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Final Regulations on Opportunity Zones

On December 19, 2019, the Internal Revenue Service (the “IRS”) and the U.S. Department of the Treasury (the “Treasury”) issued final regulations (the “Final Regulations”) under section 1400Z-2 of the Internal Revenue Code[1] regarding the opportunity zone program, which was enacted as part of the law commonly referred to as the “Tax Cuts and Jobs Act”.[2] The opportunity zone program is designed to encourage investment in distressed communities designated as “qualified opportunity zones” (“opportunity zones”) by providing tax incentives to invest in “qualified opportunity funds” (“QOFs”) that, in turn, invest directly or indirectly in the opportunity zones.

The opportunity zone statute left many uncertainties regarding the fundamental operations of the opportunity zone program. The IRS and Treasury issued two sets of proposed regulations under section 1400Z-2 in October 2018 and April 2019 (the “Proposed Regulations”). The Proposed Regulations were discussed in two of our earlier blog posts, found here and here. The Final Regulations address the many comments received in response to the Proposed Regulations and retain the basic approach and structure set forth in the Proposed Regulations, but include clarifications and modifications to the Proposed Regulations. The Final Regulations are generally taxpayer-favorable, and incorporate many of the provisions requested by commentators. However, there are certain provisions that are worse for taxpayers than under the Proposed Regulations.

The Final Regulations will be effective on March 13, 2020, and are generally applicable to taxable years beginning after that date. For the portion of a taxpayer’s first taxable year ending after December 21, 2017 that began on December 22, 2017, and for taxable years beginning after December 21, 2017 and on or before March 13, 2020, taxpayers and QOFs generally may choose to apply the Final Regulations or the Proposed Regulations, so long as, in each case, they are applied consistently and in their entirety.

This blog summarizes some of the important aspects of the Final Regulations. It assumes familiarity with the opportunity zone program.

Summary

This section lists some of the most important changes in the Final Regulations.

  • All gain on the sale of a QOF interest or underlying assets after 10 years is excluded, other than gain from ordinary course sales of inventory. The Proposed Regulations provided that if a taxpayer held an interest in a QOF for at least 10 years, then upon a sale of the QOF, all gain could be excluded, including any gain attributable to depreciation recapture or ordinary income assets. The Proposed Regulations also permitted an investor that held a qualifying interest in a QOF partnership or S corporation for at least 10 years to elect to exclude capital gains (but not other gains) realized by the QOF partnership or S corporation on the sale of underlying qualified opportunity zone property. The Final Regulations very helpfully provide that an investor that has held a qualifying interest in a QOF for at least 10 years may elect to exclude all gain realized upon its sale of an interest in a QOF as well as all gain realized upon the sale of assets by the QOF or a lower-tier partnership or S corporation QOZB, except to the extent the gain arises from the sale of inventory in the ordinary course of business.

  • Eligible gain includes gross section 1231 gain, and not net section 1231 gain. Section 1231 gains and losses generally arise when a taxpayer disposes of depreciable or real property that is used in the taxpayer’s trade or business and held for more than one year. The portion of any section 1231 gain that reflects accelerated appreciation is “recaptured” under sections 1245 or 1250 and is treated as ordinary income. If, at the end of the taxable year, the taxpayer has net section 1231 gains, then all section 1231 gains and losses are treated as long-term capital gains and losses. Alternatively, if, at the end of the taxable year, the taxpayer’s section 1231 losses equal or exceed its section 1231 gains, then all of the taxpayer’s section 1231 gains and losses are treated as ordinary income and losses. The Proposed Regulations provided that only net section 1231 gain would be eligible for deferral under section 1400Z2-(a)(1) (i.e., only section 1231 gain that would be characterized as long-term capital gain after the netting process had been completed). The Final Regulations very helpfully provide that eligible gains include gross section 1231 gains (other than section 1231 gain that is recaptured and treated as ordinary income under sections 1245 or 1250) unreduced by section 1231 losses.

  • New 62-month working capital safe harbor. The Proposed Regulations included a working capital safe harbor that permitted a QOZB that acquires, constructs, and/or substantially rehabilitates tangible business property to treat cash, cash equivalents and debt instruments with a term of 18 months or less as a reasonable amount of working capital for a period of up to 31 months if certain requirements are satisfied. The Final Regulations provide that tangible property may benefit from an additional 31-month safe harbor period, for a maximum of 62 months, in the form of either overlapping or sequential applications of the working capital safe harbor. To qualify for the 62-month safe harbor, the business must receive multiple non-de minimis cash infusions during each 31-month safe harbor period, and the subsequence cash infusion must form an integral part of the plan covered by the first working capital safe harbor.

  • Triple-net-lease. The Final Regulations contain an example concluding that a QOZB that owns a three-story mixed-use building, and (i) leases one floor of the building under a triple-net-lease, (ii) leases the other two floors under leases that are not triple-net-leases, and (iii) has employees with offices located in the building who meaningfully participate in the management and operations of building, is engaged in an active trade or business with respect to the entire leased building solely for purposes of the opportunity zone trade or business requirement. While this example is helpful because it confirms that a portion of an active trade or business may consist of a triple-net-lease, it leaves unanswered what level of activity is necessary for a real property rental business to qualify as a trade or business for purposes of the opportunity zone rules.

  • Asset aggregation approach for determining substantial improvement. In order for non-original use tangible property to be treated as zone business property, it must be “substantially improved”, which generally requires an original use investment of an amount at least equal to the property’s purchase price. For purposes of determining whether non-original use tangible property purchased by a QOZB has been substantially improved, the Final Regulations permit certain original use assets used in the same trade or business as the non-original use property and that improve the functionality of the non-original use property, to be counted for purposes of the substantial improvement test.  For example, a QOF that intends to substantially improve a hotel may now count the cost of mattresses, linens, furniture, and electronic equipment for purposes of the substantial improvement test.

  • Partnership interests valued at fair market value for purposes of the 90% test. For purposes of the 90% test, the Final Regulations require an asset that has a tax basis not based on cost, such as a partnership interest or other intangible asset, to be valued at its fair market value (rather than the unadjusted cost basis).  Accordingly, the fair market value of a carried interest or even a QOZB partnership must be re-determined at each semi-annual testing date.

  • Sin Businesses. The Final Regulations prohibit a QOZB from leasing more than a de minimis amount of its property to a sin business, but also provide that de minimis amounts of gross income (i.e., less than 5% of gross income) attributable to a sin business will not cause the business to fail to be a QOZB (e.g., a hotel with a spa that offers massage services).

  • Tangible property that ceases to be zone business property.  The statute contains a special rule pursuant to which tangible property that ceases to be zone business property will nonetheless continue to be treated as such for the lesser of: (1) five years after the date such property ceases to be qualified as zone business property; and (2) the date on which the tangible property is no longer held by the zone business. The Final Regulations prohibit a QOZB from relying on this rule unless the zone business property was used by a QOZB in a QOZ for at least two years not counting any period during which the property was being substantially improved or covered by the working capital safe harbor.

  • Expanded anti-abuse rule. The Proposed Regulations included a general anti-abuse rule under which the IRS has broad discretion to disregard or recharacterize any transaction if, based on the facts and circumstances, a significant purpose of the transaction is to achieve tax results inconsistent with the purposes of section 1400Z-2. However, the Proposed Regulations did not explain the purposes of section 1400Z-2. The Final Regulations state that the purposes of section 1400Z-2 are (i) to provide specified tax benefits to owners of QOFs to encourage the making of longer-term investments, through QOFs and QOZBs, of new capital in one or more opportunity zones and (ii) to increase the economic growth of opportunity zones, and include seven new examples illustrating the application of the anti-abuse rule. These examples demonstrate that acquiring land with a significant purpose of selling it at a profit is abusive

Overview of the Opportunity Zone Tax Benefits

The opportunity zone program generally provides three potential tax benefits to taxpayers who invest in a QOF.

First, a taxpayer may elect to defer capital gain from the sale or exchange of property with an unrelated person (generally under a 20% relatedness test) by investing all or part of its eligible gains in a QOF within 180 days after the sale or exchange.[3] The deferral ends December 31, 2026, or sooner if the taxpayer disposes of, or has an inclusion event with respect to, its interest in the QOF (the “inclusion date”), and at that time the taxpayer must recognize gain (and pay tax) with respect to the original property sale.[4]

Second, if the taxpayer holds its interest in the QOF for five years prior to the inclusion date, the taxpayer can eliminate 10% of the deferred gain with respect to the original property sale and, if the taxpayer holds its interest in the QOF for seven years prior to the inclusion date, the taxpayer can eliminate an additional 5% of the deferred gain with respect to the original property sale (for a total of 15%).[5]

Finally, if the taxpayer holds its interest in the QOF for 10 years, the taxpayer may sell its interest in the QOF, or in certain cases, the QOF or a subsidiary may sell assets, in each case before January 1, 2048, without the taxpayer being subject to tax on the appreciation in the value of the taxpayer’s interest in the QOF.[6]

Discussion of Final Regulations

  • Eligible gain.

