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Due to inclement weather conditions, the Raleigh office will be closed today, Jan. 21, 2022.

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February 15, 2022

FinTech and Special Purpose Acquisition Companies (SPACs)

Continuing the FinTech University series, join chair of Nelson Mullins FinTech and Regulation Practice and moderator, Richard Levin, and attorneys Jon Talcott, Andy Tucker, and Peter Strand for this one-hour session, "FinTech and SPACs." Continuing Legal Education (CLE) credit will be sought for all attorneys requesting. Certificates of attendance are available upon request for CPE purposes. State boards of accountancy have final authority on the acceptance of individual courses for CPE credit.

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Tax Reports

May 21, 2019

Tax Report – Qualified Opportunity Zones Guidance: Second Set of Proposed Regulations Released

By C. Wells Hall, III, Gene Crick Jr., Erin Reeves McGinnis, Maurice D. Holloway, Drew Hermiller, Samantha D'Angelo, Jeffrey K. Gurney, Chip Gray

On April 17, 2019, the United States Treasury Department (“Treasury”) issued a second set of proposed regulations (Prop. Reg. §1.1400Z-1 and -2) (“Proposed Regulations II”) under Section 1400Z of the Internal Revenue Code, as amended, (the “Code”), supplementing the initial guidance issued by Treasury on October 19, 2018 (“Proposed Regulations I,” together with Proposed Regulations II, the “Proposed Regulations”).  Proposed Regulations II provide taxpayers with further guidance on the deferral and potential elimination of gains provided through investment in a Qualified Opportunity Fund (“QOF”). 

Proposed Regulations II provide guidance on a wide array of issues, including:

  • the meaning of “substantially all” in the various places where it appears in Code Section 1400Z-2;
  • treatment of leased property used in a Qualified Opportunity Zone (“QOZ”)[1], and clarification that there is no original use requirement or substantial improvement for leased property, which can be acquired from a related lessor;
  • the sourcing of income for purposes of the gross income test and the promulgation of three safe harbors for determining whether the 50% gross income test is met;
  • the treatment of the receipt of proceeds by a QOF from the sale or disposition of QOZP (as defined below), and permitting the proceeds to be reinvested within a “reasonable period” without incurring a penalty under 90% Test (as defined below);
  • relief under the 90% Test for QOF investments made within the previous six months;
  • the extension of the 10 Year Basis Step-Up (as defined below) to gain generated by the sale of QOZP by a QOF treated as a partnership or s-corporation;
  • guidance for QOF transactions that may trigger the inclusion of some or all of an investor’s original deferred gain, including gifts, donations to charity, transfers of interests, death transfers, and corporate dividends;
  • treatment of mixed fund investments, where a taxpayer invests both eligible gains and other amounts to a QOF;
  • treatment of transfers of noncash property to a QOF;
  • guidance on the treatment of leveraged distributions made by a QOF and the application of the disguised sale rules;
  • the determination of what activities will constitute a trade or business for purposes of Code Section 1400Z-2;
  • guidance on the treatment of QOFs treated as corporations for purposes of the consolidated return regime; and
  • anti-abuse rules for transactions that are inconsistent with the intent of the law, to be applied on a facts and circumstances basis.

This Tax Report (i) analyzes the provisions of Proposed Regulations II and (ii) highlights some open issues that remain unaddressed or unclear.

Background

Code Sections 1400Z-1 and -2 were enacted as a part of The Tax Cuts and Jobs Act of 2017[2] to spur investment into certain economically distressed communities.  The program provides taxpayers who have recently realized gains with a means of deferring, and to some extent escaping, taxation of those gains as well as the ability to avoid taxation of the gain on the prospective appreciation of their investment.    

Pursuant to Code Section 1400Z-2, taxpayers with recently realized gains from the sale of stock, securities, real estate, and other capital assets may defer and even escape some taxation on that gain to the extent the gains are invested in a QOF within 180 days of the sale giving rise to the gain[3] (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 at least 5 years, the taxpayer’s basis in their QOF interest will be increased by 10 percent.  Further, 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 may elect to have the basis increased to fair market value (the “10-Year Basis Step-Up”).

A QOF is defined as a corporation or partnership that is organized for the purpose of investing its assets in qualified opportunity zone property (“QOZP” and the equity interests in such corporation or partnership “QOZ Stock” and “QOZ Partnership Interest” respectively).  A QOF is subject to a semi-annual requirement that at least 90% of its assets are invested in QOZP (the “90% Test”).  The assets of a QOF are generally tested twice a year with the results being averaged.  Noncompliance with the 90% Test will result in certain penalties applicable against a QOF and, in the case of a QOF structured as a partnership or s-corporation, a QOF’s investors. 

QOZP consists of (i) stock or partnership interests in an entity that qualifies as a qualified opportunity zone business (a “QOZB”) or (ii) tangible property that qualifies as qualified opportunity zone business property (“QOZBP”).

The treatment of an entity as a QOZB and the treatment of tangible property as QOZBP is subject to several additional rules that have been omitted here for the sake of brevity.  For a more detailed background synopsis of Code Sections 1400Z-1 and -2 and a summary of the initial guidance provided by the Treasury, see our previous Tax Report here.

Treatment of Tangible Property Leased by a QOF or QOZB

Code Section 1400Z-2 provides that tangible property that is leased by a QOZB may qualify as QOZBP for purposes of the requirement under Code Section 1400Z-2(d)(3)(A)(i) and Prop. Reg. § 1.1400Z2(d)-1(d)(3)(i) that at least 70 percent of the tangible property owned or leased by QOZB is QOZBP (the “70% Requirement”).  Proposed Regulations II clarify that tangible property leased by a QOF may also qualify as QOZBP for purposes of the 90% Test.  In each instance, Proposed Regulations II provide that such leased property is subject to two of the requirements to which tangible property that is owned by a QOF or QOZB, as applicable, are also subject.  Those requirements, as applied to leased property, are that: (i) the lease for such property must be entered into after December 31, 2017 and (ii) substantially all (meaning 70 percent, as discussed below) of the use of such tangible property must be in a QOZ during substantially all (meaning 90 percent, as discussed below) of the period for which the property is leased.  However, Proposed Regulations II provide that, in contrast to the treatment of purchased tangible property, the “original use” and “substantially all” requirements of Code Section 1400Z-2(d)(2)(D)(i)(II) will not apply to leased tangible property for purposes of the 90% Test and the 70% Requirement. 

