The United States Treasury Department (“Treasury”) recently issued correcting amendments (the “Amendments”) to the final regulations (the “Final Regulations”) under Section 1400Z of the Internal Revenue Code, as amended (the “Code”) previously released on December 19, 2019. The Amendments contained certain modifications that may have an effect on taxpayers who have deferred capital gains by making an investment in a Qualified Opportunity Fund (a “QOF”). These include (i) a broadened scope of the QOF investments to be reported on IRS Form 8997, (ii) a clarification regarding the application of the alternative valuation method for purposes of a QOF’s ownership of a subsidiary partnership or corporation treated as a qualified opportunity zone business (a “QOZB”) and (iii) clarifications regarding the application of the Working Capital Safe Harbor (as defined below) applicable to cash and cash equivalents held by a QOZB.

Background

Code Sections 1400Z-1 and -2 were enacted as a part of The Tax Cuts and Jobs Act of 2017[i] 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 avoiding, taxation of those gains as well as the 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 (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 any event treated as an “inclusion event” by the Final Regulations) 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”) for purposes of a sale of the taxpayer’s QOF interest or the sale of assets by the QOF.

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 QOZB or (ii) tangible property that qualifies as qualified opportunity zone business property (“QOZBP”).

For a summary of the prior guidance provided by Treasury including proposed Treasury Regulations and the Final Regulations, see our previous Tax Reports:

• New Qualified Opportunity Zones Guidance: Proposed Regulations and Revenue Ruling 2018-29
• Qualified Opportunity Zones Guidance: Second Set of Proposed Regulations Released
• Qualified Opportunity Zones: Final Regulations Released

Information to be Included on Form 8997

Under the Final Regulations, taxpayers who have qualifying investments in one or multiple QOFs are required to report to the IRS any such investments held by the taxpayer as of the end of each taxable year. The Amendments expand the scope of this reporting requirement to include any qualifying investment held at any point during the taxable year. Accordingly, any qualifying investment in a QOF held by a taxpayer and sold or otherwise disposed of prior to the end of a taxable year will still be required to be included on the taxpayer’s Form 8997 for the year of disposition.

Acquired QOZ Stock and QOZ Partnership Interests to be Valued by Unadjusted Cost Basis Pursuant to the Alternative Valuation Method for Purposes of the 90% Test

To determine compliance with the 90% Test, a QOF is required, on a semiannual basis, to use one of two valuation methods as set forth in the Final Regulations — the applicable financial statement valuation method and the alternative valuation method. QOFs using the alternative valuation method are required to use unadjusted cost basis as the value of property acquired by purchase or constructed by the QOF. All other assets are to be valued pursuant to fair market value. The Amendments explicitly stipulate that QOZ Stock and QOZ Partnership Interests acquired by a QOF will be treated as purchased by the QOF (and thus valued pursuant to unadjusted cost basis for purposes of the alternative valuation method).

Clarification Regarding the Application of the Working Capital Safe Harbor

The Final Regulations expanded, under certain circumstances, the period during which cash or cash equivalents held by a QOZB could be treated as a “reasonable amount of working capital” under Section 1397C(e)(1) and thus not count against the QOZB for purposes of the limitations on the ownership “non-qualified financial property” (the “Working Capital Safe Harbor”). Pursuant to the Final Regulations, an initial contribution of cash to a QOZB (normally eligible for treatment as working capital under the Working Capital Safe Harbor for a period of 31 months) may be eligible for working capital treatment for an additional 31 months upon a subsequent contribution of cash that also qualifies for the Working Capital Safe Harbor (essentially starting the 31 month clock over for the initial cash contribution as of the date of the second cash contribution). The Amendments clarify the limitations that govern the ability of a subsequent cash contribution to restart the 31-month period of an initial cash contribution under the Working Capital Safe Harbor. Specifically, the Amendments stipulate (i) that the cash from and initial contribution of working capital was expended in accordance with the working capital plan of the QOZB, (ii) any subsequent cash contribution must form an integral part of the working capital plan covering the initial contribution and (iii) any subsequent cash contribution must constitute a substantial amount of working capital. This last element is likely to prevent QOF owners from manipulating the expanded Working Capital Safe Harbor by extending an initial Working Capital Safe Harbor period merely through the investment of a de minimis cash at the end of such period.

If you have any questions or comments about the foregoing summary of the Amendments, please contact Gene Crick, Wells Hall, or Drew Hermiller who have contributed to the preparation of this Report, or any other member of the Nelson Mullins Opportunity Zone Practice Group.