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October 31, 2018
The United States Treasury Department (“Treasury”) issued proposed regulations (Prop. Reg. §1.1400Z-2) (the “Proposed Regulations”) on October 19, 2018, under Section 1400Z-2 of the Internal Revenue Code, as amended, (the “Code”) and released Revenue Ruling 2018-29, (the “Revenue Ruling”), each providing taxpayers with further guidance on the deferral of gains from investment in a qualified opportunity fund (“QOF”).
The Proposed Regulations provide guidance on:
The Revenue Ruling provides guidance on:
This Tax Report (i) highlights some of the open issues related to investment in Qualified Opportunity Zones (“QOZs”) that have been addressed by the Proposed Regulations and the Revenue Ruling, (ii) highlights some open issues that remain unaddressed, and (iii) summarizes various provisions of the Proposed Regulations.
The Tax Cuts and Jobs Act of 2017 (P.L. 115-97) included a provision, supported by Senator Tim Scott of South Carolina, designed to spur investment into certain economically distressed communities. The program provides taxpayers with recently realized gains a means of deferring, and to some extent escaping, taxation of those gains.
Pursuant to Section 1400Z-2 of the Code, taxpayers with recently realized gains from the sale of stock, securities and other capital assets may defer and even escape some gain recognition to the extent the recently realized gains are invested in an QOF, within 180 days of the sale giving rise to the gain (the “180-day period”). Once invested in a QOF, the taxpayer’s deferred gain must be recognized on the earlier of the date of sale of the taxpayer’s interest in the QOF or December 31, 2026. However, if the taxpayer’s interest in the QOF is held for a long enough period, the deferred gain may be minimized by as much as 15 percent and any post-investment appreciation on such interest may be eliminated. If the taxpayer’s interest in the QOF is held for at least 5 years, the taxpayer’s basis in their interest will be increased by 10 percent. If such interest is held for at least 7 years, the taxpayer’s basis will be increased by an additional 5 percent. If such interest is held for at least 10 years, the taxpayer’s basis will be increased to fair market value (the “10-year basis step-up”). The following example illustrates these rules:
Thus, A was able to (i) defer recognition of his original gain for 7 years, (ii) eliminate 15 percent of his original gain, and (iii) eliminate all of his “new” gain (i.e., gain attributable to the appreciation of his interest in the QOF since the time of his purchase of such interest).
A QOF is defined as a corporation or partnership that is organized for the purpose of investing its assets in Qualified Opportunity Zone Property (“QOZ Property”). A QOF is subject to a semi-annual requirement that at least 90% of its assets are invested in QOZ Property (the “90 Percent Asset Test”). Under that test, the assets of the QOF will be tested on the last day of the first 6-month period of the QOF’s taxable year and the last day of its taxable year with the two testing dates then being averaged. The following example illustrates these rules:
Noncompliance with the 90 Percent Asset Test will result in a monthly penalty equal to product of: (i) the amount by which the QOF’s assets are under the 90 percent threshold, and (ii) a statutorily specified underpayment rate (defined as the Federal short-term rate plus 3 percentage points).
QOZ Property consists of (i) stock or partnership interests in an entity that qualifies as a Qualified Opportunity Zone Business (a “QOZ Business”) or (ii) in tangible property that qualifies as Qualified Opportunity Zone Business Property (“QOZ Business Property”).
Under the law, stock or partnership interests in an entity that qualifies as a QOZ Business must be acquired after December 31, 2017 by the QOZ at its original issue for cash. To qualify as a QOZ Business: (i) substantially all of the tangible property owned or leased by the business must be QOZ Business Property; (ii) at least fifty percent of the business’s total gross income must be derived from the active conduct of a trade or business, (iii) a substantial portion of the intangible property of the business must be used in the active conduct of a trade or business, (iv) the business must not be: (A) a private or commercial golf course or country club, (B) a massage parlor, hot tub or suntan facility, (C) a racetrack or other gambling facility, or (D) a package liquor/alcoholic beverages facility, and (v) less than five percent of the assets of the business may be attributable to “nonqualified financial property.”
“Nonqualified financial property” is defined as debt, stock, partnership interests, options, futures contracts, forward contracts, warrants, notional principal contracts, annuities, and other similar property (not including reasonable amounts of working capital held in cash, cash equivalents, or debt instruments with a term of 18 months or less, and debt instruments acquired in the ordinary course of business). In certain circumstances, noted below, the Proposed Regulations would extend this working capital exception to amounts held for up to 30 months.
