On April 17, the Treasury Department released a second round of guidance, bringing additional clarity to the Qualified Opportunity Fund (or QOF) regime enacted by 2017’s Tax Cuts and Jobs Act. Some important questions remain unanswered, but this second installment of proposed regulations re-confirms a key takeaway: Treasury means business about popularizing opportunity zone deals and making them taxpayer friendly.
Key insights from the new guidance follow:
- Accommodations for Multi-Asset QOFs: Earlier we were concerned that investors would have to exit their qualified opportunity investment ONLY by selling the QOF entity itself, obviously discouraging multi-asset QOFs. Instead, the new regs permit QOFs to be organized as multi-asset investment vehicles that dispose of assets and distribute or reinvest gains. QOFs will have one year to deploy disposition proceeds without impairing their 90% asset test. Dispositions made during the 10-year holding period are confirmed to be taxable, but after that, QOF investors can elect to exclude their share of later-realized capital gains. This could allow a four-asset QOF that sells three assets after 10 years ultimately to have all four qualify for a tax-free QOF exit.
- Potentially Harsh Treatment of Carried Interest: There’s disappointing news on whether a carried interest will qualify for the tax-free exit for a promoter. The new regs confirm that QOF benefits are not available for carried interest. Even worse, the new regs adopt an unexpectedly harsh methodology that could eat into the tax-free character of a promoter’s capital Going forward, promote and capital invested by a promoter should be segregated to avoid this; QOF deals that have already closed may need restructuring.
- Only Certain Leveraged Distributions Permitted: We had hoped that a QOF could do a leveraged recap right after a qualified opportunity zone business (or QOZB) building project was completed to garner early cash returns for investors. Good news: the new regs “bless” this concept, so it is achievable. Bad news: the new regs apply special rules that may make a levered recap feasible either by waiting two years after the last capital contribution or requiring careful design to avoid the disguised sale debt-financed distribution rules.
- “Asset-by-Asset” Testing: The new regs resolve a major ambiguity in the rules about which particular QOZB properties must be improved to qualify as “good” assets under the asset tests. Treasury opted for an “asset-by-asset” approach, requiring that each QOZB asset be substantially improved or newly placed in service to qualify as “good.”
- “Active Trade or Business” Defined; Further Accommodation for Real Estate Development in QOZBs: The new regs make it easier to comply with the QOZB rules mandating that the business be actively conducted. Treasury gives broad protections for QOZBs owning and operating real property, but merely leasing a building on a triple-net lease won’t qualify.
- Generous Treatment of Leased Property: Newly leased property can qualify as a “good” asset under the new regs, provided that substantially all its use is inside an opportunity zone. This even works for a lease from a related party if certain anti-abuse rules are met. The leased property is exempted from the original use or substantial improvement requirements. Leased property valuation methodologies are also provided.
- Holding Period Requirements Set at 90%: The new regs provide that a QOZB must stay qualified for “substantially all” of the QOF’s holding period, setting its meaning at 90%. Unfortunately, there is no guidance with respect to how a future holding period is taken into account for this purpose. For example, if a minimum 10-year holding period is planned, it would seem that a QOZB that fails to qualify for the first 11 months of the QOF’s holding period would meet this test overall, and yet that wouldn’t be knowable at the time the QOF reports its asset test results to the IRS.
- “Cross-Border” QOZBs Accommodated: Businesses with customers or clients outside an opportunity zone are safe harbored in the new regs–so long as half the services (based on hours or amounts paid) are performed in the opportunity zone. Another safe harbor alternative: if the tangible property and management or operational functions located in the opportunity zone are each necessary to generate 50% of gross income.
- Accommodation for Governmental Delays and Staged Development: Many clients are worried about the 31-month deadline for the use of the working capital. The new regs provide that the 31-month period is tolled for delays attributable to waiting for government action. In addition, the new regs clarify that working capital can be contributed in stages, with separate overlapping 31-month plans. So multi-stage QOF deals will be allowed. The 1-year deadline to reinvest QOF disposition proceeds (discussed above) is also tolled for government delays.
- Broad Rollover Flexibility: The new regs confirm that capital gain rollovers can be made by contributing property to a QOF (not just cash). If the contributed asset is appreciated, an “investment with mixed funds” will result, with the appreciation component not qualifying for QOF benefits. However, for QOFs that operate through QOZBs, the rule that QOZB interests must be obtained in exchange for cash would limit the practical flexibility afforded by this rule. Surprisingly, the new regs allow an investor to gain QOF rollover status from purchases of QOF interests in the secondary market.
- Treatment of 1231 Gain Rollovers Clarified: The new regs now make clear that Section 1231 gains that are treated as capital gains may be rolled over into a QOF, and that those 1231 gains are deemed realized on the last day of the taxable year (for measuring the 180-day re-investment period).
- Taxpayers May Rely on the Proposed Rules: Similar to the first round of guidance, taxpayers generally may rely on the proposed regulations prior to finalization if they apply the rules consistently and in their entirety.
- Tax Benefits of Qualified Opportunity Zones
- Tax-Backed Projects in Qualified Opportunity Zones
- Treasury Releases Qualified Opportunity Fund (QOF) Guidance
As the Chair of Jackson Walker’s Tax practice, Brian Dethrow focuses on tax and business planning for complex corporate, partnership, family, and inter-generational transactions. Clients who count on Brian for their transactional and tax planning include sophisticated businesses – Fortune 500 to large family-controlled – and wealthy families. His broad experience with innovative tax and corporate planning, particularly involving the energy industry, spans M&A and partnership work, international tax, private equity funds, bankruptcy and insolvency tax planning, net operating loss preservation, workouts, business succession, asset protection, and gift and estate tax reduction strategies. In his practice, Brian has also worked with ultra-wealthy families on FLPs, charitable remainder and lead trusts, and family foundations. Brian has been recognized by The Best Lawyers in America for his work in tax law and has been listed among D Magazine‘s “Best Lawyers in Dallas” list since 2009.
Argyrios C. Saccopoulos regularly represents buyers, sellers, and joint venture partners in M&A and real estate transactions, including federal income tax considerations of debt financings, merger agreements, and dealings in stock, partnership interests, and blocker structures. Argyrios has extensive experience counseling fund sponsors and investors on federal income tax aspects of fund formations and investments. Argyrios advises clients on the formation, qualification, and operations of real estate investment trusts, including their use in captive fund structures, and has previously advised some of the largest publicly listed REITs in the United States in REIT compliance matters. Additionally, Argyrios advises clients endeavoring to qualify for the new “qualified opportunity zone” tax incentive structures implemented as part of the Tax Cuts and Jobs Act.
The opinions expressed are those of the authors and do not necessarily reflect the views of the firm, its clients, or any of its or their respective affiliates. This article is for informational purposes only and does not constitute legal advice.