Below are questions submitted by the audience during our webinar Window of Opportunity: The IRS Issues Initial Guidance on Qualified Opportunity Zone Rules. The webinar was on November 2, 2018. Here's the presentation from the webinar and our whitepaper on the new regulations.
- If I am a partner of a partnership and want to use the gain on an individual transaction by the partnership in 2018, what information must I receive from the partnership and do I have until the end of June 2019 for my investment?
You are right, if you are going to elect to defer gain at the partner level, the 180-day period does not begin until the last day of the partnership taxable year in which the realization event occurred—which is the date on which the partner "recognizes" its allocable share of the gain absent a partnership-level election to defer. Given that (i) the gain occurred in 2018; and (ii) if the last day of the partnership taxable year is on December 31, 2018, you would have until the end of June 2019 to make the investment into a QOF.
As an alternative, you may elect to treat your own 180-day period as being the same as the partnership's 180-day period (thus, it would begin on the date of the realization event in 2018). The regulations are silent as to what information the partner willing to make such an election must obtain from the partnership, but presumably you would want documentation that provides assurance as to the amount of the gain and that the partnership will characterize the gain as "capital" (as opposed to "ordinary") on your K-1.
- If a qualified opportunity fund (QOF) is taxed as a partnership that invests in qualified opportunity zone property (QOZ Property), how would the inside basis of the property be determined? Even if based on cost, given that the entity owners' outside basis would be zero, how would flow-through entity owners receive depreciation deduction benefits? Would the deduction be suspended until outside basis is restored?
Those are insightful and important questions. The second set of proposed regulations that are expected to address these issues. To say much more than that, would involve significant speculation. The Treasury Assistant Secretary for Tax Policy, David Kautter, said on December 13 that it would be "about January before we come out with additional guidance" regarding the QOF rules. Moroses, Dylan & Cooper, Stephen, Next Opportunity Zone Rules Expected in January, Kautter Says, Tax Notes (Dec. 14, 2018). Previously, the additional regulations were expected prior to the end of 2018.
- If a QOF owns multiple QOZ Properties, must the QOF sell all of the QOF Properties at one time?
There is no prohibition on sales of QOZ Property. The question is how tax-efficient those sales will be. The paradigm the drafters of the legislation appear to be thinking of is that a taxpayer invests in a QOF for ten years, and the QOF is a venture capital-type business and uses the investment to develop technology in a research center located in a QOZ; then after ten years the taxpayers that invested in the QOF all sell their interests in the QOF to a strategic investor or in an initial public offering, and the taxpayer/investors have no gain due to the step-up to fair market value in their QOF interests for a sale after the ten year holding period. Other types of investments are eligible for the QOF benefits too; it is just this venture capital paradigm is what maximizes the tax benefits and fits most conveniently into the rules.
This issue of multiple exits is particularly challenging for real estate QOFs that own multiple properties and wants to sell them individually at opportune times. For instance, the QOF would realize gain from the sale of a property, and if the QOF is a partnership it would, under general partnership tax principles, allocate that gain to partners who presumably would have to pay tax on it. (If the QOF is a C-corporation, the QOF would presumably have to pay the tax itself.) There is a hope that if the sale happens after the ten year holding period, at least if the QOF is a partnership, the gain on sale of the property would not result in tax for the taxpayers/partners. The policy argument for no tax for the taxpayer/partners is that the sale by the QOF of a property would result in an allocation of gain to the taxpayers/partners, so that the subsequent step-up in their bases in their QOF interests to fair market does not really benefit them, if they already paid tax on the sale of the property by the QOF. Therefore, it would place such taxpayers/partners on the same tax footing as a taxpayer/partner that sells her QOF that still holds its properties, if the taxpayers/partners in this real estate scenario do not have to pay tax on the gain realized by the QOF in a sale after the ten year holding period. We are waiting to see how the next set of regulations handle this issue, and more generally the tax treatment of interim gains reinvested by a QOF.
- A QOF is considering buying a working farm. What "substantial improvements" would be required (in what amounts and by what dates) in order to preserve the tax benefits of a QOF for investors?
The substantial improvement test is met if, during any 30-month period beginning after the date of acquisition of the property, additions to basis with respect to such property in the hands of the QOF exceed an amount equal to the adjusted basis of such property at the beginning of that 30-month period in the hands of the QOF.