The Final Regulations maintain the rule that eligible gain (i.e., gain eligible to be deferred under the opportunity zone program) is limited to gain that is treated as capital gain for federal income tax purposes,[7] and generally falls within three categories (i) gains from the sale or exchange of capital assets as defined in section 1221(a), (ii) section 1231 gains (as described below), and (iii) any other income treated as capital gain under any provision of the Internal Revenue Code (e.g., REIT and RIC capital gain dividends). However, the Final Regulations include certain revisions and clarifications related to the definition of eligible gain and the time period for investing eligible gain in a QOF.

Eligible gain includes gross section 1231 gain.

Section 1231 gains and losses generally arise when a taxpayer disposes of depreciable or real property that is used in the taxpayer’s trade or business and held for more than one year. The portion of any section 1231 gain that reflects accelerated appreciation is “recaptured” under sections 1245 or 1250 and is treated as ordinary income. The character of any remaining section 1231 gains and losses (i.e., after applying the recapture rules) is determined by netting the taxpayer’s annual section 1231 gains against its section 1231 losses.  If, at the end of the taxable year, the taxpayer has net section 1231 gains, then all section 1231 gains and losses are treated as long-term capital gains and losses.[8] Alternatively, if, at the end of the taxable year, the taxpayer’s section 1231 losses equal or exceed its section 1231 gains, then all of the taxpayer’s section 1231 gains and losses are treated as ordinary income and losses.

The Proposed Regulations provided that only net section 1231 gain would be eligible for deferral under section 1400Z2-(a)(1) (i.e., only section 1231 gain that would be characterized as long-term capital gain after the netting process had been completed).[9] A number of commentators noted that, because the netting process occurs at the end of a taxpayer’s taxable year, taxpayers would not be certain whether their section 1231 gains would be eligible gains for purposes of investing in QOFs until after they determined whether they had net 1231 gains at the end of the taxable year.

The Final Regulations provide that eligible gains include gross section 1231 gains (other than section 1231 gain that is recaptured and treated as ordinary income under sections 1245 or 1250) unreduced by section 1231 losses and that the 180-day period for investing eligible section 1231 gain begins on the date of the sale or exchange giving rise to the gain, rather than on the last day of the taxable year in which the sale or exchange occurs.[10]

This is a very favorable change for taxpayers as it increases the amount of gain available for investment in a QOF and permits the taxpayer to invest in a QOF as soon as the asset is sold.[11] Moreover, the Final Regulations provide that any deferred section 1231 gain that is invested in a QOF will not be taken into account in computing whether a taxpayer has a net 1231 gain or loss for the year.[12] Thus, if a taxpayer that otherwise would have had a net section 1231 gain at the end of the year makes a qualifying investment in a QOF in an amount equal to its gross section 1231 gain, its section 1231 loss will be characterized as an ordinary loss that can offset ordinary income even though, absent the QOF investment, the 1231 loss would have reduced the taxpayer’s long-term capital gain income.

Gains from sales to, or exchanges of property with, a QOF or QOZB may not be eligible gain, and the property sold or exchanged may not be zone business property.

Qualified opportunity zone business property (“zone business property”) is property acquired by a QOF or qualified opportunity zone business (“QOZB”) by purchase from an unrelated party. Zone business property does not include property that is sold to a QOF or QOZB by a related party or property that is contributed to a QOF or QOZB in a tax-free transfer under section 351 or 721. Practitioners requested guidance on whether an investor could sell property to, or exchange property with, a QOF or QOZB, contribute an amount equal to the gain on the sale or exchange to the QOF, and treat the gain as “eligible gain” and the purchase as a purchase from an unrelated party.

The preamble to the Final Regulations (the “Preamble”) warns that under generally applicable federal income tax principles (such as the step transaction doctrine and circular cash flow principles) and depending on the facts and circumstances, the transaction described above may be recharacterized as a contribution of the property to the QOF (and then possibly to the QOZB) in which case, the investor would not be treated as investing eligible gain in the QOF, and the property would not qualify as zone business property.[13] This result generally would follow regardless of whether the taxpayer would be considered related to the QOF following the transaction.

Installment sales.

In general, a taxpayer reports gain from an installment sale of property in the taxable years during which the payments are received, rather than in the year of the sale (the “installment method”).[14] For purposes of investing gains from an installment sale in a QOF, it was unclear whether there is one 180-day period for all gain from the installment sale that begins on the date of the sale or whether there are multiple 180-day periods, each beginning when payment is received and gain is recognized under the installment method. The Final Regulations helpfully permit investors with eligible gain from an installment sale to elect to start the 180-day period with respect to the gain on either (i) the date each payment under the installment sale is received or (ii) the last day of the taxable year in which the eligible gain would be recognized, disregarding the deferral election.[15]  Therefore, under the Final Regulations, a taxpayer that receives multiple installment sale payments during a year, each of which gives rise to installment sale capital gain, may elect to have multiple separate 180-day periods, each beginning on the date a payment is received, or may elect to have a single 180-day period that begins on the last day of the taxable year.

The Final Regulations also helpfully clarify that capital gain realized with respect to an installment sale that occurred before December 22, 2017 (i.e., the effective date of section 1400Z-2) may be eligible gain if a payment under the installment sale is received after that date.[16]

180-day period for REIT and RIC capital gain dividends.

The Final Regulations generally provide that the 180-day period for REIT and RIC capital gain dividends[17] generally begins at the end of the taxable year in which the capital gain dividend would otherwise be recognized by the taxpayer.[18] However, a taxpayer may elect to begin the 180-day period on (i) the day that capital gain dividends (other than undistributed capital gain dividends) are paid by the REIT or RIC,[19] or (ii) in the case of undistributed capital gain dividends, the last day of the REIT or RIC’s taxable year.[20]  Regardless of which 180-day period is chosen, the aggregate amount of a taxpayer’s eligible gain with respect to capital gain dividends received from a REIT or RIC cannot exceed the aggregate amount of capital gain dividends designated or reported by the REIT or RIC for the taxpayer’s taxable year.[21] Any investment by a taxpayer in a QOF in excess of this amount would be treated as a non-qualifying investment in the QOF.

Extension of 180-day period for owners of passthrough entities.

The Proposed Regulations provided that owners of a partnership, S corporation, or non-grantor trust (a “passthrough entity”) with eligible gains from a passthrough entity that does not make a deferral election may elect to use either the same 180-day period as the passthrough entity or the 180-day period beginning on the last day of the passthrough entity’s taxable year.[22] The Final Regulations provide a third option that permits the owners of a passthrough entity to elect to start the 180-day period on the due date of the passhthrough entity’s tax return (without extension) for the taxable year of the gain, giving the owners additional time to determine their distributive share of eligible gain, if any.[23]

Roll over of gain from inclusion events.

An election to defer gain may not be made with respect to gain from a sale or exchange if an election previously made with respect to the sale or exchange is in effect.  The Proposed Regulations included an example whereby a taxpayer disposed of its entire interest in a QOF prior to December 31, 2026, and wanted to defer the gain from the inclusion event by making a new investment in a QOF.  The example concluded that a new deferral election could be made with respect to the taxpayer’s investment of an amount equal to the gain from the inclusion event in either the original QOF or a new QOF within 180 days of the inclusion event.  A commentator requested that taxpayers be permitted to elect to defer any gain arising from an inclusion event, whether the inclusion event represents all or only a part of the initially deferred gain. The Final Regulations include this change and provide that gain arising from an inclusion event is eligible for the deferral election even if the taxpayer retains a portion of its qualifying investment in the QOF after the inclusion event.[24]  The 180-day period for gain from an inclusion event begins on the date of the inclusion event and the taxpayer’s holding period for the new QOF investment begins on the date of the new investment is made.[25]

Offsetting-positions transactions.

The Proposed Regulations generally provided that eligible gains do not include capital gain from a position that is or has been part of an offsetting-positions transaction.[26]  In response to comments expressing concern regarding the extension of the offsetting-positions transactions rule to transactions that are not straddles under section 1092, the Final Regulations generally limit these rules to certain positions that were part of straddle under section 1092 during the taxable year (or, in certain cases, a prior year).

Eligible gain must otherwise have been subject to U.S. federal income tax.

The Final Regulations clarify that deferral of eligible gain generally is available only for capital gain that would be subject to U.S. federal income tax but for the making of a valid deferral election.[27] Accordingly, a non-U.S. investor may make a deferral election with respect to capital gain that is effectively connected with a U.S. trade or business and not exempt from tax under an income tax treaty, and a tax-exempt investor may make a deferral election with respect to capital gain that is treated as “unrelated business taxable income”[28]. This rule was designed to ensure that U.S. persons and foreign persons are eligible for the benefits of the opportunity zone program under the same conditions.

