[Federal Register Volume 85, Number 8 (Monday, January 13, 2020)]
[Rules and Regulations]
[Pages 1866-2001]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2019-27846]
[[Page 1865]]
Vol. 85
Monday,
No. 8
January 13, 2020
Part II
Department of the Treasury
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Internal Revenue Service
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26 CFR 1
Investing in Qualified Opportunity Funds; Final Rule
Federal Register / Vol. 85 , No. 8 / Monday, January 13, 2020 / Rules
and Regulations
[[Page 1866]]
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DEPARTMENT OF THE TREASURY
Internal Revenue Service
26 CFR Part 1
[TD 9889]
RIN 1545-BP04
Investing in Qualified Opportunity Funds
AGENCY: Internal Revenue Service (IRS), Treasury.
ACTION: Final regulation.
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SUMMARY: This document contains final regulations governing the extent
to which taxpayers may elect the Federal income tax benefits provided
by section 1400Z-2 of the Internal Revenue Code (Code) with respect to
certain equity interests in a qualified opportunity fund (QOF). The
final regulations address the comments received in response to the two
notices of proposed rulemaking issued under section 1400Z-2 and provide
additional guidance for taxpayers eligible to elect to temporarily
defer the inclusion in gross income of certain gains if corresponding
amounts are invested in certain equity interests in QOFs, as well as
guidance on the ability of such taxpayers to exclude from gross income
additional gain recognized after holding those equity interests for at
least 10 years. The final regulations also address various requirements
that must be met for an entity to qualify as a QOF, including
requirements that must be met for an entity to qualify as a qualified
opportunity zone business. The final regulations affect entities that
self-certify as QOFs and eligible taxpayers that make investments,
whether qualifying or non-qualifying, in such entities.
DATES:
Effective date: The final regulations contained in this document
are effective on March 13, 2020.
Applicability dates: See SUPPLEMENTARY INFORMATION.
FOR FURTHER INFORMATION CONTACT: Concerning section 1400Z-2 and these
regulations generally, Alfred H. Bae, (202) 317-7006, or Kyle C.
Griffin, (202) 317-4718, of the Office of Associate Chief Counsel
(Income Tax and Accounting); concerning issues related to C
corporations and consolidated groups, Jeremy Aron-Dine, (202) 317-6848,
or Sarah Hoyt, (202) 317-5024, of the Office of Associate Chief Counsel
(Corporate); concerning issues related to gains from financial
contracts, REITs, or RICs, Andrea Hoffenson or Pamela Lew, (202) 317-
7053, of the Office of Associate Chief Counsel (Financial Institutions
and Products); concerning issues related to investments by foreign
persons, Eric Florenz, (202) 317-6941, or Milton Cahn (202) 317-6937,
of the Office of Associate Chief Counsel (International); concerning
issues related to partnerships, S corporations or trusts, Marla
Borkson, Sonia Kothari, or Vishal Amin, at (202) 317-6850, and
concerning issues related to estates and gifts, Leslie Finlow or
Lorraine Gardner, at (202) 317-6859, of the Office of Associate Chief
Counsel (Passthroughs and Special Industries). These numbers are not
toll-free numbers.
SUPPLEMENTARY INFORMATION:
Background
This document amends the Income Tax Regulations (26 CFR part 1) by
adding final regulations under section 1400Z-2 of the Code. Section
13823 of Public Law 115-97, 131 Stat. 2054 (December 22, 2017),
commonly referred to as the Tax Cuts and Jobs Act (TCJA), added
sections 1400Z-1 and 1400Z-2 to the Code. Section 1400Z-1 addresses the
designation of population census tracts located in the 50 states, U.S.
territories, and the District of Columbia as qualified opportunity
zones (QOZs). See Notice 2018-48, 2018-28 I.R.B. 9, and Notice 2019-42,
2019-29 I.R.B. 352, for the list of population census tracts designated
as QOZs (each, a QOZ designation notice).
Section 1400Z-2 provides two main Federal income tax benefits to
eligible taxpayers that make longer-term investments of new capital in
one or more designated QOZs through QOFs and qualified opportunity zone
businesses. The first main Federal income tax benefit provided by
section 1400Z-2 is the ability of an eligible taxpayer, upon the making
of a valid election, to defer until as late as December 31, 2026, the
inclusion in gross income of certain gains that would otherwise be
recognized in a taxable year if the taxpayer invests a corresponding
amount of such gain in a qualifying investment in a QOF within a 180-
day statutory period. The eligible taxpayer may potentially exclude 10
percent of such deferred gain from gross income if the eligible
taxpayer holds the qualifying investment in the QOF for at least five
years. See section 1400Z-2(b)(2)(B)(iii). An additional five percent of
such gain may potentially be excluded from gross income if the eligible
taxpayer holds that qualifying investment for at least seven years. See
section 1400Z-2(b)(2)(B)(iv). The second main Federal income tax
benefit provided by section 1400Z-2 is the ability for the eligible
taxpayer, upon the making of a separate valid election, to exclude from
gross income any appreciation on the eligible taxpayer's qualifying
investment in the QOF if the eligible taxpayer holds the qualifying
investment for at least 10 years. See section 1400Z-2(c).
On October 29, 2018, the Department of the Treasury (Treasury
Department) and the IRS published a notice of proposed rulemaking (REG-
115420-18) in the Federal Register (83 FR 54279) containing a first set
of proposed regulations under section 1400Z-2 (October 2018 proposed
regulations). The October 2018 proposed regulations addressed the type
of gain that is eligible for deferral by eligible taxpayers, the timing
by which eligible taxpayers must invest amounts in QOFs corresponding
to the gains to be deferred, and the manner in which eligible taxpayers
could make deferral elections of any gains. The October 2018 proposed
regulations also provided rules for the self-certification of QOFs,
valuation of QOF assets, and general guidance on the requirements for a
corporation or partnership to be a qualified opportunity zone business,
including providing that the term ``substantially all'' as used in
section 1400Z-2(d)(3)(A)(i) means at least 70 percent. The Treasury
Department and the IRS received 180 written and electronic comments
responding to the October 2018 proposed regulations. A public hearing
on the October 2018 proposed regulations was held on February 14, 2019.
A second notice of proposed rulemaking (REG-120186-18) was
published in the Federal Register (84 FR 18652) on May 1, 2019,
containing additional proposed regulations under section 1400Z-2 (May
2019 proposed regulations). The May 2019 proposed regulations updated
portions of the October 2018 proposed regulations to address various
issues, including: The definition of the term ``substantially all'' in
each of the various places the term appears in section 1400Z-2;
transactions resulting in the inclusion under section 1400Z-2(a)(1)(B)
and (b) of eligible gain that an eligible taxpayer elected to defer
under section 1400Z-2(a); the treatment of leased property used by a
QOF or qualified opportunity zone business; the use of qualified
opportunity zone business property in the QOZ; the sourcing of gross
income to the qualified opportunity zone business; and the ``reasonable
period'' for a QOF to reinvest proceeds from the sale of qualifying
assets without paying the penalty imposed by section 1400Z-2(f)(1). The
Treasury Department and
[[Page 1867]]
the IRS received 127 written and electronic comments responding to the
May 2019 proposed regulations. A public hearing on the May 2019
proposed regulations was held on July 9, 2019.
The October 2018 proposed regulations and the May 2019 proposed
regulations are collectively referred to in this Treasury decision as
the ``proposed regulations.'' All comments received on the proposed
regulations are available at www.regulations.gov or upon request.
The preamble to the May 2019 proposed regulations stated that the
Treasury Department and the IRS would schedule tribal consultation with
officials of governments of Federally recognized Indian tribes (Indian
tribal governments) before finalizing the proposed regulations to
obtain additional input, within the meaning of the Treasury
Department's Tribal Consultation Policy (80 FR 57434, September 23,
2015), in accordance with Executive Order 13175, ``Consultation and
Coordination with Indian tribal governments'' (65 FR 67249, November 6,
2000), on the ability of entities organized under the law of an Indian
tribe to be QOFs or qualified opportunity zone businesses, whether any
additional guidance may be needed regarding the ability of QOFs or
qualified opportunity zone businesses to lease tribal government
Federal trust lands or leased real property located on such lands, and
any other tribal implications of the proposed regulations. This tribal
consultation took place via telephone on October 21, 2019
(Consultation) (see part VI. of the Special Analyses for additional
discussion).
After full consideration of all comments received on the proposed
regulations, including comments received from the Consultation, and the
testimony heard at both public hearings, this Treasury decision adopts
the proposed regulations with modifications in response to such
comments and testimony, as described in the Summary of Comments and
Explanation of Revisions following this Background.
For dates of applicability, see Sec. Sec. 1.1400Z2(a)-1,
1.1400Z2(b)-1, 1.1400Z2(c)-1, 1.1400Z2(d)-1, 1.1400Z2(d)-2,
1.1400Z2(f)-1, 1.1502-14Z, and 1.1504-3 set forth in this document,
which provide that the final regulations set forth in Sec. Sec.
1.1400Z2(a)-1 through 1.1400Z2(d)-2, 1.1400Z2(f)-1, 1.1502-14Z, and
1.1504-3 are generally applicable for taxable years beginning after
March 13, 2020. With respect to 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 may choose either (1) to apply the
final regulations set forth in Sec. Sec. 1.1400Z2(a)-1 through
1.1400Z2(d)-2, 1.1400Z2(f)-1, 1.1502-14Z, and 1.1504-3 contained in
this document, if applied in a consistent manner for all such taxable
years, or (2) to rely on each section of proposed Sec. Sec.
1.1400Z2(a)-1 through 1.1400Z2(g)-1, except for proposed Sec.
1.1400Z2(c)-1, contained in the notice of proposed rulemaking documents
published on October 29, 2018, and on May 1, 2019, in the Federal
Register (83 FR 54279; 84 FR 18652), but only if relied upon in a
consistent manner for all such taxable years. Taxpayers relying on each
section of proposed Sec. Sec. 1.1400Z2(a)-1 through 1.1400Z2(g)-1,
except for proposed Sec. 1.1400Z2(c)-1, contained in the notice of
proposed rulemaking documents published on October 29, 2018, and on May
1, 2019, in the Federal Register (83 FR 54279; 84 FR 18652), must apply
Sec. 1.1400Z2(c)-1 of the final regulations contained in this document
with respect to any elections made under section 1400Z-2(c).
Summary of Comments and Explanation of Revisions
I. Overview
The final regulations set forth in Sec. Sec. 1.1400Z2(a)-1 through
1.1400Z2(f)-1, 1.1502-14Z, and 1.1504-3 (section 1400Z-2 regulations)
retain the basic approach and structure of the proposed regulations,
with certain revisions. The Treasury Department and the IRS have
refined and clarified certain aspects of the proposed regulations in
these final regulations to make the rules easier to follow and
understand. Specifically, proposed Sec. 1.1400Z2(d)-1 has been split
into two separate sections: Sec. Sec. 1.1400Z2(d)-1 and 1.1400Z2(d)-2.
Further, the Treasury Department and the IRS have combined duplicative
rules regarding QOFs and qualified opportunity zone businesses, and
have added defined terms to allow the reader to more intuitively grasp
the meaning of the numerous provisions cross-referenced in the final
regulations.
This Summary of Comments and Explanation of Revisions discusses
those revisions as well as comments received in response to each of
Sec. Sec. 1.1400Z2(a)-1 through 1.1400Z2(g)-1 of the proposed
regulations (proposed Sec. Sec. 1.1400Z2(a)-1 through 1.1400Z2(g)-1).
The rules proposed in the October 2018 proposed regulations and the May
2019 proposed regulations are explained in greater detail in the
Explanation of Provisions sections of the preambles to each set of
proposed regulations.
II. Comments on and Changes to Proposed Sec. 1.1400Z2(a)-1
Proposed Sec. 1.1400Z2(a)-1 prescribed rules regarding the
election to defer gains under section 1400Z-2(a)(1), including rules
regarding which taxpayers are eligible to make the election, which
gains are eligible for deferral, and the method by which eligible
taxpayers may make deferral elections. This part II describes the
revisions made to proposed Sec. 1.1400Z2(a)-1 based on the comments
received on those proposed rules, including revisions to the definition
of eligible gain and revisions to the rules applying the statutory 180-
period and other requirements with regard to the making of a qualifying
investment in a QOF.
A. Definitions and Related Operating Rules
1. Eligible Gain
Proposed Sec. 1.1400Z2(a)-1(b)(2) generally provided that an
amount of gain would be eligible for deferral under section 1400Z-2(a)
if the gain (i) is treated as a capital gain for Federal income tax
purposes that would be recognized for Federal income tax purposes
before January 1, 2027, if section 1400Z-2(a)(1) did not apply to defer
recognition of the gain; and (ii) did not arise from a sale or exchange
with a related person within the meaning of section 1400Z-2(e)(2)
(eligible gain). This part II.A.1. describes the comments received on
various aspects of the proposed definition of eligible gain and
explains the revisions, based on those comments, adopted by Sec.
1.1400Z2(a)-1(b)(11) of the final regulations.
a. Gains From Section 1231 Property
Proposed Sec. 1.1400Z2(a)-1(b)(2)(iii) of the May 2019 proposed
regulations provided that the only gain arising from property used in
the taxpayer's trade or business (section 1231 property) eligible for
deferral under section 1400Z-2(a)(1) was ``capital gain net income''
for a taxable year, which was defined as the amount by which the
capital gains arising from all of a taxpayer's section 1231 property
exceeded all of the taxpayer's losses from section 1231 property for a
taxable year. The Treasury Department and the IRS have reconsidered
this approach based on the numerous comments received on this aspect of
the May 2019 proposed regulations.
[[Page 1868]]
i. Section 1231 Generally
Section 1231 governs the character of a taxpayer's gains or losses
with respect to section 1231 property not otherwise characterized by
section 1245 or 1250. Section 1231(b) defines ``section 1231 property''
generally as depreciable or real property that is used in the
taxpayer's trade or business and held for more than one year, subject
to enumerated exceptions (for example, property held by the taxpayer
primarily for sale to customers in the ordinary course of the
taxpayer's trade or business).
Under section 1231(a)(1), if a taxpayer's aggregate gains from each
sale and exchange (each gain, a section 1231 gain) during the taxable
year exceed the taxpayer's aggregate losses from each sale and exchange
(each loss, a section 1231 loss), the taxpayer's section 1231 gains and
section 1231 losses are treated as long-term capital gains and long-
term capital losses, respectively. However, if the aggregate section
1231 gains do not exceed the aggregate section 1231 losses (that is,
the aggregate amount of section 1231 gains equals or is less than the
aggregate amount of section 1231 losses), those gains and losses are
not treated as gains and losses from sales or exchanges of capital
assets (that is, they are treated as ordinary income and ordinary
losses). See sections 64, 1221, 1222, and 1231(a)(2) of the Code.
Several provisions of the Code may apply to limit the long-term
capital treatment otherwise potentially provided under section
1231(a)(1). For example, prior to the aggregation of section 1231 gains
and losses under section 1231(a), the recapture rules of sections 1245
and 1250 must be applied on an asset-by-asset basis. Section 1245,
which applies to sales, exchanges, or dispositions of depreciable
tangible and intangible property, characterizes any gain recognized as
ordinary income (as defined in section 64) to the extent depreciation
or amortization has been allowed or allowable with respect to that
property. Section 1250 provides a similar ``pre-aggregation'' recapture
rule with regard to sales, exchanges, or dispositions of depreciable
real property that is not section 1245 property, and it characterizes
as ordinary income (as defined in section 64) any gain recognized in
excess of straight line depreciation.
Section 1231(c), on the other hand, sets forth a ``post-
aggregation'' recapture provision, requiring the net section 1231 gain
for any taxable year to be treated as ordinary income to the extent
that such gain does not exceed the non-recaptured net section 1231
losses. Non-recaptured net section 1231 losses are net section 1231
losses for the five most recent preceding taxable years of the taxpayer
that have not yet been recaptured. However, section 1231(c)(5),
provides that the principles of section 1231(a)(4) apply for purposes
of section 1231(c). Under section 1231(a)(4), to determine whether
gains exceed losses for the section 1231(a) character determination,
section 1231 gains are included only if and to the extent that they are
taken into account in computing gross income, and section 1231 losses
are included only if and to the extent that they are taken into account
in computing taxable income.
Essentially, the operation of the ``pre-aggregation'' recapture
rules under sections 1245 and 1250, as well as the ``post-aggregation''
recapture rule under section 1231(c), requires a gain recognized with
respect to section 1231 property potentially to be treated as ordinary
income, even if that gain otherwise would have been characterized
differently under section 1231(a) in the absence of such recapture
rules.
Section 64 defines the term ``ordinary income'' for purposes of
subtitle A of the Code (subtitle A), which includes sections 1231,
1245, 1250, and 1400Z-2, to include ``any gain from the sale or
exchange of property which is neither a capital asset nor property
described in section 1231(b),'' and provides further that ``[a]ny gain
from the sale or exchange of property which is treated or considered,
under other provisions of this subtitle, as `ordinary income' shall be
treated as gain from the sale or exchange of property which is neither
a capital asset nor property described in section 1231(b).'' See for
example, sections 1231(c), 1245, and 1250; see also Sec. Sec. 1.1245-
1(a)(1), 1.1245-1(b)(2), 1.1250-1(a)(1), 1.1250-1(b)(1), and 1.1250-
1(c)(1).
ii. Comments on Treatment of Section 1231 Property
Commenters suggested that the gross amount of section 1231 gain
realized from sales or exchanges of section 1231 property should be
eligible gain, provided that such gain is determined to be capital gain
at the end of the taxable year by taking into account all section 1231
gains and section 1231 losses. Some commenters also recommended that
the 180-day period for investment begin on the date of the sale or
exchange that gives rise to a section 1231 gain instead of at the end
of the taxable year. Many of the commenters recognized that, because
section 1231(a)(1) requires a netting process to determine whether
section 1231 gains and losses are capital in character, investors might
not be certain if any of the section 1231 gain invested from sales or
exchanges before the end of the taxable year is capital in character.
Therefore, several commenters suggested that gross section 1231 gains
be eligible for investment on the date of the sale or exchange,
contingent on such gains being capital in character as determined by
the netting process at the end of the taxable year. Under this
approach, if the section 1231 gains invested in a QOF during a taxable
year are determined not to be capital in character because section 1231
gains for the year do not exceed section 1231 losses, the section 1231
gains invested that year would constitute an investment that does not
qualify for deferral under section 1400Z-2(a)(1) (a non-qualifying
investment).
In the alternative, many commenters recommended an election to
permit a taxpayer to begin the 180-day period for section 1231 gains on
the last day of the taxable year. This election would accommodate the
needs of taxpayers who are unable to determine whether section 1231
gains will be capital in character until all transactions involving
section 1231 property have been completed for a taxable year. As a
model for this elective approach, commenters referred to proposed Sec.
1.1400Z2(a)-1(c)(2)(iii)(B), which permits a partner to elect to align
its 180-day period with that of the partnership, that is, the date of
the sale or exchange giving rise to such gain.
Commenters observed that because gain that is deferred under
section 1400Z-2 would not be taken into account in computing gross
income until recognized, pursuant to section 1231(a)(4), any deferred
gains would be excluded from the section 1231(a) character
determination. As a result, taxpayers could ensure that section 1231
gains do not exceed section 1231 losses for a taxable year under
section 1231(a) by investing the excess of gains realized from the sale
or exchange of section 1231 property over the losses from those sales,
thus, rendering all section 1231 losses, that otherwise would be
capital in character, ordinary in character. However, commenters noted
that section 1231(a)(4) gives rise to a circularity issue if applied in
this manner. If the only section 1231 gains that are eligible for
deferral under section 1400Z-2 are capital character section 1231
gains, then, if a taxpayer invests an amount of section 1231 gains in a
QOF such that the character determination under section 1231(a)
produces ordinary character gains and
[[Page 1869]]
losses for a taxable year, then all section 1231 gains in that taxable
year would not be eligible gains. Therefore, in light of the
application of section 1231(a)(4), a taxpayer could only defer an
amount of section 1231 gains such that even after subtracting deferred
gains, the remaining non-deferred section 1231 gains for the taxable
year would still exceed section 1231 losses. In many cases, this excess
amount would be substantially less than the gross amount of section
1231 gains realized from the sale or exchange section 1231 property for
the taxable year. To resolve both the issue of shifting the character
of otherwise capital character section 1231 losses to ordinary
character section 1231 losses and the circularity issue described
previously, a commenter suggested treating section 1231 gains deferred
under section 1400Z-2 as if they were ``taken into account in computing
gross income'' for purposes of section 1231(a)(4). Under such a rule,
even if the full amount of section 1231 gains that are capital in
character were deferred under section 1400Z-2, section 1231 gains would
still exceed section 1231 losses and both section 1231 gains and losses
would retain their capital character after the application of section
1231(a).
Several commenters also requested additional rules with respect to
the application of the rules of section 1231(c) (described earlier) to
deferred section 1231 gain. Commenters suggested a rule providing that
deferred section 1231 gain to the extent of non-recaptured net section
1231 losses be treated as ordinary income when those gains are
recognized rather than in the year of gain deferral. In some instances,
this approach may require a taxpayer to account for its non-recaptured
net section 1231 losses for a period longer than the five most recent
taxable years section 1231(c) requires. A commenter suggested that the
extension of the recapture period be accomplished by means of an
election by the taxpayer at the time any section 1231 gain is deferred
under section 1400Z-2. In electing to defer section 1231 gain, a
taxpayer also would elect to extend the section 1231(c) recapture
period to the longer of the statutory five-year period or the taxable
year that includes December 31, 2026. Alternatively, some commenters
asked that section 1231(c) not apply at all to deferred section 1231
gains.
One commenter also noted that the term ``capital gain net income''
already is defined in section 1222(9), and that its separate definition
and use in the section 1400Z-2 regulations might lead to confusion.
In response to these comments, the final regulations provide that
eligible gains that may be deferred pursuant to section 1400Z-
2(a)(1)(A) and the section 1400Z-2 regulations include gains from the
sale or exchange of property described in section 1231(b) not required
to be characterized as ordinary income by sections 1245 or 1250
(qualified section 1231 gains), regardless of whether section 1231(a)
(without regard to section 1231(a)(4)) would determine those gains to
be capital or ordinary in character. As noted earlier, section 64
provides that gains from the sale or exchange of section 1231 property
generally are not considered ordinary income for purposes of subtitle
A, although recaptured income under section 1245 or 1250 would be
ordinary income under section 64.
However, the final regulations do not set forth a special rule to
address the application of section 1231(a)(4) for purposes of applying
section 1400Z-2 and the section 1400Z-2 regulations. Thus, section
1231(a)(4) applies to eligible section 1231 gains deferred pursuant to
section 1400Z-2(a)(1)(A) as it would under similar deferral provisions,
such as sections 453 and 1031. That is, unless a section 1231 gain (as
defined in section 1231(a)(3)(A)) is taken into account in computing
gross income in a taxable year, section 1231(a)(4) does not include
that gain in calculating whether section 1231 gains exceed section 1231
losses under section 1231(a)(1) for the taxable year.
Additionally, these final regulations do not alter the statutory
application of the section 1231(c) recapture of net ordinary loss.
Therefore, if a deferral election with respect to an eligible section
1231 gain is made in year 1, any non-recaptured net section 1231 losses
from the five most recent taxable years that precede year 1 apply to
recapture as ordinary income in year 1 any net section 1231 gain that
has not been deferred in year 1. In other words, the section 1231(c)
amount that would have applied to the eligible section 1231 gain absent
a deferral election and corresponding investment in a QOF is not an
attribute associated with the deferred eligible section 1231 gain that
is taken into account in applying section 1231 in the ultimate year in
which the deferred gain is included in income under section 1400Z-2(b)
and the section 1400Z-2 regulations. Instead, when deferred eligible
section 1231 gain is subsequently included in income on December 31,
2026, or on an earlier date as a result of an inclusion event, section
1231(c) will recapture net section 1231 gain in the year of inclusion
by taking into account non-recaptured section 1231 losses only from the
five most recent taxable years preceding the taxable year of inclusion.
Unlike the net approach of the proposed regulations, the final
regulations adopt a gross approach to eligible section 1231 gains
without regard to any section 1231 losses. In addition, under the final
regulations, the character of eligible section 1231 gains, other than
as gains arising from the sale or exchange of section 1231 property, is
not determined until the taxable year such gains are taken into account
in computing gross income pursuant to section 1231(a)(4). Accordingly,
the term ``capital gain net income'' used in the proposed regulations
is no longer applicable when referring to the amount of any gain from
the sale or exchange of section 1231 property that is eligible for
deferral under section 1400Z-2(a)(1)(A) and the section 1400Z-2
regulations.
The Treasury Department and the IRS have determined that a gross
approach that does not apply section 1231(a) and (c) (gross approach)
to determine eligible gain from the sale or exchange of section 1231
property is consistent with the long-standing rules of section 64, and
is appropriate due to the complexity of applying section 1231 to
deferred gains generally. Moreover, limiting eligible gain from the
sale or exchange of section 1231 property to an amount less than the
net section 1231 gains for a taxable year would impose a significant
administrative burden on persons that are required to report the
recognition of such gains during the taxable year under Federal income
tax accounting principles (eligible taxpayers). Similarly, a gross
approach to determine eligible section 1231 gains eliminates complexity
and uncertainty in determining eligible gain for partnerships and S
corporations that are eligible taxpayers.
As discussed in part II.A.3.a. of this Summary of Comments and
Explanation of Revisions, because eligible gains include the gross
amount of eligible section 1231 gains unreduced by section 1231 losses
regardless of character, it is not necessary for an investor to wait
until the end of the taxable year to determine whether any eligible
section 1231 gains are eligible gains. As a consequence, the final
regulations provide that the 180-day period for investing an amount
with respect to an eligible section 1231 gain for which a deferral
election is to be made begins on the date of the sale or exchange that
gives rise to the eligible section 1231 gain.
[[Page 1870]]
b. Character of Eligible Gain
Section 1400Z-2(a)(1)(A) provides that if a taxpayer has ``gain
from the sale to, or exchange with, an unrelated person of any property
held by the taxpayer,'' the taxpayer may elect to exclude from gross
income for the taxable year the aggregate amount of such gain invested
by the taxpayer in a QOF during the 180-day period beginning on the
date of such sale or exchange. The Treasury Department and the IRS
considered whether ``gain'' eligible for deferral under section 1400Z-2
should include both gain from the disposition of a capital asset as
well as gain treated as ordinary income under subtitle A.
As noted in part II.A.1.a, section 64 of the Code provides
generally that for purposes of subtitle A, the term ``ordinary income''
includes any gain from the sale or exchange of property which is
neither a capital asset nor property described in section 1231(b). Any
gain from the sale or exchange of property which is treated or
considered, under other provisions of subtitle A, as ``ordinary
income'' shall be treated as gain from the sale or exchange of property
which is neither a capital asset nor property described in section
1231(b). Thus, for purposes of subtitle A, including section 1400Z-2,
section 64 defines gains treated as ordinary income as categorically
different from gains from the sale or exchange of capital assets or
section 1231 property.
In this regard, proposed Sec. 1.1400Z2(a)-1(b)(2)(i) as contained
in the October 2018 proposed regulations provided that an amount of
gain is an ``eligible gain,'' and thus is eligible for deferral under
section 1400Z-2(a), if the gain is treated as a capital gain for
Federal income tax purposes. In addition, the May 2019 proposed
regulations provided that the only gain arising from section 1231
property eligible for deferral under section 1400Z-2(a)(1) was
``capital gain net income'' for a taxable year, which was defined as
the amount by which the capital gains arising from all of a taxpayer's
section 1231 property exceeded all of the taxpayer's losses from
section 1231 property for a taxable year.
Based on the statutory text of section 1400Z-2(a)(1)(A), several
commenters requested that the final regulations permit taxpayers to
treat both capital gains and ordinary gains (that is, gains treated as
ordinary income) as eligible gains. For example, commenters requested
that gain from property used in a trade or business required to be
characterized as ordinary income, such as recapture income under
section 1231(c) or 1245(a), should be permitted to be invested in a
QOF.
After consideration of the language, structure and purpose of
section 1400Z-2 as a whole, the Treasury Department and the IRS have
determined that it would be inconsistent with section 64 and the
statutory framework of section 1400Z-2 to extend the meaning of the
term ``gain'' in section 1400Z-2(a)(1) to gain required to be treated
as ordinary income under subtitle A, including section 1245 gain. The
interpretation of the Treasury Department and the IRS of the text and
structure of the statute is confirmed by the legislative history, which
explicitly identifies ``capital gains'' as the gains that are eligible
for deferral. See H.R. Rep. No. 115-466, at 537-540 (Dec. 15, 2017)
(Conference Report).
Accordingly, the Treasury Department and the IRS have retained in
the final regulations the general rule set forth in the proposed
regulations that limits eligible gains to gains treated as capital
gains for Federal income tax purposes. For purposes of section 1400Z-
2(a)(1), eligible gains generally include gains from the disposition of
capital assets as defined in section 1221(a), gains from the
disposition of property described in section 1231(b), and income
treated as capital gain under any provision of the Code, such as
capital gain dividends distributed by certain corporations. For this
purpose, both long-term capital gain and short-term capital gain may be
determined to be eligible gain under the section 1400Z-2 regulations.
However, consistent with section 64, any gain required to be treated as
ordinary income under subtitle A, such as section 1245 recapture
income, is not eligible gain.
In that regard, one commenter suggested that, unlike other
investors in QOFs, existing residents of a QOZ should be provided a
special accommodation not available to other eligible taxpayers--such
residents should be permitted to invest any gain, regardless of
character, in QOFs and elect to defer the corresponding amounts in
accordance with section 1400Z-2. The Treasury Department and the IRS
have determined that neither the statutory language nor legislative
history of section 1400Z-2 supports different treatment for residents
of QOZs regarding the deferral of eligible gains. Section 1400Z-2
references the term ``taxpayer,'' which section 7701(a)(14) defines as
``any person subject to any internal revenue tax.'' In turn, section
7701(a)(1) defines the term ``person'' to include ``an individual, a
trust, estate, partnership, association, company or corporation.''
The Treasury Department and the IRS have determined that
construction of the term ``taxpayer'' in accordance with section
7701(a)(14) would be consistent with the language and purpose of
section 1400Z-2 as a whole, and therefore would give effect to the
intent of Congress. Moreover, disparate treatment of eligible taxpayers
residing in QOZs and those who do not is not warranted given that the
statute equally incents investment in QOZs by any taxpayer, including
those that have historically invested in businesses operated within
QOZs and those that have not. Accordingly, the section 1400Z-2
regulations do not adopt the comment recommending special treatment for
residents of QOZs to invest ordinary income, including gain required to
be treated as ordinary income under subtitle A, in QOFs.
c. Gain From Sales of Capital Assets, Unreduced by Any Losses
One commenter also requested clarification that the deferral
election under section 1400Z-2(a)(1) applies to the gross amount of
gain treated as capital gain unreduced by losses. The proposed
regulations generally provided that in the case of gain from the sale
of a capital asset as defined under section 1221, the full amount of
capital gain from that sale or exchange, unreduced by any losses, is
eligible gain that generally may be invested during the 180-day period
beginning on the date of the sale or exchange of the property giving
rise to the gain.
The section 1400Z-2 regulations retain the general rule of the
proposed regulations providing that the full amount of gain that would
be recognized from the sale or exchange of a capital asset as defined
under section 1221, unreduced by any losses, is eligible gain and
therefore eligible taxpayers do not have to net a gain from a section
1221 capital asset against the sum of the taxpayer's losses from
section 1221 capital assets. Thus, if a capital gain is realized by an
eligible taxpayer during a taxable year, section 1400Z-2 and the
section 1400Z-2 regulations generally do not require that any losses
reduce the amount of the gain that may be an eligible gain.
However, gain that otherwise may qualify as a capital gain may be
required to be recharacterized or redetermined by other provisions of
the Code. For example, sections 1245 and 1250 may require gain that
potentially could be characterized as capital in nature to instead be
treated as ordinary income ``notwithstanding any other provision of
[[Page 1871]]
this subtitle,'' referring to subtitle A, which includes section 1400Z-
2. Consistent with section 64, if a provision of the Code requires the
character of a potential capital gain to be recharacterized,
redetermined, or treated as ordinary income for purposes of subtitle A,
such gain cannot be, and is not, treated as other than ordinary income
under the Code, and therefore is not eligible gain for purposes of
section 1400Z-2 and the section 1400Z-2 regulations. See Sec. Sec.
1.1245-1(a)(1), 1.1245-1(b)(2), 1.1250-1(a)(1), 1.1250-1(b)(1), and
1.1250-1(c)(1).
d. Gains From Sales to, or Exchanges of Property With, a QOF or
Qualified Opportunity Zone Business
The October 2018 proposed regulations provided that eligible gain
does not include gain from the sale to, or the exchange of property
with, a person that is related to the taxpayer within the meaning of
section 1400Z-2(e)(2). Section 1400Z-2(d)(2)(D) and the May 2019
proposed regulations provided that qualified opportunity zone business
property that a QOF owns must be acquired by the QOF by purchase from
an unrelated party. As a result, property that is purchased by a QOF
from a related party, as well as property that is contributed to a QOF
in a transfer to which section 351 or section 721(a) applies, is not
qualified opportunity zone business property.
Commenters have requested confirmation that eligible gain includes
gain arising from the sale to, or the exchange of property with, a QOF
if the amount of the gain is later invested in that QOF. Commenters
similarly have requested confirmation that gain from the sale to, or
the exchange of property with, a qualified opportunity zone business is
eligible for investment into the QOF that owns the qualified
opportunity zone business. Relatedly, commenters have requested that
the final regulations provide that a sale to, or an exchange of
property with, a QOF or qualified opportunity zone business, followed
by an investment of the amount of the sales proceeds into the QOF,
would not be characterized as a purchase from a related party for
purposes of section 1400Z-2(d)(2)(D).
One commenter expressed concern that, if a taxpayer sold property
to an unrelated QOF and then invested the amount of the sales proceeds
in the same QOF, that sequence of transactions could be characterized
under circular cash flow principles as if the taxpayer contributed the
property directly to the QOF (and each transfer of the amount of the
sales proceeds would be disregarded for Federal income tax purposes).
If this construct applied, the acquired property would not qualify as
qualified opportunity zone business property.
The Treasury Department and the IRS agree that generally applicable
Federal income tax principles would require this result if, under the
facts and circumstances, the consideration paid by the QOF or by a
qualified opportunity zone business returns to its initial source as
part of the overall plan. See Rev. Rul. 83-142, 1983-2 C.B. 68; Rev.
Rul. 78-397, 1978-2 C.B. 150. Under the step transaction doctrine and
circular cash flow principles, the circular movement of the
consideration in such a transaction would be disregarded for Federal
income tax purposes, including for purposes of section 1400Z-2 and the
section 1400Z-2 regulations. Thus, the transaction would be treated for
Federal income tax purposes as a transfer of property to the purchasing
QOF for an interest therein or, if applicable, as a transfer of
property to a QOF for an interest therein followed by a transfer of
such property by the QOF to the purchasing qualified opportunity zone
business.
Accordingly, an eligible taxpayer's gain from a sale to or an
exchange of property with an unrelated QOF (acquiring QOF), as part of
a plan that includes the investment of the consideration received by
the eligible taxpayer back into the acquiring QOF, is not eligible gain
to the eligible taxpayer because the transaction would not be
characterized as a sale or exchange to an unrelated person for Federal
income tax purposes. Similarly, an eligible taxpayer's gain from a sale
to or an exchange of property with an unrelated qualified opportunity
zone business (acquiring qualified opportunity zone business) is not
eligible gain to the eligible taxpayer if the sale occurs as part of a
plan that includes (i) the investment of the consideration received by
the eligible taxpayer back into the QOF that owns the acquiring
qualified opportunity zone business, followed by (ii) the contribution
by the QOF of that consideration to the qualified opportunity zone
business. Furthermore, because the transaction is not treated as a
``purchase'' of tangible property by the qualified opportunity zone
business from an unrelated party, the newly acquired property will not
qualify as qualified opportunity zone business property under section
1400Z-2(d)(2)(D).
The Treasury Department and the IRS also note that, if an eligible
taxpayer sells property to, or exchanges property with, an unrelated
qualified opportunity zone business as part of a plan that includes the
investment of the consideration by the taxpayer back into the QOF that
owns the acquiring qualified opportunity zone business, the transaction
potentially may be recast or recharacterized as a non-qualifying
investment even if the QOF retains the consideration (rather than
transferring the consideration to the qualified opportunity zone
business). See Sec. 1.1400Z2(f)-1(c)(1). See also part II.D
(discussing the transfer of property for a qualifying investment) and
part VI.A (discussing the applicability of the step transaction
doctrine) of this Summary of Comments and Explanation of Revisions.
e. Gain Not Subject to Federal Income Tax
The Treasury Department and the IRS received comments regarding the
scope of the term ``eligible gain'' with respect to gains realized by
persons that generally are not subject to Federal income tax with
respect to those gains, such as persons that are not United States
persons under section 7701(a)(30) (foreign persons) or that are
entities generally exempt from tax under the Code. Some commenters
suggested that an eligible gain should include all realized capital
gains, including gains that are not subject to Federal income tax.
However, other commenters stated that permitting deferral elections
with respect to gains that are not subject to Federal income tax would
be inappropriate because section 1400Z-2 is premised on the assumption
that a person could make qualified investments in a QOF only with
respect to amounts of capital gains for which taxation is deferred.
The Treasury Department and the IRS have determined that eligible
taxpayers generally should be able to make an election under section
1400Z-2(a)(1) and the section 1400Z-2 regulations only for capital
gains that would be subject to tax under subtitle A before January 1,
2027 (subject to Federal income tax) but for the making of a valid
deferral election under section 1400Z-2(a)(1) and the section 1400Z-2
regulations. Section 1400Z-2 defers the time when eligible gains are
included in income, and there would not be any taxable income to defer
for a gain that is not subject to Federal income tax. This approach
ensures that both United States persons and foreign persons may be
eligible for the Federal income tax benefits of section 1400Z-2 under
the same conditions. Moreover, particularly with respect to foreign
persons, the lack of any requirement that a gain be subject to Federal
income tax would make it difficult for the IRS to verify the extent to
which the amount being invested in
[[Page 1872]]
a QOF was, in fact, with respect to a capital gain.
Accordingly, the final regulations clarify that deferral of a gain
under section 1400Z-2(a)(1) and the section 1400Z-2 regulations
generally is available only for capital gain that would be subject to
Federal income tax but for the making of a valid deferral election
under section 1400Z-2(a)(1) and the section 1400Z-2 regulations. Thus,
for example, a deferral election may generally be made by nonresident
alien individuals and foreign corporations with respect to an item of
capital gain that is effectively connected with a U.S. trade or
business. Further, individual bona fide residents of U.S. territories
who are United States persons may generally make a deferral election
with respect to an item of capital gain that is derived from sources
outside their territory of residence. Similarly, an organization that
is subject to the unrelated business income tax imposed by section 511
may generally make a deferral election with respect to an item of
capital gain to the extent the item would be included in computing the
organization's unrelated business taxable income (such as under the
unrelated debt-financed income rules).
In contrast, an eligible taxpayer who is not a United States person
within the meaning of section 7701(a)(30), or who is treated as a
resident of another country for purposes of an applicable income tax
treaty (foreign eligible taxpayer), should not be able to elect to
defer an item of capital gain if, in the taxable year in which such
gain is includible, the item is treated as exempt from Federal income
tax under a provision of an applicable income tax treaty (for example,
capital gain that is effectively connected with a U.S. trade or
business but is not attributable to a permanent establishment of the
taxpayer within the United States). To prevent foreign eligible
taxpayers from taking inconsistent positions with respect to treaty
benefits in the taxable year of deferral and the taxable year of
inclusion, the final regulations provide that a foreign eligible
taxpayer cannot make a deferral election under section 1400Z-2(a) and
the section 1400Z-2 regulations with respect to an eligible gain unless
the foreign eligible taxpayer irrevocably waives, in accordance with
forms and instructions, any treaty benefits that would exempt that gain
from Federal income tax at the time of inclusion pursuant to an
applicable U.S. income tax convention.
In the event that forms and instructions have not yet been
published incorporating the treaty waiver requirement for a foreign
eligible taxpayer for the taxable year that the deferral election
applies to, the final regulations require the attachment of a written
statement to waive such treaty benefits. Eligible taxpayers other than
foreign eligible taxpayers will only be required to make this treaty
waiver if and to the extent required in forms and publications.
The Treasury Department and the IRS have determined that it would
be unduly burdensome to require a partnership to determine the extent
to which a capital gain would be, but for a deferral election by the
partnership under section 1400Z-2(a) and the section 1400Z-2
regulations, subject to Federal income tax by its direct or indirect
partners because partnerships do not generally have sufficient
information about the tax treatment and positions of their partners to
perform this analysis. Thus, in the case of partnerships, the final
regulations provide an exception to the general requirement that gain
be subject to Federal income tax in order to constitute eligible gain.
The Treasury Department and the IRS are aware that foreign persons
who are not subject to Federal income tax may plan to enter into
transactions including, but not limited to, the use of partnerships
formed or availed of to circumvent the rule generally requiring
eligible gains to be subject to Federal income tax. Therefore, under an
anti-abuse rule added in Sec. 1.1400Z2(f)-1(c)(2), a partnership
formed or availed of with a significant purpose of avoiding of avoiding
the requirement in Sec. 1.1400Z2(a)-1(b)(11)(i)(B) that eligible gains
be subject to Federal income tax will be disregarded, in whole or in
part to prevent the creation of a qualifying investment by the
partnership with respect to any partner that would not otherwise
satisfy the requirement of that paragraph. The anti-abuse rule may
apply even if some of the partners in the partnership are subject to
Federal income tax. See Sec. 1.1400Z2(f)-1(c)(3)(i) and (ii), Examples
1 and 2.
Finally, in response to comments expressing uncertainty as to
whether persons who do not or cannot make a valid deferral election for
eligible gains nevertheless may invest in QOFs, the Treasury Department
and the IRS note that nothing in section 1400Z-2 or the section 1400Z-2
regulations prevents persons who do not have eligible gains from
investing in QOFs. Thus, Indian tribal governments, and tax-exempt
organizations that invest amounts other than items of capital gain that
would be included in computing their unrelated business taxable income,
may invest in a QOF to the extent otherwise permitted by law or
regulation. However, those investments will not qualify for the Federal
income tax benefits under section 1400Z-2 or the section 1400Z-2
regulations. That is, those investments are not qualifying investments
described in section 1400Z-2(e)(1)(A)(i).
f. Measuring Gain From Sales or Exchanges of Virtual Currency
Section 1400Z-2 and the proposed regulations clearly provide that
eligible gain is gain that has been realized pursuant to a sale or
exchange. One commenter identified a potential obstacle in calculating
the eligible gain from sales or exchanges of certain types of digital
assets, including virtual currency. The commenter expressed concern
that the vast majority of digital assets could not directly be
exchanged for traditional types of money. The commenter explained that
these digital assets first must be converted into other digital assets
in taxable transactions before ultimately being sold for the type of
currency that would be invested in a QOF. The commenter expressed
concern that gain or loss from these intermediate transactions in which
a digital asset is exchanged for another digital asset may not
necessarily be tracked in detail. Thus, the commenter requested a
separate rule for these digital assets under which eligible gain would
be calculated by reference to the basis of the original digital asset
and to the actual proceeds received in the ultimate transaction that
converts an intermediate digital asset to money or property that would
be invested in a QOF.
Notice 2014-21, 2014-16 I.R.B. 938 provides that convertible
virtual currency is property for Federal income tax purposes, and that
general Federal income tax principles applicable to property
transactions apply to transactions involving convertible virtual
currency. Section 1400Z-2(a) applies to gain that, absent a deferral
election, would be included in the taxpayer's gross income. To
determine the amount of such gain, the taxpayer must know the basis of
the property, regardless of the type of such property. If the amount
invested in a QOF exceeds the amount of eligible gain, then the
taxpayer will have a non-qualifying investment for the amount of gain
invested in excess of eligible gain invested in the QOF and a
qualifying investment for the amount of eligible gain invested in the
QOF (mixed-funds investment). Taxpayers selling digital assets are not
prevented from investing eligible gain generated from the sale into a
QOF simply because one digital asset must be converted into another
type of
[[Page 1873]]
asset before the taxpayer can convert its assets into U.S. dollars.
Therefore, the Treasury Department and the IRS decline to adopt the
commenter's request for a special rule for digital assets.
g. Gain From a Section 1256 Contract or a Position Part of an
Offsetting-Positions Transaction
The preamble to the October 2018 proposed regulations explained
that the Treasury Department and the IRS considered allowing deferral
under section 1400Z-2(a)(1) for a net amount of capital gain related to
a straddle (as defined in section 1092(c)(1)) after the disposition of
all positions in the straddle, but concluded that such a rule would
pose significant administrative burdens. Proposed Sec. 1.1400Z2(a)-
1(b)(2)(iv) provided that, if a capital gain is from a position that is
or has been part of an offsetting-positions transaction, the gain is
not eligible for deferral under section 1400Z-2(a)(1). For this
purpose, an offsetting-positions transaction generally is 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 includes positions with respect
to personal property that is not actively traded.
Proposed Sec. 1.1400Z2(a)-1(b)(2)(iii)(A) provided that the only
gain arising from section 1256 contracts that is eligible for deferral
under section 1400Z-2(a)(1) is capital gain net income from all of a
taxpayer's section 1256 contracts for a taxable year. Additionally,
proposed Sec. 1.1400Z2(a)-1(b)(2)(iii)(B) provided that, if at any
time during the taxable year, any of the taxpayer's section 1256
contracts were part of an offsetting-positions transaction and any
other position in that transaction was not a section 1256 contract,
then no gain from any section 1256 contract is an eligible gain with
respect to that taxpayer in that taxable year.
Two commenters expressed concern about the application of the
offsetting-positions transaction rule in the October 2018 proposed
regulations to positions that are not part of a straddle under section
1092. One commenter stated that the IRS did not adequately describe its
policy concerns when extending the offsetting-positions transaction
rule beyond the scope of section 1092. The second commenter argued that
a taxpayer is permitted to recognize losses while deferring gains by
continuing to hold an asset that is not actively traded, and that
allowing deferral under section 1400Z-2(a)(1) would be no different
than having the taxpayer continue to hold its gain position. The
Treasury Department and the IRS appreciate the concerns expressed
regarding the extension of the proposed offsetting-positions
transaction rule to transactions that are not straddles under section
1092 and the final regulations do not include the provisions that
applied to transactions that are not straddles under section 1092.
Two commenters expressed concern that the proposed offsetting-
positions transaction rule excluded gains from a position that, at any
time, had been part of an offsetting-positions transaction, including
offsetting-positions transactions that occurred many years ago. The
commenters recommended either deleting the phrase ``or has been'' or
limiting application of that phrase to permit deferral of capital gain
from an offsetting-positions transaction if there is no offsetting
position on or after the enactment of the TCJA. The Treasury Department
and the IRS have concluded that the rule should not exclude gains that
have, at any time, been part of an offsetting position but should
instead exclude gains based on whether an offsetting position was in
existence during a limited time period. Limiting the application of the
straddle rules to situations in which there was an offsetting position
on or after the date of the enactment of the TCJA would, in future
years, require taxpayers and the IRS to look back over an extended
period of time. This requirement could result in significant
administrative burdens without serving a significant tax policy
purpose. As a result, the Treasury Department and the IRS have revised
the limitation on the use of gains from a straddle to net gain from a
position that was either part of a straddle during the taxable year or
part of a straddle in a prior taxable year if a loss from that straddle
is carried over under section 1092(a)(1)(B) to the taxable year.
One commenter suggested that, in the context of a straddle, the
deferral under section 1400Z-2(a)(1) of gain from the disposition of a
position in a straddle would not permit the current recognition of an
otherwise suspended loss from an offsetting position in the straddle.
The commenter also recognized, however, that it might be overly
generous for a taxpayer investing in a QOF to eliminate 15 percent of
the taxpayer's deferred gain (assuming that the taxpayer holds that QOF
interest for seven years by December 31, 2026), if the taxpayer was
also permitted ultimately to recognize all of its suspended loss from
the offsetting straddle position. The commenter suggested a rule
eliminating any suspended loss in the same proportion as any
elimination of gain in one or more offsetting positions.
The Treasury Department and the IRS have determined that there
would be significant administrative burdens for taxpayers and the IRS
in tracking specific gains deferred under section 1400Z-2(a)(1) for the
purpose of determining whether and when some or all of a deferred
straddle loss might ultimately become deductible. In addition, the
Treasury Department and the IRS have determined that the tracking of
deferred losses for multiple taxable years after the positions in the
straddle have been disposed of and a potential proportional elimination
of a suspended loss, years after the suspension, would create
additional complexity and administrative burdens for both taxpayers and
the IRS. The final regulations therefore provide a general rule that
net gain from positions that are or, as described previously, in
certain circumstances have recently been part of a straddle, are not
eligible for deferral under section 1400Z-2(a)(1).
Another commenter suggested that, absent a clearly articulated
policy concern with permitting deferral of net gain from a straddle,
the Treasury Department and the IRS should consider eliminating or
minimizing the scope of capital gains subject to the prohibition in the
proposed regulations. The Treasury Department and the IRS have
concluded that, in certain circumstances, deferral of net gain from a
straddle does not present significant policy concerns or unreasonable
administrative burdens for taxpayers and the IRS. Under the final
regulations, if during the taxable year: (i) A position was covered by
an identification under section 1092 or 1256(d), (ii) no gain or loss
with respect to any position that was part of the identified straddle
remains unrecognized at the end of the taxable year (other than gain
that would be recognized but for deferral under section 1400Z-2(a)(1)),
(iii) none of the positions in the identified straddle were part of any
other straddle during the taxable year, and (iv) none of the positions
in the identified straddle were part of a straddle in a previous
taxable year from which a loss was carried over to the taxable year
under section 1092(a)(1)(B), then the net gain during the taxable year
from positions that were part of the identified straddle is not
prevented from being an eligible gain. Net gain from an identified
straddle during the taxable year is equal to the excess of the capital
gains recognized for Federal income tax
[[Page 1874]]
purposes in the taxable year, determined without regard to section
1400Z-2(a)(1), over the sum of the capital losses and net ordinary
losses from all positions that were part of the straddle, including
capital gains and losses from section 1256 contracts and other
positions marked to market on the last business day of the taxable year
or upon transfer or termination and annual account net gain from
positions in a mixed straddle account.
The final regulations clarify that, if a taxpayer identifies a
straddle under section 1092(a)(2), the taxpayer must adjust basis in
accordance with section 1092(a)(2)(A)(ii) and (iii) when determining
the net gain during the taxable year from positions that were part of
the straddle. The net gain realized during the taxable year that is
deferred under section 1400Z-2(a)(1) is not treated as unrecognized
gain for purposes of determining whether a loss from a position in the
straddle is deferred under section 1092(a)(3)(A)(ii).
A commenter suggested that the provision in the October 2018
proposed regulations disqualifying all gains from section 1256
contracts if at any time during the taxable year, any of the taxpayer's
section 1256 contracts were part of an offsetting-positions transaction
and any other position in that transaction was not a section 1256
contract be revised to limit the disqualification to the specific type
of offsetting-positions transaction identified by the Treasury
Department and the IRS. In response to this comment, under the final
regulations net gain during the taxable year from section 1256
contracts that were not part of a straddle is not prevented from being
eligible gain.
The final regulations also provide that additional exceptions to
the general rule may be provided in guidance published in the Internal
Revenue Bulletin. The Treasury Department and the IRS request comments
on whether there are other situations that might warrant an exception
from the general rule that net gain from a position that was either
part of a straddle during the taxable year or part of a straddle in a
prior year if a loss from that straddle is carried over under section
1092(a)(1)(B) to the taxable year is not eligible gain.
2. Eligible Interests
Proposed Sec. 1.1400Z2(a)-1(b)(3) provided that an eligible
interest in a QOF must be an equity interest issued by a QOF, and that
eligible interests do not include debt instruments as defined in
section 1275(a)(1) and Sec. 1.1275-1(d). One commenter requested
clarification with respect to debt instruments issued by a QOF or a
potential investor. The commenter set forth a fact pattern in which an
eligible taxpayer lends money to a QOF prior to the sale of property
that generates eligible gain. After the sale of the property, the
taxpayer essentially transfers its creditor position in the loan to the
QOF. The commenter requested confirmation that such an arrangement
would result in a qualifying investment in a QOF. Determination of the
tax treatment of the arrangement described previously would require a
debt-equity analysis based on a careful examination of all relevant
facts and circumstances and Federal income tax principles apart from
those found in section 1400Z-2 and these regulations. Accordingly, such
an analysis would exceed the scope of these regulations.
The commenter also described a second fact pattern in which an
eligible taxpayer issues a promissory note to the QOF in exchange for
an interest in the QOF. The commenter requested clarification as to
whether such an exchange would give rise to an amount invested in the
QOF. A taxpayer can make an investment in a QOF by contributing cash or
property. The contribution of a promissory note, however, is
inconsistent with the policy of the section 1400Z-2 statute to
incentivize investments in QOZs, and is beyond the scope of these
regulations. The Treasury Department and the IRS have determined that a
taxpayer should not receive the benefits under section 1400Z-2 merely
by promising to pay, and thereby invest in a QOZ, in the future. As
such, the Treasury Department and the IRS decline to adopt this
comment.
3. 180-Day Investment Requirement
a. Section 1231 Gains
As discussed in part II.A.1.a. of this Summary of Comments and
Explanation of Revisions, proposed Sec. 1.1400Z2(a)-1(b)(2)(iii) of
the May 2019 proposed regulations provided that the 180-day period for
investment with respect to capital gain net income from section 1231
property for a taxable year began on the last day of the taxable year
without regard to the date of any particular disposition of section
1231 property.
The Treasury Department and the IRS have received numerous comments
regarding the ``capital gain net income'' approach of the May 2019
proposed regulations. In response to the May 2019 proposed regulations,
taxpayers and practitioners consistently have emphasized that the year-
long character testing period under section 1231 often can frustrate a
taxpayer's ability to defer gains resulting from sales or exchanges of
section 1231 property. Unlike typical transactions that result in
ordinary or capital gain upon their completion, taxpayers generally
lack the ability to determine whether section 1231 gain from a sale or
exchange of section 1231 property will be capital in character until
the completion of all sales or exchanges of section 1231 property
during a taxable year. See generally section 1231(a), (c) (describing
taxable-year-based determination). However, to defer recognition under
section 1400Z-2(a), taxpayers must invest eligible gain within a 180-
day period that begins on the date on which the taxpayer otherwise
would have recognized that gain (180-day investment requirement). See
section 1400Z-2(a)(1)(A) (setting forth the 180-day investment
requirement). Accordingly, commenters have recommended a wide spectrum
of approaches to integrate the rules of section 1231 with section
1400Z-2, including approaches that would (i) modify the timing of the
section 1231 calculation (including recapture), the start of the 180-
day period, or both; or (ii) allow for immediate investment of gross
section 1231 gains to be treated as eligible gains if those gains are
determined to be capital at the end of the taxable year.
As described in part II.A.1.a. of this Summary of Comments and
Explanation of Revisions, the Treasury Department and the IRS have
determined that a ``gross approach'' solely with regard to eligible
section 1231 gains (without regard to any section 1231 losses) would
eliminate unnecessary barriers to potential QOF investors.
Specifically, the final regulations provide that eligible gains include
gains from the sale or exchange of property described in section
1231(b) not required to be characterized as ordinary income by section
1245 or 1250 (eligible section 1231 gains), regardless of whether
section 1231(a) (without regard to section 1231(a)(4)) would determine
those gains to be capital or ordinary in character. This approach will
eliminate significant complexity, as well as uncertainty in determining
eligible gain for partnerships and S corporations that are eligible
taxpayers. Importantly, although the determination under section
1231(a) of the character of an eligible section 1231 gain would
ordinarily occur at the end of a taxable year, that section 1231(a)
determination is not necessary to determine whether that gain is
eligible for deferral under section 1400Z-2 and the section 1400Z-2
regulations. Because status as an
[[Page 1875]]
eligible gain relies on facts that are known at the time of a sale or
exchange, the 180-day period for an eligible taxpayer to invest an
amount with respect to an eligible section 1231 gain begins on the date
of the sale or exchange giving rise to the gain rather than at the end
of the taxable year. Therefore, an investor can invest an amount with
respect to an eligible section 1231 gain from a sale or exchange of
section 1231 property and have certainty as to the amount of the
qualifying investment on the date the investment is made. Finally,
allowing the 180-day period to begin on the date of the sale, exchange,
or other disposition that gives rise to the eligible section 1231 gain
accelerates both capital infusion into a QOZ and allows an investor to
invest eligible proceeds from dispositions of section 1231 property as
soon as any such funds are available to invest.
b. RIC and REIT Capital Gain Dividends
Several commenters noted that the application of the 180-day
investment requirement to real estate investment trust (REIT) capital
gain dividends may preclude some shareholders from making qualifying
investments in QOFs because REIT capital gain dividends are based on
the net capital gain of the REIT during the relevant taxable year of
the REIT. In other words, REITs determine that a dividend, or part
thereof, is eligible for capital gain dividend status after the REIT's
taxable year has ended, when the REIT can compute net capital gain for
the year. Thus, a shareholder may receive a dividend during the year
but may not receive the designation that the dividend is a capital gain
dividend until after the REIT's taxable year has ended. To facilitate
investment in QOZs, commenters requested that the 180-day investment
requirement apply beginning on the last day of the REIT's taxable year,
rather than the date on which the shareholder receives a dividend,
thereby providing a 180-day period after the shareholder has notice of
the dividend's capital gain designation. In the alternative, some
commenters proposed beginning the 180-day period for investment of REIT
capital gain dividends on the date that is 30 days after the close of
the REIT's taxable year. Commenters also noted that the same concerns
apply to regulated investment company (RIC) capital gain dividends and
maintained that the 180-day period should be the same for both RIC and
REIT capital gain dividends.
The Treasury Department and the IRS seek to facilitate the ability
of RIC and REIT shareholders to make qualifying investments in QOFs
that result from capital gain dividends received during a taxable year.
However, because shareholders may not have the same taxable year as the
RIC or REIT in which they are invested, these final regulations provide
that the 180-day period for RIC or REIT capital gain dividends
generally begins at the close of the shareholder's taxable year in
which the capital gain dividend would otherwise be recognized by the
shareholder. To ensure that RIC and REIT shareholders do not have to
wait until the close of their taxable year to invest capital gain
dividends received during the taxable year, these final regulations
provide that shareholders may elect to begin the 180-day period on the
day each capital gain dividend is paid. The 180-day period for
undistributed capital gain dividends, however, begins on either the
last day of the shareholder's taxable year in which the dividend would
otherwise be recognized or the last day of the RIC or REIT's taxable
year, at the shareholder's election. Regardless of the 180-day period
applicable to its capital gain dividends, the aggregate amount of a
shareholder's eligible gain with respect to capital gain dividends
received from a RIC or a REIT in a taxable year cannot exceed the
aggregate amount of capital gain dividends that the shareholder
receives as reported or designated by that RIC or that REIT for the
shareholder's taxable year. Any excess investments will be treated
under the final regulations as non-qualifying investments.
c. Installment Sales
Commenters requested clarification regarding the application of the
180-day investment requirement to gains recognized in an installment
sale pursuant to the installment method under section 453. See section
453(c) (defining the term ``installment method''). Section 453(a)
provides generally that income from an installment sale must be taken
into account for purposes of the Code under the installment method. In
general, the installment method allows taxpayers to report gain from a
sale of property in the taxable year or years during which payments are
received rather than in the year of the sale. Commenters expressed
concern that, for taxpayers who are considering investing the gain from
an installment sale in a QOF, it is not clear whether (i) there is a
single 180-day period for all income from the installment sale that
begins on the date and year of the sale (for example, March 15, 2020),
or (ii) there are multiple 180-day periods, each beginning in the year
during which a payment is received and income is recognized under the
installment method.
To provide flexibility to these types of potential investors in
QOZs, the Treasury Department and the IRS have included in these final
regulations a rule that accommodates both of the potential options
described by the commenters previously. Specifically, the final
regulations allow an eligible taxpayer to elect to choose the 180-day
period to begin on either (i) the date a payment under the installment
sale is received for that taxable year, or (ii) the last day of the
taxable year the eligible gain under the installment method would be
recognized but for deferral under section 1400Z-2. As a result, if the
taxpayer defers gain from multiple payments under an installment sale,
there might be multiple 180-day periods, or a single 180-day period at
the end of the taxpayer's taxable year, depending upon taxpayer's
election.
One commenter also requested confirmation that only capital gain
realized with respect to an installment sale that occurred after the
effective date of section 1400Z-2 (that is, December 22, 2017) should
be eligible gain. The Treasury Department and the IRS have determined
that it would be inconsistent with the general rule for eligible gains
in the final regulations, as well as installment sale case law, to
exclude from the definition of eligible gains any capital gains
recognized by an eligible taxpayer under the installment method,
regardless of whether the installment sale occurred before the
effective date of section 1400Z-2. Accordingly, the Treasury Department
and the IRS decline to adopt this comment.
d. Special 180-Day Period for Partners, S Corporation Shareholders, and
Trust Beneficiaries
The May 2019 proposed regulations provided that, for purposes of
the 180-Day Investment Requirement, the period during which a partner
must invest an amount equal to the partner's eligible gains in the
partner's distributive share generally begins on the last day of the
partnership taxable year in which the partner's allocable share of the
partnership's eligible gain is taken into account under section 706(a).
However, if a partnership does not elect to defer all of its eligible
gain, the partner may elect to treat the partner's own 180-day period
regarding the partner's distributive share of that gain as being the
same as the partnership's 180-day period.
Several commenters requested an additional special rule for
application of the 180-day investment requirement
[[Page 1876]]
with regard to partners in a partnership, shareholders in an S
corporation, and beneficiaries of a trust. These commenters highlighted
that owners of flow-through entities experience information delays
regarding the Federal income tax consequences of transactions taken by
such entities due to the ordinary course timing of Schedule K-1
issuances. As a result of this delay in receiving information necessary
to determine the existence of eligible gain, commenters contended that
partners in a partnership, shareholders in an S corporation, and
beneficiaries of a trust should have an additional option to commence
the 180-day period upon the due date of the entity's tax return.
The Treasury Department and the IRS agree with the commenters'
suggestions. As a result, the final regulations provide partners of a
partnership, shareholders of an S corporation, and beneficiaries of
decedents' estates and non-grantor trusts with the option to treat the
180-Day period as commencing upon the due date of the entity's tax
return, not including any extensions. However, the Treasury Department
and the IRS have determined that similar rules for a grantor trust are
not necessary because the grantor is treated as the owner of the
grantor trust's property for Federal income tax purposes. Therefore,
the final regulations set forth different rules applicable to the
grantor.
4. Additional Deferral of Previously Invested Gains
Section 1400Z-2(a)(2)(A) provides that no deferral election under
section 1400Z-2(a)(1) may be made with respect to a sale or exchange if
an election previously made with respect to the sale or exchange is in
effect. In proposed Sec. 1.1400Z2(a)-1(b)(4)(ii)(D), Example 4
(Proposed Example 4), a taxpayer disposed of its entire qualifying
investment in a QOF in 2025 in a transaction that constituted an event
described in proposed Sec. 1.1400Z(b)-1(c) (inclusion event) and
recognized gain as a result. In the example, the taxpayer wanted to
defer the amount of gain from the inclusion transaction by making
another qualifying investment. The example concluded that the gain
recognized due to the inclusion event may be invested in either the
original QOF or a different QOF within 180 days of the inclusion event
in order to make a new deferral election under section 1400Z-2. The
preamble to the May 2019 proposed regulations explained that, upon
disposition of that QOF interest, deferring an inclusion otherwise
mandated by section 1400Z-2(a)(1)(B) is permitted only if the taxpayer
has disposed of the entire initial investment because section 1400Z-
2(a)(2)(A) expressly prohibits the making of a deferral election under
section 1400Z-2(a)(1) with respect to a sale or exchange if an election
previously made with respect to the same sale or exchange remains in
effect.
A commenter requested that gain from an inclusion event in which a
taxpayer disposes of less than its entire investment in a QOF be
eligible for the deferral election under section 1400Z-2(a)(1). The
commenter asserted that gain arising from an inclusion event, whether
representing all or part of the initially deferred gain, represents new
gain that should be eligible for deferral under section 1400Z-2(a).
The Treasury Department and the IRS agree with the commenter. The
final regulations adopt the position that gain arising from an
inclusion event is eligible for deferral under section 1400Z-2(a) even
though the taxpayer retains a portion of its qualifying investment
after the inclusion event. Although such gain relates in part to gain
from a sale or exchange for which there was a prior election in effect,
it is no longer subject to that prior election within the meaning of
section 1400Z-2(a)(2)(A) as soon as the inclusion event triggers an
income inclusion. Therefore, if an inclusion event relates only to a
portion of a taxpayer's qualifying investment in the QOF, (i) the
deferred gain that otherwise would be required to be included in income
(inclusion gain amount) may be invested in a different QOF, and (ii)
the taxpayer may make a deferral election under section 1400Z-2(a) with
respect to the inclusion gain amount, so long as taxpayer satisfies all
requirements for a deferral election on the inclusion gain amount. To
satisfy the requirements under section 1400Z-2(a) and Sec.
1.1400Z2(a)-1(b)(11)(iv), the eligible taxpayer must treat the
inclusion gain amount to be deferred as if it were originally realized
as a result of the inclusion event. In addition, the eligible taxpayer
must meet all other requirements to defer gain under section 1400Z-2.
See section 1400Z-2(a)(1) and Sec. 1.1400Z2(a)-1(b)(11)(i)(C) (gain
that arises from a sale or exchange of property with a related person
is not eligible gain); section 1400Z-2(a)(2)(B) (election may not be
made for gain arising after December 31, 2026). Consistent with
Proposed Example 4, included in these regulations as Sec. 1.1400Z2(a)-
1(b)(7)(iv)(D), the 180-day period for the inclusion gain amount begins
on the date of the inclusion event, and the holding period for the
second QOF investment begins on the date that an amount corresponding
to the inclusion gain amount is invested in the second QOF. See Sec.
1.1400Z2(a)-1(b)(7)(iv), Example 4.
A commenter also requested clarification as to whether additional
gain deferral under section 1400Z-2(a)(1)(A), as in Proposed Example 4,
is permitted for gain included due to the operation of section 1400Z-
2(b)(1)(B), which requires the full amount of gain that was deferred
under section 1400Z-2(a)(1)(A), reduced by the amount of gain
previously included under proposed Sec. 1.1400Z2(b)-1(b) (remaining
deferred gain) to be included in income in the taxable year of the
eligible taxpayer that includes December 31, 2026. The commenter
explained that the ability to reinvest gains required to be included in
income under section 1400Z-2(b) would facilitate liquidity and capital
mobility for investors. Moreover, in the event that additional gain
deferral is permitted after a taxable year that includes December 31,
2026, the commenter requested clarification regarding the effect of
such an additional gain deferral election on items including the proper
amount includible as well as the amount of deferred gain that may be
reinvested for the benefits of the election under section 1400Z-2(c).
Proposed Example 4 only illustrated that a taxpayer may invest gain
that otherwise would be included pursuant to section 1400Z-2(b)(1)(A)
upon the complete disposition of a QOF interest prior to December 31,
2026 (that is, an inclusion event), where the amount of that gain is
reinvested in any QOF during the 180-day period beginning on the date
of the inclusion event. No inferences should be drawn regarding gains
from dispositions after December 31, 2026, because deferral of any gain
from such dispositions is expressly prohibited by section 1400Z-
2(a)(2)(B). Section 1400Z-2(b)(1) provides that all gain to which
section 1400Z-2(a)(1)(A) deferral applies must be included in income in
the taxable year that includes the earlier of the date on which a QOF
investment is sold or exchanged or December 31, 2026. Further, section
1400Z-2(a)(2)(B) provides that no deferral election may be made under
section 1400Z-2(a)(1) with respect to any sale or exchange after
December 31, 2026. Accordingly, the statutory language of section
1400Z-2 clearly states, and therefore the section 1400Z-2 regulations
provide, that (i) the ability to defer eligible gains pursuant to
section 1400Z-2(a)(1)(A) is not permitted with respect to a gain
arising after December 31, 2026, and (ii) no additional deferral of any
gain is permitted if such gain is required to be
[[Page 1877]]
included in gross income under section 1400Z-2(b)(1)(B).
5. Qualifying Investment
Section 1400Z-2 provides Federal income tax benefits to an eligible
taxpayer that makes an equity investment in a QOF described in section
1400Z-2(e)(1)(A)(i) (that is, a qualifying investment) if the
qualifying investment is held for the various statutorily prescribed
holding periods. For example, in the case of an eligible taxpayer that
maintains a qualifying investment for seven years, the eligible
taxpayer's basis in the qualifying investment will be increased by a
total amount equal to 15 percent of the amount of the taxpayer's
deferred gain. See section 1400Z-2(b)(2)(B)(iii) and (iv) (providing
for basis increases of 10 and five percent, respectively). With respect
to a qualifying investment that is sold or exchanged after being held
by the eligible taxpayer for at least 10 years, if the eligible
taxpayer makes an election under section 1400Z-2(c), the basis of the
qualifying investment will be increased to an amount equal to the fair
market value of that investment on the date on which it is sold or
exchanged. See section 1400Z-2(c).
In the May 2019 proposed regulations, the Treasury Department and
the IRS specified transactions that would cause the inclusion in gross
income of an eligible taxpayer's gain that had been deferred under
section 1400Z-2(a)(1)(B) and (b). Defined as an ``inclusion event,''
each of these transactions ``would reduce or terminate the QOF
investor's direct (or, in the case of partnerships, indirect)
qualifying investment for Federal income tax purposes or (in the case
of distributions) would constitute `cashing out' of the QOF investor's
qualifying investment. . . . It is necessary to treat such
[distributive] transactions as inclusion events to prevent taxpayers
from `cashing out' a qualifying investment in a QOF without including
in gross income any amount of their deferred gain.'' See May 2019
proposed regulations, Explanation of Provisions, part VII.A.
As indicated in the first sentence of part VII.E. (Transfers of
Property by Gift or by Reason of Death) and elsewhere in the
Explanation of Provisions in the May 2019 proposed regulations, the
termination of a direct interest in a qualifying investment that
resulted in an inclusion event terminated the status of an investment
in a QOF as a qualifying investment `` [f]or purposes of sections
1400Z-2(b) and (c).'' This is because the statutory text of each of
section 1400Z-2(a), (b), (c), and (e)(1) focuses on one holding period
of ``the taxpayer'' tested at various points during a period of at
least 10 years.
The May 2019 proposed regulations excepted certain enumerated
dispositions of qualifying investments from treatment as inclusion
events to provide for business flexibility for QOFs or qualified
opportunity zone businesses. However, those exceptions were premised
upon the requirement that the same eligible taxpayer generally be
treated as continuing to hold the same interest in the QOF, and thereby
continue to bear the Federal income tax liability associated with
holding the interest, such as by reason of section 381 or section
704(c). This degree of identity of taxpayer is fundamentally different
(and more demanding) than a mere ``step in the shoes'' concept based on
whether the transferee of the interest can tack the holding period and
basis of the transferor. Accordingly, the May 2019 proposed regulations
treated, among other transactions, gifts and section 351 exchanges as
inclusion events because, in each instance, (i) the initial eligible
taxpayer had severed the direct investment interest in the QOF and (ii)
the transferee taxpayer was not treated for Federal income tax purposes
either as the same taxpayer as the initial eligible taxpayer or as a
successor taxpayer. This is true even though in each such case, the
acquiring taxpayer's basis and holding period for purposes of
determining gain or loss may be identical to that of the taxpayer that
made the initial investment in the QOF. See id., parts VII.E (regarding
gifts) and VII.G (regarding section 351 exchanges).
Commenters have requested clarification of the treatment of
investments in QOFs under section 1400Z-2(c) that have been disposed of
by gift, in section 351 exchanges, and in other transactions treated as
inclusion events. For the foregoing reasons, the final regulations
clarify that transactions described as inclusion events result in a
reduction or termination of a qualifying investment's status as a
qualifying investment to the extent of the reduction or termination,
except as otherwise provided in Sec. 1.1400Z2(b)-1(c) or other
provisions of the section 1400Z-2 regulations. See part IV.C of this
Summary of Comments and Explanation of Revisions. Moreover, the
reduction or termination of that status applies for purposes of section
1400Z-2(c) as well as section 1400Z-2(a)(1)(B) and (b). An inclusion
event is a transaction that reduces or terminates the QOF investor's
direct (or, in the case of partnerships, indirect) qualifying
investment for Federal income tax purposes or, in the case of
distributions, constitutes a ``cashing out'' of the eligible taxpayer's
qualifying investment in the QOF. For that reason and to that extent,
the taxpayer holding the reduced investment in the QOF after the
inclusion event no longer possesses a qualifying investment. Thus, the
benefits provided under section 1400Z-2(c) generally are available only
to a taxpayer that not only makes an equity investment in a QOF
described in section 1400Z-2(e)(1)(A)(i) (that is, a qualifying
investment), but also then continuously maintains that qualifying
investment throughout statutorily prescribed holding periods.
However, consistent with that rationale, the May 2019 proposed
regulations did not treat as an inclusion event a gift by the taxpayer
to a grantor trust of which the taxpayer is the deemed owner because,
for Federal income tax purposes, the owner of the grantor trust is
treated as the owner of the trust's property and thus of the qualifying
investment in its QOF. See id., part VII.E. See also id., part VII.F.1
(providing a similar exception regarding section 381 transactions based
on a statutory successor taxpayer concept). Accordingly, eligibility
for benefits under section 1400Z-2 in these limited instances would be
maintained.
The Treasury Department and the IRS have received several comments
requesting clarification that qualifying investments include interests
received in a transfer by reason of death that is not an inclusion
event. In the case of a decedent, section 1400Z-2(e)(3) provides a
special rule requiring amounts recognized under section 1400Z-2, if not
properly includible in the gross income of the decedent, to be
includible in gross income as provided by section 691. In that specific
case, the beneficiary that receives the qualifying investment has the
obligation to include the deferred gain in gross income in the event of
any subsequent inclusion event, including for example, any further
disposition by that recipient. See id., part VII.E. In other words,
unlike an inclusion event contemplated by the general rules of section
1400Z-2(b), the obligation to include the original taxpayer investor's
deferred gain in income travels with that taxpayer's qualifying
investment to the beneficiary. Accordingly, the May 2019 proposed
regulations excepted transfers of a qualifying investment to the
deceased owner's estate, as well as distributions by the estate, from
the definition of ``inclusion event.'' See id., part VII.E.
As indicated in part VII.E. of the Explanation of Provisions of the
May 2019 proposed regulations, the Treasury Department and the IRS have
[[Page 1878]]
determined that interests received in a transfer by reason of death
continue to be a qualifying investment in the hands of the beneficiary
for purposes of section 1400Z-2(c). As described earlier, sections 691
and 1400Z-2(e)(2) require such a transfer to not give rise to an
inclusion event because the beneficiary is treated as a successor to
the original eligible taxpayer that made the qualifying investment
(that is, the beneficiary ``steps into the shoes'' of the original
taxpayer investor with regard to both the benefits of the qualifying
investment and the obligation to ultimately include the original
taxpayer's deferred gain into the beneficiary's income). As a result,
the Treasury Department and the IRS have determined that a qualifying
investment received by a beneficiary in a transfer by reason of death
should continue to be a qualifying investment in the hands of the
beneficiary for purposes of section 1400Z-2(b) and (c).