In addition, Proposed Regulations II provide that the related party restrictions under Code Section 1400Z-2(e)(2) will not apply to leased tangible property.  However, in keeping with the spirit of the related party restrictions, Proposed Regulations II require that leased tangible property be subject to a “market rate lease,” as determined under the transfer pricing rules of Code Section 482.[4]  Further, Proposed Regulations II provide that if the relevant lessor and lessee are “related,” as determined under Code Section 267 and modified by Code Section 1400Z-2(e)(2), the lessee is prohibited from making a prepayment on the lease that relates to a period of use that is in excess of 12 months.  In addition, leases between such “related parties” create a second additional requirement under which the lessee (i.e., the QOF or the QOZB, as applicable) must acquire tangible property that is QOZBP with a value equal to the value of the leased property.  This acquisition must occur within a 30 month period beginning on the date that the lessee received possession of the leased tangible property and use of such purchased tangible property must occur in a QOZ that has substantial overlap with the QOZ in which the leased tangible property is used.

Finally, Proposed Regulations II impose an additional anti-abuse rule for leased real property.  Under the rule, if at the time the lease for such real property is entered into there is a plan or expectation on the part of the QOF or QOZB, as applicable, to purchase the real property for an amount other than fair market value (determined at the time of purchase and without regard to prior lease payments), the real property will not qualify for purposes of the 90% Test or 70% Requirement.

Valuation of Leased Tangible Property

Proposed Regulations II provide that, for purposes of the 90% Test and the “substantially all of the use” requirement of Code Section 1400Z-2(D)(i)(II), leased tangible property can be valued under one of two methods: (i) the applicable financial statement valuation method or (ii) the alternative valuation method. 

Under the financial statement valuation method, leased tangible property will have the value reported on the applicable financial statement of the QOF or QOZB, as applicable, for the relevant reporting period.  To select this method, such financial statements must be prepared according to generally accepted accounting principles.

Under the alternative valuation method, leased tangible property will have a value equal to the sum of the present values of the payments made under the lease for such property.[5]  Such present values must be calculated at the time the lease for such property is entered into and must be applied for all relevant testing dates. 

Once either valuation method is selected, it must be applied to all of the leased property of the QOF or QOZB, as applicable, for all of the applicable year.  As a result, any downturn in market value of a lease within such year will not be captured under the alternative valuation method.

Reinvestment by a QOF of Proceeds from the Sale of QOZP

Proposed Regulations II provide that, for purposes of the 90% Test, proceeds from the sale or disposition by a QOF of QOZP will be treated as QOZP so long as the QOF reinvests such proceeds within a 12-month period beginning on the date of such sale or disposition.  In other words, if a QOF generates cash by selling QOZP, such cash will not count against the QOF for purposes of the 90% Test for one year following such sale.  However, to qualify for this treatment, the proceeds from the sale or disposition of QOZP must be held in the form of cash, cash equivalents or debt instruments with a term of 18 months or less.  In addition, Proposed Regulations II provide that this 12-month window may be extended if the proceeds are not reinvested due to a delay in government action (such as a delay in approving a zoning application or a building permit), so long as the application for such action has been completed.

In addition, the preamble to Proposed Regulations II makes clear that Treasury has not been able to find statutory authority to exempt QOFs and, in turn, investors in such QOFs that are structured as pass through entities, from experiencing taxable gain arising from the disposition of QOZP by a QOF or the disposition of QOZBP by a QOZB owned by a QOF.  Accordingly, while reinvestment of proceeds from sale of QOZP within a 12-month period will provide a QOF with relief from the requirements of the 90% Test, such reinvestment will not provide QOF investors with relief from the income tax consequences of the sale generating such proceeds.  In short, reinvestment will not prevent investors of pass through QOFs from being taxed on the sale of assets held in their QOF structure.

90% Test Relief for Newly Contributed Assets

Under Proposed Regulations II, any investments received by a QOF in the six months prior to a testing date will not be taken into account for the determination of a QOF’s compliance with the 90% Test.  However, to qualify for this relief, such assets must be held in cash, cash equivalents or debt instruments with a term of 18 months or less. 

In some instances, this relief may allow for a QOF to hold investments for nearly 12 months prior to investing them in QOZP.  For example, if a QOF were to receive cash investments on July 1st of a given taxable year, the QOF would be subject to only one relevant testing date with respect those investments in that taxable year (December 31st).  Under the relief granted by Proposed Regulations II, those investments would not count for that testing date.  Thus, the first relevant testing date for investments received on July 1st would be June 30th of the following year, nearly a full year after the receipt of such investments.

Expansion of 10 Year Basis Step-Up for Pass Through QOFs and QOF REITs

Proposed Regulations II expand the application of the 10 Year Basis Step-Up election available under Code Section 1400Z-2(c).  Under the expanded rule, a taxpayer that is a holder of an interest in a QOF that is treated as a partnership or s-corporation may make an election to exclude from gross income some or all of the capital gain allocated to such holder as a result of the QOFs disposition of QOZP, provided that such disposition occurred after the investor has held its interest in the QOF for 10 years.  This expanded rule only applies to items of gross income that are capital gains.  As such, this may not apply to all of the gain recognized on a QOF’s disposition of QOZP.

Similarly, Proposed Regulations II authorize a QOF that is also treated as a real estate investment trust (a “REIT”) to designate special capital gain dividends, so long as such dividends do not exceed the QOF REIT’s long-term gain on sales of QOZP.  If shares of such QOF REIT are qualified investments in the hands of a shareholder, the special capital gains dividend would be tax free to such shareholder, provided that the relevant sale of QOZP occurred after the shareholder held its interest in the QOF for 10 years.

