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Tax Cuts and Jobs Act

Proposed regs issued on deferral of gains on qualified opportunity fund investments

Thomson Reuters Tax & Accounting  

Thomson Reuters Tax & Accounting  

Preamble to Prop Reg REG-115420-18, Proposed Reg § 1.1400Z-2(a)-1, Proposed Reg § 1.1400Z-2(c)-1, Proposed Reg § 1.1400Z-2(d)-1, Proposed Reg § 1.1400Z-2(e)-1; IR 2018-206, 10/19/2018

Proposed Regs on Investing in Qualified Opportunity Funds

Draft  Form 8996, Qualified Opportunity Fund

IRS has issued proposed regs that describe and clarify the requirements that must be met by a taxpayer in order to defer the recognition of gains by investing in a qualified opportunity fund (QOF) under Code Sec. 1400Z-2, as added by the Tax Cuts and Jobs Act (TCJA, P.L. 115-97; 12/22/2017). Taxpayer may rely on these regs as indicated in the regs.

Background. Opportunity Zones, as created by the TCJA, were designed to spur investment in distressed communities throughout the country through tax benefits. Under a nomination process completed in June, 8,761 communities in all 50 states, the District of Columbia and five U.S. territories were designated as qualified Opportunity Zones. Opportunity Zones retain their designation for 10 years.

Code Sec. 1400Z-2 provides temporary deferral of inclusion in gross income for capital gains reinvested in a QOF and the permanent exclusion of capital gains from the sale or exchange of an investment in the qualified opportunity fund. A QOF is, generally, an investment vehicle organized as a corporation or a partnership for the purpose of investing in qualified opportunity zone property (other than another QOF), that holds at least 90% of its assets in qualified opportunity zone property. Qualified opportunity zone property includes: any qualified opportunity zone stock, any qualified opportunity zone partnership interest, and any qualified opportunity zone business property.

In the case of any investment in a QOF held by the taxpayer for at least 10 years and with respect to which the taxpayer makes a permanent exclusion election under Code Sec. 1400Z-2(c), the basis of the property equals the fair market value of the investment on the date that the investment is sold or exchanged. Under the permanent exclusion, any post-acquisition capital gains on investments in QO Funds that are held for at least ten years are excluded from gross income.

Proposed regs. The proposed regs address the type of gains that may be deferred by investors, the time by which corresponding amounts must be invested in QOFs, and the manner in which investors may elect to defer specified gains. The proposed regs also includes rules for self-certification as a QOF, valuation of QOF assets, and guidance on qualified opportunity zone businesses.

The proposed regs clarify that only capital gains are eligible for deferral under Code Sec. 1400Z-2(a)(1). Gains eligible for deferral generally include capital gain from an actual, or deemed, sale or exchange, or any other gain that is required to be included in a taxpayer’s computation of capital gain.

The proposed regs provide that (1) the gain to be deferred must be gain that would be recognized, if deferral under Code Sec. 1400Z-2(a)(1) were not permitted, not later than Dec. 31, 2026, the final date under Code Sec. 1400Z-2(a)(2)(B) for the deferral of gain; (2) the gain must not arise from a sale or exchange with a related person as defined in Code Sec. 1400Z-2(e)(2) (which incorporates the related person definition in Code Sec. 267(b) and Code Sec. 707(b)(1) but substitutes “20%” in place of “50%” each place it occurs).

Under the proposed regs, taxpayers eligible to elect deferral under Code Sec. 1400Z-2 include individuals, C corporations (including regulated investment companies (RICs) and real estate investment trusts (REITs)), partnerships, and certain other pass-through entities, including common trust funds described in Code Sec. 584, as well as qualified settlement funds, disputed ownership funds, and other entities taxable under Reg § 1.468B.

The proposed regs include special rules for partnerships and other pass-through entities, and for taxpayers to whom these entities pass through income and other tax items. Under these rules, the entities and taxpayers can invest in a QOF and thus defer recognition of eligible gain.