The Treasury Department and the IRS have also received a comment
suggesting that the final regulations should permit QOFs to make loans
to qualified opportunity zone businesses and treat as qualifying
investments the debt instruments arising from such loans. Confirmation
of the tax treatment of such debt instruments as qualifying investments
(that is, equity investments in a QOF) would require a debt-equity
analysis based on a careful examination of all relevant facts and
circumstances and Federal income tax principles apart from those found
in section 1400Z-2 and the section 1400Z-2 regulations. Such an
analysis would exceed the scope of these regulations. As a result, the
final regulations do not adopt the commenter's suggestion.
B. Making an Investment for Purposes of an Election Under Section
1400Z-2(a)
1. Acquisition of an Eligible Interest From a Person Other Than a QOF
Proposed Sec. 1.1400Z2(a)-1(b)(9)(iii) permitted a taxpayer to
make a deferral election under section 1400Z-2(a)(1)(A) for an eligible
interest acquired from a person other than a QOF. Commenters asked
whether the transferor of that eligible interest needed to have made an
election under section 1400Z-2(a) prior to the taxpayer's acquisition.
Commenters also asked whether the acquirer must have realized eligible
gain within the 180-day period prior to the acquisition of the eligible
interest in order for acquisition of that interest to support a
deferral election under section 1400Z-2(a)(1)(A) with respect to the
eligible gain. Additionally, commenters requested confirmation
regarding whether shares or partnership interests in a pre-existing
entity that becomes a QOF pursuant to proposed Sec. 1.1400Z2(d)-
1(a)(3) become eligible interests when the pre-existing corporation or
partnership becomes a QOF.
The final regulations do not require the transferor to have made a
prior election under section 1400Z-2(a) for the acquirer of an eligible
interest to make such an election. Further, for interests in entities
that existed before the enactment of section 1400Z-2, if such entities
become QOFs pursuant to Sec. 1.1400Z2(d)-1(a)(3), then the interests
in those entities, even though not qualifying investments in the hands
of a transferor, are eligible interests that may (i) be acquired by an
investor and (ii) result in a qualifying investment of the acquirer if
the acquirer has eligible gain and the acquisition was during the 180-
day period with respect to that gain.
2. Eligibility of Built-In Gain for Deferral
One commenter requested confirmation that the built-in gain of a
REIT, a RIC, or an S corporation potentially subject to corporate-level
tax under section 1374 or Sec. 1.337(d)-7 is eligible for deferral
under section 1400Z-2. To the extent the built-in gain is an eligible
gain, an election under section 1400Z-2 may be made for such gain of a
REIT, a RIC, or an S corporation. If such election is made, the amount
of such gain will not be included in the calculation of the entity's
net recognized built-in gain (as defined in section 1374(d)(2)) in the
year of deferral. Similarly, if a deferral election is made with
respect to an eligible gain that, absent the deferral election, would
constitute a recognized built-in gain (RBIG) within the meaning of
section 382(h)(2)(A) or section 1374(d)(3), the amount of such eligible
gain deferred as a result of a qualifying investment in a QOF is not
taken into account as RBIG in the year of deferral.
3. Grantor Trusts
A commenter pointed out that the rule in proposed Sec.
1.1400Z2(a)-1(c)(3) does not achieve the proper result for grantor
trusts that do not make the deferral election but distribute the
deferred gain to a trust beneficiary other than the deemed owner of the
trust. The commenter pointed out that the proposed rule should not
apply to grantor trusts because the deemed owner of the trust is liable
for the Federal income tax on the gain regardless of whether that gain
is distributed currently to a trust beneficiary other than the deemed
owner. The commenter also requested clarification that either the
grantor trust recognizing the gain or the deemed owner of that trust is
eligible to both make the deferral election and make a qualifying
investment, regardless of whether the grantor trust distributes the
gain to the deemed owner or to any other person. The Treasury
Department and the IRS agree with the commenter and have made the
requested adjustments in the final regulations.
C. Identification of Disposed Interests in a QOF
Under the May 2019 proposed regulations, if a taxpayer held
interests in a QOF with identical rights (for example, equivalent
shares of stock in a QOF corporation) that were acquired on different
days, and if the taxpayer disposed of less than all of those interests
on a single day, the taxpayer was required to use the first-in-first-
out (FIFO) method to identify which interests were disposed of for
certain specified purposes, such as determining the character and other
attributes of the deferred gain that is included as a result of the
disposition. In circumstances in which the FIFO method did not provide
a complete answer, taxpayers were required to use a pro-rata method. In
requesting comments as to whether methods other than the FIFO method
and the pro-rata method should be used, the Treasury Department and the
IRS stipulated that any such methods must both provide certainty as to
which fungible interest a taxpayer disposes of and allow taxpayers to
comply easily with the requirements of section 1400Z-2(a)(1)(B) and (b)
that certain dispositions of an interest in a QOF cause deferred gain
be included in a taxpayer's income.
In response, commenters requested that taxpayers be permitted to
specifically identify the QOF interests that are sold or otherwise
disposed of, and they recommended that the final regulations adopt
rules similar to those in Sec. 1.1012-1(c). Under such rules, a
taxpayer would be required to use the FIFO method only if the taxpayer
fails to adequately identify which shares were disposed of.
The Treasury Department and the IRS agree that specific
identification should be permitted for dispositions of interests in QOF
corporations. Thus, the final regulations permit taxpayers to employ
the rules and principles of Sec. 1.1012-1(c) to specifically identify
the QOF stock that is sold or otherwise disposed. If a taxpayer fails
to adequately identify which QOF shares are disposed of, then the FIFO
identification method applies. If, after application of the FIFO
method, a taxpayer is treated as having disposed
[[Page 1879]]
of less than all of its investment interests that the taxpayer acquired
on one day and the investments vary in its characteristics, then the
pro-rata method will apply to the remainder.
However, the final regulations do not extend this specific
identification methodology to the disposition of interests in a QOF
partnership because, under Federal income tax law, a partnership
interest represents an undivided, unitary interest in all of the
partnership assets and liabilities. Other than in the case of a mixed-
funds investment in a QOF partnership, where the section 1400Z-2
statute mandates a division of partnership interests, the final
regulations do not adopt the commenters' recommendation because it
would broaden the complexities associated with dividing partnership
interests into separate components with associated assets and
liabilities.
In addition, the final regulations make it clear that if a taxpayer
is required to include in income some or all of a previously deferred
gain, the gain so included has the same attributes that the gain would
have had if the recognition of gain had not been deferred under section
1400Z-2. The final regulations generally provide that forms,
instructions, and other administrative guidance control in determining
which deferred gains are associated with particular interests in QOFs.
However, the final regulations also provide that, to the extent that
such guidance does not clearly associate an investment in a QOF with an
amount of deferred gain, an ordering rule applies that permits
taxpayers to determine how to associate investments in QOFs with
particular deferred gains.
D. Property Transferred in Exchange for a Qualifying Investment Is Not
Qualified Opportunity Zone Business Property
The May 2019 proposed regulations clarify that taxpayers may
transfer property other than cash to a QOF in exchange for a qualifying
investment. A commenter asked whether property that is purchased in a
QOZ and contributed to a QOF could be qualified opportunity zone
business property, or whether such property would be excluded
automatically because it is not purchased by the QOF. The commenter
further asked why taxpayers are permitted to contribute property to a
QOF in exchange for a qualifying investment if the property cannot be
qualified opportunity zone business property.
Taxpayers are permitted to transfer property to a QOF in exchange
for a qualifying investment because the statute does not preclude
taxpayers from investing in a QOF in this manner and because permitting
such transfers is not inconsistent with the policies underlying section
1400Z-2. As the commenter noted, property that is contributed to a QOF
cannot be qualified opportunity zone business property because
qualified opportunity zone business property must be purchased by a
QOF. See section 1400Z-2(d)(2)(D)(i)(I). The QOF may retain the
contributed property among its assets that are not qualified
opportunity zone property, or it may sell the property and use the
proceeds to acquire qualified opportunity zone property in accordance
with section 1400Z-2(d) and the section 1400Z-2 regulations.
E. Amount Invested in a QOF Partnership for Purposes of Section 1400Z-
2(a)(1)(A)
The May 2019 proposed regulations contained two rules that, if
either were applicable, would reduce the amount of a taxpayer's
qualifying investment.
First, proposed Sec. 1.1400Z2(a)-1(b)(11)(ii)(A)(1) provided that,
to the extent the transfer of property to a QOF partnership is
characterized other than as a contribution (for example, a transfer
that is characterized as a disguised sale under section 707), the
transfer is not an investment within the meaning of section 1400Z-
2(a)(1)(A) (section 1400Z-2(a)(1)(A) investment). The Treasury
Department and the IRS confirm that the reference to the disguised sale
regulations under section 707 is intended to provide an existing
analytical framework and rules applicable to transfers of property to a
QOF partnership to determine whether the transfer is a contribution for
purposes of making a qualifying investment. All guidance under section
707 that otherwise would be applicable, including any exception,
applies. In particular, Sec. 1.707-4(b)(2) (relating to operating cash
flow distributions) applies to transfers to and distributions from a
QOF partnership. Therefore, to the extent a transfer of property is
characterized as a sale under the existing section 707 framework, there
is no contribution and section 1400Z-2 would not apply to the transfer.
These final regulations do not modify section 707 or the regulations in
this part under section 707.
Second, proposed Sec. 1.1400Z2(a)-1(b)(11)(ii)(A)(2) provided
that, to the extent proposed Sec. 1.1400Z2(a)-1(b)(11)(ii)(A)(1) did
not apply, the transfer to the partnership would not be treated as a
section 1400Z-2(a)(1)(A) investment to the extent the partnership makes
a distribution to the partner and the transfer to the partnership and
the distribution would be recharacterized as a disguised sale under
section 707 if (i) any cash contributed were non-cash property, and
(ii) in the case of a distribution by the partnership to which Sec.
1.707-5(b) (relating to debt-financed distributions) applies, the
partner's share of liabilities is zero. The Treasury Department and the
IRS received comments asking for clarification of the application of
proposed Sec. 1.1400Z2(a)-1(b)(11)(ii)(A)(2) and confirmation that the
regulations under section 707, including the exceptions to the
disguised sale rules, apply in determining whether a contribution, in
whole or part, is treated as part of a disguised sale. In particular,
commenters asked how debt-financed distributions should be treated and
requested confirmation that operating cash flow distributions would not
be presumed to be a part of a disguised sale.
The Treasury Department and the IRS note that, even if a
contribution were not recharacterized as a disguised sale under section
707 and the regulations in this part under section 707, the amount of
the qualifying investment is reduced under the modified application of
the section 707 disguised sale rules in Sec. 1.1400Z2(a)-
1(c)(6)(iii)(A)(2). This provision adopts the rule contained in the May
2019 proposed regulations without change. However, in making the
qualifying investment determination under this rule, the other
exceptions to the disguised sale rules still would apply. For example,
a distribution by the partnership would not reduce the amount of the
qualifying investment to the extent the operating cash flow
distribution exception of Sec. 1.707-4(b) applied.
Commenters also requested clarification regarding the Federal
income tax consequences of distributions by an ``overfunded'' QOF
partnership carried out to eliminate the amount of excess cash invested
therein. Commenters explained that, in this situation, an eligible
taxpayer would contribute a cash amount in excess of the amount that
the QOF partnership desires to invest and, within the same year, the
QOF partnership distributes the excess cash back to the eligible
taxpayer. The final regulations provide an example clarifying and
illustrating the application of the rules. The later distribution by
the QOF partnership would be tested under the normal distribution rules
for purposes of determining whether there is an inclusion event. For
QOF partnerships, there would be an inclusion event to the extent the
distribution exceeds the
[[Page 1880]]
partner's outside basis in its qualifying investment. Although the
basis in the qualifying investment is initially zero, that basis may be
increased by the partner's share of debt and net income.
F. At-Risk Basis
One commenter requested clarification that investors get at-risk
basis for their qualifying investments. The May 2019 proposed
regulations did not address whether a taxpayer has at-risk basis in its
qualifying investment. Thus, the commenter stated that there is
uncertainty under the May 2019 proposed regulations as to whether
investors' capital contributions will give rise to at-risk basis under
section 465 even though taxpayers must take zero basis in their
qualifying investments.
Section 465 generally provides that a taxpayer shall be considered
``at risk'' for an activity with respect to amounts including the
amount of money and the adjusted basis of other property contributed by
the taxpayer to the activity. The Treasury Department and the IRS note
that a taxpayer's amount at risk generally is determined by reference
to the amount of money and the basis of property contributed, not to
the basis of the interest received in exchange for the property.
Additionally, section 465 and the regulations in this part under
section 465 provide the necessary guidance for this determination. As a
result, the Treasury Department and the IRS have determined that the
commenter's requested clarification exceeds the scope of the section
1400Z-2 regulations.
G. Withholding Tax and FIRPTA
The Treasury Department and the IRS received comments regarding the
application of withholding tax regimes within the context of section
1400Z-2(a). For example, a commenter requested that a foreign taxpayer
engaging in a sale subject to withholding under section 1445(a)
(imposing a 15 percent withholding tax as part of the Foreign
Investment in Real Property Tax Act (FIRPTA)) be able to provide a
certificate or other form of documentation to avoid withholding on the
basis of the taxpayer's intention to invest the resulting gain in a QOF
pursuant to a deferral election under section 1400Z-2(a)(1). Another
commenter requested an exemption from withholding when a person enters
into an agreement with the IRS to pay the tax when the deferred gain is
included under section 1400Z-2(a)(1)(B) and (b), similar to when a gain
recognition agreement is ``triggered'' under section 367 and the
regulations in this part under section 367. The Treasury Department and
the IRS continue to consider this comment and other matters related to
the mechanics of applying section 1400Z-2 in the context of a sale
subject to withholding tax.
The final regulations clarify that section 1400Z-2 is not a
``nonrecognition provision'' for purposes of section 897(e) and Sec.
1.897-6T. See Sec. 1.1400Z2(a)-1(e). A non-recognition provision is
defined in section 897(e)(3) as any provision of the Code for ``not
recognizing gain or loss.'' Similarly, Sec. 1.897-6T(a)(2) defines a
non-recognition provision as any Code provision ``which provides that
gain or loss shall not be recognized.'' Pursuant to section 897(e)(1)
and Sec. 1.897-6T(a)(1), nonrecognition provisions generally do not
apply upon the exchange of a U.S. real property interest in a
transaction subject to FIRPTA unless the asset received in exchange is
also a U.S. real property interest. The Treasury Department and the IRS
have determined that section 1400Z-2 is not a nonrecognition provision
for purposes of section 897(e) and Sec. 1.897-6T because an election
under that provision generally defers, rather than prevents altogether,
the recognition of gain. By deferring gain recognition, section 1400Z-2
is fundamentally different from the provisions identified as
nonrecognition provisions in Sec. 1.897-6T(a)(2), such as sections
332, 351, 721, and 1031.
III. Comments on and Changes to Proposed Sec. 1.1400Z2(b)-1
Proposed Sec. 1.1400Z2(b)-1 provided rules regarding the inclusion
in income of gain deferred under section 1400Z-2(a)(1)(A), including
rules regarding which events trigger the inclusion of deferred gain,
how much gain is included, and the effects of these events on the
investor's basis and holding period in its qualifying investment.
A. General Rule Regarding Inclusion Events
Proposed Sec. 1.1400Z2(b)-1(c)(1) generally provided that, except
as otherwise provided in proposed Sec. 1.1400Z2(b)-1(c), certain
events (that is, inclusion events) result in the inclusion of gain
under proposed Sec. 1.1400Z2(b)-1(b) if and to the extent that: (i) A
taxpayer's transfer of a qualifying investment reduces the taxpayer's
equity interest in the qualifying investment; (ii) a taxpayer receives
property in a transaction treated as a distribution for Federal income
tax purposes, regardless of whether the receipt reduces the taxpayer's
ownership of the QOF; or (iii) a taxpayer claims a worthlessness
deduction with respect to its qualifying investment. Proposed Sec.
1.1400Z2(b)-1(c)(2) through (15) then provided specific rules for
certain types of transactions that are or are not treated as inclusion
events.
The Treasury Department and the IRS received several comments and
questions regarding the general rule set forth in proposed Sec.
1.1400Z2(b)-1(c)(1). For example, one commenter asked whether the
phrase ``the following events'' refers to the items in proposed Sec.
1.1400Z2(b)-1(c)(2) through (15) or whether the phrase instead refers
to the items in proposed Sec. 1.1400Z2(b)-1(c)(1)(i) through (iii).
Another commenter stated that the general rule in proposed Sec.
1.1400Z2(b)-1(c)(1)(i) could be read to suggest that there is no
inclusion event so long as a taxpayer retains an equity interest,
whether direct or indirect, in a qualifying investment after a
transfer, even though the preamble to the May 2019 proposed regulations
indicated that any reduction in a taxpayer's direct interest in a
qualifying investment is an inclusion event, other than in the case of
partnerships. Yet another commenter asserted that the specific rules in
proposed Sec. 1.1400Z2(b)-1(c)(2) through (15) appear to cover all
potentially relevant transactions and therefore the purpose of the
general rule seems unclear. As a result, commenters recommended that
the Treasury Department and the IRS clarify or eliminate the general
rule.
As explained in the preamble to the May 2019 proposed regulations,
proposed Sec. 1.1400Z2(b)-1(c) reflected the general principle that,
except as otherwise provided, an inclusion event results from: A
transfer of a qualifying investment, to the extent the transfer reduces
the taxpayer's direct equity interest; the receipt of a distribution on
or with respect to a qualifying investment, which constitutes an
impermissible ``cashing out'' of the taxpayer's qualifying investment;
or the claim of a worthlessness deduction (under section 165(g) or
otherwise) in respect of a qualifying investment. Proposed Sec.
1.1400Z2(b)-1(c)(1) set forth these principles as a general rule, and
proposed Sec. 1.1400Z2(b)-1(c)(2) through (15) provided elaborations
of, and exceptions to, the general rule. The Treasury Department and
the IRS did not intend the general rule to suggest that a taxpayer may
avoid an inclusion event by retaining an indirect interest in a QOF,
and the specific rules clearly indicated that a transfer that reduces a
[[Page 1881]]
taxpayer's direct interest is an inclusion event except as otherwise
provided.
These final regulations retain the general rule in proposed Sec.
1.1400Z2(b)-1(c)(1). However, this general rule has been clarified in
response to the foregoing comments. In addition to the changes
described in this part III, the specific rules in Sec. 1.1400Z2(b)-
1(c)(2) through (c)(15) have been clarified as necessary.
These final regulations also clarify that if a QOF is decertified,
either through the QOF's voluntary self-decertification or an
involuntary decertification, such decertification is an inclusion event
that terminates the qualifying investment status of the taxpayer's
interest in the QOF.
A commenter also requested clarification as to whether an inclusion
event terminates the application of section 1400Z-2 to an interest in a
QOF. In some cases, an inclusion event may be the result of a transfer
of the qualifying investment that reduces or terminates the owner's
interest in the QOF, but in other cases it may not (for example, a
distribution from a QOF C corporation subject to section 301(c)(3)).
Thus, the commenter argued that the occurrence of an inclusion event is
not the appropriate test for determining whether an interest in a QOF
ceases to be a qualifying investment eligible for the basis adjustments
under section 1400Z-2(b).
As discussed in part II.A.5 of this Summary of Comments and
Explanation of Revisions, the Treasury Department and the IRS have
determined that an inclusion event generally results in a reduction or
termination of a qualifying investment's status as a qualifying
investment to the extent of the reduction or termination for purposes
of section 1400Z-2(a)(1)(B), (b), and (c). However, the Treasury
Department and the IRS agree that certain types of inclusion events
(namely, certain distributions) do not terminate a taxpayer's
qualifying investment. See part IV.C of this Summary of Comments and
Explanation of Revisions.
The Treasury Department and the IRS also recognize that the
language in proposed Sec. 1.1400Z2(b)-1(g)(2), which provided that
``[t]he increases in basis under section 1400Z-2(b)(2)(B)(iii) and (iv)
only apply to that portion of the qualifying investment that has not
been subject to previous gain inclusion under section 1400Z-
2(b)(2)(A),'' could be read to suggest that all inclusion events cause
interests in a QOF to cease to be qualifying investments. In other
words, by restricting the five-year and seven-year basis increases to
qualifying investments that have ``not been subject to previous gain
inclusion,'' proposed Sec. 1.1400Z2(b)-1(g)(2) appeared to exclude any
qualifying investment that has been subject to any inclusion event,
even if substantial amounts of deferred gain remain.
The Treasury Department and the IRS have determined that qualifying
investments that have been subject to inclusion events should continue
to be eligible for the five-year and seven-year basis increases to the
extent deferred gain has not yet been recognized at the time of these
basis increases. For example, if a taxpayer invests $100x of eligible
gain in a QOF corporation and the corporation subsequently makes a
section 301(c)(3) distribution of $20x with respect to the taxpayer's
qualifying investment, the taxpayer still should be eligible to receive
a five-year basis increase of $8x (10 percent of its remaining deferred
gain of $80x) and a seven-year basis increase of $4x (five percent of
its remaining deferred gain of $80x). Section 1.1400Z2(b)-1(g)(2) of
the final regulations has been modified accordingly.
B. Transactions Treated as Distributions for Federal Income Tax
Purposes
1. Overview
Proposed Sec. 1.1400Z2(b)-1(c)(1)(ii) generally provided that,
except as otherwise provided in proposed Sec. 1.1400Z2(b)-1(c), an
inclusion event occurs if and to the extent a taxpayer receives
property in a transaction that is treated as a distribution for Federal
income tax purposes, regardless of whether the receipt reduces the
taxpayer's ownership of the QOF. Proposed Sec. 1.1400Z2(b)-1(c)(8)
modified this general rule by providing that a distribution of property
by a QOF C corporation with respect to a qualifying investment,
including a distribution of stock that is treated as a distribution of
property to which section 301 applies under section 305(b), is an
inclusion event only to the extent section 301(c)(3) applies to the
distribution. In the preamble to the May 2019 proposed regulations, the
Treasury Department and the IRS requested comments on the proposed
treatment of distributions to which section 305(b) applies.
In turn, proposed Sec. 1.1400Z2(b)-1(c)(9) generally provided that
a redemption described in section 302(d) by a QOF C corporation is an
inclusion event with respect to the full amount of the distribution.
However, if the QOF C corporation is wholly and directly owned by a
single shareholder (or by members of a single consolidated group), the
section 302(d) redemption is an inclusion event only to the extent
section 301(c)(3) applies.
2. Section 302(d) Redemptions
Commenters made several recommendations with respect to the
foregoing rules. For example, commenters questioned the treatment of
dividend-equivalent redemptions in the May 2019 proposed regulations.
One commenter acknowledged that a section 302(d) redemption reduces a
taxpayer's direct equity interest, but the commenter recommended
treating such redemptions in the same manner as section 301
distributions for purposes of section 1400Z-2 because section 302
treats such redemptions as distributions rather than as sales or
exchanges. The commenter further recommended that section 302(d)
redemptions in which each shareholder surrenders a pro rata percentage
of its shares not be treated as inclusion events. Another commenter
recognized that requiring an inclusion event only upon a complete
redemption of a shareholder's qualifying investment would enable
taxpayers to avoid taxation by retaining even a small amount of
qualifying QOF stock, but the commenter still questioned why a partial
redemption should cause acceleration. Both commenters recommended that
section 302(d) redemptions and section 301 distributions be treated
similarly for purposes of section 1400Z-2, with the exception of
complete redemptions, which would be an inclusion event to the extent
of the full amount of the distribution.
As noted in the foregoing comments, a redemption transaction
reduces a taxpayer's direct qualifying investment in a QOF, regardless
of whether such transaction is treated as a dividend for Federal income
tax purposes. The Treasury Department and the IRS have determined that
the general treatment of section 302(d) redemptions as section 301
distributions for Federal income tax purposes should not override the
general requirement that QOF shareholders must retain their direct
qualifying investment in a QOF corporation in order to retain the
benefits of section 1400Z-2. See section 1400Z-2(b)(1)(A) (``Gain to
which subsection (a)(1)(B) applies shall be included in income in the
taxable year which includes . . . the date on which such investment is
sold or exchanged . . .''). As a result, the Treasury Department and
the IRS have determined that it would be inappropriate to treat such
redemptions in the same manner as section 301 distributions for
purposes of section 1400Z-2.
[[Page 1882]]
However, in certain circumstances, a reduction in a taxpayer's
qualifying investment by virtue of a section 302(d) redemption is
meaningless. For example, if a wholly owned QOF C corporation partially
redeems its sole shareholder, the shareholder will continue to wholly
own the QOF C corporation after the redemption. Similarly, if a QOF C
corporation redeems its single outstanding class of stock from all
shareholders on a pro rata basis, each QOF shareholder will retain the
same proportionate interest in the QOF after the partial redemption.
As a result, the final regulations generally continue to treat
dividend-equivalent redemptions by QOF C corporations as inclusion
events with respect to the full amount of the distribution, with an
exception for redemptions by wholly owned QOF C corporations, which are
inclusion events only to the extent section 301(c)(3) applies. The
Treasury Department and the IRS agree with the commenter that an
additional exception should be created for pro rata section 302(d)
redemptions, so long as the QOF C corporation has only one class of
stock outstanding. The final regulations have been modified to treat
such redemptions in the same manner as redemptions by wholly owned QOF
C corporations. In other words, an inclusion event occurs only to the
extent section 301(c)(3) applies. Similarly, with respect to QOF S
corporations, the final regulations continue to treat dividend-
equivalent redemptions as inclusion events to the extent that the
distributed property has a fair market value in excess of the
shareholder's basis, including any basis adjustments under section
1400Z-2(b)(2)(B)(iii) and (iv). See part III.E.2.a of this Summary of
Comments and Explanation of Revisions.
3. Section 305 Distributions and Section 306 Redemptions
A commenter agreed with the treatment of section 305(b)
distributions in the May 2019 proposed regulations--namely, that such
distributions should be included as distributions subject to the rule
in proposed Sec. 1.1400Z2(b)-1(c)(8). However, the commenter further
recommended that the final regulations address the treatment of stock
received in a section 305(a) distribution with respect to qualifying
QOF stock. When a corporation distributes its own stock to its
shareholders, section 305(a) provides that the shareholders do not
include the distribution in gross income. The basis of the new stock
received and of the stock with respect to which the distribution is
made (old stock) is determined by allocating the basis of the old stock
between the old stock and the new stock in proportion to the respective
fair market values of the old stock and the new stock on the date on
which the new stock is distributed, and the holding period for the new
stock is the same as the holding period for the old stock. See Sec.
1.307-1(a) (regarding allocation of basis) and section 1223(4)
(regarding determination of holding period). The commenter requested
clarification that the new stock received in a section 305(a)
distribution with respect to qualifying QOF stock is also qualifying
QOF stock, with the remaining deferred gain being allocated pro rata
between the old stock and the new stock, and with the holding period
for the new stock being the same as the holding period for the old
stock. The Treasury Department and the IRS agree with the commenter's
recommendation, and the final regulations have been modified
accordingly.
The commenter also requested clarification regarding the treatment
of redemptions of section 306 stock. Section 306 stock generally
includes stock, other than common stock, that was received tax-free in
certain transactions by the shareholder disposing of such stock,
including a stock dividend under section 305(a), a corporate
reorganization described in section 368(a), or a distribution or
exchange to which section 355 (or so much of section 356 as relates to
section 355) applied. See section 306(c). Section 306(a)(2) provides
that, if a shareholder disposes of its section 306 stock in a
redemption, the amount realized is treated as a distribution of
property to which section 301 applies. The commenter recommended that
such a redemption be subject to the rules for section 301 distributions
in proposed Sec. 1.1400Z2(b)-1(c)(8).
The Treasury Department and the IRS agree that the final
regulations should address the treatment of section 306(a)(2)
redemptions. For the reasons discussed in part III.B.2 of this Summary
of Comments and Explanation of Revisions, the Treasury Department and
the IRS have determined that section 306(a)(2) redemptions should be
treated in the same manner as dividend-equivalent redemptions for
purposes of section 1400Z-2. The final regulations have been modified
accordingly.
4. Distributions Subject to Section 1059
A commenter recommended that qualifying investments in QOF C
corporations be excluded from the application of section 1059.
Alternatively, the commenter requested confirmation that (1) the
recognition of gain under section 1059(a)(2) would result in an
inclusion event to the extent of that gain, and (2) the ordering rule
in proposed Sec. 1.1400Z2(b)-1(g)(1)(ii), which applied to basis
increases under section 1400Z-2(b)(2)(B)(ii), also would apply to such
inclusion event.
The commenter contended that, in many instances, the policy
concerns underlying section 1059, as described by the commenter, would
not be applicable to distributions made by a QOF C corporation.
However, an example in the commenter's analysis illustrated that the
concerns underlying section 1059 are present any time a QOF corporation
has earnings and profits (E&P) predating the date on which a qualifying
investment is made. The Treasury Department and the IRS have determined
that, to the extent consistent with the application of section 1400Z-2,
and unless provided otherwise by the section 1400Z-2 regulations, the
rules of subchapter C apply with respect to a QOF C corporation. The
commenter's analysis did not set forth any statutory authority under
section 1400Z-2 or subchapter C for not applying section 1059 to
distributions from a QOF C corporation. As a result, the Treasury
Department and the IRS have determined that section 1059 should apply
to a QOF C corporation, and the final regulations do not adopt the
commenter's primary recommendation.
However, the Treasury Department and the IRS agree with the
commenter's alternative recommendation that the recognition of gain
under section 1059(a)(2) should result in an inclusion event to the
extent of that gain, and that the ordering rule in proposed Sec.
1.1400Z2(b)-1(g)(1)(ii) should apply to such inclusion event. The final
regulations have been modified accordingly.
C. Reorganizations of QOF Corporations
1. Overview
Proposed Sec. 1.1400Z2(b)-1(c)(10) generally provided that, if the
assets of a QOF corporation are acquired in a qualifying section 381
transaction, and if the acquiring corporation is a QOF within a
prescribed period of time after the acquisition, the transaction would
not be an inclusion event. The proposed regulations included this rule
because, after the transaction, the taxpayer would have retained a
direct qualifying investment in an acquiring QOF that is a successor to
the transferor QOF under section 381. The proposed regulations defined
the term ``qualifying section 381 transaction'' to mean an acquisitive
asset reorganization described in section
[[Page 1883]]
381(a)(2), with certain enumerated exceptions. See proposed Sec.
1.1400Z2(b)-1(a)(2)(xx).
However, if a QOF shareholder received boot in a qualifying section
381 transaction with respect to the shareholder's qualifying
investment, the taxpayer would have an inclusion event because the
taxpayer would have reduced its direct qualifying investment in the QOF
or cashed out part of its investment. For this purpose, the term
``boot'' means money or other property that section 354 or 355 does not
permit to be received without the recognition of gain. Under the May
2019 proposed regulations, if the taxpayer realizes a gain on the
transaction, the amount that gives rise to the inclusion event is the
amount of gain under section 356 that is not treated as a dividend
under section 356(a)(2). If the taxpayer realizes a loss on the
transaction, the amount that gives rise to the inclusion event is an
amount equal to the fair market value of the boot received. If a single
taxpayer or members of a single consolidated group wholly own both the
target QOF and the acquiring QOF, the boot is treated as if it were
distributed from the QOF in a separate section 301 transaction and is
only taxable to the extent section 301(c)(3) applies.
In turn, proposed Sec. 1.1400Z2(b)-1(c)(12) generally provided
that, if a QOF corporation engages in a recapitalization transaction
described in section 368(a)(1)(E) (recapitalization), or if a QOF
shareholder engages in a stock-for-stock exchange described in section
1036 (section 1036 exchange), and if the transaction does not have the
result of decreasing the shareholder's proportionate interest in the
QOF corporation, the transaction is not an inclusion event. However,
any property or boot received by the shareholder in the transaction is
treated as property or boot to which section 301 or section 356
applies, as determined under general Federal income tax principles.
Proposed Sec. 1.1400Z2(b)-1(c)(8) or (10), respectively, then
determined the extent to which the receipt of such property or boot
triggers an inclusion event. Moreover, if the transaction decreases the
shareholder's proportionate qualifying investment in the QOF
corporation, the shareholder has an inclusion event equal to the amount
of the reduction in fair market value of the shareholder's qualifying
QOF stock.
2. Proposed Treatment of Recapitalizations and Section 1036 Exchanges
Several commenters recommended that a single inclusion event rule
be applied to qualifying section 381 transactions, recapitalizations,
and section 1036 exchanges. One commenter argued that, if a taxpayer's
proportionate interest were reduced in a recapitalization or in a
section 1036 exchange, the taxpayer either would have received actual
consideration (that is, boot) in the transaction or would be deemed to
have received boot in the transaction under general Federal income tax
principles. See, for example, Rev. Rul. 74-269, 1974-1 C.B. 87. Another
commenter argued that a reduction in a shareholder's proportionate
interest by virtue of the QOF's issuance of new stock to a new investor
should not be treated as an inclusion event, and that a reduction in
the shareholder's interest by virtue of the shareholder's receipt of
non-stock consideration should be covered by the boot rules for
reorganizations. Thus, the commenters argued that recapitalizations and
section 1036 exchanges should be governed by the same rules that govern
qualifying section 381 transactions.
The Treasury Department and the IRS agree with many of the
foregoing comments. For example, the Treasury Department and the IRS
agree that the reduction of a shareholder's proportionate interest in a
QOF through a recapitalization should not be treated as an inclusion
event unless the shareholder receives, or is deemed to receive, boot in
the transaction. Thus, a shareholder should not have an inclusion event
by virtue of the QOF's issuance of qualifying QOF stock to a new
investor. The Treasury Department and the IRS also agree that the rules
for recapitalizations and section 1036 exchanges should be modified to
mirror more closely the rules for qualifying section 381 transactions.
The final regulations reflect these determinations. However, the final
regulations retain separately numbered rules for reorganizations, and
for recapitalizations and section 1036 exchanges.
3. Receipt of Boot
Commenters also recommended simplifying the proposed rules
regarding boot. For example, one commenter recommended eliminating the
special rule for the receipt of boot from a wholly owned QOF in
proposed Sec. 1.1400Z2(b)-1(c)(10)(i)(C)(2) and subjecting qualifying
section 381 transactions, recapitalizations, and section 1036 exchanges
to a single rule similar to proposed Sec. 1.1400Z2(b)-
1(c)(10)(i)(C)(1) (the general rule regarding the receipt of boot by
QOF shareholder in a qualifying section 381 transaction). Another
commenter questioned the disparate treatment of boot in reorganizations
depending on whether gain or loss is realized.
The Treasury Department and the IRS agree with commenters that the
proposed rules regarding the receipt of boot should be simplified.
Accordingly, the final regulations adopt a single rule for the receipt
of boot in a qualifying section 381 transaction. Under this rule, a
taxpayer is treated as disposing of a portion of its qualifying
investment equal to the portion of total consideration received in the
transaction with respect to the taxpayer's qualifying investment that
consists of boot. For example, if a QOF engages in a merger that is a
qualifying section 381 transaction, and if 10 percent of the
consideration received by a QOF shareholder, as measured by fair market
value, consists of boot, the QOF shareholder is treated as having
disposed of 10 percent of its qualifying investment. This rule applies
regardless of whether the QOF shareholder recognizes gain or loss on
the transaction, and regardless of whether the QOF is wholly owned.
For property or boot received in recapitalizations or section 1036
exchanges, the final regulations provide that the property or boot is
treated as property or boot to which section 301 or section 356(a) or
(c) applies, as determined under general Federal income tax principles.
The receipt of property to which section 301 applies is an inclusion
event only to the extent section 301(c)(3) applies. The receipt of boot
to which section 356(a) or (c) applies is subject to the single rule
for the receipt of boot in a qualifying section 381 transaction.
If a taxpayer receives boot with respect to its qualifying
investment in a qualifying section 355 transaction, as defined in
proposed Sec. 1.1400Z2(b)-1(a)(2)(xix), and if section 356(a) applies
to the transaction, the receipt of boot also is subject to the single
rule for the receipt of boot in a qualifying section 381 transaction.
In turn, if a taxpayer receives boot with respect to its qualifying
investment in a qualifying section 355 transaction, and if section
356(b) applies to the transaction, the receipt of boot is an inclusion
event only to the extent section 301(c)(3) applies.
4. Treatment of the Surviving or Acquiring Corporation as a QOF
A commenter also requested clarification that, in the event of
mergers, consolidations, share exchanges, asset acquisitions, and
conversions in which the acquiring or surviving enterprise is a QOF,
such
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acquiring or surviving enterprise continues to be a QOF.
Whether the surviving or acquiring corporation after a merger,
consolidation, share exchange, or asset acquisition continues to be a
QOF depends on whether the surviving or acquiring corporation satisfies
the requirements of section 1400Z-2(d) and the section 1400Z-2
regulations. Therefore, the final regulations do not adopt the
commenter's recommended clarification. For a discussion of conversions
of QOF partnerships to QOF corporations, see part III.E.1 of this
Summary of Comments and Explanation of Revisions.
D. Reorganizations of QOF Shareholders
Proposed Sec. 1.1400Z2(b)-1(c)(10)(ii) generally provided that a
transfer of a QOF shareholder's assets in a qualifying section 381
transaction (qualifying owner reorganization) is not an inclusion
event, except to the extent the QOF shareholder transfers less than all
of its qualifying investment in the transaction, because the section
381 successor to the QOF shareholder retains a direct qualifying
investment in the QOF. In other words, the section 381 successor is
treated as the historic QOF shareholder and therefore no disposition of
the direct qualifying investment in the QOF has occurred. Based on the
same rationale, proposed Sec. 1.1400Z2(b)-1(c)(2)(ii)(B) provided that
the transfer of a QOF shareholder's qualifying investment in a complete
liquidation under section 332 is not an inclusion event to the extent
section 337(a) applies (qualifying owner liquidation). Special rules
applied to S corporations that are shareholders of a QOF, and generally
tracked the rules of subchapter C described previously, to the extent
consistent with the rules of subchapter S. See proposed Sec.
1.1400Z2(b)-1(c)(7).
Proposed Sec. 1.1400Z2(b)-1(d)(1) and (2) contained special rules
for qualifying section 381 transactions in which the target corporation
was a QOF immediately before the acquisition and the acquiring
corporation is a QOF immediately after the acquisition. For purposes of
section 1400Z-2(b)(2)(B) and 1400Z-2(c), the May 2019 proposed
regulations provided that the holding period for the QOF stock
relinquished by a taxpayer is ``tacked'' onto the holding period of the
QOF stock received in the transaction, and any qualified opportunity
zone property transferred by the transferor QOF to the acquiring QOF in
connection with the transaction does not lose its status as qualified
opportunity zone property solely as a result of the transfer. However,
the May 2019 proposed regulations did not provide similar rules for
qualifying owner reorganizations or liquidations. As a result, one
commenter requested that a ``tacked'' holding period be expressly
provided for a QOF shareholder's qualifying investment in such
transactions. Another commenter requested a rule for qualifying owner
liquidations and reorganizations similar to proposed Sec. 1.1400Z2(b)-
1(c)(6)(ii)(C), which generally provided that the resulting partnership
after certain partnership mergers or consolidations is subject to
section 1400Z-2 and the section 1400Z-2 regulations to the same extent
as the original partnership before the transaction.
The Treasury Department and the IRS agree that a ``tacking'' rule
should apply to stock of a QOF shareholder after a qualifying owner
reorganization or liquidation. Section 1.1400Z2(b)-1(d)(1)(ii) of the
final regulations has been modified accordingly.
E. Partnerships, S Corporations, and Trusts
1. Inclusion Events for QOF Partnerships
Proposed Sec. 1.1400Z2(b)-1(c)(6)(i) provided inclusion rules for
QOF partnerships and partnerships that directly or indirectly own
interests in QOFs. These rules applied to transactions involving any
direct or indirect partner of a QOF to the extent of the partner's
share of any eligible gain. Proposed Sec. 1.1400Z2(b)-1(c)(6)(ii)(B)
provided that a contribution by a QOF owner of its direct or indirect
partnership interest in a qualifying investment to a partnership is not
an inclusion event to the extent the transaction is governed by section
721(a), provided the transfer does not cause a termination of a QOF
partnership, or of the direct or indirect owner of a QOF, under section
708(b)(1).
The Treasury Department and the IRS received several comments on
whether certain transactions involving QOF partnerships should be
considered inclusion events. One commenter requested clarification of
proposed Sec. 1.1400Z2(b)-1(c)(6)(iii), which provided that a
distribution of property by a QOF partnership to a partner is an
inclusion event if the distributed property has a fair market value in
excess of the partner's basis in its qualifying investment, and that
similar rules apply to distributions involving tiered partnerships. The
final regulations provide that, for amounts relating to a partner's
qualifying investment, a distribution by a QOF partnership to a partner
is an inclusion event to the extent the distribution is of cash or
property with a fair market value in excess of the partner's outside
basis in the QOF partnership. However, with respect to distributions by
a partnership that owns a QOF, such distribution will only be an
inclusion event for the indirect QOF owner if the distribution is a
liquidating distribution.
The commenter suggested that such a distribution should not be an
inclusion event to the extent the partner in the QOF ultimately would
be allocated the gain recognized upon the distribution. The commenter
also requested an exception from inclusion event treatment for section
731 distributions of a QOF interest by an upper-tier partnership to the
extent the distribution is to the partner that made the initial
qualifying investment in the QOF. The Treasury Department and the IRS
decline to adopt these recommendations. Under the rules in subchapter K
of chapter 1 of subtitle A (subchapter K), a distribution of property
with a fair market value in excess of basis reduces a partner's equity
interest in the partnership. Such a reduction is an inclusion event and
is economically the same as an investor cashing out its investment or
reducing its equity investment in the QOF.
One commenter also requested that a contribution of an interest in
a partnership that holds a direct interest in a QOF partnership to
another partnership not be considered an inclusion event. This
transaction was addressed by proposed Sec. 1.1400Z2(b)-1(c)(6)(ii)(B),
which applied to contributions under section 721(a) by a QOF owner,
including a QOF partner. See proposed Sec. 1.1400Z2(b)-1(a)(2)(xii),
which defined a QOF partner as a person that directly owns a qualifying
investment in a QOF partnership or a person that owns such a qualifying
investment through equity interests solely in one or more partnerships.
The final regulations clarify that the rule in proposed Sec.
1.1400Z2(b)-1(c)(6)(ii)(B) applies to any QOF owner that contributes
its qualifying QOF stock or direct or indirect partnership interest in
a qualifying investment to a partnership in a transaction governed by
section 721(a).
Another commenter requested that the list of inclusion events
exclude not only section 721 contributions, but also the merger of a
fund formed as a REIT into another REIT. The commenter recommended that
the final regulations clarify and expand the scope of the permitted
transactions under the rules for inclusion. The Treasury Department and
the IRS decline to adopt this
[[Page 1885]]
suggestion but note that the exceptions to inclusion event treatment
applicable to QOF C corporations, such as the exception for qualifying
section 381 transactions, also apply to RICs and REITs.
Proposed Sec. 1.1400Z2(b)-1(c)(6)(ii)(C) provided that a merger or
consolidation of a partnership holding a qualifying investment, or of a
partnership holding an interest in such partnership solely through one
or more partnerships, with another partnership in a transaction to
which section 708(b)(2)(A) applies is not an inclusion event. A
commenter noted that the May 2019 proposed regulations did not
explicitly provide that a merger of a QOF partnership into another
partnership in a transaction to which section 708(b)(2)(A) applies is
not an inclusion event, even if the acquiring partnership is a QOF
immediately after the merger.
The Treasury Department and the IRS adopt the comment in part. The
Treasury Department and the IRS have determined that the rule in Sec.
1.1400Z2(b)-1(c)(6)(iii) of the May 2019 proposed regulations, which
provided that a QOF partnership distribution with a fair market value
in excess of the distributee partner's basis is an inclusion event,
should be modified in the case of certain mergers or consolidations
under section 708(b)(2)(A).
The final regulations provide that, in the case of an assets-over
merger or consolidation of a QOF partnership with another QOF
partnership in a transaction to which section 708(b)(2)(A) applies, the
fair market value of property distributed in the merger or
consolidation is reduced by the fair market value of the partnership
interest received in the merger or consolidation for purposes of
determining whether there has been an inclusion event. Therefore, the
transaction will not be an inclusion event to a partner that receives
only a partnership interest in the resulting partnership. However,
there will be an inclusion event to the extent that a partner receives
other property that exceeds that partner's basis in the partnership.
Additionally, the final regulations provide that a merger or
consolidation of a QOF partnership with another QOF partnership in a
transaction to which section 708(b)(2)(A) applies is not an inclusion
event under Sec. 1.1400Z2(b)-1(c)(2)(i), which provides that there is
an inclusion event if a QOF ceases to exist for Federal income tax
purposes. The resulting partnership becomes subject to section 1400Z-2
and the section 1400Z-2 regulations to the same extent that the
terminated partnership was so subject prior to the transaction, and
must allocate and report any gain inclusion under section 1400Z-2(b) to
the same extent and to the same partners that the terminated
partnership would have been required to allocate and report those items
prior to the transaction.
A commenter also requested clarification that any partnership
distribution of property pursuant to a division governed by Sec.
1.708-1(d) is not an inclusion event, provided the taxpayer's
beneficial interest in a QOF has not changed and all deferred gain
still would be recognized by the same taxpayer. Several other
commenters requested that pro-rata divisions of QOF partnerships into
two or more QOF partnerships pursuant to section 708 not be treated as
inclusion events, provided the amount of a taxpayer's equity interest
in its qualifying investment remains the same.
The Treasury Department and the IRS decline to adopt a general rule
excluding divisions as inclusion events because divisions may result in
deemed distributions arising from debt shifts, as well as distributions
in excess of basis, which may result in gain recognition under the
subchapter K rules. Additionally, as described in part IV.E.4 of this
Summary of Comments and Explanation of Revisions, the final regulations
expand the rule of proposed Sec. 1.1400Z2(c)-1(b)(2)(ii) to provide
that, with the exception of gain from the sale of inventory in the
ordinary course of business, all gain from the sale of property by a
QOF partnership or by a qualified opportunity zone business that is a
partnership is eligible for exclusion as long as the qualifying
investment in the QOF has been held for at least 10 years. This change
to proposed Sec. 1.1400Z2(c)-1(b)(2)(ii) may minimize the need for
divisions of QOF partnerships as a way to dispose of certain assets.
One commenter also asked that a distribution by a QOF partnership
of its net cash flow, measured on an annual basis by reference to
taxable income, plus depreciation deductions, not constitute an
inclusion event. The Treasury Department and the IRS decline to adopt
this recommendation because allowing such distributions in excess of
the QOF partner's basis would add significant complexity, requiring the
tracing of distributions of net cash flow proceeds versus cash from
other sources.
One commenter asked why proposed Sec. 1.1400Z2(b)-1(c)(6) used the
phrase ``eligible gain.'' Proposed Sec. 1.1400Z2(b)-1(c)(6) stated, in
relevant part, that ``the inclusion rules of this paragraph (c) apply
to transactions involving any direct or indirect partner of the QOF to
the extent of such partner's share of eligible gain of the QOF.'' The
commenter further noted that proposed Sec. 1.1400Z2(b)-1(c)(6) used
this phrase three times, and the inclusion of that phrase seemed
inappropriate.
The Treasury Department and the IRS confirm that ``eligible gain''
was the intended term in proposed Sec. 1.1400Z2(b)-1(c)(6). Eligible
gain is a defined term in proposed Sec. 1.1400Z2(a)-1(b)(2), and
generally refers to gain that is eligible to be deferred under section
1400Z-2(a). The term is further defined in Sec. 1.1400Z2(a)-1(b)(11)
of the final regulations. In addition, proposed Sec. 1.1400Z2(b)-
1(c)(6) provided special rules relating to inclusion events for
partners and partnerships, and used the defined term ``eligible gain''
to reference the amount of gain deferred under section 1400Z-2(a) that
is required to be included in income upon the occurrence of certain
inclusion events.
Proposed Sec. 1.1400Z2(b)-1(c)(7)(iv) provided special rules
regarding inclusion events for conversions of S corporations to
partnerships or disregarded entities. Otherwise, the May 2019 proposed
regulations did not expressly address whether a QOF's change in
classification, such as from a partnership to a corporation, is an
inclusion event. A commenter recommended that the conversion of a QOF
from a partnership to a corporation for Federal tax purposes be treated
as neither an inclusion event nor a disposition of a qualifying
investment for purposes of the election in section 1400Z-2(c).
The Treasury Department and the IRS note that, if a partnership
elects under Sec. 301.7701-3(c)(1)(i) to be classified as an
association, under Sec. 301.7701-3(g)(1)(i) the partnership is deemed
to contribute all of its assets and liabilities to the association in
exchange for stock and to liquidate immediately thereafter. See also
Rev. Rul. 2004-59, 2004-1 C.B. 1050 (applying the same treatment to a
partnership that converts to a corporation under a state law formless
conversion statute). As provided in proposed Sec. 1.1400Z2(b)-
1(c)(2)(i), a taxpayer generally has an inclusion event for all of its
qualifying investment if the QOF ceases to exist for Federal income tax
purposes, and no specific rule in proposed Sec. 1.1400Z2(b)-1(c)
provides an exception for liquidations of QOF partnerships. Thus, the
conversion of a partnership to a corporation would be an inclusion
event. No change has been made to the
[[Page 1886]]
final regulations with respect to this comment.
2. Inclusion Events for QOF S Corporations
a. General Principle of Section 1371(a)
The May 2019 proposed regulations relied upon the principle set
forth in section 1371(a), which provides that the rules of subchapter C
of chapter 1 of subtitle A (subchapter C) applicable to C corporations
and their shareholders apply to S corporations and their shareholders,
except to the extent inconsistent with the provisions of subchapter S.
In such instances, S corporations and their shareholders are subject to
the specific rules of subchapter S. For example, similar to rules
applicable to QOF partnerships, a distribution of property to which
section 1368 applies by a QOF S corporation is an inclusion event to
the extent that the distributed property has a fair market value in
excess of the shareholder's basis, including any basis adjustments
under section 1400Z-2(b)(2)(B)(iii) and (iv). In addition, the rules
set forth in the May 2019 proposed regulations regarding redemptions,
liquidations, and reorganizations of QOF C corporations and QOF C
corporation shareholders apply equally to QOF S corporations and QOF S
corporation shareholders to the extent consistent with the rules of
subchapter S. For example, because the stock of an S corporation cannot
be held by a C corporation, no exception is provided for a liquidation
or upstream asset reorganization of an S corporation investor in a QOF.
However, the May 2019 proposed regulations also reflect that flow-
through principles under subchapter S apply to S corporations when the
application of subchapter C would be inconsistent with subchapter S.
For example, under the May 2019 proposed regulations, if an inclusion
event were to occur with respect to deferred gain of an S corporation
that is an investor in a QOF, the shareholders of the S corporation
would include the gain pro rata in their respective taxable incomes.
See section 1366(a)(1)(A). Consequently, those S corporation
shareholders would increase their bases in their S corporation stock at
the end of the taxable year during which the inclusion event occurred.
See section 1367(a)(1)(A). Pursuant to the S corporation distribution
rules set forth in section 1368, the S corporation shareholders would
receive future distributions from the S corporation tax-free to the
extent of the deferred gain amount included in income and included in
stock basis. If the S corporation has accumulated E&P, the S
corporation's accumulated adjustments account would be increased by the
same amount as the increase in stock basis to ensure the shareholders'
tax-free treatment of the future distributions. See section 1368(c),
(e)(1).
b. Specific Inclusion Event Rules for S Corporations
The May 2019 proposed regulations also set forth specific rules for
S corporations to provide certainty to taxpayers regarding the
application of particular provisions under section 1400Z-2. Regarding
section 1400Z-2(b)(1)(A), the May 2019 proposed regulations clarified
that a conversion of an S corporation that holds a qualifying
investment in a QOF to a C corporation (or a conversion of a C
corporation to an S corporation) is not an inclusion event because the
interests held by each shareholder of the C corporation or S
corporation, as appropriate, would remain unchanged with respect to the
corporation's qualifying investment in a QOF. For mixed-funds
investments in a QOF S corporation described in section 1400Z-2(e)(1),
if different blocks of stock are created for otherwise qualifying
investments to track basis in these qualifying investments, the May
2019 proposed regulations made clear that the separate blocks would not
be treated as different classes of stock for purposes of S corporation
eligibility under section 1361(b)(1).
The Treasury Department and the IRS received favorable comments
regarding the reliance of the May 2019 proposed regulations upon the
principle set forth in section 1371(a). In addition, commenters
provided favorable comments regarding the foregoing rules, which the
Treasury Department and the IRS drafted in accordance with that
principle. As a result, the final regulations adopt those rules without
modification.
c. Elimination of 25-Percent Aggregate Ownership Change Rule
The May 2019 proposed regulations set forth a special rule that,
solely for purposes of section 1400Z-2, an S corporation's qualifying
investment in a QOF would be treated as disposed of if there is a
greater-than-25 percent aggregate change in ownership of the S
corporation (25-percent aggregate ownership change rule). Under that
rule, upon a greater-than-25 percent aggregate change in ownership, the
S corporation would have an inclusion event for all of the S
corporation's remaining deferred gain, and neither section 1400Z-
2(b)(2)(B)(iii) or (iv), nor section 1400Z-2(c), would apply to the S
corporation's qualifying investment after that date. In proposing the
25-percent aggregate ownership change rule, the Treasury Department and
the IRS attempted to ``balance the status of the S corporation as the
owner of the qualifying investment with the desire to preserve the
incidence of the capital gain inclusion and income exclusion benefits
under section 1400Z-2.'' Section VII.D.3 of the preamble to the May
2019 proposed regulations.
The Treasury Department and the IRS have received comments from the
taxpayer and practitioner communities critical of the 25-percent
aggregate ownership change rule. In particular, commenters have
emphasized that the proposed rule conflicts with the stated purpose of
inclusion events under section 1400Z-2, which is to ``prevent taxpayers
from `cashing out' a qualifying investment in a QOF without including
in gross income any amount of their deferred gain.'' Section VII.A of
the preamble to the May 2019 proposed regulations. In addition,
commenters have noted that subchapter S of the Code already contains
provisions, such as section 1377, that achieve more effectively the
``balance'' intended through the proposed 25-percent aggregate
ownership change rule.
As previously stated, for purposes of the Code, including section
1400Z-2, the rules of subchapter C apply to an S corporation and its
shareholders unless inconsistent with subchapter S. See section
1371(a). For example, if an S corporation investor in a QOF were to
have an inclusion event regarding the S corporation's qualifying
investment, the rules of subchapter S would apply to ensure that the
shareholders of the S corporation would include the resulting gain pro
rata in their respective taxable incomes and increase their bases in
their S corporation stock at the end of the taxable year during which
the inclusion event occurred. See generally section 1366. However,
neither subchapter S nor section 1400Z-2 provides that the disposition
of any stock held by a shareholder of an S corporation should cause an
inclusion event under section 1400Z-2 for a qualifying investment held
by the S corporation in a QOF (that is, should be treated as a
disposition by the S corporation). Rather, the rules of subchapter S
indicate the opposite, as evidenced by the ability for S corporation
shareholders to dispose of their stock without affecting the S
corporation's tax-free treatment resulting from a like-kind exchange of
one of its assets. See generally section 1031. The Treasury Department
and the
[[Page 1887]]
IRS have determined that, like a C corporation investor in a QOF C
corporation, an S corporation investor should not have an inclusion
event for its qualifying investment solely as the result of a
disposition of shares by one of its shareholders, regardless of the
disposition's magnitude.
Furthermore, the Treasury Department and the IRS have determined
that the proposed 25-percent aggregate ownership change rule does not
achieve its stated purpose of balancing the status of the S corporation
as the owner of the qualifying investment while directing capital gain
inclusion to the proposed rule's intended parties (that is, the S
corporation's shareholders, upon an inclusion event). See section
VII.D.3 of the May 2019 proposed regulations. Indeed, the Treasury
Department and the IRS note that the proposed rule conflicts with
section 1377, the longstanding provision in subchapter S that governs
the allocation of items of income among S corporation shareholders.
Under section 1377(a)(1), each shareholder's pro rata share of any
item for any tax year generally equals the sum of the amounts
determined for the shareholder by (1) assigning an equal portion of the
item to each day of the tax year, and then (2) dividing that portion
pro rata among the shares outstanding on that day, per share, per day.
As an exception for terminations of a shareholder's interest, section
1377(a)(2) permits an S corporation and the affected shareholders (that
is, the remaining shareholders of the S corporation at the time of the
termination) to agree to a ``closing of the books'' of the S
corporation and allocate the S corporation's items of income among
those shareholders based on their ownership before and after the
termination (that is, treat the taxable year as two taxable years, the
first of which ends on the date of the termination). As highlighted by
one commenter, in the absence of a ``closing of the books'' election,
the inclusion of capital gain resulting from an inclusion event will be
allocated pro rata among all of the S corporation's shareholders as of
the end of the S corporation's taxable year, rather than to those
shareholders who were shareholders at the time the S corporation
invested its deferred capital gain in its QOF. In other words, the
allocation rules of section 1377 do not operate to match S corporation
items to specific shareholders. For these reasons, the Treasury
Department and the IRS agree with the comments received and have
removed the proposed 25-percent aggregate ownership change rule from
the final regulations.
d. Contributions of QOF Investments to a Partnership
With respect to the contribution of a qualifying investment to an
upper-tier partnership or the acquisition of an interest in an upper-
tier partnership by another person, one commenter requested that
forward section 704(c) and reverse section 704(c) principles apply to
ensure that deferred gains, or any built-in gains on the QOF interest,
are allocable to the proper taxpayers and that appropriate basis
adjustments are made. The Treasury Department and the IRS agree that
forward section 704(c) and reverse section 704(c) principles, which
otherwise would apply, also apply in this context.
In addition, several commenters requested that the final
regulations provide greater flexibility in the structuring of
investments in QOF partnerships by allowing investors to use master-
feeder structures and similar structures such as aggregator funds. The
commenters noted that proposed Sec. 1.1400Z2(b)-1(c)(6)(ii)(B)
permitted a QOF owner to contribute its direct or indirect interest in
a QOF partnership to another partnership under certain circumstances in
a transaction governed by section 721(a) without the transfer being
treated as an inclusion event. The final regulations decline to
incorporate that comment because it is inconsistent with the statute.
Specifically, section 1400Z-2(a)(1)(A) requires an eligible taxpayer to
make an investment in a QOF within 180 days of the sale or exchange
that gave rise to the eligible gain in order for the taxpayer to have
made a qualifying investment.
The final regulations clarify that, when a QOF partner contributes
its qualifying investment to a transferee partnership in a section 721
transaction, the transferee partnership is the party that recognizes
the deferred gain and is eligible for the five- and seven-year basis
adjustments. However, the transferee partnership must allocate all such
amounts to the contributing partner, applying the principles of section
704(c). The contributing partner no longer will be eligible to make the
elections under section 1400Z-2(c) and Sec. 1.1400Z2(c)-1(b)(2).
Instead, the transferee partnership will be the sole person eligible to
make these elections, and the elections will apply to all partners in
the transferee partnership for that tax year.
e. Mixed-Funds Investments in QOF Partnerships
Proposed Sec. 1.1400Z2(b)-1(c)(6)(iv) provided that a partner that
holds a mixed-funds investment in a QOF partnership (mixed-funds
partner) is treated as holding separate interests in the QOF
partnership--a qualifying investment and a non-qualifying investment--
solely for purposes of section 1400Z-2. Under proposed Sec.
1.1400Z2(b)-1(c)(6)(iv)(B), all section 704(b) allocations of income,
gain, loss, and deduction, all section 752 allocations of debt, and all
distributions made to a mixed-funds partner were treated as made to the
separate interests based on the allocation percentages of the
interests, which generally were determined based on the relative
capital contributions attributable to the qualifying investment and the
non-qualifying investment. However, if a partner received a profits
interest in the partnership in exchange for services, the May 2019
proposed regulations provided that the profits interest was a non-
qualifying investment and that the allocation percentage for the
profits interest was based on the highest share of residual profits the
mixed-funds partner would receive with respect to that interest.
The Treasury Department and the IRS received a number of comments
advocating different methods of allocating section 704(b) items, debt,
and distributions between qualifying and non-qualifying investments in
a mixed-funds investment. For example, one commenter requested that
taxpayers be allowed to treat partnership distributions as made
disproportionately to non-qualifying investments to minimize the
likelihood that a distribution will cause a qualifying investment to be
considered sold or exchanged. Another commenter requested that all debt
be allocated to the non-qualifying investment. One commenter also
recommended that gain on the sale of property by a QOF partnership be
treated as attributable to the non-qualifying investment and qualifying
investment based on each investment's share of section 704(b) gain with
respect to the property.
The Treasury Department and the IRS decline to adopt these comments
because the recommended changes would (i) increase the complexities in
determining the items attributable to qualifying and non-qualifying
investments comprising a mixed-funds investment, and (ii) be
significantly more difficult to administer for both taxpayers and the
IRS. The Treasury Department and the IRS have
[[Page 1888]]
determined that the approach in the May 2019 proposed regulations is
the most straightforward option, and the option that minimizes
administrable burden, for determining allocation percentages for
qualifying and non-qualifying investments. Therefore, the final
regulations retain the rule in the May 2019 proposed regulations and
continue to determine allocation percentages based on relative capital
contributions.
Commenters generally agreed with the rule in proposed Sec.
1.1400Z2(a)-1(b)(9)(ii) that profits interests received for services
should not be treated as qualifying investments. However, a number of
commenters requested changes to the rule for calculating allocation
percentages in the case of a profits interest received for services.
One commenter highlighted that the proposed rule could result in a
profits interest holder receiving an allocation percentage that is
higher than its actual share of residual profits. Another commenter
recommended that the allocation percentage for a profits interest be
determined by comparing the profits received by the service provider
with those derived by another significant partner that does not provide
services to the QOF partnership. Yet another commenter requested that
the final regulations incorporate the definition of ``applicable
partnership interest'' under section 1061. This commenter recommended
that the final regulations provide that the highest share of residual
profits that a partner holding the mixed-funds investment would receive
with respect to an ``applicable partnership interest'' would be
determined by the highest share of residual profits less a reasonable
return on the partner's capital interest, based on consideration of all
facts and circumstances at the time of the receipt of the interest.
The Treasury Department and the IRS decline to adopt any of these
comments because the approach in proposed Sec. 1.1400Z2(b)-1(c)(6)(iv)
is simpler and more administrable. The final regulations require a
partner who receives a profits interest for services as part of a
mixed-funds investment in a QOF partnership to determine the allocation
percentage of the profits interest based on the share of residual
profits that the mixed-funds partner would receive from the
partnership. In addition, the final regulations provide that, if the
residual share provided in the partnership agreement is not reasonably
likely to apply, then that share will be disregarded in determining
allocation percentages, and the allocation percentage for the profits
interest will be the final share of profits provided in the partnership
agreement that is likely to apply.
f. QSST and ESBT Conversions
A commenter requested clarification as to whether a conversion from
a qualified subchapter S trust (QSST) to an electing small business
trust (ESBT), and vice versa, falls within the exceptions to an
inclusion event. The final regulations confirm that neither type of
conversion is an inclusion event if the person who is both the deemed
owner of the portion of the ESBT holding the qualifying investment and
the QSST beneficiary is the person taxable on the income from the
qualifying investment both before and after the conversion. For this
purpose, Sec. 1.1361-1(j)(8) is deemed not to apply because the
conversion of a QSST to an ESBT differs from a disposition of the QSST
asset where there is recognition of gain on the asset. However, there
will be an inclusion event upon conversion if the qualifying investment
is in the grantor portion of the ESBT and the ESBT's deemed owner is a
nonresident alien.
g. Holding Periods
One commenter suggested clarifying how the principles of proposed
Sec. 1.1400Z2(b)-1(d)(1) and (2), which provided rules for holding
periods for QOF investments, would be applied to partnership
transactions described in proposed Sec. 1.1400Z2(b)-1(c)(6)(ii), such
as section 721(a) contributions and section 708(b)(2)(A) mergers or
consolidations.
Proposed Sec. 1.1400Z2(b)-1(d)(3) allowed the holding period of
qualifying investments transferred in non-inclusion events listed in
proposed Sec. 1.1400Z2(b)-1(c)(6)(ii) to tack onto the holding period
of the transferor under section 1223(1). The final regulations retain
this provision. Under Sec. 1.1400Z2(b)-1(d)(1), the holding period of
the transferee partnership will include the holding period of the
contributing partner.
h. Special Amount Includible Rule for Partnerships and S Corporations
Proposed Sec. 1.1400Z2(b)-1(e)(4) provided that, for inclusion
events involving partnerships and S corporations, the amount includible
is equal to the percentage of the qualifying QOF partnership or QOF S
corporation interest disposed of, multiplied by the lesser of (1) the
remaining deferred gain less the five-year and seven-year basis
adjustments; or (2) the gain that would be recognized by the partner or
shareholder if the interest were sold in a fully taxable transaction
for its then fair market value.
Section 1400Z-2(b)(2)(A) provides that the amount of gain included
in gross income under section 1400Z-2(a)(1)(A) is the excess of (i) the
lesser of the amount of gain excluded under paragraph (1) of that
section or the fair market value of the investment as determined as of
the date described in paragraph (1), over (ii) the taxpayer's basis in
the investment.
Several commenters requested that the special amount includible
rule for partnerships and S corporations be changed to follow the
statutory language in section 1400Z-2(b)(2)(A). Commenters acknowledged
that the special amount includible rule was intended to prevent
taxpayers from avoiding the recognition of deferred gain upon an
inclusion event when the fair market value of their qualifying
investment has diminished due to debt-financed deductions or
distributions. However, these commenters emphasized that the special
amount includible rule creates inequitable results for debt-financed
losses attributable to periods before December 31, 2026, as compared to
debt-financed losses incurred after this date. Certain commenters also
suggested that this rule has adversely affected the ability to develop
low-income housing tax credit projects and other community development
properties in QOZs.
The Treasury Department and the IRS have determined that the
proposed special amount includible rule for partnerships and S
corporations conforms to the underlying intent of the capital gain
deferral allowed under section 1400Z-2. Thus, the Treasury Department
and the IRS decline to adopt this request, and the final regulations
retain the special amount includible rule for partnerships and S
corporations found in proposed Sec. 1.1400Z2(b)-1(e)(4). Further,
although the final regulations do not limit the combining (commonly
referred to as ``twinning'') of other tax incentives with the benefits
provided by section 1400Z-2, the creation of special rules in this
regard exceeds the scope of section 1400Z-2 and the section 1400Z-2
regulations.
3. Grantor Trusts
Proposed Sec. 1.1400Z2(b)-1(c)(5)(i) provided that a taxpayer's
transfer of its qualifying investment in a QOF to a grantor trust of
which the taxpayer is the deemed owner was not an inclusion event for
purposes of section 1400Z-2(b)(1) and proposed Sec. 1.1400Z2(b)-1(c).
One commenter asked whether a gift to a ``defective grantor trust''
would be an
[[Page 1889]]
inclusion event. The Treasury Department and the IRS note that a
defective grantor trust is a grantor trust for Federal income tax
purposes, so its funding does not change the conclusion that the
transfer is not an inclusion event under section 1400Z-2. In each
situation, the deemed owner of the grantor trust's property for Federal
income tax purposes (that is, the taxpayer) would be treated as
maintaining a direct qualifying investment in the QOF for Federal
income tax purposes. See part II.A.5 of this Summary of Comments and
Explanation of Revisions (describing rationale for not treating such
transfers as inclusion events).
Another commenter stated that proposed Sec. 1.1400Z2(b)-
1(c)(5)(ii), which addressed inclusion events related to grantor
trusts, was too broad because the proposed rule applied to ``a change
in the status of a grantor trust.'' The commenter noted that this
language could be read to apply to a taxpayer that owned a QOF
investment and was the deemed owner of a grantor trust, regardless of
whether the grantor trust itself held a QOF investment. The Treasury
Department and the IRS agree with this comment. Accordingly, the final
regulations clarify that the provision applies to a change in the
status of a grantor trust owning a qualifying investment in a QOF.
A commenter also requested clarification that non-gift transactions
between a grantor trust and its deemed owner that are not recognition
events for Federal income tax purposes are not inclusion events, and
that such transactions do not start a new holding period for purposes
of section 1400Z. In such transactions, the deemed owner of the trust
continues, for Federal income tax purposes, to be the taxpayer liable
for the Federal income tax on the qualifying investment. Thus, the
Treasury Department and the IRS have determined that, like transfers by
the deemed owner to the grantor trust, these transactions (including
transfers from the grantor trust to its deemed owner) are not inclusion
events.
F. Transfers of Property by Gift or by Reason of Death, or Incident to
Divorce
1. Gifts
The May 2019 proposed regulations provided that a transfer by gift
of a qualifying investment in a QOF is an inclusion event for purposes
of section 1400Z-2(b)(1) and proposed Sec. 1.1400Z2(b)-1(c). One
commenter asserted that a donor's gift of a qualifying investment in a
QOF should not be considered a sale or exchange for purposes of section
1400Z-2, provided that the gift otherwise is not treated as a taxable
disposition for Federal income tax purposes.
As noted in the preamble to the May 2019 proposed regulations,
section 1400Z-2(b)(1) does not directly address non-sale or exchange
dispositions, such as gifts and bequests. However, the Conference
Report provides that, under section 1400Z-2(b)(1), the ``deferred gain
is recognized on the earlier of the date on which the [qualifying]
investment is disposed of or December 31, 2026.'' See Conference Report
at 539 (indicating that continued gain recognition deferral requires
the taxpayer to maintain directly the taxpayer's qualifying
investment).
Section 1400Z-2 requires the deferred Federal income tax on capital
gains to be paid by the taxpayer who incurred that gain and reinvested
an amount up to the amount of the net proceeds from the sale into the
qualifying investment in the QOF. The only exception is the recognition
under section 691 of a decedent's deferred gain that is not properly
includible in the decedent's gross income. The Treasury Department and
the IRS have concluded that (i) no authority exists to impose the
donor's deferred capital gains tax liability on the donee of the
qualifying investment, and therefore (ii) the Federal income tax on the
deferred gain must be collected from the donor at the time of the gift
of the qualifying investment. Accordingly, the final regulations
continue to provide that a gift of the qualifying investment in a QOF
is an inclusion event. In addition, consistent with the discussion in
part VII.E. of the Explanation of Provisions to the May 2019 proposed
regulations, the final regulations provide that the interest received
by the donee is no longer a qualifying investment in a QOF as a result
of the inclusion event, and thus the donee is not eligible to make an
election under section 1400Z-2(c) to adjust the basis of the interest
in the QOF to fair market value.
2. Death
The May 2019 proposed regulations generally provided that a
transfer of a qualifying investment by reason of the taxpayer's death
is not an inclusion event. See proposed Sec. 1.1400Z2(b)-1(c)(4)(ii)
(enumerating the sole exceptions to that general rule). One commenter
noted that the recipient of a deceased owner's qualifying investment
may not have the liquidity to pay the deferred tax on the gain the
decedent invested in the QOF upon an inclusion event as of December 31,
2026. The commenter requested that the final regulations permit an
election to treat death as an inclusion event, thereby making the
decedent's estate liable for the payment of the deferred tax, or grant
the recipient a further deferral until the recipient's disposition of
the qualifying investment.
The Treasury Department and the IRS note that, if a decedent who
dies after 2026 had not disposed of the qualifying investment prior to
December 31, 2026, it is possible that even the decedent could have
faced such a liquidity problem. In light of the statute's clear
direction that the deferral be terminated no later than December 31,
2026, the final regulations provide no election to a decedent's estate
to treat death as an inclusion event or provide further deferral to a
person inheriting the qualifying investment as a result of the deceased
owner's death.
One commenter also requested clarification regarding the
application of section 691 to the recipient of the qualifying
investment by reason of the death of the owner. In response, the final
regulations provide that the tax on the decedent's deferred gain is the
liability of the person in receipt of that interest from the decedent
at the time of an inclusion event.
3. Transactions Between Spouses or Incident to Divorce
A commenter requested that transfers between spouses or incident to
divorce, as described in section 1041, be excepted from the definition
of an inclusion event. Although those transactions are nonrecognition
events for Federal income tax purposes, a transfer of the qualifying
investment in such a transaction constitutes a disposition of that
interest for purposes of section 1400Z-2(a)(1)(B) and (b). Therefore,
the final regulations in Sec. 1.1400Z2(b)-1(c)(3)(ii) clarify that a
transfer described in section 1041 is an inclusion event. Accordingly,
the transferor's deferred gain is recognized, and the transferee's
interest in the QOF no longer is a qualifying investment.
G. Basis Adjustments
1. Adjustments to Basis of Qualifying QOF Stock
Under section 1400Z-2(b)(2)(B)(ii) and proposed Sec. 1.1400Z2(b)-
1(g), a taxpayer's basis in its qualifying investment is increased by
the amount of gain recognized upon an inclusion event or on December
31, 2026. Proposed Sec. 1.1400Z2(b)-1(g) also provided additional
rules regarding the timing and amount of basis adjustments under
section 1400Z-2(b)(2)(B)(ii).
[[Page 1890]]
Commenters requested clarification as to how the section 1400Z-
2(b)(2)(B)(ii) basis adjustments should be made if a taxpayer disposes
of less than all of its qualifying QOF stock or if less than all of its
qualifying QOF stock is redeemed by the QOF corporation. If an investor
has a qualifying investment with $0 basis and a corresponding $100 of
deferred gain, and if the investor were to sell its entire qualifying
investment for $100, the investor would recognize $100 of deferred
gain, increase its basis in the qualifying investment by $100, and then
recognize $0 of gain under section 1001 on the sale of the qualifying
investment. If the investor were to sell half of its investment for $50
instead, the investor would recognize $50 of deferred gain under
proposed Sec. 1.1400Z2(b)-1(e)(1) and then increase its basis in its
qualifying investment by $50. However, it is unclear under the May 2019
proposed regulations whether the $50 basis increase should be applied
to the shares that were sold, to the shares that were retained, or to
both the sold and the retained shares proportionally.
A commenter recommended that the section 1400Z-2(b)(2)(B)(ii) basis
increase be made only to those specific shares that trigger the
inclusion event. In the foregoing example, if the $50 basis adjustment
were made solely to the sold shares, the investor would recognize $50
of the deferred gain on the disposition of such shares and $0 of gain
under section 1001, and the investor would continue to have $50 of
deferred gain and $0 of basis in the retained shares. In contrast, if
all or a proportionate amount of the section 1400Z-2(b)(2)(B)(ii) basis
increase were made to the retained shares, the investor would recognize
$50 of deferred gain plus an additional $50 or $25 of gain,
respectively, under section 1001. Thus, the investor would recognize
more gain than the amount realized in the transaction. Moreover, the
retained portion of the investment still would be associated with $50
of deferred gain. Although the taxpayer would have a basis of either
$50 or $25 in its retained stock, the taxpayer could end up recognizing
gain in excess of the amount of deferred gain if the qualifying
investment appreciates sufficiently--an outcome that is contrary to the
express language of the statute. See section 1400Z-2(b)(2)(A).