The Mixed Fund Rules and Contribution of Cash or Property

Code Section 1400Z recognizes that a taxpayer may make a contribution to a QOF (a “QOF investment”)[6] in an amount that exceeds the taxpayer’s amount of gain that is eligible for the deferral and the 5, 7 and 10 year basis step up tax benefits of the law. Such a contribution is treated as a mixed investment consisting of the eligible gain portion and a portion subject to normal tax treatment (i.e., a portion not eligible for QOF benefits).  Such a mixed QOF investment[7] may occur intentionally, or unintentionally where the amount of the eligible gain is initially estimated and later determined to be smaller when tax returns are finalized, or when the amount is re-determined in connection with an audit of the taxpayer’s tax return.  The Code Section 1400Z-2(e)(1) rules governing a mixed QOF investment are referred to in this Tax Report as the “QOF Mixed Fund Rules.”

In effect, the QOF Mixed Fund Rules divide investments which exceed the amount of gain qualifying for the QOF election into two separate investments on the basis of a “vertical slice.” One slice, consisting of the qualifying QOF investment, is subject to the special QOF rules, and the other slice, consisting of the non-qualifying QOF investment, is treated under normal tax rules. The basis of each separate interest is determined as if such interest was held by different taxpayers, notwithstanding the normal pooling of basis rules applicable in determining a taxpayer’s basis in a partnership interests.

Proposed Regulations II set forth two cases where a taxpayer is treated as having created a mixed-funds investment. First, a mixed-funds investment will result if a taxpayer contributes to a QOF, in a nonrecognition transaction such as a contribution under Code Section 721, property that has a fair market value in excess of the property’s adjusted basis. Second, a mixed-funds investment will result if the amount of the investment that might otherwise support a QOF election exceeds the amount of the taxpayer’s eligible gain. In each instance, that excess (that is, the excess of fair market value over adjusted basis, or the excess of the investment amount over eligible gain, as appropriate) is treated as an investment to which the QOF deferral election does not apply.

Contributions of Property to a QOF in Nonrecognition Transactions – Application of the “Mixed Fund” Rules

If a taxpayer makes a QOF investment by transferring cash to a QOF, the amount of the taxpayer’s QOF investment is the amount of cash invested.  On the other hand, Proposed Regulations II contemplate that a taxpayer may make a contribution of property to a QOF in a nonrecognition transaction (i.e., a transfer to a partnership under Code Section 721 or a transfer to a controlled corporation under Code Section 351) or in a taxable transaction.

Proposed Regulations II provide that when a taxpayer contributes property to a QOF in a nonrecognition transaction, where under Code Sections 721 or 351 the taxpayer’s basis in the QOF would be determined, in whole or in part, by reference to taxpayer’s basis in the transferred property, the amount of the taxpayer’s QOF investment is the lesser of (a) the taxpayer’s adjusted basis in the contributed property plus any gain recognized in the transaction, which in turn equals the taxpayer’s basis in the eligible interest received in the transaction, without regard to Code Section 1400Z-2(b)(2)(B), or (b) the fair market value of the eligible interest received in the transaction, determined immediately after the contribution. This rule is applied separately to each item of property contributed to a QOF. 

Proposed Regulations II provide that the QOF Mixed Fund Rules come into play when a taxpayer contributes property to a QOF in a nonrecognition transaction (in whole or in part).  For example, when the fair market value of the eligible interest in the QOF received by the taxpayer is in excess of the taxpayer’s adjusted basis in the eligible interest received, then the taxpayer’s investment is an investment subject to the QOF Mixed Fund Rules.[8] 

If a taxpayer’s investment in a QOF is subject to the QOF Mixed Fund Rules, the taxpayer’s basis in its interest in the QOF is equal to the taxpayer’s basis in all of the QOF interests received, determined without regard to the QOF deferral and basis adjustment provisions,[9] and reduced by the basis of the taxpayer’s investment to which the QOF election applies.[10]  

With respect to taxpayers who transfer property to a QOF partnership, Proposed Regulations II also provide that the amount of such taxpayer’s qualifying investment in the QOF partnership is the lesser of the taxpayer’s net basis in the property contributed to the QOF partnership, or the net value of the property contributed by the taxpayer to the QOF partnership.[11] The amount of such taxpayer’s non-qualifying investment in the QOF partnership is the excess, if any, of the net value of the contribution over the amount treated as a QOF investment.

When a taxpayer’s investment consists of both qualifying and non-qualifying investments, the basis of a qualifying investment is the net basis of the property contributed, determined without regard to Code Section 1400Z-2(b)(2)(B) or any share of debt under Code Section 752(a). The basis of a non-QOF investment (before any debt allocation under Code Section 752) is the remaining net basis. The bases of qualifying and non-qualifying investments are increased by any debt allocated to such investments.[12]   

Application of Disguised Sale Rules to QOFs Treated as Partnerships

Special rules apply to transfers of property to QOF partnerships subject to the disguised sale and mixing bowl transaction rules. These rules involve a panoply of statutes designed to stem possible abuses involving the use of partnerships to avoid the recognition of gain when property is contributed in exchange for cash or other property. To the extent the transfer of property to a QOF partnership is re-characterized under the rules as something other than a contribution (for example, as a sale for purposes of the disguised sale rules), Proposed Regulations II prohibit the transfer from being treated as a QOF investment under Code Section 1400Z-2(a)(1)(A). 

In addition, Proposed Regulations II provide the following modifications to the application of the disguised sale rules when applied to a QOF partnership: (i) any cash contributed to such QOF is treated as non-cash property and (ii) in the case of a distribution by such QOF to which Reg. § 1.707-5(b) applies (i.e., debt-financed distributions), the partner’s share of liabilities is zero. The effect of these modifications is that leveraged distributions made by a QOF partnership within two years of an investor’s contribution of cash to such QOF will have potential to disqualify that contribution from the tax benefits of an investment in a QOF, if it is determined that the disguised sale rules apply. 