To prevent a non-U.S. investor from taking an inconsistent treaty position in the year of deferral and the year of inclusion, the Final Regulations require a non-U.S. investor that makes a deferral election to irrevocably waive any treaty benefits that would exempt the gain from U.S. federal income tax at the time of inclusion.[29]

Because a partnership may have non-U.S. and tax-exempt partners, it is possible that a partnership could have capital gain that would not be subject to U.S. federal income tax by its partners.  The IRS and Treasury declined to include a look through rule requiring a partnership that makes a deferral election to determine the extent to which its partners would be subject to U.S. federal income tax on the gain. According to the Preamble, the IRS and Treasury were concerned that such a rule would be unduly burdensome to partnerships.[30] Nevertheless, the Final Regulations contain an anti-abuse rule that permits the IRS and Treasury to disregard a partnership if it is determined that a significant purpose of the partnership is to avoid the requirement that eligible gain, absent a deferral election, would otherwise have been subject to U.S. federal income tax.[31]

Deferral election is not a FIRPTA non-recognition provision.

Under the Foreign Investment In Real Property Act (“FIRPTA”), if a non-U.S. person disposes of a U.S. real property interest, gain on the disposition is generally treated as effectively connected income subject to U.S. tax, and the transferee of the interest is generally required to withhold 15% of the amount realized by the non-U.S. person on the disposition.[32]  An exemption from the tax and withholding obligations exists to the extent certain gain “non-recognition” provisions apply.[33]

In response to requests for clarification, the Final Regulations provide that section 1400Z-2 is not a gain non-recognition provision for purposes of FIRPTA because an election under section 1400Z-2 generally defers, rather than excludes altogether, the recognition of gain.[34]

Commenters had also requested relief from the 15% withholding tax on eligible FIRPTA gains for which a non-U.S. investor intends to make a deferral election under section 1400Z-2. The IRS and Treasury declined to include a special FIRPTA withholding rule and therefore a non-U.S. person that elects to defer gain on the sale of a FIRPTA asset by investing in a QOF will be subject to a 15% withholding tax on the amount realized from the sale even though the substantive tax on the gain will not be due until December 31, 2026 (or an earlier disposition of the QOF interest).[35]

  • Gain exclusion election after 10 years.

All gain on the sale of a QOF interest or underlying assets after 10 years is excluded, other than gain from the sale of ordinary course inventory.

Under section 1400Z-2(c), a taxpayer that has held a qualifying interest in a QOF for at least 10 years may elect to treat its basis in the interest in the QOF as an amount equal to the fair market value of the interest in the QOF on the date of the taxpayer’s sale or exchange of the interest (the “step-up election”).

The Proposed Regulations provided that if a taxpayer made the step-up election, then all gain could be excluded, including any gain attributable to depreciation recapture or ordinary income assets, and as a result, the taxpayer could avoid all tax on appreciation on the sale of an interest in a QOF that had been held for at least 10 years.[36] The Proposed Regulations also permitted an investor that held a qualifying interest in a QOF partnership or S corporation for at least 10 years to elect to exclude gains realized by the QOF partnership or S corporation on the sale of underlying qualified opportunity zone property (as defined below) (the “asset sale election”), but not gains realized by a lower-tier partnership or S corporation QOZB held by the QOF.[37] In contrast to a step-up election, an asset sale election permitted an investor to exclude only capital gains from sales of qualifying property and required the investor to recognize any depreciation recapture or other ordinary income realized on the underlying asset sale, as well as any income or gain on sales of non-qualified opportunity zone property.

The Final Regulations considerably broaden the gain exclusion for asset sales by QOFs and lower-tier partnership or S corporation QOZBs held by a QOF and generally permit an investor that has held a qualifying interest in a QOF for at least 10 years to elect to exclude all gain realized on an underlying sale of any asset by a QOF or lower-tier partnership or S corporation QOZB, except to the extent the gain arises from the sale of inventory in the ordinary course of business.[38]  This is a significant change that will make it much easier for QOFs to structure business investments and eliminates the need for multi-asset real estate QOFs to hold each property in a separate QOF or QOZB.

An asset sale election is made for each taxable year in which the investor intends to exclude gain, may be made regardless of whether the investor has made the election in prior years, and applies to all gains for the taxable year (including gains from sales by a QOF or lower-tier zone partnership or S corporation), other than gains from the sale of inventory in the ordinary course of business.[39]

To ensure that future opportunity zone benefits attributable to the reinvestment of proceeds from asset sales for which gain and loss is not recognized as a result of an asset sale election, unless the QOF in fact distributes to the electing investor an amount equal to its share of the net proceeds from the sale within 90 days of the sale, the QOF is deemed to distribute to each electing QOF investor its share of net proceeds from the asset sale on the last day of the QOF’s tax year and the QOF investor is deemed to recontribute the proceeds to the QOF as a non-qualifying investment.[40]  Thus, if the net proceeds are not timely distributed to the electing QOF investor, going forward, the investor will have a mixed-funds investment and only a portion of any future asset sales will be eligible for exclusion.  However, if the proceeds are actually timely distributed to an electing QOF investor with only a qualifying interest, the investor’s entire remaining interest would continue to be a qualifying interest and future asset sales generally should continue to be eligible for full exclusion.

The Final Regulations clarify that when an investor makes a step-up election or asset sale election, (i) the basis of the investor’s QOF partnership interest is adjusted to an amount equal to its net fair market value, plus the investor’s share of partnership debt relating to that interest and (ii) the fair market value cannot be less than the investor’s allocable share of non-recourse debt.[41]

The Final Regulations also clarify that if a taxpayer’s basis in its QOF partnership interest is adjusted as a result of a step-up election, the bases of the QOF and lower-tier partnership assets are also adjusted immediately prior to the sale in a manner similar to the way they would be if the QOF partnership and any lower-tier partnerships owned by the QOF partnership had a section 754 election in effect, whether or not an actual section 754 election is in place for any of the partnerships.[42]

10-year gain exclusion election available for distributions treated as sales or exchanges.

The Final Regulations clarify that an investor may make a step-up election with respect to gain resulting from certain distributions by QOF corporations or partnerships that are treated as gains from the sale or exchange of property for U.S. federal income tax purposes (such as distributions under sections 301(c)(3), 731(a), 1059(a)(2), and 1368(b)(2) and (c)(3)).[43]

  • Rules relating to inclusion events.

The Proposed Regulations generally provided that certain events result in a taxpayer’s inclusion of its deferred gain prior to December 31, 2026 (“inclusion events”). Treasury and the IRS received a number of comments and questions regarding the inclusion event rules, and in response to these comments, the Final Regulations modify and clarify the rules related to inclusion events. In addition, the Final Regulations expand the list of inclusion events in the Proposed Regulations, by adding the voluntary or involuntary termination of QOF status, a QOF’s check-the-box election resulting in a change in tax classification of the QOF, and a transfer to a spouse incident to divorce, as inclusion events.[44] The Final Regulations also provide that gain recognized in an inclusion event will be taxed at the applicable federal income tax rate for the year in which the inclusion event occurs, and not the year in which the deferral election is made.[45]

Inclusion events with respect to partnerships.

The Final Regulations confirm that a contribution of a QOF interest to a partnership is not an inclusion event so long as the contribution does not cause the QOF to terminate.[46]  Also, mergers of QOF partnerships generally do not trigger inclusion events so long as the surviving partnership is a QOF.[47]

The Final Regulations provide that a partnership distribution is an inclusion event to the extent that cash or the fair market value of property distributed exceeds the partner’s outside basis in the QOF partnership.[48] However, with respect to a distribution by a partnership that owns a QOF, such a distribution generally will be an inclusion event for the indirect QOF owner if the distribution is a liquidating distribution.[49]

The Final Regulations do not adopt a general rule excluding a division of a QOF partnership as an inclusion event because divisions may result in distributions or deemed distributions that may result in gain recognition under the partnership rules.[50]

Inclusion events with respect to S corporations.

The Final Regulations generally adopt without modification the Proposed Regulations provisions addressing S-corporation inclusion events, except for the rule that treated an S corporation’s qualifying investment in a QOF as disposed of if there were a greater-than-25% total change in ownership of the S corporation.[51] This rule was eliminated in the Final Regulations.

Inclusion events with respect C corporations.

Under the Proposed Regulations, certain redemptions and distributions from C corporations and certain corporate reorganizations are treated as inclusion events.  The Final Regulations clarify these rules. For example, the Proposed Regulations provided that a dividend-equivalent redemption is an inclusion event with respect to the entire amount of the distribution unless all of the stock of the QOF corporation is owned by a single shareholder or members of a single consolidated group.[52] The Final Regulations retain this rule, but include an additional exception for pro rata redemptions where the QOF corporation has only one class of stock outstanding.[53]

The Final Regulations retain the rule in the Proposed Regulations that distributions of stock under section 305(a) are not inclusion events and clarify that the stock received in the distribution is qualifying QOF stock.[54] The Final Regulations also provide that extraordinary dividends resulting in section 1059(a)(2) gain are inclusion events.[55]

Under the Proposed Regulations, section 381 transactions, recapitalizations and section 1036 stock-for-stock exchanges were subject to different rules in determining whether they resulted in an inclusion event, and whether boot was treated as an inclusion event depended on whether gain or loss was recognized.[56] The Final Regulations generally provide that section 381 transactions, recapitalizations and section 1036 exchanges, are treated as inclusion events to the extent of any boot received.[57]

Transfers at death.