Similarly, commenters recommended that, in the case of a dividend-
equivalent redemption of qualifying QOF stock owned by a sole
shareholder of a QOF corporation, the section 1400Z-2(b)(2)(B)(ii)
basis increase for any section 301(c)(3) gain or 1059(a)(2) gain be
made only to the redeemed shares.
The Treasury Department and the IRS agree with the commenters that,
if a shareholder of a QOF corporation sells less than all of its
qualifying QOF stock, the section 1400Z-2(b)(2)(B)(ii) basis increase
should be made only to those specific shares that are sold. The final
regulations have been revised accordingly. Otherwise, issues relating
relating to the treatment of basis upon a redemption are beyond the
scope of the final regulations. The Treasury Department and the IRS
continue to study such issues. See REG-143686-07, 84 FR 11686 (March
28, 2019).
2. Basis Adjustments to QOF Partnership Interests and QOF S Corporation
Stock
a. General Application of Five-Year and Seven-Year Basis Increases
A commenter noted that the May 2019 proposed regulations, unlike
the preamble, did not specifically provide that the five-year and
seven-year basis increases to a qualifying investment are basis for all
purposes of the Code, and recommended that the final regulations
confirm this result. The Treasury Department and the IRS agree with
this comment. Accordingly, the final regulations in Sec. 1.1400Z2(b)-
1(g)(4)(ii) and (g)(5)(i) specifically provide that five-year and
seven-year basis adjustments to a qualifying investment in a
partnership or S corporation described in section 1400Z-2(b)(2)(B)(iii)
and (iv) and section 1400Z-2(c) are basis for all purposes of the Code,
including for purposes of suspended losses under sections 704(d) and
1366(d).
b. Specific Stock Basis Rules for S Corporations
The May 2019 proposed regulations provided that, if an S
corporation is an investor in a QOF, the S corporation must adjust the
basis of its qualifying investment in the manner set forth for C
corporations in proposed Sec. 1.1400Z2(b)-1(g), except as otherwise
provided in those proposed regulations. This rule does not affect
adjustments to the basis of any other asset of the S corporation. The S
corporation shareholder's pro-rata share of any recognized deferred
capital gain at the S corporation level will be separately stated under
section 1366 and will adjust the shareholders' stock basis under
section 1367. In addition, the May 2019 proposed regulations made clear
that any adjustment to the basis of an S corporation's qualifying
investment under section 1400Z-2(b)(2)(B)(iii) or (iv) or section
1400Z-2(c) will not (1) be separately stated under section 1366, and
(2) adjust the shareholders' stock basis under section 1367 until the
date on which an inclusion event with respect to the S corporation's
qualifying investment occurs. If a basis adjustment under section
1400Z-2(b)(2)(B)(ii) is made as a result of an inclusion event, then
the basis adjustment will be made before determining the other tax
consequences of the inclusion event.
The Treasury Department and the IRS received favorable comments
regarding the foregoing rules, which the Treasury Department and the
IRS drafted in accordance with the principle of section 1371(a), as
discussed in part III.E.2.a of this Summary of Comments and Explanation
of Revisions. As a result, the final regulations adopt these rules
without modification.
3. Basis Adjustments by Reason of Death
Several commenters requested clarification regarding the basis of a
qualifying investment in the hands of a deceased owner's heir, legatee,
or beneficiary. More specifically, commenters requested clarification
as to whether the basis adjustment under section 1014 would apply less
the amount of unrecognized gain.
If the decedent's investment in a QOF exceeded the gain the
decedent elected to defer under section 1400Z-2(a), the investment is a
mixed-funds investment that is treated as two separate investments--a
qualifying investment subject to section 1400Z-2, and a non-qualifying
investment to which section 1400Z-2 is inapplicable. See section 1400Z-
2(e)(1). Proposed Sec. 1.1400Z2(a)-1(b)(11)(i)(D) identified the basis
of the non-qualifying investment as the taxpayer's total basis in the
QOF less the basis of the qualifying investment, in each case
determined without the zero-basis rule and without any other basis
adjustment provided for in section 1400Z-2(b)(2)(B). In general, this
amount equals the taxpayer's total investment in the QOF less the
amount of gain invested on which the capital gains tax was deferred.
Because section 1400Z-2 is inapplicable to the non-qualifying
investment, the recipient's basis in the non-qualifying investment on
the death of the owner is governed by section 1014. As with other
income in respect of a decedent, the estate tax value is not reduced by
the liability for the deferred income tax.
However, section 1400Z-2(b)(2)(B) applies with regard to the
recipient's basis in the qualifying investment. This section provides
that the basis of the qualifying investment is zero, with
[[Page 1891]]
specified increases for gain recognized at the time of an inclusion
event and for qualifying investments held for at least five or seven
years. This provision governs without regard to section 1014. Because a
taxpayer's basis in its qualifying investment is zero except as
otherwise provided in section 1400Z-2(b)(2)(B) and section 1400Z-2(c)
(which concerns qualifying investments held for at least 10 years), the
Treasury Department and the IRS have determined that section 1014 does
not apply to adjust the basis of an inherited qualifying investment to
its fair market value as of the deceased owner's death.
H. Earnings and Profits
A commenter requested guidance regarding the E&P consequences of
section 1400Z-2 and the section 1400Z-2 regulations. Specifically, the
commenter recommended that any increase to E&P as a result of gain
deferred under section 1400Z-2 be deferred until such gain is included
in income upon either an inclusion event or December 31, 2026.
As noted by the commenter, section 312(f)(1) provides that gain or
loss realized on the sale or other disposition of property by a
corporation increases or decreases the E&P of such corporation, but
only to the extent the realized gain or loss was recognized in
computing taxable income under the law applicable to the year in which
such sale or disposition was made. Section 1400Z-2 and the section
1400Z-2 regulations enable a taxpayer to defer recognition of an
eligible gain in the year the eligible gain was realized. As a result,
the amount of gain so deferred does not increase the taxpayer's E&P in
the year of realization. See section 312(f)(1). When the gain
eventually is included in income upon an inclusion event or on December
31, 2026, the taxpayer's E&P will be increased. See Sec. 1.312-6(b).
The Treasury Department and the IRS have determined that section 312
and the regulations in this part under section 312 provide this result
in their current form, and therefore no additional rules are necessary.
However, the examples set forth in Sec. 1.1400Z2(b)-1(g)(3) have been
revised to illustrate the application of the existing E&P rules within
the context of section 1400Z-2.
The commenter also recommended that the amount of basis adjustments
resulting from the application of section 1400Z-2(b)(2)(B)(iii) and
(iv) and section 1400Z-2(c) should be treated as tax-exempt income that
causes an increase to E&P under Sec. 1.312-6(b). Section 1.312-6(b)
provides that, among other items, income exempted from Federal income
tax by statute is entered into the computation of E&P for a particular
period. The basis increases under section 1400Z-2(b)(2)(B)(iii) and
(iv) exempt from tax under subtitle A those gains that are deferred
under section 1400Z-2(a). Similarly, the election under section 1400Z-
2(c) potentially exempts from tax under subtitle A those gains that are
attributable to the appreciation of QOF investments. Therefore, these
basis increases are tax-exempt income for purposes of computing E&P and
will increase the E&P of the taxpayer at the time such increases are
made. As noted previously, the Treasury Department and the IRS have
determined that section 312 and the regulations in this part under
section 312 provide this result in their current form and that no
additional rules are necessary.
One commenter further asserted that Sec. 1.312-6(b) should not
apply to income that is exempt from tax as a result of the basis
increases under section 1400Z-2 in order to facilitate passing the
benefits of a REIT's qualifying investments to the REIT's shareholders.
See part IX.B of this Summary of Comments and Explanation of Revisions.
However, the Treasury Department and the IRS have determined that
section 312 and Sec. 1.312-6(b) appropriately apply to income that is
exempt from tax under subtitle A as a result of these basis increases.
Thus, the final regulations have not been revised in response to this
comment.
I. Voluntary Inclusion; Applicable Tax Rate
A commenter requested that a QOF investor be permitted to
voluntarily recognize the full amount of deferred gain in a taxable
year of the investor's choosing prior to the statutorily required year
of inclusion under section 1400Z-2(b)(1), and at the Federal income tax
rate applicable to the chosen recognition year. The investor would
remain fully invested in the QOF, and therefore the basis increases at
the five-year mark and seven-year mark, as well as the basis adjustment
to fair market value after 10 years, still would be available with
regard to the taxpayer's qualifying investment. If the investor meets
the requirements for one or more of these basis adjustments, the
investor could request a refund of the tax paid on the appropriate
amount of the gain in a prior year.
According to the commenter, voluntary gain recognition prior to the
statutorily provided year of inclusion would accomplish two purposes.
First, the investor could eliminate the risk that the tax rate under
subtitle A in the statutorily required year of inclusion would be
significantly higher than in the year of voluntary inclusion. Second,
the investor would possess the flexibility to pay a tax liability in a
year during which the investor is certain to have available the
necessary amount of funds.
The Treasury Department and the IRS do not adopt the commenter's
recommendation. Section 1400Z-2(b) specifies two events upon which an
investor's deferred gain under section 1400Z-2(a)(1) may be included in
income. First, deferred gain is included in income upon the occurrence
of an inclusion event as explained further in these regulations in
Sec. 1.1400Z2(b)-1. Second, deferred gain is included on December 31,
2026. It is not contemplated under the statute or legislative history
that a taxpayer may choose to include deferred gain in income at
another time and continue to remain invested in a QOF. Accordingly, if
a taxpayer wishes to include deferred gain in income, it may cause the
occurrence of an inclusion event, with the effect that the investor's
ownership of the QOF would terminate for all purposes, including the
basis adjustment to fair market value under section 1400Z-2(c).
Another commenter inquired whether the proper Federal income tax
rate to apply to the gain recognized pursuant to section 1400Z-2(b)(1)
is the Federal income tax rate at the time of the investment and
deferral election, or the Federal income tax rate in the taxable year
of inclusion. The May 2019 proposed regulations provided that, if
section 1400Z-2(a)(1)(B) and (b) require a taxpayer to include in
income some or all of a previously deferred gain, the gain so included
has the same attributes in the taxable year of inclusion that it would
have had if tax had not been deferred. Thus, if the Federal income tax
rate were considered an ``attribute'' of the gain, the rate applicable
in the year of deferral arguably would apply to gain recognized under
section 1400Z-2(b)(1).
Although the May 2019 proposed regulations provided rules for the
tax attributes of the amount deferred in the year of inclusion, the May
2019 proposed regulations did not discuss the Federal income tax rates
for the year of inclusion. The final regulations clarify that gain
recognized pursuant to section 1400Z-2(b)(1) and the section 1400Z-2
regulations is subject to taxation at the applicable Federal income tax
rates for the year of inclusion, not of the year of deferral.
[[Page 1892]]
J. Availability of Basis Adjustments Under Section 1400Z-
2(b)(2)(B)(iii) and (iv)
Section 1400Z-2(b) provides that gain deferred under section 1400Z-
2(a)(1)(A) is included in income in the taxable year that includes the
earlier of the date on which the QOF investment was sold or exchanged
or December 31, 2026. Therefore, in order to be eligible for both the
five-year and seven-year basis increases under section 1400Z-
2(b)(2)(B)(iii) and (iv), respectively, a taxpayer must invest eligible
gain in a qualifying investment no later than December 31, 2019.
Eligibility solely for the five-year basis increase requires an
investment of eligible gain no later than December 31, 2021. Commenters
requested that the statutory inclusion date be postponed to December
31, 2027 or December 31, 2028 to provide investors additional time to
consider investing in a QOF, and still receive the benefit of the five-
and seven-year basis increases with the benefit of final regulatory
guidance.
The Treasury Department and the IRS note that the December 31,
2026, date is mandated by statute, and that there is no indication that
Congress intended a later inclusion date. Therefore, the final
regulations do not adopt this recommendation.
Another commenter requested confirmation that the inclusion dates
in section 1400Z-2(b)(1) do not apply to the five-year and seven-year
basis increases under section 1400Z-2(b)(2)(B)(iii) and (iv). As a
consequence, a qualifying investment would be eligible for these basis
increases regardless of whether the full amount of deferred gain has
been recognized, and regardless of when the qualifying investment is
made.
As discussed in parts III.A and III.I of this Summary of Comments
and Explanation of Revisions, the basis adjustments provided by section
1400Z-2(b)(2)(B)(iii) and (iv) are based on an eligible taxpayer's
remaining deferred gain. Moreover, section 1400Z-2(b)(1) clearly
requires all deferred gain to be taken into account no later than
December 31, 2026. After that date, there will be no remaining deferred
gain to be excluded from Federal income tax as a result of the five- or
seven-year basis adjustments. As a consequence of the commenter's
recommendation, the five- and seven-year basis increases would operate
not only to exclude a portion of the deferred gain from Federal income
tax, but also to exclude a portion of subsequent appreciation in the
value of a qualifying investment from Federal income tax. The Treasury
Department and the IRS have determined that the statutory text of
section 1400Z-2 does not adequately support the commenter's
recommendation, and have clarified the final regulations.
In addition, a commenter requested that the five-year and seven-
year basis increases under section 1400Z-2(b)(2)(B) be elective rather
than automatic, based on the commenter's position that an investor
should be allowed to choose to recognize deferred gain that otherwise
would be eliminated due to those basis increases. The statute and
legislative history do not indicate that the basis increases under
section 1400Z-2(b)(2)(B) operate at the taxpayer's option once the
requisite five- and seven-year holding periods have been met.
Accordingly, the Treasury Department and the IRS decline to adopt this
recommendation.
K. Commencement of the Holding Period for a QOF Investment
In Examples 1 and 7 in proposed Sec. 1.1400Z2(b)-1(f), the holding
period for a qualifying investment in a QOF begins on the date on which
the qualifying investment is acquired rather than on the day after the
date of its acquisition. One commenter noted that, under Rev. Rul. 70-
598, 1970-2 C.B. 168, and general Federal income tax principles, the
holding period for a capital asset begins on the day after the
acquisition of the asset.
The Treasury Department and the IRS acknowledge the divergence
between (i) the day on which the holding period of a qualifying
investment begins, and (ii) the day on which the holding period for a
capital asset ordinarily would begin. However, the Treasury Department
and the IRS have determined that no provision of the Code, nor any
Federal income tax principle, requires conformity in this context. As a
result, the final regulations do not modify the date on which the
holding period for a qualifying investment commences.
L. QOF Exit and Reinvestment
Commenters requested that the final regulations provide a rule that
would permit an investor to dispose of its entire interest in a
qualifying investment and reinvest the resulting proceeds in another
QOF within a short period of time, such as 180 days. Under this rule,
the investor would be permitted to tack the holding period of the
disposed qualifying investment onto the new qualifying investment for
purposes of the five-year, seven-year, and ten-year basis adjustments
under section 1400Z-2(a)(2)(B)(iii) and (iv) and section 1400Z-2(c),
respectively. This rule would allow an investor to disinvest in a
particular QOF as long as the investor remains invested in QOFs, in the
aggregate, for the requisite holding periods. One commenter indicated
that such a rule would expose investors to a lower risk of loss, which
would facilitate investments in professionally managed QOFs from a
wider variety of consumer-type investors.
The Treasury Department and the IRS acknowledge the additional
investment flexibility that would be provided through adoption of the
commenters' recommendation. However, the Treasury Department and the
IRS have found no support for this recommendation in the statutory text
of section 1400Z-2 or its underlying legislative history. As a result,
the final regulations do not incorporate the commenters'
recommendation. With regard to the effect of specific transactions on
the holding period of a qualifying investment for purposes of the basis
adjustments under sections 1400Z-2(a)(2)(B)(iii) and (iv) and 1400Z-
2(c), the final regulations provide taxpayers with provisions that
address specific inclusion events.
IV. Comments on and Changes to Proposed Sec. 1.1400Z2(c)-1
Section 1400Z-2(c) provides that in the case of any investment held
by the taxpayer for at least 10 years and with respect to which the
taxpayer makes an election under section 1400Z-2(c), the basis of such
property will be equal to the fair market value of such investment on
the date that the investment is sold or exchanged. Proposed Sec.
1.1400Z2(c)-1 set forth proposed rules concerning the election under
section 1400Z-2(c), including special rules for QOF partnerships and
QOF S corporations.
A. Gain Exclusion for Asset Sales by QOFs and Qualified Opportunity
Zone Businesses
Proposed Sec. 1.1400Z2(c)-1(b)(2)(ii)(A)(1) provided that an
investor in a QOF partnership or a QOF S corporation may elect to
exclude some, or all, of the capital gain arising from the QOF's sale
of qualified opportunity zone business property upon satisfaction of
the 10-year holding period in section 1400Z-2(c). A commenter requested
guidance regarding a fact pattern in which a QOF that has been held for
the requisite 10-year holding period owns multiple qualified
opportunity zone businesses. Specifically, the commenter requested
confirmation that the gain from each separate disposition of interests
in qualified opportunity zone businesses,
[[Page 1893]]
after a 10-year holding period of a qualifying investment, qualifies
for the basis adjustment and potential gain exclusion under section
1400Z-2(c).
The Treasury Department and the IRS agree that, in the case of a
QOF partnership or QOF S corporation, the disposition of QOF assets,
including interests in qualified opportunity zone businesses, may
qualify for the election under section 1400Z-2(c) if the qualifying
investment in the QOF partnership or QOF S corporation meets the 10-
year holding period of section 1400Z-2(c), notwithstanding the disposal
of interests in qualified opportunity zone businesses at different
times. A rule that requires a single disposition of all QOF assets in
order to qualify for the benefits under section 1400Z-2(c) would
provide an incentive for QOFs and their investors to dispose of a
qualified opportunity zone business at a time when, in the absence of
section 1400Z-2(c), such a disposition would not be made for reasons
unrelated to section 1400Z-2. The final regulations permit interests in
qualified opportunity zone businesses to be disposed of at different
times. This rule provides taxpayers flexibility consistent with the
principle that the economic success of the QOF and the qualified
opportunity zone businesses should be the overriding concern when an
investor decides whether to dispose of an interest in a qualified
opportunity zone business.
One commenter also requested clarification regarding the
application of section 1400Z-2(c) to a disposition of assets at less
than fair market value, including situations in which the property sold
is government-owned or low-income housing. If an investment is held for
at least 10 years by a QOF and a taxpayer makes an election under
section 1400Z-2(c), then the basis of the investment is equal to fair
market value on the date that the investment is sold or exchanged.
Proposed Sec. 1.1400Z2(c)-1(b)(2)(ii)(A)(1) applied the basis
adjustment rule in section 1400Z-2(c) to the disposition of assets by a
QOF partnership. Under general Federal income tax principles, the fair
market value of property will generally be equal to the actual sales
price of such property when a buyer and seller are unrelated. Fair
market value under section 1400Z-2(c) is consistent with these
principles. Therefore, in a disposition of assets of a QOF to an
unrelated party where the taxpayer makes a valid election under section
1400Z-2(c), the relevant fair market value of the assets generally
would be the sale price. In a disposition of assets to a related party,
the fair market value for purposes of section 1400Z-2(c) would be
determined with consideration of the principles of section 482.
B. Application of Section 1400Z-2(c) Election to Certain Gain
Commenters asked whether taxpayers may make an election under
section 1400Z-2(c) with respect to section 301(c)(3) gain or section
731 gain on a qualifying investment. The Treasury Department and the
IRS have determined that an election under section 1400Z-2(c) should be
available for gain resulting from section 301(c)(3), section 731(a),
section 1059(a)(2), or section 1368(b)(2) or (c)(3) on a qualifying
investment because such gain is treated as gain from the sale or
exchange of property for Federal income tax purposes.
C. Inclusion Events
As discussed in part III of this Summary of Comments and
Explanation of Revisions, proposed Sec. 1.1400Z2(b)-1(c) provided
rules regarding various events that trigger the inclusion of deferred
gain under section 1400Z-2(b) and proposed Sec. 1.1400Z2(b)-1(b).
Commenters requested guidance as to whether, and to what extent, such
inclusion events, as well as events that occur after December 31, 2026,
also would cause a qualifying investment to lose eligibility for the
election under section 1400Z-2(c) and proposed Sec. 1.1400Z2(c)-1.
Specifically, commenters asked whether an inclusion event with respect
to gain under section 301(c)(3) would preclude an election under
section 1400Z-2(c). See proposed Sec. 1.1400Z2(b)-1(c)(8) and related
provisions in proposed Sec. 1.1400Z2(b)-1(c)(9) through (12).
As discussed in part II.A.5 of this Summary of Comments and
Explanation of Revisions, the Treasury Department and the IRS have
determined that an inclusion event generally would cause a qualifying
investment to lose eligibility for the election under section 1400Z-
2(c) and Sec. 1.1400Z2(c)-1. However, the Treasury Department and the
IRS have determined that gain resulting from section 301(c)(3), section
731(a), section 1059(a)(2), or section 1368(b)(2) or (c)(3) should not
preclude a taxpayer from making a subsequent election under section
1400Z-2(c) for its qualifying investment. Therefore, a QOF C
corporation shareholder or QOF S corporation shareholder is eligible to
make an election under section 1400Z-2(c) for a qualifying investment
regardless of the extent to which the shareholder has received
distributions subject to section 301(c)(3), section 1059(a)(2), or
section 1368(b)(2) or (c)(3) with respect to such investment.
Similarly, in the case of inclusion events under Sec. 1.1400Z2(b)-
1(c)(6)(iii) (partnership distributions) and Sec. 1.1400Z2(b)-
1(c)(7)(ii) (distributions by QOF S corporation), the section 1400Z-
2(c) election continues to be available to a partner or S corporation
shareholder, respectively, as long as the QOF owner continues to hold a
qualifying investment in the QOF partnership or QOF S corporation,
despite the distribution that caused an inclusion event. The final
regulations have been modified accordingly.
Commenters also recommended that an ordering rule similar to
proposed Sec. 1.1400Z2(b)-1(g)(1)(ii) be applied to the election under
section 1400Z-2(c), so that such a basis increase would occur
immediately before determining the results under section 301(c) and
section 1059(a). The final regulations adopt such a rule.
D. QOF REIT Capital Gain Dividends Identified With a Date
Proposed Sec. 1.1400Z2(c)-1(e) provided rules for QOF REITs to
identify capital gain dividends with a date so that some shareholders
could elect to receive the amount of such dividends tax-free under
section 1400Z-2(c). One commenter recommended that the term ``QOF RIC''
be added throughout the final regulations alongside all references to
QOF REITs to ensure that the regulations apply equally to QOF RICs and
QOF REITs.
The Treasury Department and the IRS understand that a Business
Development Company (BDC) that is a RIC may qualify as a QOF. The
Treasury Department and the IRS have determined that, if a RIC meets
the qualifications for, and elects to be, a QOF RIC, that entity and
its shareholders should receive the same treatment under these
regulations as a QOF REIT and its shareholders. This change is
reflected in the final regulations. The proportionality rule for QOF
REITs identifying a capital gain dividend with a date in the May 2019
proposed regulations was proposed under the authority granted to the
Secretary under section 857(g)(2). The Treasury Department and the IRS
apply a similar proportionality requirement to RICs (see Rev. Rul. 89-
81, 1989-1 C.B. 226), and thus have maintained the proportionality rule
for both QOF RICs and QOF REITs identifying capital gain dividends with
a date.
[[Page 1894]]
E. Special Rules for QOF Partnerships and QOF S Corporations
1. Section 1400Z-2(c) Election by Transferee Partnership
The transferee partnership of a qualifying investment in a QOF
partnership, following a section 721(a) contribution (including those
resulting from a merger of QOF partnerships), provided there is no
inclusion event, is eligible to make the section 1400Z-2(c) election to
exclude from gross income gains and losses from the disposition of
property held by a QOF (other than gains and losses from the sale of
inventory in the ordinary course of a business), so long as the 10-year
holding period requirement is satisfied. See Sec. 1.1400Z2(b)-
1(d)(1)(ii) (transferee partnership has a tacked holding period). The
final regulations clarify this rule and provide reporting requirements
for the transferee partnership in making the section 1400Z-2(c)
election.
2. Basis Adjustment Amount on the Sale of a Qualifying Investment
Proposed Sec. 1.1400Z2(c)-1(b)(2)(i) provided that, if a taxpayer
sells or exchanges a qualifying investment in a QOF partnership that
has been held for at least 10 years, and the taxpayer makes the
election described in section 1400Z-2(c), the basis of the partnership
interest is adjusted to an amount equal to the fair market value of the
interest, including debt. The Treasury Department and the IRS received
comments asking for clarification of the phrase ``including debt'' in
the proposed rule. Specifically, commenters requested a rule that more
clearly states that the basis of the partnership interest is adjusted
to an amount equal to the net fair market value of the QOF partnership
interest plus the partner's share of debt. One commenter suggested that
a ``gross fair market value'' rule would encourage QOF partnerships to
borrow money and distribute the proceeds, which could increase debt
within QOZs while reducing cash amounts held by QOF partnerships,
potentially exacerbating the plight of the economically distressed
communities. In addition, several commenters asked for clarification
that the fair market value of the QOF partnership interest cannot be
less than the partner's allocable share of non-recourse debt,
consistent with section 7701(g).
The Treasury Department and the IRS agree with the commenters that
clarification is needed. Accordingly, the final regulations clarify
that the basis of the partnership interest is adjusted to an amount
equal to its net fair market value, plus the partner's share of
partnership debt relating to that interest, so that the partner would
recognize no gain or loss on a sale or exchange of the qualifying QOF
partnership interest after at least 10 years. The final regulations
also state that the fair market value cannot be less than the partner's
allocable share of non-recourse debt. In addition, the final
regulations note that, in the case of a sale or exchange of qualifying
S corporation shares, the basis is adjusted to an amount equal to the
fair market value of the shares immediately prior to the sale or
exchange.
3. Adjustment to Basis of QOF Partnership Assets on Sale of a
Qualifying Investment
Proposed Sec. 1.1400Z2(c)-1(b)(2)(i) provided that, if a
taxpayer's basis is adjusted under section 1400Z-2(c), the bases of the
QOF partnership assets also are adjusted immediately prior to the sale
or exchange. The adjustment is calculated in a manner similar to a
section 743(b) adjustment as if the transferor partner had purchased
its interest in the QOF partnership for an amount of cash equal to the
fair market value of the partnership interest immediately prior to the
sale or exchange, assuming that a valid section 754 election had been
in place. The Treasury Department and the IRS received comments asking
for clarification that (i) the assets of lower-tier partnerships also
should be adjusted pursuant to this rule, (ii) no actual section 754
election is required, and (iii) generally applicable guidance issued
pursuant to sections 743(b) and 754 applies in this context.
The Treasury Department and the IRS agree with the commenters that
clarification is needed. Accordingly, the final regulations clarify
that the adjustment applies to any partnerships directly or indirectly
owned, solely through one or more partnerships (tiered partnerships),
by the QOF partnership, whether or not an actual section 754 election
is in place for any of the partnerships. Guidance issued pursuant to
sections 743(b) and 754 applies as it would outside of the context of
section 1400Z-2. Further, because section 1400Z-2(c) is designed to
result in no gain or loss to the transferor QOF partner, the final
regulations provide that, to the extent the existing rules of sections
743(b) and 755 operate in a manner that results in recognition of gain
or loss on the transaction, the basis adjustments are to be made to the
extent necessary to eliminate any such gain or loss.
4. Sales or Exchanges of Property by QOF Partnerships and QOF S
Corporations
The May 2019 proposed regulations provided that, if a QOF
partnership or QOF S corporation disposes of qualified opportunity zone
property after a taxpayer is treated as holding its qualifying
investment in the QOF partnership or QOF S corporation for 10 years,
the taxpayer may make an election to exclude from gross income some or
all of the capital gain arising from the disposition. The Treasury
Department and the IRS received comments requesting that, in addition
to capital gain from the sales of qualified opportunity zone property
by a QOF, capital gain from the sales of property by a qualified
opportunity zone business that is held in partnership form should be
eligible for exclusion as long as the qualifying investment in the QOF
has been held for 10 years. The final regulations adopt this
recommendation for QOF partnerships and QOF S corporations.
Commenters also requested that all types of gains and losses,
including gains and losses from the sales of inventory, section 1231
gains and losses, and depreciation recapture, be eligible for exclusion
under this special election for QOF partnerships and QOF S
corporations. Other commenters suggested that the exclusion election
should apply to all gains and losses of QOF partnerships or QOF S
corporations other than gains and losses from the sales of inventory in
the ordinary course of business. The final regulations adopt the
recommendation to exclude ordinary course inventory sales from the
exclusion election.
The final regulations set forth two requirements for the QOF
partnership or QOF S corporation and the taxpayer when the taxpayer
wishes to make an election to exclude gains and losses upon sales of
assets other than inventory sold in the ordinary course of a trade or
business by the QOF. First, the taxpayer must make the election for
each taxable year in which it wishes to exclude the QOF's gains and
losses from all sales and exchanges of assets. This election may be
made regardless of whether the taxpayer has made an election for any
prior taxable year. The election will apply to all gains and losses,
other than gains and losses from sales of inventory in the ordinary
course of business, of the QOF partnership or QOF S corporation for
that taxable year, including any gains and losses from a lower-tier
partnership. The election must be made by the taxpayer on the
applicable form filed with its Federal
[[Page 1895]]
tax return for the year in which the sale or exchange occurs.
The second requirement is designed to eliminate future section
1400Z-2 benefits attributable to the reinvestment of proceeds from
asset sales for which gain and loss is not recognized under section
1400Z-2. Under this provision, and solely for purposes of determining
the amount of a QOF owner's qualifying investment and non-qualifying
investment, the QOF is treated as distributing to each electing QOF
owner its share of net proceeds from the asset sales on the last day of
the QOF's tax year. For a QOF S corporation, such deemed distributions
and recontributions will have no Federal income tax consequence other
than the adjustment of the respective values of qualifying and non-
qualifying investments in a QOF S corporation. For example, such deemed
distributions will have no impact on an accumulated adjustments account
of a QOF S corporation, and will not be treated as a disproportionate
distribution of a QOF S corporation.
For a QOF partner that holds a mixed-funds investment, any
distribution will be allocated to the separate interests of the QOF
partner pursuant to Sec. 1.1400Z2(b)-1(c)(6)(iv)(B). This rule
provides that any distribution will be allocated proportionately
between the qualifying and non-qualifying investments of the partner.
Immediately after the deemed distribution, the distributee QOF owner is
treated as recontributing the amount received in exchange for a non-
qualifying investment.
In determining the post-contribution qualifying investment and non-
qualifying investment of a QOF partnership, the QOF partnership is
required to value each interest based on the underlying value of the
partnership's assets, determined in accordance with the principles of
Sec. 1.704-1(b)(2)(iv) at the end of its taxable year. For this
purpose, the amount of the net proceeds from an asset sale is equal to
the amount realized from the sale, less any indebtedness included in
the amount realized that would constitute a qualified liability under
Sec. 1.707-5(a)(6) if property subject to the debt had been
contributed to a lower-tier partnership. An actual distribution of
sales proceeds within 90 days of that asset sale will reduce the amount
of the deemed distribution and deemed recontribution.
In determining the post-contribution qualifying investment and non-
qualifying investment of a QOF S corporation, the QOF S corporation is
required to value each interest based on the underlying value of the
QOF S corporation's assets. For this purpose, the amount of the net
proceeds from an asset sale is equal to the amount realized from the
sale, less any indebtedness included in the amount realized that would
constitute a qualified liability under the principles of Sec. 1.707-
5(a)(6). An actual distribution of sales proceeds within 90 days of
that asset sale will reduce the amount of the deemed distribution and
deemed recontribution.
F. Controlled Foreign Corporations
A commenter requested that a United States shareholder investor in
a QOF that is a controlled foreign corporation (CFC) organized in a
U.S. territory be permitted to make section 1400Z-2(c) elections with
respect to assets sold by the CFC, thereby eliminating any subpart F
income or tested income resulting from these transactions. The
commenter analogized this treatment to rules in proposed Sec.
1.1400Z2(c)-1(b)(2)(ii) providing that, in certain cases, the owners of
a QOF partnership or QOF S corporation can make a section 1400Z-2(c)
election with respect to their distributive or pro rata shares of
capital gain from the QOF's disposition of assets.
However, the rules for income inclusions with respect to CFCs are
not analogous to those for partnerships or S corporations. Unlike
partnerships and S corporations, CFCs are not treated as flow-through
entities for purposes of the Code. Additionally, in contrast with
partnerships and S corporations, only certain U.S. taxpayer owners of
CFCs (United States shareholders) are required to have current income
inclusions with respect to CFCs, and these United States shareholders
are required to currently include in gross income only certain income
earned by a CFC (for example, subpart F income). These rules effectuate
the policies underlying the subpart F and global intangible low-taxed
income under section 951A(a) (GILTI) regimes--to prevent United States
shareholders from deferring or eliminating U.S. tax on certain income
by earning such income through CFCs. Such policies generally are not
applicable to partnerships and S corporations, which generally are
treated as flow-through entities for purposes of the Code. See H.R.
Rep. No. 1447 at 57-58 (1962); S. Rep. No. 1881 at 78-80 (1962); S.
Comm. on the Budget, Reconciliation Recommendations Pursuant to H. Con.
Res. 71, S. Print No. 115-20, at 370 (2017).
As opaque entities, CFCs are more analogous to domestic C
corporations than to partnerships or S corporations because the income
of CFCs and domestic C corporations may be subject to U.S. taxation
when earned (at the United States shareholder-level in the case of a
CFC) and also when distributed as a dividend to U.S. taxpayer
shareholders. This result with respect to domestic C corporations is
not changed by section 1400Z-2, which does not permit a shareholder of
a domestic QOF C corporation to make a section 1400Z-2(c) election with
respect to either the QOF C corporation's capital gains from sales of
assets or dividends distributed to such shareholder, unless section
1059(a)(2) applies to such dividends. Allowing this benefit for United
States shareholders of QOFs that are CFCs organized in a U.S. territory
would thus provide an unwarranted advantage to shareholders of QOF C
corporations organized under the laws of U.S. territories compared to
shareholders of QOF C corporations organized under the laws of the 50
states or the District of Columbia. The Treasury Department and the IRS
have determined that there is no statutory or policy basis for such
disparate treatment. Accordingly, the comment is not adopted. A comment
with respect to QOFs that are passive foreign investment companies
(within the meaning of section 1297(a)) is rejected for similar
reasons.
G. Permitting Elections Through December 31, 2047
The October 2018 proposed regulations preserved the ability of
taxpayers to make an election under section 1400Z-2(c) until December
31, 2047. The Treasury Department and the IRS requested comments on
whether some other period would better align with taxpayers' economic
interests and the purposes of the statute, and whether alternative
approaches would be appropriate. For example, the preamble to the
October 2018 proposed regulations noted the possibility of allowing for
an automatic basis step-up immediately before the end of 2047. The
Treasury Department and the IRS will continue to consider the
appropriateness of such an approach, including ways to address how best
to value investments in QOFs absent a sale or exchange between
unrelated persons by December 31, 2047.
V. Comments on and Changes To Proposed Sec. 1.1400Z2(d)-1
Section 1400Z-2(d) sets forth requirements that an entity
classified for Federal income tax purposes as a partnership or
corporation must satisfy to qualify as a QOF or as a qualified
[[Page 1896]]
opportunity zone business that is owned, in whole or in part, by one or
more QOFs.
Section 1400Z-2(d)(1) defines a QOF as a partnership or corporation
that (i) is organized for the purpose of investing in ``qualified
opportunity zone property'' (other than another qualified opportunity
fund), and (ii) must hold at least 90 percent of its assets in
qualified opportunity zone property, determined by the average of the
percentage of qualified opportunity zone property held in the entity as
measured on two semiannual testing dates (90-percent investment
standard). Section 1400Z-2(d)(2) defines the term ``qualified
opportunity zone property'' to mean property directly held by a QOF
that consists of (i) stock in a corporation that is qualified
opportunity zone stock, (ii) partnership interests that are qualified
opportunity zone partnership interests, or (iii) tangible property that
is qualified opportunity zone business property.
A QOF's directly held interest in a partnership or corporation will
be treated as a qualified opportunity zone partnership interest or
qualified opportunity zone stock, and thus qualified opportunity zone
property, for purposes of the 90-percent investment standard if the
interest or stock satisfies the requirements set forth in section
1400Z-2(d)(2)(B) or (C), as applicable. First, the QOF must have
acquired the interest or stock from the partnership or corporation,
respectively, solely in exchange for cash after December 31, 2017.
Second, at the time of issuance of the interest or stock, as well as
during substantially all of the QOF's holding period for such interest
or stock, the entity must qualify as a ``qualified opportunity zone
business'' (or, if newly formed, must have been organized for such
purpose).
Section 1400Z-2(d)(2)(D) provides that tangible property will be
treated as qualified opportunity zone business property if the tangible
property is used in a trade or business of the QOF and satisfies three
general requirements. First, the QOF must have acquired the tangible
property after December 31, 2017 (post-2017 acquired tangible property)
from a person that is not related (as defined in section 179(d)(2), and
modified by section 1400Z-2(e)(2)) and not a member of the same
controlled group (as defined in section 179(d)(2)(B) and (d)(7)) in a
transaction resulting in the QOF holding the tangible property with
other than a transferred basis (within the meaning of section
7701(a)(43)) or with a section 1014 basis (post-2017 acquisition
requirement). Second, the original use of the post-2017 acquired
tangible property in the QOZ must begin with the QOF (original use
requirement), or the QOF must substantially improve the post-2017
acquired tangible property (substantial improvement requirement).
Third, during substantially all of the QOF's holding period for such
post-2017 acquired tangible property, substantially all of the use of
post-2017 acquired tangible property has been in a QOZ. Under section
1400Z-2(d)(2)(D)(ii), the substantial improvement requirement is met
only if, during any 30-month period beginning after the date of
acquisition of the post-2017 acquired tangible property, there are
``additions to basis with respect to such property'' held by the QOF
that, in the aggregate, exceed the adjusted basis of the post-2017
acquired tangible property held by the QOF as of the beginning of that
30-month period.
Section 1400Z-2(d)(3)(A) defines the term ``qualified opportunity
zone business'' as a trade or business (other than an enumerated ``sin
business'' under section 144(c)(6)(B)) that meets each of the following
two requirements. First, substantially all of the tangible property
owned or leased in connection with the trade or business must be
qualified opportunity zone business property. See section 1400Z-
2(d)(3)(A)(i). Second, the trade or business must satisfy the following
requirements provided in paragraphs (2), (4), and (8) of section
1397C(b): (i) At least 50 percent of the total gross income of such
entity must be derived from the active conduct of the trade or business
in the QOZ (50-percent gross income requirement); (ii) a substantial
portion of the intangible property of such entity must be used in the
active conduct of the trade or business in the QOZ; and (iii) less than
five percent of the average of the aggregate unadjusted bases of the
property of such entity must be attributable to nonqualified financial
property (NQFP and five-percent NQFP limitation, respectively). See
section 1400Z-2(d)(3)(A)(ii).
Proposed Sec. 1.1400Z2(d)-1, introduced in the October 2018
proposed regulations and expanded in the May 2019 proposed regulations,
provided guidance for applying each of the provisions of section 1400Z-
2(d). In general, the proposed regulations addressed (i) QOF self-
certification procedures, (ii) valuation methods for determining
satisfaction of the 90-percent investment standard, (iii) how various
types of property can qualify as qualified opportunity zone property,
including qualified opportunity zone business property, and (iv) how
trades or businesses can satisfy the requirements for qualifying as
qualified opportunity zone businesses. The Treasury Department and the
IRS have received numerous comments regarding the proposed rules set
forth in proposed Sec. 1.1400Z2(d)-1. The remainder of this part V
discusses those comments in the order of the rules set forth in
proposed Sec. 1.1400Z2(d)-1 and describes the changes in the final
regulations in response to those comments.
A. Certification of an Entity as a QOF
1. Consideration of Revisions to QOF Self-Certification Requirements
Section 1400Z-2(e)(4)(A) directs the Treasury Department and the
IRS to prescribe regulations for the certification of QOFs for purposes
of section 1400Z-2. In order to facilitate the certification process
and minimize the information collection burden placed on taxpayers,
proposed Sec. 1.1400Z2(d)-1(a)(1) generally permits any taxpayer that
is a corporation or partnership for Federal income tax purposes to
self-certify as a QOF, provided that the entity is eligible to self-
certify. Proposed Sec. 1.1400Z2(d)-1(a)(1)(i) permits the Commissioner
of Internal Revenue (Commissioner) to determine the time, form, and
manner of the self-certification in IRS forms and instructions or
guidance published in the Internal Revenue Bulletin.
In this regard, the Commissioner has determined that self-
certification must be reported annually on a timely filed Form 8996.
Form 8996 requires the taxpayer to certify that, for the first period
during which an entity will certify as a QOF, the QOF must include in
its organizing documents (1) a statement of the purpose of investing in
qualified opportunity zone property (as required by section 1400Z-
2(d)(1)) by the end of the first QOF year, and (2) a description of the
qualified opportunity zone business that a QOF expects to engage in,
either directly or indirectly through a lower-tier operating entity.
The Treasury Department and the IRS received several comments
regarding the certification process outlined in the proposed
regulations. Several commenters requested that the requirements set
forth in Form 8996 be incorporated into the final regulations. Other
commenters recommended that the final regulations require individuals
who manage the QOFs (fund managers) to certify that they have not been
indicted or convicted of fraud, embezzlement, or theft, similar to
requirements under section 45D of the Code for the New Markets Tax
Credit program. One commenter recommended the use of licensing
procedures for fund managers similar to those used in the
[[Page 1897]]
Small Business Investment Company (SBIC) licensure program administered
by the Small Business Administration. Other commenters recommended that
QOF certification require the QOF to receive a letter of support from
the local government of the QOZ in which the QOF will operate.
Several commenters also recommended that the final regulations
require a taxpayer to identify, at the time of QOF certification, the
QOF's intended community development outcomes and objectives. For
example, one commenter requested that, as part of the QOF certification
process, a QOF must certify that the QOF will create quality jobs for
low-income individuals, develop affordable housing, and achieve other
beneficial community outcomes. To facilitate the ability of a QOF to
make such certification, one commenter suggested that the final
regulations provide a safe harbor for certification for a QOF that
undergoes an independent, third-party verification (similar to the
SBIC's annual third-party impact assessment) to establish that the QOF
meets the needs of the community, fund managers, and investors.
The Treasury Department and the IRS appreciate the commenters'
recommendations regarding QOF certification. In developing the proposed
regulations, as well as Form 8996, the Treasury Department and the IRS
intended to strike a balance between providing taxpayers with a
flexible and efficient process for organizing QOFs, while ensuring that
investments in such vehicles will be properly directed toward the
economic development of low-income communities. The suggested
recommendations, while potentially helpful for directing such
investment and limiting abuse, likely would present numerous obstacles
for potential QOF investors and ultimately reduce, rather than
increase, the total amount of investment in low-income communities. As
a result, the final regulations do not adopt the commenters'
recommendations. However, the Treasury Department and the IRS will
consider these comments in the event that additional guidance on QOF
certification is warranted.
2. Consideration of Indian Tribal Governments and Corporations as
Eligible Entities To Certify as QOFs
Several commenters requested that Indian tribal governments and
corporations organized under Indian tribal laws should be included in
the definition of entities eligible to be a QOF. Proposed Sec.
1.1400Z2(d)-1(e)(1) provided that, if an entity is not organized in one
of the 50 states, the District of Columbia, or the U.S. territories, it
is ineligible to be a QOF. Similarly, proposed Sec. 1.1400Z2(d)-
1(e)(2) provided that, if an entity is not organized in one of the 50
states, the District of Columbia, or the U.S. territories, an equity
interest in the entity is neither qualified opportunity zone stock nor
a qualified opportunity zone partnership interest. The Treasury
Department and the IRS have determined that, for purposes of both
proposed Sec. 1.1400Z2(d)-1(e)(1) and (2), an entity ``organized in''
one of the 50 states includes an entity organized under the law of a
Federally recognized Indian tribe if the entity's domicile is located
in one of the 50 states or the District of Columbia. Such entity
satisfies the requirement in section 1400Z-2(d)(2)(B)(i) and (C) that
qualified opportunity zone stock be stock in a domestic corporation,
and a qualified opportunity zone partnership interest be an interest in
a domestic partnership. See section 7701(a)(4) (defining the term
``domestic'').
The Treasury Department and the IRS appreciate the sovereignty of
Indian tribal governments. However, an entity eligible to be a QOF must
be subject to Federal income tax, including the penalty imposed by
section 1400Z-2(f)(1) where a QOF fails to meet the 90-percent
investment standard, regardless of the laws under which the entity is
established or organized. No individual who participated in the
Consultation disagreed with the position that an entity organized under
the law of an Indian tribal government is eligible to be a QOF, if the
entity's domicile is located in one of the 50 states or the District of
Columbia, but that such entity would be subject to Federal income tax.
Accordingly, the Treasury Department and IRS affirm these positions and
incorporate a reference to entities organized under the law of an
Indian tribal government in the definition of the term ``eligible
entity.''
3. QOF Decertification Rules and Federal Income Tax Consequences
In the October 2018 proposed regulations, the Treasury Department
and the IRS announced an intention to publish additional guidance
regarding QOF decertification. See 83 FR 54283 (September 29, 2018).
Comments were received on this topic, including comments requesting a
mechanism to permit a QOF to self-decertify, as well as comments
requesting guidance on the ability of the IRS to decertify a QOF. The
Treasury Department and the IRS have included in the final regulations
a provision to allow a QOF to self-decertify. This rule specifies that
self-decertification becomes effective at the beginning of the month
following the month specified by the taxpayer. The month specified by
the taxpayer must not be earlier than the month in which the taxpayer
files its self-decertification. For example, if a QOF wishes to
decertify on May, the earliest date that the QOF could be decertified
would be June 1st, provided that all applicable procedures were
followed.
The Treasury Department and the IRS are developing additional
instructions regarding QOF self-decertification including instructions
regarding the time, form, and manner of QOF self-decertification.
Additionally, the Treasury Department and the IRS continue to consider
the circumstances under which involuntary decertification of a QOF
would be warranted, and intend to propose guidance regarding those
circumstances. As noted in part III.A. of this Summary of Comments and
Explanation of Revisions, the final regulations include a rule
providing that the decertification of a QOF, whether voluntary or
involuntary, is an inclusion event for eligible taxpayers that hold a
qualifying investment in that QOF. See Sec. 1.1400Z2(b)-1(c)(15).
4. Entities That Are Not QOFs During the First Month of Their Taxable
Year
Under proposed Sec. 1.1400Z2(d)-1(a)(2), an entity may become a
QOF during a month that is not the first month of the QOF's taxable
year. Several commenters suggested that the Treasury Department and the
IRS provide additional detail and clarification regarding this proposed
rule. One commenter suggested that the final regulations permit QOFs to
select as the QOF's first six-month period testing date either (i) the
corresponding day of the month that is six months after the date of
certification, or (ii) the last day of a month that is not more than
six months after that certification date. Another commenter requested
confirmation that the term ``month'' means a period of time between the
same dates in successive calendar months in order to provide a
consistent measuring period. A commenter also asserted that the first
six-month period testing date should fall on the last day of that first
six-month period, even if that period ends later than the end of the
taxable year. The Treasury Department and the IRS will consider adding
clarifying language to the Instructions to the Form 8996, ``Qualified
Opportunity Fund,'' to address these comments.
[[Page 1898]]
5. Qualification of Existing Entities as QOFs or Qualified Opportunity
Zone Businesses
Section 1400Z-2(d)(1) provides, in relevant part, that a QOF is
``any investment vehicle which is organized as a corporation or a
partnership for the purpose of investing in qualified opportunity zone
property.'' Accordingly, the statute does not indicate whether such
partnership or corporation must be newly formed or could be a
preexisting entity. Likewise, neither the definition of the term
``qualified opportunity zone partnership interest'' nor the definition
of the term ``qualified opportunity zone stock'' explicitly states that
the partnership or corporation may be a preexisting entity. See section
1400Z-2(d)(2)(B)(i), (C). Several commenters have requested
confirmation as to whether existing entities could qualify as QOFs or
qualified opportunity zone businesses. In addition, one commenter
inquired as to whether preexisting entities could use an adjusted tax
basis for valuing assets purchased before 2018 to improve the ability
for such entities to qualify as QOFs.
The Treasury Department and the IRS have addressed these comments
in the final regulations. The final regulations confirm that
preexisting entities are not barred from qualifying as QOFs or
qualified opportunity zone businesses. Like newly formed partnerships
and corporations, however, the final regulations require preexisting
entities to satisfy all requirements applicable to QOFs under section
1400Z-2 and the section 1400Z-2 regulations.
To value assets acquired prior to 2018, the final regulations
provide that preexisting entities must use either (i) the applicable
financial statement valuation method set forth in Sec. 1.1400Z2(d)-
1(b)(3) of the final regulations, if the QOF has an applicable
financial statement within the meaning of Sec. 1.475(a)-4(h) (AFS), or
(ii) the alternative valuation method set forth in Sec. 1.1400Z2(d)-
1(b)(4) of the final regulations. Under the applicable financial
statement valuation method, the value of each asset that is owned or
leased by a QOF is the value of that asset as reported on the QOF's AFS
for the relevant reporting period (rather than the adjusted tax basis
of the asset). Under the alternative valuation method for purchased
assets, a QOF must use the QOF's unadjusted cost basis of the asset
under section 1012, section 1013 (with regards to inventory), or its
fair market value. See part V.B of this Summary of Comments and
Explanation of Revisions (providing additional discussion regarding the
valuation of assets for purposes of the 90-percent investment
standard).
6. Clarification Regarding Entities That May Appraise Property
A commenter requested clarification regarding which entities may
appraise property required to be valued for purposes of section 1400Z-
2(d), including for purposes of determining compliance with the 90-
percent investment standard. The Treasury Department and the IRS
decline to provide additional guidance on appraisals in the final
regulations. However, the Treasury Department and the IRS note that
entities that may appraise property for valuation purposes under
section 1400Z-2 and the section 1400Z-2 regulations are the same
entities that may appraise property for AFS purposes.
B. Valuation of Assets for Purposes of the 90-Percent Investment
Standard
1. Comments Regarding Determination Dates, Includable Assets, and Safe
Harbors
Section 1400Z-2(d)(1) provides that a QOF must maintain an average
of 90 percent of its assets in qualified opportunity zone property,
measured on both the last day of the first six-month period and on the
last day of the taxable year (that is, the 90-percent investment
standard). Section 1400Z-2(f)(1) provides that, if a QOF fails to
maintain the 90-percent investment standard, the QOF must pay a penalty
for each month that the QOF fails to meet that standard. Proposed Sec.
1.1400Z2(d)-1(b) provided that, to meet the requirements of the 90-
percent investment standard, a QOF may value its assets on a semiannual
basis using (i) the AFS valuation method, if the QOF has an AFS, or
(ii) the alternative valuation method.
The Treasury Department and the IRS received several comments
regarding the application of the 90-percent investment standard. For
example, a commenter requested confirmation that the 90-percent
investment standard is determined for each year of the QOF's existence.
Another commenter suggested that the final regulations make explicit
that the 90-percent investment standard will be considered to have been
fully satisfied for any year if the QOF meets the 90-percent investment
standard on at least two semiannual testing dates. The Treasury
Department and the IRS agree with the commenters that the proposed
rules should be clarified. As a result, the final regulations make
clear that a QOF may determine whether the 90-percent investment
standard is satisfied by valuing its assets on the semiannual testing
dates as provided by section 1400Z-2(d)(1).
Several commenters also suggested that the final regulations
provide greater clarity regarding the assets of a QOF taken into
account for determining whether the 90-percent investment standard is
satisfied. Commenters inquired as to whether selling commissions,
offering expenses, deferred gain, investments in intangible property,
and financial accounting depreciation are included or excluded in that
valuation calculation. The Treasury Department and the IRS confirm that
all of a QOF's assets cognizable for Federal income tax purposes are
required to be valued on each semiannual testing date in determining
whether the 90-percent investment standard is satisfied. However, mere
expenses arising from organizing a QOF or day-to-day operations with
regard thereto (such as selling commissions, organization expenses,
offering expenses, and similar expenses) do not result in any QOF asset
cognizable for Federal income tax purposes and therefore are not taken
into account to any extent in determining satisfaction of the 90-
percent investment standard.
Two commenters suggested that the Treasury Department and the IRS
should include in the final regulations a grace period for the QOF's
first year to meet the 90-percent investment standard. The Treasury
Department and the IRS have determined that the statutory text of
section 1400Z-2 does not permit adoption of the commenters' suggestion,
but rather requires that the 90-percent investment standard be met for
each taxable year of the QOF's existence. As a result, the final
regulations do not incorporate this suggestion.
In addition, a commenter recommended that, if a qualified
opportunity zone business qualifies on each relevant testing date, then
that entity should be treated also as qualifying during the periods
between each relevant testing date. The Treasury Department and the IRS
agree that if an entity satisfies all of the requirements of a
qualified opportunity zone business determined as of the end of the
entity's taxable year, the entity qualifies as a qualified opportunity
zone business for the entire taxable year of the entity. However, a QOF
and an entity whose equity the QOF owns may have different taxable
years, making it difficult to determine whether the entity qualifies as
a qualified opportunity zone business of the QOF on a semiannual basis
based
[[Page 1899]]
on the QOF's taxable year pursuant to section 1400Z-2(d)(1).
Accordingly, the Treasury Department and the IRS have provided a safe
harbor rule for determining on the two semiannual testing dates of a
QOF whether an entity is a qualified opportunity zone business for at
least 90 percent of the cumulative holding period beginning on the
first date the QOF's self-certification is effective and the end of the
entity's most recent taxable year ending on or before a semiannual
testing date of the QOF for purposes of the 90-percent investment
standard.
Finally, the Treasury Department and the IRS note that, if a QOF
operates a business through an entity that is transparent for Federal
income tax purposes, the transparent entity is not treated as a
qualified opportunity zone business in which the QOF has invested. Such
transparent entities include a qualified subchapter S subsidiary (as
defined in section 1361(b)(3)(B)), a grantor trust, or an entity
disregarded as separate from the QOF under Sec. 301.7701-3. For
Federal income tax purposes, the assets of the transparent entity are
treated as assets of the QOF, and therefore are taken into account for
determining whether the QOF satisfies the 90-percent investment
standard. The 70-percent tangible property standard for qualified
opportunity zone businesses set forth in Sec. 1.1400Z2(d)-1(d)(1)(i)
(70-percent tangible property standard) is not relevant with respect to
the assets directly held by a transparent entity owned by a QOF.
2. Ability of a QOF With an AFS To Use the Alternative Valuation Method
Proposed Sec. 1.1400Z2(d)-1(b)(2) 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-percent investment
standard. 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 AFS for the relevant reporting period. Proposed Sec.
1.1400Z2(d)-1(b)(2)(ii) clarified that a QOF may select the AFS
valuation to value an asset leased by the QOF only if the AFS of the
QOF (1) is prepared according to U.S. generally accepted accounting
principles (GAAP) and (2) requires an assignment of value to the lease
of the asset.
A commenter recommended that the final regulations allow a QOF to
elect to use unadjusted cost basis to value tangible assets (that is,
the alternative valuation method), regardless of whether the QOF has an
AFS. The Treasury Department and the IRS note that the proposed
regulations would accommodate the commenter's request without change.
Specifically, under the proposed regulations and these final
regulations, a QOF with an AFS may use the alternative valuation
method.
3. Alternative Valuation Method
a. Valuation of Intangible Assets With a Tax Basis Not Based on Cost
Under the alternative valuation method set forth in proposed Sec.
1.1400Z2(d)-1(b)(3), the value of each asset that is owned by a QOF is
the QOF's unadjusted cost basis of the asset under section 1012 or
section 1013 (with regard to inventory). One commenter considered the
application of the alternative valuation method to partnership
interests with a tax basis not based on cost. The commenter agreed that
the alternative valuation method generally provided an appropriate
valuation methodology with regard to property that has been acquired by
purchase, but questioned whether that method provided an appropriate
means to value a partnership interest.
The Treasury Department and the IRS agree that applying the
alternative valuation method to partnership interests, as well as other
intangible assets with a tax basis not based on cost, would be
inconsistent with the intent and purpose of the statute. As a result,
the final regulations reflect the commenter's observation and provide
that the alternative valuation method may be used to value only assets
owned by a QOF that are acquired by purchase or constructed for fair
market value. In such instances, the QOF's unadjusted cost basis of the
asset is determined under section 1012 or section 1013 (with regard to
inventory). The final regulations also provide that the value of each
asset owned by a QOF that is not purchased or constructed for fair
market value equals the asset's fair market value. A QOF determines
that fair market value on the last day of the first six-month period of
the taxable year and on the last day of the taxable year.
b. Valuation of Assets Leased by a QOF
Proposed Sec. 1.1400Z2(d)-1(b)(3)(iii)(A) provided that the value
of each asset that is leased by a QOF is equal to the present value of
the leased asset. The ``present value'' of such leased asset is (i)
equal to the sum of the present values of each payment under the lease
for the asset, and (ii) calculated at the time at which the QOF enters
into the lease for the asset. See proposed Sec. 1.1400Z2(d)-
1(b)(3)(iii)(C)(1), (2). Once calculated, that present value is used as
the value for the asset by the QOF for all testing dates for purposes
of the 90-percent investment standard. See proposed Sec. 1.1400Z2(d)-
1(b)(3)(iii)(C)(3). To determine the present value of the lease
payments, the proposed regulations provided that the discount rate is
the applicable Federal rate (AFR) under section 1274(d)(1). See
proposed Sec. 1.1400Z2(d)-1(b)(3)(iii)(B) (present value determined
under section 1274(d)(1) by substituting the term ``lease'' for ``debt
instrument''). The final regulations clarify the rules to be used to
determine the AFR for a particular lease, and provide that the short-
term AFR must be used. The Treasury Department and the IRS have
determined that use of the short-term AFR will provide a simple and
objective rule for taxpayers and practitioners.
Prior to the publication of the May 2019 proposed regulations, the
Treasury Department and the IRS received comments requesting that the
final regulations provide flexibility regarding the valuation of
leases. For example, one commenter requested that the final regulations
permit QOFs to use a type of basis other than the basis used for GAAP
(for example, cost basis under section 1012). This comment was
particularly relevant to Indian tribal governments, which typically
rely upon leases. Another commenter had suggested that QOFs and
qualified opportunity zone businesses should be able to elect to use
Federal income tax basis to determine the value of assets for these
purposes. The commenter reasoned that the value of the operating lease,
as a non-qualifying asset, would be $0 and would not affect the 90-
percent investment standard.
The Treasury Department and the IRS have determined that the
alternative valuation method for leased assets, as set forth in
proposed Sec. 1.1400Z2(d)-1(b)(3), addresses the concerns raised by
these commenters. In addition, the Treasury Department and the IRS note
that no participant of the Consultation requested additional guidance
regarding these issues. Therefore, proposed Sec. 1.1400Z2(d)-1(b)(3)
has not been modified as a result of those comments.
With regard to the 90-percent investment standard, a commenter
suggested that the Treasury Department and the IRS consider a valuation
method for leases that are negotiated at arms-length under section 482.
This valuation method would value the lease (i) as having a value of $0
regardless of whether the QOF has an AFS, or (ii) at the unadjusted
cost basis of the lease, similar to purchased property. Another
commenter requested that the value of leased property be excluded from
the
[[Page 1900]]
numerator and denominator of the fraction-based test underlying the 90-
percent investment standard, while the value of substantial
improvements to leased property should be included. Another commenter
suggested that leased property should be valued at the lease's fair
market value.
The Treasury Department and the IRS have determined that the
proposed regulations provided a comprehensive method to value leased
property to satisfy the 90-percent investment standard. While the
commenters' recommended rules would provide value in certain instances,
the Treasury Department and the IRS have concluded that such rules
would inject significant complexity into the final regulations that
would outweigh any potential resulting benefits. As a result, the final
regulations retain the method provided in the proposed regulations with
some clarifications. For example, the term of a lease that is being
valued for purposes of the 90-percent investment standard includes
periods during which the lessee may extend the lease at a pre-defined
rent. The terms of a pre-defined market rate rent must follow the
criteria set forth under section 482 with a rebuttable presumption that
terms of a lease between unrelated parties is market rate.
4. Option To Disregard Recently Contributed Property to a QOF for
Purposes of the 90-Percent Investment Standard
Under proposed Sec. 1.1400Z2(d)-1(b)(4), a QOF may choose to
determine compliance with the 90-percent investment standard by
excluding certain eligible property from both the numerator and
denominator of the fraction-based test underlying that standard. Such
excluded amount of property must satisfy each of the following
criteria: (1) The amount of contributed property was received by the
QOF partnership or the QOF corporation solely in exchange for an
interest in the partnership or stock in the corporation; (2) that
contribution or exchange occurred not more than six months before the
date of the test from which the amount of property is excluded; and (3)
between the date of that contribution or exchange and the date of the
underlying asset test, the amount of property was held continuously in
cash, cash equivalents, or debt instruments with a term of 18 months or
less. Finally, proposed Sec. 1.1400Z2(d)-1(b)(4) provided that a QOF
need not be consistent from one semiannual test to another in whether
it avails itself of this option.
While commenters largely agreed with the approach set forth in
proposed Sec. 1.1400Z2(d)-1(b)(4), many commenters suggested
significant revisions. For instance, commenters suggested that the
permitted six-month period (that is, the period between the date of
contribution or exchange and the testing date) should be extended to a
12-month period, starting on the date of the contribution or exchange,
to facilitate increased investments into beneficial qualified
opportunity zone property. Another commenter recommended that the final
regulations provide QOFs with a 31-month period to deploy capital into
a qualified opportunity zone property, and thereby provide QOFs with a
rule similar to the 31-month working capital safe harbor (as defined in
part V.O of this Summary of Comments and Explanation of Revisions) for
qualified opportunity zone businesses.
The Treasury Department and the IRS have considered each of these
recommendations and have concluded that their adoption would achieve
results inconsistent with the purposes of section 1400Z-2. In
particular, the Treasury Department and the IRS have determined that
the commenters' recommended rules would permit the holding of capital
for extended periods of time without deployment into qualifying
investments, and ultimately into QOZs. A delay of such capital
investment would reduce, rather than increase, investments in QOZs and
thereby delay the type of economic growth for which section 1400Z-2 was
enacted to achieve.
One commenter suggested that a QOF should control, by election, the
decision to disregard recently contributed property. Under the
commenter's approach, a QOF could either disregard the recently
contributed property, or upon an election, include the property in both
the numerator and the denominator of the fraction-based test underlying
the 90-percent investment standard. However, if the QOF elects to
disregard the property, the commenter argued that both the numerator
and the denominator of the fraction-based test would be zero, resulting
in an undefined mathematical result. In the alternative, the commenter
suggested that the Treasury Department and the IRS should treat
recently contributed property as qualified opportunity zone property
only if, and to the extent that, such property is invested in qualified
opportunity zone property before the next QOF testing date following
that contribution.
The Treasury Department and the IRS have determined that the option
to disregard recently contributed property provides a sufficiently
expansive rule set to address the concerns raised by the commenter,
namely that by excluding recently contributed property from both the
numerator and denominator, the resulting fraction may be undefined. The
commenter's solution to allow a QOF to elect to disregard property,
although potentially helpful to taxpayers in certain cases, would
significantly increase the complexity of the mechanics for determining
compliance with the 90-percent investment standard. Moreover, the
commenter presumes that a QOF would have no other property to include
in the denominator, which would allow a mathematically correct result.
Further, the alternative suggested by the commenter is similar to the
proposed rule and would result in the same outcome. Accordingly, the
final regulations do not incorporate the commenter's suggestions.
Because several commenters requested flexibility in timing of
investments, the final regulations provide that a QOF has until the
fifth business day after the contribution of the property to exchange
such property into cash, cash equivalents, or debt instruments with a
term of 18 months or less.
In addition, one commenter suggested that, with regard to periods
during which the previously described contributed property is
disregarded, the Treasury Department and the IRS should require that
the capital be held in mission-driven institutions such as Community
Development Financial Institutions (CDFIs), low-income credit unions,
or minority-owned depository institutions. While the Treasury
Department and the IRS appreciate the policy objectives underlying this
recommendation, section 1400Z-2 does not provide sufficient authority
to incorporate this recommendation into the final regulations.
5. Wind-Down Period Safe Harbor for Applying 90-Percent Investment
Standard to Dissolving QOFs
For purposes of applying the 90-percent investment standard, two
commenters requested that the final regulations provide a wind-down
safe harbor period that would precede the start of the QOF's
dissolution phase. The commenters reasoned that during a QOF wind-down
period which the commenters suggested could last for up to two years,
QOFs would hold larger amounts of non-qualifying property because the
dissolving QOF typically would dispose of business assets (that is,
qualified opportunity zone business property) in exchange for cash or
other non-qualifying property. The
[[Page 1901]]
commenter contended that the policy rationale for a wind-down period
safe harbor for QOF dissolutions would parallel the policy rationale
for proposed safe harbor provisions that facilitate the development and
operation by QOFs of start-up businesses.
The Treasury Department and the IRS acknowledge the policy
arguments set forth by the commenter. However, the final regulations do
not adopt the commenter's recommendation. In particular, the Treasury
Department and the IRS note that section 1400Z-2 was enacted to
encourage the development of operating businesses in QOZs and thereby
increase the economic development of the communities located in those
designated census tracts. Safe harbors provided by the proposed and
final regulations to facilitate the success of start-up businesses in
QOZs advances the achievement of those purposes. A QOF wind-down safe
harbor for purposes of the 90-percent investment standard, however,
potentially would encourage the opposite effect-that is, QOF
dissolutions and disinvestment from QOZs.
C. Consideration of Synthetic Equity as Qualified Opportunity Zone
Stock or Partnership Interest
Under proposed Sec. 1.1400Z2(d)-1(c), qualified opportunity zone
stock and a qualified opportunity zone partnership interest generally
must satisfy three requirements. First, such stock or partnership
interest must be stock in a corporation or an interest in a partnership
that is acquired by a QOF after December 31, 2017 from the corporation
or the partnership solely in exchange for cash. See proposed Sec.
1.1400Z2(d)-1(c)(2)(i)(A) (regarding qualified opportunity zone stock),
(c)(3)(i) (regarding qualified opportunity zone partnership interests).
Second, at the time of acquisition, the corporation whose stock was
acquired, or the partnership whose interest was acquired, must either
be a qualified opportunity zone business, or in the process of becoming
a qualified opportunity zone business. See proposed Sec. 1.1400Z2(d)-
1(c)(2)(i)(B) (regarding qualified opportunity zone stock), (c)(3)(ii)
(regarding qualified opportunity zone partnership interests). Third,
during substantially all of the QOF's holding period for the stock or
partnership interest, the corporation or partnership must qualify as a
qualified opportunity zone business. See proposed Sec. 1.1400Z2(d)-
1(c)(2)(i)(C) (regarding qualified opportunity zone stock), (c)(3)(iii)
(regarding qualified opportunity zone partnership interests).
The Treasury Department and the IRS received comments recommending
that the final regulations include in the definition of the term
``qualified opportunity zone stock'' any interest constituting
synthetic equity under section 409(p)(6)(C) or an employee stock option
plan. The synthetic equity definitions recommended by the commenters
include an expansive range of interests, some of which would require
potentially complex rules to ensure their proper application in the
section 1400Z-2 regulations. The Treasury Department and the IRS
continue to consider synthetic equity for purposes of the definitions
of ``qualified opportunity zone stock'' and ``qualified opportunity
zone partnership interest,'' but have determined that specific rules to
address synthetic equity would add inappropriate complexity to the
final regulations. As a result, the final regulations do not
incorporate the commenters' recommendation.
D. Qualified Opportunity Zone Business Property Purchased by QOF or
Qualified Opportunity Zone Business
Under proposed Sec. 1.1400Z2(d)-1(c)(4)(i)(A) and (d)(2)(i)(A),
property that is purchased (as defined in section 179(d)(2)) by a QOF
or a qualified opportunity zone business from an unrelated party (as
defined in section 1400Z-2(e)(2)) qualifies as ``qualified opportunity
zone business property,'' provided that the property satisfies all
other requirements under section 1400Z-2(d)(2)(D)(i).
1. Qualification of Property Constructed by an Eligible Entity
The Treasury Department and the IRS received several comments
requesting that the final regulations expand the definition of the term
``qualified opportunity zone business property'' to include an eligible
entity's self-constructed property. One commenter recommended that the
final regulations treat construction costs of such self-constructed
property as part of the property's purchase price. To determine the
acquisition date for each testing period, one commenter suggested that
the final regulations utilize the approach provided under former
section 168(k)(2) and Sec. 1.168(k)-1(b)(4)(iii). Former section
168(k)(2)E)(i) and Sec. 1.168(k)-1(b)(4)(iii) provided that if a
taxpayer manufactures, constructs or produces property for use in its
trade or business (or for its production of income), the property will
be treated as acquired when the taxpayer begins manufacturing,
constructing or producing the property. Under Sec. 1.168(k)-
1(b)(4)(iii), manufacturing, construction or production of the property
begins when physical work of a significant nature begins. Another
commenter suggested that, if an eligible entity's self-constructed
property is not to be included as purchased property, (i) the
incorporation of non-qualifying property into new construction should
not taint the new property, and (ii) that new property should be
treated as a separate asset under section 1400Z-2(d)(2)(D)(i)(III).
The Treasury Department and the IRS have determined that tangible
property is not disqualified from constituting qualified opportunity
zone business property solely because the property is manufactured,
constructed, or produced, rather than purchased, by the eligible
entity. However, to qualify as qualified opportunity zone business
property, such tangible property must be manufactured, constructed, or
produced by the eligible entity with the intent to use the property in
the trade or business of the eligible entity in a QOZ. In addition, the
materials and supplies used for the construction of the qualified
opportunity zone business property must be qualified opportunity zone
business property. Self-constructed property must otherwise meet the
requirements of section 1400Z-2(d)(2)(D)(i).
For purposes of the 90-percent investment standard and the 70-
percent tangible property standard, an eligible entity must determine
the date on which such self-constructed property will be treated as
acquired. The Treasury Department and the IRS agree with the prior
commenter that applying a standard similar to former section 168 and
the regulations thereunder make logical sense. Thus, the final
regulations provide that, for purposes of the 90-percent investment
standard and the 70-percent tangible property standard, self-
constructed property will be treated as acquired on the date physical
work of a significant nature begins. Physical work of a significant
nature does not include preliminary activities such as planning or
designing, securing financing, exploring or researching, and will
depend on a facts and circumstances analysis. The final regulations
also provide a safe harbor to determine when physical work of a
significant nature begins. An eligible entity may choose the date on
which the eligible entity paid or incurs more than 10 percent of the
total cost of the property, excluding the cost of any land and
preliminary activities such as planning and designing, securing
financing, exploring or researching.
[[Page 1902]]
2. Qualification of Property Contributed to a QOF
Several commenters suggested that property contributed to a QOF,
and used in the QOF's trade or business, should be treated as qualified
opportunity zone business property. Under section 1400Z-
2(d)(2)(D)(i)(I), to qualify as qualified opportunity zone business
property, the property must be purchased from an unrelated party.
Property contributed by an entity to a QOF, while potentially used in
the QOF's trade or business, will not be considered qualified
opportunity zone business property because the QOF has not purchased,
leased, or self-constructed the contributed property. Because the
commenters' suggestion would not be consistent with the text of section
1400Z-2(d)(2)(D)(i)(I), the final regulations do not adopt it.
3. Qualification of Property Purchased Before Statutory Deadline
A commenter asserted that, by requiring the purchase of property to
have occurred after December 31, 2017, the proposed regulations will
irrationally exclude owners of property purchased on or before that
date from the benefits of section 1400Z-2. Another commenter raised
similar concerns, and requested that the final regulations treat as
qualified opportunity zone business property otherwise qualifying
property acquired by a QOF or qualified opportunity zone business prior
to the publication date of the October 2018 proposed regulations. While
the Treasury Department and the IRS are sympathetic to the concerns
expressed by these commenters, the text of section 1400Z-2(d) does not
provide authority to allow property purchased on or before December 31,
2017, to be treated as qualified opportunity zone business property.
One commenter requested confirmation that contractual rights to
real property (including easements, land leases, timber deeds,
agricultural leases, and water rights) qualify as an acquisition by
purchase, and therefore could qualify as qualified opportunity zone
business property. The Treasury Department and the IRS acknowledge the
common usage of these types of arrangements, particularly in rural
industries. While the text of section 1400Z-2 requires qualified
opportunity zone business property to be purchased or leased, the
Treasury Department and the IRS note that contractual rights may
qualify as leases under the rules discussed in part V.E of this Summary
of Comments and Explanation of Revisions. If such contractual rights do
not meet the requirements of either purchased or leased property,
however, the final regulations provide that the contractual rights will
not qualify as qualified opportunity zone property.
4. Qualification of Property Based on Factors Not Consistent With
Section 1400Z-2
For purposes of determining whether property qualifies as qualified
opportunity zone business property, the text of section 1400Z-
2(d)(2)(D)(i) sets forth requirements regarding the property's
acquisition, location, and use. The Treasury Department and the IRS
have received comments requesting that the final regulations provide
exceptions to those statutory requirements. For example, a commenter
requested that the final regulations provide rules that focus on the
use of the subject property at the time the property is acquired, but
exclude any consideration regarding the location of the property.
Similarly, another commenter suggested that the final regulations
should provide an exception to allow residents of a QOZ to treat
previously purchased property as qualified opportunity zone business
property. Commenters also have suggested that property owned by
residents of a QOZ, as well as land, should be treated as completely
exempt from the post-2017 acquisition requirement.
The Treasury Department and the IRS appreciate the commenters'
recommendations. However, each of these suggested rules would conflict
with the statutorily imposed acquisition, location, and use
requirements set forth in section 1400Z-2(d)(2)(D)(i). As a result, the
final regulations do not adopt the commenters' recommendations.
5. Qualification of Property Purchased From Related Persons
Section 1400Z-2(d)(2)(D)(iii) limits the purchase of qualified
opportunity zone property to purchases from parties who are not related
parties, as that term is defined in section 1400Z-2(e)(2). Proposed
Sec. 1.1400Z2(d)-1(c)(4)(i)(A) and (d)(2)(i)(A) provide that property
must be acquired by a QOF or qualified opportunity zone business from a
person that is not related under section 1400Z-2(e)(2). Under that
statutory provision, persons are related to each other for purposes of
section 1400Z-2 if such persons are described in section 267(b) or
707(b)(1), determined by substituting ``20 percent'' for ``50 percent''
each place the phrase ``50 percent'' occurs in those sections. See
section 1400Z-2(e)(2).
The Treasury Department and the IRS received numerous comments
requesting that the final regulations treat property purchased from a
related person (under section 1400Z-2(e)(2)) as qualified opportunity
zone business property. To prevent potential abuse that could arise
from such related-party transactions, one commenter suggested that the
final regulations should require purchases between related parties to
be negotiated at arm's length. Other commenters recommended that the
final regulations allow otherwise qualifying purchases by a QOF or
qualified opportunity zone business to be carried out with (i)
businesses or partnerships that owned property located in a QOZ prior
to the QOZ's designation, and (ii) residents of a QOZ prior to such
time. The Treasury Department and the IRS note that the text of section
1400Z-2, as described above, does not permit property purchased from a
related party to qualify as qualified opportunity zone property, and
therefore decline to adopt these comments.
