjusted cost of real property outside of the qualified opportunity zone.
The proposed regulations provide three safe harbors and a facts-and-circumstances test for determining whether sufficient income is derived from a trade or business in a qualified opportunity zone for purposes of the 50% test in IRC Section 1397C(b)(2). Businesses only need to meet one of these safe harbors to satisfy that test.
The first safe harbor in the proposed regulations requires that at least 50% of the services performed (based on hours) for such business by its employees and independent contractors (and employees of independent contractors) are performed within the qualified opportunity zone. The second safe harbor is based upon the amounts paid by the trade or business for services performed in the qualified opportunity zone by employees and independent contractors and provides that if at least 50% of the services performed for the business by its employees and independent contractors (and employees of independent contractors) are performed in the qualified opportunity zone, based on amounts paid for the services performed, the business meets the 50% gross income test found in IRC Section 1397C(b)(2).
Under the third safe harbor, the proposed regulations provide that a trade or business may satisfy the 50% gross income requirement if (1) the tangible property of the business that is in a qualified opportunity zone and (2) the management or operational functions performed for the business in the qualified opportunity zone are each necessary to generate 50% of the gross income of the trade or business.
QOF reinvestment rule
The proposed regulations provide that proceeds received by the QOF from the sale or disposition of (1) qualified opportunity zone business property, (2) qualified opportunity zone stock, and (3) qualified opportunity zone partnership interests are treated as qualified opportunity zone property for purposes of the 90% investment requirement described in IRC Section 1400Z-1(d)(1) and IRC Section 1400Z-1(f). This applies as long as the QOF reinvests the proceeds received by the QOF from the distribution, sale, or disposition of such property during the 12-month period beginning on the date of such distribution, sale, or disposition.
The one-year rule is intended to allow QOFs adequate time in which to reinvest proceeds from qualified opportunity zone property. Further, in order for the reinvested proceeds to be counted as qualified opportunity zone business property, from the date of a distribution, sale, or disposition until the date proceeds are invested in other qualified opportunity zone property, the proceeds must be continuously held in cash, cash equivalents, and debt instruments with a term of 18 months or less. A QOF may reinvest proceeds from the sale of an investment into another type of qualifying investment. The proposed regulations also provide a relief to the QOF if the failure to meet the 12-month deadline for the 90% asset test is due to a delay by the government’s action during the application process.
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