QOZ Business Property, in turn, is defined as tangible property used in a QOZ Business for which: (i) the original use of such property commences with the QOZ Business (or QOF, where applicable), or alternatively following acquisition by a QOZ Business (or QOF), where applicable) such property is “substantially improved” and (ii) during substantially all of the holding period for the QOZ Business (or QOF, where applicable), substantially all of the use of such property occurs in a QOZ.
To “substantially improve” non-original-use property a QOZ Business (or QOF, where applicable) must make an investment in such property over a 30-month period in an amount that exceeds the QOZ Business’s (or QOF’s, where applicable) purchase price for such property.
QOFs may be single or multi-investor vehicles. In addition, there is no requirement that QOFs be capitalized exclusively with amounts corresponding to an investor’s deferred gain. To the extent any such investor invests additional amounts, the investor is treated as having made separate investments. In addition, Opportunity Funds may have leverage.
Issues Addressed by the Proposed Regulations and the Revenue Ruling
What types of entities are eligible to defer gains by investing in a QOZ?
The Proposed Regulations make clear that individuals, C corporations (including regulated investment companies (“RIC’s”) and real estate investment trusts (“REIT’s”)), partnerships and certain other pass-through entities (including S corporations and trusts) with eligible capital gains are able to make an election to defer such gains.
Accordingly, the Proposed Regulations provide rules that permit a partnership (or other pass-through entity) to make a deferral election. In the event a partnership does not make such an election, the Proposed Regulations provide rules that allow a partner of the partnership to do so on an individual basis. Under these rules, if a partnership makes a deferral election, no part of the deferred capital gain will be required to be allocated to the partners. Thus, if a partnership makes a deferral election, the gain will not pass through to the partners of the partnership. However, to the extent that a partnership does not make a deferral election, the partners’ share of the gain will be allocated to them, as per the rules of Subchapter K. In that circumstance, a partner may still elect to defer their individual share of the gain (so long as they elect to do so within the applicable 180-day period).
When does the 180-day period begin for eligible capital gains?
Under the statutory language of Section 1400Z-2, a taxpayer is required to make an investment in a QOF during the 180-day period beginning on the date of the sale or exchange giving rise to such gain. However, gains realized by a partnership are not passed through to partners of such partnership until the end of the partnership’s taxable year. Furthermore, certain capital gains are the result of tax rules that provide for a deemed sale of an unspecified date giving rise to such gains. The Proposed Regulations address both situations.
Partnerships and other pass-through entities will generally be treated as commencing the 180-day period on date of the sale or exchange giving rise to such gain. In the event such entity does not make a deferral election, a partner, equity holder or beneficiary of such entity will generally be treated as commencing the 180-day period on the last day of the entity’s tax year when such gain is allocated. However, the Proposed Regulations also provide that a partner may elect to commence the 180-day period on the date that the entity’s 180-day period would have begun had it made a deferral election (relieving the partner, equity holder or beneficiary of the need to wait until the end of the taxable year to use their allocable portion of such gain to make an investment in a QOF).
In addition, the Proposed Regulations contain several examples that clarify the beginning of the 180-day period in various instances of capital gain realization (deemed or otherwise). These examples include the following.
Can the original use of land be considered to have commenced with the QOF?
In the Revenue Ruling, a taxpayer purchased an existing building located on land within a QOZ. The IRS determined that, given the permanence of land, the original use of land in a QOZ can never be considered as having commenced with a QOF. In addition, because the building located on such land existed prior to the QOF’s purchase, the building’s original use did not commence with the QOF. Consequently, for the land and the building to qualify as QOZ Business Property, the taxpayer was required to substantially improve the building. Notably, the IRS determined that the taxpayer was not required to substantially improve the land.
Is the basis of land taken into consideration when substantially improving an existing building located on land within a QOZ?
The IRS ruled that when substantially improving an existing building located on land within a QOZ, the basis allocable to the land on which the building sits is not taken into account when determining the amount of additions to basis a taxpayer must invest to substantially improve QOZ Business Property.