Another commenter requested that the final regulations provide
clarification as to whether any sponsorship arrangement with a sponsor,
who is a QOF investor, would establish relatedness included in the
definition of ``related person'' under section 1400Z-2(e)(2). The
Treasury Department and the IRS have determined that (i) specific rules
to address sponsorship agreements would introduce significant,
additional complexity into the final regulations, and (ii) the proposed
regulations provide adequate guidance to address the commenter's
request. As a result, the final regulations do not incorporate specific
rules to address sponsorship agreements.
The final regulations, however, have added rules to address the
qualification of property purchased in certain ``sponsor-like''
arrangements as qualified opportunity zone business property. With
regard to these arrangements, the final regulations provide that, in
the case of real property that is purchased by a QOF or qualified
opportunity zone business, if at the time of the purchase there was a
plan, intent, or expectation for the real property to be repurchased by
the seller of the real property for an amount of consideration other
than the fair market value of the real property, the purchased real
property is not qualified opportunity zone business property. Under
this rule, the ``fair market value of the real property'' refers to the
fair market value of that property at the time of the repurchase by the
seller.
[[Page 1903]]
E. Qualified Opportunity Zone Business Property Leased by QOF or
Qualified Opportunity Zone Business
Proposed Sec. 1.1400Z2(d)-1(c)(4)(i)(B) and (d)(2)(i)(B) provided
that a QOF or qualified opportunity zone business may treat leased
tangible property as qualified opportunity zone business property for
purposes of satisfying the 90-percent investment standard and the 70-
percent tangible property standard. To qualify, the leased tangible
property must satisfy the following two general requirements: First,
analogous to owned tangible property, leased tangible property must be
acquired under a lease entered into after December 31, 2017. Second,
and also similar to owned tangible property, substantially all of the
use of the leased tangible property must be located within a QOZ during
substantially all of the period for which the business leases the
property.
1. General Comments Requesting Additional Rules and Clarifications
The Treasury Department and the IRS received several comments
agreeing with the rules addressing leased tangible property set forth
in the May 2019 proposed regulations. However, many commenters
requested that the Treasury Department and the IRS further clarify
whether certain types of leased property qualify as qualified
opportunity zone business property. Similarly, other commenters
recommended that the final regulations provide additional detailed
rules and examples, and include definitions for leases, lease-like
arrangements, and licenses for purposes of determining whether such
instruments qualify as qualified opportunity zone property.
As described further in this part V.E of the Summary of Comments
and Explanation of Revisions, the Treasury Department and the IRS have
provided additional details and examples in the final regulations to
respond to the commenters' concerns and recommendations. For example,
the final regulations exempt State and local governments, as well as
Indian tribal governments, from the market-rate requirement for leased
tangible property that otherwise must be satisfied to qualify as
qualified opportunity zone business property. In addition, the final
regulations provide rules that permit certain short-term leased
property to lessors located outside of a QOZ to be counted as qualified
opportunity zone business property for purposes of satisfying the 70-
percent use test. The final regulations also contain additional
examples to clarify the application of the rules regarding leased
tangible property.
2. Qualification of Tangible Property Subject to an Existing Lease
Section 1400Z-2(d)(2)(D)(i)(I) requires tangible property to be
purchased after December 31, 2017, which the May 2019 proposed
regulations followed in requiring that leased tangible property be
acquired under a lease entered into after December 31, 2017. One
commenter requested that the final regulations treat an existing lease
of property the same as a new lease of property for purposes of
determining whether the property subject to the existing lease is
qualified opportunity zone business property. The Treasury Department
and the IRS note that the leased tangible property rules were included
in the May 2019 proposed regulations to provide parity among diverse
business models (for example, parity between business models that
utilize purchased tangible property and those that utilize leased
tangible property). To achieve that parity, the Treasury Department and
the IRS have determined that in general acquisitions of tangible
property by purchase or lease should be treated consistently. In
addition, the Treasury Department and the IRS note that section 1400Z-2
requires the acquisition of such property to occur after December 31,
2017. Therefore, the final regulations confirm that property subject to
an existing lease will not constitute qualified opportunity zone
business property unless the lease was entered into on or after
December 31, 2017.
3. Requirement That the Terms of Lease Must Be Market Rate Between
Parties
Proposed Sec. 1.1400Z2(d)-1(c)(4)(i)(B)(2) and (d)(2)(i)(B)(2)
provided that, to qualify as qualified opportunity zone business
property, the terms of a lease must be market rate at the time at which
the lease was entered into (market-rate lease requirement). For this
purpose, whether a lease is market rate (that is, whether the terms of
the lease reflect common, arms-length market pricing in the locale that
includes the QOZ) is determined in accordance with the regulations
under section 482. This limitation operates to ensure that all of the
terms of the lease are market rate. The proposed regulations applied
the market-rate lease requirement to leases between unrelated parties
and related parties.
The Treasury Department and the IRS received multiple comments
regarding the market-rate lease requirement. For example, many
commenters requested that the final regulations not apply the market-
rate lease requirement to leases between unrelated parties. Rather,
these commenters recommended that the final regulations provide a
presumption that such unrelated-party leases are arms-length. The
Treasury Department and the IRS agree with the commenters'
recommendation. Accordingly, the final regulations provide that there
will be a rebuttable presumption that, with regard to leases between
unrelated parties, the terms of the lease were market rate (that is,
the lease satisfies the market-rate lease requirement).
In addition, the Treasury Department and the IRS received several
comments requesting that the final regulations exempt from the market-
rate lease requirement leases between an unrelated party and a state or
local government. Commenters explained that such leases are subject to
numerous requirements and other special rules. The Treasury Department
and the IRS agree with the commenters, and have determined that, based
on the same rationale, Indian tribal governments likewise should be
exempt from the market-rate lease requirement. As a result, the final
regulations provide that, for purposes of satisfying the market-rate
lease requirement, 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.
Another commenter suggested that the final regulations replace the
market-rate lease requirement with a requirement that a subject lease
must have reasonable terms. This commenter, however, acknowledged that
a ``reasonableness'' standard likely would inject additional
uncertainty into the final regulations. The Treasury Department and the
IRS appreciate the commenter's suggestion and agree that a
``reasonableness'' standard would pose additional uncertainty for
taxpayers in determining whether the terms of a subject lease are
reasonable. Moreover, the Treasury Department and the IRS believe that
such a standard would be too complex to administer. As a result, the
final regulations do not adopt the commenter's suggestion.
4. Plan, Intent, or Expectation of QOF or Qualified Opportunity Zone
Business To Purchase Leased Real Property
Proposed Sec. 1.1400Z2(d)-1(c)(4)(i)(E) and (d)(2)(i)(E) provided
an anti-abuse rule to prevent the use of leases to circumvent the
substantial improvement requirement for purchases by QOFs or qualified
opportunity zone businesses of real property (other than unimproved
land). If, at the time a QOF or qualified
[[Page 1904]]
opportunity zone business enters into a lease for real property (other
than unimproved land), there was a plan, intent, or expectation for the
QOF or qualified opportunity zone business to purchase the real
property for an amount of consideration other than the fair market
value of the land (as determined at the time of the purchase without
regard to any prior lease payments) the leased real property does not
qualify as qualified opportunity zone business property at any time.
A commenter suggested that the Treasury Department and the IRS
should consider eliminating from this anti-abuse rule the reference to
a plan, intent, or expectation to purchase the leased property. Rather,
the commenter asserted that, even if the QOF or qualified opportunity
zone business had such ``plan, intent, or expectation,'' the anti-abuse
rule should not be applied if there were a fixed purchase price option,
consistent with general Federal income tax principles governing the
distinction between a lease and a sale, with a strike price not less
than a specified amount of the fair market value at the time the option
is entered into.
The Treasury Department and the IRS have considered the commenter's
suggestion and have determined that such a rule might enable QOFs and
qualified opportunity zone businesses to circumvent the substantial
improvement requirement because leased property from an unrelated party
is not required to be substantially improved. Thus, the final
regulations do not reflect this suggestion.
F. Treatment of Inventory for Purposes of Determining Substantial Use
in QOZ
Under section 1400Z-2(d)(2)(D)(i)(III), the term ``qualified
opportunity zone business property'' refers to tangible property used
in a trade or business of a QOF or qualified opportunity zone business
if, during substantially all of the holding period of the QOF or
qualified opportunity zone business for such property, substantially
all of the use of such property was in a QOZ. Prior to the publication
of the May 2019 proposed regulations, commenters inquired how inventory
would be treated for purposes of determining whether substantially all
of the tangible property is used in the QOZ. To address those
questions, the May 2019 proposed regulations provided a safe harbor
that inventory would not fail to qualify as qualified opportunity zone
business property simply because the inventory is in transit outside
the QOZ due to transport (i) from a vendor to a facility of the trade
or business that is in a QOZ, or (ii) from a facility of the trade or
business that is in a QOZ to customers outside the QOZ (inventory
transit safe harbor). See proposed Sec. 1.1400Z2(d)-1(c)(4)(iii)
(setting forth the inventory transit safe harbor).
1. Inventory as Qualified Opportunity Zone Business Property and
Application of 90-Percent Investment Standard and 70-Percent Tangible
Property Standard
As part of the May 2019 proposed regulations, the Treasury
Department and the IRS requested comments as to whether inventory,
including raw materials, should be excluded from both the numerator and
denominator of the fraction used to determine compliance with the 90-
percent investment standard and the 70-percent tangible property
standard. In response, some commenters recommended that the final
regulations exclude inventory from the 90-percent investment standard
and the 70-percent tangible property standard. These commenters based
that recommendation upon their conclusion that inventory should never
be treated as qualified opportunity zone business property because such
inventory (i) is a transitory asset, (ii) does not add value to the
QOZ, and (iii) does not meet the requirements for either the original
use or substantial improvement requirement. Other commenters agreed
that inventory should be excluded from the 70-percent tangible property
standard, emphasizing that any requirement that taxpayers measure
inventory would be significantly burdensome.
Several additional commenters, however, recommended that the final
regulations treat inventory, in a limited manner, as qualified
opportunity zone business property. These commenters suggested that
taxpayers should be allowed to elect on an annual basis whether to
exclude inventory from the numerator and denominator for purposes of
the 90-percent investment standard and the 70-percent tangible property
standard. Another commenter contended that inventory should be limited
to a certain percentage of total qualified opportunity zone property,
suggesting that 15 or 20 percent of such total property would provide a
reasonable maximum.
The Treasury Department and the IRS also received numerous requests
that the final regulations provide additional detail and clarity
regarding the general application of section 1400Z-2 to inventory. Like
the commenters described previously, these commenters noted that the
proposed regulations did not specify whether inventory is properly
includable in the numerator of the 70-percent tangible property
standard or the 90-percent investment standard. These commenters also
highlighted that the proposed regulations did not clarify whether
inventory must be original use property or substantially improved
property.
The Treasury Department and the IRS acknowledge the concerns raised
by these commenters and agree that additional rules regarding the
treatment of inventory would be appropriate. As a result, the final
regulations provide that, for purposes of determining compliance with
the 90-percent investment standard and the 70-percent tangible property
standard, a QOF or qualified opportunity zone business 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. The final regulations also provide that, once a QOF or
qualified opportunity zone business makes such choice, the QOF or
qualified opportunity zone business must apply that choice consistently
with respect to all semiannual tests during the holding period in which
the QOF, or the qualified opportunity zone business of the QOF, holds
the inventory. The Treasury Department and the IRS have determined that
these rules will provide appropriate flexibility for QOFs and qualified
opportunity zone businesses, as well as certainty regarding the
application of the 90-percent investment standard and the 70-percent
tangible property standard.
2. Comments Regarding Application of 90-Percent Investment Standard to
Inventory in Transit
Commenters also expressed concern that inventory in transit on the
last day of the taxable year of a QOF would be counted against the QOF
when determining whether the QOF has met the 90-percent investment
standard. Several commenters recommended that inventory in transit,
either from the vendor or to the ultimate customer, be excluded from
the numerator and denominator for purposes of the 90-percent investment
standard, but should qualify for the 70-percent use test. Another
commenter suggested that the location of inventory in transit should be
taken into account in determining whether the inventory is qualified
opportunity zone business property. One commenter generally agreed with
the approach of the May 2019 proposed regulations with regard to
inventory in transit, but requested clarification that (i) the distance
traveled during the course of the transit, or (ii) the manner of the
transit, does not affect application of the inventory transit safe
harbor. The
[[Page 1905]]
commenter also requested clarification as to whether the inventory
transit safe harbor covers instances in which the inventory is
warehoused briefly (that is, for less than 30 days) in a location
outside of the QOZ while in the process of transit.
The Treasury Department and the IRS appreciate the commenters'
concerns regarding the manner by which transported inventory is treated
for purposes of applying the 90-percent investment standard. To provide
certainty for QOFs as well as qualified opportunity zone businesses on
this matter, the final regulations set forth a rule that provides that
(i) the distance traveled in the course of the transit, and (ii) the
fact that the inventory is briefly warehoused while in transit, does
not affect the application of the inventory transit safe harbor. The
Treasury Department and the IRS intend for these provisions to
complement the inventory transit safe harbor, which the final
regulations adopt in full.
G. Definition of ``Substantially All'' for Purposes of Qualified
Opportunity Zone Property and Qualified Opportunity Zone Business
Determinations
The definitions of the terms ``qualified opportunity zone
property'' and ``qualified opportunity zone business'' incorporate
several ``substantially all'' requirements. For example, with regard to
(1) qualified opportunity zone stock, (2) qualified opportunity zone
partnership interests, and (3) qualified opportunity zone business
property, to qualify as qualified opportunity zone property, the
corporation or partnership must have qualified as a qualified
opportunity zone business, and the qualified opportunity zone business
property must have been used in a QOZ, during ``substantially all'' of
the QOF's holding period of such stock, interest, or business, as
appropriate. See section 1400Z-2(d)(2)(B)(i)(III) (regarding qualified
opportunity zone stock); section 1400Z-2(d)(2)(C)(iii) (regarding
qualified opportunity zone partnership interests); section 1400Z-
2(d)(2)(D)(i)(III) (regarding qualified opportunity zone businesses).
In this holding period context, the May 2019 proposed regulations
defined ``substantially all'' of a QOF's holding period as 90 percent
of the total holding period of the QOF. See proposed Sec. 1.1400Z2(d)-
1(c)(5).
In addition to QOF holding period requirements, the term
``substantially all'' appears in a ``use'' context. Specifically,
tangible property used in a trade or business of a QOF or in a
qualified opportunity zone business will not qualify as qualified
opportunity zone business property unless ``substantially all'' of the
use of such tangible property was within the geographic boundaries of a
QOZ. See section 1400Z-2(d)(2)(D)(i)(III), (3)(A)(i). In this ``use''
context, the May 2019 proposed regulations defined ``substantially
all'' of the use of tangible property in a QOZ by a trade or business
of a QOF, or by a qualified opportunity zone business, as 70 percent of
the total use of such tangible property. See proposed Sec.
1.1400Z2(d)-1(c)(6), (d)(2)(iv).
Lastly, the term ``substantially all'' appears in the context of
the portion of a business's tangible property that must be qualified
opportunity zone business property in order for the business to qualify
as a qualified opportunity zone business. Specifically, a trade or
business qualifies as a qualified opportunity zone business only if
(among the satisfaction of other requirements) ``substantially all'' of
the tangible property owned or leased by the taxpayer for the trade or
business is qualified opportunity zone business property. See section
1400Z-2(d)(3)(A)(i). For this determination of whether the trade or
business owns or leases a sufficient amount of qualified opportunity
zone business property, the October 2018 proposed regulations defined
``substantially all'' as an amount equal to 70 percent of the total
amount of tangible property owned or leased by the trade or business
(70-percent tangible property standard). See proposed Sec.
1.1400Z2(d)-1(d)(3).
As discussed in the respective preambles to the October 2018 and
May 2019 proposed regulations, the Treasury Department and the IRS
provided a higher threshold in the holding period context to preserve
the integrity of the statute and ensure that investors focus their
investments within the geographic borders of QOZs. Therefore, the term
``substantially all,'' as used in the holding period context, was
defined in the proposed regulations as 90 percent of the QOF's total
holding period. The Treasury Department and the IRS determined that a
percentage threshold higher than, for example 70 percent, was warranted
because taxpayers can more easily control and determine the period for
which they hold property. In addition, given the lower 70-percent
thresholds for testing both the use of tangible property in the QOZ and
the amount of owned and leased tangible property of a qualified
opportunity zone business that must be qualified opportunity zone
business property, applying a 70-percent threshold in the holding
period context could result in an unacceptably low percentage of a
qualified opportunity zone business's tangible property being used in a
QOZ.
The Treasury Department and the IRS, however, recognized that the
operations of certain types of businesses may extend beyond the census
tract boundaries that define QOZs. Accordingly, the ``substantially
all'' thresholds provided by the proposed regulations with regard to
required amounts and use of tangible property owned or leased by a
trade or business were set to a 70-percent standard. The Treasury
Department and the IRS determined that a 70-percent standard would
appropriately tie the ability of investors in QOFs to receive
preferential capital gains treatment to a consequential amount of
tangible property being used by the underlying business within a QOZ.
Importantly, the Treasury Department and the IRS also determined that a
70-percent standard would provide businesses with an appropriate degree
of flexibility to conduct their day-to-day operations, and therefore
avoid significantly distorting or otherwise limiting the introduction
of new businesses and investment in QOZs.
1. Consideration of Uniform 90-Percent ``Substantially All'' Standard
Commenters have suggested that the term ``substantially all''
should be interpreted as requiring a 90-percent standard with regard to
each instance in which the term is used in section 1400Z-2. As
described previously, the Treasury Department and the IRS have
determined that the policy considerations underlying each use of the
term ``substantially all'' are not uniform, and therefore a uniform
standard would fail to effectuate such policies in all cases. For
example, the Treasury Department and the IRS established the 70-percent
tangible property standard and 70-percent use test to provide
``substantially all'' requirements for qualified opportunity zone
businesses that, while substantial, would ensure that a diverse
spectrum of businesses would be able to operate in QOZs. However, the
Treasury Department and the IRS selected a higher 90-percent threshold
regarding holding periods of QOFs (under the 90-percent investment
standard) to encourage long-term direct or indirect investments in
those qualified opportunity zone businesses. In addition, due to the
compound application of the 90-percent threshold, the 70-percent
tangible property standard, and the 70-percent use test, the Treasury
Department and the IRS sought to ensure that each percentage
[[Page 1906]]
requirement, when taken together, would remain significant.
Another commenter that advocated for a uniform 90-percent standard
specifically contended that the 70-percent use test presented an
inappropriately low threshold to ensure that acceptable amounts of new
economic activity are introduced in QOZs. The Treasury Department and
the IRS appreciate the commenter's perspective, but have determined
that a 70-percent standard achieves an appropriate balance between
providing proper flexibility to potential investors in QOZs and
limiting the potential for abuse. A 90-percent use threshold would pose
a much stricter standard than the proposed 70-percent standard, and
potentially would discourage investment in QOZs. As a result, the final
regulations retain the 70-percent use test.
Several commenters recommended that, solely with regard to real
estate businesses, the final regulations should adopt a threshold of 90
percent for the substantially all use test. The Treasury Department and
the IRS have determined that such industry-specific rules would (i) not
be consistent with section 1400Z-2 or its underlying policy, and (ii)
present administratively burdensome tracking requirements under which
taxpayers, as well as the IRS, would need to apply different rules for
different types of businesses. As a result, the final regulations do
not adopt this recommendation.
2. Clarification Regarding the Measurement of ``Use'' for the 70-
Percent Use Test
Several commenters requested clarification regarding the scope of
the term ``use'' under section 1400Z-2(d)(2)(D)(i)(III). Similarly,
other commenters requested that the final regulations clarify the
meaning of the term ``use'' with regard to qualified opportunity zone
property located both inside, and outside the geographic borders of a
QOZ. Taken together, commenters generally requested easily applicable
metrics for determining compliance with the 70-percent use test that
are responsive to the practical realities of businesses that utilize a
range of tangible property in addition to real estate.
The Treasury Department and the IRS agree with the commenters that
guidance regarding the meaning and application of the term ``use''
would be significantly helpful to taxpayers. As a result, the final
regulations provide that tangible property of a trade or business is
counted for purposes of satisfying the 70-percent use test (qualified
tangible property) to the extent the tangible property is (1) located
within the geographic borders of a QOZ, and (2) in connection with the
ordinary conduct of the trade or business, utilized in the QOZ in the
performance of an activity of the trade or business that contributes to
the generation of gross income for the trade or business. The final
regulations explicitly provide that this determination is based upon
the amount of time during which the use of the subject tangible
property meets those two requirements.
3. Application of 70-Percent Use Test to Mobile Tangible Property
The Treasury Department and the IRS received several comments
regarding the application of the 70-percent use test to mobile tangible
property that a trade or business might utilize both inside and outside
a QOZ or in multiple QOZs. Commenters noted that many trades or
businesses rely on delivery vehicles, construction equipment, service
trucks and other types of mobile tangible property to generate gross
income. Ordinarily, such trades or businesses will deploy mobile
tangible property without regard to QOZ boundaries, at times utilizing
the property inside a QOZ, while at other times utilizing the property
outside of a QOZ. As a result, these commenters requested that the
final regulations articulate standards or safe harbors for determining
whether a mobile tangible property satisfies the 70-percent use test to
qualify as qualified opportunity zone business property.
The Treasury Department and the IRS appreciate the concerns raised
by these commenters. To provide standards that more effectively respond
to the day-to-day customary operation of trades or businesses, the
final regulations set forth specific rules clarifying the application
of the 70-percent use test to mobile tangible property. The Treasury
Department and the IRS have drafted these rules to strike an
appropriate balance between allowing flexibility for business
development and ensuring that such business development primarily
benefits low-income communities comprising QOZs.
For example, the final regulations provide a safe harbor for
tangible property utilized in rendering services both inside and
outside the geographic borders of a QOZ. Under this safe harbor, a
limited amount of such tangible property may be excluded from the
general time of use calculation underlying the 70-percent use test.
Specifically, the safe harbor permits up to 20 percent of the tangible
property of a trade or business to be treated as satisfying the 70-
percent tangible property standard if the tangible property is utilized
in activities both inside and outside of the geographic borders of a
QOZ, and if (i) the trade or business has an office or other fixed
location located within a qualified opportunity zone (QOZ office), and
(ii) the tangible property is operated by employees of the trade or
business who regularly use a QOZ office of the trade or business in the
course of carrying out their duties, and are managed directly,
actively, and substantially on a day-to-day basis by one or more
employees of the trade or business at a QOZ office. In addition, in
order to qualify for the safe harbor, the tangible property must not be
operated exclusively outside of the geographic borders of a qualified
opportunity zone for a period longer than 14 consecutive days for the
generation of gross income for the trade or business.
In addition, the final regulations provide a similar safe harbor
for short-term leased tangible property. Under this rule, tangible
property leased by a trade or business located within the geographic
borders of a QOZ to a lessee that utilizes the tangible property at a
location outside of a QOZ is qualified tangible property if the
following two requirements are satisfied. First, consistent with the
normal, usual, or customary conduct of the trade or business, the
tangible property must be parked or otherwise stored at a location
within a QOZ when the tangible property is not subject to a lease to a
customer of the trade or business. Second, the lease duration of the
tangible property (including any extensions) must not exceed 30
consecutive days. This special leased tangible property rule, however,
is not subject to a limitation similar to the 20-percent limitation
with regard to non-leased mobile tangible property due to the highly
mobile nature of tangible property typically leased to customers by
leasing businesses.
4. Use of Tangible Property in Multiple QOZs Aggregated for the 70-
Percent Use Test
The Treasury Department and the IRS have received comments
recommending that the final regulations clarify the manner in which use
of tangible property is measured if such use occurs in multiple QOZs.
To respond to these comments, the final regulations specifically
provide that, if tangible property is used in one or more QOZs,
satisfaction of the 70-percent use test is determined by aggregating
the number of days the tangible property in each QOZ is utilized. The
Treasury
[[Page 1907]]
Department the IRS have determined that the policy underlying the 70-
percent use test would be effectuated through the introduction of new
economic activity into any low-income community designated as a QOZ,
regardless of specific designation.
A commenter highlighted potential confusion caused by circular
language in proposed Sec. 1.1400Z2(d)-1(c)(9)(i)(A). In general,
proposed Sec. 1.1400Z2(d)-1(c)(9) described the fraction by which the
70-percent use test is calculated. Proposed Sec. 1.1400Z2(d)-
1(c)(9)(i)(A) referred to the value of qualified opportunity zone
business property that meets the requirements of Sec. 1.1400Z2(d)-
1(c)(4)(i)(A)-(C), (E), and (F). The commenter noted that this
reference results in a circular analysis because qualified opportunity
zone business property is the item calculated by the previously
described fraction, and proposed Sec. 1.1400Z2(d)-1(c)(4)(i)(D) sets
forth the ``substantially all'' test for use in a QOZ. In other words,
the 70-percent use fraction must be calculated before one can determine
whether property qualifies as qualified opportunity zone business
property.
The Treasury Department and the IRS appreciate the commenter's
point. The final regulations set forth a significantly revised
calculation for determining satisfaction of the 70-percent use test
that does not implicate the issue raised by the commenter. In addition,
the final regulations clarify that the use of tangible property in a
QOZ is determined on an asset-by-asset basis. See part V.G. of this
Summary of Comments and Explanation of Revisions.
5. Application of Holding Period Requirements Under Section 1400Z-2
The Treasury Department and the IRS received numerous requests for
clarification regarding the manner by which QOFs can meet the holding
period requirements under section 1400Z-2(d)(2)(B)(i)(III) and
(d)(2)(C)(iii) (90-percent qualified opportunity zone property holding
period) and QOFs and qualified opportunity zone businesses can meet the
holding period requirement under section 1400Z-2(d)(2)(D)(i)(III) (90-
percent qualified opportunity zone business property holding period).
For example, several commenters suggested that QOFs and qualified
opportunity zone businesses should test for satisfaction of the two 90-
percent holding period requirements only at the end of their holding
period for the property. One commenter recommended that the final
regulations provide QOFs with an election to test for satisfaction of
the 90-percent holding period requirement based on either (i) the
taxpayer's actual holding period as of a testing date, or (ii) the
taxpayer's projected holding period. See V.B.1. of this Summary of
Comments and Explanation of Revisions.
The Treasury Department and the IRS agree that the rules for
determining satisfaction of the 90-percent qualified opportunity zone
property holding period requirement and 90-percent qualified
opportunity zone business property holding period requirement should be
clarified. Accordingly, the final regulations provide that the
determination of whether the two 90-percent holding period requirements
are satisfied is made on a semiannual basis, based on the cumulative
amount of time the QOF or qualified opportunity zone business has held
the property.
Stock or partnership interests will satisfy the 90-percent
qualified opportunity zone property holding period requirement if
during 90-percent of the QOF's holding period for the stock or
partnership interest, beginning on the date that it's self-
certification as a QOF is effective and ending on the relevant
semiannual testing date, the corporation or partnership qualified as a
qualified opportunity zone business. Similarly, tangible property will
satisfy the 90-percent qualified opportunity zone business property
holding period requirement only if the tangible property satisfied the
70-percent use test for at least 90 percent of the period during which
the QOF or qualified opportunity zone business has held such property.
As noted in part V.B.1. of this Summary of Comments and Explanation of
Revisions, the determination of whether an eligible entity engaged in a
trade or business qualified as a qualified opportunity zone business is
determined at the end of the entity's taxable year but a QOF has
semiannual testing dates on which it must determine if the entity was a
qualified opportunity zone business for 90 percent of the QOF's holding
period of the equity of the entity. Because status as a qualified
opportunity zone business is defined with respect to an entity's
taxable year, taxpayers may encounter difficulties when a QOF's
semiannual testing date falls before the end of the entity's taxable
year. The final regulations therefore provide a safe harbor for
purposes of complying with the 90-percent holding period test. Under
the safe harbor, the QOF may limit the period tested to the period that
starts with the beginning of the QOF's status as a QOF and lasts until
the last day of the entity's latest taxable year and ends on or before
the relevant testing date.
To determine whether qualified opportunity zone business property
meets the statutory holding period requirements, a QOF or qualified
opportunity zone business must measure the use of the property on a
semiannual basis, on the same testing dates as the 90-percent
investment standard. (If QOFs with diverse taxable years invest in the
same qualified opportunity zone business, the business may have to
measure use of the property semiannually for each investing QOF). The
purposes of section 1400Z-2 and the section 1400Z-2 regulations are to
provide specified tax benefits to owners of QOFs to encourage the
making of longer-term investments of new capital, through QOFs and
qualified opportunity zone businesses, into one or more QOZs and to
increase the economic growth therein. The Treasury Department and the
IRS have determined that, if the final regulations were to permit QOFs
or qualified opportunity zone businesses to use a projected holding
period, or to measure the holding period only at the end of their
holding period in the property, the previously described policy goals
of section 1400Z-2 would be compromised. In addition, such approaches
would pose administrative difficulties for the IRS in administering
holding period requirements in instances in which a period of ownership
extends beyond the statute of limitations for assessing the QOF.
6. Consideration of Cure Periods and Other Relief Regarding Application
of 90-Percent Investment Standard
Commenters noted that, under the proposed regulations, no relief
was available to a QOF that discovered that the entity in which it
invested failed to qualify as a qualified opportunity zone business.
Several commenters emphasized that the 90-percent investment standard
posed a high threshold with severe consequences for a trade or business
that failed to qualify as a qualified opportunity zone business for a
testing date. As an example, one commenter described a scenario in
which an entity qualified as a qualified opportunity zone business
during one year, but failed to satisfy the 90-percent qualified
opportunity zone property holding period during the next year, and
therefore lost any potential to satisfy the 90-percent qualified
opportunity zone property holding period for that stock or partnership
interest in later years--regardless of whether the otherwise compliant
trade or business permanently cured the defect that lead to the second-
year failure. As a result, commenters recommended various ``grace
periods'' during which an entity
[[Page 1908]]
would be treated as a qualified opportunity zone business even if the
entity failed one or more requirements under section 1400Z-2.
The Treasury Department and the IRS agree that entities should be
afforded appropriate relief to cure a defect that prevents
qualification as a qualified opportunity zone business for purposes of
the 90-percent qualified opportunity zone property holding period,
without penalty to the investing QOF under section 1400Z-2(f).
Accordingly, the final regulations provide a six-month period for an
entity in which a QOF has invested to cure a defect that caused the
entity to fail to qualify as a qualified opportunity zone business. The
six-month cure period corresponds to both the testing periods for both
the qualified opportunity zone business and the QOF as required in
sections 1400Z-2(d)(1) and (3). The final regulations provide that
during that six-month cure period, the QOF can treat the interest held
in the entity as qualified opportunity zone property. Upon the
conclusion of the six-month cure period, if the entity again fails to
qualify as a qualified opportunity zone business, the QOF must
determine if the QOF meets the 90-percent investment standard, taking
into account its ownership in the non-qualifying entity. If the QOF
fails to meet the 90-percent investment standard, the final regulations
provide that the QOF must determine the penalty applicable to each
month in which the QOF failed to meet the 90-percent investment
standard, including each month during and prior to the six-month cure
period. The final regulations specify that a qualified opportunity zone
business can utilize a six-month cure period only once.
The Treasury Department and the IRS note that, in addition to this
six-month cure period, a QOF can assert a defense of reasonable cause
under section 1400Z-2(f)(3) if the QOF becomes subject to a penalty for
failure to satisfy the 90-percent investment standard. Specifically,
section 1400Z-2(f)(3) provides that no penalty may be imposed for
failure to meet the 90-percent investment standard ``if it is shown
that such failure is due to reasonable cause.'' The Treasury Department
and the IRS view this relief under the statute, as well as the six-
month cure period provided by the final regulations, as sufficient
relief to address the commenters' concerns.
One commenter suggested that the Treasury Department and the IRS
consider whether the 90-percent qualified opportunity zone property
holding period should be tolled due to circumstances beyond the control
of the QOF or qualified opportunity zone business. The Treasury
Department and the IRS note that section 1400Z-2(f)(3) provides that a
QOF can assert a defense of reasonable cause if the QOF becomes subject
to the penalty for failure to maintain the 90-percent investment
standard. Based on the existence of this statutory relief, the Treasury
Department and the IRS have determined that a QOF possesses appropriate
recourse (that is, a reasonable cause defense) with regard to
circumstances beyond the QOF's control.
H. Original Use of Tangible Property Acquired by Purchase
Section 1400Z-2(d)(2)(D) requires either that the original use of
qualified opportunity zone business property in the QOZ commences with
the QOF or qualified opportunity zone business or that the QOF or
qualified opportunity zone business substantially improve the property.
Similar requirements are also found in other sections of the Code.
Under the now-repealed statutory frameworks of both section 1400B
(related to the DC Zone) and section 1400F (related to Renewal
Communities), qualified property for purposes of those provisions was
required to have its original use in a zone or to meet the requirements
of substantial improvement as defined under those provisions. Following
the publication of the October 2018 proposed regulations, the Treasury
Department and the IRS received numerous questions and comments on the
meaning of ``original use.'' Several commenters requested confirmation
as to whether (i) tangible property could be previously used property,
rather than solely new property; (ii) property previously placed in
service in the QOZ for one use, but subsequently placed in service for
a different use by an acquirer, could qualify as original use; and
(iii) property previously used in the QOZ could be placed in service in
the same QOZ by an acquiring, unrelated taxpayer.
After carefully considering the comments and questions received
regarding the October 2018 proposed regulations, the May 2019 proposed
regulations generally provided that the ``original use'' of tangible
property acquired by purchase by any person commences on the date on
which that person or a prior person (i) first places the property in
service in the QOZ for purposes of depreciation or amortization, or
(ii) first uses the property in the QOZ in a manner that would allow
depreciation or amortization if that person were the property's owner.
Therefore, tangible property located in the QOZ that has been
depreciated or amortized by a taxpayer other than the QOF or qualified
opportunity zone business would not satisfy the original use
requirement of section 1400Z-2(d)(2)(D)(i)(II) under the May 2019
proposed regulations. Conversely, tangible property, other than land,
located in the QOZ that has not yet been depreciated or amortized by a
taxpayer other than the QOF or qualified opportunity zone business
would satisfy the original use requirement of section 1400Z-
2(d)(2)(D)(i)(II) under those proposed regulations. The May 2019
proposed regulations also clarified that used tangible property will
satisfy the original use requirement for a QOZ so long as the property
has not been previously used in the QOZ (that is, has not previously
been used within that QOZ in a manner that would have allowed it to be
depreciated or amortized, by any taxpayer).
1. Reliance on Certificate of Occupancy for ``Original Use''
Determination
Several commenters of the May 2019 proposed regulations recommended
that the final regulations permit taxpayers to rely on certificates of
occupancy for determining whether a property satisfies the original use
requirement. For example, commenters suggested that, if a certificate
of occupancy has not been received for property consisting of a
structure, the property has not been used prior to the issuance of the
certificate and therefore potentially could satisfy the original use
requirement. Another commenter requested that the final regulations
treat real property as meeting the original use requirement if the
property receives a certificate of occupancy following a certain number
of years without a certificate. Another commenter suggested that,
similar to the rules under Sec. Sec. 1.46-3(d)(2), 1.150-2(c), and
1.179-4(e), the final regulations permit QOFs and qualified opportunity
zone businesses to elect to have ``original use'' measured from the
date on which (i) the property is placed into service, or (ii) the
certificate of occupancy is granted under local law.
[[Page 1909]]
The Treasury Department and the IRS appreciate the commenters'
objective to increase certainty regarding ``original use''
determinations. However, the Treasury Department and the IRS note that
standards applicable to certificates of occupancy vary by jurisdiction
and therefore fail to provide a uniform standard. In addition, the
processes for obtaining a certificate of occupancy vary significantly
based on jurisdiction and likely would introduce additional complexity
and uncertainty. As a result, the final regulations do not adopt the
commenters' recommendation.
2. Consideration of Treating Acquired Non-Business Property or Newly
Rezoned Property as ``Original Use'' Property
Several commenters recommended that the final regulations clarify
that property previously used for non-business purposes may be treated
as ``original use'' property in a QOZ upon its acquisition. For
support, these commenters emphasized that such property would not have
been depreciated or amortized. Similarly, one commenter requested that
the final regulations provide a special rule that real property located
in an area newly rezoned pursuant to a local government's master plan
be treated as ``original use property'' because the local government's
rezoning would fundamentally change the real property's use. Other
commenters contended that no previously used property in a QOZ should
qualify as satisfying the original use requirement regardless of
whether, for example, the property had been depreciated or amortized.
The Treasury Department and the IRS have considered each of the
arguments set forth by the commenters and have concluded that acquired
property previously used in a QOZ does not satisfy the original use
requirement. A rule treating historically used property in a QOZ as
``original use'' property because such property's prior use was
nonbusiness in nature or classified differently under a local
government's master plan would fail to sufficiently encourage the
introduction of new capital investments into QOZs. Accordingly, the
final regulations retain the rules set forth in the proposed
regulations that a property's ``original use'' commences on the date on
which the property is first (i) placed into service in the QOZ and is
depreciated or amortized, or (ii) used in a manner that would allow
depreciation or amortization.
3. Consideration of Safe Harbor Based on Belief That Property Was Not
Placed Into Service
One commenter requested that the Treasury Department and the IRS
provide a safe harbor to treat property acquired by a taxpayer as
satisfying the original use requirement if the taxpayer believed that
the property had not yet been placed into service. The commenter
contended that, if such taxpayer held that belief, the acquired
property should be treated as ``original use'' property even if the
taxpayer subsequently discovers that the property actually had been
placed in service shortly before its acquisition. The Treasury
Department and the IRS decline to adopt this comment because the
purposes of section 1400Z-2 and the section 1400Z-2 regulations are to
provide specified tax benefits to owners of QOFs to encourage the
making of longer-term investments, through QOFs and qualified
opportunity zone businesses, of new capital in one or more QOZs and to
increase the economic growth of such QOZs. The Treasury Department and
the IRS have determined that the commenter's recommended safe harbor
would not help achieve those goals.
4. Consideration of Newly Constructed Buildings Acquired Prior To Being
Placed Into Service
A commenter requested clarification regarding whether a building
that is newly constructed and sold to a purchaser meets the original
use requirement with respect to the purchaser. The commenter noted that
potential QOF investors intend to invest in QOZs by acquiring newly
constructed buildings for their trades or businesses that, prior to
acquisition, have not been placed into service for purposes of
depreciation. In such circumstances, the commenter noted that potential
QOF investors have expressed uncertainty regarding the application of
the original use requirement.
The Treasury Department and the IRS appreciate the commenter's
concern and have determined that such newly constructed buildings
satisfy the original use requirement. The construction of new buildings
in economically disadvantaged communities, which are acquired for the
purpose of introducing new businesses into such communities, clearly
achieves the policy goals underlying section 1400Z-2 and should be
encouraged. Accordingly, the final regulations provide an example that
provides certainty with regard to the acquisition of such newly
constructed buildings.
5. Qualification of Demolished Property, Overwhelmingly Improved
Property, and Property Improvements as ``Original Use'' Property
One commenter requested that the final regulations provide that an
improvement made to non-qualified property used in a QOZ satisfies the
original use requirement. The commenter reasoned that such treatment
would be appropriate because, under the May 2019 proposed regulations,
improvements made by a lessee to leased property are treated as
separate property for purposes of section 1400Z-2(d)(2)(D)(i) and
therefore as satisfying the original use requirement. The Treasury
Department and the IRS appreciate the argument raised by the commenter,
but have determined that the administrative burdens that would arise
for taxpayers and the IRS from tracking improvements made to such non-
qualified property would significantly exceed those arising from the
tracking of lessee improvements. As a result, the final regulations do
not adopt the commenter's recommendation.
A commenter also requested that the final regulations treat
tangible property that has not been purchased, but has been
overwhelmingly improved, as ``original use'' property. Section 1400Z-
2(d)(2)(D)(i)(I) requires that property must be acquired after December
31, 2017 to qualify as qualified opportunity zone business property.
While a QOZ would benefit from the overwhelming improvement of
currently owned property located within the QOZ, such improvement does
not satisfy the statutory requirement set forth in section 1400Z-
2(d)(2)(D)(i)(I). Therefore, the final regulations do not incorporate
the commenter's recommendation.
Another commenter requested that the Treasury Department and the
IRS confirm that newly constructed real property, or substantially
improved property, that otherwise meets the requirements of section
1400Z-2(d)(2)(D), will not fail to qualify as qualified opportunity
zone business property solely because the property is constructed upon
leased land. The Treasury Department and the IRS note that land,
including leased land, does not need to be substantially improved
within the meaning of section 1400Z-2(d)(2)(D)(i)(II) and 1400Z-
2(d)(2)(D)(ii). Cf. Sec. 1400Z2(d)-1(c)(7)(iv)(B) and (d)(4)(iv)(B).
Accordingly, if property otherwise qualifies as qualified opportunity
zone business property, the fact that the property is constructed on
leased land will not disqualify the
[[Page 1910]]
property from being treated as qualified opportunity zone business
property.
6. Treatment of Property That Qualifies for Certain Low-Income Housing
Credits
A commenter requested that the final regulations address the
application of credits provided under section 42(a) of the Code for
investment in certain low-income housing buildings (section 42
credits). Specifically, the commenter requested that the final
regulations provide that a property that qualifies for section 42
credits be treated as satisfying the original use requirement. The
Treasury Department and the IRS continue to consider the combining of
other tax incentives (including credits) with the benefits provided by
section 1400Z-2. As a result, the final regulations do not incorporate
the commenter's request.
7. Application of Original Use Requirement to Leased Tangible Property
A commenter recommended that the final regulations require that
leased tangible property located in a QOZ be (i) originally used in the
QOZ, and (ii) substantially improved. The Treasury Department and the
IRS note that, under the proposed regulations, improvements made by a
lessee to leased property satisfy the original use requirement and are
considered purchased property to the extent of the unadjusted cost
basis of those improvements (as under section 1012). However, the
proposed regulations do not set forth any requirement that leased
property be substantially improved. After considering the commenter's
analysis, the Treasury Department and the IRS have determined that a
rule requiring both original use and substantial improvement with
regard to leased tangible property would be inconsistent with section
1400Z-2 and unnecessary.
8. Vacancy Period for Original Use Requirement
In the May 2019 proposed regulations, the Treasury Department and
the IRS proposed that, where a building or other structure has been
vacant for at least five years prior to being purchased by a QOF or
qualified opportunity zone business, the purchased building or
structure will satisfy the original use requirement. Specifically, the
May 2019 proposed regulations provided that, if property has been
unused or vacant for an uninterrupted period of at least five years,
original use in the QOZ commences on the date after that period when
any person first so uses or places the property in service in the QOZ.
See proposed Sec. 1.1400Z2(d)-1(c)(4)(i)(B)(6), (c)(7)(i),
(d)(2)(i)(B)(6). The Treasury Department and the IRS requested comments
regarding that proposed approach, including the length of the vacancy
period and how such a standard might be administered and enforced.
a. Duration of Vacancy Period Required To Satisfy Original Use
Requirement
The Treasury Department and the IRS received several comments
regarding the five-year vacancy requirement set forth in the May 2019
proposed regulations. While some commenters expressed approval, others
contended that a five-year vacancy period would be inappropriately
long. Commenters also recommended vacancy periods in excess of five
years, contending that any shorter vacancy period would increase the
number of vacant properties exempt from the substantial improvement
requirement, and therefore decrease the overall magnitude of property
development in QOZs. One commenter requested that the final regulations
include, in addition to a five-year vacancy requirement, safeguards to
reduce the incentive for taxpayers to vacate buildings for tax
benefits.
In particular, several commenters suggested that the final
regulations provide a vacancy period threshold similar to the threshold
provided in Sec. 1.1394-1(h), which requires a vacancy period of ``at
least one-year.'' See Sec. 1.1394-1(h) (setting forth an original use
requirement for purposes of qualified zone property under section
1397D, with regard to the issuance of enterprise zone facility bonds
under section 1394). However, numerous commenters disagreed with that
approach, contending that the vacancy period required under Sec.
1.1394-1(h) responds to a different policy objective than the section
1400Z-2 policy objective of increasing new economic development in
QOZs. These commenters also contended that a one-year vacancy period
would constitute an unacceptably weak standard that potentially would
encourage owners of property in QOZs to attempt to artificially satisfy
the vacancy requirement by ceasing occupation of a property for one
year.
Commenters also recommended rules consisting of multiple vacancy
periods to accommodate different types of situations involving vacant
buildings. For example, a commenter recommended that the final
regulations require (i) a vacancy period spanning not less than two
years, or (ii) a five-year vacancy period, if less than 25 percent of
the rentable square footage of the subject property is rented or
occupied. Another commenter, while expressing general approval
regarding the five-year vacancy period requirement, suggested that
properties already vacant for at least one year at the time of QOZ
designation should qualify as vacant.
The Treasury Department and the IRS appreciate the commenters'
suggestions and recommendations, and have modified the proposed five-
year vacancy requirement to better effectuate the policy of section
1400Z-2. Accordingly, the final regulations provide a special one-year
vacancy requirement for property that was vacant prior to and on the
date of publication of the QOZ designation notice that listed the
designation of the QOZ in which the property is located, and through
the date on which the property was purchased by an eligible entity. The
Treasury Department and the IRS have determined that a shorter vacancy
period for property vacant at the time of their QOZ designation is
appropriate because (i) such buildings do not present the same
potential for abuse (for example, causing a building to be vacant for
one year to convert the building to ``original use'' property), and
(ii) the infusion of capital investments into vacant property that
contributed to the QOZ's designation would achieve a core policy
objective of section 1400Z-2.
With respect to property not vacant as of the time of such QOZ
designation notice but that later become vacant, the final regulations
require the property to be vacant continuously for at least three
years. The Treasury Department and the IRS agree that a one-year
vacancy requirement similar to that imposed under Sec. 1.1394-1(h)
would spur capital investment into needed areas. However, a three-year
vacancy period for property that was not vacant at the time of QOZ
designation will more effectively facilitate such investment while
alleviating concerns that QOFs and qualified opportunity zone
businesses would intentionally cease occupying property to convert
otherwise used property into ``original use'' property.
b. Buildings Located on Brownfield Sites Qualify as ``Original Use''
Property
The Department of the Treasury and the IRS have received several
comments regarding the application of section 1400Z-2 and the section
1400Z-2 regulations to brownfield site redevelopment. A ``brownfield
site'' comprises ``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.'' Comprehensive
[[Page 1911]]
Environmental Response, Compensation and Liability Act of 1980, section
101(39) (42 U.S.C. 9601(39)). The Environmental Protection Agency has
defined these sites as ``abandoned, idled or under-used industrial and
commercial facilities where expansion or redevelopment is complicated
by real or perceived environmental contamination.'' 60 FR 49276
(September 22, 1995). Cleaning up and reinvesting in these properties
increases local tax bases, facilitates job growth, utilizes existing
infrastructure, takes development pressures off of undeveloped, open
land, and both improves and protects the environment.
Commenters have recommended that the final regulations contain
rules to facilitate brownfield redevelopment, particularly rules to
provide that the real property composing the brownfield site be treated
as ``original'' use property under section 1400Z-2(d)(2)(D)(i)(II). One
commenter contended that, because of the degree of contamination
present in brownfield sites, remediation and construction periods for
these properties generally extend beyond 30 months. The Treasury
Department and the IRS agree with this observation, and have included
rules in the final regulations to adopt the commenters' recommendation.
Specifically, the final regulations provide that all real property
composing a brownfield site, including land and structures located
thereon, will be treated as satisfying the original use requirement of
section 1400Z-2(d)(2)(D)(i)(II). To alleviate concerns that the
property purchased will not be remediated, the final regulations also
provide that the eligible entity must make investments in the
brownfield site to ensure that the site meets basic safety standards
for human health and the environment. The final regulations also make
clear that remediation of contaminated land is taken into account for
determining if the land has been more than minimally improved, and that
the QOF or qualified opportunity zone business must make investments
into the brownfield site to improve its safety and environmental
standards.
c. Clarification of the Term ``Vacant'' for Purposes of Applying the
Vacant Property Rules
The Treasury Department and the IRS received multiple suggestions
to clarify the meaning of the term ``vacant''. One commenter suggested
that the definition of the term should be modified to add the phrase
``substantially unused or substantially vacant.'' For this purpose, the
commenter recommended that the term ``substantially vacant'' be defined
to require that greater than 70 percent of the square footage of the
subject building be unoccupied.
In addition, commenters suggested that the final regulations define
the term ``vacant'' in a manner similar to the term under Sec. 1.1394-
1(h). Accordingly, these commenters requested that the final
regulations include a provision disregarding de minimis, incidental
uses of property. See Sec. 1.1394-1(h) (providing that ``de minimis
incidental uses of property, such as renting the side of a building for
a billboard, are disregarded''). Another commenter suggested that the
definition of ``vacant'' be revised to allow for clearly delineated
portions of a larger property to be treated as vacant after five years
of uninterrupted vacancy, even if the rest of the larger property had
not been unoccupied.
One commenter also suggested that property that had involuntarily
transferred to local government control be included in the definition
of the term ``vacant.'' This commenter emphasized that local
governments often acquire brownfield sites and other blighted
properties through tax delinquency, abandonment, bankruptcy, and other
similar events. As a result, many local governments hold large
inventories of vacant properties with varying histories of use. The
commenter contended that a bright-line treatment of such properties as
``vacant'' for purposes of the original use requirement will eliminate
burdens regarding the determination of historical use and, importantly,
expedite capital investment in properties located in distressed
communities.
Several commenters suggested that the final regulations set forth a
vacancy definition that relies upon vacant property determinations
carried out by Federal, state, and local governmental authorities
(including, for example, a local government waiver process to
demonstrate vacancy). Commenters also suggested that a vacancy
definition similarly could rely upon vacant property determinations by
public utilities. In addition, some commenters contended that a vacancy
definition should take into account a spectrum of factors, including
the structure of the subject property and the length of time during
which the property's structure had been significantly damaged or
otherwise decrepit.
The Treasury Department and the IRS agree that the final
regulations should provide a definition for the term ``vacant'' for
purposes of Sec. 1.1400Z2(d)-1. Under the final regulations, real
property, including land and buildings, is considered to be in a state
of vacancy if the property is ``significantly unused.'' A building or
land will be considered to be ``significantly unused'' under the final
regulations if more than 80 percent of the building or land, as
measured by the square footage of useable space, is not being used.
In addition, the Treasury Department and the IRS appreciate that a
bright-line test for ``vacancy'' would facilitate the ability for local
governments to increase capital investment in underused property and
increase economic activity in their respective communities. As a
result, the final regulations provide that an eligible entity that
purchases real property from a local government that the local
government holds as the result of an involuntary transfer (including
through abandonment, bankruptcy, foreclosure, or receivership) may
treat all property composing the real property (including the land and
structures thereon) as satisfying the original use requirement of
section 1400Z-2(d)(2)(D)(i)(II).
d. Requests To Require All Vacant Buildings To Be Substantially
Improved
Multiple commenters recommended that the final regulations provide
that no building, regardless of occupancy, be treated as satisfying the
original use requirement. One commenter also suggested that the final
regulations (i) require all vacant buildings to be substantially
improved, and (ii) not permit such buildings to be treated as
originally used in a QOZ by a QOF or qualified opportunity zone
business. The Treasury Department and the IRS appreciate the
commenters' recommendations and suggestions, and agree that the
improvement of all buildings acquired by a QOF or qualified opportunity
zone businesses would significantly benefit the QOZs in which such
buildings are located. However, the Treasury Department and the IRS
have determined that, by permitting certain buildings to satisfy the
original use requirement, the final regulations will encourage a larger
aggregate amount of long-term investments in economically distressed
communities nationwide.
I. Substantial Improvement of Qualified Opportunity Zone Business
Property
1. Consideration of Asset-by-Asset Approach and Alternative Approaches
In the May 2019 proposed regulations, the Treasury Department and
the IRS requested comments regarding the relative strengths and
weakness of determining ``substantial improvement'' based on an asset-
by-asset approach, as compared to asset aggregation and similar
approaches. See 84 FR 18655
[[Page 1912]]
(May 1, 2019). Taxpayers and practitioners have provided numerous
responses, several of which articulated examples of difficulty in
applying an asset-by-asset approach--particularly within the context of
building renovation.
Many of these commenters requested that the final regulations adopt
an aggregate approach to determining ``substantial improvement,'' or
otherwise permit taxpayers to elect such an approach. Similarly, other
commenters requested that the final regulations permit asset
aggregation based on (i) asset location within a QOZ, or (ii) whether
the assets were acquired as part of the same transaction or business
decision. In contrast, a commenter suggested that the final regulations
adopt an approach similar to the ``integrated unit approach'' of Sec.
1.1250-1(a)(2)(ii). See Sec. 1.1250-1(a)(2)(ii) (providing for example
that, ``if two or more buildings or structures on a single tract or
parcel (or contiguous tracts or parcels) of land are operated as an
integrated unit (as evidenced by their actual operation, management,
financing, and accounting), they may be treated as a single item of
section 1250 property'').
The Treasury Department and the IRS also received several
recommendations to retain the asset-by-asset approach set forth in the
May 2019 proposed regulations. Commenters that made these suggestions
generally argued that ``substantially all'' determinations based on an
asset aggregation approach would encourage businesses to target
investments narrowly in rigidly defined areas, thereby preventing a
broader disbursement of capital investment. Such commenters also
emphasized that, by requiring the basis of each discrete asset to be
doubled in value, the proposed regulations will ensure a minimum level
of investment for each qualified asset. Because the asset-by-asset
approach of the May 2019 proposed regulations prohibits a taxpayer from
using any excess capital investment in a qualified asset to satisfy the
``doubling of basis'' requirement for a different asset, commenters
noted that the total capital investments by a taxpayer often will
exceed a doubling of the aggregate basis of all of the taxpayer's
qualified assets.
Based on the strengths and weaknesses of each of these various
approaches, the Treasury Department and the IRS have concluded that
permitting asset aggregation to a limited extent is appropriate for
carrying out ``substantial improvement'' determinations. Accordingly,
for example, the final regulations set forth an asset aggregation
approach for determining whether a non-original use asset (such as a
preexisting building) has been substantially improved. Under the
approach adopted by the final regulations, QOFs and qualified
opportunity zone businesses can take into account purchased original
use assets that otherwise would qualify as qualified opportunity zone
business property if the purchased assets (i) are used in the same
trade or business in the QOZ (or a contiguous QOZ) for which the non-
original use asset is used, and (ii) improve the functionality of the
non-original use assets in the same QOZ (or a contiguous QOZ). In the
case of purchased non-original use real property, the final regulations
require that the purchased property must be improved by more than an
insubstantial amount. Finally, if an eligible entity chooses to use
this approach, the purchased property will not be treated as original
use property, and instead, the basis of that purchased property will be
taken into account in determining whether the additions to the basis of
the non-original use property satisfy the requirements of sections
1400Z-2(d)(2)(D)(i)(II) and 1400Z-2(d)(2)(D)(ii).
For example, if a QOF purchases and intends to substantially
improve a hotel, the QOF may include ``original use'' purchased assets
in the basis of the purchased hotel to meet the substantial improvement
requirement if those purchased assets are integrally linked to the
functionality of the hotel business. These ``original use'' purchased
assets could include mattresses, linens, furniture, electronic
equipment, or any other tangible property. However, for purposes of the
substantial improvement requirement, the QOF may not include in the
basis of that hotel an apartment building purchased by the QOF that is
operated in a trade or business separate from the hotel business.
2. Aggregation of Certain Buildings To Be Treated as Single Property
The final regulations also provide that, for purposes of applying
the substantial improvement requirement, certain buildings can be
aggregated and treated as a single item of property, as that term is
used in section 1400Z-2(d)(2)(D)(ii) (single property). Specifically,
with respect to two or more buildings located within a QOZ or a single
series of contiguous QOZs (eligible building group) that are treated as
a single property, the amount of basis required to be added to those
buildings will equal the total amount of basis calculated by adding the
basis of each such building comprising the single property and
additions to the basis of each building comprising the single property
are aggregated to determine satisfaction of the substantial improvement
requirement.
To clarify which buildings may be treated as a single property, the
final regulations address eligible building groups located entirely
within a parcel of land described in a single deed, as well as groups
spanning contiguous parcels of land described in separate deeds. First,
a QOF or QOZ business may treat all buildings that compose an eligible
building group and that are located entirely within the geographic
borders of a parcel of land described in a single deed as a single
property. In addition, a QOF or QOZ business may treat all buildings
composing an eligible building group that are located entirely within
the geographic borders of contiguous parcels of land described in
separate deeds as a single property to the extent each building is
operated as part of one or more trades or businesses that meet the
following three requirements: (1) The buildings must be operated
exclusively by the QOF or by the qualified opportunity zone business;
(2) the buildings must share facilities or share significant
centralized business elements, such as personnel, accounting, legal,
manufacturing, purchasing, human resources, or information technology
resources; and (3) the buildings must be operated in coordination with,
or reliance upon, one or more of the trades or businesses (for example,
supply chain interdependencies or mixed-use facilities).
3. Inclusion of Substantial Improvement Requirement on Form 8996
A commenter recommended that the Form 8996 be revised to
incorporate the substantial improvement requirement. The Treasury
Department and the IRS appreciate the commenter's suggestion and will
consider this recommendation during the annual review of Form 8996.
4. Items Includable in Basis of Property for Substantial Improvement
Requirement
The Treasury Department and the IRS received multiple comments
requesting that the final regulations clarify what items are includable
in a property's basis for purposes of the substantial improvement
requirement. These commenters emphasized that, while section 1400Z-
2(d)(2)(D)(ii) requires a QOF or a qualified opportunity zone business
to make additions to the basis of a subject property that exceed an
amount equal to the initial adjusted basis of that property within a
30-month
[[Page 1913]]
period, the statute does not specify what items are properly includable
in that basis. Several of the commenters recommended safe harbors and
other simplifying rules to limit complexity and increase taxpayer
certainty regarding the application of the substantial improvement
requirement.
a. Consideration of Safe Harbor for ``Value Add'' Real Estate Projects
One commenter recommended that the final regulations include a safe
harbor for ``value-add'' real estate projects, which ordinarily entail
significant renovation or redevelopment of a real property to
significantly increase the price-point of the property. The commenter
asserted that a property renovated through a value-add project should
be treated as automatically satisfying the substantial improvement
requirement due to the significant magnitude of the project. The
commenter reasoned that, because a value-add project results in a
transformative modification to the QOZ property, the QOF or qualified
opportunity zone business should be relieved from undertaking a
granular analysis and confirmation of project costs for purposes of
satisfying the substantial improvement requirement. The commenter also
requested that the final regulations express a general policy that the
IRS will not challenge a decision by a QOF or qualified opportunity
zone business to capitalize expenses into basis.
The Treasury Department and the IRS acknowledge that the
commenter's recommendation would facilitate the conduct of value-add
projects in QOZs. However, the Treasury Department and the IRS have
concluded that value-add projects are similar to other types of
property renovation projects for which no special safe harbor is
provided. As a result, the Treasury Department and the IRS have
determined that no special safe harbor is warranted for value-add
projects in QOZs, and the final regulations do not incorporate the
commenter's recommendation.
b. Clarification Regarding Property Previously Placed in Service
A commenter requested that the final regulations confirm that
additions to basis of property for purposes of the substantial
improvement requirement do not include property previously placed in
service. Under section 1400Z-2, and as reflected in the proposed
regulations, property already placed in service can meet the
substantial improvement requirement if the property was not placed in
service by the QOF. Therefore, the final regulations do not adopt the
commenter's request.
c. Calculation of Basis by Reference to Pre-Depreciation Adjusted Cost
Basis
A commenter requested that, for purposes of the substantial
improvement requirement, the final regulations permit a QOF or
qualified opportunity zone business to calculate the basis of the
subject property by reference to the property's pre-depreciation
adjusted cost basis. Similarly, another commenter suggested that the
term ``adjusted basis'' be defined as cost under section 1012. In
addition, a commenter requested that the final regulations confirm that
depreciation is not taken into account in determining if a property
satisfies the substantial improvement requirement.
The Treasury Department and the IRS disagree with the suggestion
that, for determining compliance with the substantial improvement
requirement, taxpayers must use section 1012 cost basis for determining
the adjusted basis of the property. Section 1400Z-2(d)(2)(D)(ii)
provides that adjusted basis, not cost basis under section 1012, is the
appropriate standard to determine if property has been substantially
improved during the 30-month substantial improvement period. Therefore,
the final regulations provide that, property has been substantially
improved when the additions to basis of the property in the hands of
the QOF exceed an amount equal to the adjusted basis of such property
at the beginning of such 30-month substantial improvement period in the
hands of the QOF. The basis, and any additions thereto, are measured on
the testing dates set forth in section 1400Z-2(d)(1). See part V.O.1.d
of this Summary of Comments and Explanation of Revisions.
d. Effect of Certain Improvements on Requirements for Qualified
Opportunity Zone Business Property
The Treasury Department and the IRS received comments regarding the
effect of certain improvements on the qualification of tangible
property as qualified opportunity zone business property. For example,
a commenter suggested that QOFs and qualified opportunity zone
businesses should be permitted to treat tangible property purchased
before December 31, 2017 as qualified opportunity zone business
property if the QOF or qualified opportunity zone business
substantially improves the tangible property after that date. In
addition, several commenters requested that the final regulations
provide that costs resulting from the creation of intangibles, as well
as other research and development costs, count for purposes of
satisfying the Substantial Improvement Requirement.
The Treasury Department and the IRS have determined that the text
of section 1400Z-2 does not permit adoption of these suggestions.
First, section 1400Z-2(d)(2)(D)(i)(I) requires that tangible property
be acquired after December 31, 2017 to qualify as qualified opportunity
zone business property. In addition, section 1400Z-2(d)(2)(D)(i)(II)
requires that substantially improved property must be tangible property
based on the reference in that provision to section 1400Z-
2(d)(2)(D)(i). Accordingly, the final regulations do not incorporate
the commenters' recommendations.
5. Clarification of Activities and Expenses That Count as Substantial
Improvements
The Treasury Department and the IRS have received several comments
requesting clarification as to whether certain activities and expenses
count as substantial improvements for purposes of the substantial
improvement requirement. In particular, commenters requested
clarification as to whether ``substantial improvements'' to property
include (i) equipment installed in a building and used in a trade or
business, (ii) demolition costs, (iii) reasonable capitalized fees for
development, (iv) required permits, (v) necessary infrastructure, (vi)
brownfield site assessment and remediation, (vii) professional fees,
and (viii) necessary site preparation costs (including remediation and
utility upgrades). These commenters also requested that the final
regulations provide additional rules to address the applicability of
these items with regard to the substantial improvement requirement.
The Treasury Department and the IRS note that the text of section
1400Z-2(d)(2)(D)(ii) provides that any cost added to the basis of a
property improved during the 30-month improvement period will be
included in determining satisfaction of the substantial improvement
requirement. As a result, each activity or expense described by the
commenter will be included in such determination if the cost adds to
the basis of the subject property. In addition, the Treasury Department
and the IRS agree that certain expenses with regard to tangible
property (such as ``betterment'' expenses under Sec. 1.263(a)-
3(j)(1)(i)) are included in the calculation of basis of that property
for purposes of the substantial improvement requirement, even if those
expenses are properly chargeable under the Code to the basis
[[Page 1914]]
of the land on which the property is located (which does not need to be
doubled). As a result, the final regulations permit all capitalized
costs with respect to the cost of residential rental property to be
taken into account for determining satisfaction of the substantial
improvement requirement.
6. Requests for Extensions and Safe Harbors Regarding 30-Month
Substantial Improvement Period
The Treasury Department and the IRS have received several comments
regarding the 30-month substantial improvement period set forth in
section 1400Z-2(d)(2)(D)(ii), which provides the period during which a
QOF or qualified opportunity zone business can improve acquired
tangible property to satisfy the substantial improvement requirement.
In particular, many commenters recommended that the final regulations
extend this period to a period not exceeding 60 months in the event
that (i) the QOF or qualified opportunity zone business encounters a
delay not within the entity's control, (ii) the land on which the
property rests requires significant preparation or remediation, or
(iii) the scale of the project appropriately requires such extended
period. Another commenter suggested that the final regulations provide
a phase-based safe harbor, similar to that set forth in Sec. 1.148-
7(e)(1), that would allow a taxpayer to satisfy the substantial
improvement requirement if the QOF or qualified opportunity zone
business expended (i) at least 10 percent of the total invested funds
within 8 months, (ii) at least 50 percent of the total funds within 16
months, (iii) at least 75 percent of the total funds within 24 months,
and (iv) 100 percent of the total funds within 30 months.
The Treasury Department and the IRS note that the commenters'
suggestions conflict with the statutory text of section 1400Z-
2(d)(2)(D)(ii). That provision explicitly requires that (i)
improvements be made to tangible property during the 30-month period
beginning after the date of acquisition of such property, and (ii) the
measurement for ``substantial improvement'' be based on additions to
the basis of the subject tangible property, rather than the percentage
of expended funds. As a result, the final regulations do not adopt the
commenters' recommended extensions or safe harbors.
7. Safe Harbor for 90-Percent Investment Standard During 30-Month
Substantial Improvement Period
One commenter suggested that a QOF or qualified opportunity zone
business should be deemed to have met the 90-percent investment
standard throughout the 30-month substantial improvement period. The
Treasury Department and the IRS appreciate the commenter's
recommendation and have revised the final regulations to address, in
large part, the commenter's concern. The final regulations provide
that, during the 30-month substantial improvement period, eligible
tangible property in the process of being improved but not yet placed
into service or used in the trade or business of the QOF or qualified
opportunity zone business is treated as satisfying the original use
requirement and substantial improvement requirement. For property to be
eligible for this safe harbor, there must be a reasonable expectation
that, not later than the conclusion of the 30-month substantial
improvement period, the property will be used in a QOZ as part of the
trade or business of the QOF or qualified opportunity zone business, as
appropriate. The Treasury Department and the IRS, however, note that a
QOF's satisfaction of the 90-percent investment standard will be
measured with regard to all of the QOF's qualified opportunity zone
property, not just the property being substantially improved.
8. Clarification Regarding Interaction With Substantial Rehabilitation
Rules
The Treasury Department and the IRS received a request that the
final regulations clarify the interaction between the substantial
improvement requirement and the substantial rehabilitation rules under
section 42. See section 42(e)(3) (setting forth a minimum expenditure
threshold that must be satisfied for rehabilitation expenditures to be
considered sufficient to constitute a rehabilitation project eligible
for a section 42 credit). The commenter recommended that, with regard
to projects carried out in conjunction with section 42 credits, the 30-
month substantial improvement period should be subject to the rules for
substantial rehabilitation under section 42(e). The Treasury Department
and the IRS continue to consider the interaction of rules governing
other tax incentives (including credits) with section 1400Z-2 and the
regulations under section 1400Z-2. As a result, the final regulations
do not incorporate the commenter's request.
9. Qualification of Land Used for Agriculture or Renewable Energy
The Treasury Department and the IRS received multiple comments
regarding the qualification of land used for agriculture or renewable
energy as qualified opportunity zone business property. To ease
difficulties in determining qualification, one commenter suggested that
the final regulations include an option to permit the use of specific
metrics to calculate the increase of economic activity on unimproved
land used for agriculture (for example, specific metrics to calculate
increased economic activity that arises from a conversion of
agricultural property from pasture to row crops). The commenter stated
that such clarification would be useful for farmers. Another commenter
recommended that the final regulations treat land used in agricultural
activities the same as other tangible business property. Similarly, a
commenter requested that the final regulations provide a safe harbor to
alleviate difficulties in determining satisfaction of the substantial
improvement requirement with regard to farming and biofuel businesses.
The Treasury Department and the IRS acknowledge that complex and
fact-specific questions can arise when applying qualified opportunity
zone business requirements to agricultural and renewable energy
businesses. However, such complexities result in large part from the
flexibility that the Treasury Department and the IRS intended to
instill in those requirements to facilitate the inclusion of diverse
ranges of businesses in QOZs. To preserve that flexibility, and reduce
additional complexity that would result from business-specific rules
and exceptions, the final regulations do not incorporate the
commenters' suggestions.
10. Application of Substantial Improvement Requirement to Land and
Buildings Located Thereon
As provided in Rev. Rul. 2018-29, 2018 I.R.B 45, and the May 2019
proposed regulations, if land that is within a QOZ is acquired by
purchase in accordance with section 1400Z-2(d)(2)(D)(i)(I), the
requirement under section 1400Z-2(d)(2)(D)(i)(II) that the original use
of tangible property in the QOZ commence with a QOF is not applicable
to the land, whether the land is improved or unimproved. See proposed
Sec. 1.1400Z2(d)-1(c)(8)(ii)(B), (d)(4)(ii)(B). Likewise, unimproved
land located within a QOZ and acquired by purchase in accordance with
section 1400Z-2(d)(2)(D)(i)(I) is not required to be substantially
improved within the meaning of section 1400Z-2(d)(2)(D)(i)(II) and
(d)(2)(D)(ii). The May 2019 proposed regulations, however, provided
that a QOF or qualified opportunity zone business may not rely on these
rules if the land is unimproved or minimally improved
[[Page 1915]]
and the QOF or the qualified opportunity zone business purchases the
land with an expectation, an intention, or a view not to improve the
land by more than an insubstantial amount within 30 months after the
date of purchase (insubstantial improvement exception). See proposed
Sec. 1.1400Z2(d)-1(f).
a. General Applicability of Substantial Improvement Requirement to Land
The Treasury Department and the IRS received numerous comments
regarding the proposed application of the substantial improvement
requirement to land. While commenters expressed general approval
regarding this proposed approach, several commenters disagreed or
otherwise suggested revisions or clarifications. For example, multiple
commenters requested that the final regulations clarify that unimproved
land is treated as qualified opportunity zone business property.
Another commenter requested clarification as to whether land held in
conjunction with substantially improved property could be treated as
qualified opportunity zone business property even if the land was not
acquired through a capital contribution or substantially improved. With
regard to these requests for clarification, the Treasury Department and
the IRS note that land does not need to meet the original use
requirement or the substantial improvement requirement to be treated as
qualified opportunity zone business property. However, land must meet
all other relevant requirements under section 1400Z-2(d)(2)(D) and the
section 1400Z-2 regulations.
In addition, commenters recommended that the final regulations
subject unimproved land to the substantial improvement requirement to
ensure that the land will be used productively to encourage economic
growth in the QOZ in which it is located. The Treasury Department and
the IRS acknowledge the commenters' recommendations and agree that an
integral policy of section 1400Z-2 is to encourage the making of
longer-term investments of new capital into QOZs to enhance economic
growth and development. However, the Treasury Department and the IRS
continue to appreciate that ``land is a crucial business asset for
numerous types of operating trades or businesses aside from real estate
development, and the degree to which it is necessary or useful for
taxpayers seeking to grow their businesses to improve the land that
their businesses depend on will vary greatly by region, industry, and
particular business.'' 84 FR 18652, 18655 (May 1, 2019). Therefore, the
Treasury Department and the IRS have concluded that the imposition of a
substantial improvement requirement on all types of trades or
businesses for land used in such trades or businesses ``may encourage
noneconomic, tax-motivated business decisions, or otherwise effectively
prevent many businesses from benefitting under the opportunity zone
provisions'' and ``would inject a significant degree of additional
complexity'' into the final regulations. Id.
b. Eligibility of Naturally Occurring Structures for Substantial
Improvement
A commenter requested that the final regulations clarify that
naturally occurring structures are eligible for substantial improvement
(including any preservation expenses incurred). The commenter contended
that the substantial improvement requirement should be determined based
on the aggregate expenditure made to improve such natural structures.
In addition, the commenter requested that, with regard to trades or
businesses in which the value of the land substantially exceeds any
building thereon, the rationale of Rev. Rul. 2018-29 should apply
without regard to the value of buildings constructed on the land
relative to the value of the land (i) provided that the buildings were
substantially improved, and (ii) taking into account improvements to
natural structures on the land. The commenter also noted that
``naturally occurring structures'' should include vegetation (including
trees and other plants) and water sources (including ponds and
wetlands).
The Treasury Department and the IRS appreciate the commenter's
request for clarity, but note that the proposed regulations did not
subject land to the substantial improvement requirement. As provided in
the October 2018 proposed regulations, the Treasury Department and the
IRS have determined that ``an absence of a requirement to increase the
basis of land itself would address many of the comments that taxpayers
have made regarding the need to facilitate repurposing vacant or
otherwise unutilized land.'' 83 FR 54279 (October 29, 2018). However,
the Treasury Department and the IRS agree with the commenter that
expenditures to improve land and any naturally occurring structures
located thereon can be taken into account for purposes of the
requirement that land be improved by more than an insubstantial amount
under the final regulations.
c. Application of Substantial Improvement Requirement to Land Expected
To Be Only Insubstantially Improved
As described previously, proposed Sec. 1.1400Z2(d)-1(f) prohibits
a QOF or qualified opportunity zone business, in certain instances,
from relying on rules that except land from the substantial improvement
requirement. Specifically, such exception does not apply if (i) the
subject land is unimproved or minimally improved, and (ii) the QOF or
qualified opportunity zone business purchased the land with an
expectation not to improve the land by more than an insubstantial
amount (insubstantial improvement exception). See proposed Sec.
1.1400Z2(d)-1(f). This rule helps ensure that the QOZ in which such
land is located receives an appropriate amount of capital investment
from QOF investors.
The Treasury Department and the IRS received several comments and
recommendations regarding the proposed insubstantial improvement
exception. For example, one commenter recommended that the final
regulations adopt a two-part test, which would require that (i) the
subject land be used as a material income-producing factor in the
section 162 trade or business conducted by the purchaser, and (ii) the
use of the land be in a different trade or business than the use in the
hands of the seller, or the purchaser make more than insubstantial
improvements to the land. Another commenter requested clarification
that the insubstantial improvement exception be revised to permit
improvements to be completed after the 30-month substantial improvement
period. In addition, a commenter requested that the final regulations
provide that capital investments of at least 20 percent of the total
cost basis of the subject land made within a 30-month period beginning
on the acquisition date be deemed to have improved the land by more
than an insubstantial amount.
The Treasury Department and the IRS acknowledge that the
commenters' recommendations would provide additional flexibility for
investors that acquire unimproved land located within a QOZ. However,
the Treasury Department and the IRS have determined that the
commenters' suggested rules likely would reduce overall capital
investments in low-income communities by either (i) introducing
significant additional complexity into the final regulations, or (ii)
relaxing the timing requirements for capital investment for an
inappropriate duration. As a result, the final
[[Page 1916]]
regulations do not adopt the commenters' recommendations.
Commenters also recommended that the final regulations limit the
application of the insubstantial improvement exception solely to land
the value of which is small in relation to the value of the structures
on the land. One commenter argued that, with regard to a circumstance
in which the value of the subject land on which a structure is located
significantly exceeds the value of the structure, substantially
improving only the structure should not be considered a genuine
economic investment in the real property as an aggregate. Similarly,
multiple commenters requested that the final regulations provide
additional detail for determining the amount of capital improvement
necessary to exceed an ``insubstantial amount'', including percentage
thresholds that would provide a clear amount that needs to be improved.
Such threshold amounts ranged from 20 percent to 33 percent.