The Final Regulations retain the rule that death is not an inclusion event (because the obligation to include the decedent’s deferred gain is transferred to the beneficiary who will be required to recognize the gain on December 31, 2026 or upon an earlier inclusion event).[58] However, the Final Regulations make clear that a beneficiary’s interest in a qualifying investment in a QOF does not benefit from a basis step-up under section 1014, and therefore the beneficiary takes a carryover basis in the decedent’s QOF interest, which will typically be zero (unless there have been increases in basis as a result of the decedent holding the interest for five or seven years).[59] While it is reasonable to deny the beneficiary of an interest in a QOF a basis step-up for the deferred gain that was contributed to the QOF and has not been included in income, it is unclear why the Final Regulations deny a basis step-up with respect to appreciation of the interest during the decedent’s lifetime. Nevertheless, if the beneficiary ultimately has a 10-year holding period (including the decedent’s holding period), the beneficiary should be able to dispose of the interest without recognizing gain.

  • Carried interests.

Under the Proposed Regulations, if an investment fund sponsor makes an investment in a QOF with funds attributable to capital gains for which a deferral election has been made and also receives a carried interest in the QOF in exchange for services, the sponsor is treated as having a “mixed-funds investment” and solely for purposes of section 1400Z-2 is treated as holding separate interests in the QOF partnership—a qualifying investment and a non-qualifying investment.[60] The carried interest is treated as a non-qualifying investment, and the tax benefits of the opportunity zone rules only apply to the deferred capital gain amount and not the amount attributable to the carried interest. All partnership items, including partnership debt, are allocated pro rata between the qualifying and non-qualifying investments, based on the relative allocation percentages of each interest.[61] Under the Proposed Regulations, the allocation percentage for carried interests is the highest percentage interest in residual profits attributable to the carried interest.[62]

The Final Regulations generally retain the rules addressing mixed-fund interests, but modify the rule for the allocation percentage for carried interests and require that a partner receiving a carried interest determine the allocation percentage of the carried interest based on the share of residual profits the mixed-funds partner would receive with respect to that interest, disregarding any allocation of residual profits for which there is not a reasonable likelihood of application.[63]

  • Rules for measuring the value of QOF assets for purposes of the 90% test.

At least 90% of a QOF’s assets are required to consist of qualified opportunity zone property (the “90% test”), measured semi-annually on (i) the last day of the first six-month period of the taxable year of the QOF, and (ii) on the last day of the taxable year of the QOF (e.g., June 30 and December 31 would be the relevant testing dates for a calendar-year QOF).[64] Qualified opportunity zone property is qualified opportunity zone stock, qualified opportunity zone partnership interests or zone business property (collectively, “zone property”).

The Preamble recognizes that a QOF and a lower-tier entity owned by the QOF may have different taxable years, making it difficult to determine whether the lower-tier entity qualifies as a QOZB of the QOF on a semi-annual basis based on the QOF’s taxable year pursuant to the statute. Accordingly, the Final Regulations provide a safe harbor rule under which a QOF may include the equity of a lower-tier entity in both the numerator and denominator of the 90% test if the entity was a QOZB for at least 90% of the QOF’s cumulative holding period of the entity beginning on the effective date of the QOF’s self-certification and ending on the last day of the entity’s most recent taxable year ending on or before the semi-annual testing date.[65]

Practitioners also requested clarification regarding the assets taken into account for determining whether the 90% test is satisfied. The IRS and Treasury confirm that all of a QOF’s assets that are treated as assets for federal income tax purposes are required to be valued on each semi-annual testing date in determining whether the 90% test is met. However, because mere expenses arising from organizing a QOF or day-to-day operations (e.g., selling commissions, organization expenses, offering expenses, and similar expenses) are not treated as assets for federal income tax purposes, they are not taken into account for purposes of the 90% test.

Valuation methods.

In order for a QOF to determine whether it satisfies the 90% test, the QOF may value its zone property on a semi-annual basis using either (i) the applicable financial statement (“AFS”)[66] valuation method, if the QOF has an AFS,[67] or (ii) the alternative valuation method.

Under the Proposed Regulations, for purposes of the alternative valuation method, the value of each asset owned by a QOF was equal to the unadjusted cost basis of the asset. This permitted a QOF that received a carried interest with a nominal cost basis that was not zone business property to treat the carried interest as having only nominal value for purposes of the 90% test.  The Final Regulations modify the Proposed Regulations to provide that the value of assets owned by a QOF that are acquired by purchase or constructed for fair market value is the QOF’s unadjusted cost basis of the asset.[68] However, for an asset that has a tax basis not based on cost, such as a partnership interest or other intangible asset, the value of the asset is equal the asset’s fair market value, as determined on the last day of the first six-month period of the taxable year and on the last day of the taxable year.[69]  Accordingly, under the alternative valuation method, the fair market value of a carried interest or even a QOZB partnership must be re-determined at each semi-annual testing date.[70]  This rule also applies to a partnership interest held by a QOZB.

  • Qualified opportunity zone business property – original use test.

Newly constructed property.

The statute requires that the original use of zone business property begin with the QOF or QOZB or that the QOF or QOZB substantially improve the property.[71]

Several commentators recommended that the Final Regulations include a bright-line rule that would allow taxpayers to rely on certificates of occupancy for determining whether property satisfies the original use requirement. The IRS and Treasury declined to adopt this recommendation because different jurisdictions have varying standards for certificates of occupancy, and the Final Regulations retain the rule in the Proposed Regulations that the original use of property commences on the date on which the property is first (i) placed into service in the qualified opportunity zone and is depreciated or amortized, or (ii) used in a manner that would allow depreciation or amortization.[72] However, the Final Regulations do include an example in which newly constructed property purchased by a QOF from a developer that has not yet placed the property in service for purposes of depreciation satisfies the original use test.[73]

Self-constructed property.

Tangible property owned by a QOF or QOZB generally must be purchased from an unrelated party after December 31, 2017 to qualify as zone business property.[74] Under the statute and Proposed Regulations, it was unclear how this rule applied to self-constructed property.

The Final Regulations generally provide that tangible property that is manufactured, constructed, or produced, rather than purchased, by a QOF or QOZB may qualify as zone business property so long as (i) the property is manufactured, constructed, or produced beginning after December 31, 2017 with the intent to use the property in a trade or business in an opportunity zone, and (ii) the materials and supplies used in the manufacturing, construction, or production are zone business property.[75]

Vacant property.

The Proposed Regulations contained a rule that permitted a QOF or QOZB to treat an investment in a previously used building or other structure that had been vacant for at least five consecutive years before the QOF or QOZB placed the property in service in the QOZ as an original use asset.[76] The Final Regulations substantially shorten the vacancy requirement to one year if the property was vacant for at least one year prior to the designation of the tract as a qualified opportunity zone and the property remains vacant through the date the property is purchased by a QOF or QOZB.[77] Vacant property that does not meet this requirement will qualify as original use property if it is continuously vacant for at least three years (instead of five years under the Proposed Regulations).[78] The Final Regulations define “vacant” property as property that is “significantly unused”, meaning more than 80% of the building or land, as measured by the square footage or useable space, is not being used.[79]

Brownfield sites.

A “brownfield site” is “real property, the expansion, redevelopment, or reuse of which may be complicated by the presence or potential presence of a hazardous substance, pollutant, or contaminant.”[80] In order to facilitate brownfield redevelopment, the Final Regulations provide that all real property composing a brownfield site (i.e., land and structures) will be treated as satisfying the original use test, provided within a reasonable period, the QOF or QOZB, as applicable, makes investments to ensure that the brownfield site meets basic safety standards for human health and the environment.[81]

Property purchased from local governments.

The Final Regulations permit a QOF or QOZB that purchases real property from a local government that the local government holds as the result of an involuntary transfer (e.g., abandonment, bankruptcy, foreclosure, or receivership) to treat all of the real property (including the land and structures) as original use property.[82]

Leased property

In order to qualify as zone business property, the Proposed Regulations generally required the terms of a lease to be market rate at the time at which the lease was entered into.[83] The Final Regulations incorporate a rebuttable presumption that, for leases between unrelated parties, the terms of the lease are market rate, and provide that tangible property acquired by lease from a state or local government, or an Indian tribal government, is not considered tangible property acquired by lease from a related party.[84]

  • Zone business property – substantial improvement test.

Asset aggregation approach for determining substantial improvement.

In the Proposed Regulations, the IRS and the Treasury Department requested comments regarding whether the determination of “substantial improvement” of property should be based on an asset-by-asset approach or on an asset aggregation or similar approach.  The Final Regulations helpfully provide that a QOF or QOZB is permitted to take into account the cost of purchased original use assets that otherwise would qualify as zone business property in determining whether additions to the basis of non-original use property satisfy the substantial improvement test, so long as the purchased property (i) is located in the same opportunity zone (or a contiguous opportunity zone), and is used in the same trade or business, as the non-original use property and (ii) improves the functionality of the non-original use property.[85]  If a QOF or QOZB chooses this approach, it must improve any non-original use real property by more than an insubstantial amount. As an example, the Final Regulations provide that a QOF that intends to substantially improve a hotel, may take into account the mattresses, linens, furniture, electronic equipment and other tangible property that is used in the hotel business for purposes of determining whether the hotel has been substantially improved.[86]

Aggregation of buildings for determining substantial improvement.