Meaning of “Substantially All”

The phrase “substantially all” appears in various places in Code Section 1400Z-2.  However, the statute does not provide a definition or threshold as to the meaning of “substantially all.”  As discussed above, Proposed Regulations I[13] clarified that for purposes of determining whether an entity is a QOZB under Code Section 1400Z-2(d)(3)(A)(i), the threshold test is whether at least 70 percent of the tangible property owned or leased by a trade or business is QOZBP.[14]  Although the meaning of substantially all was clarified for this purpose, Proposed Regulations I left open the meaning of “substantially all” in other places throughout Code Section 1400Z-2(d)(2).  Specifically, the meaning of substantially all was not addressed with respect to the use of QOZP and with respect to a QOF’s holding period for QOZ Stock or QOZ Partnership Interests. Proposed Regulations II clarify the meaning of substantially all for these purposes.

Proposed Regulations II clarify that in the case of tangible property that is owned or leased by a QOF, a trade or business of the QOF will satisfy the requirement under Prop. Reg. § 1.1400Z-2(d)-1(c)(4)(i)(D) that “substantially all” of the use of such tangible property by the QOF be in a QOZ if at least 70 percent of the use of such tangible property occurs in a QOZ.[15]  For purposes of determining whether the holding period requirements in Prop. Reg. § 1.1400Z-2(d)-1(c)(4)(i)(D) are satisfied with respect to tangible property that is owned or leased by a QOZB, the term “substantially all” means at least 90 percent. The IRS and Treasury Department justified a 90 percent test for the holding period, rather than 70 percent test for other uses of the term substantially all, because taxpayers can more easily control and determine how long they hold the property.

In addition, Proposed Regulations II clarify that with respect to the requirement under Code Section 1400Z-2(d)(3) that a “substantial portion” of the intangible property of a QOZB be used in the active conduct of a trade or business located within a QOZ, the phrase “substantial portion” means at least 40%.

What Constitutes the Active Conduct of a Trade or Business

Code Section 1400Z-2 requires that a QOZB conduct an active trade or business.  While the question of what activities constitute an active trade or business has long been the subject of debate and litigation among tax practitioners, the IRS and the courts, it has not yet been addressed with respect to the QOZ program.  Proposed Regulations II address the issue and make use of the well-settled jurisprudence addressing the deduction of ordinary expenses incurred in a trade or business under Code Section 162.  Accordingly, Proposed Regulations II define an active trade or business for purposes of Code Section 1400Z-2 as a trade or business within the meaning of Code Section 162.  The effect of this cross-reference is that the existing jurisprudence and settled law under Code Section 162 will be applicable to the determination of the existence of an active trade or business for purposes of Code Section 1400Z-2.  Consistent with that application, Proposed Regulations II provide that the ownership and operation (including leasing) of real property used in a trade or business will be treated as the active conduct of a trade or business under Code Section 1400Z-2.  However, merely entering into a triple-net-lease with respect to real property will not be treated as an active trade or business.

Expansion of the Working Capital Safe Harbor

Proposed Regulations II clarify that the written designation for planned use of working capital as provided for in Proposed Regulations I (the “Working Capital Safe Harbor”) covers the development of a trade or business as well as acquisition, construction or substantial improvement of tangible property.  Thus, working capital used on the development of real estate projects should clearly qualify for the Working Capital Safe Harbor.  In addition, Proposed Regulations II provide that the 31-month period for using working capital covered by the Working Capital Safe Harbor may be extended if such use is delayed due a delay in government action for which an application was completed during the 31-month period.

Safe Harbors for 50% Gross Income Tests

Under Code Section 1400Z-2(d)(3)(A)(ii), a QOZB operating a trade or business within a QOZ must derive at least 50% of its total gross income “from the active conduct of such business” (the “50% Gross Income Test”).  Proposed Regulations II provide three safe harbors for determining whether sufficient income will satisfy the 50% Gross Income Test.  Only one of the safe harbors must be met to satisfy the 50% Gross Income Test.  The three safe harbors require that:

  • at least 50% of the services performed (based on hours) for a QOZB by its employees and independent contractors (and employees of independent contractors) are performed within a QOZ; 
    • The percentage for this safe harbor is calculated as a fraction, the numerator of which is the total number of hours during which the employees and independent contractors performed services for the QOZB within the QOZ during the taxable year and the denominator is the total number of hours that the employees and independent contractors spent performing services for the QOZB anywhere during the taxable year.
       
  • at least 50% of the services performed by a QOZB’s employees and independent contractors (and employees of independent contractors) are performed for the QOZB within the QOZ, based on amounts paid for such services; or
    • The percentage for this safe harbor is calculated as a fraction, the numerator of which is the total amount paid by the QOZB for employee and independent contractor services performed within a QOZ during the taxable year and the denominator is the total amount paid by the QOZB for employee and independent contractor services performed anywhere during the taxable year.
       
  • both the tangible property of a QOZB located within a QOZ and the management or operational functions of the QOZB performed for the QOZB within the QOZ are necessary to generate 50% of the gross income of the QOZB. 
    • Proposed Regulations II provide that if a QOZB only has a PO box or some other form of a delivery address within a QOZ, such address will not constitute a factor necessary to generate gross income by such business for purposes of this third safe harbor.

In addition to these three safe harbors, Proposed Regulations II provide that QOZBs not meeting such safe harbors may still be able to meet the requirements of the 50% Gross Income Test if, based upon all of the facts and circumstances of the business, the IRS determines that at least 50% of the gross income of such business was derived from the active conduct of a trade or business located within a QOZ.