The Treasury Department and the IRS appreciate the logic of
comparing the value of the land to the value of any structures on the
land when considering the proposed insubstantial improvement exception
for land. However, a rule that makes a distinction between high-value
land and low-value land properties would disadvantage investors who
planned to make investments in QOZs with higher land value relative to
the existing structures on that land. A disproportionate relationship
between land value and structure value may exist for a variety of
reasons, many of which do not warrant separate treatment. Moreover, a
rule that includes the basis of land in the substantial improvement
calculation could make development prohibitively expensive for some
QOFs and qualified opportunity zone businesses. Accordingly, the final
regulations do not distinguish between real property with high or low
value land in relation to the structures built upon that land in the
application of the exception to substantial improvement.
The Treasury Department and the IRS agree with the commenters that
QOFs and qualified opportunity zone businesses should improve land by
more than an insubstantial amount. The Treasury Department and the IRS,
however, decline to assign a specific percentage threshold to the
concept of insubstantial improvement because an appropriate amount of
improvement for a particular parcel of land is a highly fact dependent
inquiry. Instead, the Treasury Department and the IRS will regard
improvements to the land, such as an irrigation system for a farming
business or grading of the land with a sufficient nexus to a trade or
business of the QOF or qualified opportunity zone business, as more
than an insubstantial amount of improvement. Further, the Treasury
Department and the IRS view this requirement that land be more than
insubstantially improved as clarifying the overall requirement that
land be qualified opportunity zone business property. Thus, the
proposed rule concerning the qualification of land as qualified
opportunity zone business property is moved from Sec. 1.1400Z2(d)-1(f)
to the special rules concerning land and improvements on land in Sec.
1.1400Z2(d)-2(b)(4)(iv)(C).
d. Severability of Land From Buildings for Purposes of Applying the
Substantial Improvement Requirement
A commenter requested that land on which an existing building is
located, and which is not substantially improved, be severable from the
existing building for purposes of applying the substantial improvement
requirement. Specifically, the commenter recommended that such land
should be treated as qualified opportunity zone business property, if
(i) the QOF or the qualified opportunity zone business uses or improves
the land as part of its trade or business, and (ii) the land otherwise
meets the tests for being qualified opportunity zone business property.
However, as noted above, the proposed regulations did not subject
land to the substantial improvement requirement. Instead, the land to
which the commenter refers would qualify as qualified opportunity zone
business property if all other requirements set forth in section 1400Z-
2 and the section 1400Z-2 regulations are satisfied (including the
insubstantial improvement exception). For these reasons, as well as the
rationale for the insubstantial improvement exception described in part
V.J.10.c of this Summary of Comments and Explanation of Revisions, the
final regulations do not adopt the commenter's recommendation.
11. Speculative Land Purchasing
Several commenters requested that the final regulations provide
more stringent rules to prevent the acquisition of land for speculative
investment, as well as increased substantial improvement standards with
regard to land. These commenters also requested that the final
regulations clarify that land does not need to be improved more than an
insubstantial amount if (i) the use of the land is integral to the
business, and (ii) the land is reasonably expected to generate economic
activity that was not reasonably expected prior to its purchase. Other
commenters requested that land have a minimum level of improvement to
be considered qualified opportunity zone business property. One
commenter suggested that land should be improved by 33 percent of its
basis. Another suggested that land that is not improved should not
count as qualified opportunity zone business property if the value of
the land does not exceed a certain threshold percentage of the QOF's
assets.
The Treasury Department and the IRS appreciate the commenters'
concerns regarding speculative land purchasing. However, the Treasury
Department and the IRS have determined that a bright-line standard
would be inappropriately restrictive because the determination of
whether such land would qualify as qualified opportunity zone business
property would require consideration of all relevant facts and
circumstances. See additional discussion at VII.B of this Summary of
Comments and Explanation of Revisions. Accordingly, the final
regulations do not adopt additional rules for speculative land
purchasing.
J. Transactions Between Qualified Opportunity Zone Businesses
Proposed Sec. 1.1400Z2(b)-1(c)(10)(i)(A) generally provided that
the acquisition of a QOF corporation's assets in a qualifying section
381 transaction is not an inclusion event if the acquiring corporation
is a QOF within a prescribed period of time after the acquisition. See
parts III.C and III.D of this Summary of Comments and Explanation of
Revisions. In turn, proposed Sec. 1.1400Z2(b)-1(d)(1) and (2) provided
that the holding period for the target QOF stock is ``tacked'' onto the
holding period of the acquiring QOF stock, and any qualified
opportunity zone property transferred by the transferor QOF to the
acquiring QOF in the transaction does not lose its status as qualified
opportunity zone property solely as a result of the transfer. In
addition, proposed Sec. 1.1400Z2(b)-1(c)(6)(ii)(C) provided that a
merger or consolidation of a partnership holding a qualifying
investment, or of a partnership that holds an interest in such
partnership solely through one or more partnerships, with another
partnership in a transaction to which section 708(b)(2)(A) applies is
not an inclusion event, to the extent section 721 applies. See part
III.E.1.b of this Summary of Comments and Explanation of Revisions.
As one commenter observed, however, the proposed regulations did
not expressly address the merger of a qualified opportunity zone
business
[[Page 1917]]
corporation with another qualified opportunity zone business
corporation, or the merger of a qualified opportunity zone business
partnership with another qualified opportunity zone business
partnership. Thus, it is unclear whether the successor business would
be treated as succeeding to the target business's original use of, and
substantial improvements to, qualified opportunity zone business
property for purposes of section 1400Z-2(d)(2)(D), and whether the
QOF's stock or partnership interest in the successor business would be
treated as acquired ``solely in exchange for cash'' for purposes of
section 1400Z-2(d)(2)(B) and (C). The commenter recommended that, after
a merger of qualified opportunity zone businesses, the original use and
substantial improvement status of the target's property should
continue, and the QOF's interest in the successor business should be
considered to have been acquired solely in exchange for cash. Another
commenter recommended more generally that, when QOFs or qualified
opportunity zone businesses transact in qualified assets among
themselves, those assets should retain their status as qualified
assets, and the transferee QOF or qualified opportunity zone business
should be afforded a new working capital safe harbor of up to 31 months
to the extent the transferee intends to inject additional capital with
respect to the transferred property.
The Treasury Department and the IRS agree that, if a qualified
opportunity zone business that is a corporation engages in a
transaction described in section 381(a)(2) with another qualified
opportunity zone business, or if a qualified opportunity zone business
that is a partnership engages in a transaction described in section
708(b)(2)(A) with another qualified opportunity zone business, the
original use and substantial improvement status of the transferor
business's property should continue, and the QOF's interest in the
successor business should be considered to have been acquired solely in
exchange for cash. The final regulations have been modified
accordingly. See Sec. Sec. 1.1502-14Z and 1.1504-3 for special rules
applicable to consolidated groups.
However, the Treasury Department and the IRS do not agree that a
successor qualified opportunity zone business or a successor QOF should
be afforded a new 31-month working capital safe harbor because such a
rule would be patently inconsistent with treating the entity as a
``successor'' for other purposes, such as original use. The Treasury
Department and the IRS also do not agree that a qualified asset should
retain its status as such if it is transferred from one QOF or
qualified opportunity zone business to another QOF or qualified
opportunity zone business in a transaction not described in section
381(a)(2) or section 708(b)(2)(A) because the transferee in such
transactions is not a ``successor'' to the transferor.
K. Operation of Section 1397C Requirements Incorporated by Reference
1. 50-Percent Gross Income Requirement
Section 1397C(b) sets forth eight requirements that a corporation
or partnership must satisfy to qualify as a ``qualified business
entity'' and therefore an ``enterprise zone business.'' Section 1400Z-
2(d)(3)(A), which describes the requirements that a trade or business
must satisfy to qualify as a ``qualified opportunity zone business,''
incorporates paragraphs (2), (4), and (8) of section 1397C(b)(2). See
section 1400Z-2(d)(3)(A)(ii). With regard to gross income, section
1397C(b)(2) requires that ``at least 50 percent of the total gross
income of such entity is derived from the active conduct of such
business.''
The Treasury Department and the IRS interpret section 1400Z-
2(d)(3)(A)(ii)'s incorporation of section 1397C(b)(2) to require that a
corporation or partnership, in order to qualify as a qualified
opportunity zone business, must derive at least 50 percent of its total
gross income from the active conduct of a trade or business within
``a'' QOZ (50-percent gross income requirement). In response to
commenters' requests for clarification, the May 2019 proposed
regulations provided three safe harbors and a facts-and-circumstances
test for determining whether a trade or business in a QOZ has generated
sufficient income to satisfy the 50-percent gross income requirement.
The Treasury Department and the IRS requested comments regarding those
proposed safe harbors, including suggestions for additional safe
harbors and revisions to the proposed rules to prevent abuse.
a. Satisfaction of 50-Percent Gross Income Requirement Through
Activities in Multiple QOZs
The Treasury Department and the IRS have received comments
requesting clarification that a trade or business can satisfy the 50-
percent gross income requirement by aggregating activities carried out
by the trade or business in multiple QOZs. Specifically, commenters
emphasized that the proposed regulations, in numerous instances,
referenced a trade or business ``within the QOZ'' rather than ``within
a QOZ.'' These commenters asserted that the use of the word ``the''
could be interpreted as requiring that 50 percent of the total gross
income from a trade or business (as well as a startup business relying
on an applicable safe harbor) be derived from activities carried out
solely within a single QOZ.
The Treasury Department and the IRS did not interpret the 50-
percent gross income requirement as requiring a trade or business to
carry out all activities necessary to satisfy the requirement in only
one QOZ. Give the purpose of section 1400Z-2 to encourage economic
growth in all QOZs, the Treasury Department and the IRS intended
taxpayers and practitioners to apply the 50-percent gross income
requirement by aggregating all activities of a trade or business
carried out among all QOZs in which the trade or business operates. As
a result, the final regulations have been revised to clarify that
intended interpretation.
b. Requirement That Activities of Trade or Business Be Carried Out in a
QOZ
The Treasury Department and the IRS also received comments
suggesting that the 50-percent gross income requirement does not
require a qualified opportunity zone business to generate 50 percent of
its total gross income from the active conduct of its business ``in a
qualified opportunity zone.'' As stated in the preamble of the May 2019
proposed regulations, the phrase ``such business'' in section
1397C(b)(2) refers to a business mentioned in the preceding sentence,
which discusses ``a qualified business within an empowerment zone.''
See 84 FR 18652, 18658 (May 1, 2019). In applying section 1397C to
section 1400Z-2, references in section 1397C to ``an empowerment zone''
are treated as referring to a QOZ. See id. Therefore, the final
regulations do not adopt this comment, but rather provide that the
corporation or partnership must derive at least 50 percent of its total
gross income from the active conduct of a business within a QOZ.
2. Services Performed in a QOZ Based on Hours and Amounts Paid for
Services
The May 2019 proposed regulations provided that, if at least 50
percent of the services performed for the trade or business are
performed in a QOZ, based on (i) total number of hours performed by
employees and independent contractors and employees of independent
contractors in a QOZ (hours performed test), or (ii) amounts paid to
employees and independent
[[Page 1918]]
contractors and employees of independent contractors in a QOZ (amounts
paid test), then the trade or business is deemed to satisfy the 50-
percent gross income requirement. See proposed Sec. 1.1400Z2(b)-
1(d)(5)(i)(A) (setting forth the hours performed test), (d)(5)(i)(B)
(setting forth the amounts paid test). As provided in the preamble to
the May 2019 proposed regulations, the hours performed test is intended
to address businesses located in a QOZ that primarily provide services.
See 84 FR 18652, 18658 (May 1, 2019). In addition, the preamble
explained that the amounts paid test is based upon amounts paid by the
trade or business for services performed in the QOZ during the taxable
year by employees and independent contractors, and employees of
independent contractors. See id.
a. Calculations and Recordkeeping for Hours Performed and Amounts Paid
Tests
The Treasury Department and the IRS received comments requesting
clarification on how to calculate and track ``hours worked'' and
``amounts paid'' for purposes of the hours performed test and the
amounts paid test. For example, some commenters highlighted
difficulties in distinguishing employees from independent contractors.
In particular, a commenter asked whether a trade or business is
required to include hours worked by, or payments made to, third-party
accountants, lawyers, or investment bankers in determining whether
those safe harbors have been met. Commenters also criticized the
inclusion of independent contractors and employees of independent
contractors, as unreasonable for the hours performed test and amounts
paid test because newer businesses, which may be unable to hire full
time employees, might not be able to require independent contractors to
work primarily in QOZs.
The Treasury Department and the IRS appreciate the commenters'
requests and suggestions. With regard to determining satisfaction of
the hours performed test and amounts paid test, a majority of the
services performed (measured by hours worked or amounts paid) must be
provided by employees and independent contractors, and employees of
independent contractors, in a QOZ for the trade or business. These
calculations do not take into account hours worked by, or amounts paid
to, independent contractors and their employees for services that are
not performed for the qualified opportunity zone business.
With regard to recordkeeping, the Treasury Department and the IRS
have determined that taxpayers and practitioners should be afforded
flexibility rather than be encumbered by rigid tracking requirements.
However, the Treasury Department and the IRS expect qualified
opportunity zone businesses to maintain adequate records and implement
sound processes to track hours worked by and amounts paid to employees,
independent contractors, and employees of independent contractors for
purposes of the hours performed and amounts paid tests. Further, the
classification of an employee as opposed to an independent contractor
must be determined based upon all relevant facts and circumstances
under the applicable common law standard and all relevant provisions of
the Code and general principles of tax law.
b. Clarification Regarding Services Provided by Partners in a
Partnership
Commenters requested that the final regulations clarify that hours
worked by, and amounts paid to, partners in a partnership that provide
services to the partnership's trade or business count towards
satisfying the hours performed test and amounts paid test. In
particular, these commenters emphasized that such partners constitute
neither employees nor independent contractors of the subject trade or
business. As a result, the commenters noted that such hours worked, and
amounts paid, were not specifically covered by either safe harbor.
The Treasury Department and the IRS agree that hours worked by, and
amounts paid to, partners in a partnership for services provided to the
partnership's trade or business should be taken in account for the
hours performed and amounts paid tests. Therefore, the final
regulations adopt the commenter's suggestion. In order to ensure that
amounts paid to partners are for services provided to the trade or
business of the partnership, the final regulations provide that
guaranteed payments for services (within the meaning of section 707(c))
to a partner are the only amounts that will be taken into account for
the amounts paid test.
c. Clarification Regarding Services Provided by Partners in a
Partnership
Some commenters criticized the hours performed test and amounts
paid test based on the commenters' view that neither test is
sufficiently stringent. These commenters encouraged the Treasury
Department and the IRS to combine all three safe harbors into one
conjunctive, three-prong approach to provide a better measure of
overall business activity occurring within a QOZ. Commenters also
requested that the operative threshold be raised from 50 percent of
hours worked and amounts paid to 75 percent to ensure that the
residents of the QOZ sufficiently benefit from the economic activity
created by the QOF investments.
The Treasury Department and the IRS appreciate the policy concerns
underlying the commenters' recommendations. However, the Treasury
Department and the IRS have determined that the hours performed test
and amounts paid test strike an appropriate balance between (i)
ensuring economic activity is created in a QOZ (that is, by requiring
that at least half of the services performed, determined by hours or
amounts paid, be performed in a QOZ), and (ii) providing operating
businesses with appropriate flexibility to expand and provide services
outside of a QOZ. Therefore, the final regulations do not adopt these
comments.
3. Clarification Regarding the Application of the Business Functions
Test
In addition to the hours performed test and the amounts paid test,
the May 2019 proposed regulations provided a ``business functions
test.'' Under that test, a trade or business satisfies the 50-percent
gross income requirement if each of (i) the tangible property of the
trade or business located in a QOZ, and (ii) the management or
operational functions performed in the QOZ, are necessary for the
generation of at least 50 percent of the gross income of the trade or
business (business functions test). See proposed Sec. 1.1400Z2(b)-
1(d)(5)(i)(C) (setting forth the business functions test). The May 2019
proposed regulations requested comments on the business functions test.
See 84 FR 18652, 18659 (May 1, 2019).
In response, the Treasury Department and the IRS received several
comments requesting that the final regulations clarify the application
of the business functions test. Many commenters emphasized that the
business functions test fails to provide clearly the manner by which to
determine when an asset generates income, as well as which managerial
and operational staff are necessary for the generation of income.
Commenters requested that the final regulations clarify (i) the meaning
of the term ``operational functions,'' and (ii) the method for tracing
income generated from tangible property and managerial or operational
functions in the QOZ. Also, a commenter highlighted that
[[Page 1919]]
administrative ``back office'' functions are necessary functions for
the generation of income, although administrative tasks may not be as
intrinsically related to the operation of the trade or business.
In addition, a commenter requested that the final regulations
provide additional guidance regarding mobile workforces and portable
assets. The commenter noted that the May 2019 proposed regulations set
forth an example involving a business with a mobile workforce and
portable assets that returned to the business' headquarters on a daily
basis, but the example does not address a situation in which the
tangible assets of the business are almost entirely located in a QOZ at
all times, but the business is operated by a workforce which may be
remote, mobile, or shared with other businesses. See proposed Sec.
1.1400Z2(b)-1(d)(5)(i)(E)(1), 84 FR 18652, 18659 (May 1, 2019). The
commenter noted that the example does not clearly indicate whether an
employee's activities outside of a QOZ, even while performing key
operational roles inside of a QOZ, would cause their work not to be
treated as an ``operational function'' that is ``necessary'' for the
generation of the business' gross income. The commenter requested that
the final regulations describe what is meant by management or
operational functions and whether management functions, operational
functions, and the location of tangible property are similarly weighted
when applying the business functions test.
Commenters also noted that the business functions test could
encourage businesses to bring high-skilled, high-income workers into a
QOZ, but may not encourage businesses to create jobs for lower-skilled
residents of the QOZ. Commenters requested additional examples
describing what may or may not meet the business functions test,
particularly within the context of fixed assets that are managed or
operated by service providers, some of which are physically located
outside of a QOZ.
The Treasury Department and the IRS appreciate the commenters'
request for clarity regarding the application of the business functions
test. Based on comments received, the Treasury Department and the IRS
have determined that the business functions test would present an
achievable and readily applicable safe harbor for businesses that are
headquartered in a QOZ and for which the bulk of business activity
occurs in a QOZ. However, the Treasury Department and the IRS
acknowledge that businesses with unconventional management and
operational structures, as well as tangible property located both
inside and outside of a QOZ, would benefit from additional guidance.
For those difficult cases, the Treasury Department and the IRS continue
to study the commenters' request for clarification regarding the
business functions test and may consider providing additional rules and
examples through guidance published in the Internal Revenue Bulletin.
L. Requirement To Use Substantial Portion of Intangible Property in a
Trade or Business
Section 1400Z-2(d)(3) provides that a qualified opportunity zone
trade or business must satisfy the intangible property requirement set
forth in section 1397C(b)(4). Section 1400Z-2(d)(3)'s incorporation of
section 1397C(b)(4) requires that, with respect to any taxable year, a
substantial portion of the intangible property of a qualified
opportunity zone business must be used in the active conduct of a trade
or business within the QOZ (intangible property use test). However,
section 1397C does not provide a definition for the term ``substantial
portion.'' To provide additional certainty for determinations regarding
whether a substantial portion of intangible property is used in the
active conduct of a trade or business within a QOZ, the May 2019
proposed regulations provided that the term ``substantial portion''
means at least 40 percent of the intangible property of the qualified
opportunity zone business. See proposed Sec. 1.1400Z2(b)-1(d)(5)(ii),
84 FR 18652, 18659 (May 1, 2019).
1. Clarification Regarding Determinations of Location and ``Use'' of
Intangible Property
The Treasury Department and the IRS received comments requesting
that the final regulations clarify the methods for determining the
location and ``use'' of intangible property. Commenters contended that
any uncertainty with regard to those determinations could discourage
qualified opportunity zone businesses from developing and using
intangible property. These commenters suggested that the Treasury
Department and the IRS should consider a number of relevant factors for
determining the location and use of intangible property, including (i)
where a business provides services or has customers, (ii) where the
business' tangible assets are located, (iii) how and where the business
is marketed, and (iv) the geographic scope of the legal rights to use
the intangible property.
One commenter suggested that, with regard to ``use,'' a
determination based on both gross revenue and the location in which
such revenue is earned would be appropriate. For example, the commenter
contended that an active trade or business that uses intangible
property both inside and outside a QOZ should undertake a comparison of
gross revenues derived inside the QOZ as well as outside the QOZ. Some
commenters suggested that the final regulations adopt a rule similar to
the safe harbors used for the 50-percent gross income test which would
be based on the location of a business' employees or tangible property
located within a QOZ. A commenter noted that a rule that ties ``use''
to tangible property or employees would help prevent abusive situations
and ensure that economic activity occurs within a QOZ.
Commenters also suggested methods for determining the situs of
intangible property. Commenters noted that, for state property law
purposes, the location of intangible property generally is treated as
the location at which the owner of that property is located. These
commenters asserted that such a determination might be difficult in
situations in which a business owner has locations both inside and
outside of a QOZ. For example, if a business has a management and
operations headquarters in a QOZ, and a technology research and
development facility located outside of a QOZ, commenters expressed
uncertainty regarding how to determine or measure the location of the
business' intangible property. Another commenter suggested that the
final regulations provide a rule or rebuttable presumption that
connects the situs of an intangible property to a tangible property
located within a QOZ if the portion of tangible property that is used
for a trade or business inside the QOZ corresponds to the portion of
intangible property deemed to be used inside the QOZ. This commenter
also noted that a rule providing that an intangible property's location
depends upon a tangible property's location could undercut the
requirement for substantial use of intangible property in the QOZ.
The Treasury Department and the IRS appreciate the commenters'
concerns regarding determinations of location and ``use'' of intangible
property for purposes of applying the intangible property use test. To
increase certainty in making such determinations, the final regulations
provide that intangible property of a qualified opportunity zone
business is used in the active conduct of a trade or business in a QOZ
if the following two requirements are
[[Page 1920]]
satisfied. First, the use of the intangible property must be normal,
usual, or customary in the conduct of the trade or business. In
addition, the intangible property must be used in the QOZ in the
performance of an activity of the trade or business that contributes to
the generation of gross income for the trade or business.
2. Consideration of 40-Percent Threshold for Use of Intangible Property
Commenters generally agreed with the 40-percent threshold for
defining the minimum level of use necessary to satisfy the section
1397C(b)(4) requirement that a substantial portion of intangible
property be used in a QOZ. However, some commenters asserted that the
threshold percentage should be increased to more effectively prevent
abuse. Commenters highlighted the potential for abusive transactions
involving intangible property, noting that intangible property is
highly mobile, may appreciate significantly in value, and is not
subject to the same restrictions that apply to tangible property under
section 1400Z-2(d)(2)(D) (regarding qualified opportunity zone business
property). These commenters suggested that the final regulations apply
anti-abuse rules similar to those set forth in section 1400Z-2(d)(2)(D)
to the use by a trade or businesses of intangible property.
The final regulations adopt the 40-percent threshold for
determining whether a ``substantial portion'' of the intangible
property of a qualified opportunity zone business is used in the trade
or business in a QOZ. After considering the concerns of commenters
regarding potential abuses involving intangible property, the Treasury
Department and the IRS have determined that the 40-percent threshold
requires an appropriately substantial amount of intangible property to
be used in a QOZ. In addition, the Treasury Department and the IRS have
determined that a 40-percent threshold will provide appropriate
flexibility for trades and businesses to expand and operate outside of
a QOZ.
3. Clarification Regarding Reference to ``Such Business'' in Section
1397C(b)(4)
A commenter requested clarification regarding whether an
intellectual property holding company can be a qualified opportunity
zone business in light of section 1397C(d)(4), which excludes any trade
or business the activities of which consist predominantly of developing
or holding intangibles for sale or license. This commenter noted that
section 1397C(b)(4) provides the following condition: ``a substantial
portion of the intangible property of such entity is used in the active
conduct of any such business.'' The commenter requested that the final
regulations confirm whether the use of ``such business'' in section
1397(b)(4) incorporates the qualified business definition set forth in
section 1397C(d).
As provided in the preamble to the May 2019 proposed regulations,
the Treasury Department and the IRS addressed a similar question with
regard to section 1397C(b)(2), which provides that, in order to be a
``qualified business entity'' (in addition to other requirements found
in section 1397C(b)) with respect to any taxable year, a corporation or
partnership must derive at least 50 percent of its total gross income
``from the active conduct of such business.'' See 84 FR 18652, 18658
(May 1, 2019). As noted in that preamble, the phrase ``such business''
refers to a business mentioned in the preceding sentence, referring to
section 1397C(b)(1), which discusses ``a qualified business within an
empowerment zone.'' See id. The preamble goes on to state that for
purposes of applying section 1400Z-2, references in section 1397C to
``an empowerment zone'' are treated as meaning a qualified opportunity
zone. Therefore, section 1400Z-2 does not incorporate the concept of
``qualified business'' within an empowerment zone under section
1397C(d), but instead reads ``such business'' in section 1397C(b)(2)
and (4) to refer to ``a business within a qualified opportunity zone.''
As a result, the Treasury Department and the IRS have concluded that
the exception set forth in section 1397C(d)(4) has no application with
respect to the qualification of an intellectual property holding
company as a qualified opportunity zone business.
M. Limitation on Nonqualified Financial Property of Qualified
Opportunity Zone Business
Section 1400Z-2(d)(3) incorporates section 1397C(b)(8), which
limits the portion of the qualified opportunity zone business' assets
that may be held in nonqualified financial property (NQFP) to less than
five percent of the average of the aggregate unadjusted bases of the
property of the entity in a taxable year (five-percent NQFP
limitation). Section 1397C(e) defines the term ``nonqualified financial
property'' as debt, stock, partnership interests, options, futures
contracts, forward contracts, warrants, notional principal contracts,
annuities, and other similar properties. However, section 1397C(e)
excludes from that definition reasonable amounts of working capital
held in cash, cash equivalents, or debt instruments with a term of 18
months or less.
1. Consideration of Industry-Specific Revisions to Five-Percent NQFP
Limitation
The Treasury Department and the IRS received several
recommendations that the final regulations tailor the five-percent NQFP
limitation to provide flexibility for certain industries. For example,
several commenters expressed a general concern that ordinary-course
transactions in the real estate sector may be prohibited by the
definition of NQFP. One commenter noted that the definition of NQFP may
cover commonplace items such as leases with prepaid or front-loaded
rent that are treated in part as loans, prepaid expenses, prepaid
development fees, and options to acquire property. The commenter
requested that (i) the definition of NQFP provide exceptions for the
aforementioned items, and (ii) the five-percent NQFP limitation be
revised to exclude commonplace real estate transactions. For support,
the commenter asserted that the definition of NQFP creates a trap for
the unwary and that the five-percent NQFP limitation was not intended
to prevent qualified opportunity zone businesses from engaging in the
ordinary-course real estate transactions that develop QOZs.
The Treasury Department and the IRS also received comments
requesting similar revisions to the five-percent NQFP limitation to
accommodate other industries. For example, a commenter requested that
insurance company general account assets be excluded from the
definition of NQFP. The commenter emphasized that insurance companies
are required to invest a significant portion of their assets in
financial property to satisfy obligations to policy holders. By not
excluding insurance companies from the five-percent NQFP limitation,
the commenter reasoned that the section 1400Z-2 regulations would
prevent insurance companies from being qualified opportunity zone
businesses.
The Treasury Department and the IRS acknowledge the concerns raised
by the commenters. However, sections 1400Z-2(d)(3)(A)(ii) and
1397C(b)(8) provide a clear statutory definition of NQFP and an equally
clear limitation on the percentage of NQFP that a qualified opportunity
zone business may own. As a result, the final regulations do not adopt
the commenters' recommended
[[Page 1921]]
revisions to the five-percent NQFP limitation.
2. Consideration of Special Rules To Facilitate the Use of Tax-Exempt
Municipal Bonds
Several commenters stressed the importance of adequate
infrastructure for the economic development of a QOZ, and the critical
role of tax-exempt municipal bonds in the financing of infrastructure
projects. These commenters recommended that the final regulations
provide favorable treatment for municipal bonds used to finance new or
improve existing infrastructure projects located within a QOZ. In
particular, these commenters recommended that the final regulations
treat municipal bonds essentially as qualified opportunity zone
property in which a QOF would be eligible to invest. Further, these
commenters recommended that the final regulations treat municipal bonds
as property that would not be treated as NQFP in the hands of an entity
seeking to qualify as a qualified opportunity zone business. In support
of these recommendations, a commenter highlighted that two-thirds of
all domestic infrastructure projects are financed by municipal bonds.
This commenter reasoned that, if the final regulations were not to
remove municipal bonds from the definition of NQFP, infrastructure
developments that might otherwise occur would not be financed.
The Treasury Department and the IRS recognize the significant need
for additional investment in public infrastructure in QOZs, and that
expanded debt and equity tax incentives could facilitate such increased
investment. In addition, the Treasury Department and the IRS
acknowledge that municipal bonds provide an important source of
financing for infrastructure projects. However, section 1400Z-2(d) does
not contemplate direct investments in municipal bonds as qualifying
property for QOFs. Municipal bonds, which are intangible debt
instruments, cannot qualify under the statutory categories of qualified
opportunity zone property because municipal bonds are neither (i)
equity in a qualified opportunity zone business nor (ii) a tangible
asset that is qualified opportunity zone business property. A QOF could
make a direct equity investment in tangible property that meets the
definition of qualified opportunity zone business property, and the
property also may have municipal bond financing (for example, a private
water facility financed with tax-exempt private activity bonds under
section 142 of the Code). Further, if held by a qualified opportunity
zone business, municipal bonds generally constitute NQFP and can
qualify for the reasonable working capital safe harbor only in limited
circumstances in which the bonds have a term of 18 months or less. For
the foregoing reasons, the Treasury Department and the IRS decline to
adopt the recommendations of these commenters regarding municipal bond
investments.
3. Consideration of Special Rules To Facilitate Tiered Entity
Structures
The Treasury Department and the IRS have received several comments
regarding the application of sections 1400Z-2(d)(3)(A)(ii) and
1397C(b)(4) to groups of related corporations and partnerships
structured to conduct integrated qualified opportunity zone businesses.
In particular, several commenters expressed concern that the text of
section 1397C(e) prohibits qualified opportunity zone businesses from
owning operating subsidiaries due to the inclusion of stock and
partnership interests in the statutory definition of NQFP. However, one
commenter contended that Congress clearly intended the statute only to
prevent qualified opportunity zone businesses from owning publicly
traded securities that are passive investments, rather than prevent the
ownership of operating subsidiaries. Accordingly, the commenter
recommended that the definition of NQFP be clarified to prohibit
actively traded personal property for purposes of Sec. 1.1092(d)-1,
but not equity interests in operating subsidiaries.
Similarly, other commenters requested that all requirements for a
qualified opportunity zone business under section 1400Z-2(d)(3)
(including the five-percent NQFP limitation) be applied to an entire
group that conducts an integrated business. These commenters asserted
that an entity-by-entity test would not be appropriate because such
integrated businesses often are organized by entity-specific functions
that, in the view of the commenters, would distort the intended
application of the five-percent NQFP limitation. For example, an
integrated business carried out by a holding corporation that owns all
of the equity interests in an operating subsidiary and a treasury
subsidiary might comply with the five-percent NQFP limitation if tested
in the aggregate, even though the treasury subsidiary, tested on its
own, would exceed that limitation.
The Treasury Department and the IRS agree that section 1400Z-
2(d)(3) should be applied in a manner that permits flexibility to
taxpayers in structuring and conducting qualified opportunity zone
businesses. However, with regard to the five-percent NQFP limitation,
sections 1397C(b)(8) and 1397C(e) clearly provide that (i) less than
five percent of the average of the aggregate unadjusted bases of the
property of the subject entity, rather than any group of related
entities, must be attributable to NQFP, and (ii) the definition of the
term ``nonqualified financial property'' includes stock and partnership
interests. As a result, the final regulations do not adopt a group-
based test for purposes of the five-percent NQFP limitation.
In addition, the final regulations do not adopt a group-based
approach for testing the remaining requirements for a qualified
opportunity zone business under section 1400Z-2(d)(3). The Treasury
Department and the IRS have determined that an inconsistent application
of the requirements for qualified opportunity zone business
qualification would significantly increase the complexity of the final
regulations and create potential traps for unwary taxpayers. In
addition, the Treasury Department and the IRS note that these section
1400Z-2(d)(3) requirements (including the five-percent NQFP limitation)
can be applied on a group basis with regard to a qualified opportunity
zone business that owns interests in function-specific entities
disregarded as separate from their owner for Federal income tax
purposes.
N. Trade or Business of a Qualified Opportunity Zone Business
1. Significance of Trade or Business Concept in Section 1400Z-2
Section 1400Z-2(d)(2)(D)(i) and (d)(3)(A)(i) require that qualified
opportunity zone business property be tangible property used in the
trade or business of a QOF or qualified opportunity zone business.
Under section 1400Z-2(d), both QOFs and qualified opportunity zone
businesses must meet ``substantially all'' property requirements. For
QOFs, at least 90 percent of the qualified entity's property must be
qualified opportunity zone property, which includes qualified
opportunity zone stock and qualified opportunity zone partnership
interests (that is, the 90-percent investment standard). For qualified
opportunity zone businesses, at least 70 percent of the qualified
entity's property must be qualified opportunity zone business property
(that is, the 70-percent tangible property standard). In addition,
section 1400Z-2(d)(3)(A)(ii) imposes an additional requirement on
qualified opportunity zone businesses but not on QOFs. Under this
requirement, at least
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50 percent of the total gross income of a qualified entity must be
derived from the active conduct of a trade or business within a QOZ
(that is, the 50-percent gross income requirement).
2. Proposed Definition Based on a ``Trade or Business'' Under Section
162
The October 2018 proposed regulations contained the term ``active
conduct of a trade or business'' in several provisions. See proposed
Sec. 1.1400Z2(d)-1(d)(5). Following the publication of that proposal,
the Treasury Department and the IRS received comments asking whether
future guidance would define the phrase ``active conduct of a trade or
business'' for purposes of section 1400Z-2. Commenters also expressed
concern that the leasing of real property by a qualified opportunity
zone business may not amount to the active conduct of a trade or
business if the business has limited leasing activity.
With regard to the term ``trade or business,'' the May 2019
proposed regulations set forth a definition for QOFs and qualified
opportunity zone businesses that referenced section 162 of the Code.
See 84 FR 18652, 18659 (May 1, 2019). See also Sec. 1.1400Z2(d)-
1(c)(4)(ii) (regarding QOFs); Sec. 1.1400Z2(d)-1(d)(2)(ii) (regarding
qualified opportunity zone businesses). Section 162(a) permits a
deduction for ordinary and necessary expenses paid or incurred in
carrying on a trade or business. Because neither the Code nor the
regulations define the meaning of a ``trade or business'' under section
162, courts have established requirements to determine the existence of
a trade or business. The Supreme Court has set forth a two-pronged
test, providing that, ``to be engaged in a trade or business, the
taxpayer must be involved in the activity with continuity and
regularity and that the taxpayer's primary purpose for engaging in the
activity must be for income or profit.'' Commissioner v. Groetzinger,
480 U.S. 23, 25 (1987). With respect to the requirement that the
activity must be engaged for income or profit, the Court has expressly
provided that section 162 qualification ``requires only an intent to
earn an economic profit.'' Portland Golf Club v. Commissioner, 497 U.S.
154, 164, 169 (1990) (citing Commissioner v. Groetzinger for the
Court's observation that it ``has ruled that a taxpayer's activities
fall within the scope of [section] 162 only if an intent to profit has
been shown'').
3. Application of Section 162 Trade or Business Standard to Start-Up
Businesses
While commenters agreed that section 162 provides an appropriate
standard for trade or business qualification under section 1400Z-
2(d)(2)(D)(i) and (d)(3)(A)(i), many noted significant uncertainties in
applying the section 162 standard to a trade or business of a QOF or
qualified opportunity zone business that does not expect to generate
profits immediately. In general, these commenters have noted that QOF
property used in a start-up business cannot qualify as qualified
opportunity zone property unless the start-up business that utilizes
such property qualifies as a section 162 trade or business. With regard
to QOFs that hold an equity interest in a newly formed partnership or
corporation organized for the purpose of being a qualified opportunity
zone business, commenters have questioned how section 162 would apply
if the partnership or corporation experiences a start-up phase of
significant duration. See section 1400Z-2(d)(2)(B)(i)(II) and
(d)(2)(C)(ii). With regard to qualified opportunity zone businesses,
commenters similarly have expressed uncertainty regarding the
qualification of a start-up business as a qualified opportunity zone
business if the start-up business has not yet matured to a trade or
business under section 162.
a. Comments Suggesting Safe Harbors for Start-Up Businesses
To provide certainty to current and potential investors of start-up
businesses in QOZs, commenters suggested a variety of safe harbors.
These suggestions included (1) a grace period for a QOF to use tangible
property in a trade or business to satisfy the 90-percent investment
standard, as well as (2) a provision similar to that under Sec. 1.45D-
1(d)(4)(iv) in the New Markets Tax Credit regulations that treats an
entity as engaged in the active conduct of a trade or business if, at
the time an investment is made, there is a reasonable belief that the
entity will generate revenues during the subsequent three-year period.
To support the addition of a safe harbor for start-ups, commenters
correctly noted that section 1400Z-2 contemplates the start-up phase of
a trade or business. Sections 1400Z-2(d)(2)(B)(i)(II) and
(d)(2)(C)(ii), as discussed previously, reference newly formed
partnerships and corporations organized for the purpose of being a
qualified opportunity zone business. In addition, commenters
highlighted section 1400Z-2(d)(2)(D)(ii), which provides QOFs 30 months
to improve tangible property acquired for use in a QOF's trade or
business to meet the substantial improvement requirement.
b. Comments Requesting Clarifications and Simplifying Rules for Start-
Up Businesses
Commenters also requested that the final regulations provide a
number of clarifications or simplifying rules. For example, commenters
requested clarification on whether the conduct of a section 162 trade
or business must have begun by the conclusion of a working capital safe
harbor period in situations in which the plan underlying the
development of the trade or business contemplates the utilization of
multiple contributions to which a working capital safe harbor would
otherwise apply. Another commenter requested that the final regulations
include an example to clarify that the conduct of a trade or business
would be required only upon the conclusion of all working capital safe
harbors carried out as components of a single integrated plan.
Consistent with that request, commenters contended that many types of
business ventures, to achieve qualification as a section 162 trade or
business, require start-up periods in excess of a single 31-month
working capital safe harbor period.
With regard to simplifying rules, a commenter suggested that the
final regulations treat the development of a section 162 trade or
business as a qualifying section 162 trade or business, regardless of
whether the operations that constitute the trade or business have
actually begun. Other commenters requested clarification that the
ongoing development of real estate constitutes the active conduct of a
trade or business even if rent or other revenues are not yet being
collected. Similarly a commenter suggested that the final regulations
treat a QOF as engaged in a trade or business under section 162 even if
the subject business activity had generated no income. Another
commenter suggested that the ``active conduct'' requirements set forth
in paragraphs (2) and (4) of section 1397C(b) should not be treated as
applying to section 1400Z-2(d)(3)(A)(ii).
c. Creation of New 62-Month Working Capital Safe Harbor for Start-Up
Businesses
The Treasury Department and the IRS appreciate the commenters'
concerns and recommendations regarding the application of the section
162 trade or business standard to start-up businesses. To provide
taxpayers with
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straightforward and responsive rules, the Treasury Department and the
IRS have created an additional 62-month safe harbor for start-up
businesses (62-month working capital safe harbor). Unlike the 31-month
working capital safe harbor, this start-up-focused safe harbor
addresses each qualified opportunity zone business requirement, other
than the ``sin business'' prohibition under section 1400Z-
2(d)(3)(A)(iii).
As set forth in the final regulations, the 62-month working capital
safe harbor provides that, during the maximum 62-month covered period,
(1) NQFP in excess of the five-percent NQFP limitation will not cause a
trade or business to fail to qualify as a qualified opportunity zone
business, and (2) gross income earned from the trade or business will
be counted towards satisfying the 50-percent gross income requirement
(each of clauses (1) and (2) function in a manner similar to the 31-
month working capital safe harbor). In addition, the 62-month working
capital safe harbor provides that, during the maximum 62-month covered
period, (i) tangible property purchased, leased, or improved by a
business with cash covered by a working capital safe harbor, pursuant
to the plan submitted with respect to that safe harbor, will count
towards satisfaction of the 70-percent tangible property standard, and
(ii) intangible property purchased or licensed with that cash, and
pursuant to that plan, likewise will count towards the satisfaction of
the 40-percent intangible property use test.
To qualify for a maximum 62-month safe harbor period, a start-up
business must receive multiple cash infusions during its start-up
phase. Specifically, under the 62-month working capital safe harbor, a
start-up business can qualify for a 31-month safe harbor period with
respect to the business' first cash infusion. Upon receipt of a
subsequent contribution of cash (subsequent cash infusion), 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 the business satisfies the following two conditions. First,
the subsequent cash infusion must be independently covered by an
additional working capital safe harbor. Second, the working capital
safe harbor plan for the subsequent cash infusion must form an integral
part of the working capital safe harbor plan that covered the initial
cash infusion.
To ensure the proper application of the 62-month working capital
safe harbor, the final regulations also provide additional operating
rules. For example, the final regulations make clear that, regardless
of the number of subsequent cash infusions, the 62-month working
capital safe harbor cannot extend past the 62 month-period beginning on
the date of the first cash infusion covered by the safe harbor (for
example, a subsequent cash infusion received 60 months after the date
of the first cash infusion will be covered by the 62-month working
capital safe harbor for only two months). In addition, the 62-month
working capital safe harbor features a minimum investment threshold for
each subsequent cash infusion to ensure that a de minimis subsequent
infusion does not unlock a subsequent 31-month period for previously
covered tangible and intangible property. The final regulations also
provide that tangible property covered by the 62-month working capital
safe harbor plan is not considered qualified opportunity zone business
property for purposes of the special rule in section 1400Z-2(d)(3)(B).
4. Expansion of 30-Month Substantial Improvement Period
The October 2018 proposed regulations provided a 30-month
substantial improvement period of tangible property for purposes of
applying the substantial improvement requirement. Under that proposal,
tangible property is treated as substantially improved by a QOF or
qualified opportunity zone business only if, during any 30-month period
beginning after the date of acquisition of the property, additions to
the basis of the property in the hands of the QOF or qualified
opportunity zone business exceed an amount equal to the adjusted basis
of the property at the beginning of the 30-month period in the hands of
the QOF or qualified opportunity zone business. See proposed Sec.
1.1400Z2(d)-1(c)(8) (setting forth the requirement with regard to
QOFs); proposed Sec. 1.1400Z2(d)-1(d)(4) (setting forth the
requirement with regard to qualified opportunity zone businesses). The
May 2019 proposed regulations provided that the term trade or business
means a trade or business within the meaning of section 162, for both
QOFs and qualified opportunity zone businesses, and requested comments
on whether additional clarification or guidance was needed.
Several commenters pointed out that the proposed regulations are
unclear regarding the treatment of tangible property during the 30-
month substantial improvement period for a QOF and a qualified
opportunity zone business that is not utilizing 31-month working
capital safe harbor. Commenters noted that the proposed regulations do
not clarify whether non-original use tangible property undergoing a
substantial improvement process will be treated as qualified
opportunity zone business property during the 30-month substantial
improvement period. A commenter noted that just as startup businesses
have difficulty satisfying the ``used in a trade or business
requirement'' found in section 1400Z-2(d)(2)(D)(i), a QOF or qualified
opportunity zone business generally will not be able to use tangible
property in a section 162 trade or business during a 30-month
substantial improvement period.
Another commenter requested a new safe harbor for work in progress,
applicable to both QOFs and qualified opportunity zone businesses,
unrelated to the working capital safe harbor. The commenter noted that
some projects do not need working capital and that, without an
additional safe harbor, projects not utilizing the working capital safe
harbor would fail to qualify as qualified opportunity zone business
property during the 30-month substantial improvement period. The
commenter requested that assets held for work in progress be treated as
qualified opportunity zone business property for the 90-percent
investment standard found in section 1400Z-2(d)(1) (and the property be
treated as used in a trade or business) during the substantial
improvement period, if certain criteria are met.
The Treasury Department and the IRS recognize that QOFs are
ineligible to utilize the benefits of the working capital safe harbor
since the requirements found in paragraphs (2), (4), and (8) of section
1397C(b) are not applicable to QOFs, and that not all qualified
opportunity zone businesses will be able to utilize the working capital
safe harbor for a variety of reasons. Therefore, the final regulations
provide that for QOFs and qualified opportunity zone businesses,
tangible property purchased, leased, or improved by a trade or business
that is undergoing the substantial improvement process but has not been
placed in service or used in a trade or business by the QOF or
qualified opportunity zone business is treated as used in a trade or
business and satisfies the requirements of section 1400Z-2(d)(2)(D)(i)
for the 30-month substantial improvement period with respect to that
property. In order to receive such treatment, the QOF or qualified
opportunity zone business
[[Page 1924]]
must reasonably expect that the property will be substantially
improved, as defined in section 1400Z-2(d)(2)(D)(ii), and used in a
trade or business in the QOZ by the end of the 30-month substantial
improvement period.
5. Consideration of Excluding Real Estate Speculation From the
Definition of ``Trade or Business''
A commenter suggested that the final regulations modify the
definition of the term ``trade or business'' to specifically exclude
real estate speculation. The commenter asserted that real estate
speculation on projects carried out within QOZs presents a significant
potential for abuse, and reasoned that a specific exclusion of real
estate speculation from the definition of ``trade or business'' would
eliminate such potential. The Treasury Department and the IRS
appreciate the concern raised by the commenter, but note that the final
regulations address real estate speculation abuse by requiring that
land (1) be more than insubstantially improved and (2) be used in the
trade or business of a QOF or qualified opportunity zone business.
Accordingly, the final regulations do not adopt the commenter's
recommendation.
6. Consideration of Triple-Net-Leases for Active Conduct a Trade or
Business Requirement
Proposed Sec. 1.1400Z2(d)-1(d)(5)(ii)(B)(2) provided that, solely
for the purposes of determining whether a trade or business qualified
as a qualified opportunity zone business, the ownership and operation,
including leasing, of real property qualifies as an active conduct of a
trade or business. The proposed rule, however, provided that merely
entering into a triple-net-lease with respect to real property owned by
a taxpayer does not constitute an active conduct of a trade or business
by such taxpayer. See proposed Sec. 1.1400Z2(d)-1(d)(5)(ii)(B)(2)
(second sentence). The Treasury Department and the IRS determined that,
solely for purposes of determining qualified opportunity zone business
qualification, triple-net-leases constitute inappropriately passive
activities similar to holding publicly traded stock or securities.
a. Comments Suggesting Special Definitions for ``Triple-Net-Lease''
In general, commenters requested additional guidance regarding the
meaning of the term ``triple net lease'' for purposes of applying
proposed Sec. 1.1400Z2(d)-1(d)(5)(ii)(B)(2). Several commenters
suggested that the final regulations define the term ``triple-net-
lease'' as a lease in which the tenant, in addition to rent and
utilities, pays the tenant's proportionate share of the taxes,
insurance, maintenance, and other fees for the property leased.
Multiple commenters recommended that a triple-net-lease of a taxpayer
be defined to constitute an active conduct of a trade or business if
the taxpayer meaningfully participates in the management or operations
of the trade or business of the lessee. Similarly, another commenter
requested that the final regulations define a triple-net-lease to
exclude arrangements pursuant to which a taxpayer retains contractual
responsibility for meaningful capital obligations or meaningful
operating obligations. The commenter indicated that an obligation to
maintain certain structural or operating systems of a building would
qualify as a meaningful capital obligation, while obligations to
provide cleaning or grounds-keeping services would qualify as
meaningful operating obligations.
b. Comments Suggesting Active Trade or Business Qualification Based on
Section 162 Case Law
Another commenter recommended that the final regulations adopt a
rule based on case law under section 162 to determine whether a triple-
net-lease qualifies as the active conduct of a trade or business.
According to the commenter, the case law under section 162 allows a
deduction for ordinary and necessary expenses paid or incurred in
carrying on any trade or business related to a triple-net-lease if the
landlord, or an employee, agent, or contractor of the landlord,
performs the services related to the taxes, maintenance, insurance, and
similar fees even though the landlord receives payment for these
services from the tenant. Therefore, the commenter suggested that a
triple-net-lease in which the landlord, or an employee, agent, or
contractor of the landlord, performs these services should qualify as
the active conduct of a trade or business, regardless of which party
ultimately bears the cost for these services.
c. Comments Suggesting Special Rules for Active Trade or Business
Qualification
Commenters also recommended that the final regulations provide
special rules for determining whether a taxpayer entering into a
triple-net-lease with respect to real property owned by a taxpayer
constitutes an active conduct of a trade or business by such taxpayer.
For example, a commenter contended that a triple-net-lease qualify as
the active conduct of a trade or business if (1) the underlying
property meets the test under the original use requirement or the
substantial improvement requirement, and (2) assuming all other
requirements are met, qualifies as qualified opportunity zone business
property. For support, the commenter highlighted the May 2019 proposed
regulations, which provided that leased property can qualify as
qualified opportunity zone business property to a tenant that is a QOF
or a qualified opportunity zone business. This commenter reasoned that,
because leased property would be qualified opportunity zone business
property to a tenant notwithstanding the fact that the property was
subject to a triple-net-lease, it could also be qualified opportunity
zone business property to the landlord. Therefore, under the
commenter's reasoning, a lessor's participation in a triple-net-lease
could constitute the active conduct of a trade or business.
Commenters also recommended that lessor participation in certain
arrangements that utilize the rehabilitation tax credit under section
47 of the Code should qualify as an active conduct of a trade or
business. In such arrangements, a landlord owns a building that is the
subject of a rehabilitation project. The landlord acquires the
property, obtains permits and approvals, assembles the development
team, raises the funds necessary to develop the property, and places
the rehabilitated structure into service. After that initial phase, the
landlord leases the building to a tenant, who may further lease the
property to a subtenant. The landlord transfers the rehabilitation tax
credits to the original tenant pursuant to section 50(d)(5). The
commenter noted that this arrangement between the landlord and the
original tenant may constitute a triple-net-lease. As a result, the
commenter recommended that the final regulations adopt a rule to
provide specifically that such arrangements constitute the active
conduct of a trade or business.
d. Comments Suggesting Triple-Net-Leases Qualify as an Active Trade or
Business
However, other commenters disagreed with the premise of proposed
Sec. 1.1400Z2(d)-1(d)(5)(ii)(B) that merely entering into a triple-
net-lease for property owned by a taxpayer does not constitute the
active conduct of a trade or business. Several commenters noted that
triple-net-leases cause capital to enter a QOZ and provide property for
use in trades or businesses within the QOZ. These commenters also
[[Page 1925]]
emphasized that landlords and tenants often prefer triple-net-lease
arrangements, as opposed to employing a separate property manager or
agent of the landlord, because tenants often are better positioned to
control and maintain the leased property. Accordingly, the commercial
real estate industry widely employs triple-net-leasing.
e. Revisions to Proposed Triple-Net-Lease Rule for Active Trade or
Business Qualification
The Treasury Department and the IRS appreciate the comments and
recommendations received with respect to triple-net-leases. In general,
the final regulations confirm that merely entering into a triple-net-
lease with respect to real property owned by a taxpayer does not
constitute the active conduct of a trade or business by such taxpayer.
To illustrate the application of this rule, the final regulations set
forth examples describing a triple-net-lease as a lease arrangement
pursuant to which the tenant is responsible for all of the costs
relating to the leased property (for example, paying all taxes,
insurance, and maintenance expenses) in addition to paying rent. In an
instance in which the taxpayer's sole business consists of a single
triple-net-lease of a property, the final regulations confirm that the
taxpayer does not carry out an active trade or business with respect to
that property solely for purposes of section 1400Z-2(d)(3)(A).
The Treasury Department and the IRS agree with commenters that, in
certain cases, a taxpayer that utilizes a triple-net-lease as part of
the taxpayer's leasing business could be treated as conducting an
active trade or business solely for purposes of section 1400Z-
2(d)(3)(A). Accordingly, the final regulations provide an example in
which a lessor leases a three-story mixed-use building to three
tenants, each of which rents a single floor. In that example, (i) the
lessor leases one floor of the building under a triple-net-lease, but
leases the remaining two floors under leases that do not constitute
triple-net-leases, and (ii) the employees of the lessor meaningfully
participate in the management and operations of those two floors. As a
result, the example provides that the lessor is treated as carrying out
an active trade or business with respect to the entire leased building
solely for purposes of section 1400Z-2(d)(3)(A).
O. Safe Harbor for Reasonable Amounts of Working Capital
The October 2018 proposed regulations provided a 31-month working
capital safe harbor for QOF investments in qualified opportunity zone
businesses that acquire, construct, or rehabilitate tangible business
property, which includes both real property and other tangible property
used in a business operating in a QOZ (31-month working capital safe
harbor). See proposed Sec. 1.1400Z2(d)-1(d)(5)(iv); 83 FR 54279, 54284
(October 29, 2018). Solely for purposes of applying section 1397C(e)(1)
to the definition of a qualified opportunity zone business under
section 1400Z-2(d)(3), working capital assets held by the business are
treated as reasonable in amount under sections 1397C(b)(2) and 1400Z-
2(d)(3)(A)(ii) for a period of up to 31 months. See id. To qualify, the
qualified opportunity zone business (1) must have a written plan that
identifies the financial property as property held for the acquisition,
construction, or substantial improvement of tangible property in the
QOZ, (2) must have a written schedule consistent with the ordinary
business operations of the business that the property will be used
within 31 months, and (3) must substantially comply with the schedule.
See id.
The May 2019 proposed regulations provided revisions to the 31-
month working capital safe harbor in response to comments. First, the
May 2019 proposal modified the rule requiring a written designation for
planned use of working capital to include the development of a trade or
business in the QOZ as well as acquisition, construction, and/or
substantial improvement of tangible property. See proposed Sec.
1.1400Z2(d)-1(d)(5)(iv)(A); 84 FR 18652, 18659 (May 1, 2019). Second,
the May 2019 proposal provided that exceeding the 31-month period does
not violate the 31-month working capital safe harbor if the delay is
attributable to waiting for government action the application for which
is completed during the 31-month period. See proposed Sec.
1.1400Z2(d)-1(d)(5)(iv)(C); 84 FR 18652, 18659 (May 1, 2019). The May
2019 proposed regulations also clarified that a business may benefit
from multiple overlapping or sequential applications of the working
capital safe harbor, provided that each application independently
satisfies all of the requirements in proposed Sec. 1.1400Z2(d)-
1(d)(5)(iv)(A) through (C) (multiple safe harbor rule). See proposed
Sec. 1.1400Z2(d)-1(d)(5)(iv)(D).
1. Additional Guidance Regarding Reasonable Delays to Toll the 31-Month
Working Capital Safe Harbor
The Treasury Department and the IRS have received several comments
and requests for additional guidance regarding delays relating to
governmental action, as well as delays arising from a variety of other
events. With regard to applying proposed Sec. 1.1400Z2(d)-
1(d)(5)(iv)(C), one commenter requested confirmation as to whether a
delay attributable to governmental action, the application for which is
completed during the 31-month period, means that (i) the governmental
action must be pending at the end of the 31-month period or (ii) a
waiting period for governmental action at any time ``stops the clock''
on the 31-month period (and therefore the waiting period is added at
the end of the 31-month period). The commenter noted that, in certain
instances, a governmental action might be completed predictably within
a relatively short period of time, and therefore automatic tolling
might provide an overly generous result. Another commenter, however,
emphasized that the governmental permitting guidelines regarding
natural resource projects lack predictable completion timeframes
because such projects often require the receipt of several state and
local permits that are subject to various timelines. As a result, this
commenter requested that the 31-month period be tolled to accommodate
successive permits in a circumstance in which the business has received
the first serious of permits that initially tolled the 31-month period.
Commenters also recommended that the final regulations provide
that, in additional to delays resulting from governmental action,
certain events outside of a business' control will toll the 31-month
working capital safe harbor. For example, several commenters requested
that events delaying the 31-month period include, among other
occurrences, severe weather conditions, natural disasters, labor
stoppages, financing delays, and supply shortages. Another commenter
requested that trades or businesses receive an extension of the 31-
month period to account for delays arising from the cleanup of a
brownfield site due because the cleanup of such a site ordinarily will
require other lengthy regulatory approval from states and local
governments.
The Treasury Department and the IRS acknowledge the concerns raised
by the commenters. In many ordinary-course instances, however,
applicants can
[[Page 1926]]
obtain governmental permits through a routine process of predictable
duration. The Treasury Department and the IRS continue to expect a
qualified opportunity zone business, to the maximum extent practicable,
to take any actions during the governmental permitting period that are
necessary for the improvement of tangible property subject to the 31-
month working capital safe harbor. Therefore, with regard to instances
in which governmental delay does not pose a substantial obstacle for
improving such tangible property, a tolling of the 31-month period
would not be appropriate.
The Treasury Department and the IRS have determined that the 31-
month working capital safe harbor should be tolled in certain
instances, however, and have clarified and expanded the scope of
proposed Sec. 1.1400Z2(d)-1(d)(5)(iv)(C). In general, the final
regulations make clear that, if a governmental permitting delay has
caused the delay of a project covered by the 31-month working capital
safe harbor, and no other action could be taken to improve the tangible
property or complete the project during the permitting process, then
the 31-month working capital safe harbor will be tolled for a duration
equal to the permitting delay. In such case, the final regulations
require that the permit for the governmental action was completed
during the 31-month period. The final regulations also provide that, if
a project that otherwise meets the requirements of the 31-month working
capital safe harbor is located within a QOZ designated as a part of a
Federally declared disaster area (as defined in section 165(i)(5)(A)),
the qualified opportunity zone business may receive up to an additional
24 months to consume its working capital assets, provided the project
is delayed due to that disaster.
2. Clarification Regarding Overlapping or Sequential Applications of
the 31-Month Working Capital Safe Harbor
The Treasury Department and the IRS received several comments and
requests for clarification regarding the multiple safe harbor rule. In
particular, commenters questioned whether a successive application of
the 31-month working capital safe harbor can occur for the same piece
of tangible property, given that multiple 31-month harbor periods can
be utilized for that same piece of tangible property. These commenters
contended that a successive application of the 31-month working capital
safe harbor would appropriately accommodate practical realities of
improving tangible property in a trade or business (such as ordinary
course-improvement projects that typically require durations in excess
of 31 months).
The Treasury Department and the IRS confirm that a qualified
opportunity zone business may string together subsequent or overlapping
working capital safe harbors with respect to the same tangible
property. Accordingly, the final regulations specifically provide that
a qualified opportunity zone business may choose to apply subsequent
31-month working capital safe harbors for a maximum 62-month period
(that is, a duration equal to two working capital safe harbor periods),
provided that each 31-month period satisfies the requirements for
applying a 31-month working capital safe harbor. To qualify for a
subsequent 31-month working capital safe harbor period, (i) working
capital subject to an expiring 31-month period must be expended in
accordance with each requirement set forth in the section 1400Z-2
regulations, and (ii) the subsequent infusions of working capital must
form an integral part of the plan covered by the initial 31-month
working capital safe harbor.
3. Treatment of Tangible Property Not Used Upon Conclusion of a 31-
Month Working Capital Safe Harbor
Commenters also noted that, although the May 2019 proposed
regulations expanded the 31-month working capital safe harbor to
include the development of a trade or business, the proposal failed to
clarify the application of the safe harbor regarding situations in
which the qualified opportunity zone business does not use the tangible
property in the QOZ by the end of the 31-month period. For example,
commenters requested that the final regulations describe circumstances
in which a business that uses a contribution of working capital during
a 31-month period, but does not use the tangible property in a trade or
business in the QOZ by the end of the 31-month period, may continue to
be covered by the 31-month working capital safe harbor. These
commenters asserted that such a business should continue to receive
coverage by the safe harbor if, based on a consideration of the
relevant facts and circumstances, the business diligently and
reasonably continues to develop the trade or business and uses the
tangible property in a trade or business in the QOZ within a reasonable
period of time.
Another commenter suggested that the final regulations provide a
rebuttable assumption that all working capital that will be expended by
the business has been expended before each testing date, including
future tranches of working capital that, as part of the working capital
plan, will be used to substantially improve or construct new property
in a QOZ. Similarly, a commenter suggested that the final regulations
provide that, if a trade or business receives serial capital
contributions under a common written plan, the trade or business must
use cash equal to the first capital contribution within 31 months, but
is not required to use 70 percent of its tangible property in the QOZ
by the end of the 31-month period associated with the first capital
contribution. In addition, a commenter suggested that the 31-month
working capital safe harbor be revised to provide that the 70-percent
tangible property standard would not be applied until all working
capital has been expended and the substantially improved (or new)
property is placed in service by the business in the QOZ.
The Treasury Department and the IRS appreciate the commenters'
suggestions and requests for clarification, and have included
additional guidance in the final regulations. In general, the final
regulations permit a qualified opportunity zone business to treat
tangible property for which working capital covered by the 31-month
working capital safe harbor is expended as (i) used in the trade or
business of the qualified opportunity zone business, and (ii) qualified
opportunity zone business property throughout the period during which
such working capital is covered by the safe harbor. The final
regulations make clear that such improvements must be made pursuant to
the written plan governing the expenditure of the working capital
assets. In addition, the tangible property subject to such improvements
must be used in a trade or business, within the meaning of section 162,
of the qualified opportunity zone business by the end of the 31-month
working capital safe harbor. The final regulations also clarify that
unexpended amounts of working capital covered by the 31-month working
capital safe harbor are not, following the conclusion of the final safe
harbor period, treated as tangible property for purposes of applying
the 70-percent tangible property standard.
4. Consideration of Special Debt-Financed Safe Harbor for QOFs and
Qualified Opportunity Zone Businesses
A commenter requested that the final regulations provide a new safe
harbor to cover debt-financed work-in-progress projects that (i) would
operate in addition to the 31-month working capital safe harbor, and
(ii) could be
[[Page 1927]]
applied by QOFs and qualified opportunity zone businesses. For support,
the commenter emphasized that many construction projects are debt
financed and would not be covered by the 31-month working capital safe
harbor during the construction period. Accordingly, the absence of a
debt-financed safe harbor would complicate the ability to carry out
construction projects within QOZs.
The commenter suggested that, if certain requirements were met, the
final regulations should provide that (i) assets held for work-in-
progress construction projects be treated as qualified opportunity zone
business property during the construction period, and (ii) the QOF or
qualified opportunity zone business be treated as engaged in a section
162 trade or business. Requirements suggested by the commenter for this
safe harbor included (1) mandatory increases to the basis of the trade
or business in the qualified opportunity zone business property by a
prescribed multiple during the 31-month period, (2) periodic
certification requirements during the construction period, and (3)
continuous and diligent construction by the trade or business until the
completion of project and the placed-in-service date of the subject
building. Upon such date, the commenter suggested that the final
regulations retroactively treat (i) the work-in-progress property as
qualified opportunity zone business property, and (ii) the trade or
business as engaged in a section 162 trade or business beginning on the
first day of the investment by the QOF in the trade or business and
throughout the project's construction period.
The Treasury Department and the IRS appreciate the commenter's
recommendation and are sympathetic to the commenter's concern regarding
the existing business practice of using debt to finance construction.
However, section 1397C(e) clearly treats as NQFP any debt with a term
greater than 18 months. Based on the text of section 1397C(e), the
final regulations do not adopt the commenter's request to provide a
special safe harbor for debt-financed construction projects.
5. Consequence of Failure To Qualify for a 31-Month Working Capital
Safe Harbor
The Treasury Department and the IRS received comments requesting
clarification with regard to the consequences that would result if a
trade or business fails to satisfy the requirements for a 31-month
working capital safe harbor, including the imposition of penalties. In
general, if a qualified opportunity zone business fails to satisfy the
conditions for applying a 31-month working capital safe harbor, then
the qualified opportunity zone business must satisfy the requirements
of section 1400Z-2 and the 1400Z-2 regulations for qualifying as a
qualified opportunity zone business in the absence of the safe harbor.
Such failure could cause a QOF to fail to satisfy the 90-percent
investment standard, which would result in penalties to the QOF as
provided under section 1400Z-2 and the section 1400Z-2 regulations.
P. Real Property Straddling QOZ and Non-QOZ Census Tracts
To determine whether a QOZ is the location of services, tangible
property, or business functions for purposes of satisfying the
requirements of section 1400Z-2(d)(3)(A)(ii), proposed Sec.
1.1400Z2(d)-1(d)(5)(viii) provided that section 1397C(f) applies,
substituting the term ``QOZ'' for the term ``empowerment zone'' in each
instance in which the term ``empowerment zone'' appears. In addressing
the circumstance in which a business owns real property that is located
in more than one census tract, only one of which is a QOZ, proposed
Sec. 1.1400Z2(d)-1(d)(5)(viii) provided that if (1) the amount of real
property based on square footage located within the QOZ is substantial
as compared to the amount of real property based on square footage
outside of the QOZ (square footage test); and (2) the real property
outside of the QOZ is contiguous to part or all of the real property
located inside the QOZ, then all of the property is deemed to be
located within a QOZ.
1. Consideration for Eliminating Proposed Square Footage Test
Several commenters praised the Treasury Department and the IRS for
allowing real property that straddles census tracts to be treated as
located within a QOZ for purposes of determining whether the QOZ should
be treated as the location of services, tangible property, or business
functions. However, one commenter suggested that the proposed square
footage test be eliminated. The commenter reasoned that only property
located entirely within the geographic borders of a QOZ should be
treated as within a QOZ because section 1400Z-2 was enacted to increase
investment and business activity in QOZ, rather than non-QOZ census
tracts. That commenter further contended that, if the proposed square
footage test were to be finalized, at least 75 percent of the square
footage or value of the property should be located in the QOZ, with an
allocation of capital gains and profits to the property located within
the QOZ.
The Treasury Department and the IRS decline to adopt the
commenter's recommendations. With regard to the commenter's suggestion
to eliminate the proposed square footage test, the Treasury Department
and the IRS note that parcels of real property commonly extend across
census tract lines, particularly in highly populated areas. As a
result, the Treasury Department and the IRS have determined that
guidance addressing such situations would provide flexibility for
potential investors in QOZs, and therefore is consistent with the
underlying policy of section 1400Z-2. Based on the same rationale for
providing appropriate flexibility to QOF investors and encourage
additional investment within QOZs, the Treasury Department and the IRS
decline to adopt the commenter's suggestion to require that at least 75
percent of the square footage or value of the real property be located
in the QOZ in order for real property to be treated as wholly located
within the QOZ.
2. Clarification Regarding Applicability of the Unadjusted Cost Test
A number of commenters noted that the preamble to the May 2019
proposed regulations set forth an unadjusted cost test, rather than the
square footage test, to determine whether property that straddles QOZ
and non-QOZ census tracts would be treated as located within a QOZ
(unadjusted cost test). See 84 FR 18652, 18658 (May 1, 2019) (setting
forth the unadjusted cost test); proposed Sec. 1.1400Z2(d)-
1(d)(5)(viii) (setting forth the square footage test). These commenters
highlighted the relative strengths of each of these tests, and the
flexibility afforded by multiple approaches for taxpayers with land
that straddles QOZ and non-QOZ census tracts. The Treasury Department
and the IRS acknowledge that both tests would provide helpful guidance
such taxpayers and accordingly have revised the final regulations to
include both the square footage test and the unadjusted cost test.
3. Consideration of Revisions to the Square Footage Test and the
Unadjusted Cost Test and Additional Safe Harbors
The Treasury Department and the IRS received numerous comments and
recommendations regarding the square footage test and the unadjusted
cost basis test, including rules that would govern the application of
such tests in certain circumstances. For example, one commenter
suggested that, with regard to real property acquired as a single
[[Page 1928]]
parcel, the final regulations should apply the unadjusted cost test and
set forth a presumption that unadjusted cost is allocated based on the
area of the real property located inside, as compared to outside, the
QOZ. In applying this presumption to buildings, however, the commenter
suggested that the final regulations should apply the square footage
test.
The Treasury Department and the IRS also received several
recommendations regarding appropriate thresholds for the safe harbor
tests. For instance, one commenter requested that the final regulations
provide a rule to treat real property located in a QOZ as substantial,
as compared to real property located outside of a QOZ, if more than 50
percent of the total square footage of real property is located inside
of the QOZ. Another commenter suggested that the percentage of property
located in a QOZ should be increased to at least 75 percent of the
total square footage of the property. A third commenter suggested that
the final regulations provide a safe harbor to treat real property
located within a QOZ as substantial if more than 50 percent of the real
property is located in the QOZ, as measured by square footage,
unadjusted cost, fair market value, or other types of quantitative
measures. The commenter indicated that such quantitative measures might
reference the occurrence of business activities conducted on the
portion of the real property located inside of the QOZ that are
integral to the business activities conducted on the portion of real
property located outside of the QOZ.
The Treasury Department and the IRS have determined that the square
footage test and the unadjusted cost test provide appropriate levels of
flexibility for owners of property that straddles QOZ and non-QOZ
census tracts. While adoption of the commenters' recommendations would
increase the degree of guidance available to owners of such parcels,
the Treasury Department and the IRS have concluded that the complexity
resulting from adoption of these recommendations would outweigh their
intended benefits. As a result, the final regulations do not adopt the
commenters' recommendations.
4. Requested Clarification for Applying the Unadjusted Cost Test to
Leased Property
One commenter requested clarification in applying the unadjusted
cost test to leased property. Under proposed Sec. 1.1400Z2(d)-
1(d)(3)(ii)(B)(3), to determine the value of tangible property owned by
a qualified opportunity zone business for purposes of the 70-percent
tangible property standard, the unadjusted cost basis of the property
under section 1012 may be used. For tangible property leased by a
qualified opportunity zone business to meet the requirements of section
1400Z-2(d)(3)(A)(i), a taxpayer may use the methodology in proposed
Sec. 1.1400Z2(d)-1(d)(3)(ii)(B)(4). Because the unadjusted cost of
real property may be used to determine whether property located inside
of a QOZ is substantial relative to property located outside of a QOZ,
the commenter requested clarification on which method to use.
The Treasury Department and the IRS acknowledge that such guidance
could benefit taxpayers and practitioners in applying these rules.
However, because the valuation methodology in proposed Sec.
1.1400Z2(d)-1(d)(3)(ii)(B)(4) is used to value property to meet the
statutory requirements for the 70-percent tangible property standard,
the Treasury Department and the IRS decline to apply these
methodologies for all purposes. Accordingly, qualified opportunity zone
businesses may use only the square footage test or the unadjusted cost
test, to determine if the subject property is located substantially
within a QOZ when property straddles QOZ and non-QOZ tracts. The method
chosen must be applied consistently throughout the holding period under
section 1400Z-2(d)(2)(D)(iii) for such property.
5. Requested Clarification Regarding Contiguous Requirement for
Straddle Property
A number of commenters requested clarification regarding the
requirement that real property located outside of a QOZ be contiguous
to all or part of the real property located inside the QOZ. Some
commenters requested that the contiguity requirement be relaxed in the
following circumstances: (1) Two or more parcels of real property that
are not contiguous because they are separated by public property, such
as a road or a sidewalk; and (2) two or more parcels of real property
that are not contiguous because a third-party owns a right that burdens
the bordering area between the two tracts, such as an easement or other
right-of-way. Similarly, commenters have recommended that the
contiguity requirement be treated as satisfied in cases in which a
development project that is located outside of a QOZ, but in a location
either adjacent to or within a short distance from a QOZ.
The Treasury Department and the IRS appreciate the commenters'
request, and agree that the final regulations should clarify and define
contiguous property. As a result, the final regulations provide that
parcels or tracts of land will be considered contiguous if they possess
common boundaries, and would be contiguous but for the interposition of
a road, street, railroad, stream or similar property. In addition, the
final regulations exclude from the definition of the term ``common
boundaries'' boundaries of parcels of land that touch only at a common
corner.
6. Extension of Straddle Safe Harbor Principles for Purposes of the 70-
Percent Use Test
The Treasury Department and the IRS received multiple
recommendations that the final regulations extend the principles of
proposed Sec. 1.1400Z2(d)-1(d)(5)(viii) to determine whether real
property is used in a QOZ for the 70-percent use test. A portion of
these commenters requested that the extension of these principles apply
to QOFs as well as qualified opportunity zone businesses. These
commenters contended that QOFs and qualified opportunity zone
businesses should be treated similarly in this context to further the
policy of introducing new capital investment into QOZs.
For purposes of determining whether real property qualifies as
qualified opportunity zone business property, the Treasury Department
and the IRS have determined that it would be appropriate to extend the
treatment of real property that straddles QOZ and non-QOZ tracts to the
70-percent use test. The final regulations also confirm that this
extension of treatment applies to both qualified opportunity zone
businesses and QOFs. The extension of this concept provides flexibility
for trades or businesses within QOZs, and the Treasury Department and
the IRS note that the requirements for substantiality (that is, the
square footage and unadjusted cost tests) and contiguity will minimize
the occurrence of abusive arrangements.
7. Requested Expansion of QOZ Definition Under Section 1400Z-2
The Treasury Department and the IRS received a comment requesting
that the final regulations expand the definition of a QOZ.
Specifically, the commenter suggested that the definition of a QOZ be
revised to include any census tract in which a development or project
is located if (1) the relevant statistics of the census tract meet the
criteria that were originally used to identify eligible QOZ tracts; (2)
the development or project is located within one-quarter mile of an
existing or proposed high-quality transit stop; or (3) the census tract
is located
[[Page 1929]]
directly adjacent to, or within a short distance from, an existing QOZ.
For support, the commenter contended that the process to nominate
census tracts as QOZs may have omitted other tracts with similar
statistical profiles that might have qualified as QOZs if the selection
process were to have had a longer duration.
Another commenter recommended that the final regulations expand the
QOZ concept by treating certain projects located completely outside a
QOZ as though such projects are located within a QOZ. Specifically, the
commenter suggested that project components located outside of a QOZ
that are connected or necessary to the project components located
inside of the QOZ should be treated as if located in a QOZ. For
support, the commenter provided examples of industries that rely on
natural resources that might be located outside of a QOZ, and may be of
limited portability due to their connection to certain geological or
topographic land features.
The Treasury Department and the IRS appreciate the commenters'
recommendations but decline to incorporate them in the final
regulations. With regard to the commenter's request to expand the
definition of a QOZ, the Treasury Department and the IRS have
determined that such recommendation is not supported by the text of
section 1400Z-1, which sets forth the process for QOZ designation.
Moreover, the Treasury Department and the IRS note that Rev. Proc.
2018-16, 2018-9 I.R.B. 383, provided additional guidance to the Chief
Executive Officers of each state regarding the manner by which certain
population census tracts may be designated as QOZs. With regard to the
commenter's request to expand the concept of QOZs to include certain
projects located entirely outside of QOZs, the Treasury Department and
the IRS have determined that the section 1400Z-2 regulations provide
appropriate flexibility to facilitate the development of projects and
economic activity that extend beyond the geographic boundaries of QOZs.
The commenter's recommendation, if adopted, would exceed that degree of
flexibility and in certain cases potentially conflict with locational
requirements of section 1400Z-2.