Thus, while the original use of land cannot commence with a QOF, there is no requirement to substantially improve land. Furthermore, in situations where an existing building is located on such land and the taxpayer seeks to substantially improve their QOZ Business Property (i.e., the land and the building located on it), the taxpayer need only increase its basis by an amount that exceeds its basis allocable to the building located on such land. For example, if a taxpayer (though a QOF) purchased land with a building located on it for $100 and $60 of such purchase price was allocable to the land and $40 was allocable to the building, the taxpayer (through the QOF) would only need to invest $41 on improvements to the building over a 30-month period to have substantially improved its QOZ Business Property.[i]
Is there any relief period for QOF’s to deploy invested cash before being subject to the 90 Percent Asset Test?
Commentators have noted that developing a new business or constructing or improving real estate assets may take longer than six months and consequently, a QOF may not be able to deploy its cash assets fast enough to avoid monthly penalties under the 90 Percent Asset Test. In response, the Proposed Regulations have provided a working capital safe harbor for QOF investments in QOZ Businesses. In general, cash (that would otherwise not be invested by the QOF within the QOF’s applicable 6-month period for purposes of the 90 Percent Asset Test) can be invested as working capital in a QOZ Business. Thus, by investing any excess cash into a QOZ Business’s working capital, a QOF can avoid monthly penalties under the 90 Percent Asset Test. However, for the business holding such cash as working capital to qualify as a QOZ Business (and thus qualify as QOZ Property for the 90 Percent Asset Test), certain requirements must be met.
Under the safe harbor, the QOZ Business must:
Note that the working capital safe harbor requires the QOF to own stock or partnership interest in an entity that qualifies as a QOZ Business. If the QOF were to directly own real estate assets (as QOZ Business Property) but no QOZ Business, any cash not yet invested would be subject to the 90 Percent Asset Test.
Can a fund wait to elect to be a QOF in order to avoid the 90 Percent Asset Test?
The Proposed Regulations state that the monthly penalty under the 90 Percent Asset Test will not apply to any month before an entity becomes a QOF (via self-certification, discussed below). However, the Proposed Regulations also state that investments in an entity eligible for treatment as a QOF are not eligible for deferral until the entity’s first month as a QOF.
Thus, for example, a fund that simply holds investments without electing to be a QOF (thereby avoiding the consequences of the 90 Percent Asset Test) may run the risk of preventing gain deferral (and potentially the 10-year basis step-up) for its investors if the fund does not elect to be a QOF by the end of the taxable year in which its investors realized their eligible gains. This would be true even if such investors invested their eligible gains within their respective 180-day periods.
What kinds of gains are eligible for deferral via investment in a QOF?
Citing the legislative history of Section 1400Z-2, the Proposed Regulations clarify that only capital gains are eligible for deferral. This includes capital gain from actual or deemed sales or exchanges and any other gain that is required to be included in a taxpayer’s computation of capital gain. The Proposed Regulations also specify that (i) for any gain to be eligible it must be gain that, absent a QOF deferral election, would be recognized by December 31, 2026, and (ii) the gain must not arise from a sale or exchange with a related person as defined elsewhere in the Code. In addition, the Proposed Regulations provide that all of the tax attributes of the deferred gain will be preserved through the deferral period and taken into account when the deferred gain is eventually recognized.
Can a taxpayer make multiple elections within 180 days for various parts of the gain from a single sale or exchange of property?
The Proposed Regulations clarify that while multiple elections cannot be made for the same portion of gain, a separate election can be made for a portion of a gain for which no election has been made. Thus a taxpayer could take a $100 gain and make an election for $60 for an investment in one QOF and make an election for the remaining $40 for an investment in a different QOF. However, all portions of such gain (both the $60 and $40 portions) would be subject to the same 180-day period which would commence on the date of the sale or exchange (or deemed sale or exchange) giving rise to such gain.
Is the 10-year basis step-up available for sales of investments after the expiration of the QOZ designations on December 31, 2028?
The Proposed Regulations extend the end of the period in which a sale of a QOF interest is available for a 10-year basis step-up to December 31, 2047. Thus, a full basis step-up on a QOF interest is available for a sale or exchange of such interest occurring after a QOZ designation expires.
However, to be eligible for a 10-year basis step-up, a taxpayer must first have made an investment in a QOF with an eligible gain and have made an election to defer such gain. Thus, a taxpayer must have realized an eligible gain by the end of 2026 and must have invested such gain in a QOF by the end of June 2027 (the last day of the last eligible 180-day period).