The Final Regulations also provide that two or more buildings within an opportunity zone or a single series of contiguous opportunity zones and located on land described in a single deed may be treated as a single property for purposes of the substantial improvement test. Alternatively, if the buildings are not described in a single deed, but are located on contiguous parcels of land, the buildings may be treated as a single property for purposes of the substantial improvement requirement so long as they (i) are operated exclusively by the QOF or QOZB, (ii) share facilities or significant business resource elements, (such as personnel, accounting, manufacturing, legal, and human resources), and (iii) are operated in coordination with one or more of the trades or businesses, such as supply chain interdependencies or mixed-use facilities.[87]

The Final Regulations provide that if two or more buildings are treated as a single property, then the amount of basis required to be added will be the total basis of each building, and additions to the basis of each building comprising the single property are aggregated to determine satisfaction of the substantial improvement requirement.[88]  This rule is helpful but is not as favorable as the broad aggregation rules that some commentators had sought.

Improvement of unimproved land by more than an insubstantial amount.

The Proposed Regulations provided that unimproved land within an opportunity zone that is acquired by purchase does not need to satisfy the original use test or be substantially improved to qualify as zone business property[89] so long as the land is used in a trade or business of a QOF or QOZB and, at the time of acquisition, the QOF or QOZB has an expectation, an intention, or a view to improve the land by more than an insubstantial amount within 30 months after the date of purchase.[90] The Proposed Regulations did not address how to determine whether land is improved by more than an insubstantial amount. The Final Regulations declined to adopt a specific threshold, but provide that to make this determination, improvements to the land, such as grading, clearing of the land, remediation of the contaminated land, and acquisition of related zone business property that facilitates the use of the land in a trade or business of the eligible entity will be taken into account.[91]

  • Zone business property – treatment of inventory for purposes of determining substantial use in an opportunity zone.

Under the statute, zone business property is tangible property used in a trade or business of the QOF or QOZB, if during substantially all of the QOF’s or QOZB’s holding period for the property, substantially all of the use of such property is in an opportunity zone.[92] The Proposed Regulations considered to what extent inventory would qualify as zone business property for purposes of determining whether substantially all of the QOF’s or QOZB’s tangible property is used in an opportunity zone, and provided that inventory (including raw materials) can qualify as zone business property even if in transit (i) from a vendor to a facility of the trade or business in the opportunity zone, or (ii) from a facility of the trade or business in the opportunity zone to customers outside the opportunity zone.[93] Practitioners raised concerns that inventory should not be treated as zone business property because it is a transitory asset, does not add value to the opportunity zone, and does not meet the requirements of the original use test or substantial improvement requirement. In response to these concerns, the Final Regulations provide that, for purposes of determining compliance with the 90% test and the 70% test[94], a QOF or QOZB may choose to (i) include inventory in both the numerator and the denominator, or (ii) exclude inventory entirety from both the numerator and the denominator.[95] This election must be made consistently with respect to all semi-annual tests during the holding period in which the QOF or QOZB holds the inventory.[96]

  • Rules relating to QOZB requirements.

50% gross income requirement.

The statute requires a QOZB to derive at least 50% of its total gross income from the active conduct of a trade or business within an opportunity zone.[97]

The Final Regulations clarify that taxpayers may aggregate all activities conducted by a trade or business in multiple opportunity zones for purposes of determining whether the 50% gross income requirement is met.[98]

The Final Regulations also adopt the three safe harbors and facts-and circumstances-test set forth in the Proposed Regulations that allow an entity to satisfy the 50% gross income requirement, and provide several clarifications to these safe harbors.

Under the safe harbors, a trade or business will satisfy the 50% gross income requirement if at least 50% of the services performed – based on hours worked (the “hours safe harbor”) or based on amounts of compensation paid by the trade or business (the “compensation safe harbor”) – for the business by its employees and independent contractors (and their employees) are performed within an opportunity zone.[99] The Final Regulations clarify that (i) the services performed by partners for a partnership are taken into account in determining whether the hours safe harbor is met[100], and (ii) guaranteed payments for services provided by a partner to a partnership, but not the partner’s share of partnership profits that are not guaranteed payments, are taken into account for purposes of the compensation safe harbor.[101] For purposes of both of these safe harbors, services provided by, or amounts paid to, an independent contractor or its employees are not taken into account if the services were not provided to the QOZB.[102]

New 62-month working capital safe harbor for start-ups.

The statute provides that to qualify as a QOZB, less than 5% of the average of the aggregate unadjusted bases of the entity’s property can be attributable to “nonqualified financial property”.[103]   This rule restricted the ability of QOZBs to receive capital and develop new businesses or construct or rehabilitate real estate and other tangible property.  To address this concern the Proposed Regulations included a working capital safe harbor which permitted a QOZB that acquires, constructs, and/or substantially rehabilitates tangible business property to treat cash, cash equivalents and debt instruments with a term of 18 months or less as a reasonable amount of working capital for a period of up to 31 months if certain requirements are satisfied (the “working capital safe harbor”). Under the working capital safe harbor, any tangible property that is being acquired, constructed and/or substantially improved with the working capital and that is expected to qualify as zone business property at the end of the safe harbor period, is treated as being used in the active conduct of a trade or business during the construction and improvement period (for up to 31 months). Commenters expressed concern that, notwithstanding the working capital safe harbor, a start-up business may not be able to meet the trade or business standard of section 162 that is incorporated into the QOZB requirements because a start-up may not generate profits for a significant period of time.[104]

To address these concerns, the Final Regulations create a new “62-month working capital safe harbor”. Under the Final Regulations, in addition to the initial 31-month working capital safe harbor, tangible property may benefit from an additional 31-month safe harbor period, for a maximum of 62 months, in the form of either overlapping or sequential applications of the working capital safe harbor. To qualify for the 62-month safe harbor, the business must receive multiple non-de minimis cash infusions during each 31-month safe harbor period. Specifically, under the 62-month working capital safe harbor, a business can qualify for an initial 31-month safe harbor period with respect to the business’ first cash infusion. Upon receipt of a subsequent contribution of cash, the business can both (i) extend the original 31-month safe harbor period that covered the initial cash infusion, and (ii) receive safe-harbor coverage for the subsequent cash contribution for a maximum 31-month period, if (A) the subsequent cash infusion is independently covered by an additional working capital safe harbor and (B) the working capital safe harbor plan for the subsequent cash infusion forms an integral part of the working capital safe harbor plan that covered the initial cash infusion.[105] The 62-month safe harbor period cannot extend beyond the 62-month period starting on the date of the first cash infusion.[106]

Safe harbor for 90% test during the 30-month substantial improvement period.

The Final Regulations contain a safe harbor under which tangible property purchased, leased, or improved by a trade or business that is undergoing the substantial improvement process, but has not yet been placed in service or used in the QOF’s or QOZB’s trade or business is treated as zone business property for the duration of the 30-month substantial improvement period for the property, provided the QOF or QOZB expects the property to be used in its trade or business in an opportunity zone by the end of the 30-month period. This rule may be helpful to QOFs, which are not eligible for the working capital safe harbor.

Triple-net-leases.

The Proposed Regulations provided that solely for the purposes of determining whether a trade or business qualifies as a QOZB, the ownership and operation, including leasing, of real property qualifies as an active conduct of a trade or business.[107] However, merely entering into a triple-net-lease with respect to real property does not constitute an active trade or business.[108] The Final Regulations generally preserve the rule that a taxpayer whose sole business involves a single triple-net-lease of property is not engaged in the active conduct of a trade or business.[109]  However, the Final Regulations also make clear that a taxpayer whose business triple-net-leases property as a component of its business may, in certain circumstances, be engaged in an active trade or business. Thus, where a taxpayer that owns a three-story mixed-use building leases one floor of the building under a triple-net-lease, and leases the other two floors under leases that are not triple-net-leases, and the employees of the taxpayer meaningfully participate in the management and operations of building, the Final Regulations conclude that the taxpayer is engaged in an active trade or business with respect to the entire leased building solely for purposes of the opportunity zone trade or business requirement.[110] Although the example is helpful because it confirms that a real estate rental business can qualify for the opportunity zone benefits even if a portion of its business consists of triple-net-leasing, the example does not provide any guidance on the level of activity required to qualify as an active real estate trade or business. Nevertheless, it does appear that meaningful participation by employees in the management and operations of the real estate is an important factor.

Limitation on subsidiaries of QOZBs.

As mentioned above, the statute provides that to qualify as a QOZB, less than 5% of the average of the aggregate unadjusted bases of the entity’s property can be attributable to “nonqualified financial property”, including stock or partnership interests [111] Commentators requested that the nonqualified financial property limitation be modified in a way that would permit a QOZB to conduct its business activities through a subsidiary corporation or partnership.  The Final Regulations declined to adopt this recommendation.[112]

Intangible property.