Q. Application of Section 1397C Requirements and Safe Harbors to QOFs
The October 2018 and May 2019 proposed regulations provided safe
harbors to address requirements described in section 1397C that trades
or businesses must satisfy to qualify as qualified opportunity zone
businesses. These safe harbors, including the 31-month working capital
safe harbor and the active trade or business safe harbors, did not
specifically apply to QOFs. Several commenters requested clarification
regarding whether such requirements described in section 1397C for
qualified opportunity zone businesses also apply to QOFs. Many
commenters suggested that, while QOFs should not be subject to
statutory requirements imposed on qualified opportunity zone
businesses, QOFs should be permitted to apply safe harbors that address
section 1397C requirements. In addition, two commenters suggested that
the 31-month working capital safe harbor should be made available to a
QOF that otherwise meets the requirements for the safe harbor.
The Treasury Department and the IRS note that the text of section
1400Z-2 does not support the application of the section 1397C
requirements to QOFs, but rather limits the application of those
requirements to qualified opportunity zone businesses. Consequently,
the Treasury Department and the IRS have concluded that any safe harbor
made available under the proposed regulations to address a section
1397C requirement imposed on a qualified opportunity zone business
likewise should not be extended to QOFs. As a result, the final
regulations do not incorporate the commenters' recommendations.
R. Consideration of QOF Reliance Rule Regarding Satisfaction of
Qualified Opportunity Zone Business Requirements
Commenters have requested that the final regulations provide a
special QOF reliance rule. Such rule would provide that an entity may
be treated as a qualified opportunity zone business for the duration of
a QOF's ownership of the stock or partnership interest in that entity
if, at the time the QOF acquires its interest in the trade or business,
(i) the QOF does not have control over the trade or business and (ii)
the QOF reasonably expects the entity will satisfy each requirements
described in section 1400Z-2(d)(3) to qualify as a qualified
opportunity zone business.
The Treasury Department and the IRS note that, for stock or a
partnership interest to be treated as qualified opportunity zone
property and counted toward the 90-percent investment standard, the
trade or business must meet the requirements of section 1400Z-2(d)(3).
A QOF is responsible for ensuring that the requirements of section
1400Z-2(d)(3) are met when reporting the value of the QOF's assets on
Form 8996. Therefore, the Treasury Department and the IRS decline to
accept the commenter's suggestion.
S. Certain Businesses Described in Section 144(c)(6) Not Eligible To Be
Qualified Opportunity Zone Businesses
Section 1400Z-2(d)(3)(A)(iii) provides that the term ``qualified
opportunity zone business'' means a trade or business that, in addition
to satisfying other requirements described in section 1400Z-2(d)(3)(A),
is not a business described in section 144(c)(6)(B) (commonly referred
to as a ``sin business''). Section 144(c)(6)(B) lists as a sin business
any (i) private or commercial golf course, (ii) country club, (iii)
massage parlor, (iv) hot tub facility, (v) suntan facility, (vi)
racetrack or other facility used for gambling, or (vii) store the
principal business of which is the sale of alcoholic beverages for
consumption off premises. Section 1400Z-2(d)(1), which sets forth the
definitional requirements for a QOF, does not prohibit QOFs from
directly conducting section 144(c)(6)(B) sin businesses.
1. Consideration of General Application and Adoption of de minimis
Threshold
The Treasury Department and the IRS have received several comments
regarding the general application of the sin business prohibition. Many
commenters have emphasized that section 1400Z-2 explicitly prohibits
qualified opportunity zone businesses from being a sin business, but
sets forth no such prohibition for QOFs. These commenters also have
noted, however, that section 1400Z-2 does not contain any specific
provision that prohibits a qualified opportunity zone business from
leasing property to a sin business. In addition, commenters have
contended that a de minimis use of property in any sin business should
not, on its own, prevent that property from qualifying as qualified
opportunity zone business property of a QOF. Similarly, commenters
recommended that the final regulations provide rules prohibiting a
qualified opportunity zone business from leasing more than a de minimis
amount of its property to a sin business. These commenters emphasized
that section 1400Z-2(d)(3)(A)(iii) clearly conveyed Congress' intent
that a qualified opportunity zone business should not be a sin
business, and therefore should not be permitted to circumvent the
substance of the sin business prohibition simply through leasing its
property to such business.
The Treasury Department and the IRS appreciate all of the comments
[[Page 1930]]
submitted on this issue. First, the final regulations do not extend the
prohibition on sin businesses to the definition of a QOF because, as
highlighted by several commenters, section 1400Z-2 explicitly prohibits
qualified opportunity zone businesses from operating sin businesses,
but sets forth no similar prohibition for QOFs. See section 1400Z-
2(d)(3)(A)(iii) (setting forth sin business prohibition for qualified
opportunity zone businesses); section 1400Z-2(d)(1) (providing QOF
definition). In addition, the Treasury Department and the IRS agree
that section 1400Z-2 does not explicitly prohibit a qualified
opportunity zone business from leasing its property to a sin business.
However, the Treasury Department and the IRS have determined that the
purpose of section 1400Z-2(d)(3)(A)(iii) is to prevent qualified
opportunity zone businesses from operating sin businesses, which a
qualified opportunity zone business nonetheless could carry out simply
by leasing such property to a sin business. To ensure that the purpose
of section 1400Z-2(d)(3)(A)(iii) is effectuated, the final regulations
prohibit a qualified opportunity zone business from leasing more than
five percent of its property to a sin business. The Treasury Department
and the IRS have determined that this de minimis threshold will reduce
the risk of a qualified opportunity zone business inadvertently
violating the sin business prohibition.
2. Consideration of Request for Additional Detail Regarding ``Sin
Business'' Qualification
Commenters also requested that the final regulations provide
additional detail regarding the spectrum of businesses covered by the
descriptions set forth in section 144(c)(6)(B). One commenter requested
confirmation that the ``alcoholic beverage'' restriction be limited to
the clear meaning of a traditional ``liquor store'' that sells
alcoholic beverages to customers for consumption off premises, but not
to restaurants, wineries, breweries, or distilleries. Another commenter
requested clarification that full-service spa facilities operated in
hotels and other similar properties do not constitute prohibited sin
businesses.
The Treasury Department and the IRS agree with the commenters that
additional detail regarding the qualification of a business as a ``sin
business'' would be helpful in certain cases. However, the Treasury
Department and the IRS have determined that the rules suggested by the
commenters, as well as similar provisions, would inject significant
complexity into the final regulations and likely cause additional
uncertainty regarding the scope of the term ``sin business'' due to its
inherently factual nature. As a result, the final regulations do not
incorporate the commenters' recommendations.
U. Tangible Property That Ceases To Be Qualified Opportunity Zone
Business Property
Section 1400Z-2(d)(3)(B) provides a special rule that permits a
qualified opportunity zone business to treat tangible property that
ceases to be qualified opportunity zone business property as qualified
opportunity 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
the qualified opportunity zone business. The phrase ``ceases to be
qualified opportunity zone business property'' indicates that the
tangible property must have been used in a trade or business for a
period of time. The Treasury Department and the IRS have determined
that tangible property must have been qualified opportunity zone
business property used in a trade or business for at least two years.
Therefore, the final regulations provide that a qualified
opportunity zone business may apply section 1400Z-2(d)(3)(B) only if
the qualified opportunity zone business property was qualified
opportunity zone business property used by a qualified opportunity zone
business in a QOZ for at least two years. Further, to ensure that only
qualified opportunity zone business property used in a qualified
opportunity zone business is eligible for the benefits of section
1400Z-2(d)(3)(B), the final regulations provide that the 31-month
working capital safe harbor period and the 30-month substantial
improvement period pursuant to which tangible property may be treated
as qualified opportunity zone business property for purposes of the 70-
percent tangible property standard, are not taken into consideration in
determining whether property meets the requirements for eligibility
under section 1400Z-2(d)(3)(B).
V. Exceptions Based on Location in Which an Entity Is Created, Formed
or Organized
The proposed regulations clarified that a QOF must be an entity
classified as a corporation or partnership for Federal tax purposes. In
addition, a QOF must be created or organized in one of the 50 states,
the District of Columbia, or a U.S. territory, or organized under the
laws of an Indian tribal government. If an entity is organized in a
U.S. territory but not in one of the 50 states or in the District of
Columbia, then the entity may be a QOF only if the entity is organized
for the purpose of investing in qualified opportunity zone property
that relates to a trade or business operated in the territory in which
the entity is organized.
The proposed regulations further clarified that qualified
opportunity zone property may include stock or a partnership interest
in an entity classified as a corporation or partnership for Federal
income tax purposes. In addition, that entity must be a corporation or
partnership created or organized in, or under the laws of, one of the
50 states, the District of Columbia, or a U.S. territory, or organized
under the laws of an Indian tribal government. If an entity is
organized in a U.S. territory but not in one of the 50 states or in the
District of Columbia, then an equity interest in the entity may be a
qualified opportunity property only if the entity conducts a qualified
opportunity zone business in the U.S. territory in which the entity is
organized.
The proposed regulations defined a U.S. possession, now referred to
as a U.S. territory, to mean any jurisdiction outside of the 50 states
and the District of Columbia in which a designated QOZ exists under
section 1400Z-1. This definition includes the following jurisdictions:
(1) American Samoa, (2) Guam, (3) the Commonwealth of the Northern
Mariana Islands, (4) the Commonwealth of Puerto Rico, and (5) the U.S.
Virgin Islands.
Certain comments discussed the interaction between the section
1400Z-2 rules and the rules for taxation of controlled foreign
corporations (as defined in section 957) (CFCs). One commenter
requested the basis for the proposed rule requiring that a QOF be
organized in one of the 50 states, District of Columbia, or a U.S.
territory, but did not request any change. Other than for clarifying
that an entity qualifying as a QOF or qualified opportunity zone
business can be organized under the laws of an Indian tribal
government, this rule is being finalized without change. This rule was
proposed due to the difficulty of tracking whether a foreign entity
continuously satisfies the requirements for QOF status. Additionally, a
foreign entity may not be subject to Federal income tax; thus, imposing
the penalty under section 1400Z-2(f)(1) if the entity
[[Page 1931]]
fails to maintain the 90-percent investment standard set forth in
section 1400Z-2(d)(1) could be difficult. Finally, a foreign entity is
unlikely to be a QOF given the requirement that a QOF must invest
almost exclusively in QOZs, which must themselves be located only in
the United States and U.S. territories.
As noted previously, although a QOF cannot be an entity organized
in a foreign country, it can be an entity organized in a U.S.
territory. A corporation organized in a U.S. territory is treated as a
CFC on a given day if the ownership requirements in section 957 are
satisfied on that day. A United States shareholder (as defined in
section 951(b)) of a CFC generally includes in gross income, for its
taxable year in which or with which the CFC's taxable year ends, its
pro rata share of the CFC's subpart F income (as defined in section
952) under section 951(a) (subpart F regime), as well as the United
States shareholder's global intangible low-taxed income under section
951A(a) (GILTI regime), which is based on the tested income (as defined
in section 951A(c)(2)(A)) of the CFC and other items relevant to
determining the amount of the United States shareholder's inclusion in
gross income under section 951A(a).
The proposed rules relating to entities organized in U.S.
territories are adopted without change.
VI. Comments on and Changes to Proposed Sec. 1.1400Z2(e)-1
Proposed Sec. 1.1400Z2(e)-1 provided rules regarding mixed-funds
investments. This part VI of this Summary of Comments and Explanation
of Revisions addresses comments regarding proposed Sec. 1.1400Z2(e)-1
as well as comments regarding provisions of section 1400Z-2(e) that
were not addressed in the proposed regulations, such as the definition
of ``related persons'' in section 1400Z-2(e)(2). For a discussion of
whether certain transactions between investors and QOFs or qualified
opportunity zone businesses are treated as transactions between related
persons, see part II.A.1.d of this Summary of Comments and Explanation
of Revisions.
A. Related Persons and the Step Transaction Doctrine
Section 1400Z-2(e)(2) provides that, for purposes of section 1400Z-
2, parties are ``related'' if their relationship satisfies either
section 267(b) or 707(b)(1), with the threshold for relatedness lowered
from 50 percent to 20 percent. This definition applies to two
categories of transactions. First, eligible gain must arise from a sale
or exchange with an unrelated party. See section 1400Z-2(a)(1) and
proposed Sec. 1.1400Z2(a)-1(b)(2)(i)(C). Second, in order for tangible
property to qualify as qualified opportunity zone business property, a
QOF or qualified opportunity zone business must acquire the subject
tangible property from an unrelated party. See section 1400Z-
2(d)(2)(D)(i)(I) and proposed Sec. 1.1400Z2(d)-1(c)(4)(i)(A). The
proposed regulations did not further elaborate on the statutory
definition of ``relatedness.''
One commenter recommended that a sale be considered to take place
between unrelated parties for purposes of section 1400Z-2 and the
section 1400Z-2 regulations if, as part of an overall plan, the seller
and buyer become unrelated in a series of transactions that includes
the tested sale. The commenter noted that certain other income tax
regulations determine ``relatedness'' after the last step in a series
of related transactions and advocated a similar rule in the section
1400Z-2 regulations.
The Treasury Department and the IRS have determined that all
relevant provisions of the Code and general principles of tax law,
including the step transaction doctrine, govern the determination
whether a transaction is between unrelated parties for purposes of
section 1400Z-2 and the section 1400Z-2 regulations. Accordingly, the
final regulations do not include a specific step transaction rule as
requested by the commenter.
B. Non-Qualifying Investment in a QOF Corporation for Which No Stock Is
Received
Commenters requested clarification regarding the treatment of
mixed-funds investments in QOF corporations. More specifically,
commenters asked for clarification regarding situations in which a
shareholder with a qualifying investment in a QOF corporation makes a
non-qualifying investment in the QOF but receives no stock in exchange
(that is, a meaningless-gesture contribution). One commenter requested
confirmation that the shareholder in such situations has a mixed-funds
investment, and that the basis in the non-qualifying investment is
determined without regard to section 1400Z-2(b)(2)(B). Another
commenter questioned whether the shareholder would have two implicit
blocks of stock in the QOF, with separate basis determinations and with
distributions and redemptions being apportioned between the qualifying
and non-qualifying blocks of stock (analogous to the result under the
special rules for QOF partnerships discussed in part III.E.1 of this
Summary of Comments and Explanation of Revisions), or whether each
share of QOF stock would have an identical basis under general Federal
income tax principles.
The final regulations confirm that a meaningless-gesture
contribution results in a mixed-funds investment. However, the Treasury
Department and the IRS have determined that addressing the foregoing
questions regarding basis in a mixed-funds investment in a QOF
corporation is beyond the scope of the final regulations. The Treasury
Department and the IRS continue to study such issues. See REG-143686-
07, 84 FR 11686 (March 28, 2019).
VII. Comments on and Changes to Proposed Sec. 1.1400Z2(f)-1
Proposed Sec. 1.1400Z2(f)-1 prescribed rules for QOFs that fail to
maintain the 90-percent investment standard of section 1400Z-2(d)(1)
and proposed Sec. 1.1400Z2(d)-1. In particular, proposed Sec.
1.1400Z2(f)-1(b) specified the time period in which proceeds must be
reinvested in qualifying property, and proposed Sec. 1.1400Z2(f)-1(c)
provided a general anti-abuse rule.
A. Time Period for a QOF To Reinvest Proceeds
1. Reinvestment
Section 1400Z-2(e)(4)(B) provides that the Secretary shall
prescribe such regulations as may be necessary or appropriate to ensure
that a QOF has a reasonable period of time to reinvest the return of
capital from investments in qualified opportunity zone property and to
reinvest proceeds received from sale or disposition of qualified
opportunity zone property. To this end, proposed Sec. 1.1400Z2(f)-1(b)
provided that if a QOF received proceeds from the return of capital or
the sale or disposition of some or all of its qualified opportunity
zone property, and if the QOF reinvested some or all of the proceeds in
qualified opportunity zone property by the last day of the 12-month
period beginning on the date of the distribution, sale, or disposition,
then the proceeds were treated as qualified opportunity zone property
in evaluating whether the QOF satisfied the 90-percent investment
standard, but only to the extent the proceeds were continuously held in
cash, cash equivalents or debt instruments with a term of 18-months or
less. Several commenters have requested modifications to this
reinvestment rule for QOFs.
In the proposed regulations, the Treasury Department and the IRS
requested comments addressing
[[Page 1932]]
whether an analogous rule for qualified opportunity zone businesses
would be beneficial. Multiple commenters have requested an extension of
this QOF reinvestment rule to qualified opportunity zone businesses so
that certain dispositions of qualified opportunity zone business
property would not adversely affect satisfaction of the 70-percent
tangible property standard in section 1400Z-2(d)(3)(A)(i). The primary
argument for the extension of the QOF reinvestment rule to qualified
opportunity zone businesses is that like a QOF, a qualified opportunity
zone business may dispose of assets and reinvest proceeds in other
qualified opportunity zone business property. These commenters assert
that a qualified opportunity zone business in the course of its
business operations is more likely to acquire and dispose of assets
than the QOF itself.
Because section 1400Z-2(e)(4)(B) specifically directs the Secretary
to prescribe regulations relating to the time period for QOFs to
reinvest proceeds from the sale of qualified opportunity zone property
and does not explicitly refer to qualified opportunity zone businesses,
the Treasury Department and the IRS decline to extend this reinvestment
concept to similar dispositions by a qualified opportunity zone
business. However, qualified opportunity zone businesses may avail
themselves of the working capital safe harbor to enable proceeds to
qualify as qualified opportunity zone business property.
Proposed Sec. 1.1400Z2(f)-1(b) also provides that the 12-month
reinvestment period is tolled while waiting on government action if the
QOF has completed the application for action and is awaiting a
government response. A commenter requested that the time period for
waiting on government action be expanded to 24 months if a state of
emergency is declared by the federal government in the jurisdiction in
which the qualified opportunity zone property is located. The Treasury
Department and the IRS agree that the reinvestment period should be
expanded if additional delays are caused by a Federally declared
natural disaster, and have modified the rules relating to the
reinvestment period to allow for such expansion. However, a QOF must
invest proceeds as originally planned before the disaster. For example,
if a QOF is unable to invest in a certain qualified opportunity zone
business property because the property is located in a Federally
declared disaster area, the QOF must invest the proceeds in similar
property located in that QOZ.
2. Nonrecognition Provisions and Their Application to Section 1400Z-2
In the preamble to the proposed regulations, the Treasury
Department and the IRS requested comments identifying prior examples of
tax regulations that would exclude from gross income gain from the sale
or disposition of assets held by a QOF or qualified opportunity zone
business without an operative statutory nonrecognition provision. Other
code sections that permit nonrecognition of income or gain have
operative language permitting nonrecognition. In response, one
commenter recommended a rule that would exclude from gross income the
gain from the disposition of assets by a QOF if the gain was reinvested
in ``qualifying assets'' within a 180-day period after the disposition.
In support of this recommendation, the commenter explained that such a
rule would encourage reinvestment in assets located in the areas
designated as QOZs. A second commenter submitted a similar
recommendation with an additional suggestion that to qualify for
nonrecognition treatment on the disposition of assets, a QOF or
qualified opportunity zone business must satisfy a minimum holding
period for the qualified opportunity zone property or qualified
opportunity zone business property. Another commenter suggested that
nonrecognition treatment for the disposition of QOF or qualified
opportunity zone business assets should follow the principles of
sections 1031 and 1033. This commenter cited Sec. 1.1031(k)-1 with its
qualified intermediary rules as an example of a regulation that expands
the scope of the underlying Code section. While the Treasury Department
and the IRS understand that such a rule would provide additional
benefits for QOFs and qualified opportunity zone businesses, the
statutory regime permits gain deferral only at the QOF owner level;
section 1400Z-2 does not contemplate nonrecognition of gain arising
from transactions at any other level. Consequently, in order for a QOF
or qualified opportunity zone business to receive nonrecognition
treatment on the disposition of assets, the disposition must qualify
for nonrecognition treatment under another provision of subtitle A.
Accordingly, the Treasury Department and the IRS do not adopt this
recommendation.
B. Land Banking
As provided in Rev. Rul. 2018-29, 2019 I.R.B. 45, and the proposed
regulations, land that is purchased and located within a qualified
opportunity zone is not subject to either the original use requirement
under section 1400Z-2(d)(2)(D)(i)(II) or the substantial improvement
requirement under sections 1400Z-2(d)(2)(D)(i)(II) and 1400Z-
2(d)(2)(D)(ii). See additional discussion at V.H, and V.I, of this
Summary of Comments and Explanation of Revisions. However, in certain
circumstances, unimproved land might be held in a manner that is
inconsistent with the purposes of section 1400Z-2, such as if a parcel
of unimproved land does not receive new capital investment or is not
the subject of increased economic activity or output. As a result, the
Treasury Department and the IRS have requested and received comments
related to the application of the anti-abuse rule under section 1400Z-
2(e)(4)(C) to so-called ``land banking'' and similar arrangements in
addition to the general anti-abuse rule in proposed 1.1400Z2(f)-1(c).
Some commenters objected to the use of the term ``land banking'' to
describe the practice of holding land primarily for speculative
investment and without an intention to develop a trade or business on
that land and similar arrangements. These commenters noted that a
commonly used second definition of the term land banking involves
certain arrangements whereby a local government may acquire real
property and convert the property to productive use, or hold the
properties for long-term strategic purposes with the objective of
community development rather than to earn a profit. The Treasury
Department and the IRS recognize that the use of the term ``land
banking'' in the final regulations may cause confusion with this second
definition. In response to this comment, these final regulations do not
use the term ``land banking'' or another alternate term and instead
describe the non-qualifying arrangements as holding land for
speculative investment.
Several commenters requested that the final regulations explicitly
identify the policy reasons that holding land for speculative
investment is inconsistent with the purposes of section 1400Z-2.
Commenters also requested specific examples of land use that would be
abusive under the regulations. Some commenters recommended that
specific types of land use be enumerated as per se abusive including
long-term holding of vacant land and speculative passive holding of
vacant land. Another commenter recommended an anti-abuse rule that
would prohibit arrangements that only marginally improve land while
providing a significant tax benefit to investors without a clear and
direct economic benefit to the community.
[[Page 1933]]
Other commenters requested an explicit definition for the
arrangements that constitute holding land for speculative investment.
Several commenters requested and recommended a standard for the use of
land that would be considered abusive. Multiple commenters indicated
that such an anti-abuse standard should incorporate the principles of
proposed Sec. 1.1400Z2(d)-1(f), which provides that a QOF may not rely
on the proposed rules for qualified opportunity zone property in
proposed Sec. 1.1400Z2(d)-1(c)(8)(ii)(B) and (d)(4)(ii)(B) if land is
unimproved or minimally improved and the QOF or qualified opportunity
zone business purchases the land with an expectation, an intention, or
a view not to improve the land by more than an insubstantial amount
within 30 months after the date of purchase. Regarding the minimal
improvement or insubstantial improvement standard, commenters requested
that the final regulations include either a bright-line threshold or
provide examples of insubstantial improvement to land. In addition to a
bright-line threshold for insubstantial improvement, one commenter
suggested that the final regulations require that QOFs or qualified
opportunity zone businesses provide a timeline for the improvements to
be made on the unimproved land.
One commenter provided an illustration of a potentially problematic
fact pattern in which a taxpayer, a QOF or a qualified opportunity zone
business, constructs a small shed for use by an attendant on a parking
lot and charges customers to park on the lot which is, except for the
attendant's shed, vacant land. According to the commenter, this example
may represent improvements that fall in the range between insubstantial
and substantial improvement and would not be captured by a rule that
prohibits the practice of holding unimproved land merely for passive
investment due to the profit motivated trade or business activities on
the lot. By contrast, referring to a similar fact pattern, another
commenter provided an analysis that the proposed regulations were
sufficient to thwart speculative land investment of this type. The
commenter suggested that there were two existing proposed rules that
would apply to such an arrangement (1) the requirement that tangible
property must be used in the trade or business of a QOF or a qualified
opportunity zone business to be considered qualified opportunity zone
business property; and (2) the general anti-abuse rule in proposed
Sec. 1.1400Z2(f)-1(c). Under the commenter's analysis, the parking lot
fact pattern would meet the trade or business standard; however, under
the general anti-abuse rule, a significant purpose of the transaction
would be a speculative investment purpose, therefore, the arrangement
could be recast.
The Treasury Department and the IRS have provided examples to
illustrate the application of the general anti-abuse rule to two fact
patterns related to the acquisition of land that multiple commenters
have indicated require additional guidance. The first example involves
a taxpayer that establishes a parking lot business on a land parcel in
a QOZ. The second example involves a taxpayer that acquires farmland,
repurposes the land for a different principal business activity, and
makes a significant investment of capital and labor into that new
business. In the parking lot example, notwithstanding the fact that the
business has built small structures on an otherwise empty lot, because
a significant purpose for the acquisition of the land is to hold the
land for speculative investment, the anti-abuse rule functions to
recharacterize the transaction so that the taxpayer may not receive the
benefits of section 1400Z-2. By contrast, in the second example, the
taxpayer's post-acquisition investment tends to show that land is being
used to develop an operating business in the QOZ, rather than merely
being held with a minimum level of activity to reap the benefit of
appreciation on what is essentially bare land. These examples serve to
reiterate the guiding principle that land held for speculative purposes
does not further the purposes of section 1400Z-2 and the section 1400Z-
2 regulations.
C. General Anti-Abuse Rule
A number of comments addressed the anti-abuse rule of proposed
Sec. 1.1400Z2(f)-1(c), which provides that section 1400Z-2 and the
1400Z-2 regulations must be applied in a manner consistent with the
purposes of section 1400Z-2. To this end, if a significant purpose of a
transaction is to achieve a tax result that is inconsistent with the
purposes of section 1400Z-2, then the proposed regulations provided
that the Commissioner can recast a transaction to achieve consistency
with the purposes of section 1400Z-2. The determination of whether a
tax result is inconsistent with the purposes of section 1400Z-2
requires a facts and circumstances analysis.
Many commenters requested an articulation of the purposes of
section 1400Z-2 to assist taxpayers in avoiding a recast of their
transaction. The Treasury Department and the IRS have determined that
the purposes of section 1400Z-2 and the section 1400Z-2 regulations are
to provide specified tax benefits to owners of QOFs to encourage the
making of longer-term investments, through QOFs and qualified
opportunity zone businesses, of new capital in one or more QOZs and to
increase the economic growth of such QOZs. Therefore, these purposes
have been included in the text of the anti-abuse rule in the final
regulations.
Another commenter requested a safe harbor from the anti-abuse rule
for failure to comply with the rules, where the entity's efforts are in
good faith. The Treasury Department and the IRS disagree that the
purposes of section 1400Z-2 are so elusive that a good faith attempt to
comply with the rules would be subject to the anti-abuse rule. As
stated previously, the purposes of section 1400Z-2 and the section
1400Z-2 regulations are to provide specified tax benefits to owners of
QOFs to encourage the making of longer-term investments, through QOFs
and qualified opportunity zone businesses, of new capital in one or
more QOZs and to increase the economic growth of such QOZs.
Accordingly, the Treasury Department and the IRS decline to provide a
good faith exception.
Several commenters requested enumeration of specific instances of
per se abuse. Items that might be on this list include: Non-qualifying
investments; a specific rule to ensure that taxpayers do not exploit
the inventory safe harbor to evade the 90-percent investment standard
for QOFs or the 70-percent tangible property standard; and a rule,
similar to an ``anti-stuffing'' rule, that establishes that certain
transactions undertaken to qualify property as qualified opportunity
zone property, but with transitory effect, would be deemed abusive.
Other commenters suggested adding to the list of per se abuses
activities that would be harmful to the community in which the QOF or
qualified opportunity zone business operates, such as dramatically
increased rents, a high number of tenant evictions, lack of direct or
sustained community benefit, and activities not vetted by community or
local government and that result in a dislocation of community
residents. To this end, several commenters suggested that QOFs and
qualified opportunity zone businesses identify, ex ante, one or more
beneficial community outcomes that the QOF and qualified opportunity
zone businesses intend to achieve. These outcomes would include
creating quality jobs, developing affordable housing, and investing in
community
[[Page 1934]]
facilities that benefit low-income residents of the community. One
commenter recommended a safe harbor from the anti-abuse provision for
QOFs that receive third party certification demonstrating the QOF's
public benefit. The commenter cited benefit corporation legislation and
standards under the Small Business Administration as precedent for this
approach.
The Treasury Department and the IRS are appreciative of the
comments received on the anti-abuse provision. Accordingly, several
examples of the operation of the general anti-abuse rule have been
included in the final regulations.
VIII. Comments on and Changes to Proposed Sec. 1.1400Z2(g)-1
Proposed Sec. 1.1400Z2(g)-1 prescribed rules regarding the Federal
income tax treatment of QOFs owned by members of consolidated groups.
A. Section 1400Z-2 and the Consolidated Return Regulations
As discussed in part II.A.1 of this Summary of Comments and
Explanation of Revisions, section 1400Z-2 and the section 1400Z-2
regulations permit the deferral of eligible gain when a taxpayer makes
a qualifying investment in a QOF. The deferred gain is tracked by the
taxpayer's basis in its qualifying investment and is included in gross
income upon an inclusion event.
Section 1501 provides that an affiliated group of corporations, as
defined in section 1504, may elect to file a consolidated income tax
return. The regulations under section 1502 provide rules applicable to
consolidated groups. Many of the consolidated return provisions aim to
treat members of a consolidated group as a single entity. For example,
the investment adjustment rules under Sec. 1.1502-32 affect the
determination of members' basis in the stock of subsidiary members. The
purpose of the investment adjustment rules is to treat the consolidated
group as a single entity by ensuring that members' items of income,
gain, deduction, and loss are taken into account by the tax system
once, and only once.
As stated in the preamble to the May 2019 proposed regulations, the
respective frameworks of section 1400Z-2 and the consolidated return
regulations are incompatible in many respects. The preamble emphasized
that special rules would be required to harmonize the policy objectives
of sections 1400Z-2 and 1502; for example, special rules would be
required under Sec. Sec. 1.1502-13, 1.1502-19, and 1.1502-32. For this
reason, among others, the Treasury Department and the IRS proposed
treating stock of a QOF C corporation as not stock for purposes of
section 1504. Accordingly, under the May 2019 proposed regulations, a
QOF C corporation could be the common parent of a consolidated group
but could not be a subsidiary member of the consolidated group.
However, the Treasury Department and the IRS requested comments on
whether the burden of potentially applying two different sets of
consolidated return rules would be outweighed by the benefits of
permitting QOF C corporations to be subsidiary members of consolidated
groups.
The Treasury Department and the IRS received numerous comments
regarding the consolidated return rules in the May 2019 proposed
regulations. For example, as a procedural matter, commenters
recommended moving these rules to the regulations under sections 1502
and 1504. The Treasury Department and the IRS agree with this
recommendation and have moved the rules regarding the Federal income
tax treatment of QOFs owned by members of consolidated groups from
Sec. 1.1400Z2(g)-1 to Sec. Sec. 1.1502-14Z and 1.1504-3.
Part VIII.B.1 of this Summary of Comments and Explanation of
Revisions sets forth summaries of the comments received with respect to
the consolidated return rules in the May 2019 proposed regulations. The
remainder of part VIII of this Summary of Comments and Explanation of
Revisions provides the responses of the Treasury Department and the IRS
and describes the revisions adopted in the final regulations.
B. QOF C Corporation as a Subsidiary Member of a Consolidated Group
1. Comments on Consolidating Subsidiary QOF C Corporations
Commenters requested generally that QOF C corporations be permitted
to join in the filing of consolidated income tax returns as subsidiary
members. The commenters maintained that, if consolidation of subsidiary
QOF C corporations were permitted, investors would possess greater
flexibility to structure and manage qualifying investments, which would
result in increased investment in QOZs. Consistent with the preamble to
the May 2019 proposed regulations, commenters acknowledged that, if a
QOF C corporation could be a subsidiary member of a consolidated group
(QOF member), special rules might be needed under Sec. 1.1502-13
(regarding intercompany transactions), Sec. 1.1502-19 (regarding
excess loss accounts, or ELAs), and Sec. 1.1502-32 (regarding stock
basis adjustments). In particular, commenters suggested adopting rules
similar to the rules in proposed Sec. 1.1400Z2(b)-1(e)(4) for pass-
through entities to resolve complications arising from the interaction
of section 1400Z-2 and Sec. 1.1502-32.
Commenters also suggested alternatives to a blanket permission for
QOF corporations to be subsidiary members of a consolidated group. For
example, some commenters requested that subsidiary QOF C corporations
formed as members of, or acquired by, a consolidated group prior to the
publication of the May 2019 proposed regulations (pre-existing QOF
subs) be permitted to continue as QOF members. Commenters argued that,
even if the Treasury Department and the IRS decline to generally allow
the consolidation of subsidiary QOF C corporations, grandfathering
these pre-existing QOF subs would be appropriate. Those commenters
stressed that many taxpayers had evaluated, structured, and completed
transactions prior to the issuance of the May 2019 proposed regulations
based on the assumption that subsidiary QOF C corporations could join
in the filing of consolidated returns. One commenter suggested that QOF
members formed within a reasonable grace period after the issuance of
the May 2019 proposed regulations also be grandfathered.
As a second alternative, commenters requested that taxpayers be
allowed to convert their QOF members into partnerships and treat those
entities as partnerships retroactive to the date of the qualifying
investment. These commenters also requested that the final regulations
provide rules to ensure that such restructuring would not constitute an
inclusion event. Similarly, commenters requested that taxpayers be
allowed to retroactively treat a QOF C corporation either as a
nonmember of a consolidated group or as a member of the consolidated
group that is not a QOF.
Commenters also requested rules detailing the consequences of
deconsolidating pre-existing QOF subs if the Treasury Department and
the IRS decline to allow pre-existing QOF subs to remain members of the
consolidated group. The commenters requested that the deconsolidation
event not be treated as an inclusion event and suggested multiple
approaches with regard to stock basis adjustments, ELA inclusions,
application of the unified loss rule, and other issues on
deconsolidation.
[[Page 1935]]
2. Election To Consolidate a Subsidiary QOF C Corporation
As discussed in part VIII.B.1 of this Summary of Comments and
Explanation of Revisions, commenters requested that subsidiary QOF C
corporations be permitted to join in the filing of consolidated returns
while acknowledging that additional rules may be required to harmonize
the operation of section 1400Z-2 and the consolidated return
regulations. In response to these comments, the final regulations
permit the consolidation of subsidiary QOF C corporations, subject to
certain conditions. The final regulations also include special rules to
coordinate the simultaneous application of section 1400Z-2 and the
consolidated return regulations to QOF members.
a. Conditions To Consolidate a Subsidiary QOF C Corporation
These final regulations permit the consolidation of a subsidiary
QOF C corporation only if certain conditions are satisfied.
Specifically, except in very limited circumstances, and consistent with
the general principles of section 1400Z-2, the consolidated group
member that makes the qualifying investment in the QOF member (QOF
investor member) must maintain a direct equity interest in the QOF
member. In addition, the final regulations require all QOF investor
members to be wholly owned, directly or indirectly, by the common
parent of the consolidated group. The Treasury Department and the IRS
have determined that these conditions will help preserve the integrity
of the consolidated return regulations and ensure that taxpayers apply
section 1400Z-2 and the section 1400Z-2 regulations in a manner
consistent with the policies underlying section 1400Z-2 and the
consolidated return regulations.
Failure to satisfy either of the foregoing conditions for
consolidation will result in the deconsolidation of the QOF member.
Part VIII.B.4 of this Summary of Comments and Explanation of Revisions
describes the Federal income tax consequences of deconsolidation of a
QOF member.
i. Direct Ownership Requirement
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. See Sec. 1.1400Z2(b)-1(c) and
part III.A of this Summary of Comments and Explanation of Revisions;
see also the preamble to the May 2019 proposed regulations.
Accordingly, to consolidate a subsidiary QOF C corporation, the
investor member generally must retain direct ownership of the QOF stock
of the QOF member (QOF member stock). In addition, the QOF investor
member generally is subject to the same rules regarding inclusion
events as an investor in a non-member QOF. However, the final
regulations provide a limited exception for certain transfers of QOF
member stock that are treated as intercompany transactions and are
eligible for single-entity treatment. See part VIII.C.3 of this Summary
of Comments and Explanation of Revisions for a discussion of this
limited exception.
The direct ownership requirement is not a section 1502-specific
rule, for this requirement generally applies outside of consolidation
as well. The operation of the section 1400Z-2 rules requires close
monitoring of a QOF owner's basis in the qualifying investment. See
generally part III.G of this Summary of Comments and Explanation of
Revisions. Moreover, as noted in the preamble to the May 2019 proposed
regulations, application of the investment adjustment rules of Sec.
1.1502-32 results in substantial and ongoing stock basis adjustments to
QOF member stock that are unrelated to the rules and policies of
section 1400Z-2 and that complicate the operation of section 1400Z-2 in
the consolidated group context. In addition, the transfer of QOF member
stock between consolidated group members, and across ownership chains,
further increases the complexity of appropriately tracking the QOF
investor member's basis in its QOF member stock. Therefore, the
Treasury Department and the IRS have determined that applying the
general rule in Sec. 1.1400Z2(b)-1(c) (regarding dispositions of
qualifying investments) inside the consolidated group, by imposing the
direct ownership requirement on the QOF investor member, would simplify
the administration of section 1400Z-2 to QOF members. But see part
VIII.C.3 of this Summary of Comments and Explanation of Revisions for a
discussion of an exception to the general rule for certain intercompany
sales of qualifying investments.
ii. Wholly Owned QOF Investor Member
The requirement that each QOF investor member itself be wholly
owned, directly or indirectly, by the common parent of the consolidated
group further serves to prevent uneconomic or other inappropriate
outcomes that otherwise might be achieved through the interaction of
sections 1400Z-2 and 1502.
Under the general affiliation rules, to be a member of a
consolidated group, an includible corporation need not be wholly owned.
Instead, only 80 percent of the vote and value of the stock of an
includible corporation must be owned directly by other consolidated
group members. Therefore, an includible corporation that is owned 80
percent by members of a consolidated group and 20 percent by non-
members can be a member of the consolidated group (80/20 member).
The final regulations impose a stricter requirement for the
ownership of QOF investor members to ensure the application of the
inclusion rules of section 1400Z-2(b) conforms to the policy underlying
section 1400Z-2. As emphasized in part III.G of this Summary of
Comments and Explanation of Revisions, the application of key
provisions under section 1400Z-2 depends upon a close monitoring of the
basis of the qualifying investment in the hands of the QOF owner. If
QOF investor members were not required to be wholly owned, a
consolidated group effectively could alienate and monetize a
substantial portion of its qualifying investment by selling shares in
QOF investor members or in higher-tier members in a QOF investor
member's ownership chain, but the consolidated group would continue to
enjoy section 1400Z-2 benefits because direct ownership of the
qualifying investment would not change hands. The requirement that each
QOF investor member be wholly owned, directly or indirectly, by the
common parent also limits incongruities in the application of Sec.
1.1502-32 to an ownership chain that includes a QOF member. Both of
these issues are discussed later in this part VIII.B.2.a of this
Summary of Comments and Explanation of Revisions.
Under Sec. 1.1502-76(b), a consolidated group includes in its
computation of taxable income all income, gain, deduction, and loss
items of a consolidated group member, regardless of the percentage of
the member's stock that is directly or indirectly (economically) held
by the common parent. However, under Sec. 1.1502-32, the investment
adjustments that are made to the stock of that member (and up the chain
through tiers of stock ownership to the common parent) reflect only the
pro rata stock ownership held at each tier. For example, assume that
the common parent owns 80 percent of another member (R) (an 80/20
member), which owns 80 percent of the QOF investor member (also an 80/
20 member), which wholly owns the QOF member. In that case, the
consolidated group's use of a $100 loss of the QOF
[[Page 1936]]
member would result in an $80 reduction of basis in the stock of the
QOF investor member held by R, but only a $64 reduction of basis in the
stock of R held by the common parent. Adding a third 80/20 member to
the QOF member's ownership chain would result in a 51 percent indirect
interest, and adding a fourth 80/20 member would result in a 41 percent
indirect interest, thereby further reducing the extent to which the QOF
member's tax items used by the consolidated group are reflected in
stock basis up the chain.
The facial incongruity between the full inclusion of taxable items
and the pro rata adjustment to stock basis generally does not upset the
equilibrium of the consolidated return system because the rules apply
to income and gain as well as deduction and loss items. In other words,
even though a consolidated group may receive an overstated benefit in
the case of loss and deduction items (that is, full use of a member's
loss with only a pro rata decrease in the basis of the member's stock),
the consolidated group also must take into account all of a member's
income despite holding less than all of the member's stock (and getting
only a pro rata increase in the basis of the member's stock). Over the
course of years, this situation generally will remain in balance.
However, the interaction of the foregoing rules with the rules
under section 1400Z-2 upsets this balance in the case of 80/20 members
with outside investors. In fact, the exclusion of gain under section
1400Z-2(c) upon the sale or exchange of a qualifying investment not
only ensures that there will be no balancing over the course of years,
but also may offer opportunities to magnify the imbalance.
The Treasury Department and the IRS are aware that, outside of
consolidation, taxpayers can monetize the value of a qualifying
investment by selling an indirect interest in the QOF (that is, stock
in the QOF owner). However, in that case, the QOF owner would retain
all of its ownership of the qualifying investment. Because the
consolidated group computes its taxable income and tax liability as a
single entity (headed by the common parent), the sale of a portion of
the indirect interest in the QOF member out from under the common
parent is the functional equivalent of a non-consolidated QOF owner
disposing of part of its qualifying investment. Therefore, these
regulations require that the QOF investor member be wholly owned,
directly or indirectly, by the common parent.
b. Effects of Consolidating a Subsidiary QOF C Corporation
The preamble to the May 2019 proposed regulations noted, and
commenters have acknowledged, that allowing a QOF C corporation to
become a subsidiary member of a consolidated group would necessitate
the imposition of special rules. In addition to the requirements for
consolidation of a QOF member discussed in part VIII.B.2.a of this
Summary of Comments and Explanation of Revisions, these final
regulations add special rules that coordinate the application of the
consolidated return provisions and the rules in section 1400Z-2 by
imposing restrictions on the application of the full range of
consolidated return rules. The Treasury Department and the IRS have
determined that this approach is preferable to the alternative--
creating a complex set of parallel consolidated investment adjustment
rules and intercompany transaction rules applicable to QOF member stock
and transactions by QOF members.
First, as stated in the preamble to the May 2019 proposed
regulations, a special rule is needed to effectuate and harmonize the
ELA rules under Sec. 1.1502-19 and the rules of section 1400Z-2.
Section 1.1502-19 allows a consolidated group to use tax attributes of
a member (M) in excess of the consolidated group's investment in M
without recognition of gain. Instead, members owning M stock must track
the negative basis (that is, the ELA) in their M shares and must
include the ELA in income upon the occurrence of specified events,
including the disposal of M stock. However, upon a sale or exchange of
a qualifying investment, section 1400Z-2(c) permits an investor that
has held its qualifying investment for at least 10 years to elect to
treat its basis in the qualifying investment as equal to fair market
value. Thus, an investor may eliminate the appreciation on its
qualifying investment by making the election under section 1400Z-2(c).
As further noted in the preamble to the May 2019 proposed regulations,
the existence of negative stock basis is unique to the consolidated
return regulations and is not contemplated by section 1400Z-2.
Accordingly, these final regulations include a rule under which the
investor member must take its ELA into account pursuant to Sec.
1.1502-19 before its basis in the QOF member stock is adjusted to fair
market value under section 1400Z-2(c).
Second, the final regulations include a special rule to determine
when a distribution by a QOF member to the QOF investor member
constitutes an inclusion event. Generally, as provided in Sec.
1.1400Z2(b)-1(c)(8), a distribution by a QOF C corporation is an
inclusion event to the extent section 301(c)(3) applies to the
distribution. In a consolidated group, intercompany distributions are
governed by the rules in Sec. 1.1502-13(f), and distributions in
excess of the distributee's basis in the distributor do not result in
income to the distributee under section 301(c)(3); rather, the excess
amount creates or increases the distributee's ELA in the distributor
stock. Thus, to coordinate the application of section 1400Z-2 and the
consolidated return rules, these final regulations provide that a
distribution by a QOF member to a QOF investor member is an inclusion
event to the extent the distribution otherwise would create or increase
an ELA in the QOF member stock.
Third, the final regulations include a special rule for computing
the amount includible by an investor member upon the occurrence of an
inclusion event. Generally, the amount includible under section 1400Z-
2(b)(2) is determined by reference to the investor's basis in the
qualifying investment. However, when a subsidiary QOF C corporation is
a member of a consolidated group, Sec. 1.1502-32 applies to adjust the
QOF investor member's basis in the stock of the QOF member to reflect
the QOF member's income, gain, deduction, or loss. The preamble to the
May 2019 proposed regulations raised the issue of how to properly
determine the QOF investor member's amount includible when its basis in
the QOF member includes basis adjustments unrelated to section 1400Z-2.
Commenters recommended that the final regulations adopt rules
similar to those for pass-through entities to compute the QOF investor
member's amount includible under section 1400Z-2. The investment
adjustment rules under Sec. 1.1502-32 are similar to the partnership
basis provisions of section 705, and these final regulations adopt
rules similar to the special rule for pass-through entities in Sec.
1.1400Z2(b)-1(e)(4). The Treasury Department and the IRS have
determined that the adoption of this rule to compute the QOF investor
member's amount includible, in conjunction with the imposition of
certain conditions for consolidation (as discussed in part VIII.B.2.a
of this Summary of Comments and Explanation of Revisions), will avoid
many complexities in the application of the inclusion rules of section
1400Z-2 within a consolidated group.
[[Page 1937]]
Fourth, the final regulations include a special rule applicable to
transactions between the QOF's separate affiliated group (QOF SAG) and
other members of the consolidated group. A QOF SAG is, with respect to
a QOF member, the affiliated group that would be determined under
section 1504(a) if the QOF member were the common parent. The final
regulations treat a sale or exchange of property between a QOF SAG
member and a member of the consolidated group that is not a member of
such QOF SAG as a transaction that is not an intercompany transaction.
Conversely, transactions between QOF SAG members, and transactions
between a QOF SAG member and a member of the consolidated group that is
not a member of such QOF SAG other than a sale or exchange of property,
are intercompany transactions that are subject to the rules of Sec.
1.1502-13.
This rule is necessary to effectuate the application of section
1400Z-2 in a consolidated group. As noted previously in this part
VIII.B.2.b of this Summary of Comments and Explanation of Revisions,
the election under section 1400Z-2(c) potentially allows taxpayers to
permanently exclude their gain on a qualifying investment held for at
least 10 years. The availability of this benefit places additional
import on ensuring that the gain excluded as a result of the election
under section 1400Z-2(c) is not inflated by bargain sales within the
consolidated group. Treating property transactions between the QOF SAG
and other members as currently taxable helps ensure that any such
transactions are bona fide, arm's-length transactions. This treatment
also is consistent with treating the QOF as a separate entity for
purposes integral to the rules of section 1400Z-2 (for example,
treating a contribution to a QOF member as a qualifying investment).
Fifth, the final regulations provide that a consolidated group is
not treated as a single entity for purposes of determining whether a
QOF member or a qualified opportunity zone business satisfies the
investment standard rules in section 1400Z-2(d) and (f) and Sec. Sec.
1.1400Z2(d)-1 and 1.1400Z2(f)-1. Instead, these rules generally apply
separately to each consolidated group member that is a QOF or qualified
opportunity zone business. For example, in measuring whether a QOF
member meets the 90-percent investment standard, only property
(including qualified opportunity zone stock or qualified opportunity
zone partnership interests) owned by the QOF member itself is taken
into account. To preserve the separate-entity treatment of the QOF, the
QOF member cannot take into account property transferred to a member of
the consolidated group that is not a member of the QOF member's QOF SAG
in satisfying the requirements in section 1400Z-2(d). This issue was
identified in the preamble to the May 2019 proposed regulations. See
also the discussion of the inapplicability of the intercompany
transaction regulations to property transactions between QOF members
and certain other consolidated group members in this part VIII.B.2.b of
this Summary of Comments and Explanation of Revisions.
c. Anti-Avoidance Rule
As discussed in parts VIII.A, VIII.B, and VIII.C.2 of this Summary
of Comments and Explanation of Revisions, the interactions between the
consolidated return regulations and section 1400Z-2 are novel and
complex, particularly for QOF members whose consolidation is allowed
under these final regulations in response to comments received on the
May 2019 proposed regulations. In response to comments, these final
regulations also make single-entity treatment available for purposes of
section 1400Z-2 following certain transfers of qualifying investments,
including deemed transactions, between members of a consolidated group.
To prevent inappropriate interactions between the two sets of rules,
certain consolidated return regulations have been made inapplicable in
relation to QOF members and qualifying investments transferred between
consolidated group members, and the application of other consolidated
return rules has been modified. However, due to the novelty of the
interactions between the rules, the Treasury Department and the IRS are
concerned that additional, unanticipated issues may arise from those
interactions, which might be exploited to produce results that violate
the purposes underlying section 1400Z-2 or the consolidated return
regulations.
To be responsive to comments received but still provide the
flexibility necessary to obtain an appropriate balancing of the
purposes underlying section 1400Z-2 and the consolidated return rules,
these final regulations include an anti-avoidance rule. This rule
provides that, if a transaction is structured with a view to avoiding
the application of the rules of section 1400Z-2 and the section 1400Z-2
regulations or the consolidated return regulations (including section
1.1502-14Z), appropriate adjustments will be made to carry out the
purposes of section 1400Z-2 and the section 1400Z-2 regulations. For
example, if a consolidated group engages in a restructuring (such as a
distribution described in section 355) with a purpose to make use of
stock basis adjustments under Sec. 1.1502-32 resulting from increases
in the basis of stock under section 1400Z-2(b) in a sale or exchange
transaction but without disposing of any part of the consolidated
group's direct ownership of the relevant qualifying interest, the
transaction will be treated as an inclusion event with regard to an
appropriate amount of deferred gain.
3. Transition Relief
As discussed in part VIII.B.1 of this Summary of Comments and
Explanation of Revisions, commenters requested transition relief for
pre-existing QOF subs. The Treasury Department and the IRS have
determined that transition relief is appropriate, and these final
regulations include multiple elective relief options.
Under the final regulations, a pre-existing QOF sub may elect to be
reclassified as a QOF partnership, a QOF C corporation that is not a
member of the consolidated group, or a member of the consolidated group
that is not a QOF (reclassification election). A reclassification
election is effective as of the first day the pre-existing QOF sub was
acquired or formed by members of the consolidated group (day one). If a
pre-existing QOF sub makes a reclassification election, appropriate
adjustments (for example, with respect to basis adjustments under Sec.
1.1502-32 and E&P under Sec. 1.1502-33) must be made to account for
the change in status of the pre-existing QOF sub. In addition, if a
pre-existing QOF sub was a QOF C corporation before being acquired by a
consolidated group, and if the consolidated group elects to treat the
pre-existing QOF sub as a QOF partnership as of day one (that is, the
date it was acquired by the consolidated group), the conversion from a
QOF C corporation to a QOF partnership on day one is an inclusion
event. See Sec. 1.1400Z2(b)-1(c)(2).
In the alternative, a pre-existing QOF sub that meets certain
conditions may elect to maintain its status as a QOF C corporation and
remain a member of the consolidated group. See part VIII.B.2.a of this
Summary of Comments and Explanation of Revisions, which describes the
conditions for such an election. If a pre-existing QOF sub elects to
remain a member of the consolidated group, the pre-existing QOF sub
will be subject to unique rules and restrictions not typically
applicable to a consolidated group member, as discussed in part
VIII.B.2.b of this Summary of Comments and Explanation
[[Page 1938]]
of Revisions. The pre-existing QOF sub will have 90 days from the date
of publication of these final regulations to satisfy the conditions for
consolidating as a subsidiary QOF C corporation.
Transition relief is available only to pre-existing QOF subs. QOF C
corporations formed after the publication of the May 2019 proposed
regulations are not eligible for transition relief, but any such QOF C
corporation may elect to be treated as a subsidiary member of a
consolidated group. See part VIII.B.2 of this Summary of Comments and
Explanation of Revisions for a discussion of the conditions and effects
of consolidating a subsidiary QOF C corporation.
4. Deconsolidation of Subsidiary QOF C Corporation
The final regulations also provide rules regarding the
deconsolidation of QOF members. Deconsolidation can occur when a QOF
member fails to meet the general section 1504 affiliation requirements
or fails to satisfy the conditions in these final regulations to
consolidate a subsidiary QOF C corporation. In addition,
deconsolidation can occur when a pre-existing QOF sub fails to elect in
a timely manner one of the transition relief provisions discussed in
part VIII.B.3 of this Summary of Comments and Explanation of Revisions.
If a QOF member deconsolidates, the deconsolidation is treated as a
disposition for purposes of applying the rule in Sec. 1.1502-19 that
requires any ELA in the QOF member's stock to be included in income,
and it is treated as a transfer of all of the QOF member stock for
purposes of applying the unified loss rule in Sec. 1.1502-36. However,
the deconsolidation constitutes an inclusion event only to the extent
the deconsolidation event also constitutes an inclusion event as
defined in Sec. 1.1400Z2(b)-1(c). For example, if a QOF member
deconsolidates because the investor member sells 25 percent of the QOF
member stock to a nonmember, the QOF deconsolidates and Sec. Sec.
1.1502-19 and 1.1502-36 will apply to all QOF shares owned by members,
but there will be an inclusion event only for 25 percent of the shares.
In addition, if the investor member has positive basis in QOF member
stock because of investment adjustments under Sec. 1.1502-32, the
investor member retains such basis in the QOF member following
deconsolidation, but such basis is not taken into account in computing
the investor member's amount includible under section 1400Z-2(b) post-
deconsolidation.
A special E&P rule applies if the QOF member deconsolidates before
December 31, 2026. The special E&P rule reverses the general rule for
deconsolidations in Sec. 1.1502-33(e) to provide that the QOF member
retains its E&P, and to require elimination from the consolidated group
of any QOF member's E&P taken into account by other members under Sec.
1.1502-33. This special rule will permit the QOF C corporation to make
section 301(c)(1) distributions, to the extent of its E&P, following
deconsolidation without triggering inclusion of the investor member's
remaining deferred gain under section 1400Z-2(b).
5. Treatment of QOF Stock Under Section 1504
The May 2019 proposed regulations treated stock in a QOF C
corporation as not stock for purposes of section 1504. As discussed in
part VIII.A of this Summary of Comments and Explanation of Revisions,
the purpose of this rule was to prevent a subsidiary QOF C corporation
from being included as a member of an affiliated group filing
consolidated returns. However, commenters noted that, under this
proposed rule, the dividends received deduction under section 243 would
be unavailable to corporate shareholders of QOF C corporations because
qualification for that deduction depends on the distributing
corporation and shareholder being part of the same affiliated group.
Commenters recommended that, even if the final regulations preclude a
subsidiary QOF C corporation from being a member of an affiliated group
for purposes of joining in the filing of a consolidated return, the
final regulations should permit a QOF C corporation to be a member of
an affiliated group for purposes of the dividends received deduction.
In response to the foregoing comments, these final regulations
provide that QOF stock is not treated as stock only for purposes of
determining eligibility to join in the filing of a consolidated return
under section 1501. Therefore, this rule will not affect the
availability of the dividends received deduction or any other provision
that cross-references affiliation status under section 1504 other than
consolidated group membership.
C. Qualifying Investments by Members of a Consolidated Group
In response to the May 2019 proposed regulations, commenters raised
many questions regarding the interaction of the intercompany
transaction rules of Sec. 1.1502-13 and section 1400Z-2. For example,
commenters asked about the application of Sec. 1.1502-13 when a
qualifying investment is transferred in an intercompany transaction.
Many of the issues noted by commenters arise regardless of whether the
QOF is a member of a consolidated group.
The stated purpose of Sec. 1.1502-13 is to provide rules to
clearly reflect the taxable income (and tax liability) of the
consolidated group as a whole by preventing intercompany transactions
from creating, accelerating, avoiding, or deferring consolidated
taxable income or consolidated tax liability. In other words, the
existence of intercompany transactions must not affect consolidated
taxable income or consolidated tax liability. Therefore, Sec. 1.1502-
13 generally determines the tax treatment of items resulting from
intercompany transactions by treating members of a consolidated group
as divisions of a single entity (single-entity treatment).
1. Investment in QOF Member as Qualifying Investment
As discussed in part VIII.B.1 of this Summary of Comments and
Explanation of Revisions, commenters requested that subsidiary QOF C
corporations be permitted to join in the filing of consolidated
returns. In connection with this request, commenters also sought
clarification of the application of Sec. 1.1502-13 to the gain
deferred under section 1400Z-2 when an investor member makes an
otherwise qualifying investment in a QOF member.
The Treasury Department and the IRS proposed to exclude a
subsidiary QOF C corporation from consolidation because, among other
reasons, the Treasury Department and the IRS determined that section
1400Z-2 is inconsistent with the intercompany transaction regulations
under Sec. 1.1502-13. In particular, the Treasury Department and the
IRS highlighted that the stated purpose of the regulations under Sec.
1.1502-13 is to ensure that the existence of an intercompany
transaction (a transaction between two members of a consolidated group)
does not result in the creation, prevention, acceleration, or deferral
of consolidated taxable income or tax liability. Based on comments from
taxpayers and practitioners, the Treasury Department and the IRS have
considered approaches to provide additional investment structures for
potential investors in QOZs while ensuring the compatibility of such
structures with the consolidated return regulations. As a result, the
final regulations provide that an investment of eligible gain by the
investor member into a QOF member is not treated as an intercompany
transaction for purposes
[[Page 1939]]
of Sec. 1.1502-13 and, thus, is a qualifying investment for purposes
of section 1400Z-2.
2. Treatment of S's Intercompany Gain as Eligible Gain
These final regulations also include rules that clarify whether and
when capital gain from an intercompany transaction can constitute
eligible gain for purposes of section 1400Z-2.
When a member (S) sells property to another member of the
consolidated group (B) and recognizes gain, the gain is an intercompany
gain subject to Sec. 1.1502-13. The matching rule of Sec. 1.1502-
13(c) may apply to redetermine the attributes of S's intercompany gain
and to control the timing of the reporting of S's intercompany gain.
Commenters requested clarification as to whether S's intercompany gain
qualifies as an eligible gain that can be deferred under section 1400Z-
2 and, if so, the time at which S is treated as having an eligible
gain.
The final regulations clarify that S's gain and B's gain on the
property (if any) is treated as eligible gain to the extent the gain
would be an eligible gain if S and B were divisions of a single entity.
Moreover, the gain is treated as an eligible gain at the time the gain
would be taken into account (without regard to the potential
application of section 1400Z-2) if S and B were divisions of a single
entity.
3. Application of Sec. 1.1502-13 to Intercompany Transfer of a
Qualifying Investment
In discussing the complications arising from the interaction of
section 1400Z-2 and Sec. 1.1502-13, the preamble to the May 2019
proposed regulations generally focused on issues that would arise if a
subsidiary QOF C corporation were a member of a consolidated group.
Neither the May 2019 proposed regulations nor the preamble thereto
included any language on the general application of Sec. 1.1502-13 to
the transfer of qualifying investments. Whether and how Sec. 1.1502-13
applies to an intercompany transfer of a qualifying investment is an
issue regardless of whether the QOF is a QOF C corporation or a QOF
partnership, and regardless of whether the QOF C corporation is a QOF
member.
Commenters detailed the technical impediments under the current
intercompany transaction regulations to achieving single-entity
treatment when a member of the consolidated group transfers its
qualifying investment in an intercompany transaction, and they
requested guidance to grant single-entity treatment to a consolidated
group after such an intercompany transaction. Commenters also noted
that section 1400Z-2(c) does not appear to permit an election for the
basis increase to be made by any party other than the taxpayer who
makes the qualifying investment.
As discussed in the preamble to the May 2019 proposed regulations,
the availability of benefits and the continuation of deferral under
section 1400Z-2 are determined with respect to the holder's basis in
the qualifying investment. For example, a shareholder's basis in its
QOF stock differs from a shareholder's basis in the stock of non-QOF C
corporations. Because of the difficulties in tracking basis for
purposes of section 1400Z-2 following the transfer of QOF shares in
certain nonrecognition transactions (for example, in exchanges to which
section 351 applies or in reorganizations described in section
368(a)(1)(B)), the regulations generally applicable to investors in a
QOF C corporation (whether or not the QOF C corporation is a QOF
member) provide that the transfer of QOF shares in such nonrecognition
transactions is an inclusion event under section 1400Z-2(b).
The same basis tracking issues exist within a consolidated group
and are magnified by the application of Sec. 1.1502-32, which adjusts
an upper-tier member's basis in the stock of a lower-tier member to
reflect items of income, gain, loss, and deduction produced by the
lower-tier member. As discussed in part VIII.B.2.a.ii of this Summary
of Comments and Explanation of Revisions, basis adjustments to lower-
tier member stock ``tier up'' within a consolidated group under Sec.
1.1502-32. In other words, economic items recognized by lower-tier
members result in basis adjustments to the stock of upper-tier members,
resulting in blended basis at the upper tiers. Moreover, because an
upper-tier member may have economic items of its own, the basis of the
upper-tier members' stock is further blended. This blended basis in the
consolidated group creates additional tracking issues with regard to
section 1400Z-2.
In the interest of administrability and simplicity, the Treasury
Department and the IRS decline to impose complex new rules for tracing
the basis in a qualifying investment through tiers of entities and
across ownership chains within a consolidated group. Instead, to permit
the movement of qualifying investments within consolidated groups to
satisfy business needs, these final regulations allow consolidated
groups to obtain single-entity treatment only on a fully taxable
intercompany transfer of a qualifying investment. In a fully taxable
transaction, B takes a cost basis in the qualifying investment; thus,
S's basis in the qualifying investment is not replicated. As a result,
in a fully taxable transaction, the gain deferred under section 1400Z-2
is not replicated in the consolidated group. All other intercompany
transfers of qualifying investments are treated as not constituting
intercompany transactions for purposes of Sec. 1.1502-13.
As noted earlier in this part VIII.C.3 of this Summary of Comments
and Explanation of Revisions, single-entity treatment for intercompany
transfers of qualifying investments is not currently available under
the consolidated return regulations. The limited application of the
intercompany transaction rules in Sec. 1.1502-13 under these final
regulations provides consolidated groups with a workable option for
making necessary transfers of qualifying investments within the
consolidated group while preventing complications under the section
1400Z-2 rules.
To further facilitate single-entity treatment, these final
regulations enable B to make an election under section 1400Z-2(c)
following a transfer of a qualifying investment that is treated as an
intercompany transaction. Specifically, if Sec. 1.1502-13 applies to
treat S and B as divisions of a single entity for purposes of section
1400Z-2, then B (and not S) makes the election under section 1400Z-2(c)
(if eligible), as it is the member that actually owns an interest in
the qualifying investment at the time of its disposition by the single
entity. B is eligible to make the election under section 1400Z-2(c)
only if and when, treating S and B as a single entity, the single
entity would be eligible to make such an election. For example, under
single-entity treatment, S and B's holding period in the qualifying
investment is combined to determine whether the 10-year requirement for
the election under section 1400Z-2(c) has been met.
4. Treating Investment by One Member as Qualifying Investment by
Another Member
Under the May 2019 proposed regulations, the requirements in
section 1400Z-2 applied separately to each member of a consolidated
group. Thus, the same member of the consolidated group must both sell
the capital asset giving rise to eligible gain and timely invest the
proceeds in a qualifying investment. Commenters argued that this
requirement is overly restrictive and may limit the ability of
taxpayers to
[[Page 1940]]
make use of section 1400Z-2 as intended by Congress. Instead,
commenters recommended that the Treasury Department and the IRS adopt a
single-entity approach that permits a QOF investment by one member to
be treated as a qualifying investment by another member with eligible
gain. One commenter also requested that this treatment be applied to
investments made prior to June 1, 2019, allowing for a one-month grace
period following the publication of the May 2019 proposed regulations.
In response to these comments, and to further the purposes of
section 1400Z-2, the final regulations include an election to treat the
investment by one member (M2) as a qualifying investment by another
member (M1). The election is available when M1 has an eligible gain and
M2 makes an investment in a QOF that would be a qualifying investment
if M1 (rather than M2) had made the investment. If the consolidated
group makes this election, for all Federal income tax purposes M1 is
treated as making an investment in the QOF and immediately selling the
qualifying investment to M2 for fair market value. The sale of the
qualifying investment from M1 to M2 is subject to Sec. 1.1502-13, as
discussed in part VIII.C.3 of this Summary of Comments and Explanation
of Revisions.
The Treasury Department and the IRS decline to adopt the
recommendation to treat M2's investment as a qualifying investment by
M1 retroactively because such treatment is available only by election,
subject to certain conditions. However, taxpayers generally have the
option to apply these final regulations in their entirety, and in a
consistent manner, to taxable years beginning after December 21, 2017,
or to the portion of any taxable year after December 21, 2017. If a
taxpayer chooses to adopt these final regulations in their entirety for
taxable years beginning after December 21, 2017, or to the portion of
any taxable year after December 21, 2017, then taxpayers may elect to
treat an investment by M2 as a qualifying investment by M1 as of the
earlier date.
IX. Comments Not Specifically on Regulatory Text
A. Reporting
The Treasury Department and the IRS have received hundreds of
comments on whether reporting of the QOF and qualified opportunity zone
investments was needed, and what type of information should be
reported. On May 1, 2019, the Treasury Department published a notice
and request for information to seek public input on the development of
public information collection and tracking related to investment in
qualified opportunity funds. See 84 FR 18648. As indicated in the
proposed regulations, the Treasury Department and the IRS were
considering certain changes to the Form 8996 requiring QOFs to report
additional information regarding the location of their investments.
Several comments suggested that no additional reporting should be
required and that the amount of reporting already required was
sufficient. Several other comments requested that additional reporting
be allowed, but to not be onerous or prohibitive in either cost or
time. Other comments suggested that the reporting should be coordinated
with other government agencies, such as the Department of Housing and
Urban Development (HUD) or the Treasury Department's CDFI Fund, and
local and state governments.
Many commenters requested additional reporting, on items such as
location of investments, job creation in the QOZ, the impact on the
local economy, number of units of affordable housing built, and any
reduction in poverty. These comments requested that such information be
made public, including a database which the public can use to track
projects nationally and the creation of a standardized set of
performance metrics. One commenter asked for reporting guidelines for
entities that lend capital to QOFs.
The Treasury Department and the IRS are appreciative of the
comments received focused on requiring reporting of data in addition to
what is useful for tax administration purposes. Comments received in
this regard are not adopted in these final regulations. However, On
October 30, 2019, the IRS released an early release draft of Form 8996
for public review. The early release draft includes additional
reporting requirements for QOFs. The information required to be
reported focuses on data useful for tax administration purposes, data
that may also be instructive in measuring the impact and effectiveness
of the statute.
B. REITs
Several commenters discussed passing the benefits of a REIT's
qualifying investments to the REIT's shareholders. These comments
include applying the 1400Z-2(c) basis adjustment rules for E&P purposes
so that distributions of gain from the disposition of a qualifying
investment will not result in ordinary income to the REIT's
shareholders. Additionally, the commenters asked that REITs have the
ability to distribute tax-exempt capital gain dividends to the extent
attributable to the REIT's gain with respect to its qualifying
investments. The Treasury Department and the IRS have concluded that
such special rules for REITs and their shareholders would create a
vehicle in which taxpayers that do not make a qualifying investment for
the required period of time pursuant to section 1400Z-2 would
nevertheless receive the benefits of that section. Thus, these changes
were not accepted. REITs may still qualify and elect to be QOF REITs or
may distribute capital gain dividends to their shareholders who in turn
may invest those capital gain dividends in a QOF pursuant to section
1400Z-2.
C. Policy
In addition to comments concerning the proposed regulations,
several comments were received concerning the tax benefits of the
statute. For example, some commenters requested preferred treatment for
various classes of individuals and entities, including veterans,
healthcare practitioners, needy individuals, and residents of QOZs.
Several other commenters requested that the Treasury Department and the
IRS should disallow the tax benefits provided by section 1400Z-2 if
entities fail to build a sufficient number of affordable housing units.
Another commenter suggested that the tax benefits provided by section
1400Z-2 in general should be disallowed if a QOF or qualified
opportunity zone business fails to operate solely within a QOZ.
Many commenters requested a rule requiring managers of QOFs to
certify that they had not been convicted of financial crimes within the
past three years, and register with the local government that they are
managing a QOF. Further, many commenters suggested requiring QOF
managers to demonstrate that their actions have not encouraged any
additional displacement of residents in low income areas. Some
commenters were concerned with the impact that QOFs and qualified
opportunity zone businesses will have on existing small businesses
located within QOZs.
Several commenters requested that the Treasury Department and the
IRS require that QOFs and qualified opportunity zone businesses
coordinate their activities with other Federal agencies, like HUD, and
CDFI Fund, and state and local government and housing agencies. Several
others suggested allowing local jurisdictions to add criteria that is
consistent with a locality's needs and goals. Two commenters stated
that the capital invested in QOFs should be invested in
[[Page 1941]]
small and midsize businesses, rather than large corporations. Another
commenter suggested additional guidance to permit housing finance
agencies to layer their programs within QOZs with QOFs or qualified
opportunity zone businesses. One commenter requested guidance on using
QOF investments to satisfy requirements pertaining to certain
depository institutions under the Community Reinvestment Act.
Several commenters requested coordination and integration with
local government authorities including measures to coordinate projects
within QOZs with other government funded projects and a formal process
for local and regional authorities to review projects in QOZs. Another
comment suggested that the Treasury Department and the IRS mandate
cooperation by QOFs with local community banks to determine who needs
the most assistance.
The Treasury Department and the IRS received several comments
concerned that QOFs and qualified opportunity QOZ businesses would not
benefit the existing residents and businesses in designated QOZs. These
commenters suggested adding provisions to the final regulations aimed
at the prevention of displacement of residents, and targeted incentives
to aid the neediest of QOZs. Several others suggested that the Treasury
Department and the IRS require that QOF investments target local
businesses with established ties to the local communities and that
serve the local community's needs. Another comment requested that
preference should be shown to local and/or minority owned businesses,
or sustainably focused companies. Finally, a commenter suggested that
there should be a requirement that a minimum number of local residents
be employed by a QOF or qualified opportunity zone business.
In addition to the comments noted earlier, the Treasury Department
and the IRS received comments requesting that certain items, such as
food inventory or business related property owned by the residents of
QOZs, should qualify as qualified opportunity zone business property.
The Treasury Department and the IRS will continue to study the
issues addressed in these comments. However, many of these comments are
outside the scope of these final regulations. In addition the Treasury
Department and the IRS are concerned with the potential complexity
associated with creating rules that would interfere with the ultimate
intent of the statute, which is to invest new capital in low-income
communities.
D. QOZ Designations
The Treasury Department and the IRS received many comments
regarding section 1400Z-1 and the process for designating QOZs. Several
comments requested that the determination process be reopened, so new
QOZs could be designated. One commenter requested that if no investment
has occurred in a QOZ, that accommodation be provided to replace it
with another QOZ. Another comment suggested that some designated QOZs
either do not meet the statutory requirements or were mistakenly
nominated.
The Treasury Department and the IRS are appreciative of the
comments received on the designation of the QOZs. Section 1400Z-1
provides the statutory authority for one round of nominations and
designations. Thus, there are no current or proposed plans to reopen
consideration of additional census tracts to be designated as QOZs.
Several comments were received questioning how QOFs and qualified
opportunity zone businesses would be treated after the QOZ designation
expires. Another commenter asked for clarification for the treatment of
QOFs and qualified opportunity zone businesses if the census tract
boundaries change during the designation period. Under the October 2018
proposed regulations and Sec. 1.1400Z2(c)-1(b) of the final
regulations, although QOZ designations expire on December 31, 2028, a
taxpayer who makes an election under section 1400Z-2(a) and whose
holding period in the qualifying investment is at least 10 years, is
eligible to make an election described in section 1400Z-2(c) on the
sale or exchange of the qualifying investment. Accordingly, if a
portion of the taxpayer's 10-year holding period under section 1400Z-
2(c) accrues after the relevant census tract's QOZ designation expires
on December 31, 2028, this fact alone should not disqualify a
taxpayer's properly executed QOF investment from the benefit of section
1400Z-2(c).
E. Questions and Comments on the Penalty Under Section 1400Z-2(f)(1)
Under section 1400Z-2(f)(1), if a QOF fails to meet the 90-percent
investment standard, the QOF shall pay a penalty for each month it
fails to meet the requirements in an amount equal to the excess of the
amount equal to 90-percent of its aggregate assets over the aggregate
amount of qualified opportunity zone property held by the QOF,
multiplied by the underpayment rate established under section
6621(a)(2) for such month.
Several commenters requested clarification on the mechanics of this
penalty, including whether there is a possibility of the QOF, or its
investors, of losing the benefits, if the QOF fails to meet the 90-
percent investment standard for an extended period of time.
Two other commenters requested that, to calculate the penalty, only
the assets that were the subject of the deferral election, should be
included. They reason that the statute could be interpreted to assess a
QOF based upon a shortfall related to its aggregate assets, regardless
of the source of financing for those assets.
One commenter requested that the Treasury Department and the IRS
eliminate the testing dates under section 1400Z-2(d)(2)(A) and instead
adopt a penalty based on a per month penalty.
Finally, one commenter suggested that the Treasury Department and
the IRS should use the anti-abuse provision to create penalties for
failing to invest in entities that meet the policy objectives mentioned
in a prior section.
The Treasury Department and the IRS appreciate the comments
received on the penalty imposed on QOFs under section 1400Z-2(f)(1).
All comments will be considered for future guidance.
F. Reasonable Cause
Under section 1400Z-2(f)(3), no penalty shall be imposed on a QOF
with respect to any failure to meet the 90-percent investment standard
if it is shown that the failure is due to reasonable cause.
Multiple commenters requested clarification on what would
constitute reasonable cause. Several commenters requested that
reasonable cause should be defined to include circumstances that are
outside the QOF's control to deploy capital into qualifying
investments. The Treasury Department and the IRS are cognizant that
this is an area for which commenters requested relief. The final rules
provide a 6 month period in which QOFs may choose to disregard recently
contributed property from the 90-percent investment standard. That rule
may be elected in circumstances in which a QOF is unable to deploy its
capital into qualified opportunity zone property.
Another commenter requested that the final rule provide a non-
exhaustive list of circumstances that would constitute reasonable
cause. The final rule does not adopt these comments. The determination
of whether there is reasonable cause for penalty relief in a particular
case is inherently factual. The Treasury Department and the IRS have
[[Page 1942]]
determined that the appropriate standards for determining whether the
reasonable cause exception to the penalty applies in a particular case
are the general standards set out in the ``Penalty Handbook,'' which is
included in Internal Revenue Manual (IRM) at section 20.1. The Treasury
Department and the IRS will consider whether further guidance specific
to the penalty under section 1400Z-2(f)(1) is necessary in the future.
G. Regulatory Flexibility Act
The Treasury Department and the IRS received comments on the
Regulatory Flexibility Act (5 U.S.C. chapter 6) (RFA) urging that an
RFA analysis on the potential significant economic effect of these
final regulations on small entities be conducted by the Treasury
Department and the Small Business Administration. The Treasury
Department and the IRS do not agree that an analysis is required. There
is a lack of data as to the extent to which small entities invest in
QOFs, will certify as QOFs, or receive equity investments from QOFs.