To address your question, we would need to know what the assets of the "working farm" are. For instance, does the farm include livestock, equipment and buildings? If livestock is a material portion of the farm's assets and the livestock was used in the QOZ before the purchase by the QOF, there would be an issue with respect to meeting the substantial improvement test for the livestock.
For instance, dairy cows qualify for 100% expensing. So the QOF purchases a dairy cow with the farm in the QOZ and after one year under 100% expensing the cow has zero tax basis remaining. So at the end of the first 30-month period, the QOF only needs to have made a $1 capital improvement to the cow. But how is a capital improvement made to a cow, even if only has to be a $1 improvement? A similar issue arises with some equipment that is not easily subject to capital improvements, if the equipment was used in the QOZ prior to its purchase by the QOF.
If the farm has an existing building on it, then during some 30-month period, the tax basis of the building must be greater than it was at the start of such period. However, there is not guidance as to how many 30-month periods the QOF can wait to apply this test. Must the test be applied before the end of 2026? Before the end of the ten year holding period? Before the end of the recovery period for the asset in question. If the test can be applied to the 30-month period that includes the year in which the building is fully depreciated for tax purposes, then $1 of capital improvement after the building has been fully deprecated would be sufficient to meet the test.
The best approach would be for the QOF to purchase raw farm land. Then the QOF can buy new or used (but from outside the QOZ) the necessary equipment and livestock and build any required buildings. Such an approach would avoid application of the substantial improvement requirement.
- How will the active gross income rule work for digital companies?
Fifty percent of the QOZ business's (i.e., a partnership or a corporation that is a subsidiary of a QOF) gross income must be from the "active conduct "of a business in a QOZ . The proposed regulations reserve on the definition of the "active conduct" of a QOZ business; thus, we still do not know whether the Treasury will select one of the pre-existing definitions of "active" provided by the Code or if it will define a new standard.
To the extent a digital company owns a significant portion of intangible assets, a "substantial" portion of its assets must be used in the active business. However, it is not clear if "substantial" portion will mean 90 percent, 70 percent or some other percentage.
We hope the additional proposed regulations, which are now expected in January, to provide guidance on such matters.
- For purposes of meeting the 50 percent of gross income from a QOZ business, can a OZ business manage that by having contracts that make it clear that the title to the goods sold passes in, or the license made is consummated in or the services provided are provided at the OZ business's offices in the QOZ?
Since the proposed regulations reserve on the definition of the "active conduct" of a QOZ business, it is not clear how "active conduct" will be defined or what factors might be considered in determining whether a business is conducted "in" a QOZ. For example, we do not know whether the Treasury will select one of the pre-existing definitions of "active" provided by the Code to adopt in its guidance, or if it will define a new standard. One of the aspects of this issue to be clarified in next set of proposed regulations is whether an active business can be conducted by independent contractors rather than employees.
- Are there rules with respect leverage on the properties in a QOZ?
There are no restrictions on the acquisition of QOZ Property with mortgage, mezzanine or other financing. However, to address a technical point, a partner in QOF to satisfy the requirement that in order to defer the tax on a capital gain at least the amount of the capital gain must be invested in the QOF, a partner cannot take advantage of the deemed capital contribution principles provided for in Section 752 of the Internal Revenue Code for the partner's portion of nonrecourse debt incurred by a QOF (or a subsidiary of a QOF). The proposed regulations also address the question of whether liabilities incurred by a QOF classified as a partnership will implicate the "mixed funds" rules due to the deemed contribution of money that occurs when a partner is allocated a share of partnership liabilities. The proposed regulations clarify that such a deemed contribution is not treated as a separate investment in a QOF. However, several unanswered questions remain surrounding QOF-level liabilities, including the effect of liabilities on the fair market value step up election. For instance, the step up rule does not appear to address the fact that a buyer when determining the purchase price for a QOF interest presumably will take into account (i.e., reduce the purchase price for) any QOF-level liabilities associated with that interest. As a result, a taxpayer's amount realized on the sale of a QOF interest (which would include the taxpayer's relief from its share of QOF-level liabilities) could exceed the fair market value of the interest and result in a significant amount of gain. We hope the additional proposed regulations will provide guidance on this matter.
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This Mayer Brown article provides information and comments on legal issues and developments of interest. The foregoing is not a comprehensive treatment of the subject matter covered and is not intended to provide legal advice. Readers should seek specific legal advice before taking any action with respect to the matters discussed herein.