The statute requires that, with respect to any taxable year, a substantial portion of the intangible property of a QOZB must be used in the active conduct of a trade or business within an opportunity zone.[113] The Proposed Regulations provide that, for these purposes, the term substantial portion means at least 40%.[114] To provide greater certainty in determining where intangible property is located and used, the Final Regulations provide that intangible property of a QOZB is used in the active conduct of a trade or business in an opportunity zone if (i) the use of the intangible property is normal, usual, or customary in the conduct of the trade or business, and (ii) the intangible property is used in the opportunity zone in the performance of an activity of the trade or business that contributes to the generation of gross income for the trade or business.[115]

Sin businesses.

The statute prohibits a QOZB, but not a QOF, from operating a golf course, country club, massage parlor, hot tub facility, suntan facility, racetrack or other facility used for gambling, or any store the principal business of which is the sale of alcoholic beverages for consumption off premises.[116] These businesses are commonly referred to as “sin businesses”. According to the Preamble, commentators expressed concern that taxpayers could circumvent Congress’ clear intent to prohibit QOZBs from operating sin businesses by having a QOZB lease property to a sin business. These commentators recommended that QOZBs be prohibited from leasing property to sin businesses. Treasury and the IRS agreed and the Final Regulations prohibit a QOZB from leasing more than a de minimis amount of its property to a sin business.[117] However, the Final Regulations also provide that de minimis amounts of gross income (i.e., less than 5% of gross income) attributable to a sin business will not cause the business to fail to be a QOZB (e.g., a hotel with a spa that offers massage services).

Tangible property that ceases to be zone business property.

The statute provides a special rule that permits a QOZB to treat tangible property that ceases to be zone business property as zone business property for the lesser of five years after (i) the date on which such tangible property ceases to be so qualified, or (ii) the date on which such tangible property is no longer held by QOZB.[118]  The Final Regulations prohibit a QOZB from relying on this rule unless the zone business property was used by a QOZB in a QOZ for at least two years, not taking into account the period during which the property was covered by the 31-month working capital safe harbor or the 30-month substantial improvement period.[119]

Six-month cure period for failure to qualify as a QOZB.

For “substantially all” of a QOF’s holding period for interests in a QOZB partnership or corporation, the QOZB must satisfy all of the requirements to be a QOZB.  For this purpose, “substantially all” means 90% of the QOF’s holding period. The Final Regulations afford an entity a six-month period to cure a defect that prevents its qualification as a QOZB for purposes of the 90% holding period requirement, without penalty to the investing QOF.[120] The six-month period corresponds to testing periods for both the QOZB and the QOF.[121] At the end of the six-month period, if the entity fails to qualify as a QOZB, the QOF must determine if it satisfies the 90% test, taking into account its ownership in the non-qualifying entity, and if it does not, penalties apply to all months in which the QOF failed the 90% test (even months during and prior to the six-month cure period). The six-month cure period may only be applied once to a QOZB.[122]

  • Certification and decertification.

The Final Regulations generally retain the proposed rules for self-certification of a QOF and added a provision allowing a QOF to voluntarily de-certify its QOF status. However, the Final Regulations do not contain rules for involuntary decertification or address whether repeated failures to satisfy the 90% test will lead to a revocation of QOF status.[123]  The Preamble notes that the IRS and Treasury continue to consider the circumstances under which involuntary decertification of a QOF would be warranted.

  • Consolidated groups with QOF corporations.

The Final Regulations make a number of changes to the application of the opportunity zone rules to consolidated groups.  Notably, the Final Regulations eliminate the proposed rule that a QOF C corporation may not be a subsidiary member of a consolidated group, so long as certain requirements are satisfied,[124] including that the QOF investor member (i.e., the group member that makes the qualifying investment in the QOF member) generally must (i) retain direct ownership of the QOF member stock and (ii) be wholly-owned, directly or indirectly, by the common group parent.[125]

The Final Regulations also permit a consolidated group to elect to treat the investment by one member as a qualifying investment by another member of the group.[126]  If the election is made, then for all federal income tax purposes, the group member that realized the gain is treated as making an investment in the QOF and immediately selling the qualifying investment to the other member for fair market value.[127]

In addition, under the Final Regulations, a consolidated group is not treated as a single entity for purposes of determining whether a QOF or QOZB group member satisfies the QOF or QOZB requirements, but rather each QOF or QOZB group member must independently satisfy these tests.[128]

Finally, the Final Regulations include a number of rules to coordinate the opportunity zone rules with the consolidated return rules, as well as an anti-abuse rule for consolidated groups under which a transaction that is structured with a view to circumventing the opportunity zone rules or the consolidated return rules may be recharacterized to carry out the purposes of the opportunity zone rules.[129]

  • Anti-abuse rule.

The Proposed Regulations included a general anti-abuse rule under which the IRS has broad discretion to disregard or recharacterize any transaction if, based on the facts and circumstances, a significant purpose of the transaction is to achieve tax results inconsistent with the purposes of section 1400Z-2.[130] The Final Regulations adopt this rule and explicitly state that the purposes of section 1400Z-2 are (i) to provide specified tax benefits to owners of QOFs to encourage the making of longer-term investments, through QOFs and QOZBs, of new capital in one or more opportunity zones and (ii) to increase the economic growth of opportunity zones.[131]  In response to requests for additional guidance on instances of abuse, the Final Regulations include seven new examples to illustrate the application of the anti-abuse rule.

The Preamble to the April 2019 Proposed Regulations provided that the anti-abuse rule would apply to the passive ownership of land for speculation in which no new investment is made.[132] Practitioners requested that Treasury and the IRS clarify what activities would be treated as holding land for speculation. The Final Regulations address this issue in the examples illustrating the general anti-abuse rule. In one example, the taxpayer is treated as holding land for speculation even though the taxpayer paves the land, constructs a small shed for a parking attendant, and operates a parking lot business, because, at the time the land was acquired, the taxpayer had no plan to substantially develop or use the land in a manner that would increase substantially its economic productivity, but instead had purchased the land with a significant purpose of selling it at a profit and excluding gain.[133] A second example provides that a taxpayer does not hold land for speculation where the taxpayer purchases land used for hog and pig farming and repurposes the land to use it for sheep and goat farming by making a significant investment of capital and labor into the new business.[134] In this second example, it did not matter that at the time of purchase, the land was expected to significantly increase in value over the next 10 years.


[1] All references to section numbers are to the Internal Revenue Code or Treasury regulations issued thereunder.

[2] The Treasury has also published a “Frequently Asked Questions” that addresses some of the changes in the Final Regulations. U.S. Dept. Treas., “Final Regulations on Opportunity Zones: Frequently Asked Questions”, Dec. 19, 2019, https://home.treasury.gov/news/press-releases/sm864.

[3] Section 1400Z-2(a)(1). Only an amount equal to the gain from the sale, and not the entire amount of the proceeds, needs to be invested in the QOF, and the tax benefits are available only to the extent of the gain. That is, no tax benefits are available to the extent that a taxpayer invests amounts in a QOF that exceed its capital gains realized from sales or exchanges of property with unrelated persons during the 180-day period.

[4] Section 1400Z-2(b)(1). The obligation to pay tax with respect to deferred gain from the sale or exchange of the original property by the end of 2026 will create “phantom income” for QOF investors: the investors in the QOF will have tax liability for these prior gains without cash to pay the tax.

[5] Section 1400Z-2(b)(2)(B). Note that a taxpayer can eliminate an additional 5% of deferred gain after seven years only if the QOF investment was made before the end of 2019.

[6] Section 1400Z-2(c).

[7] Treas. Reg. § 1.1400Z2(a)-1(b)(11)(i)(A).

[8] Under a recharacterizaton rule, net section 1231 gain for any taxable year is treated as ordinary income to the extent the gain does not exceed the non-recaptured net section 1231 losses. Section 1231(c). Non-recaptured net section 1231 losses are net section 1231 losses for the five preceding tax years of the taxpayer that have not been recaptured. The Final Regulations do not alter the application of section 1231(c) recapture of net ordinary loss. Therefore, if a deferral election with respect to section 1231 gain is made, any non-recaptured net section 1231 losses from the preceding five years apply to recapture as ordinary income only net section 1231 gain that the taxpayer has not elected to defer in that year and is not treated as associated with the deferred eligible section 1231 gain.

[9] Prop. Reg. § 1.1400Z2(a)-1(b)(2)(iii).

[10] Treas. Reg. § 1.1400Z2(a)-1(b)(11)(iii)(A).

[11] Assume that a taxpayer realizes $100 of section 1231 gains in June and $100 of section 1231 losses in December (and no amounts are subject to recapture).  Under the Proposed Regulations, the taxpayer would have no eligible gains that could be invested in a QOF, but would not know this until December.  Under the Final Regulations, the taxpayer has $100 of eligible gains that may be invested in a QOF when they are realized in June. Furthermore, if the taxpayer invests all of the $100 of section 1231 gains in a qualifying investment in a QOF, the $100 of section 1231 gains will not be taken into account in determining whether the taxpayer has net section 1231 gains or losses at the end of the taxable year, and the $100 of section 1231 losses will be ordinary.