To be an eligible interest in a QOF, the proposed regs clarify that an investment in the QOF must be an equity interest in the QOF, including preferred stock or a partnership interest with special allocations. Thus, an eligible interest cannot be a debt instrument. Provided that the eligible taxpayer is the owner of the equity interest for Federal income tax purposes, status as an eligible interest is not impaired by the taxpayer’s use of the interest as collateral for a loan, whether a purchase-money borrowing or otherwise. Also, the deemed contributions of money under Code Sec. 752(a) do not result in the creation of an investment in a QOF.

Under Code Sec. 1400Z-2(a)(1)(A), to be able to elect to defer gain, a taxpayer must generally invest in a QOF during the 180-day period beginning on the date of the sale or exchange giving rise to the gain. Some capital gains, however, are the result of Federal tax rules deeming an amount to be a gain from the sale or exchange of a capital asset, and, in many cases, the statutory language providing capital gain treatment does not provide a specific date for the deemed sale. The proposed regs provide that, except as specifically provided in the proposed regs, the first day of the 180-day period is the date on which the gain would be recognized for Federal income tax purposes, without regard to the deferral available under Code Sec. 1400Z-2.

If a taxpayer acquires an original interest in a QOF in connection with a gain deferral election under Code Sec. 1400Z-2(a)(1)(A), if a later sale or exchange of that interest triggers an inclusion of the deferred gain, and if the taxpayer makes a qualifying new investment in a QOF, then the proposed regs provide that the taxpayer is eligible to make a Code Sec. 1400Z-2(a)(2) election to defer the inclusion of the previously deferred gain. Deferring an inclusion otherwise mandated by Code Sec. 1400Z-2(a)(1)(B) in this situation is permitted only if the taxpayer has disposed of the entire initial investment without which the taxpayer could not have made the previous deferral election under Code Sec. 1400Z-2.

The proposed regs provide that all of the deferred gain’s tax attributes are preserved through the deferral period and are taken into account when the gain is included. Such preserved tax attributes include those taken into account under Code Sec. 1(h)Code Sec. 1222Code Sec. 1256, and any other applicable Code provision. If a taxpayer disposes of less than all of its fungible interests in a QOF, the proposed regs provide that the QOF interests disposed of must be identified using a first-in, first-out (FIFO) method. (Proposed Reg § 1.1400Z-2(a)-1(b)(6)) Where the FIFO method does not provide a complete answer, such as where gains with different attributes are invested in indistinguishable interests at the same time, the proposed regs provide that a pro rata method must be used to determine the character, and any other attributes, of the gain recognized. (Proposed Reg § 1.1400Z-2(a)-1(b)(7))

Gains of pass-through entities. Proposed Reg § 1.1400Z-2-1(c)(1) provides that a partnership may elect to defer all or part of a capital gain to the extent that it makes an eligible investment in a QOF. If the election is made, no part of the deferred gain is required to be included in the distributive shares of the partners under Code Sec. 702, and the gain is not subject to Code Sec. 705(a)(1). If all or any portion of a partner’s distributive share satisfies all of the rules for eligibility under Code Sec. 1400Z-2(a)(1) (including not arising from a sale or exchange with a person that is related either to the partnership or to the partner), then the partner generally may elect its own deferral with respect to the partner’s distributive share. The partner’s deferral is potentially available to the extent that the partner makes an eligible investment in a QOF.

Consistent with the general rule for the beginning of the 180-day period, the partner’s 180-day period generally begins on the last day of the partnership’s tax year, because that is the day on which the partner would be required to recognize the gain if the gain is not deferred. However, the proposed regs provide an alternative for situations in which the partner knows (or receives information) on both the date of the partnership’s gain and the partnership’s decision not to elect deferral under Code Sec. 1400Z-2. In that case, the partner may choose to begin its own 180-day period on the same date as the start of the partnership’s 180-day period.