180-Day Period With Respect to 1231 Gains

Code Section 1231(a)(1) provides that Section 1231 gains are treated as capital gains and are recognized only to the extent they exceed Section 1231 losses.  Under the rules of  Code Section 1231, the determination of any excess Section 1231 gains is determinable only on the last day of the taxable year.  Therefore, Proposed Regulations II provide that a QOF investor’s 180-day period for investing such excess Section 1231 gains begins on the last day of the taxable year. Presumably, the election provided for in Proposed Regulations I, under which a partner could elect to use a partnership’s date of gain realization (i.e., the actual date of occurrence of the sale or disposition giving rise to the gain realization) for purposes of such partner’s 180-day period for its allocable share of the partnership’s gain, is not available for Section 1231 gains.

Original Use of Tangible Property

Proposed Regulations I left open the definition of “original use.”  Code Section 1400Z-2(d)(2)(D)(i)(II) requires that tangible property acquired by purchase[16] have its original use in a QOZ commencing with a QOF or, failing that, that the QOF substantially improve the property in order for the property to be treated as QOZBP.  Proposed Regulations II provide that for purposes of the original use of tangible property, original use within a QOZ commences on the date any person first places the property into service in a QOZ for purposes of depreciation or amortization (or first uses the property in a manner that would allow depreciation or amortization if that person were the property’s owner). If property has been unused or vacant for an uninterrupted period of at least 5 years, then the original use of such property commences on the date after that period when any person first uses or places property in service in the QOZ (for purposes of depreciation or amortization).  For used tangible property, the original use requirement will be satisfied if the property has not been previously so used or placed into service within the QOZ. If tangible property has been previously used or placed into service within the QOZ by someone other than the QOF or QOZB, it must be substantially improved in order to satisfy the original use requirements.  In addition, improvements made by a lessee to leased property will satisfy the original use requirement to the extent of the unadjusted cost basis of such improvements, as determined in accordance with Code Section 1012.

Proposed Regulations II also address original use with respect to land.  Proposed Regulations II amplified the treatment of unimproved land as discussed in Proposed Regulations I and Revenue Ruling 2018-29 and reiterate that unimproved land in a QOZ acquired by purchase does not need to be substantially improved and the original use requirement is not applicable to land. This has raised concerns over “land banking” where taxpayers purchase land solely to hold it and sell it tax-free due to the fact that unimproved land does not need to be substantially improved. It should be noted however that land can only be treated as QOZBP if it is used in a QOF’s trade or business, so the opportunity for abuse is minimized to some extent. However, given the potential for abuse, if a significant purpose for acquiring unimproved land is to achieve a more favorable tax result, the general anti-abuse rules in Prop. Reg. §1.1400Z-2(f)-1(c) (discussed below) will apply to treat the acquisition of the land as an acquisition of non-qualifying property.  In addition, in the Explanation of Provisions that was published with Proposed Regulations II (the “Explanation of Provisions”), Treasury notes that investments that involve the use of land that is inconsistent with the purpose of Code Section 1400Z-2 will not be given the tax benefits of such section.  As an example, Treasury provided that were a QOF to acquire a parcel of land currently used for producing an agriculture crop and subsequently fail to invest any new capital into the land or increase the economic activity or output of such land, the purposes of Code Section 1400Z-2 would not be met and such investment would not qualify QOZ tax benefits.

Safe Harbor for Use of Inventory in Transit

Proposed Regulations II provide that for purposes of the “use” requirement of QOZBP under Code Section 1400Z-2(d)(D)(i)(II), inventory (which includes raw materials, as noted in the Explanation of Provisions) may still be treated as being used in a QOZ even if it is in transit from a vendor to a trade or business facility located in a QOZ or from such a facility to customers who are not located in the QOZ.

Real Property Straddling a QOZ

Under Proposed Regulations II, where a QOF or a QOZB holds real property that straddles multiple census tracts, some of which are not designed as a QOZ, all of such property will be deemed to be located inside the QOZ if the amount of real property (based on square footage) located within the QOZ is substantial as compared to the amount of real property (based on square footage) located outside of the QOZ.  Real property located within a QOZ in such situations will be considered substantial if the unadjusted cost of the property inside a QOZ is greater than the unadjusted cost of the property located outside of the QOZ.  This determination applies for purposes of determining the location of services, tangible property or business functions of a QOZ or QOZB.

Inclusion Events

Under Code Section 1400Z-2(a), an eligible taxpayer may elect to defer recognition of some or all of its gain to the extent that the taxpayer timely invests in an equity interest of a QOF (a “Deferred Gain”).  Generally, the QOF investor recognizes the Deferred Gain on the earlier of the date of sale or exchange of their interest in the QOF or December 31, 2026.  Proposed Regulations II provide generally that an inclusion event may occur when a transfer of an equity investment in a QOF reduces the QOF investor’s equity interest in a QOF for federal income tax purposes or when such investor receives property that is treated as a distribution from the QOF for federal income tax purposes. For these purposes, property includes cash, tangible property and securities other than securities of a QOF corporation. Proposed Regulations II treat these transactions as inclusion events, which effectively prevent QOF investors from exiting a QOF investment without recognizing any amount of the Deferred Gain.

Pursuant to Proposed Regulations II,[17] the nonexclusive list of inclusion events includes (among others) the following events (if and to the extent that):