[12] Treas. Reg. § 1.1400Z2(a)-1(c)(1)(i)-(ii).

[13] Preamble 21-24.

[14] Section 453.

[15] Treas. Reg. § 1.1400Z2(a)-1(b)(11)(viii)(B).

[16] Treas. Reg. § 1.1400Z2(a)-1(b)(11)(viii)(A).

[17] To the extent that a RIC or a REIT has net capital gain for a taxable year, it may designate as capital gain dividends the dividends that it pays during the year, the dividends that it is deemed to pay during the year, or certain deficiency dividends that it pays for that year. Sections 852(b)(3) and 857(b)(3). In general, a REIT or RIC capital gain dividend is treated by the shareholders that receive it as a gain from the sale or exchange of a capital asset held for more than one year.

[18] Treas. Reg. § 1.1400Z2(a)-1(b)(7)(ii)(A).

[19] Treas. Reg. § 1.1400Z2(a)-1(b)(7)(ii)(B).

[20] Treas. Reg. § 1.1400Z2(a)-1(b)(7)(ii)(C).

[21] Treas. Reg. § 1.1400Z2(a)-1(b)(7)(ii)(B).

[22] Prop. Reg. § 1.1400Z2(a)-1(c)(8)(iii)(A)-(B), -1(c)(9).

[23] Treas. Reg. § 1.1400Z2(a)-1(c)(8)(iii)(B), -1(c)(9).

[24] Treas. Reg. § 1.1400Z2(a)-1(b)(11)(iv).

[25] Prop. Reg. § §1.1400Z2(a)-1(b)(7)(iv)(D).

[26] Prop. Reg. § 1.1400Z2(a)-1(b)(2)(iv).  For this purpose, an offsetting-positions transaction generally included a transaction in which a taxpayer has substantially diminished the taxpayer’s risk of loss from holding one position with respect to personal property by holding one or more other positions with respect to personal property (whether or not of the same kind) and included positions with respect to personal property that is not actively traded.

[27] Treas. Reg. § 1.1400Z2(a)-1(b)(11)(i)(B).

[28] Unrelated business taxable income generally means income derived by a tax-exempt organization from any regularly conducted trade or business that is not substantially related to the organization’s tax-exempt purpose. Sections 512 and 513.

[29] Treas. Reg. § 1.1400Z2(a)-1(b)(11)(ix)(A)(2).

[30] Treas. Reg. § 1.1400Z2(a)-1(b)(11)(ix)(B).

[31] Treas. Reg. § 1.1400Z2(a)-1(c)(2)(ii).

[32] Sections 897 and 1445.

[33] Section 897(e)(1) and Treas. Reg. § 1.897-6T(a)(1).

[34] Treas. Reg. § 1.1400Z2(a)-1(e).

[35] According to the Preamble, Treasury and the IRS will continue to consider matters related to the mechanics of applying the QOZ rules in the context of a sale subject to FIRPTA withholding.  Preamble 59-60.

[36] Prop. Reg. § 1.1400Z-2(c)-1(b)(2)(i).

[37] Prop. Reg. § 1.1400Z-2(c)-1(b)(2)(ii).

[38] Treas. Reg. § 1.1400Z2(c)-1(b)(2)(ii)(A).

[39] Treas. Reg. § 1.1400Z2(c)-1(b)(2)(ii).  The investor must make the election on the applicable form filed with its tax return for the year in which the sale or exchange occurs.  Treas. Reg. § 1.1400Z2(c)-1(b)(2)(ii)(D).

[40] Treas. Reg. § 1.1400Z2(c)-1(b)(2)(ii)(B). The deemed distribution is solely for purposes of determining the amount of a QOF investor’s qualifying and non-qualifying investment in the QOF and not for other tax purposes.

[41] Treas. Reg. § 1.1400Z2(c)-1(b)(2)(i).

[42] Treas. Reg. § 1.1400Z2(c)-1(b)(2)(i).

[43] Treas. Reg. § 1.1400Z2(c)-1(b)(3)(ii)(A).

[44] Treas. Reg. § 1.1400Z2(b)-1(c)(2)(i), -1(c)(3)(ii), -1(c)(15).

[45] Treas. Reg. § 1.1400Z2(a)-1(c)(1)(ii).

[46] Treas. Reg. § 1.1400Z2(b)-1(c)(6)(ii)(B).

[47] Treas. Reg. § 1.1400Z2(b)-1(c)(6)(ii)(C).

[48] Treas. Reg. § 1.1400Z2(b)-1(c)(6)(iii).

[49] Treas. Reg. § 1.1400Z2(b)-1(c)(6)(iii).

[50] Preamble 80.

[51] Prop. Reg. § 1.1400Z2(b)-1(c)(7)(i)(E).

[52] Prop. Reg. § 1.1400Z2(b)-1(c)(9)(i)(A).

[53] Treas. Reg. § 1.1400Z2(b)-1(c)(9)(i).

[54] Prop. Reg. § 1.1400Z2(b)-1(c)(8)(ii).

[55] Treas. Reg. § 1.1400Z2(b)-1(c)(8)(i).

[56] Prop. Reg. § 1.1400Z2(b)-1(c)(10), (12).

[57] Treas. Reg. § 1.1400Z2(b)-1(c)(12)(ii).

[58] Sections 691, 1400Z-2(e)(3).

[59] Treas. Reg. § 1.1400Z2(b)-1(f)(6).

[60] Prop. Reg. § 1.1400Z2(b)-1(c)(6)(iv).

[61] Prop. Reg. § 1.1400Z-2(a)-1(b)(10)(ii)(B)(4).

[62] Prop. Reg. § 1.1400Z-2(b)-1(c)(6)(iv)(D).

[63] Treas. Reg. § 1.1400Z2(b)-1(c)(6)(iv)(D). The Final Regulations include an example demonstrating the application of this rule:  Assume partners A and B form a QOF partnership by contributing $900 and $100 of eligible gain, respectively, in exchange for capital interests in the QOF partnership. A also agrees to provide services to the QOF partnership in exchange for a carried interest. The QOF partnership agreement provides that partnership profits are first allocated to the capital interests until the capital interest holders receive a 10% preferred return with respect to those interests. Next, QOF partnership profits are allocated 15% to A with respect to A’s carried interest, 10% to A with respect to A’s capital interest, and 75% to B until the capital interests receive a 1,000% preferred return. Thereafter, QOF partnership profits are allocated 1% to A’s carried interest and 99% to the capital interests. There is no reasonable likelihood that QOF partnership profits will be sufficient to result in an allocation in the last tranche. Under an example in the Final Regulations, A’s share of residual profits of the QOF partnership with respect to A’s carried interest is 15%, the final allocation of QOF partnership profits to A’s profits interest that is reasonably likely to apply. The allocation percentage for A’s capital interest in the QOF partnership is 10%. Thus, allocations and distributions made to A are treated as made 60% (15/25) to A’s non-qualifying carried interest and 40% (10/25) to A’s qualifying QOF partnership interest. See Treas. Reg. § 1.1400Z2(b)-1(c)(6)(iv)(E)(1) (Example 1).

[64] Section 1400Z-2(d)(1).

[65] Treas. Reg. § 1.1400Z2(d)-1(b)(2)(C).

[66] A taxpayer’s applicable financial statement is generally the taxpayer’s primary financial statement. This can be the taxpayer’s financial statement that is filed with the Securities and Exchange Commission or other federal agency or any other certified audited financial statement prepared in accordance with U.S. generally accepted accounting principles (GAAP). Treas. Reg. § 1.475(a)-4(h).

[67] The Proposed Regulations provided that a QOF may utilize the AFS valuation method to value each asset owned or leased by the QOF for purposes of determining compliance with the 90% test only if the AFS of the QOF (i) is prepared according to U.S. GAAP and (ii) requires an assignment of value to the lease of the asset. Prop. Reg. § 1.1400Z2(d)-1(b)(2). Under the AFS valuation method, the value of each asset owned or leased by the QOF equals the value of that asset as reported on the QOF’s applicable financial statements for the relevant reporting period.  These requirements were retained in the Final Regulations.

[68] Treas. Reg. § 1.1400Z2(d)-1(b)(4)(ii)(A).

[69] Treas. Reg. § 1.1400Z2(d)-1(b)(4)(ii)(B).

[70] The Final Regulations generally retain the proposed rules related to the valuation of leases under the alternative valuation method for purposes of the 90% test.

[71] Section 1400Z-2(d)(2)(D).

[72] Treas. Reg. § 1.1400Z2(d)-2(b)(3)(i)(A).

[73] Treas. Reg. § 1.1400Z2(d)-2(b)(3)(i)(D).

[74] Prop. Reg. § 1.1400Z-2(d)-1(c)(4)(i)(A), -1(d)(2)(i)(A).