The proposed regs state that rules analogous to the rules provided for partnerships and partners apply to other pass-through entities (including S corporations, decedents’ estates, and trusts) and to their shareholders and beneficiaries.

How to elect deferral. Under the proposed regs, the deferral elections must be made at the time and in the manner provided by IRS. Taxpayers will make deferral elections on Form 8949, which will be attached to their Federal income tax returns for the tax year in which the gain would have been recognized if it had not been deferred.

Election to increase basis of investment. Pursuant to Code Sec. 1400Z-2(e)(1)(B), the proposed regs reiterate that a taxpayer may make the election to step-up basis in an investment in a QOF that was held for 10 years or more only if a proper deferral election under Code Sec. 1400Z-2(a) was made for the investment. Taxpayers are allowed to make the basis step-up election under Code Sec. 1400Z-2(c) after a qualified opportunity zone designation expires. The ability to make the election is preserved until Dec. 31, 2047, 20 1/2 years after the latest date that an eligible taxpayer may properly make an investment that is part of an election to defer gain under Code Sec. 1400Z-2(a). Thus, the last day of the 180-day period for that gain would be in late June 2027. A taxpayer deferring such a gain would achieve a 10-year holding period in a QOF investment only in late June 2037. Thus, the proposed rule would permit an investor in a QOF that makes an investment as late as the end of June 2027 to hold the investment in the QOF for the entire 10-year holding period described in Code Sec. 1400Z-2(c), plus another 10 years.

Rules for QOFs. The proposed regs allow IRS to determine the time, form, and manner of the self-certification in IRS forms and instructions or in guidance published in the Internal Revenue Bulletin. It is expected that taxpayers will use new Form 8996 (Qualified Opportunity Fund), both for initial self-certification and for annual reporting of compliance with the 90% asset test in Code Sec. 1400Z-2(d)(1). It is also expected that the Form 8996 would be attached to the taxpayer’s Federal income tax return for the relevant tax years.

The proposed regs allow a QOF both to identify the tax year in which the entity becomes a QOF and to choose the first month in that year to be treated as a QOF. If an eligible entity fails to specify the first month it is a QOF, then the first month of its initial tax year as a QOF is treated as the first month that the eligible entity is a QOF. A deferral election under Code Sec. 1400Z-2(a) may only be made for investments in a QOF. Accordingly, a proper deferral election under Code Sec. 1400Z-2(a) may not be made for an otherwise qualifying investment that is made before an eligible entity is a QOF.

Effective date. The proposed regs generally are proposed to be effective on or after the date of publication in the Federal Register. However:

…An eligible taxpayer may rely on the rules of Proposed Reg § 1.1400Z-2(a)-1 with respect to eligible gains that would be recognized before the final regs’ date of applicability, but only if the taxpayer applies the rules in their entirety and in a consistent manner.

…A taxpayer may rely on the rules in Proposed Reg § 1.1400Z-2(c)-1 with respect to dispositions of investment interests in QOFs in situations where the investment was made in connection with an election under Code Sec. 1400Z-2(a)that relates to the deferral of a gain such that the first day of 180-day period for the gain was before the final regs’ date of applicability. This reliance is dependent on the taxpayer’s applying the rules of Proposed Reg § 1.1400Z-2(c)-1 in their entirety and in a consistent manner.

…A QOF may rely on the rules in proposed Proposed Reg § 1.1400Z-2(d)-1 with respect to tax years that begin before the final regs’ date of applicability, but only if the QOF applies the rules in their entirety and in a consistent manner.

…A taxpayer may rely on the rules in Proposed Reg § 1.1400Z-2(e)-1 with respect to investments and deemed contributions of money that occur before the final regs’ date of applicability, but only if the taxpayer applies the rules in their entirety and in a consistent manner.

References: For qualified opportunity zones, see FTC 2d/FIN ¶I-8820United States Tax Reporter ¶14,00Z-14.

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