On a related point, note that, due to the fact that deferred gain must be recognized on the earlier of the sale of such taxpayer’s investment in the QOF or December 31, 2026, in order to qualify for the second, 5 percent step-up in basis, such QOF investment must have been made no later than December 31, 2019 – 7 years prior to the December 31, 2026 recognition date.
How does a taxpayer make an election to defer gain?
The Proposed Regulations state that deferral elections are to be made at the time and in the manner provided by the IRS in subsequent guidance. The preamble to the Proposed Regulations notes that it is anticipated that taxpayers will make deferral elections on IRS Form 8949, which would be attached to their federal tax returns for the taxable year in which the gain would have been realized. The preamble further notes that form instructions for making the election are expected to be released very shortly after the Proposed Regulations are published. As of the date of this Tax Report no instructions have been released.
Does an entity need to certify itself as a QOF?
The Proposed Regulations permit a corporation or partnership to self-certify as a QOF, provided that such entity meets the requirement of a QOF. The Proposed Regulations permit the IRS to publish guidance on the time and manner of the self-certification. The preamble to the Proposed Regulations notes that it is anticipated that IRS Form 8996 will be used both for self-certification and for annual reporting of compliance with the 90 Percent Asset Test. The Form 8996 would be attached to the corporation’s or partnership’s annual federal tax return.
The Proposed Regulations also allow an entity qualifying as a QOF to identify the year in which such entity became a QOF and the first month in such year that such entity became a QOF. However, if an entity fails to specify the first month in which it was a QOF, the first month of such entity’s initial taxable year as a QOF is treated as the first month as a QOF.
How is the 90 Percent Asset Test applied to a QOF that starts in a month other than the first month of the year?
Under the Proposed Regulations, the first 6-month testing period for the 90 Percent Asset Test applies to the first 6-month period composed entirely of months in the taxable year in which the entity was a QOF. For example, if an entity self-certifies as a QOF beginning in April, then the entity’s testing dates for purposes of the 90 Percent Asset Test will be the end of September and the end of December. If a QOF begins in a month after June, then the only testing date for the 90 Percent Asset Test for that taxable year will be the last day of the QOF’s taxable year.
Can a pre-existing entity qualify as a QOF or as an entity operating a QOF Business?
The Proposed Regulations state that there is no prohibition on pre-existing entity being a QOF or operating a QOB so long as those entities satisfy the statutory qualifications.
How much of the tangible property of a QOZ Business must be QOZ Business Property (i.e., what does “substantially all” mean)?
Commentators have noted that the phrase “substantially all” is used in multiple places in Section 1400Z-2, but no clear definition of the phrase is given. The Proposed Regulations state that if at least 70 percent of the tangible property owned or leased by a QOZ Business is QOZ Business Property, then the business will be treated as having “substantially all” of its tangible property classified as QOZ Business Property (and thus meeting one of the requirements for treatment as a QOZ Business).
The preamble to the Proposed Regulations note that the IRS is requesting comments on the meaning of “substantially all” with respect to the other areas of Section 1400Z-2 in which the phrase appears.
Open Issues and Questions
Will the sale of QOZ Property by a QOF dampen some of the benefit of the 10-year basis step-up available to long term investors?
Under Section 1400Z-2 and the applicable rules of subchapter K of the Code, in the event that a QOF, organized as a partnership, sells a piece of QOZ Property, the gain on the sale of such property will pass through to and be recognized by investors in the QOF. Accordingly, such investors will get basis in their interest in the QOF in an amount equal to their individual share of such recognized gain. Thus, even if an investor in a QOF were to hold onto their interest in the QOF for 10 years, such investor would still be required to pay capital gains tax on the sale of the QOZ Property and would receive basis for such gain, which would dampen the benefit they would subsequently receive from any 10-year basis step-up. While commentators have noted these consequences and discussed the possibility of regulatory relief, the Proposed Regulations do not appear to grant any. In general, the Proposed Regulations do not contain any provisions that would change this treatment.
In light of the potential for realization of pass-through gain from the sale of QOZ Property, it is possible that investors will consider forming QOFs as corporations rather than partnerships. A QOF structured as a corporation would be required to pay tax on the sale of the QOZ Property, but the investor would not pay any tax until they sell their interest in the QOF, at which time they may be eligible for a full basis step-up (if they held their interest for 10 years).