However, the Treasury Department and the IRS project that most of the
investment flowing into QOFs will come from large corporations and
wealthy individuals, though some of these funds would likely flow
through an intermediary investment partnership. There may be some QOFs
and qualified opportunity zone businesses that will be classified as
small entities; however, the number of small entities significantly
affected is not likely to be substantial.
Effective/Applicability Dates
Sections 1.1400Z2(a)-1 through 1.1400Z2(f)-1, 1.1502-14Z, and
1.1504-3 generally apply to taxable years beginning after March 13,
2020. However, for the portion of a taxpayer's first taxable year
ending after December 22, 2017, that began on December 22, 2017, and
for taxable years beginning after December 21, 2017, and on or before
March 13, 2020, taxpayers may choose either (1) to apply the rules set
forth in Sec. Sec. 1.1400Z2(a)-1 through 1.1400Z2(f)-1, 1.1502-14Z,
and 1.1504-3 contained in this document, if applied in their entirety
and in a consistent manner for all such taxable years, or (2) to rely
on each section of the proposed regulations under Sec. Sec.
1.1400Z2(a)-1 through 1.1400Z2(g)-1, except for Sec. 1.1400Z2(c)-1,
issued on October 29, 2018, and on May 1, 2019, but only if applied in
their entirety and in a consistent manner for all such taxable years.
See section 7805(b)(7)
Special Analyses
I. Regulatory Planning and Review--Economic Analysis
Executive Orders 13711, 13563, and 12866 direct agencies to assess
costs and benefits of available regulatory alternatives and, if
regulation is necessary, to select regulatory approaches that maximize
net benefits (including potential economic, environmental, public
health and safety effects, distributive impacts, and equity). Executive
Order 13563 emphasizes the importance of quantifying both costs and
benefits, of reducing costs, of harmonizing rules, and of promoting
flexibility. For purposes of Executive Order 13771, this rule is
deregulatory.
The final regulations have been designated as subject to review
under Executive Order 12866 pursuant to the Memorandum of Agreement
(April 11, 2018) between the Treasury Department and the Office of
Management and Budget (OMB) regarding review of tax regulations. The
Office of Information and Regulatory Affairs has designated these
regulations as economically significant under section 1(c) of the
Memorandum of Agreement. Accordingly, the OMB has reviewed these
regulations.
A. Need for the Final Regulations
As a part of the Tax Cuts and Jobs Act (TCJA), Congress enacted
section 1400Z, which provided tax incentives related to investment in
qualified opportunity zones (QOZs). The Treasury Department and the IRS
issued proposed regulations related to section 1400Z-2 on October 29,
2018 (October 2018 proposed regulations) and May 1, 2019 (May 2019
proposed regulations), together referred to as the proposed
regulations. The numerous comments to the proposed regulations indicate
substantial interest in the opportunity zone tax incentives provided in
section 1400Z-2. The comments demonstrate a variety of opinions on how
to interpret ambiguous parts of section 1400Z-2 and on how section
1400Z-2 interacts with other sections of the tax code and corresponding
regulations. The Treasury Department and the IRS are aware of concerns
raised by commenters that some investors have been reticent to make
substantial investments in QOZs without first having additional clarity
on which investments would qualify to receive the preferential tax
treatment specified by the TCJA.
Based on these considerations, the final regulations are needed to
bring clarity to instances where the meaning of the statute was unclear
and to respond to comments received on the proposed regulations.
B. Background and Overview
Congress enacted section 1400Z-2, in conjunction with section
1400Z-1, as a temporary provision to encourage private sector
investment in certain lower-income communities designated as QOZs (see
Senate Committee on Finance, Explanation of the Bill, at 313 (November
22, 2017)). To this effect, taxpayers may elect to defer the
recognition of capital gain to the extent of amounts invested in a
qualified opportunity fund (QOF), provided that such amounts are
invested during the 180-day period beginning on the date such capital
gain would have been recognized by the taxpayer. Inclusion of the
deferred capital gain in income occurs on the date the investment in
the QOF is sold or exchanged or on December 31, 2026, whichever comes
first. For investments in a QOF held longer than five years, taxpayers
may exclude 10 percent of the deferred gain from inclusion in income,
and for investments held longer than seven years, taxpayers may exclude
a total of 15 percent of the deferred gain from inclusion in income. In
addition, for investments held longer than 10 years, the post-
acquisition gain on the qualifying investment in the QOF also may be
excluded from income. In turn, a QOF is required under the statute to
hold at least 90 percent of its assets in qualified opportunity zone
property, as measured by the average percentage of assets held on the
last day of the first six-month period of the taxable year of the fund
and on the last day of the taxable year. The statute requires a QOF
that fails this 90-percent investment standard to pay a penalty for
each month it fails to satisfy this requirement.
C. Economic Analysis
1. Baseline
The Treasury Department and the IRS have assessed the economic
effects of the final regulations relative to a no-action baseline
reflecting anticipated Federal income tax-related behavior in the
absence of these final regulations.
2. Summary of Economic Effects
The final regulations provide certainty and clarity to taxpayers
regarding utilization of the tax preferences for capital gains provided
in section 1400Z-2 by defining terms, calculations, and acceptable
forms of documentation. The Treasury Department and the IRS project
that this added certainty and clarity generally
[[Page 1943]]
will encourage taxpayers to increase the amount of investment located
in QOZs relative to the no-action baseline. The certainty and clarity
added by the final regulations and the specific regulatory decisions
they entail will further bring the volume and diversity of investment
in QOZs and in non-QOZs closer to the intent and purpose of the
statute, relative to the alternative regulatory approaches that were
considered, including the no-action baseline.
The Treasury Department and the IRS have not attempted to quantify
the economic effects of any changes in business activity stemming from
these final regulations, in part because of the uncertainty regarding
the patterns of investment that will materialize as a result of QOF
activity and the distribution of investments across opportunity zones.
The Treasury Department and the IRS do not have readily available data
or models that predict with reasonable precision the decisions that
taxpayers would make under the final regulations versus alternative
regulatory approaches, including the no-action baseline. Nor do they
have readily available data or models that would measure with
reasonable precision the loss or gain in economic surplus resulting
from these investment and business decisions relative to the decisions
that would be made under an alternative regulatory approach. Such
estimates would be necessary to quantify the economic effects of the
final regulations versus alternative approaches. Subject to these
limitations, the next two sections of these Special Analyses provide a
qualitative assessment of the economic effects of the final regulations
relative to the alternative regulatory approaches that were considered.
The Treasury Department and the IRS welcome comments on this
economic analysis as well as analysis regarding how choices made in
this regulation will materially affect specific types of investments
that are likely to attract capital that has been invested in QOFs.
3. Number of Affected Taxpayers
Because section 1400Z-2 is a new provision and many of the entities
affected by these regulations have not yet been formed, there is
considerable uncertainty regarding the number of taxpayers that will
eventually be affected by the final regulations. Based in part on the
preliminary number of taxpayers filing Form 8996 for tax year 2018 and
the assumption that a QOF will on average have 10 investors, the
Treasury Department and the IRS project that between 5,500 and 12,000
QOFs, 6,000 to 15,000 qualified opportunity zone businesses, and 55,000
to 120,000 investors in QOFs will eventually be affected by the final
regulations.
4. Economic Effects of Provisions Substantially Revised From the
Proposed Regulations
a. Eligible Gains From Section 1231 Property
The final regulations provide that a gain is eligible for deferral
under section 1400Z-2(a) if the gain is treated as a capital gain for
Federal income tax purposes. There is uncertainty, however, regarding
how to treat gains arising from selling section 1231 property. Section
1231 property is certain property used in a trade or business, such as
depreciable property and land, and also includes capital assets subject
to an involuntary conversion, such as arising from a natural disaster
or theft. Under the Code, gains from the sale or exchange of section
1231 property are characterized as capital gains if the sum of all
section 1231 transactions for the taxable year is positive. If the sum
of all section 1231 transactions for the year is negative, then the
losses are ordinary losses.\1\
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\1\ One source of ambiguity is determining whether gain from
selling an item of section 1231 property that is potentially
eligible for deferral should be included in the summation of 1231
property in the year the deferral begins or the year the deferral
ends.
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The Treasury Department and the IRS considered two main options for
the treatment of gains from section 1231 property.\2\ The primary issue
is whether the amount of the gains eligible for deferral is based on
the sum of all sales over the taxable year or on an item-by-item basis.
These approaches are also referred to as the net approach and gross
approach, respectively.
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\2\ The Treasury Department and the IRS also considered the
option of not issuing specific guidance on this topic but determined
that this was clearly inferior to the two main options.
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The statute also sets a 180-day requirement for investment in a QOF
beginning on the date of the sale or exchange generating the gain, to
be eligible for deferral under section 1400Z-2(a). The two options for
calculating eligible section 1231 gains further determine when the 180-
day requirement begins. When gains are based on the sum of sales over
the taxable year, the 180-day period starts at the end of the taxable
year, after it is determined whether the sum is positive or negative,
and how large the net positive gain is. When gains are counted item-by-
item, it is possible, although not necessary, to start the 180-day
period from the date of each sale.
The proposed regulations used the net approach. Under the proposed
regulations, the only gain arising from section 1231 property eligible
for deferral under section 1400Z-2(a) was the amount by which the gains
arising from all of a taxpayer's section 1231 property exceeded all of
the taxpayer's losses from section 1231 property for a taxable year. In
addition, the proposed regulations provided that the 180-day period for
investment with respect to capital gain net income from section 1231
property for a taxable year began on the last day of the taxable year
without regard to the date of any particular disposition of section
1231 property.
The final regulations adopt the gross approach. Under the final
regulations, eligible section 1231 gains are determined on an item-by-
item basis and therefore positive gains are not reduced by section 1231
losses. Furthermore, the amount of the gain is known at the time of
each sale so it is not necessary for the taxpayer to wait until the end
of the taxable year to determine whether any positive section 1231
sales will be offset by losses. As a consequence, the final regulations
further provide that the 180-day period for investing an amount with
respect to an eligible section 1231 gain for which a deferral election
has been made begins on the date of the sale or exchange that gives
rise to the section 1231 gain. In addition, the final regulations do
not determine the character of eligible section 1231 gains, other than
as gains arising from the sale or exchange of section 1231 property,
until the taxable year such gains are taken into account in computing
gross income pursuant to section 1231(a)(4). The treatment of section
1231 property under the gross option is essentially the same treatment
provided in the final regulations for gain arising from the sale of a
capital asset as defined by section 1221.
To illustrate this discussion, suppose that Corporation A sells two
pieces of section 1231 property during the taxable year, one for a $100
gain early in its taxable year and the other for a $30 loss later in
its taxable year. Suppose that Corporation B also sells two pieces of
section 1231 property during the taxable year, one for a $20 gain, the
other for a $50 loss. Neither taxpayer realizes any other capital gain
during the taxable year.
Under the net approach, Corporation A's net gain is $70, which is
positive. Thus, it would be able to defer up to $70 in capital gain by
investing in a QOF. Corporation B has a net loss from selling section
1231 property. This net loss would be treated as ordinary and no
[[Page 1944]]
gains would be deferrable under section 1400Z-2(a). Furthermore,
although Corporation A sells the first piece of property for a gain
early in its taxable year, it would not be able to make a qualifying
investment in a QOF until the last day of the taxable year, because it
needs to wait until the end of the tax year to determine whether it is
eligible to defer any of the gain.
Under the gross approach, only the gains need to be accounted for.
Corporation A would be able to defer $100 in gain and Corporation B
would be able to defer $20. In this case, the amount of gain eligible
for deferral increases for both taxpayers. The total amount of gain
eligible for deferral increases from $70 to $120 compared to the net
approach.
Although not determinative, we note that the gross approach, as
adopted under the final regulations, will generally expand the pool of
gains eligible for deferral under section 1400Z-2(a) relative to the
net approach specified under the proposed regulations.\3\ Based on
recent taxpayer records, the Treasury Department and the IRS estimate
that the gross option may increase the amount of eligible gains by four
to eight percent compared to the net option. The increase in
potentially eligible gains overstates the likely increase in investment
in QOFs resulting from using the gross approach (rather than the net
approach) for two different reasons. First, for many taxpayers, the
amount of section 1231 gains is not likely to be a binding constraint
on the amount of investment made by the taxpayer into a QOF because of
the ability of the taxpayer to defer other sources of capital gains.
Second, taxpayers have considerable discretion over when to realize
gains, and even under the net approach taxpayers could often plan on
selling section 1231 property with sufficient net gain in a taxable
year to cover the amount of desired QOF investment. The Treasury
Department and the IRS have not attempted to estimate the overall
effect of this provision of the final regulations (relative to the
proposed regulations) on either QOZ or non-QOZ investment.
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\3\ For a given set of section 1231 sales, positive gains for
each individual taxpayer will never be lower under the gross
approach than the net approach; this result follows from
mathematical principles and is not specific to this example. In
practice, taxpayers might choose to recognize gains differently
under the two approaches. This difference complicates any projection
of actual gains that would be eligible for deferral.
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An additional effect of the gross option would be to minimize the
tax considerations of determining the best time to sell section 1231
property, leading to a more efficient use of resources. Under the gross
option, taxpayers would be less likely to delay or rush selling section
1231 property in order to achieve the desired amount of net gain that
would be eligible for deferral within a particular year. Also, under
the gross option, taxpayers would have more flexibility in realizing
gains eligible to be invested in a QOF in calendar year 2019.
The Treasury Department and the IRS considered several variations
to these two primary options. For example, one intermediate option
would have required taxpayers to wait to determine the capital gain
character of section 1231 property sales until summing at the end of
the taxable year, but then allow the gross amount of gains to be
eligible for deferral if the net is positive. Under this intermediate
option, Corporation A would be eligible to defer $100 in gain, while
Corporation B would not be able to defer any amount. The pool of
eligible gains would be greater than under the net option, but less
than the gross option. This intermediate option would also have the
costs similar to the net option regarding the need for taxpayers to
wait to until the end of the taxable year before investing in a QOF.
The number of taxpayers expected to be affected by this aspect of
the final regulations ranges between 36,000 and 80,000 investors in
QOFs.
b. Sales or Exchanges of Property by QOF Partnerships and QOF S
Corporations
The Treasury Department and the IRS considered three options for
how owners of QOF partnerships and QOF S corporations may exclude gains
from tax on qualifying investments in the QOF held longer than 10
years. First, the Treasury Department and the IRS considered not
providing a specialized rule for QOF partnerships and QOF S
corporations. Under this option, owners of a QOF would need to sell or
exchange their QOF ownership interest to another party in order to
receive the exemption from tax on the gain. For certain business
structures, this would not be the most efficient way to dispose of the
assets of the QOF. For example, suppose QOF A has 20 partners and QOF A
owns two commercial buildings that are qualified opportunity zone
business property. If another investor B would like to purchase one of
the buildings, it would generally be easier for QOF A to sell the
building to investor B directly, rather than investor B buying out the
partnership interests of several or all of the partners of QOF A. Under
this first option, the owners of QOF A would only receive tax free gain
from their investment if they are able to find an investor willing to
buy their partnership interests in QOF A. This option would likely lead
to relatively high negotiating costs and may reduce the pool of
potential buyers for QOF assets.
Second, the May 2019 proposed regulations proposed that investors
in a QOF partnership or a QOF S corporation could elect to exclude
capital gains arising from the QOF selling qualified opportunity zone
property from gross income. This option would provide a simpler way for
owners of pass-through QOFs to receive tax-free gain, but it would
apply only in certain cases. It would apply only to capital gains and
not ordinary gains, such as the recapture of depreciation deductions.
Also, this option would apply only to QOFs selling qualified
opportunity zone property, and would not apply to qualified opportunity
zone business property sold by a qualified opportunity zone business
that is a subsidiary of the QOF.
Third, the final regulations allow QOF owners to elect to exclude
from gross income all gains and losses of a QOF partnership or QOF S
corporation (except those deriving from sales of inventory in the
ordinary course of business). This would allow the gains from the sale
of qualified opportunity zone business property by a qualified
opportunity zone business to flow through to the owners of the QOF as
excluded from income. This election can be made on an annual basis, but
it must apply to all gains and losses of the QOF partnership or QOF S
corporation for that taxable year. In addition, when the proceeds from
the asset sales are reinvested, rather than distributed as cash, then
the QOF owner's share of the qualifying investment is reduced as the
reinvested amount is deemed to be a non-qualifying investment.
These rules generally match the tax treatment that would exist for
an owner of a QOF partnership or QOF S corporation after selling a
qualifying investment in the QOF after it has been held at least 10
years, but would avoid the extra costs associated with negotiating the
selling price of the interest in the QOF, rather than the underlying
assets owned by the QOF or qualified opportunity zone business. The
Treasury Department and the IRS project that this approach will lead to
a reduction in transactions costs for taxpayers relative to alternative
approaches (the no-action baseline and the proposed regulations), and
will continue to treat similar taxpayers similarly. The number of
taxpayers
[[Page 1945]]
expected to be affected by this rule ranges between 5,000 and 11,500
QOFs, and 50,000 to 115,000 investors in QOFs.
c. Substantial Improvement of Qualified Opportunity Zone Business
Property
Section 1400Z-2(d)(2)(D) requires that if tangible property was
already used in a QOZ (non-original use asset) when purchased by a QOF
or qualified opportunity zone business, then it needs to be
substantially improved by the QOF or qualified opportunity zone
business before it can become qualified opportunity zone business
property. Substantial improvement, as defined by section 1400Z-
2(d)(2)(D)(ii), requires the QOF or qualified opportunity zone business
to more than double the adjusted basis of the property within 30 months
after acquiring the property. The Treasury Department and the IRS
considered two options for how to measure substantial improvement.
First, the proposed regulations provided an asset-by-asset
approach. This option would require each property to be substantially
improved in order to become qualified opportunity zone business
property. For example, if a QOF purchases an existing commercial
building, a separate determination for each piece of tangible property
associated with the building would be needed, such as the structure
itself, and every item of furniture and equipment within the building
that is not part of the building structure.
This approach would limit the ability of taxpayers to purchase
property already used within a QOZ, place that property in service in
the taxpayer's business with little improvement from the previous
owner, and have the property be qualified opportunity zone business
property. This option would also likely encourage the purchase and
substantial improvement of existing property with low existing basis;
that is, property where it is easier for improvement expenditures to
double the existing basis. Such properties are more likely to be older
and more in need of repair and upgrades.
Second, the final regulations allow taxpayers to use an asset-by-
asset approach (as provided in the proposed regulations) or a more
aggregative approach. The final regulations allow purchased original
use property to count towards the determination of whether non-original
use property has been substantially improved if such purchased original
use property improves the functionality of the non-original use
property along with other conditions. Also, certain betterment
expenses, such as environmental remediation or utility upgrades, which
are properly chargeable to the basis of the land, may be added to the
basis of a building on the land that was non-original use property for
the purpose of calculating substantial improvement of that building.
These rules in effect expand the definition of what expenses could be
considered improvements for a particular asset. In some cases, this
option could reduce compliance costs for taxpayers, as it is not always
clear under the Code and regulations when expenditures should be
considered an improvement of an existing property, for example a
building, or be considered separate depreciable property.
These rules will make it easier for purchased non-original use
property to be substantially improved compared to the proposed
regulations. This will help to smooth the cliff effect that occurs with
the statutory requirement that improvements need to more than double
the cost basis. For example, suppose a QOF purchases a non-original use
building in a QOZ for $1 million, makes $950,000 in improvements to the
building that bring that building into good condition for that local
market, and purchases $50,001 of furniture or equipment for use within
the building. This building would not meet the substantial improvement
test under the proposed regulations but it would meet it under the
final regulations.
In addition, the final regulations allow a QOF or qualified
opportunity zone business to aggregate multiple buildings into a single
property for purposes of the substantial improvement test. The
buildings must either be entirely located within a parcel of land
described in a single deed, or the buildings may be on contiguous
parcels of land with separate deeds if certain conditions are met that
indicate the buildings are related in management or use.
This rule would expand the number of existing buildings in a QOZ
that could be purchased by a QOF or a qualified opportunity zone
business and be deemed to have met the substantial improvement test
relative to the first option. For example, one expensive renovation
project would provide excess ``improvement expenses'' that could be
applied to other buildings. This increases the likelihood that certain
substantial renovation projects would be undertaken. However, the
ability to aggregate improvement of non-original use property could
effectively allow a QOF or qualified opportunity zone business to
purchase property already fully in use in a QOZ and count it as
qualified opportunity zone business property, though use by the new
owner would be qualitatively similar to the previous owner.
In summary, the Treasury Department and the IRS considered two
primary options for how much aggregation to allow when determining
whether purchased non-original use property satisfied the substantial
improvement test. The different options would likely have different
effects on the amount and distribution of non-original use property
purchased by QOFs and qualified opportunity zone businesses. The
proposed regulations would not allow any aggregation, and instead
require each of the assets purchased under this option to receive
substantial improvement. This would focus improvement expenditures on
properties most in need of considerable rehabilitation to remain
productive.
The final regulations allow aggregation, and will likely encourage
the purchase and improvement of more non-original use property compared
to the proposed regulations. The final regulations will also likely
lead to a broader mix of properties purchased and improved relative to
the first option. However, the final regulations also increase the
likelihood that some buildings will meet the substantial improvement
test when the individual building receives little to moderate
improvements. Overall, the rules provided in the final regulations make
it easier for a non-original use property to be substantially improved
relative to the proposed regulations, which will encourage more
investment through QOFs.
The Treasury Department and the IRS project that the number of
taxpayers expected to be affected by this rule ranges between 5,500 and
12,000 QOFs plus 6,000 to 15,000 qualified opportunity zone businesses.
d. Vacancy
Property that is eligible for opportunity zone treatment must be
``original use'' or substantially improved. This statutory language
leaves open the question of the conditions under which vacant property
that is developed and used by an opportunity zone business might count
as original use.\4\ The Treasury Department and the IRS considered
options of one, three, or five years for how long existing property
located in a QOZ must be vacant before the purchase
[[Page 1946]]
of such property would allow it to be considered original use property.
The May 2019 proposed regulations proposed that property would need to
be vacant for at least five years prior to the purchase by a QOF or
qualified opportunity zone business in order to satisfy the original
use requirement under section 1400Z-2(d)(2)(D)(i)(II).
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\4\ The Treasury Department and the IRS also considered taking
no action but determined that providing a definition of vacancy and
setting a time period for when vacant property could be purchased
and considered original use property would be beneficial relative to
providing no specific guidance.
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In selecting among these options, the Treasury Department and the
IRS recognize that vacant property is an underused resource to the
owner and potential users of the property, and can lower the value and
use of neighboring property. The Treasury Department and the IRS
further recognize that property could become vacant due to economic
reasons unrelated to section 1400Z-2, but also because the owner
strategically let the property become or stay vacant in expectation
that the property would have a higher resale value if it were eligible
to be original use property under section 1400Z-2(d)(2)(D)(i)(II).
A shorter period of required vacancy provides a greater incentive
for owners of vacant property to keep it vacant for purposes of later
selling it for use as original use property. This incentive may also
result in owners vacating property that is currently occupied. On the
other hand, a longer period of required vacancy means that on average
properties would remain vacant for a longer period before being sold
and put into productive use, which would increase the likelihood that
such property (and possibly surrounding property) would be
inefficiently used.
The final regulations provide that the required time of vacancy is
three years except for property that was vacant as of the date of
publication of the QOZ designation notice in which the designation of
the QOZ is listed, in which case the vacancy period is one year. This
one-year period for vacant property at the time of designation provides
an incentive for property that was vacant for economic reasons at the
time of publication of the QOZ designation notice to be quickly placed
back into service through sale to a new owner, thus reducing the social
costs that would occur if those properties remained unused, relative to
the longer three-year period. The three-year period for property that
was not initially vacant makes it costly for owners to strategically
limit the use of the property in order to gain a more favorable
condition for selling the property in the future, relative to a shorter
period. The Treasury Department and the IRS recognize, however, that
even under this three-year specification, there may be situations where
a property becomes vacant for a period of time due to economic reasons
and the owner of that property decides to let the property remain
vacant in order to receive an expected higher price upon selling after
the three-year vacancy period is met.
The number of taxpayers expected to be affected by this rule ranges
between 5,500 and 12,000 QOFs plus 6,000 to 15,000 qualified
opportunity zone businesses.
e. Subsidiary of a Consolidated Group
The statute is silent regarding the treatment of corporate
taxpayers that file consolidated returns and seek to invest in a QOF.
The Treasury Department and the IRS considered two options to address
this issue. Under the proposed regulations a consolidated group could
invest in a corporate QOF only if the QOF would not be treated as part
of the consolidated group for tax filing purposes. That is, a QOF could
not be a subsidiary of a consolidated group, because of concerns of
potential conflicts between the section 1400Z-2 rules and the
consolidated group rules in Sec. 1.1502. Under this approach, the
gains and losses of a corporate QOF would not be shared with the
consolidated group owning the QOF when determining aggregate tax
liability of the consolidated group, but rather the QOF would file its
own tax return, leading to a small increase in compliance burden.
This treatment could affect the choice of QOF entity for a
consolidated corporate group that wanted to own a QOF, making a
partnership QOF a more likely choice as tax attributes of the
partnership QOF (income, deductions, credits, etc.) would flow to the
member of the consolidated corporate group that owns the QOF. Sharing
those tax attributes of a partnership QOF with other members of the
group is subject to certain limitations. However, if the QOF is a
corporate subsidiary member of the consolidated group, there is more
flexibility with how tax attributes of the QOF are shared with the rest
of the consolidated group. In addition, some corporate consolidated
groups are likely to favor a using a corporate form due to familiarity
with the corporate rules that would lead to lower organizational costs.
These additional organizational or tax compliance costs are not likely
to be large, but nevertheless may discourage investment in QOFs for
some consolidated groups.
Therefore, the final regulations permit corporate taxpayers filing
consolidated returns to own a QOF that is a subsidiary member of the
consolidated group; and, as provided in the proposed regulations, a
corporate QOF may be the parent member of a consolidated group. This
option will reduce the limitations on the organizational structure of
QOF investments that would have occurred under the proposed
regulations. The final regulations permit the consolidation of a
subsidiary QOF corporation only if certain conditions are satisfied.
Specifically, except in very limited circumstances, the group member
making the qualifying investment in the QOF member (investor member)
must maintain direct equity interest of the QOF member stock. More
importantly, all investor members must be wholly owned, directly or
indirectly, by the common parent of the group. The final regulations
also provide special rules to govern the treatment of an investment of
eligible gain in the subsidiary QOF in order not to conflict with the
consolidated return rules found in Sec. 1.1502. However, these rules
are not expected to be overly burdensome, because the choice of
establishing the QOF as a subsidiary member of the consolidate group
are elective; taxpayers would not choose to consolidate a corporate QOF
subsidiary unless the benefits to the taxpayer were greater than the
costs.
One drawback to allowing QOFs to be part of subsidiary member of a
consolidated group is that there would be less information available
regarding taxable income and loss of the QOF and its subsidiary
qualified opportunity zone businesses, as that information will be
reported as part of the aggregated income and deductions of the parent
on the consolidated tax return.
The number of taxpayers expected to be affected by these rules
ranges between 25 and 500.
5. Economic Effects of Provisions Not Substantially Revised From the
Proposed Regulations
a. Definition of Substantially All
There are five uses of the term ``substantially all'' in section
1400Z-2 but the statute is ambiguous regarding the precise meaning of
this term. The final regulations establish thresholds for all five uses
of this term. The final regulations provide that ``substantially all''
means at least 90 percent with regard to the three holding period
requirements in section 1400Z-2(d)(2) and at least 70 percent with
regard to section 1400Z-2(d)(3)(A)(i) and in the context of ``use'' in
section 1400Z-2(d)(2)(D)(i)(III). The Treasury Department and the IRS
have not attempted to assess how taxpayers would have interpreted these
terms in the absence of specific guidance and
[[Page 1947]]
therefore have not projected whether these regulations will increase or
decrease investment in QOZs or non-QOZ's relative to regulatory
alternatives.
In choosing what values to assign to the substantially all terms,
the Treasury Department and the IRS considered the economic
consequences of setting the thresholds higher or lower. Setting the
threshold higher would reduce investment in QOFs but would increase the
percentage of that investment that would be located within a QOZ. One
reason why a higher threshold would reduce overall investment in QOFs
is that it will be more difficult for businesses with diverse
operations and/or multiple locations to satisfy the threshold. Setting
the threshold lower would increase investment in QOFs but reduce the
percentage of that investment that is located within a QOZ.
A lower threshold would further increase the likelihood that a
taxpayer may receive the benefit of the preferential treatment on
capital gains without placing in service more tangible property within
a QOZ than would have occurred in the absence of section 1400Z-2. This
effect would be magnified by the way the different requirements in
section 1400Z-2 interact. For example, these final regulations imply
that, in certain limited fact patterns, a QOF could satisfy the
substantially all standards with as little as 40 percent of the
tangible property effectively owned by the fund being used within a
QOZ. This could occur if 90 percent of QOF assets are invested in a
qualified opportunity zone business, in which 70 percent of the
tangible assets of that business are qualified opportunity zone
business property; and if, in addition, the qualified opportunity zone
business property is only 70 percent in use within a QOZ, and for 90
percent of the holding period for such property. Multiplying these
shares together (0.9 x 0.7 x 0.7 x 0.9 = 0.4) generates the result that
a QOF could satisfy the requirements of section 1400Z-2 under the final
regulations with just 40 percent of its assets effectively in use
within a QOZ.
The Treasury Department and the IRS have not undertaken
quantitative estimates of the volume of investment that would be placed
in QOZs under the different thresholds for ``substantially all''
because we do not have data or models that can predict spatial patterns
of investment with reasonable precision. The Treasury Department and
the IRS further recognize that the specified thresholds may indirectly
affect investment outside of QOZs; we have likewise not undertaken
quantitative estimates of this investment effect.
The Treasury Department and the IRS have determined that the
substantially all thresholds provided in the final regulations
represent an appropriate balance between the ability of investors in
QOFs to receive preferential capital gains treatment only for placing a
consequential amount of tangible property (used in the underlying
business) within a QOZ, and the flexibility provided to business
operations so as not to significantly distort the types of businesses
that can qualify for opportunity zone funds.
b. Treatment of Leased Property
The Treasury Department and the IRS have determined that leased
property that is located in a QOZ may be treated as qualified
opportunity zone business property under certain conditions. This
determination means, effectively, that the value of leased property
should be included in both in the numerator and the denominator of the
90-percent investment standard and the substantially all tests.\5\ We
project that the inclusion of leased property will enhance the
efficiency of business decisions compared to other available regulatory
options because leasing is a common business practice and because
business decisions would be distorted if otherwise similar property
(owned versus leased) were treated differently.
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\5\ Under the statute, the value of leased property is included
in the denominator of the substantially all test. The statute is
ambiguous, however, as to whether leased property should be included
in the numerator.
---------------------------------------------------------------------------
This treatment of leased property is efficiency-enhancing (compared
to alternative treatments) because of other features of the statute.
For example, a start-up business that leased office space within a QOZ
and owned tangible property in the form of computers and other office
equipment would likely fail the substantially all test (if the office
space is sufficiently valuable relative to the other tangible property)
because the leased property is included in the denominator of the
substantially all test; this failure to satisfy the substantially all
test would occur despite all of this business's operations being
located within a QOZ. This possibility may lead the business to
purchase rather than lease its office property, a decision that
significantly changes the nature of the business's risk and expenses.
The Treasury Department and the IRS recognize that the treatment of
leased property as qualified opportunity zone business property may
weaken the incentive for taxpayers to construct new real property or
renovate existing real property within a QOZ, as taxpayers would be
able to lease existing real property in a zone without improving it and
thereby become a qualified opportunity zone business (assuming the
other conditions of the statute were met). However, allowing the
leasing of existing real property within a zone may encourage fuller
utilization and improvement of such property and limit the abandonment
or destruction of existing productive property within a QOZ when new
tax-favored real property becomes available.
In summary, the Treasury Department and the IRS project that the
inclusion of leased property in both the numerator and the denominator
of the 90-percent investment standard and the substantially all test
will increase economic activity within QOZs relative to alternative
decisions including the no-action baseline. This provision will reduce
potential distortions between owned and leased property that may occur
under other options.
c. Valuation of Property
The final regulations provide taxpayers with a choice between two
methods for determining the asset values for purposes of the 90-percent
investment standard in section 1400Z-2(d)(1) for QOFs or the value of
tangible property for the substantially all test in section 1400Z-
2(d)(3)(A)(i) for qualified opportunity zone businesses. Under the
first method (applicable financial statement valuation method), the
taxpayer values owned or leased property as reported on its applicable
financial statement for the reporting period. Under the alternative
valuation method, the taxpayer sets the value of owned property equal
to the unadjusted cost basis of the property under section 1012. The
final regulations specify that the value of leased property under the
alternative method equals the present value of total lease payments at
the beginning of the lease. The value of the property under the
alternative method for the 90-percent investment standard and
substantially all test does not change over time as long as the
taxpayer continues to own or lease the property.
The Treasury Department and the IRS project that the two methods
will, in the majority of cases, provide similar values for leased
property at the time that the lease begins because, as beginning in
2019, generally accepted accounting principles (GAAP) require public
companies to calculate the present value of lease payments in order to
recognize the value of leased assets on the balance sheet. However,
there are situations in which the two methods may differ in the value
they assign to leased property.
[[Page 1948]]
On financial statements, the value of the leased property declines over
the term of the lease. Under the alternative method, the value of the
leased asset is calculated once at the beginning of the lease term and
remains constant while the term of the lease is still in effect. This
difference in valuation of property over time between using financial
statements and the alternative method also exists for owned property.
In addition, the two approaches would generally apply different
discount rates, thus leading to some difference in the calculated
present value under the two methods.
The Treasury Department and the IRS provide the alternative method
to allow for taxpayers that either do not have applicable financial
statements or do not have them available in time for the asset tests.
In addition, the alternative method is simpler, thus reducing
compliance costs, and provides greater certainty in projecting future
compliance with the 90-percent investment standard and the
substantially all test. Thus, even some taxpayers with applicable
financial statements may choose to use the alternative method. One
drawback to the alternative method is that it is less likely to provide
accurate asset valuation over time because it does not account for
depreciation or other items that may affect the value of assets after
the time of purchase, and, over time, the values used for the sake of
the 90-percent investment standard and the substantially all test may
diverge from the actual value of the property.
Because this provision provides an election to taxpayers, the
Treasury Department and the IRS project that this provision will
slightly increase investment in QOFs, relative to not providing an
election. The Treasury Department and the IRS have not estimated the
proportion of taxpayers likely to use the alternative method nor the
volume of increased investment in QOFs relative to not providing an
election.
d. Gross Income Requirement of Section 1397C(b)(2)
Section 1400Z-2(d)(3)(A)(ii) incorporates the requirement of
section 1397C(b)(2) that a qualified business entity must derive at
least 50 percent of its total gross income during a taxable year from
the active conduct of a qualified business in a zone. The final
regulations provide multiple safe harbors for determining whether this
standard has been satisfied.
Two of these safe harbors provide that the 50 percent of gross
income standard would be satisfied if the majority of the labor input
of the trade or business is located within a QOZ and provide two
different methods for measuring the labor input of the trade or
business. The labor input can be measured in terms of hours (hours
performed test) or compensation paid (amounts paid test) of employees,
independent contractors, and employees of independent contractors for
the trade or business. The final regulations clarify that guaranteed
payments to partners in a partnership for services provided to the
trade or business are also included in the amounts paid test. The final
regulations provide that if at least 50 percent of the labor input of
the trade or business is located within a QOZ (as measured by one of
the two provided approaches), then the section 1397C(b)(2) requirement
is satisfied.
In addition, a third safe harbor (business functions test) provides
that the 50-percent gross income requirement is met if the tangible
property of the trade or business located in a QOZ and the management
or operational functions performed in the QOZ are each necessary for
the generation of at least 50 percent of the gross income of the trade
or business.
The determination of the location of income for businesses that
operate in multiple jurisdictions can be complex, and the rules
promulgated by taxing authorities to determine the location of income
are often burdensome and may distort economic activity. The provision
of alternative safe harbors in the final regulations should reduce the
compliance and administrative burdens associated with determining
whether this statutory requirement has been met. In the absence of such
safe harbors, some taxpayers may interpret the 50 percent of gross
income standard to require that a majority of the sales of the entity
must be located within a zone. The Treasury Department and the IRS have
determined that a standard based strictly on sales would discriminate
against some types of businesses (for example, manufacturing) in which
the location of sales is often different from the location of the
production, and thus would preclude such businesses from benefitting
from the incentives provided in section 1400Z-2. Furthermore, the
potential distortions introduced by the provided safe harbors would
increase incentives to locate labor inputs within a QOZ. To the extent
that such distortions exist, they further the statutory goal of
encouraging economic activity within QOZs. Given the flexibility
provided to taxpayers in choosing a safe harbor, other distortions,
such as to business organizational structuring, are likely to be
minimal.
e. Working Capital Safe Harbor
Section 1400Z-2 contains several rules limiting taxpayers from
benefitting from the deferral and exclusion of capital gains from
income offered by that section without also locating investment within
a QOZ. The final regulations clarify the rules related to nonqualified
financial property and what amounts can be held in cash and cash
equivalents as working capital. A qualified opportunity zone business
is subject to the requirements of section 1397C(b)(8), that less than 5
percent of the aggregate adjusted basis of the entity is attributable
to nonqualified financial property. The final regulations establish a
working capital safe harbor consistent with section 1397C(e)(1), under
which a qualified opportunity zone business may hold cash or cash
equivalents for a period not longer than 31 months and not violate
section 1397C(b)(8). The final regulations also provide that qualified
opportunity zone businesses may utilize multiple working capital safe
harbors, provided that each one satisfies all of the conditions of the
safe harbor provided in the final regulations. In the case where
multiple working capital safe harbors applies to the same unit of
tangible property, then total length of time the working capital safe
harbor may last is 62 months.
The Treasury Department and the IRS expect that the establishment
of the working capital safe harbors under these parameters will provide
net economic benefits. Without specification of the working capital
safe harbor, some taxpayers would not invest in a QOF for fear that the
QOF would not be able to deploy the funds soon enough to satisfy the
90-percent asset test. Thus, this rule would generally encourage
investment in QOFs by providing greater specificity to how an entity
may consistently satisfy the statutory requirements for maintaining a
QOF without penalty.
A longer or a shorter period could have been chosen for the working
capital safe harbor. A shorter time period would minimize the ability
of taxpayers to use the investment in a QOF as a way to lower taxes
without actually investing in tangible assets within a QOZ, but
taxpayers may also forego legitimate investments within an opportunity
zone out of concern of not being able to deploy the working capital
fast enough to meet the requirements. A longer period would have the
opposite effects. Taxpayers could potentially invest in a QOF and
receive the benefits of the tax incentive for multiple years before the
money is invested into a QOZ.
[[Page 1949]]
f. QOF Reinvestment Rule
The final regulations provide that a QOF has 12 months from the
time of the sale or disposition of qualified opportunity zone property
or the return of capital from investments in qualified opportunity zone
stock or qualified opportunity zone partnership interests to reinvest
the proceeds in other qualified opportunity zone property before the
proceeds would not be considered qualified opportunity zone property
with regards to the 90-percent investment standard. This rule provides
clarity and gives substantial flexibility to taxpayers in satisfying
the 90-percent investment standard. The Treasury Department and the IRS
have not projected the effect of this rule on the volume of investment
held by QOFs compared to a no action baseline.
g. Clarity Regarding Electing Post-10-Year Gain Exclusion if Zone
Designation Expires
The final regulations specify in Sec. 1.1400Z2(c)-1 that
expiration of a zone designation would not impair the ability of a
taxpayer to elect the exclusion from gains for investments held for at
least 10 years, provided the disposition of the investment occurs prior
to January 1, 2048. The Treasury Department and the IRS considered four
alternatives regarding the interaction between the expiration of the
designated zones and the election to exclude gain for investments held
more than 10 years. A discussion of the economic effects of the four
options follows.
(i) Remaining Silent on Electing Post-10-Year Gain Exclusion
The first alternative would be for the final regulations to remain
silent on this issue. Section 1400Z-2(c) permits a taxpayer to increase
the basis in the property held in a QOF longer than 10 years to be
equal to the fair market value of that property on the date that the
investment is sold or exchanged, thus excluding post-acquisition
capital gain on the investment from tax. However, the statutory
expiration of the designation of QOZs on December 31, 2028, makes it
unclear to what extent investments in a QOF made after 2018 would
qualify for this exclusion.
In absence of the guidance provided in the final regulations, some
taxpayers may have believed that only investments in a QOF made prior
to January 1, 2019, would be eligible for the exclusion from gain if
held greater than 10 years. Such taxpayers may have rushed to complete
transactions within 2018, while others may choose to hold off
indefinitely from investing in a QOF until they received clarity on the
availability of the 10-year exclusion from gain for investments made
later than 2018. Other taxpayers may have planned to invest in a QOF
after 2018 with the expectation that future regulations would be
provided or the statute would be amended to make it clear that
dispositions of assets within a QOF after 2028 would be eligible for
exclusion if held longer than 10 years. The ambiguity of the statute
would likely lead to uneven response by different taxpayers, dependent
on the taxpayer's interpretation of the statute, which may lead to an
inefficient allocation of investment across QOZs.
(ii) Providing a Clear Deadline for Electing Post-10-Year Gain
Exclusion
The alternative adopted by the final regulations clarifies that as
long as the investment in the QOF was made with funds subject to a
proper deferral election under section 1400Z-2(a), then the 10-year
gain exclusion election is allowed as long as the disposition of the
investment occurs before January 1, 2048. This rule would provide
certainty to taxpayers regarding the timing of investments eligible for
the 10-year gain exclusion. Taxpayers would have a more uniform
understanding of what transactions would be eligible for the favorable
treatment on capital gains. This would help taxpayers determine which
investments provide a sufficient return to compensate for the extra
costs and risks of investing in a QOF. This rule would likely lead to
an increase in investment within QOFs compared the final regulations
remaining silent on this issue.
However, setting a fixed date for the disposition of eligible QOFs
investments could introduce economic inefficiencies. Some taxpayers
might dispose of their investment in a QOF by the deadline in the
proposed regulation primarily in order to receive the benefit of the
gain exclusion, even if that selling date is not optimal for the
taxpayer in terms of the portfolio of assets that the taxpayer could
have chosen to invest in were there no deadline. Setting a fixed
deadline may also generate an overall decline in asset values in some
QOZs if many investors in QOFs seek to sell their portion of the fund
within the same time period. This decline in asset values may affect
the broader level of economic activity within some QOZs or affect other
investors in such zones that did not invest through a QOF. In
anticipation of this fixed deadline, some taxpayers may choose to
dispose of QOF assets earlier than the deadline to avoid an anticipated
``rush to the exits,'' but this would seem to conflict with the purpose
of the incentives in the statute to encourage ``patient'' capital
investment within QOZs. While the final regulations may produce these
inefficiencies, by providing a long time period for which taxpayers may
dispose of their investment within a QOF and still qualify for the
exclusion the final regulations will lead any such inefficiencies to be
minor.
(iii) Providing No Deadline for Electing Gain Exclusion
As an alternative, the final regulations could have provided no
deadline for electing the 10-year gain exclusion for investments in a
QOF, while still stating that the ability to make the election is not
impaired solely because the designation of one or more QOZs ceases to
be in effect. While this alternative would eliminate the economic
inefficiencies associated with a fixed deadline and would likely lead
to greater investment in QOFs, it could introduce substantial
additional administrative and compliance costs. Taxpayers would also
need to maintain records and make efforts to maintain compliance with
the rules of section 1400Z-2 on an indefinite basis.
(iv) Providing Fair Market Value Basis Without Disposition of
Investment
Another alternative considered would allow taxpayers to elect to
increase the basis in their investment in the QOF if held at least 10
years to the fair market value of the investment without disposing of
the property, as long as the election was made prior to January 1,
2048. (Or, the final regulations could have provided that, at the close
of business of the day on which a taxpayer first has the ability to
make the 10-year gain exclusion election, the basis in the investment
automatically sets to the greater of current basis or the fair market
value of the investment.) This alternative would minimize the economic
inefficiencies of the proposed regulations resulting from taxpayers
needing to dispose of their investment in the opportunity zone at a
fixed date not related to any factor other than the lapse of time.
However, this approach would require a method of valuing unsold assets
that could raise administrative and compliance costs. It may also
require the maintenance of records and trained compliance personnel for
over two decades.
(v) Summary
As discussed in section V.B of the Explanation of Provisions of the
October 2018 proposed regulations, the Treasury Department and the IRS
have determined the ability to exclude gains
[[Page 1950]]
for investment held at least 10 years in a QOF is integral to the
TCJA's purpose of creating QOZs. The final regulations provide a
uniform signal to all taxpayers on the availability of this tax
incentive, which should encourage greater investment, and a more
efficient distribution of investment, in QOFs than in the absence of
the final regulations. The relative costs and benefits of the various
alternatives are difficult to measure and compare. The final
regulations would likely produce the lowest compliance and
administrative costs among the alternatives and any associated economic
inefficiencies are likely to be small.
II. Paperwork Reduction Act
The collections of information in these final regulations are in
Sec. Sec. 1.1400Z2(b)-1(h), 1.1502-14Z(c)(2), (f)(2)(ii), (iii), and
(iv), (f)(3), and (h), and 1.1504-3(b)(2) and (c). The information in
all of the collections of information provided will be used by the IRS
for tax compliance purposes.
A. Partnership and S Corporation Collections of Information
The final regulations establish a new collection of information in
Sec. 1.1400Z2(b)-1(h). In Sec. 1.1400Z2(b)-1(h)(1), the collection of
information requires a partnership that takes a deferral election to
notify all of its partners of the deferral election and their shares of
the deferred gain. Similar requirements are set forth in Sec.
1.1400Z2(b)-1(h)(4) regarding S corporations and S corporation
shareholders.
The collection of information in Sec. 1.1400Z2(b)-1(h)(2) requires
indirect owners of a QOF partnership that sell or otherwise dispose of
all or a portion of their indirect interest in the QOF partnership in a
transaction that is an inclusion event to notify the QOF owner so it
can recognize an appropriate amount of deferred gain. Lastly, the
collection of information in Sec. 1.1400Z2(b)-1(h)(3) requires a QOF
partner to notify the QOF partnership of an election under section
1400Z-2(c) to adjust the basis of the qualifying QOF partnership
interest that is disposed of in a taxable transaction. Similar
requirements again are set forth in Sec. 1.1400Z2(b)-1(h)(4) regarding
QOF S corporations and QOF S corporation shareholders.
The collection of information contained in this final regulation
will not be conducted using a new or existing IRS form. The
notifications required by Sec. 1.1400Z2(b)-1(h)(1) will be provided by
the respective partnership to its partners n order to properly track
the amount of eligible gain invested in a QOF. The notification
requires a statement to be sent by the partnership electing deferral to
the relevant partners.
The notifications required by Sec. 1.1400Z2(b)-1(h)(2) will be
provided by indirect owners of a QOF partnership to the QOF owner and
must include information needed in order to enable the QOF owner, in a
timely manner, to recognize an appropriate amount of deferred gain. The
notification requires a statement to be sent from an indirect owner of
a QOF partnership to the QOF owner.
The notifications required by Sec. 1.1400Z2(b)-1(h)(3) will be
provided by a QOF partner to a QOF partnership to inform the
partnership that the partner made an election under section 1400Z-2(c)
to adjust the basis of the qualifying QOF partnership interest disposed
of in a taxable transaction. The notification requires a statement be
sent by the partner electing deferral under section 1400Z-2(c) to the
QOF partnership.
Similar notifications between shareholders and S Corporations are
also required by Sec. 1.1400Z2(b)-1(h)(4).
The likely respondents are partnerships and partners, and S
corporations and S corporation shareholders.
Estimated total annual reporting burden: 8,500 hours.
Estimated average annual burden per respondent: 1 hour.
Estimated number of respondents: 8,500.
Estimated frequency of responses: One time notification.
B. Collections of Information Under Existing Tax Forms
The collections of information imposed on consolidated groups in
these regulations are contained in Sec. Sec. 1.1502-14Z(c)(2),
(f)(2)(ii), (iii), (iv), and (f)(3), 1.1502-14Z(h), and 1.1504-3(b)(2)
and (c). The collection of information provided by these regulations
has been approved by the Office of Management and Budget (OMB) under
control number 1545-0123. The information is required to inform the IRS
on whether, and to what extent, a taxpayer makes any of the
consolidated group elections as described in these regulations. For
purposes of the Paperwork Reduction Act, 44 U.S.C. 3501 et seq. (PRA),
the reporting burden associated with the collection of information in
Form 1065, ``U.S. Return of Partnership Income,'' Form 1120, ``U.S.
Corporation Income Tax Return,'' Form 851, ``Affiliations Schedule,''
and/or Form 8996 will be reflected in the Paperwork Reduction Act
Submission associated with OMB control number 1545-0123.
The consolidated return rules in Sec. Sec. 1.1502-14Z and 1.1504-3
provide for certain elections that are available to consolidated
groups. These elections may require the consolidated group and/or the
QOF to file original, amended or superseding returns and attach an
election statement to such return with the required information to make
the applicable election. Section 1.1504-3(b)(2) generally allows the
consolidated group (subject to certain requirements and limitations) to
elect to consolidate a subsidiary QOF C corporation that was formed or
acquired by the consolidated group after May 1, 2019. In order to make
the Sec. 1.1504-3(b)(2) election, the consolidated group must attach
an election statement as described in Sec. 1.1504-3(c) to its Form
1120 and include the QOF C corporation as a subsidiary member on its
Form 851. Section 1.1502-14Z(c)(2) allows a consolidated group to elect
to treat an investment of one member as a qualifying investment by
another member. This election is available to consolidated groups after
March 13, 2020. The consolidated group must attach an election
statement as described in Sec. 1.1502-14Z(h)(2) with its Form 1120.
The elections provided in Sec. 1.1502-14Z(f) are available only to
consolidated groups that formed or acquired a subsidiary QOF C
corporation and included the subsidiary QOF C corporation in its
consolidated group prior to May 1, 2019. These elections allow the
consolidated group to treat the subsidiary QOF C corporation as (i) a
QOF partnership, (ii) a non-member QOF C corporation, (iii) a non-QOF C
corporation, or (iv) to continue treating the pre-existing QOF
subsidiary corporation as a member of the consolidated group. In
general, if the consolidated group makes an election under Sec.
1.1502-14Z(f), the consolidated group is required to amend its Form
1120 to account for the changes resulting from the election and to
attach the applicable election statement as provided in Sec. 1.1502-
14Z(h)(3). If the consolidated group makes an election to treat the QOF
C corporation as a QOF partnership as described in Sec. 1.1502-
14Z(f)(2)(ii), the QOF partnership is required to file its own Form
1065 as well as a new Form 8996 for the taxable year the election is
effective. If the consolidated group elects to treat the subsidiary QOF
C corporation as not a member of the group (as described in Sec.
1.1502-14Z(f)(2)(iii)), the subsidiary
[[Page 1951]]
QOF C corporation is required to file its own Form 1120 and include its
Form 8996 with the return for the taxable year the election is
effective.
The following table displays the number of respondents estimated to
be required to report on Form 1120, Form 851, Form 8996 and/or Form
1065, with respect to the collections of information required by the
these consolidated group regulations. Due to the absence of available
tax data, estimates of respondents required to attach a statement to
other types of tax returns, as applicable, are not available.
------------------------------------------------------------------------
Number of respondents
(estimated)
------------------------------------------------------------------------
Transition Relief Elections--Sec.
1.1502-14Z(f):
Form 1120............................. 10 to 100.
Expected Number of Consolidated C
Corporations formed after May 1, 2019:
Form 1120............................. 0 to 50.
------------------------------------------------------------------------
Source: RAAS:CDW.
The numbers of respondents in the table were estimated by the
Research, Applied Analytics and Statistics Division (RAAS) of the IRS
from the Compliance Data Warehouse (CDW).
Data for Form 1120 represents estimates of the total number of
taxpayers that may attach an election statement to their Form 1120 to
make the elections in Sec. Sec. 1.1.1502-14Z(c)(2), (f)(2)(ii), (iii),
and (iv), and (f)(3), and 1.1504-3(b)(2). The lower bound estimate is
based on the number of consolidated group taxpayers filing Form 1120
and Form 8996 through July 2019. The upper bound estimate is based on
consolidated group taxpayer filing trends, the observed filings to
date, and uncertainty about the number of future filers. Accordingly,
the difference between the lower bound and upper bound estimates
reflect an estimate of the possible number of respondents as a result
of the changes made by TCJA and the regulations.
An agency may not conduct or sponsor and a person is not required
to respond to a collection of information unless it displays a valid
OMB control number.
III. Regulatory Flexibility Act
Pursuant to the Regulatory Flexibility Act (5 U.S.C. chapter 6), it
is hereby certified that the final regulations will not have a
significant economic impact on a substantial number of small entities
under section 601(6) of the Regulatory Flexibility Act (small
entities).
As discussed elsewhere in this preamble, the final regulations
provide certainty and clarity to taxpayers regarding the utilization of
the tax preference for capital gains provided in section 1400Z-2 by
defining terms, calculations, and acceptable forms of documentation.
The Treasury Department and the IRS anticipate that this clarity
generally will encourage taxpayers to invest in QOFs and will increase
the amount of investment located in QOZs. Investment in QOFs is
entirely voluntary, and the certainty that would be provided by these
final regulations, will minimize any compliance or administrative
costs, such as the estimated average annual burden (1 hour) under the
Paperwork Reduction Act. For example, the final regulations provide
multiple safe harbors for the purpose of determining whether the 50-
percent gross income test has been met as required by section 1400Z-
2(d)(3)(A)(ii) for a qualified opportunity zone business. Taxpayers
affected by these final regulations include QOFs, investors in QOFs,
and qualified opportunity zone businesses in which a QOF holds an
ownership interest. The final regulations will not directly affect the
taxable incomes and liabilities of qualified opportunity zone
businesses; they will affect only the taxable incomes and tax
liabilities of QOFs (and owners of QOFs) that invest in such
businesses. Although there is a lack of available data regarding the
extent to which small entities invest in QOFs, will certify as QOFs, or
receive equity investments from QOFs, the Treasury Department and the
IRS project that most of the investment flowing into QOFs will come
from large corporations and wealthy individuals, though some of these
funds would likely flow through an intermediary investment partnership.
It is expected that some QOFs and qualified opportunity zone businesses
would be classified as small entities; however, the number of small
entities significantly affected is not likely to be substantial.
For the reasons explained previously, the Treasury Department and
the IRS certify that the final regulations will not have a significant
economic impact on a substantial number of small entities. Pursuant to
section 7805(f), the notice of proposed rulemaking preceding these
final regulations was submitted to the Chief Counsel for Advocacy of
the Small Business Administration for comment on its impact on small
business.
IV. Unfunded Mandates Reform Act
Section 202 of the Unfunded Mandates Reform Act of 1995 (UMRA)
requires that agencies assess anticipated costs and benefits and take
certain other actions before issuing a final rule that includes any
Federal mandate that may result in expenditures in any one year by a
state, local, or tribal government, in the aggregate, or by the private
sector, of $100 million in 1995 dollars, updated annually for
inflation. In 2019, that threshold is approximately $154 million. This
rule does not include any Federal mandate that may result in
expenditures by state, local, or tribal governments, or by the private
sector in excess of that threshold.
V. Executive Order 13132: Federalism
Executive Order 13132 (entitled Federalism) prohibits an agency
from publishing any rule that has federalism implications if the rule
either imposes substantial, direct compliance costs on state and local
governments, and is not required by statute, or preempts state law,
unless the agency meets the consultation and funding requirements of
section 6 of the Executive Order. This rule does not have federalism
implications and does not impose substantial direct compliance costs on
state and local governments or preempt state law.
VI. Executive Order 13175: Consultation and Coordination With Indian
Tribal Governments
Executive Order 13175 requires that Federal departments and
agencies engage in consultation procedures in certain circumstances
where regulations are issued which have substantial direct effects with
respect to the Federal Government and Indian tribes. As noted in the
Background, on October 21, 2019, the Treasury Department and the IRS
held a government-to-government tribal consultation on Opportunity
Zones (Consultation). Seven organizations representing tribal interests
participated, with one tribal designee providing comments expressing
support for the May 2019 proposed regulations. In addition, many tribes
submitted written comments in response to the proposed regulations, and
the presiding officer of one Indian tribe provided oral testimony at
the February 14, 2019 public hearing.
Several commenters requested that Indian tribal governments and
corporations organized under Indian tribal laws should be included in
the definition of entities eligible to be a QOF. The final regulations
provide that an entity ``organized in'' one of the 50 states includes
an entity organized under the law of a federally recognized Indian
tribe if the entity's domicile is located in one of the 50 states or
the District of Columbia. Such entity satisfies the requirement in
section 1400Z-2(d)(2)(B)(i) and (C) that
[[Page 1952]]
qualified opportunity zone stock is stock in a domestic corporation,
and a qualified opportunity zone partnership interest is an interest in
a domestic partnership.
The Treasury Department and the IRS, while acknowledging the
sovereignty of Indian tribal governments, also note that an entity
eligible to be a QOF must be subject to Federal income tax, including
the penalty imposed by section 1400Z-2(f)(1) where a QOF fails to meet
the 90-percent investment standard, regardless of the laws under which
it is established or organized. Tribal commenters at the Consultation
did not disagree with the position that if an entity organized under
the law of an Indian tribal government is eligible to be a QOF, and the
entity's domicile is located in one of the 50 states or the District of
Columbia, that such entity would be subject to Federal income tax
because the QOF would include investors from outside of the tribe.
Accordingly, the Treasury Department and IRS affirm these positions and
incorporate a reference to entities organized under the law of an
Indian tribal government in the definition of the term ``eligible
entity.''
Several tribal commenters, commenting on the October 2018 proposed
regulations (83 FR 54279), requested that leased tangible property
qualify as qualified opportunity zone business property for purposes of
the section 1400Z-2 although the statute only addresses the
qualification of tangible property acquired by purchase, as defined in
section 179(d)(2), as qualified opportunity zone business property. The
commenters stated that typically long-term ground leases of land held
in trust by the Federal government are used for economic development
purposes because such real property is generally not transferred
through a sale. As provided for in the May 2019 proposed regulations
(84 FR 18652), leased tangible property may qualify as qualified
opportunity zone business property held by a QOF of qualified
opportunity zone business, provided the regulatory requirements are
met. At the Consultation, no participant requested additional guidance
on this provision, or disagreed with the position taken by the Treasury
Department and the IRS.
Prior to the publication of the May 2019 proposed regulations (84
FR 18652), the Treasury Department and the IRS received a comment
requesting that the final regulations provide flexibility regarding the
valuation of leases. The commenter requested that the final regulations
permit QOFs to use a basis for valuing property other than the basis
used for GAAP purposes (for example, cost basis under section 1012).
Because Indian tribal governments typically rely upon leases of land
held in trust by the Federal Government for economic development and
recent changes to GAAP methods require the recognition of leasehold
interests valued at the present value of prospective lease payments
over the lifetime of the lease, the commenter was concerned that
applying GAAP methods to value long-term leasehold interests would
result in eligible entities not qualifying as QOFs or qualified
opportunity zone businesses. In responding to this comment, as well as
other comments expressing similar concerns, the Treasury Department and
the IRS determined that the alternative valuation method for leased
tangible property, as set forth in the final regulations, addresses the
concerns raised by these commenters. In addition, the Treasury
Department and the IRS note that no participant of the Consultation
requested additional guidance regarding these issues. Therefore,
proposed Sec. 1.1400Z2(d)-1(b)(3) has not been modified as a result of
those comments.
Following the Consultation, one tribe submitted additional comments
regarding the issue of whether leased property is qualified opportunity
zone business property. First, the commenter asked for clarification on
whether leasehold interests of the real property subject to a sublease
can be qualified opportunity zone business property for a qualified
opportunity zone business where the sublease is entered into after
December 31, 2017. The Treasury Department and the IRS, while declining
to clarify the rule, generally do not view tangible property acquired
under a sublease entered into after December 31, 2017, as necessarily
different from tangible property acquired under a lease entered into
after December 31, 2017, to the extent that the tangible property
otherwise would qualify as qualified opportunity zone business
property.
Second, the commenter inquired whether a leasehold interest that
was assigned by a tribe to a qualified opportunity zone business would
not qualify as qualified opportunity zone business property because the
leasehold interest is not tangible property solely being leased or
subleased to the qualified opportunity zone business. The Treasury
Department and the IRS agree that assigning an existing lease, the
parties to which are not related persons within the meaning of section
1400Z-2(e)(2), to another entity would not prevent the tangible
property subject to the lease from qualifying as qualified opportunity
zone business property. However, it should be noted that assigning an
existing lease that was entered into by unrelated persons to an
assignee that is related person with respect to the lessee may make the
leased tangible property subject to the special rules for leases
between related persons within the meaning of section 1400Z-2(e)(2).
In addition to these comments, one tribe requested a more robust
reporting regime to measure the benefits of section 1400Z-2. As
discussed in part IX.A. of this Summary of Comments and Explanation of
Revision, the Treasury Department and the IRS have modified the Form
8996 to request additional reporting information from QOFs for tax
administration purposes, which may also be helpful in measuring the
impact and effectiveness of section 1400Z-2 on designated qualified
opportunity zones.
VII. Congressional Review Act
The Administrator of the Office of Information and Regulatory
Affairs of the Office of Management and Budget has determined that this
is a major rule for purposes of the Congressional Review Act (CRA) (5
U.S.C. 801 et seq.).
Drafting Information
The principal authors of these final regulations are Alfred Bae and
Kyle Griffin, Office of the Associate Chief Counsel (Income Tax &
Accounting); Jeremy Aron-Dine and Sarah Hoyt, Office of the Associate
Chief Counsel (Corporate); and Marla Borkson, Sonia Kothari, and Vishal
Amin, Office of the Associate Chief Counsel (Passthroughs and Special
Industries). Other personnel from the Treasury Department and the IRS
participated in their development.
Statement of Availability of IRS Documents
IRS Revenue Procedures, Revenue Rulings, and Notices cited in this
preamble are published in the Internal Revenue Bulletin (or Cumulative
Bulletin) and are available from the Superintendent of Documents, U.S.
Government Publishing Office, Washington, DC 20402, or by visiting the
IRS website at http://www.irs.gov.
List of Subjects in 26 CFR Part 1
Income Taxes, Reporting and recordkeeping requirements.
Adoption of Amendments to the Regulations
Accordingly, 26 CFR part 1 is amended as follows:
[[Page 1953]]
PART 1--INCOME TAXES
0
Paragraph 1. The authority citation for part 1 is amended by adding
sectional authorities for Sec. Sec. 1.1400Z2(a)-1 through 1.1400Z2(f)-
1, 1.1502-14Z, and 1.1504-3 in numerical order to read in part as
follows:
Authority: 26 U.S.C. 7805 * * *
Section 1.1400Z2(a)-1 also issued under 26 U.S.C. 1400Z-2(e)(4).
Section 1.1400Z2(b)-1 also issued under 26 U.S.C. 1400Z-2(e)(4).
Section 1.1400Z2(c)-1 also issued under 26 U.S.C. 1400Z-2(e)(4).
Section 1.1400Z2(d)-1 also issued under 26 U.S.C. 1400Z-2(e)(4).
Section 1.1400Z2(d)-2 also issued under 26 U.S.C. 1400Z-2(e)(4).
Section 1.1400Z2(f)-1 also issued under 26 U.S.C. 1400Z-2(e)(4).
* * * * *
Section 1.1502-14Z also issued under 26 U.S.C. 1400Z-2(e)(4) and
1502.
* * * * *
Section 1.1504-3 also issued under 26 U.S.C. 1400Z-2(e)(4) and
1504(a)(5).
* * * * *
0
Par. 2. Section 1.1400Z2-0 is added to read as follows:
Sec. 1.1400Z2-0. Table of Contents.
This section lists the table of contents for Sec. Sec.
1.1400Z2(a)-1 through 1.1400Z2(f)-1.
Sec. 1.1400Z2 (a)-1 Deferring tax on capital gains by investing in
opportunity zones
(a) Deferring tax on capital gains.
(1) Overview.
(2) Procedure for deferring gain.
(b) Definitions.
(1) 30-month substantial improvement period.
(2) 70-percent tangible property standard.
(3) 70-percent use test.
(4) 90-percent investment standard.
(5) 90-percent qualified opportunity zone property holding
period.
(6) 90-percent qualified opportunity zone business property
holding period.
(7) 180-day period.
(8) Boot.
(9) Consolidated group.
(10) Deferral election.
(11) Eligible gain.
(12) Eligible interest.
(13) Eligible taxpayer.
(14) Inclusion event.
(15) Mixed-funds investment.
(16) Non-qualifying investment.
(17) Property.
(18) QOF.
(19) QOF C corporation.
(20) QOF corporation.
(21) QOF RIC.
(22) QOF REIT.
(23) QOF owner.
(24) QOF partner.
(25) QOF partnership.
(26) QOF S corporation.
(27) QOF shareholder.
(28) QOZ designation notice.
(29) Qualified opportunity zone business.
(30) Qualified opportunity zone business property.
(31) Qualified opportunity zone partnership interest.
(32) Qualified opportunity zone property.
(33) Qualified opportunity zone stock.
(34) Qualifying investment.
(35) Qualifying QOF partnership interest.
(36) Qualifying QOF stock.
(37) Qualifying section 355 transaction.
(38) Qualifying section 381 transaction.
(39) Related persons.
(40) Remaining deferred gain.
(41) Section 1400Z-2 regulations.
(c) Operational and special rules.
(1) Attributes of gains included in income under section 1400Z-
2(a)(1)(B).
(2) Identification of which interest in a QOF corporation has
been disposed of.
(3) Pro-rata method.
(4) Examples.
(5) Making an investment for purposes of an election under
section 1400Z-2(a).
(6) Amount invested for purposes of section 1400Z-2(a)(1)(A).
(7) Eligible gains that a partnership elects to defer.
(8) Eligible gains that the partnership does not defer.
(9) Passthrough entities other than partnerships.
(d) Elections.
(1) Taxable year of deferral election.
(2) Taxable years after deferral election.
(e) Interaction of section 1400Z-2 and Sec. 1.897-6T.
(f) Treatment of mixed-funds investments.
(1) Investments to which no election under section 1400Z-2(a)
applies.
(2) Treatment of deemed contributions of money under section
752(a).
(3) Treatment of contributions to QOF corporation in which no
stock is received.
(4) Example.
(g) Applicability dates.
(1) In general.
(2) Prior periods.
Sec. 1.1400Z2 (b)-1 Inclusion of gains that have been deferred under
section 1400Z-2(a).
(a) Scope.
(b) General inclusion rule.
(c) Inclusion events.
(1) In general.
(2) Termination or liquidation of QOF or QOF owner.
(3) Transfer of an investment in a QOF by gift or incident to
divorce.
(4) Transfer of an investment in a QOF by reason of the
taxpayer's death.
(5) Grantor trusts.
(6) Special rules for partners and partnerships.
(7) Special rules for S corporations.
(8) Distributions by a QOF corporation.
(9) Dividend-equivalent redemptions and redemptions of section
306 stock.
(10) Qualifying section 381 transactions.
(11) Section 355 transactions.
(12) Recapitalizations and section 1036 transactions.
(13) Section 304 transactions.
(14) Deduction for worthlessness.
(15) Decertification of a QOF.
(16) Other inclusion and non-inclusion events.
(d) Holding periods.
(1) Holding period for qualifying investment.
(2) Status of QOF assets as qualified opportunity zone property.
(e) Amount includible.
(1) In general.
(2) Property received from a QOF in certain transactions.
(3) Gain recognized on December 31, 2026.
(4) Special amount includible rule for partnerships and S
corporations.
(5) Limitation on amount of gain included after statutory five-
year and seven-year basis increases.
(f) Examples.
(g) Basis adjustments.
(1) Basis adjustments under section 1400Z-2(b)(2)(B)(ii)
resulting from the inclusion of deferred gain.
(2) Amount of basis adjustment under section 1400Z-
2(b)(2)(B)(iii) and (iv).
(3) Examples.
(4) Special partnership rules.
(5) Basis adjustments in S corporation stock.
(6) Basis in the hands of a taxpayer who received a qualifying
investment in a QOF by reason of the prior owner's death.
(h) Notifications by partners and partnerships, and shareholders
and S corporations.
(1) Notification of deferral election.
(2) Notification of deferred gain recognition by indirect QOF
owner.
(3) Notification of section 1400Z-2(c) election by QOF partner
or QOF partnership.
(4) S corporations.
(i) Reserved.
(j) Applicability dates.
(1) In general.
(2) Prior periods.
Sec. 1.1400Z2 (c)-1 Investments held for at least 10 years.
(a) Scope.
(b) Investment for which an election can be made.
(1) In general.
(2) Special election rules for QOF partnerships and QOF S
corporations.
(3) Basis adjustments upon sale or exchange of qualifying QOF
stock.
(c) Extension of availability of the election described in
section 1400Z-2(c).
(d) Examples.
(e) Capital gain dividends paid by a QOF RIC or QOF REIT that
some shareholders may be able to elect to receive tax free under
section 1400Z-2(c).
(1) Eligibility.
(2) Definition of capital gain dividend identified with a date.
(3) General limitations on the amounts of capital gain with
which a date may be identified.
(4) Determination of the amount of capital gain with which a
date may be identified.
(f) Applicability dates.
Sec. 1.1400Z2 (d)-1 Qualified opportunity funds and qualified
opportunity zone businesses.
(a) Overview.
(1) Eligible entity.
(2) Self-certification as a QOF.
[[Page 1954]]
(3) Self-decertification of a QOF.
(4) Involuntary decertification.
(b) Valuation of property for purposes of the 90-percent
investment standard and the 70-percent tangible property standard.
(1) In general.
(2) Special rules.
(3) Applicable financial statement valuation method.
(4) Alternative valuation method.
(c) Qualified opportunity zone property.
(1) In general.
(2) Qualified opportunity zone stock.
(3) Qualified opportunity zone partnership interest.
(d) Qualified opportunity zone business.
(1) In general.
(2) Satisfaction of 70-percent tangible property standard.
(3) Operation of section 1397C requirements adopted by
reference.
(4) Trade or businesses described in section 144(c)(6)(B) not
eligible.
(5) Tangible property of a qualified opportunity zone business
that ceases to be qualified opportunity zone business property
(6) Cure period for qualified opportunity zone businesses.
(e) Applicability dates.
(1) In general.
(2) Prior periods.
Sec. 1.1400Z2 (d)-2 Qualified opportunity zone business property
(a) Qualified opportunity zone business property.
(1) In general.
(2) Qualified opportunity zone business property requirements.
(b) Tangible property owned by an eligible entity.
(1) Purchase requirement.
(2) Original use or substantial improvement requirement.
(3) Original use of tangible property acquired by purchase.
(4) Substantial improvement of tangible property acquired by
purchase.
(c) Tangible property leased by an eligible entity.
(1) Qualifying acquisition of possession.
(2) Arms-length terms.
(3) Additional requirements for tangible property leased from a
related person.
(4) Plan, intent, or expectation for purchases not for fair
market value.
(d) Holding period and use within a qualified opportunity zone
of owned or leased tangible property.
(1) In general.
(2) Valuation of owned and leased property.
(3) Substantially all of an eligible entity's holding period for
owned or leased tangible property.
(4) Substantially all of the use of owned or leased tangible
property in a qualified opportunity zone.
(e) Applicability dates.
(1) In general.
(2) Prior periods.
Sec. 1.1400Z2 (e)-1 [Reserved]
Sec. 1.1400Z2 (f)-1 Administrative rules- penalties, anti-abuse, etc.
(a) In general.
(b) Time period for a QOF to reinvest certain proceeds.
(1) In general.
(2) Federally declared disasters.
(c) Anti-abuse rules.
(1) General anti-abuse rule.
(2) Special anti-abuse rule for partnerships.
(3) Examples.
(d) Applicability dates.
(1) In general.
(2) Prior periods.
0
Par. 3. Section 1.1400Z2(a)-1 is added to read as follows:
Sec. 1.1400Z2 (a)-1 Deferring tax on capital gains by investing in
opportunity zones.
(a) Deferring tax on capital gains--(1) Overview. Under section
1400Z-2(a) of the Internal Revenue Code (Code) and the section 1400Z-2
regulations (as defined in paragraph (b)(41) of this section), an
eligible taxpayer may elect to defer recognition of some or all of one
or more eligible gains that otherwise would be recognized by the
eligible taxpayer in the taxable year to the extent that the eligible
taxpayer timely acquires a qualifying investment in a qualified
opportunity fund (QOF) within the meaning of section 1400Z-2(d)(1) and
Sec. 1.1400Z2(d)-1. Paragraph (a)(2) of this section describes how a
taxpayer elects to defer gain. Paragraph (b) of this section defines
terms used in the section 1400Z-2 regulations. Paragraph (c) of this
section provides operational rules for applying section 1400Z-2 and the
section 1400Z-2 regulations, including special rules regarding the
election to defer gain under section 1400Z-2(a) and this section when
an eligible taxpayer that is a partnership, S corporation, trust, or
decedent's estate recognizes an eligible gain in a taxable year.
Paragraph (d) of this section provides the manner in which a deferral
election under section 1400Z-2(a) must be made. Paragraph (e) of this
section provides the treatment of section 1400Z-2 for purposes of Sec.
1.897-6T. Paragraph (f) of this section provides rules for mixed-funds
investments. Paragraph (g) of this section provides dates of
applicability. See Sec. Sec. 1.1502-14Z and 1.1504-3 for special rules
applicable to consolidated groups that invest in QOFs.
(2) Procedure for deferring gain. A taxpayer defers gain, in whole
or in part, by making an election on its Federal income tax return for
the taxable year in which the gain would be included if not deferred.
The election must be made in the manner prescribed by the Internal
Revenue Service in guidance published in the Internal Revenue Bulletin
or in forms and instructions (see Sec. Sec. 601.601(d)(2) and 601.602
of this chapter).
(b) Definitions. The following definitions apply for purposes of
section 1400Z-2 and the section 1400Z-2 regulations:
(1) 30-month substantial improvement period. The term 30-month
substantial improvement period means any 30-month period, beginning
after the date of acquisition of tangible property, in which additions
to the basis of the tangible property in the hands of the QOF or
qualified opportunity zone business (see Sec. 1.1400Z2(d)-2(b)(4))
exceed an amount equal to the adjusted basis of such property at the
beginning of the 30-month period in the hands of the QOF or qualified
opportunity zone business.
(2) 70-percent tangible property standard. The term 70-percent
tangible property standard means the requirement in section 1400Z-
2(d)(3)(A)(i) that a qualified opportunity zone business must satisfy
with respect to qualified opportunity zone business property (see Sec.
1.1400Z2(d)-2) that the qualified opportunity zone business holds,
whether the qualified opportunity zone business property is owned by
the qualified opportunity zone business or leased by the qualified
opportunity zone business from another person.
(3) 70-percent use test. The term 70-percent use test means the
test used to determine if a QOF or qualified opportunity zone business
satisfies the requirement in sections 1400Z-2(d)(2)(D)(i)(III) and
1400Z-2(d)(3)(A)(i) that substantially all of the use of tangible
property was in a qualified opportunity zone.