  • a QOF investor transfers, directly or indirectly, an equity interest in a QOF and such transfer reduces the investor’s continuing interest in the QOF;
  • a distribution of property with respect to a QOF investor’s interest in a QOF reduces the investor’s continuing interest in the QOF;
  • a QOF investor’s claim of a deduction or loss is due to worthlessness with respect to stock such investor holds in a QOF corporation;
  • a QOF investor transfers an interest in a QOF by gift, whether outright or in trust;
  • a disposition of an interest in a QOF made by a decedent’s QOF investor’s estate or trust;
  • a QOF partnership distributes property to a partner and the distributed property has a fair market value in excess of the partner’s basis in its QOF interest;
  • a taxable disposition interests in a QOF investor that is also an S corporation if, immediately after the disposition, the aggregate percentage of the S corporation’s ownership as of the date of investment into the QOF changes by more than 25%;
  • a distribution by a QOF S corporation of property with respect to qualifying QOF stock under Code Section 1368 to the extent such distribution is treated as gain from the sale or exchange of property under Code Sections 1368(b)(2) and (c);
  • a liquidation of a QOF corporation in a transaction to which Code Sections 331 or 332 apply;
  • a disposition of a QOF investor’s stock in a QOF corporation in a transaction to which Code Section 304 applies;
  • other than a qualifying Code Section 381(a)(2) transaction, a conversion of a QOF S corporation to a partnership or a disregarded entity; 
  • a distribution by a QOF C corporation of cash or property with a value that is in excess of the basis of a QOF investor’s stock in such corporation (for this purpose, a distribution of property includes a distribution of stock by a QOF C corporation which is treated as a distribution of property to which Code Section 301 applies pursuant to Code Section 305(b)); 
  • a redemption of a QOF investor’s stock in a QOF corporation to the extent treated as an exchange of property under Code Section 302;
  • a transfer of a QOF investor’s stock in a QOF corporation in a transaction to which Code Section 351 applies;
  • a stock-for-stock exchange of a QOF investor’s stock in a QOF corporation in a transaction to which Code Section 368(a)(1)(B) applies;
  • a distribution to shareholders by a corporate QOF investor of its stock in a QOF corporation in a transaction to which Code Section 355 applies; and
  • various acquisitive asset reorganizations involving a QOF corporation.

Amount of the Deferred Gain in the Case of an Inclusion Event

Proposed Regulations II determine the amount of Deferred Gain that is includable in gross income in the case of an inclusion event that occurs prior to December 31, 2026.[18]  If all of the QOF interest is disposed of by the taxpayer, all of the Deferred Gain will be recognized, subject to any appropriate basis adjustments (discussed below).  If less than all of the taxpayer's interest in the QOF interest is disposed of, Proposed Regulations II provide generally for the recognition of the proportion of the remaining Deferred Gain that equals the same proportion that the fair market value of the portion of QOF interest disposed of bears to the fair market value of the total QOF interest immediately before the inclusion event, subject to appropriate basis adjustments.

However, in the event of partnership distributions, C corporation distributions, dividend equivalent distributions, certain corporate reorganizations, Code Section 355 transactions, or  distributions in connection with recapitalizations and transactions under Code Section 1036 or Code Section 304,  the amount of gain included in gross income is equal to the lesser of: (i) the remaining Deferred Gain, or (ii) the amount that gave rise to the inclusion event. Also see the ordering rule under Basis Adjustments below.

Basis Adjustments

Proposed Regulations II provide that basis adjustments made for the recognition of income (i) upon December 31, 2026 or (ii) upon an inclusion event are made immediately after Deferred Gain is taken into account.   In the event a basis adjustment is required for certain inclusion events (set forth immediately below), the basis adjustment will be made prior to determining the tax consequences of the inclusion event.  Such inclusion events are as follows:

  • a reduction in direct tax ownership of an interest in a QOF;
  • a redemption of an interest in a QOF;
  • a distribution by a QOF C or S corporation in excess of a QOF investor’s basis; and
  • a distribution by a QOF partnership of property with a fair market value in excess of a QOF investor’s basis.

In addition, Proposed Regulations II clarify that if a QOF investor makes an election under Code Section 1400Z-2(c) to apply the 10 Year Basis Step-Up to their QOF interests, the basis adjustment for such election is made immediately before the investor disposes of their QOF interests.  If such disposition is of interests in a QOF partnership, the QOF partnership’s assets will be adjusted as if the QOF partnership had a Code Section 754 election in place prior to such disposition of interests.

Holding Periods

Proposed Regulations II provide holding period rules that apply to interests in a QOF for purposes of determining the five and seven year basis increases and the Ten Year Basis Step-Up.  Generally, unless otherwise provided, the length of time that an interest in a QOF has been held is determined without regard to the period for which the QOF investor had held property exchanged for such interest. Special rules apply in QOF corporation transactions.  The holding period for QOF stock received by a QOF investor in a qualifying Section 381(a)(2) transaction, a reorganization described in Code Section 368(a)(1)(E) or a Code Section 1036 exchange shall include the period for which the QOF investor held the stock exchanged in such transaction as long as the stock received has the same basis in whole or in part in the investor’s hands as the stock exchanged.  The holding period of qualified stock in a controlled corporation received by a QOF investor from the distributing corporation in a Code Section 355 transaction shall include the period for which the investor held the stock exchanged, provided the stock received has the same basis in whole or in part in the investor’s hands as the stock exchanged.  The holding period of an interest in a QOF held by an investor who received such interest as a gift (which was not an inclusion event or by reason of the prior owner’s death) includes the time during which the QOF interest was held by the donor or the deceased owner, respectively.

Transfers by Gift, Transfers at Death, and Transfers to Grantor Trusts

Proposed Regulations II[19] provide that a transfer of a QOZ investment by gift, whether outright or in trust, is an inclusion event, regardless of whether that transfer is a completed gift for Federal gift tax purposes, and regardless of the taxable or tax-exempt status of the donee of the gift.  

Code Section 1400Z-2(e)(3) provides that in the case of a decedent, amounts not previously includible in the gross income of the decedent are includible in gross income as provided by Code Section 691, dealing with income in respect of a decedent (“IRD”). Under the IRD rules, there is no step up in the basis of the asset upon the death of the holder, and the intrinsic gain continues to be subject to the inclusion rules in the hands of the transferee – that is, the transferee “steps into the shoes” of the decedent, and a subsequent inclusion event will trigger the recognition of the Deferred Gain.