It should be noted, that the preamble to the Proposed Regulations states that “[m]any stakeholders have requested guidance not only on the length of a ‘reasonable period of time to reinvest’ [(discussed below)] but also on the Federal income tax treatment of any gains that the QOF reinvests during such a period (emphasis added).” The preamble goes on to say that “[i]n the forthcoming notice of proposed rulemaking, the Treasury Department and the IRS will invite additional public comment on the scope of statutorily permissible policy alternatives. The Treasury Department and the IRS will carefully consider those comments in evaluating the widest range of statutorily permissible possibilities.”
How long will QOZ’s have to comply with the 90 Percent Asset Test following the sale of assets by the QOZ?
Section 1400Z-2 authorizes regulations that give a QOF a reasonable period of time to reinvest the proceeds of sales from investments in QOZ Property. The preamble to the Proposed Regulations notes that “if a QOF shortly before a [90 Percent Asset Test] testing date sells QOZ Property, that QOF should have a reasonable amount of time in which to bring itself into compliance with the 90 Percent Asset Test.” The preamble goes on to say that “[s]oon-to-be-released proposed regulations will provide guidance on these reinvestments by QOFs.” Thus, while this issue remains open, forthcoming guidance will address it.
What constitutes the “active conduct of a trade or business” for purposes of qualifying as a QOZ Business?
Under Section 1400Z-2, to qualify as a QOZ Business: (i) at least 50 percent of the gross income of such business must be derived from the “active conduct of a trade or business”; and (ii) a substantial portion of the intangible property of such business must be used in the “active conduct of a trade or business.” However, the Proposed Regulations have not yet included a definition for the phrase “active conduct of a trade or business” (though the Proposed Regulations did include and reserve a section headed by that phrase).
How is the acquisition of vacant land by a QOF treated?
While the Revenue Ruling makes clear that when land in a QOZ is purchased with an existing building located on it, the QOF must substantially improve the building by investing an amount that exceeds the amount of the purchase price allocable to the building. The Revenue Ruling also states that the original use of land can never begin with a QOF. However, the Revenue Ruling does not specifically address the original use and substantial improvement requirements of Section 1400Z-2 when a QOF purchases land that does not have an existing building located on it.
Because the original use requirement cannot be met for land (as per the Revenue Ruling), a QOF would likely look to meet the original use requirement in some other way or, alternatively, meet the substantial improvement requirement. It is unclear if building a new building on the land would meet either or both requirements.
Can investors in a QOF treated as a partnership get basis for partnership debt and apply such basis against distributions of the proceeds of such debt?
With respect to QOFs treated as a partnership, the Proposed Regulations clarify that any basis that a partner receives as a result of such partner’s allocable share of the QOF’s debt (as per Section 752(a) of the Code) (“752(a) basis”) will be disregarded for purposes of determining the amount of such partner’s investment in the QOF that is subject to the deferral election (and, consequently, the various basis-step ups). In other words, 752(a) basis is bifurcated for purposes of determining the amount of gain attributable to such partner’s disposition (or deemed disposition on December 31, 2026) of their interest in the QOF.
Because the Proposed Regulations do not address the treatment of 752(a) basis with respect to the provisions of subchapter K, there is no indication that 752(a) basis should be treated differently in any other context (such as the applicability of 752(a) basis to the QOF’s distribution of debt proceeds to the partners or the allocation of 752(a) basis for purposes of deducting partnership losses).
In addition, the Proposed Regulations do not address how any potential bifurcated treatment of 752(a) basis will be accounted for and whether there will be any tracking mechanism for bifurcated bases or a floor below which a QOF could not make return of capital distributions to partners.
Other Provisions of the Proposed Regulations
Permissible types of investments in a QOF.
The Proposed Regulations state that to be an eligible interest in a QOF, an investment in the QOF must be an equity interest in the QOF. This includes preferred stock or a partnership interest with preferred or special allocations. Debt instruments issued by a QOF will not be an eligible interest. However, the Proposed Regulations state that the use by a taxpayer of an equity interest in a QOF as collateral for a loan will not prevent such equity interest from being eligible as an investment in a QOF.
Disposal of less than all of fungible interests in a QOF.
Under the Proposed Regulations, if a taxpayer holds investment interests in a QOF with identical interests (i.e., fungible interests) and such interests were acquired on different days and, subsequently, on a single day the taxpayer disposes of less than all of such interests, the first-in-first-out (“FIFO”) method will be used to identify which interests were disposed of and whether there is an applicable gain deferral election for such interests. Where the FIFO method does not provide a complete answer, including where gains with different tax attributes are invested in fungible interests at the same time, a pro-rata method will be used to determine the attributes of the gain recognized from the sale of disposed interests.