[75] Treas. Reg. § 1.1400Z-2(d)-1(b)(1)(iii)(A).  For purposes of the 90% test and the 70% test, a QOF or QOZB must determine the date on which self-constructed property is treated as acquired. The Final Regulations provide that self-constructed property is treated as acquired on the date physical work of a significant nature begins. Treas. Reg. § 1.1400Z-2(d)-1(b)(1)(iii)(B). The determination of whether physical work is of a significant nature depends on the facts and circumstances, but physical work does not include preliminary activities such as planning or designing, securing financing, exploring, or researching. Treas. Reg. § 1.1400Z-2(d)-1(b)(1)(iii)(B). The Final Regulations provide a safe harbor to determine when physical work of a significant nature begins under which a QOF or QOZB may choose the date on which it paid or incurred more than 10% of the total cost of the property, excluding the cost of any land and preliminary activities. Treas. Reg. § 1.1400Z-2(d)-1(b)(1)(iii)(C).

[76] Prop. Reg. § 1.1400Z-2(d)-1(c)(7).

[77] Treas. Reg. § 1.1400Z2(d)-2(b)(3)(i)(B).

[78] Treas. Reg. § 1.1400Z2(d)-2(b)(3)(i)(B).

[79] Treas. Reg. § 1.1400Z2(d)-2(b)(3)(iii).

[80] Comprehensive Environmental Response, Compensation and Liability Act of 1980, section 101(39) (42 U.S.C. 9601(39)).

[81] Treas. Reg. § 1.1400Z2(d)-2(b)(3)(iv).

[82] Treas. Reg. § 1.1400Z2(d)-2(b)(3)(v).

[83] Prop. Reg. §§ 1.1400Z2(d)-1(c)(4)(i)(B)(2) and 1.1400Z2-1(d)(2)(i)(B)(2).

[84] Treas. Reg. §§ 1.1400Z2(d)-1(b)(4)(iii)(D)(2)-(3) and 1.1400Z2(d)-2(c)(2)(ii)-(iii).

[85] Treas. Reg. § 1.1400Z2(d)-2(b)(4)(iii)(A).

[86] Treas. Reg. § 1.1400Z2(d)-2(b)(4)(iii)(D)(1).

[87] Treas. Reg. § 1.1400Z2(d)-1(b)(4)(v)(A)-(C).

[88] Treas. Reg. § 1.1400Z2(d)-1(b)(4)(v)(D).

[89] Prop. Reg. § 1.1400Z-2(d)-1(c)(8)(ii)(B); -1(d)(4)(ii)(B).

[90] Prop. Reg. § 1.1400Z-2(d)-1(f).

[91] Treas. Reg. § 1.1400Z2(d)-1(b)(4)(iv)(C).

[92] Section 1400Z-2(d)(2)(D)(i).

[93] Prop. Reg. § 1.1400Z2(d)-2(d)(2)(B)(2)(iii).

[94] Under the 70% test, at least 70% of the tangible property owned or leased by a QOZB must be zone business property. Prop. Reg. § 1.1400Z-2(d)-1(c)(6).

[95] Treas. Reg. § 1.1400Z2(d)-2(d)(2)(B)(2)(iii).

[96] Treas. Reg. § 1.1400Z2(d)-2(d)(2)(B)(2)(iii).

[97] Section 1400Z-2(d)(3)(A).

[98] Treas. Reg. § 1.1400Z1(d)-1(d)(3)(i).

[99] Prop. Reg. § 1.1400Z2(d)-1(d)(5)(i)(A) and (B). The third safe harbor, the “management and property safe harbor”, is satisfied if (1) the tangible property of the business located in the QOZ and (2) the management or operational functions performed for the business in the opportunity zone are each necessary to generate 50% of the gross income of the trade or business. Prop. Reg. § 1.1400Z-2(d)-1(d)(5)(i)(C). The Final Regulations do not include any significant modifications or clarifications related to this test.

[100] Treas. Reg. § 1.1400Z1(d)-1(d)(3)(i)(A).

[101] Treas. Reg. § 1.1400Z1(d)-1(d)(3)(i)(B).

[102] Preamble 213.

[103] Section 1400Z-2(d)(3)(A).  Nonqualified financial property includes debt, stock, partnership interests, options, future contracts, forward contracts, swaps, annuities, and similar property (excluding reasonable amounts of working capital held in cash, cash equivalents, or debt instruments with a term of 18 months or less, or ordinary course trade or business notes receivable). Section 1400Z-2(d)(3)(A).

[104] A trade or business generally exists under section 162 if the taxpayer engages in the activity with continuity and regularity and the taxpayer’s primary purpose for engaging in the activity is for income or profit.

[105] Treas. Reg. § 1.1400Z2(d)-1(d)(3)(v).

[106] Treas. Reg. § 1.1400Z2(d)-1(d)(3)(v).

[107] Prop. Reg. § 1.1400Z2(d)-1(d)(5)(ii)(B)(2).

[108] Prop. Reg. § 1.1400Z2(d)-1(d)(5)(ii)(B)(2).

[109] Treas. Reg. § 1.1400Z2(d)-1(d)(5)(iii)(C)(1).  The examples in the Final Regulations describe a triple-net-lease as an arrangement under which the tenant is required to pay for all of the expenses relating to the leased property (e.g., taxes, insurance, and maintenance) in addition to rent.

[110] Treas. Reg. § 1.1400Z2(d)-1(d)(5)(iii)(C)(2).

[111] Section 1400Z-2(d)(3)(A).

[112] Preamble 224-26.

[113] Section 1400Z-2(d)(3).

[114] Prop. Reg. § 1.1400Z2(d)-1(d)(5)(ii).

[115] Treas. Reg. § 1.1400Z2(d)-1(d)(3)(ii)(B).

[116] Section 1400Z-2(d)(3)(A).

[117] Treas. Reg. § 1.1400Z2(d)-1(d)(4)(i). For this purpose, de minimis means less than 5% of the net rentable square footage for real property and less than 5% of the value for all other tangible property.

[118] Section 1400Z-2(d)(3)(B).

[119] Treas. Reg. § 1.1400Z2(d)-1(d)(2)(ix)(E)(5).

[120] Treas. Reg. § 1.1400Z2(d)-1(d)(6)(i).

[121] Treas. Reg. § 1.1400Z2(d)-1(d)(6)(i).

[122] Treas. Reg. § 1.1400Z2(d)-1(d)(6)(iii).

[123] However, an example in the Final Regulations provides that the general anti-abuse rule would apply to disallow the tax benefits under the opportunity zone program where a QOF repeatedly fails the 90% test and never intended to qualify as a QOF. Treas. Reg. § 1.1400Z-2(f)-1(c)(3)(vi).

[124] Treas. Reg. § 1.1400Z-2(g)-1(b)(1). The Proposed Regulations provided that QOF stock is treated as not stock for purposes of the consolidated return rules, with the result that a QOF C corporation could be the common parent of a consolidated group, but not a subsidiary member of a consolidated group. Prop. Reg. § 1.1400Z-2(g)-1(b)(1).

[125] Preamble 282-83. Section 1400Z-2 sets forth a general requirement that a QOF owner must retain its direct qualifying investment in a QOF in order to retain the benefits of that section.

[126] Treas. Reg. § 1.1502-14Z(c)(2)(i).

[127] Treas. Reg. § 1.1502-14Z(c)(2)(ii).

[128] Treas. Reg. § 1.1502-14Z(b)(1)(v).

[129] Treas. Reg. § 1.1502-14Z(b)(v)(2).

[130] Prop. Reg. § 1.1400Z2(f)-1(c)(1).

[131] Treas. Reg. § 1.1400Z2(f)-1(c)(1).

[132] Preamble to the April 2019 Proposed Regulations at 14.

[133] Treas. Reg. § 1.1400Z2(f)-1(c)(3)(iv).

[134] Treas. Reg. § 1.1400Z2(f)-1(c)(3)(v).

© 2020 Proskauer Rose LLP.

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About this Author

David S Miller, Proskauer, derivatives issuance lawyer, cross border lending transactions attorney
Partner

David Miller is a partner in the Tax Department. David advises clients on a broad range of domestic and international corporate tax issues. His practice covers the taxation of financial instruments and derivatives, cross-border lending transactions and other financings, international and domestic mergers and acquisitions, multinational corporate groups and partnerships, private equity and hedge funds, bankruptcy and workouts, high-net-worth individuals and families, and public charities and private foundations. He advises companies in virtually all major industries,...

212.969.3006
Amanda Nussbaum, Tax Attorney, Proskauer Rose Law Firm
Partner

Amanda H. Nussbaum is a Partner in the Tax Department and also is a member of the Private Investment Funds Group. Her practice concentrates on planning for and the structuring of domestic and international private investment funds, including venture capital, buyout, real estate and hedge funds, as well as advising those funds on investment activities and operational issues. She also represents many types of investors, including tax-exempt and non-U.S. investors, with their investments in private investment funds.

212-969-3642
Sean Webb Tax Attorney
Associate

Sean is an associate in the Tax Department. He earned his J.D. from UCLA School of Law and his LL.M. from NYU School of Law, where he served as a graduate editor for the Tax Law Review.

Prior to law school, Sean lived and worked in Shanghai, China, where he learned Mandarin. He has served as a translator for Stanford Law School’s China Guiding Cases Project. He received his B.A. from McGill University.

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