Consistent with the IRD tax regime, Proposed Regulations II provide that the transfer of a QOZ investment by reason of the taxpayer’s death is not an inclusion event. Transfers by reason of death include a transfer to the deceased owner’s estate, a distribution of a QOZ investment by the deceased owner’s estate, a distribution of a QOZ investment by the deceased owner’s trust that is made by reason of the deceased owner’s death, the passing of a jointly owned QOZ investment to the surviving co-owner by operation of law, and any other transfer of a QOZ investment at death by operation of law.  A transfer by reason of death does not include a subsequent sale, exchange, or other disposition by the deceased taxpayer’s estate or trust, which would instead constitute an inclusion event. Similarly, any disposition by a legatee, heir, or beneficiary who received the QOZ investment by reason of the taxpayer’s death and any disposition by the surviving joint owner or other recipient who received the QOZ investment by operation of law on the taxpayer’s death would be an inclusion event.

Under the grantor trust rules, the grantor of a grantor trust is treated as the deemed owner of the assets of the trust.  Consistent with this construct, Proposed Regulations II provide that if the owner of a QOZ investment contributes the interest in the investment to a grantor trust, the contribution is not an inclusion event.  However, a change in the status of a grantor trust, whether the termination of grantor trust status or the creation of grantor trust status, is an inclusion event. The termination of grantor trust status as the result of the death of the owner of a QOZ investment is not an inclusion event. However, the provisions of Proposed Regulations II dealing with transfers of interests in QOF investments will apply to distributions or dispositions by the trust.

General Anti-Abuse Rule

Proposed Regulations II provide that if a significant purposes of a given transaction is to obtain a tax result that is inconsistent with the policy purposes of Code Section 1400Z-2, the IRS will have the power to recast the transaction, for tax purposes, to achieve a result consistent with such purposes.  The application of the rule is based on all of the facts and circumstances surrounding the transaction.

Consolidated Return Rules

Proposed Regulations II acknowledge that the framework of the QOZ regime and the consolidated return regulations are incompatible in many respects and instead of trying to forcibly harmonize the two frameworks, Proposed Regulations II elects to treat stock in a QOF classified as a corporation as not stock for purposes of determining affiliation under the consolidated return rules.  Accordingly, a QOF classified as a corporation can be the common parent of a consolidated group, but cannot be a subsidiary member of a consolidated group.

Proposed Regulations II provides that the deferral rules apply separately to each member of a consolidated group.  Thus, the member of the consolidated group that sells a capital asset that results in the gain must be the same member that makes the corresponding investment in the QOF in order to defer the gain.

When a member of a consolidated group makes a qualifying investment in a QOF (the “QOF Owner”), Proposed Regulations II treat the special basis adjustments applicable to such qualifying investment as tax-exempt income to such QOF Owner.  Consequently, members of the consolidated group who own stock in the QOF Owner will get to increase their basis in the stock of the QOF Owner by the amount of the applicable basis adjustments to the QOF Owner’s investment in the QOF.

In applying the anti-loss duplication rules in the consolidated return regulations, an interest in a QOF is taken into account in determining whether there is a duplicated loss.  However, if loss duplication exists, the loss duplication cannot be cured by reducing the QOF Owner’s basis in such investment.  To the extent a qualifying investment would be subject to attribute reduction, the basis in the QOF Owner’s stock is reduced instead.

Unresolved issues

While both Proposed Regulations I and Proposed Regulations II have provided a great deal of clarity on the application of the basic rules set forth in Code Section 1400Z-2, there are a few issues that remain unresolved and a few others that have arisen in light of the contents of the Proposed Regulations.  Below is a brief summary of a few of these.

  • Inconsistent Treatment Between Structure Levels – While Code Section 1400Z-2 anticipates that either a QOF or a QOZB can operate a trade or business and hold QOZBP, many of the provisions of Code Section 1400Z-2 as well as Proposed Regulations I and II apply exclusively to either a QOF or a QOZB but not to both.  This can require significant structuring requirements (including the increasingly standard practice of having a QOF hold its investments through a lower tiered partnership) that do not have an obvious policy rationale.  While there has been much commentary discussing these inconsistencies and curious structuring requirements, the legislative history of Code Section 1400Z-2 and the Explanation of Provisions of both Proposed Regulations I and II have not addressed the issue or indicated that any resolution may be forthcoming.  Below is a summary of a few of the prominent examples of such inconsistent treatment:
    • The Working Capital Safe Harbor is only applicable to a trade or business run by a QOZB and not to a trade or business run by a QOF.  Consequently, to make use of the extra 31 months for deployment of investor cash (as provided for in the safe harbor), a QOF must form a lower tier QOZB and shift such cash down to that entity.  Presumably, the same trade or business that would ultimately be operated by such QOZB (such as the development and leasing of real property) could be also operated by a QOF holding QOZBP directly.  Were the Working Capital Safe Harbor to apply at the QOF level, the QOF would have no need to undertake the administrative expense and burden of creating a subsidiary.
    • The new expansion of the 10 Year Basis Step-Up for pass through QOFs applies only to the sale by a QOF of QOZP and not to the sale of QOZBP by a QOZB.  Consequently, investors of a QOF partnership structured with a subsidiary QOZB partnership holding QOZBP (as discussed directly above) will still be subject to capital gain upon the sale of QOZBP by the subsidiary QOZB.  In such a structure, a tax-free exit for investors upon the winding up of the QOF will still appear to require the sale of an entity (i.e., interests in the QOF or interests in the QOZB).
    • The requirements of paragraphs (2), (4) and (8) of Code Section 1397C(b) apply only to a QOZB.  Presumably, this means that a trade or business of a QOF that directly holds QOZB would not be subject to the 50% Gross Income Test, the requirements regarding the use of intangible property or the 5 percent ownership limitation on Nonqualified Financial Property (as defined in Code Section 1397C(e)) (the “5% NQFP Test”).  It should be noted, however, that the Explanation of Provisions of Proposed Regulations II did request comments on this point.
    • The new 12 month relief for the reinvestment of sale proceeds applies only to the sale of QOZP by a QOF for purposes of the 90% Test and not to the sale of QOZBP by a QOZB for purposes of the 5% NQFP Test.  If a QOZB sells a significant amount of QOZBP assets and the proceeds of such sale are not covered by a working capital plan as provided under the Working Capital Safe Harbor, such cash will count against the QOZB for purposes of the NQFP, even if reinvested within 12 months.
    • The stipulation that the determination of the existence of a trade or business of a QOZB shall be determined in accordance with Code Section 162 does not apply to a trade or business of a QOF owning QOZBP directly.  However the jurisprudence of the determination of the existence of a trade or business elsewhere in the Code indicates that similar treatment should apply to such a QOF.
    • The ability of an investor to contribute property to a QOF in exchange for an interest in the QOF and obtain Code Section 1400Z-2 tax benefits does not extend to the QOF’s contribution of such property down to a subsidiary QOZB.  Any qualifying interest that a QOF obtains from a subsidiary QOZB is still required to be obtained for cash.
  • Substantial Improvement requirements still apply on an asset by asset basis.  The calculations needed to determine whether QOZBP has been substantially improved apply to each piece of QOZBP individually.  While this may not be problematic for QOZBs that hold primarily real estate assets, there may be significant administrative burden for QOZBs that are run as actual operating companies.  For example, a sporting goods store operating since 2015 within a QOZ may have thousands of items of tangible property.  If the store was purchased by a QOF to be operated as a QOZB, the QOF would be required to substantially improve the store’s items of tangible property.  Under the current requirements of Code Section 1400Z-2 and the Proposed Regulations, such substantial improvement would technically need to be calculated for each item individually.  It should be noted, however, that the Explanation of Provisions of Proposed Regulations II did request comments on this point.
  • The new expansion of the 10 Year Basis Step-Up for pass through QOFs applies only to capital gain generated by the sale of QOZP.  In the event that the sale of QOZP by a QOF triggered ordinary gain (for instance, gain from depreciation of the QOZP) it appears the basis step-up election of Code Section 1400Z-2(c) would not relieve QOF investors from recognition of such gain.
  • Will the key deadline dates of Code Section 1400Z-2 be extended?  Under the current rules of Code Section 1400Z-2 and the Proposed Regulations, an investor wishing to maximize their tax benefits with respect to an investment in a QOF must make such investment by the end of 2019.  Given the release dates of administrative guidance by Treasury (October 2018 for Proposed Regulations I and April 2019 for Proposed Regulations II) such investors have a relatively short timeframe to educate themselves about QOF investments. Given that concern, there are currently bills being proposed in Congress which may extend the relevant deadlines for investment.  However, as of the publication of this Report there is no indication whether such bills or any other attempt at timeline extension will be successful.