Treatment of gains from Section 1256 (“mark-to-market”) contracts.
The Proposed Regulations allow for deferral eligibility only for a taxpayer’s capital gain net income from Section 1256 contracts for a taxable year. The Proposed Regulations also provide that the 180-day period for investing capital gain net income from Section 1256 contracts begins on the last day of the taxpayer’s taxable year. In addition, the Proposed Regulations prohibit deferral of gain from any Section 1256 contract if at any time during the taxpayer’s taxable year, any of the taxpayer’s Section 1256 contracts were part of an offsetting positions transaction in which any of the other positions were not also a Section 1256 contract.
Asset valuation method for the 90 Percent Asset Test.
The Proposed Regulations require a QOF to use the asset values that are reported on the QOF’s applicable financial statement for the taxable year for purposes of the 90 Percent Asset Test. If the QOF does not have an applicable financial statement, the Proposed Regulations required the QOF to use the cost of assets as the applicable valuation.
Location of eligible entities.
The Proposed Regulations state that an entity eligible for treatment as a QOF (i.e., a partnership or a corporation) must be created or organized in one of the 50 U.S. states, the District of Columbia or a U.S. possession. However, if an entity is organized in a U.S. possession but not in one of the 50 U.S. states or the District of Columbia, it must be organized for the purpose of investing in QOZ Property that relates to a trade or business operated in the possession in which the entity is organized. The same rules apply to the qualification requirements for entities eligible for treatment as QOZ property (i.e., QOZ Stock or QOZ Partnership Interests). The Proposed Regulations also clarify that a U.S. possession includes the following U.S. territories: American Samoa, Guam, the Commonwealth of the Northern Mariana Islands, Puerto Rico, and the U.S. Virgin islands.
Proposed effective dates.
The Proposed Regulations are proposed to be effective on or after the date final regulations are published in the Federal Register. However, certain portions of the Proposed Regulations may be relied on earlier if the rules are applied by the taxpayer in a consistent manner.
Nelson Mullins will continue to monitor the status of the Proposed Regulations and other guidance, as well as comments submitted by other professional groups. If you have questions or comments about the foregoing summary of the Proposed Regulations or the Revenue Ruling, please contact Drew Hermiller, John MacMaster, Wells Hall, Gene Crick, Maurice Holloway, Erin Reeves McGinnis, Kay Gordon, or Jeff Gurney of the firm, who have contributed to the preparation of this Tax Report.
 The preamble to the Proposed Regulations states that the Treasury Department and the IRS are working on additional published guidance, including additional proposed regulations expected to be published in the near future, which will address other issues under Section 1400Z-2 that are not addressed in the Proposed Regulations including: the meaning of “substantially all” in each of the various places where it appears in Section 1400Z-2; the transactions that may trigger the inclusion of gain that has been deferred under a deferral election; the “reasonable period” for a QOF to reinvest proceeds from the sale of qualifying assets without paying a penalty; administrative rules applicable when a QOF fails to maintain the required 90 percent investment standard; and information reporting for QOFs.
 Note that while the Tax Cuts and Job Act created a new gain deferral mechanism with QOFs, it also significantly narrowed the availability of the popular gain deferral mechanism available under Section 1031 of the Code (now applicable only to the sale or exchange of real property). While gain deferral available under Section 1031 is available for exchanges of real estate regardless of whether such real estate is located in a QOZ, Section 1031 does not include any of the basis step-up / gain elimination benefits available to taxpayers who invest in a QOF.
 The requirement that (i) QOF be either a corporation or a partnership and (ii) an equity interest in QOZ Property be either stock of a corporation or a partnership interest raises the issue of whether a single member LLC treated as a disregarded entity can qualify as a QOF or QOZ Property. Under a strict reading of Section 1400Z-2, any QOF or QOZ Property intended to be held as a partnership interest, may require extra entities to properly structure the ownership of such interest. We expect further clarification on this issue.
 While the Proposed Regulations do not discuss how the basis rules of Subchapter K interact with the provisions of Section 1400Z-2 (other than with respect to recognition of deferred gain – discussed below), QOFs structured as partnerships may look to leverage to give partners outside basis for purposes of deducting potential losses. Without outside basis allocated from partnership debt, partners in a QOF may have no basis until they receive a 10 percent basis step-up after holding their interests in the QOF for 5 years or, if earlier, their deferred gain is included in gross income on December 31, 2026.
 Note that the Proposed Regulations anticipate the ability to roll a deferred gain over more than once via investment in a QOF, provided that any subsequent gain deferral election relates to the entirety of the previously deferred gain.
 Sales or exchanges between related parties are any sales between (i) members of a family; (ii) an individual and a corporation more than 20 percent in value of the outstanding stock of which is owned, directly or indirectly, by or for such individual; (iii) two corporations which are members of the same controlled group; (iv) a grantor and a fiduciary or any trust; (v) a fiduciary of a trust and a fiduciary of another trust, if the same person is a grantor of both trusts; (vi) a fiduciary of a trust and a beneficiary of such trust; (vii) a fiduciary of a trust and a beneficiary of another trust, if the same person is a grantor of both trusts; (viii) a fiduciary of a trust and a corporation more than 20 percent in value of the outstanding stock of which is owned, directly or indirectly, by or for the trust or by or for a person who is a grantor of the trust; (ix) a person and an organization to which Section 501 (relating to certain education and charitable organizations which are exempt from tax) applies and which is controlled directly or indirectly by such person or (if such person is an individual) by members of the family of such individual; (x) a corporation and a partnership if the same persons own – (A) more than 20 percent in value of the outstanding stock of the corporation, and (B) more than 20 percent of the capital interest, or the profits interest, in the partnership; (xi) an S corporation and another S corporation, if the same persons own more than 20 percent in value of the outstanding stock of each corporation; (xii) an S corporation and a C corporation, if the same persons own more than 20 percent in value of the outstanding stock of each corporation; or (xiii) except in the case of a sale or exchange in satisfaction of a pecuniary bequest, an executor of an estate and a beneficiary of such estate. See Sections 1400Z-2(e)(2), 267(b) and 707(b)(1).
 It is worth noting that, despite the issuance by the Treasury Department of some much needed guidance, investing in a QOF remains subject to a great deal of uncertainty and significant investment risk. These risks include but are not limited to: illiquidity of investment, potential lack of control over the management of a QOF, risk of tax penalties under the 90 Percent Asset Test, risk of failure of a QOF or a QOF Business to qualify as such, reliance on a QOF investment manager with inherently minimal experience in the management of a QOF, and fees and expenses related to maintaining a QOF and complying with QOF and QOZ Business requirements. These and other risks can disqualify a QOF investor from the tax benefits promised by an investment in the QOF.
 An investor’s effective federal tax rate on a sale of QOZ Property for a QOZ structured as a corporation would be 21% and would be paid by the corporation (assuming the corporation does not issue a dividend). The effective federal tax rate for the same sale for an investor in a QOZ structured as a partnership would be 20% (assuming the highest applicable rate). Note that in a QOZ structured as a corporation, the corporation pays the tax rather than the investor. Thus, the overall tax cost to the investor is similar (21% vs. 20%). However, with a QOF structured as a corporation, the investor would be able to avoid paying the tax cost out of pocket.
 The concept of an active trade or business is a common one in the Code, and a large body of judicial definitions and administrative guidance on the issue exist, albeit in other contexts. The Supreme Court’s standard for a trade or business under Section 162, as articulated in Commissioner v. Groetzinger, 480 U.S. 23 (1987), requires an activity to be conducted (i) with “continuity and regularity” and (ii) with the primary purpose of earning income or making a profit. Groetzinger held that, under the facts of the case, a professional gambler was engaged in a trade or business.
[i] The Revenue Ruling does not address the issue of “substantial improvement” in circumstances where investment is made in the stock or partnership interests of a QOZ Business and the proceeds of such investment are used for a variety of purposes to enhance that business, such as the purchase of new equipment, research and development and other costs. Under general tax principles these expenditures would be subject to capitalization, but might also be entitled to elective or other current deduction (i.e., under Section 179 of the Code). Under current guidance, it is unclear whether such enhancements of a QOZ Business would be taken into account in determining whether a “substantial improvement” has occurred, and whether, conversely, there would still be a requirement that the bases of each pre-existing asset of the QOZ Business be increased – as was the case for the building described in the Revenue Ruling.
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