Nelson Mullins will continue to monitor the status of the Proposed Regulations and comments submitted by other professional groups during the regulatory process. We may participate in the submission of comments on the Proposed Regulations. If you have any questions or comments about the foregoing summary of the Proposed Regulations, please contact Gene Crick, Samantha D’Angelo, Chip Gray, Jeff Gurney, Wells Hall, Drew Hermiller, Maurice Holloway, or Erin Reeves McGinnis who have contributed to the preparation of this Report, or any other member of the firm’s Opportunity Zone practice group.


[1] A list of officially designated QOZs can be found here: https://www.irs.gov/pub/irs-drop/n-18-48.pdf.
[2] P.L. 115-97.  References to “Section” in this Report refer to Sections of the Internal Revenue Code of 1986 (the “Code”) and references to “Reg. §” refer to Proposed and Final Regulations promulgated under the Code.
[3] Proposed Regulations I clarified that individuals who are allocated gains as a result of their interest in a pass through entity will generally be treated as realizing those gains on December 31 of the year in which the transaction giving rise to such gains occurred.  However, such investors may be able to make an election to be treated as realizing those gains on the date that the pass through entity engaged in the transaction generating the gains.
[4] Generally speaking, the transfer pricing rules under Code Section 482 require that the lease terms at issue reflect the terms of a typical “arm’s length” lease in the region in which the property subject to the lease sits.
[5] The present value of lease payments are calculated using the discount rate provided for in Code Section 1274(d)(1), determined by substituting the term “lease” for “debt instrument."
[6] Proposed Regulations II refer to a qualifying investment in a QOF as a “section 1400Z-2(a)(1)(A) investment.” The term “QOF investment” is used in this Tax Report for the convenience of the reader.
[7] A “mixed fund investment” is defined in Prop. Reg. §1.1400Z-2(b)-1(a)(2)(v)).
[8] Proposed Regulations II further provide that where there is a transfer to a corporation of built-in loss property which is subject to Code Section 362(e)(2), the taxpayer is deemed to have made an election under Code Section 362(e)(2)(C), resulting in the adjustment of the transferor’s basis in the stock received for property so that it does not exceed the fair market value of the property transferred.
9] Code Section 1400Z-2(b)(2)(B).
[10] Code Section 1400Z-2(e)(1)(A)(i) . In both cases, Proposed Regulations II provide that the taxpayer’s basis in the QOF subject to the QOF Mixed Fund Rules is determined without regard to the QOF deferral and basis adjustment provisions of Code Section 1400Z-2(b)(2)(B).
[11] For these purposes, net basis is defined as the excess, if any, of the adjusted basis of the property contributed to the partnership, over the amount of any debt to which the property is subject or that is assumed by the partnership in the transaction.  Net value is the excess of the gross fair market value of the property contributed, over the amount of the debt assumed. Prop. Reg. § 1.1400Z-2(b)-1(c)(4).
[12] Proposed Regulations II provide for basis adjustments for debt allocable to the partner under Prop. Reg. § 1.1400Z-2(b)-1(c)(6)(iv).
[13] Prop. Reg. § 1.1400Z2(d)-1(d)(3)(i).
[14] Code Section 1400Z-2(d)(3)(A)(i).
[15] Proposed Regulations II did not address what constitutes “use” of tangible property.
[16] As defined under Code Section 179(d)(2).
[17] Prop. Reg. § 1.1400Z-2(a)-1(c).
[18] Prop. Reg. § 1.1400Z-2(a)-1(e).
[19] Prop. Reg. §1.1400Z-2(b)-1(c).



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