(4) 90-percent investment standard. The term 90-percent investment
standard means the requirement provided in section 1400Z-2(d)(1) that a
QOF must hold at least 90 percent of its assets in qualified
opportunity zone property, as defined in section 1400Z-2(d)(2) and
Sec. 1.1400Z2(d)-1(c)(1), determined by the average of the percentage
of qualified opportunity zone property held by the QOF as measured on
the last day of the first six-month period and on the last day of the
taxable year of the QOF.
(5) 90-percent qualified opportunity zone property holding period.
The term 90-percent qualified opportunity zone property holding period
means the minimum portion of a QOF's holding period in stock of a
corporation or interests in a partnership, during which the corporation
or partnership qualifies as a qualified opportunity zone business in
order for the stock or the partnership interests to meet the
substantially all requirement under section 1400Z-2(d)(2)(B)(i)(III) to
be treated as qualified
[[Page 1955]]
opportunity zone stock or the substantially all requirement under
section 1400Z-2(d)(2)(C)(iii) to be treated as qualified opportunity
zone partnership interests, as applicable, held by the QOF.
(6) 90-percent qualified opportunity zone business property holding
period. The term 90-percent qualified opportunity zone business
property holding period means the minimum portion of a QOF's or
qualified opportunity zone business's holding period in tangible
property during which the 70-percent use test with respect to the
tangible property must be satisfied, in order for the tangible property
to meet the requirement under section 1400Z-2(d)(2)(D)(i)(III) to be
treated as qualified opportunity zone business property held by the QOF
or qualified opportunity zone business.
(7) 180-day period--(i) In general. Except as otherwise provided
elsewhere in this section, the term 180-day period means the 180-day
period referred to in section 1400Z-2(a)(1)(A) with respect to any
eligible gain meeting the requirements of paragraph (b)(11) of this
section that begins on the day on which the gain would be recognized
for Federal income tax purposes if the eligible taxpayer did not elect
under section 1400Z-2 and the section 1400Z-2 regulations to defer
recognition of that gain.
(ii) 180-day period for RIC and REIT capital gain dividends--(A)
General rule. Unless the shareholder of a regulated investment company
(RIC) or real estate investment trust (REIT) chooses to apply paragraph
(b)(7)(ii)(B) of this section, the 180-day period for a RIC or REIT
capital gain dividend begins on the last day of the shareholder's
taxable year in which the capital gain dividend would otherwise be
recognized by the shareholder.
(B) Elective rule. Notwithstanding the general rule in paragraph
(b)(7)(ii)(A) of this section, a shareholder of a RIC or REIT may
choose to treat the 180-day period with respect to a capital gain
dividend that the shareholder receives from the RIC or REIT as
beginning on the date of the dividend distribution; provided, however,
that the aggregate amount of the shareholder's eligible gain with
respect to capital gain dividends from the RIC or REIT is limited to
the aggregate amount of capital gain dividends reported for that
shareholder by the RIC for that shareholder's taxable year or
designated for that shareholder by the REIT for that shareholder's
taxable year.
(C) Undistributed capital gains. If section 852(b)(3)(D) or
857(b)(3)(C) (concerning undistributed capital gains) requires the
holder of shares in a RIC or REIT to include an amount in the
shareholder's long-term capital gains, the rule in paragraph
(b)(7)(ii)(B) of this section does not apply to that amount. The 180-
day period with respect to the included undistributed capital gain
begins, at the shareholder's election, on either the last day of the
RIC or REIT's taxable year or the last day of the shareholder's taxable
year in which the amount would otherwise be recognized as long-term
capital gains by the shareholder.
(iii) 180-day period for partners, S corporation shareholders, and
owners of other passthrough entities. See paragraph (c)(8) and (9) of
this section for rules relating to the determination of the 180-day
period for partners, S corporation shareholders, or beneficiaries of a
trust or decedent's estate in cases in which a partnership, S
corporation, trust, or decedent's estate is not an eligible taxpayer
with respect to an eligible gain, or does not make a deferral election
with respect to an eligible gain.
(iv) Examples. The following examples illustrate the principles of
paragraph (b)(7)(i) through (iii) of this section.
(A) Example 1. Regular-way trades of stock. Individual A sells
stock at a gain in a regular-way trade on an exchange (that is, in a
transaction in which a trade order is placed on the trade date, and
settlement of the transaction, including payment and delivery of the
stock, occurs a standardized number of days after the trade date).
The 180-day period with respect to A's gain on the stock begins on
the trade date.
(B) Example 2. Capital gain dividends received by a REIT
shareholder. REIT and Shareholder are calendar year taxpayers. REIT
distributes a dividend to Shareholder on March 1, Year 1. REIT
designates the March 1 dividend as a capital gain dividend before 30
days after the close of Year 1. Shareholder's 180-day period with
respect to that capital gain dividend begins on December 31, Year 1.
However, Shareholder may choose to begin the 180-day period on March
1, Year 1. If so, an equity interest in a QOF received by
Shareholder in exchange for an investment of an amount corresponding
to that capital gain dividend may be a qualifying investment to the
extent that Shareholder's aggregate elected deferrals of dividends
from REIT for Year 1 do not exceed Shareholder's aggregate capital
gain dividends from REIT for the taxable year.
(C) Example 3. Multiple capital gain dividends received by a RIC
shareholder. RIC is a calendar year taxpayer. RIC distributes a
dividend of $100 to Shareholder, a calendar year taxpayer, on March
1, Year 1 and distributes another dividend of $50 to Shareholder on
June 1, Year 1. RIC reports both the March 1 and June 1 dividends as
capital gain dividends on Shareholder's Form 1099-DIV for Year 1.
Shareholder's 180-day period with respect to both capital gain
dividends begins on December 31, Year 1. However, Shareholder may
choose to begin the 180-day period for the $100 RIC capital gain
dividend on March 1, Year 1, and may choose to begin the 180-day
period for the $50 RIC capital gain dividend on June 1, Year 1.
Thus, if Shareholder makes a single investment of $200 in a QOF in
exchange for an eligible interest (as defined in paragraph (b)(12)
of this section) on July 1, Year 1, absent any other eligible gain,
Shareholder may treat $150 of the eligible interest as a qualifying
investment in the QOF (that is, the amount that corresponds to the
aggregate amount of the RIC capital gain dividends in Year 1) and
$50 of the eligible interest as a non-qualifying investment therein.
(D) Example 4. Additional deferral of previously deferred
gains--(1) Facts. Taxpayer A invested in a QOF and properly elected
to defer realized gain. On March 15, 2025, A disposes of its entire
investment in the QOF in a transaction that, under sections 1400Z-
2(a)(1)(B) and (b), triggers an inclusion of gain in A's gross
income. Section 1400Z-2(b) determines the date and amount of the
gain included in A's income. That date is March 15, 2025, the date
on which A disposed of its entire interest in the QOF. A wants to
make a deferral election with respect to A's gain from the disposal
of the QOF investment.
(2) Analysis. Under paragraph (b)(7)(i) of this section, the
180-day period for making another investment in a QOF begins on the
day on which section 1400Z-2(b) requires the prior gain to be
included. As prescribed by section 1400Z-2(b)(1)(A), that is March
15, 2025, the date of the inclusion-triggering disposition. Thus, in
order to make a deferral election under section 1400Z-2, A must
invest the amount of the inclusion in the original QOF or in another
QOF during the 180-day period beginning on March 15, 2025, the date
when A disposed of its entire investment in the QOF.
(8) Boot. The term boot means money or other property that section
354 or 355 does not permit to be received without the recognition of
gain.
(9) Consolidated group. The term consolidated group has the meaning
provided in Sec. 1.1502-1(h).
(10) Deferral election. The term deferral election means an
election under section 1400Z-2(a) and the section 1400Z-2 regulations
made before January 1, 2027, with respect to an eligible gain.
(11) Eligible gain--(i) In general. An amount of gain is an
eligible gain, and thus is eligible for deferral under section 1400Z-
2(a) and the section 1400Z-2 regulations, if the gain--
(A) Is treated as a capital gain for Federal income tax purposes or
is a qualified 1231 gain within the meaning of paragraph
(b)(11)(iii)(A) of this section, determined by--
(1) Not taking into account any losses unless otherwise specified
in the section 1400Z-2 regulations; and
[[Page 1956]]
(2) Taking into account any other provision of the Code that
requires the character of potential capital gain to be recharacterized
or redetermined as ordinary income, as defined in section 64, for
purposes of the Code;
(B) Would be recognized for Federal income tax purposes and subject
to tax under subtitle A of the Code before January 1, 2027 (subject to
Federal income tax), if section 1400Z-2(a)(1) did not apply to defer
recognition of the gain; and
(C) Does not arise from a sale or exchange of property with a
person that, within the meaning of section 1400Z-2(e)(2), is related
to--
(1) The eligible taxpayer that would recognize the gain in the
taxable year in which the sale or exchange occurs if section 1400Z-
2(a)(1) and the section 1400Z-2 regulations did not apply to defer
recognition of the gain; or
(2) Any passthrough entity or other person recognizing and
allocating the gain to the eligible taxpayer described in paragraph
(b)(11)(i)(C)(1) of this section.
(ii) Portion of eligible gain not already subject to a deferral
election. In the case of an eligible taxpayer who has made an election
under section 1400Z-2(a) and the section 1400Z-2 regulations regarding
some but not all of an eligible gain, the portion of that eligible gain
with respect to which no election under section 1400Z-2(a) and the
section 1400Z-2 regulations has been made remains an eligible gain for
which a deferral election may be made.
(iii) Qualified 1231 gains--(A) Definition. A section 1231 gain (as
defined in section 1231(a)(3)(A)) recognized on the sale or exchange of
property defined in section 1231(b) (1231(b) property) is a qualified
1231 gain to the extent that it exceeds any amount with respect to the
1231(b) property that is treated as ordinary income under section 1245
or section 1250.
(B) 180-day period. For the applicable 180-day period with respect
to a qualified 1231 gain, see paragraph (b)(7) of this section.
(C) Attributes of included income when deferral ends. For the
Federal income tax treatment of the later inclusion of a qualified 1231
gain deferred under section 1400Z-2(a)(1) and the section 1400Z-2
regulations, see paragraph (c)(1) of this section.
(iv) Gain arising from an inclusion event--(A) In general. Gain
that is otherwise required to be included in gross income under Sec.
1.1400Z2(b)-1(e)(1), whether from the disposition of an entire interest
in a QOF or a disposition of a partial interest, may be eligible for
deferral under section 1400Z-2(a)(1), provided that all of the
requirements to elect to defer gain under section 1400Z-2(a)(1)(A) are
met. For purposes of determining whether such gain is eligible gain
under section 1400Z-2(a)(1)(A) and this paragraph (b)(11)(iv)(A), the
eligible taxpayer should treat such inclusion gain as if it was
originally realized upon the occurrence of the inclusion event rather
than on the sale or exchange that gave rise to the eligible gain to
which the inclusion event relates.
(B) 180-day period. The 180-day period for investing gain from an
inclusion event begins on the date of the inclusion event.
(C) Holding period. The holding period for a qualifying investment
attributable to eligible gain arising from an inclusion event begins on
the date that the gain is reinvested in a QOF.
(v) No deferral for gain realized upon the acquisition of an
eligible interest. Gain is not eligible for deferral under section
1400Z-2(a)(1) and the section 1400Z-2 regulations if such gain is
realized upon the contribution, exchange, or other transfer of property
to a QOF in exchange for an eligible interest (see paragraph
(c)(6)(ii)(C) of this section) or the transfer of property to an
eligible taxpayer in exchange for an eligible interest (see paragraph
(c)(6)(iv) of this section).
(vi) Gain from section 1256 contracts and from positions in a
straddle--(A) General rule. Except as otherwise explicitly provided in
paragraph (b)(11)(vi)(B), (C), or (D) of this section, eligible gain
for a taxable year does not include--
(1) Gain from a section 1256 contract as defined in section
1256(b);
(2) Gain from a position that was part of a straddle as defined in
section 1092 (straddle) during the taxable year; or
(3) Gain from a position that was part of a straddle in a previous
taxable year if, under section 1092(a)(1)(B), a loss from any position
in that straddle is treated as sustained, subject to the limitations of
section 1092(a)(1)(A), during the taxable year.
(B) Exception for net gain from certain section 1256 contracts.
Paragraph (b)(11)(vi)(A)(1) of this section does not apply to the net
gain during the taxable year from section 1256 contracts that were not
part of a straddle at any time during the taxable year (qualified
section 1256 contracts). For purposes of this paragraph (b)(11)(vi)(B),
the net gain during the taxable year from qualified section 1256
contracts is determined by taking into account all capital gains and
losses from such contracts for the taxable year that are recognized for
Federal income tax purposes, determined without regard to section
1400Z-2(a)(1). The 180-day period with respect to any eligible gain
described in this paragraph (b)(11)(vi)(B) begins on the last day of
the taxable year, and the character of that gain when it is later
included under sections 1400Z-2(a)(1)(B) and 1400Z-2(b) is determined
under the general rule in paragraph (c)(1) of this section. If, under
section 1256(a)(4), section 1092 does not apply to a straddle, such
straddle is not treated as a straddle for purposes of this paragraph
(b)(11)(vi)(B).
(C) Exception for net gain from certain identified straddles--(1)
Paragraph (b)(11)(vi)(A) of this section does not apply to the net gain
during the taxable year from positions in a straddle if--
(i) During the taxable year, the positions were part of an
identified straddle under section 1092(a)(2), part of an identified
mixed straddle under Sec. 1.1092(b)-3T (and, as applicable, Sec.
1.1092(b)-6), part of an identified straddle under section 1256(d), or
included in a mixed straddle account under Sec. 1.1092(b)-4T;
(ii) All gains and losses with respect to the positions that were
part of such straddle or included in such mixed straddle account are
recognized by the end of the taxable year (other than gain that would
be recognized but for deferral under section 1400Z-2(a)(1));
(iii) None of the positions in such straddle or mixed straddle
account were part of a straddle during the taxable year, other than a
straddle described in paragraph (b)(11)(vi)(C)(1)(i) and (ii) of this
section; and
(iv) None of the positions in such straddle or mixed straddle
account were part of a straddle in a previous taxable year if, under
section 1092(a)(1)(B), a loss from any position in such straddle is
treated as sustained, subject to the limitations of section
1092(a)(1)(A), during the taxable year.
(2) For purposes of paragraph (b)(11)(vi)(C)(1) of this section,
net gain during the taxable year from an identified straddle or mixed
straddle account described in paragraph (b)(11)(vi)(C)(1)(i) through
(iv) of this section is equal to the excess of the capital gains
recognized in the taxable year for Federal income tax purposes,
determined without regard to section 1400Z-2(a)(1), from all of the
positions that were part of that straddle over the sum of the capital
losses and net ordinary loss (if any) from all of the positions that
were part of that straddle. For purposes of this paragraph
(b)(11)(vi)(C)(2), capital gains and losses from an identified straddle
or mixed straddle account include capital gains and losses from section
1256 contracts
[[Page 1957]]
and other positions marked to market either upon termination or on the
last business day of the taxable year, as well as annual account net
gain from positions in a mixed straddle account covered by Sec.
1.1092(b)-4T. In addition, for purposes of this paragraph
(b)(11)(vi)(C)(2), net ordinary loss means the excess of ordinary
losses over ordinary gains.
(3) If a straddle is an identified straddle described in section
1092(a)(2), the basis adjustment provisions described in sections
1092(a)(2)(A)(ii) and (iii) must be applied in determining the net gain
during the taxable year from positions that were part of that straddle.
(4) The 180-day period with respect to any eligible gain described
in paragraph (b)(11)(vi)(C)(2) of this section begins on the earlier of
the date when all of the positions that are, or have been, part of the
straddle are disposed of (or otherwise terminated) or the last day of
the taxable year.
(5) If net gain described in paragraph (b)(11)(vi)(C)(2) of this
section is deferred under section 1400Z-2(a)(1), that gain is not
treated as unrecognized gain for purposes of section 1092(a)(3)(A)(ii).
(D) Additional exceptions to the general rule. Additional
exceptions to the general rule in paragraph (b)(11)(vi)(A) of this
section may be prescribed in guidance published in the Internal Revenue
Bulletin (see Sec. 601.601(d)(2) of this chapter).
(E) Examples. The following examples illustrate the rules described
in paragraph (b)(11)(vi) of this section. All of the examples assume
that Taxpayer holds the positions described as capital assets and that
Taxpayer holds no offsetting positions other than those described in
the examples.
(1) Example 1. Taxpayer owns 100 shares of publicly traded
Company X common stock and acquires put options on 100 shares of
Company X common stock during the taxable year. Taxpayer does not
make any straddle identifications under section 1092. During the
taxable year, Taxpayer sells all 100 shares of its Company X common
stock and has a $40 capital gain. During the taxable year, Taxpayer
also closes out all of its put options on Company X common stock and
has a $30 capital loss. That $40 of capital gain is from a position
that was part of a straddle during the taxable year because the
position in Company X common stock and the position in put options
on Company X stock are offsetting positions as defined in section
1092(c). Under paragraph (b)(11)(vi)(A) of this section, none of
Taxpayer's $40 of capital gain is eligible gain.
(2) Example 2. Taxpayer's taxable year is the calendar year.
Taxpayer owns 100 shares of publicly traded Company Y common stock
and has a basis in each share of $10.00. Taxpayer also owns put
options on 100 shares of Company Y common stock. Taxpayer makes a
valid and timely identification under section 1092(a)(2) of the 100
shares of Company Y common stock and the put options on the 100
shares of Company Y common stock. On January 10, Year 1, Taxpayer
closes out all of the put options and has a $30.00 capital loss. On
March 10, Year 1, Taxpayer sells 40 shares of the Company Y common
stock for $11.00 per share. At the end of Year 1, the fair market
value of each of the 60 remaining shares of Company Y common stock
held by Taxpayer is $10.50. Under section 1092(a)(2)(A)(ii), when
the put options are closed out at a loss of $30.00, the basis of
each of Taxpayer's shares of Company Y common stock is increased by
$0.30 ($30.00/100). Thus, Taxpayer has a gain of $28.00 ((40 *
$11.00)-(40 * $10.30)) on the sale of the 40 shares of Company Y
common stock. Paragraph (b)(11)(vi)(A) of this section applies to
all of Taxpayer's gain during the taxable year from the straddle.
Because Taxpayer has unrecognized gain from the straddle at the end
of the taxable year, paragraph (b)(11)(vi)(C) of this section does
not shield any of Taxpayer's gain from that result. The $28 of gain
is thus not eligible gain. Taxpayer must recognize and include in
taxable income for the taxable year the $28.00 capital gain. Under
section 1092(a)(2)(A)(iv), Taxpayer may not deduct the $30.00 loss
from the put options.
(3) Example 3. The facts are the same as in paragraph
(b)(11)(vi)(E)(2) of this section (Example 2), except Taxpayer sells
the 100 shares of Company Y common stock on March 10, Year 1, for
$11.50 per share. Under section 1092(a)(2)(A)(ii), as in paragraph
(b)(11)(vi)(E)(2) of this section (Example 2), when the put options
are closed out at a loss of $30.00, the basis of each of Taxpayer's
shares of Company Y common stock is increased by $0.30 ($30.00/100).
Taxpayer has a gain of $120.00 ((100 * $11.50)-(100 * $10.30)) on
the sale of the 100 shares of Company Y common stock. Taxpayer has
net gain during the taxable year from the identified straddle of
$120.00. Under paragraph (b)(11)(vi)(C) of this section, paragraph
(b)(11)(vi)(A) of this section does not apply to prevent the $120.00
net gain from being eligible gain. As in paragraph (b)(11)(vi)(E)(2)
of this section (Example 2), under section 1092(a)(2)(A)(iv),
Taxpayer may not deduct the $30.00 loss from the put options.
(4) Example 4. Taxpayer's taxable year is the calendar year.
Taxpayer owns 100 shares of publicly traded Company Z common stock
and has a basis in each share of $10. Taxpayer also owns put options
on 100 shares of Company Z common stock. In Year 1, Taxpayer closes
out the put options at a $100 loss. At the end of Year 1, the fair
market value of each of the shares of Company Z common stock held by
Taxpayer is $15 and, under section 1092(a)(3), Taxpayer has $500 of
unrecognized gain. Because Taxpayer's unrecognized gain on the
Company Z common stock at the end of Year 1 exceeds Taxpayer's loss
on the put options, Taxpayer's loss is deferred under section
1092(a)(1). During Year 2, Taxpayer sells 40 shares of Company Z
common stock for $14 per share. Taxpayer has a gain of $160 ((40 *
$14)-(40 * $10)) on the sale of the 40 shares of Company Z common
stock. Under paragraph (b)(11)(vi)(A) of this section, because
Taxpayer's Company Z common stock was part of a straddle in a
previous taxable year and a loss from a position in that straddle
was deferred under section 1092(a) at the end of Year 1, the
preceding taxable year, Taxpayer's $160 Year 2 gain on the sale of
the Company Z common stock is not eligible gain. At the end of Year
2, the fair market value of each of the 60 remaining shares of
Company Z common stock held by Taxpayer is $10 and Taxpayer has no
unrecognized gain on its Company Z common stock. Under section
1092(a)(1)(B), Taxpayer's $100 loss from Year 1 is treated as
sustained in Year 2. Because Taxpayer has no unrecognized gain on
its Company Z common stock at the end of Year 2, Taxpayer may deduct
the $100 loss in Year 2. In Year 3, Taxpayer sells the remaining 60
shares of Company Z common stock for $50 per share. Taxpayer has a
gain of $2,400 ((60 * $50)-(60 * $10)) on the sale of the 60 shares
of Company Z common stock. Because there was no loss from the
straddle deferred under section 1092(a) at the end of Year 2,
paragraph (b)(11)(vi)(A) of this section does not apply to prevent
the $2,400 of Year 3 net gain from being eligible gain.
(5) Example 5. Taxpayer's taxable year is the calendar year. On
October 5, Year 1, Taxpayer buys 100 shares of publicly traded
Exchange Traded Fund A (ETF A) and acquires offsetting section 1256
contracts on the index that underlies the ETF A shares. Taxpayer
makes a valid and timely identification of all 100 ETF A shares and
the offsetting section 1256 contracts under Sec. 1.1092(b)-3T. On
December 31, Year 1, the fair market value of the ETF A shares has
increased by $500, and the fair market value of the section 1256
contracts has decreased by $450. On December 31, Year 1, Taxpayer
sells the ETF shares for a $500 gain. In addition, under section
1256(a)(1), the section 1256 contracts are treated as sold for fair
market value on December 31, Year 1, for a $450 loss. Pursuant to
Sec. 1.1092(b)-3T(b)(4), Taxpayer has a net short term capital gain
from the identified mixed straddle of $50 ($500-$450). Under
paragraph (b)(11)(vi)(C) of this section, paragraph (b)(11)(vi)(A)
of this section does not apply to prevent the $50 of net short term
capital gain from being eligible gain.
(vii) [Reserved]
(viii) Eligible installment sale gains--(A) In general. The term
eligible gain includes gains described in this paragraph (b)(11) that
would be recognized by an eligible taxpayer under the installment
method pursuant to section 453 and with Sec. Sec. 1.453-1 through
1.453-12 for a taxable year, provided such gain otherwise meets the
requirements of this paragraph (b)(11). This includes gains recognized
under the installment method under section 453 from an installment sale
that occurred before December 22, 2017.
(B) 180-day period for gain from installment sales. For gains
reported on
[[Page 1958]]
the installment method, an eligible taxpayer may treat the date the
payment on the installment sale is received or the last day of the
taxable year in which the eligible taxpayer would have recognized the
gain under the installment method as the beginning of the 180-day
period described in paragraph (b)(7) of this section. Thus, if an
eligible taxpayer receives one or more payments on an installment sale
and treats the date the payment on the installment sale is received as
the beginning of the 180-day period, each payment will begin a new 180-
day period.
(ix) Additional rules for determining if gain is subject to Federal
income tax--(A) Application of a treaty--(1) In general. For purposes
of paragraph (b)(11)(i)(B) of this section, whether gain would be
subject to Federal income tax is determined after application of any
treaty exemption provision that an eligible taxpayer elects to apply
under any applicable U.S. income tax convention.
(2) Treaty waiver. An eligible taxpayer who is not a United States
person within the meaning of section 7701(a)(30) (or an eligible
taxpayer who is a United States person within the meaning of section
7701(a)(30) but who is treated as a resident of another country under
an applicable U.S. income tax convention) may not make an election to
defer gain pursuant to section 1400Z-2(a) after the applicability date
of this section (see paragraph (g) of this section) unless such
eligible taxpayer irrevocably waives, in accordance with forms and
instructions (see Sec. 601.602 of this chapter), any treaty benefits
that would exempt such gain from being subject to Federal income tax at
the time of inclusion pursuant to an applicable U.S. income tax
convention. In the event that such forms and instructions that include
such waiver have not yet been published when an election pursuant to
paragraph (d)(1) of this section is required to be made, such an
eligible taxpayer must attach a written statement, signed under
penalties of perjury, to any forms on which an election is made
pursuant to paragraph (d)(1) of this section, which states ``With
respect to gain deferred pursuant to an election under section 1400Z-
2(a), the below signed taxpayer irrevocably waives any treaty benefits
that would exempt such gain from being subject to Federal income tax at
the time of inclusion pursuant to an applicable U.S. income tax
convention.'' If such an eligible taxpayer chooses to apply the section
1400Z-2 regulations in a consistent manner for all taxable years (see
paragraph (g)(2)(i) of this section), the taxpayer must include the
signed statement required under this paragraph (b)(11)(ix)(A)(2) with
the first annual report described in paragraph (d)(2) of this section
that is required to be filed on a date that is after March 13, 2020. An
eligible taxpayer not described in the first sentence of this paragraph
(b)(11)(ix)(A)(2) will only be required to make the waiver described in
this paragraph (b)(11)(ix)(A)(2) if and to the extent required in forms
and publications (see Sec. 601.602 of this chapter).
(3) Non-application to certain entities. This paragraph
(b)(11)(ix)(A) does not apply to an entity described in paragraph
(b)(11)(ix)(B) of this section.
(B) Gain of a partnership. Subject to Sec. 1.1400Z2(f)-1(c), with
respect to a partnership, the requirement in paragraph (b)(11)(i)(B) of
this section that a gain be subject to Federal income tax does not
apply to an otherwise eligible gain of the partnership, provided the
partnership acquires the eligible interest with respect to such gain.
See Sec. 1.1400Z2(f)-1(c)(3)(i) and (ii), Examples 1 and 2, for
illustrations of the application of Sec. 1.1400Z2(f)-1(c) (providing
an anti-abuse rule) to a partnership.
(12) Eligible interest--(i) In general. For purposes of section
1400Z-2, an eligible interest in a QOF is an equity interest issued by
the QOF, including preferred stock or a partnership interest with
special allocations. Thus, the term eligible interest excludes any debt
instrument including those within the meaning of section 1275(a)(1) and
Sec. 1.1275-1(d). An eligible interest includes a pre-existing
interest in an entity that becomes a QOF pursuant to Sec. 1.1400Z2(d)-
1(a)(1)(iii).
(ii) Use as collateral permitted. Provided that the eligible
taxpayer is the owner of the equity interest in the QOF for Federal
income tax purposes, status as an eligible interest is not impaired by
using the interest as collateral for a loan, whether as part of a
purchase-money borrowing or otherwise.
(iii) Deemed contributions not creating mixed-funds investment. See
paragraph (f)(2) of this section for rules regarding deemed
contributions of money to a partnership pursuant to section 752(a).
(13) Eligible taxpayer. An eligible taxpayer is a person that is
required to report the recognition of gains during the taxable year
under Federal income tax accounting principles. Thus, for example,
eligible taxpayers include individuals; C corporations, including RICs
and REITs; organizations subject to tax under section 511; and
partnerships, S corporations, trusts, and decedents' estates to the
extent permitted by paragraphs (c)(7) through (9) of this section.
(14) Inclusion event. The term inclusion event has the meaning
provided in Sec. 1.1400Z2(b)-1(c).
(15) Mixed-funds investment. The term mixed-funds investment means
an investment a portion of which is a qualifying investment and a
portion of which is a non-qualifying investment.
(16) Non-qualifying investment. The term non-qualifying investment
means an investment in a QOF described in section 1400Z-2(e)(1)(A)(ii).
(17) Property--(i) In general. The term property means money,
securities, or any other property.
(ii) Inclusion events regarding QOF corporation distributions. For
purposes of Sec. 1.1400Z2(b)-1(c), in the context in which a QOF
corporation makes a distribution, the term property does not include
stock (or rights to acquire stock) in the QOF corporation that makes
the distribution.
(18) QOF. The term QOF means a qualified opportunity fund, as
defined in section 1400Z-2(d)(1) and Sec. 1.1400Z2(d)-1.
(19) QOF C corporation. The term QOF C corporation means a QOF
corporation other than a QOF S corporation.
(20) QOF corporation. The term QOF corporation means a QOF that is
classified as a corporation for Federal income tax purposes.
(21) QOF RIC. The term QOF RIC means a QOF that elects to be taxed
as a RIC for Federal income tax purposes. For purposes of section
1400Z-2 and the section 1400Z-2 regulations, a RIC is a regulated
investment company within the meaning of section 851.
(22) QOF REIT. The term QOF REIT means a QOF that elects to be
taxed as a REIT for Federal income tax purposes. For purposes of
section 1400Z-2 and the section 1400Z-2 regulations, a REIT is a real
estate investment trust within the meaning of section 856.
(23) QOF owner. The term QOF owner means a QOF shareholder or a QOF
partner.
(24) QOF partner. The term QOF partner means a person that directly
owns a qualifying investment in a QOF partnership or a person that owns
such a qualifying investment through equity interests solely in one or
more partnerships.
(25) QOF partnership. The term QOF partnership means a QOF that is
classified as a partnership for Federal income tax purposes.
(26) QOF S corporation. The term QOF S corporation means a QOF
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corporation that has elected under section 1362 to be an S corporation.
(27) QOF shareholder. The term QOF shareholder means a person that
directly owns a qualifying investment in a QOF corporation.
(28) QOZ designation notice. The term QOZ designation notice means
a notice designating population census tracts as qualified opportunity
zones (QOZs) in guidance published in the Internal Revenue Bulletin
(see Sec. 601.601(d)(2) of this chapter).
(29) Qualified opportunity zone business. The term qualified
opportunity zone business has the meaning provided in section 1400Z-
2(d)(3) and Sec. 1.1400Z2(d)-1(d).
(30) Qualified opportunity zone business property. The term
qualified opportunity zone business property has the meaning provided
in section 1400Z-2(d)(2)(D) and Sec. 1.1400Z2(d)-2.
(31) Qualified opportunity zone partnership interest. The term
qualified opportunity zone partnership interest has the meaning
provided in section 1400Z-2(d)(2)(C) and Sec. 1.1400Z2(d)-1(c)(3).
(32) Qualified opportunity zone property. The term qualified
opportunity zone business property has the meaning provided in section
1400Z-2(d)(2)(A) and Sec. 1.1400Z2(d)-1(c)(1).
(33) Qualified opportunity zone stock. The term qualified
opportunity zone stock has the meaning provided in section 1400Z-
2(d)(2)(B) and Sec. 1.1400Z2(d)-1(c)(2).
(34) Qualifying investment. The term qualifying investment means an
eligible interest, or portion thereof, in a QOF to the extent that a
deferral election is made and applies with respect to such eligible
interest or portion thereof and the IRS has been timely notified of the
deferral election. An eligible interest in a QOF ceases to be a
qualifying investment of the owner upon, and to the extent of, the
occurrence of an inclusion event with regard to that eligible interest,
or portion thereof, except as is expressly provided otherwise in Sec.
1.1400Z2(b)-1(c) or other provisions of the section 1400Z-2
regulations.
(35) Qualifying QOF partnership interest. The term qualifying QOF
partnership interest means a direct or indirect interest in a QOF
partnership that is a qualifying investment.
(36) Qualifying QOF stock. The term qualifying QOF stock means
stock in a QOF corporation that is a qualifying investment.
(37) Qualifying section 355 transaction. The term qualifying
section 355 transaction means a distribution described in Sec.
1.1400Z2(b)-1(c)(11)(i)(B).
(38) Qualifying section 381 transaction. The term qualifying
section 381 transaction means a transaction described in section
381(a)(2), except the following transactions:
(i) An acquisition of assets of a QOF by a QOF shareholder that
holds a qualifying investment in the QOF;
(ii) An acquisition of assets of a QOF by a tax-exempt entity as
defined in Sec. 1.337(d)-4(c)(2);
(iii) An acquisition of assets of a QOF by an entity operating on a
cooperative basis within the meaning of section 1381;
(iv) An acquisition by a QOF of assets of a QOF shareholder that
holds a qualifying investment in the QOF;
(v) A reorganization of a QOF in a transaction that qualifies under
section 368(a)(1)(G);
(vi) A transaction, immediately after which one QOF owns an
investment in another QOF; and
(vii) A triangular reorganization of a QOF within the meaning of
Sec. 1.358-6(b)(2)(i), (ii), or (iii).
(39) Related persons. The term related when used with regard to
persons and the term related persons means that there is a relationship
described in section 267(b) or 707(b)(1), determined by substituting
``20 percent'' for ``50 percent'' each place it occurs in such
sections. The term unrelated when used with regard to persons means
that there is no relationship described in preceding sentence.
(40) Remaining deferred gain. With respect to a qualifying
investment, the term remaining deferred gain means the full amount of
gain that was deferred under section 1400Z-2(a)(1)(A), reduced by the
amount of gain previously included under Sec. 1.1400Z2(b)-1(b). After
December 31, 2026, an eligible taxpayer's remaining deferred gain is
$0.
(41) Section 1400Z-2 regulations. The term section 1400Z-2
regulations means the regulations in this chapter, which are prescribed
in whole or in part under section 1400Z-2.
(c) Operational and special rules--(1) Attributes of gains included
in income under section 1400Z-2(a)(1)(B). If section 1400Z-2(a)(1)(B),
section 1400Z-2(b), and the section 1400Z-2 regulations require a
taxpayer to include in income some or all of a previously deferred
gain, the rules of paragraphs (c)(1)(i) and (ii) of this section apply
with respect to such gain.
(i) Deferral year attributes. The gain so included per paragraph
(c)(1) of this section has the same attributes in the taxable year of
inclusion that the gain would have had if recognition of the gain had
not been deferred under section 1400Z-2(a)(1)(A). These attributes
include those taken into account by sections 1(h), 1222, 1231(b), 1256,
and any other applicable provisions of the Code.
(ii) Inclusion year treatment. The gain so included per paragraph
(c)(1) of this section is subject to the same Federal income tax
provisions and rates that would apply to any other gains that are
realized and recognized at the same time as the included gain and that
have the same attributes as the deferred gain. For example, when a
deferred qualified 1231 gain, as defined in paragraph (b)(11)(iii) of
this section, is required to be included in income, the included
section 1231 gain is treated as if it were a section 1231 gain (within
the meaning of section 1231(a)(3)(A)) that was recognized on the date
of inclusion.
(iii) Rules for associating included gain with deferred gains--(A)
In general. For purposes of paragraphs (c)(1)(i) and (ii) of this
section, a taxpayer determines which previously deferred gain is
associated with a qualifying investment in accordance with guidance
published in the Internal Revenue Bulletin or in forms and instructions
(see Sec. Sec. 601.601(d)(2) and 601.602 of this chapter). The rules
of paragraphs (c)(1)(iii)(B) and (C) of this section only apply only to
the extent a deferred gain is not clearly associated with a particular
qualifying investment under this paragraph (c)(1)(iii)(A).
(B) Only one eligible gain associated with a deferral election. If
only one eligible gain could have been deferred with respect to a
qualifying investment, that deferred gain is associated with that
qualifying investment. For example, if an eligible taxpayer makes a
deferral election with respect to an investment in a QOF and only one
eligible gain of the taxpayer satisfies the 180-day period with respect
to the investment in the QOF, that eligible gain is the gain deferred
with respect to the qualifying investment for purposes of paragraphs
(c)(1)(i) and (ii) of this section.
(C) Multiple eligible gains associated with a deferral election--
(1) In general. If more than one eligible gain may have been deferred
with respect to an investment in a QOF for which a deferral election
has been made, then for purposes of paragraphs (c)(1)(i) and (ii) of
this section, the eligible taxpayer is treated as making the investment
in the QOF first with respect to the earliest realized eligible gain,
followed by the next earliest eligible gain and any other eligible
gains in order of the date of their realization.
(2) Rule for gains realized on the same day. If in the application
of paragraph
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(c)(1)(iii)(C)(1) of this section, two eligible gains are realized on
the same day, such gains are allocated to the investment in the QOF
proportionately.
(2) Identification of which interest in a QOF corporation has been
disposed of--(i) Need for identification. If a taxpayer holds shares of
QOF stock with identical rights (fungible interests), and if the
taxpayer disposes of less than all of the fungible interests, it is
necessary to identify which interest or interests were disposed of. A
taxpayer may effect this identification in accordance with the rules
and principles of Sec. 1.1012-1(c). Consistent with Sec. 1.1012-1(c),
if a taxpayer does not adequately identify which of the fungible
interests are disposed of, the first-in, first-out identification
method (FIFO method) applies.
(ii) Consequences of identification. The identification
determines--
(A) Whether an investment disposed of is a qualifying investment or
a non-qualifying investment; and
(B) In the case of qualifying investments--
(1) The attributes of the gain addressed in paragraph (c)(1) of
this section; and
(2) The extent, if any, of an increase under section 1400Z-
2(b)(2)(B) in the basis of an investment interest that is disposed of.
(3) Pro-rata method. If, after application of the FIFO method, a
taxpayer is treated as having disposed of less than all of the
investment interests that the taxpayer acquired on one day, and if the
interests acquired on that day vary with respect to the characteristics
described in paragraph (c)(2)(ii) of this section, then a proportionate
allocation must be made to determine which interests were disposed of
(pro-rata method).
(4) Examples. The following examples illustrate the rules of
paragraph (c)(1) through (3) of this section.
(i) Example 1. Short-term gain. For 2018, taxpayer B properly
made an election under section 1400Z-2 to defer $100 of eligible
gain that, if not deferred, would have been recognized as short-term
capital gain, as defined in section 1222(1). In 2022, sections
1400Z-2(a)(1)(B) and (b) require taxpayer B to include the gain in
gross income. Under paragraph (c)(1) of this section, the gain
included in 2022 is short-term capital gain.
(ii) Example 2. Collectibles gain. For 2018, taxpayer C properly
made an election under section 1400Z-2 to defer a gain that, if not
deferred, would have been collectibles gain as defined in section
1(h)(5). In a later taxable year, section 1400Z-2(a)(1)(B) and (b)
requires some or all of that deferred gain to be included in gross
income. The gain included is collectibles gain.
(iii) Example 3. Net capital gain from section 1256 contracts.
For 2019, taxpayer D had $100 of net capital gain realized from
section 1256 contracts that is eligible gain under paragraph
(b)(11)(vi)(B) of this section. D timely invested $100 in a QOF and
properly made an election under section 1400Z-2 to defer that $100
of gain. In 2023, section 1400Z-2(a)(1)(B) and (b) requires D to
include that deferred gain in gross income. Under paragraph (c)(1)
of this section, the character of the inclusion is governed by
section 1256(a)(3), which requires a 40:60 split between short-term
and long-term capital gain. Accordingly, $40 of the inclusion is
short-term capital gain and $60 of the inclusion is long-term
capital gain.
(iv) Example 4. FIFO method. For 2018, taxpayer E properly made
an election under section 1400Z-2 to defer $300 of short-term
capital gain. For 2020, E properly made a second election under
section 1400Z-2 to defer $200 of long-term capital gain. In both
cases, E properly invested in QOF corporation Q the amount of the
gain to be deferred, resulting in a total investment in Q of $500.
The two investments are fungible interests and the price of the
interests was the same at the time of the two investments. E did not
purchase any additional interest in Q or sell any of its interest in
Q until 2024, when E sold for a gain 60 percent of its interest in
Q. E did not adequately identify which investment in QOF Q E sold.
Under paragraph (c)(2)(i) of this section, E must apply the FIFO
method to identify which investments in Q that E disposed of. 60
percent of E's total investment in Q is $300 (60% x $500), thus
under the FIFO method, E sold its entire 2018 initial investment of
$300 in Q. Under section 1400Z-2(a)(1)(B) and (b), the sale
triggered an inclusion of deferred gain. Because the inclusion has
the same character as the gain that had been deferred, the inclusion
is short-term capital gain.
(v) Example 5. FIFO method. In 2018, before Corporation R became
a QOF, Taxpayer F invested $100 to R in exchange for 100 R common
shares. Later in 2018, after R was a QOF, F invested $500 to R in
exchange for 400 R common shares and properly elected under section
1400Z-2 to defer $500 of realized short-term capital gain from a
separate investment. Even later in 2018, on different days, F
realized $300 of short-term capital gain and $700 of long-term
capital gain. On a single day that fell during the 180-day period
for both of those gains, F invested $1,000 in R in exchange for 800
R common shares and properly elected under section 1400Z-2 to defer
the two gains. In 2020, F sold 100 R common shares. F did not
adequately identify which investment in R F sold. Under paragraph
(c)(2)(i) of this section, F must apply the FIFO method to identify
which investments in R F disposed of. As determined by that
identification, F sold the initially acquired 100 R common shares,
which were not part of a deferral election under section 1400Z-2. R
must recognize gain or loss on the sale of its R shares under the
generally applicable Federal income tax rules, but the sale does not
trigger an inclusion of any deferred gain.
(vi) Example 6. FIFO method. The facts are the same as in
paragraph (c)(4)(v) of this section (Example 5), except that, in
addition, during 2021 F sold an additional 400 R common shares, and,
as with the other sale, F did not adequately identify which
investment in QOF R F sold. Under paragraph (c)(2)(i) of this
section, F must apply the FIFO method to identify which investments
in R were disposed of. As determined by this identification, F sold
the 400 common shares which were associated with the deferral of
$500 of short-term capital gain. Thus, the deferred gain that must
be included upon sale of the 400 R common shares is short-term
capital gain.
(vii) Example 7. Pro-rata method. The facts are the same as in
examples 5 and 6, except that, in addition, during 2022 F sold an
additional 400 R common shares. Under paragraph (c)(2)(i) of this
section, F must apply the FIFO method to identify which investments
in R were disposed of. In 2022, F is treated as holding only the 800
R common shares purchased on a single day, and the section 1400Z-2
deferral election associated with these shares applies to gain with
different characteristics (described in paragraph (c)(2)(ii) of this
section). Under paragraph (c)(3) of this section, therefore, R must
use the pro-rata method to determine which of the characteristics
pertain to the deferred gain required to be included as a result of
the sale of the 400 R common shares. Under the pro-rata method, $150
of the inclusion is short-term capital gain ($300 x 400/800) and
$350 is long-term capital gain ($700 x 400/800).
(5) Making an investment for purposes of an election under section
1400Z-2(a)--(i) Transfer of cash or other property to a QOF. A taxpayer
makes an investment in a QOF by transferring cash or other property to
a QOF in exchange for eligible interests in the QOF, regardless of
whether the transfer is one in which the transferor would recognize
gain or loss on the property transferred.
(ii) Furnishing services. Rendering services to a QOF is not a
transfer of cash or other property to a QOF. Thus, if a taxpayer
receives an eligible interest in a QOF for services rendered to the QOF
or to a person in which the QOF holds any direct or indirect equity
interest, then the interest in the QOF that the taxpayer receives is a
non-qualifying investment.
(iii) Acquisition of eligible interest from person other than QOF.
An eligible taxpayer may make an investment in a QOF by acquiring an
eligible interest in a QOF from a person other than the QOF, provided
that all of the requirements of section 1400Z-2(a)(1) and the section
1400Z-2 regulations for making a valid deferral election with respect
to that investment are otherwise satisfied with respect to such
acquisition. For example, an eligible taxpayer who acquires an eligible
interest in a QOF other than from the QOF also must have an eligible
gain within the 180-day period prior to the
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eligible taxpayer's acquisition of the eligible interest in the QOF.
(6) Amount invested for purposes of section 1400Z-2(a)(1)(A)--(i)
In general. In the case of any investments described in this paragraph
(c)(6), the amount of a taxpayer's qualifying investment cannot exceed
the amount of eligible gain to be deferred under the deferral election.
If the amount of an otherwise qualifying investment exceeds the amount
of eligible gain to be deferred under the deferral election, the amount
of the excess is treated as a non-qualifying investment. See paragraph
(c)(6)(iii) of this section for special rules applicable to transfers
to QOF partnerships.
(ii) Transfers to a QOF--(A) Cash. If a taxpayer makes an
investment in a QOF by transferring cash to a QOF, the amount of the
taxpayer's investment is that amount of cash.
(B) Property other than cash--Nonrecognition transactions. This
paragraph (c)(6)(ii)(B) applies if a taxpayer makes an investment in a
QOF by transferring property other than cash to a QOF and if, but for
the application of section 1400Z-2(b)(2)(B) and the section 1400Z-2
regulations, the taxpayer's basis in the resulting investment in the
QOF would be determined, in whole or in part, by reference to the
taxpayer's basis in the transferred property. This paragraph
(c)(6)(ii)(B) applies separately to each item of property transferred
to a QOF.
(1) Amount of qualifying investment. If paragraph (c)(6)(ii)(B) of
this section applies, the amount of the taxpayer's qualifying
investment is the lesser of the taxpayer's adjusted basis in the
eligible interest received in the transaction, without regard to
section 1400Z-2(b)(2)(B) and the section 1400Z-2 regulations, or the
fair market value of the eligible interest received in the transaction,
both determined immediately after the transfer.
(2) Fair market value of the eligible interest received exceeds its
adjusted basis. If paragraph (c)(6)(ii)(B) of this section applies, and
if the fair market value of the eligible interest received is in excess
of the eligible taxpayer's adjusted basis in the eligible interest
received, without regard to section 1400Z-2(b)(2)(B) and the section
1400Z-2 regulations, then the eligible taxpayer's investment in a QOF
is a mixed-funds investment to which section 1400Z-2(e)(1) applies. In
such a case, an amount equal to the adjusted basis of the eligible
interest in the hands of the eligible taxpayer is the eligible
taxpayer's qualifying investment, and the excess is the eligible
taxpayer's non-qualifying investment.
(3) Transfer of built-in loss property and section 362(e)(2). If
paragraph (c)(6)(ii)(B) of this section and section 362(e)(2) both
apply to a transaction, the eligible taxpayer and the QOF are deemed to
have made an election under section 362(e)(2)(C).
(C) Property other than cash--Taxable transactions. This paragraph
(c)(6)(ii)(C) applies if an eligible taxpayer makes an investment in a
QOF by transferring property other than cash to a QOF and if, without
regard to section 1400Z-2(b)(2)(B) and the section 1400Z-2 regulations,
the eligible taxpayer's basis in the eligible interest received would
not be determined, in whole or in part, by reference to the eligible
taxpayer's basis in the transferred property. If this paragraph
(c)(6)(ii)(C) applies, the amount of the eligible taxpayer's investment
in a QOF is the fair market value of the transferred property, as
determined immediately before the transfer. This paragraph
(c)(6)(ii)(C) applies separately to each item of property transferred
to a QOF.
(D) Basis in a mixed-funds investment. If a taxpayer's investment
in a QOF is a mixed-funds investment to which section 1400Z-2(e)(1)
applies, the taxpayer's basis in the non-qualifying investment is equal
to the taxpayer's basis in all of the eligible interests received,
determined without regard to section 1400Z-2(b)(2)(B) and the section
1400Z-2 regulations, and reduced by the basis of the taxpayer's
qualifying investment, determined without regard to section 1400Z-
2(b)(2)(B) and the section 1400Z-2 regulations.
(iii) Special rules for transfers to QOF partnerships. In the case
of an investment in a QOF partnership, the following rules apply:
(A) Amounts not treated as a qualifying investment--(1) Non-
contributions in general. To the extent the transfer of property to a
QOF partnership is characterized other than as a contribution, such as
characterization as a sale under section 707 and the regulations in
this part under section 707 of the Code, the transfer is not treated as
being made in exchange for a qualifying investment.
(2) Reductions in investments otherwise treated as contributions.
If any transfer of cash or other property to a partnership is not
treated as a contribution, in whole or in part, under paragraph
(c)(6)(iii)(A)(1) of this section, the part of the transfer to the
partnership that is not disregarded is not a qualifying investment to
the extent the partnership makes a distribution to the partner and the
transfer to the partnership and the distribution would be
recharacterized as a disguised sale under section 707 and the
regulations in this part under section 707 of the Code if:
(i) Any cash contributed were non-cash property; and
(ii) In the case of a distribution by the partnership to which
Sec. 1.707-5(b) (relating to debt-financed distributions) applies, the
partner's share of liabilities is zero.
(B) Amount invested in a QOF partnership--(1) Calculation of amount
of qualifying and non-qualifying investments. To the extent paragraph
(c)(6)(iii)(A) of this section does not apply, the amount of equity
received by an eligible taxpayer in a QOF partnership in exchange for
the lesser of the net basis or net value of the property contributed to
the QOF partnership by the eligible taxpayer is a qualifying
investment. The amount of equity received by an eligible taxpayer in a
QOF partnership that is a non-qualifying investment is the excess, if
any, of the total equity received by the eligible taxpayer over the
amount treated as a qualifying investment.
(2) Net basis. For purposes of paragraph (c)(6)(iii)(B) of this
section, net basis is the excess, if any, of--
(i) The adjusted basis of the property contributed to the
partnership; over
(ii) The amount of any debt to which the property is subject or
that is assumed by the partnership in the transaction.
(3) Net value. For purposes of paragraph (c)(6)(iii)(B) of this
section, net value is the excess of--
(i) The gross fair market value of the property contributed to the
partnership; over
(ii) The amount of the debt described in paragraph
(c)(6)(iii)(B)(2)(ii) of this section.
(4) Basis of qualifying and non-qualifying investments. The initial
basis of a qualifying investment, before application of section 1400Z-
2(b)(2)(B) and the section 1400Z-2 regulations or any section 752 debt
allocation, is the net basis of the property contributed. The basis of
a non-qualifying investment, before any section 752 debt allocation, is
the remaining net basis. The basis of the qualifying investment is
adjusted as provided in section 1400Z-2(b)(2)(B) and the section 1400Z-
2 regulations. The bases of qualifying and non-qualifying investments
are increased by any debt allocated to those investments under the
rules of Sec. 1.1400Z2(b)-1(c)(6)(iv)(B).
(5) Rules applicable to mixed-funds investments. If one portion of
an investment in a QOF partnership is a qualifying investment and
another
[[Page 1962]]
portion is a non-qualifying investment, see Sec. 1.1400Z2(b)-
1(c)(6)(iv) for the rules that apply.
(iv) Acquisitions from another person. An eligible taxpayer may
make an investment in a QOF by acquiring in a sale or exchange to which
Sec. 1.1001-1(a) applies an eligible interest in a QOF from a person
other than the QOF. The amount of the eligible taxpayer's investment in
the QOF with respect to which the eligible taxpayer may make a deferral
election is the amount of the cash, or the net fair market value of the
other property, as determined immediately before the exchange, that the
eligible taxpayer exchanged for the eligible interest in the QOF.
(v) Examples. The following examples illustrate the rules of this
paragraph (c)(6).
(A) Example 1. Transfer of built-in gain property with basis
less than gain to be deferred--(1) Facts. Individual B realizes $100
of eligible gain within the meaning of paragraph (b)(11) of this
section. B transfers unencumbered property with a fair market value
of $100 and an adjusted basis of $60 to QOF Q, a C corporation, in a
transaction that is described in section 351(a).
(2) Analysis. Paragraph (c)(6)(ii)(B) of this section applies
because B transferred property other than cash to Q and, but for the
application of section 1400Z-2(b)(2)(B), B's basis in the eligible
interests in Q would be determined, in whole or in part, by
reference to B's basis in the transferred property. The fair market
value of the eligible interest B received is $100, and, without
regard to section 1400Z-2(b)(2)(B), B's basis in the eligible
interest received would be $60. Thus, pursuant to paragraph
(c)(6)(ii)(B)(2) of this section, B's investment is a mixed-funds
investment to which section 1400Z-2(e)(1) applies. Pursuant to
paragraphs (c)(6)(ii)(B)(1) and (2) of this section, B's qualifying
investment is $60 (the lesser of the taxpayer's adjusted basis in
the eligible interest, without regard to section 1400Z-2(b)(2)(B),
of $60 and the $100 fair market value of the eligible interest
received). Pursuant to section 1400Z-2(b)(2)(B)(i), B's basis in the
qualifying investment is $0. Additionally, B's non-qualifying
investment is $40 (the excess of the fair market value of the
eligible interest received ($100) over the taxpayer's adjusted basis
in the eligible interest, without regard to section 1400Z-2(b)(2)(B)
($60)). B's basis in the non-qualifying investment is $0 (B's $60
basis in its investment determined without regard to section 1400Z-
2(b)(2)(B), reduced by the $60 of adjusted basis allocated to the
investment to which section 1400Z-2(e)(1)(A)(i) applies, determined
without regard to section 1400Z-2(b)(2)(B)). See paragraph
(c)(6)(ii)(D) of this section. Pursuant to section 362, Q's basis in
the transferred property is $60.
(B) Example 2. Transfer of built-in gain property with basis in
excess of eligible gain to be deferred. The facts are the same as in
paragraph (c)(6)(v)(A)(1) of this section (Example 1), except that B
realizes $50 of eligible gain within the meaning of paragraph
(b)(11) of this section. Pursuant to paragraph (c)(6)(i) of this
section, B's qualifying investment cannot exceed the amount of
eligible gain to be deferred (that is, the $50 of eligible gain)
under the section 1400Z-2(a) election. Therefore, pursuant to
paragraph (c)(6)(ii)(B)(1) of this section, B's qualifying
investment is $50 (the lesser of the taxpayer's adjusted basis in
the eligible interest received, without regard to section 1400Z-
2(b)(2)(B), of $60 and the $100 fair market value of the eligible
interest, limited by the amount of eligible gain to be deferred
under the section 1400Z-2(a) election). B's qualifying investment
has an adjusted basis of $0, as provided in section 1400Z-
2(b)(2)(B)(i). Additionally, B's non-qualifying investment is $50
(the excess of the fair market value of the eligible interest
received ($100) over the amount ($50) of B's section 1400Z-
2(a)(1)(A) investment). B's basis in the non-qualifying investment
is $10 (B's $60 basis in its investment determined without regard to
section 1400Z-2(b)(2)(B)), reduced by the $50 of adjusted basis
allocated to B's qualifying investment, determined without regard to
section 1400Z-2(b)(2)(B).
(C) Example 3. Transfers to QOF partnerships--(1) Facts. A and B
each realized $100 of eligible gain and each transfers $100 to a QOF
partnership. In a subsequent year, the partnership borrows $120 from
an unrelated lender and distributes $120 equally to A and B.
(2) Analysis. If the contributions had been of property other
than cash, the contributions and distributions would have been
tested under the disguised sale rules of section 707 and the
regulations in this part under section 707 of the Code, determining
the timing of the distribution and amount of the debt allocated to
each partner. Under paragraph (c)(6)(iii)(A)(2) of this section, the
cash of $200 ($100 from A and $100 from B) is treated as property
that could be sold in a disguised sale transaction and each
partner's share of the debt is zero for purposes of determining the
amount of the qualifying investment. To the extent there would have
been a disguised sale applying the rule of paragraph
(c)(6)(iii)(A)(2) of this section, the amount of the qualifying
investment would be reduced by the amount of the contribution so
recharacterized.
(D) Example 4. Return of capital by QOF partnership--(1) Facts.
A realized $100 of eligible gain and transfers $100 of cash to a QOF
partnership. Later in the partner's tax year, the partnership
distributes $20 to A in a distribution that is not recharacterized
under paragraph (c)(6)(iii)(A)(2) of this section. At the time of
the distribution, no allocations of income, gain, loss, or deduction
had been made to A, and A's share of the partnership's debt was zero
under section 752.
(2) Analysis. Because the contribution and distribution are not
recharacterized under paragraph (c)(6)(iii)(A)(2) of this section,
the amount of A's qualifying investment is $100 despite the $20
distribution. At the time the $20 distribution is made to A, A's
basis in its qualifying investment is zero, and thus the
distribution is an inclusion event under Sec. 1.1400Z2(b)-
1(c)(6)(iii).
(E) Example 5. Property contributed has built-in gain. The facts
are the same as in paragraph (c)(6)(v)(C)(1) of this section
(Example 3), except that the property contributed by A had a value
of $100 and basis of $20 and the partnership did not borrow money or
make a distribution. Under paragraph (c)(6)(iii)(B)(1) of this
section, the amount of A's qualifying investment is $20 (the lesser
of the net value or the net basis of the property that A
contributed), and the excess of the $100 contribution over the $20
qualifying investment is a non-qualifying investment. Under
paragraph (c)(6)(iii)(B)(4) of this section, A's basis in the
qualifying investment (determined without regard to section 1400Z-
2(b)(2)(B) or section 752(a)) is $20. After the application of
section 1400Z-2(b)(2)(B) but before the application of section
752(a), A's basis in the qualifying investment is zero. A's basis in
the non-qualifying investment is zero without regard to the
application of section 752(a).
(F) Example 6. Property contributed has built-in gain and is
subject to debt. The facts are the same as in paragraph (c)(6)(v)(E)
of this section (Example 5), except that the property contributed by
A has a gross value of $130 and is subject to debt of $30. Under
paragraph (c)(6)(iii)(B)(1) of this section, the amount of A's
qualifying investment is zero, the lesser of the property's $100 net
value ($130 minus $30) or $0 net basis ($20 minus $30, but limited
to zero). The entire contribution constitutes a non-qualifying
investment.
(G) Example 7. Property contributed has built-in loss and is
subject to debt. The facts are the same as in paragraph (c)(6)(v)(F)
of this section (Example 6), except that the property contributed by
A has a basis of $150. Under paragraph (c)(6)(iii)(B)(1) of this
section, the amount of A's qualifying investment is $100, the lesser
of the property's $100 net value ($130 minus $30) or $120 net basis
($150 minus $30). The non-qualifying investment is $0, the excess of
the net value ($100) over the qualifying investment ($100). A's
basis in the qualifying investment (determined without regard to
section 1400Z-2(b)(2)(B) and section 752(a)) is $120, the net basis.
After the application of section 1400Z-2(b)(2)(B), A's basis in the
qualifying investment is zero, plus its share of partnership debt
under section 752(a).
(7) Eligible gains that a partnership elects to defer. A
partnership generally is an eligible taxpayer under paragraph (b)(13)
of this section and may elect to defer recognition of some or all of
its eligible gains under section 1400Z-2(a)(2) and the section 1400Z-2
regulations.
(i) Partnership deferral election. If a partnership properly makes
a deferral election, then--
(A) The partnership defers recognition of the eligible gain under
the rules of section 1400Z-2 and the section 1400Z-2 regulations, that
is, the partnership does not recognize gain at the time it otherwise
would have in the absence of the deferral election; and
[[Page 1963]]
(B) The deferred eligible gain is not included in the distributive
shares of the partners under section 702 and is not treated as an item
described in section 705(a)(1).
(ii) Subsequent recognition. Absent any additional deferral under
section 1400Z-2(a)(1)(A) and the section 1400Z-2 regulations, any
amount of deferred gain that an electing partnership subsequently must
include in income under sections 1400Z-2(a)(1)(B) and (b) and the
section 1400Z-2 regulations is recognized by the electing partnership
at the time of inclusion, is subject to section 702 and is treated as
an item described in section 705(a)(1) in a manner consistent with
recognition at that time.
(8) Eligible gains that the partnership does not defer--(i) Federal
income tax treatment of the partnership. If a partnership does not
elect to defer some, or all, of its eligible gains, the partnership's
treatment of any such amounts is unaffected by the fact that the
eligible gains could have been deferred under section 1400Z-2 and the
section 1400Z-2 regulations.
(ii) Federal income tax treatment by the partners. If a partnership
does not elect to defer some, or all, of the eligible gains--
(A) The gains for which a deferral election are not made are
included in the partners' distributive shares under section 702 and are
treated as items described in section 705(a)(1);
(B) If a partner's distributive share includes one or more gains
that are eligible gains with respect to the partner, the partner may
elect under section 1400Z-2(a)(1)(A) and the section 1400Z-2
regulations to defer some or all of such eligible gains; and
(C) A gain in a partner's distributive share is an eligible gain
with respect to the partner only if it is an eligible gain with respect
to the partnership and it did not arise from a sale or exchange with a
person that, within the meaning of section 1400Z-2(e)(2) and the
section 1400Z-2 regulations, is related to the partner.
(iii) 180-day period for a partner electing deferral--(A) General
rule. If a partner's distributive share includes a gain that is
described in paragraph (c)(8)(ii)(C) of this section (gains that are
eligible gains with respect to the partner), the 180-day period with
respect to the partner's eligible gains in the partner's distributive
share generally begins on the last day of the partnership taxable year
in which the partner's distributive share of the partnership's eligible
gain is taken into account under section 706(a).
(B) Elective rule. Notwithstanding the general rule in paragraph
(c)(8)(iii)(A) of this section, if a partnership does not elect to
defer all of its eligible gain, the partner may elect to treat the
partner's own 180-day period with respect to the partner's distributive
share of that gain as being--
(1) The same as the partnership's 180-day period; or
(2) The 180-day period beginning on the due date for the
partnership's tax return, without extensions, for the taxable year in
which the partnership realized the gain that is described in paragraph
(c)(8)(ii)(C) of this section.
(C) Example. The following example illustrates the principles of
this paragraph (c)(8)(iii).
(1) Facts. Four individuals, A, B, C, and D, have equal
interests in a partnership, P. P has no other partners, and P's
taxable year is the calendar year. On January 17, 2019, P realizes a
capital gain of $1000x that P decides not to elect to defer.
(2) Analysis of A's election. A is aware of the capital gain
realized by P, and decides to defer its distributive shares of P's
eligible gain. A invests $250x in a QOF during February 2020. Under
the general rule in paragraph (c)(8)(iii)(A) of this section, this
investment is within the 180-day period for A, which began on
December 31, 2019, the last day of P's taxable year in which A's
share of P's eligible gain is taken into account under section
706(a).
(3) Analysis of B's election. B is also aware of the capital
gain realized by P, and decides to defer its distributive shares of
P's eligible gain. B decides to make the election provided in
paragraph (c)(8)(iii)(B)(1) of this section, and invests $250x in a
QOF during February 2019. Under the elective rule in paragraph
(c)(8)(iii)(B)(1) of this section, this investment is within the
180-day period for B, which began on January 17, 2019, the same day
as P's 180-day period.
(4) Analysis of C's election. On March 15, 2020, P provides all
of its partners with their Schedules K-1. Upon learning that its
distributive share of income from P included eligible gain, C
decides to make a deferral election, and also makes the election
provided in paragraph (c)(8)(iii)(B)(2) of this section. It then
invests $250x in a QOF during June 2020. Under the elective rule in
paragraph (c)(8)(iii)(B)(2) of this section, this investment is
within the 180-day period for C, which began on March 15, 2020, the
180-day period beginning on the due date for P's tax return without
extensions, for the taxable year in which P realized eligible gain.
(9) Passthrough entities other than partnerships--(i) S
corporations, nongrantor trusts, and estates. If an S corporation, a
nongrantor trust, or a decedent's estate realizes an eligible gain,
then rules analogous to the rules of paragraphs (c)(7) and (8) of this
section apply to that entity and to its shareholders or its
beneficiaries, as the case may be, to the extent they receive or are
deemed to receive an allocable share of the eligible gain.
(ii) Grantor trusts. If a grantor trust realizes an eligible gain,
either the trust or the deemed owner of the trust may make the election
to defer recognition of the gain and make the qualifying investment
under rules analogous to the rules of paragraphs (c)(7) and (8) of this
section (other than the rule in paragraph (c)(8)(iii) of this section
regarding the 180-day period), whether or not the gain is distributed
to the deemed owner of the trust.
(d) Elections--(1) Taxable year of deferral election. For a
deferral election with respect to any eligible gain to be valid, an
eligible taxpayer must make such election in accordance with guidance
published in the Internal Revenue Bulletin or in forms and instructions
(see Sec. Sec. 601.601(d)(2) and 601.602 of this chapter), as to the
required time, form, and manner in which an eligible taxpayer
(including a partner, S corporation shareholder, or beneficiary
applying the elective 180-day period provided in paragraphs
(c)(8)(iii)(B) and (c)(9) of this section) may make a deferral
election.
(2) Annual reporting of qualifying investments. An eligible
taxpayer must report whether the gains that have been deferred remain
deferred at the end of each taxable year, including the year of
deferral, in accordance with guidance published in the Internal Revenue
Bulletin or in forms and instructions (see Sec. Sec. 601.601(d)(2) and
601.602 of this chapter). A failure to make this report for any given
taxable year will result in a rebuttable presumption that the taxpayer
has had an inclusion event described in Sec. 1.1400Z2(b)-1(c) during
that year. The presumption described in the previous sentence may be
rebutted by the taxpayer making the report described in the first
sentence of this paragraph (d)(2) or by the taxpayer establishing to
the satisfaction of the Commissioner that an inclusion event described
in Sec. 1.1400Z2(b)-1(c) did not occur during that taxable year.
(e) Interaction of section 1400Z-2 and Sec. 1.897-6T. Section
1400Z-2 is not a nonrecognition provision, as defined in Sec. 1.897-
6T(a)(2), for purposes of Sec. 1.897-6T.
(f) Treatment of mixed-funds investments--(1) Investments to which
no election under section 1400Z-2(a) applies. If a taxpayer invests in
a QOF and makes a deferral election with respect to less than all of
that investment, the portion of the investment to which the election
does not apply is a non-qualifying investment. Similarly, an investment
in a QOF with respect to which no deferral
[[Page 1964]]
election is made is a non-qualifying investment.
(2) Treatment of deemed contributions of money under section
752(a). In the case of a QOF partnership, the deemed contribution of
money described in section 752(a) does not create or increase an
investment in the QOF described in section 1400Z-2(e)(1)(A)(ii). Thus,
any basis increase resulting from a deemed section 752(a) contribution
is not taken into account in determining the portion of a partner's
investment subject to section 1400Z-2(e)(1)(A)(i) or (ii). See Sec.
1.1400Z2(b)-1(c)(6)(iv)(B) for rules relating to the application of
section 752 to a mixed-funds investment.
(3) Treatment of contributions to QOF corporation in which no stock
is received. If a taxpayer with a qualifying investment or a non-
qualifying investment in a QOF corporation subsequently makes a non-
qualifying investment or a qualifying investment, respectively, and if
the taxpayer receives no additional QOF stock in exchange for the
subsequent investment, the taxpayer has a mixed-funds investment.
(4) Example. The following example illustrates the rules of this
paragraph (f):
(i) Facts. Taxpayer A realizes $1 million of eligible gain and
on the next day contributes $1 million to a QOF, Partnership P, in
exchange for a 50 percent interest in Partnership P. Taxpayer A
makes an election under section 1400Z-2(a) with respect to $900,000
of that eligible gain. Under section 1400Z-2(e)(1), 90 percent of
A's investment is described in section 1400Z-2(e)(1)(A)(i) (an
investment that only includes amounts to which the election under
section 1400Z-2(a) applies), and 10 percent is described in section
1400Z-2(e)(1)(A)(ii) (a separate investment consisting of other
amounts). Partnership P borrows $8 million. Under Sec. 1.752-3(a),
taking into account the terms of the partnership agreement, $4
million of the $8 million liability is allocated to A.
(ii) Analysis. Under section 752(a), A is treated as
contributing $4 million to Partnership P. Under paragraph (f) of
this section, A's deemed $4 million contribution to Partnership P is
ignored for purposes of determining the percentage of A's investment
in Partnership P subject to the deferral election under section
1400Z-2(a) or the portion not subject to the deferral election under
section 1400Z-2(a). As a result, after A's section 752(a) deemed
contribution, $900,000, or 90 percent, of A's investment in
Partnership P is described in section 1400Z-2(e)(1)(A)(i) and
$100,000, or 10 percent, is described in section 1400Z-
2(e)(1)(A)(ii).
(g) Applicability dates-(1) In general. The provisions of this
section are applicable for taxable years beginning after March 13,
2020.
(2) Prior periods. With respect to eligible gains that would be
recognized (absent the making of a deferral election) during the
portion of a taxpayer's first taxable year ending after December 21,
2017 that began on December 22, 2017, and during taxable years
beginning after December 21, 2017, and on or before March 13, 2020, an
eligible taxpayer may choose either--
(i) To apply the section 1400Z-2 regulations, if applied in a
consistent manner for all such taxable years; or
(ii) To rely on the rules in proposed Sec. 1.1400Z2(a)-1 contained
in the notice of proposed rulemaking (REG-115420-18) published on
October 29, 2018, as amplified by the notice of proposed rulemaking
(REG-120186-18) published on May 1, 2019, but only if applied in a
consistent manner for all such taxable years.
0
Par. 4. Section 1.1400Z2(b)-1 is added to read as follows:
Sec. 1.1400Z2 (b)-1 Inclusion of gains that have been deferred under
section 1400Z-2(a).
(a) Scope. This section provides rules under section 1400Z-2(b) of
the Internal Revenue Code and the section 1400Z-2 regulations (as
defined in Sec. 1.1400Z2(a)-1(b)(41)) regarding the inclusion in
income of gain deferred by a QOF owner under section 1400Z-2(a)(1)(A)
and the section 1400Z-2 regulations. This section applies to a QOF
owner only until all of such owner's gain deferred pursuant to a
deferral election has been included in income, subject to the
limitations described in paragraph (e)(5) of this section, and except
as otherwise provided in paragraph (c) or (d) of this section.
Paragraph (b) of this section provides general rules under section
1400Z-2(b)(1) regarding the timing of the inclusion in income of the
deferred gain. Paragraph (c)(1) of this section provides the general
rule regarding the determination of the extent to which an event
triggers the inclusion in gross income of all, or a portion, of an
eligible taxpayer's deferred gain, and paragraphs (c)(2) through (16)
of this section provide specific rules for certain events that are or
are not treated as inclusion events. Paragraph (d) of this section
provides rules regarding holding periods for qualifying investments.
Paragraph (e) of this section provides rules regarding the amount of
deferred gain included in gross income under section 1400Z-2(a)(1)(B)
and (b), including special rules for QOF partnerships and QOF S
corporations. Paragraph (f) of this section provides examples
illustrating the rules of paragraphs (c), (d), and (e) of this section.
Paragraph (g) of this section provides rules regarding basis
adjustments under section 1400Z-2(b)(2)(B). Paragraph (h) of this
section provides special reporting rules applicable to partners,
partnerships, and direct or indirect owners of QOF partnerships.
Paragraph (i) is reserved. Paragraph (j) of this section provides dates
of applicability.
(b) General inclusion rule. The gain to which a deferral election
applies is included in gross income, to the extent provided in
paragraph (e) of this section and in accordance with the rules of Sec.
1.1400Z2(a)-1(c)(1), in the taxable year that includes the earlier of:
(1) The date of an inclusion event; or
(2) December 31, 2026.
(c) Inclusion events--(1) In general. Except as otherwise provided
in this paragraph (c), an event is an inclusion event, if, and to the
extent that--
(i) The event reduces an eligible taxpayer's direct equity interest
for Federal income tax purposes in the qualifying investment;
(ii) An eligible taxpayer receives property in the event with
respect to its qualifying investment and the event is treated as a
distribution for Federal income tax purposes, whether or not the
receipt reduces the eligible taxpayer's ownership of the QOF;
(iii) An eligible taxpayer claims a loss for worthless stock under
section 165(g) or otherwise claims a worthlessness deduction with
respect to its qualifying investment; or
(iv) A QOF in which an eligible taxpayer holds a qualifying
investment loses its status as a QOF.
(2) Termination or liquidation of QOF or QOF owner--(i) Termination
or liquidation of QOF. Except as otherwise provided in this paragraph
(c), an eligible taxpayer has an inclusion event with respect to all of
its qualifying investment if the QOF ceases to exist for Federal income
tax purposes. For example, if a QOF partnership converts to a QOF C
corporation, or if a QOF C corporation converts to a QOF partnership or
to an entity disregarded as separate from its owner for Federal income
tax purposes, all investors in the QOF have an inclusion event with
respect to all of their qualifying investments in the QOF.
(ii) Liquidation of QOF owner--(A) Portion of distribution treated
as sale. A distribution of a qualifying investment in a complete
liquidation of a QOF owner is an inclusion event to the extent that
section 336(a) treats the distribution as if the qualifying investment
were sold to the distributee at its fair market value, without regard
to section 336(d).
(B) Distribution to 80-percent distributee. A distribution of a
qualifying investment in a complete
[[Page 1965]]
liquidation of a QOF owner is not an inclusion event to the extent
section 337(a) applies to the distribution.
(3) Transfer of an investment in a QOF by gift or incident to
divorce--(i) Transfer of an investment in a QOF by gift. Except to the
extent provided in paragraph (c)(5) of this section, a taxpayer's
transfer of a qualifying investment by gift, as defined for purposes of
chapter 12 of subtitle B of the Code, whether outright or in trust, is
an inclusion event, regardless of whether that transfer is a completed
gift for Federal gift tax purposes, and regardless of the taxable or
tax-exempt status of the donee of the gift.
(ii) Transfers between spouses incident to divorce. A transfer
between spouses or incident to divorce or otherwise as provided in
section 1041 of the Code is an inclusion event.
(4) Transfer of an investment in a QOF by reason of the taxpayer's
death--(i) In general. Except as provided in paragraph (c)(4)(ii) of
this section, a transfer of a qualifying investment by reason of the
taxpayer's death is not an inclusion event. Transfers by reason of
death include, for example:
(A) A transfer by reason of death to the deceased owner's estate;
(B) A distribution of a qualifying investment by the deceased
owner's estate;
(C) A distribution of a qualifying investment by the deceased
owner's trust that is made by reason of the deceased owner's death;
(D) The passing of a jointly owned qualifying investment to the
surviving co-owner by operation of law; and
(E) Any other transfer of a qualifying investment at death by
operation of law.
(ii) Exceptions. The following transfers are not included as a
transfer by reason of the taxpayer's death, and thus are inclusion
events:
(A) A sale, exchange, or other disposition by the deceased
taxpayer's estate or trust, other than a distribution described in
paragraph (c)(4)(i) of this section;
(B) Any disposition by the legatee, heir, or beneficiary who
received the qualifying investment by reason of the taxpayer's death;
and
(C) Any disposition by the surviving joint owner or other recipient
who received the qualifying investment by operation of law on the
taxpayer's death.
(iii) Liability for deferred Federal income tax. If the owner of a
qualifying investment in a QOF dies before an inclusion event and the
deferred gain is not includable in the decedent's gross income, the
gain that the decedent elected to defer under section 1400Z-2(a) and
the section 1400Z-2 regulations will be includable in the gross income,
for the taxable year in which occurs an inclusion event, of the person
described in section 691(a)(1).
(iv) Qualifying investment in the hands of the person described in
section 691(a)(1). A qualifying investment received in a transfer by
reason of death listed in paragraph (c)(4)(i) of this section continues
to be a qualifying investment under Sec. 1.1400Z2(a)-1(b)(34).
(5) Grantor trusts--(i) Contributions to grantor trusts. If the
owner of a qualifying investment contributes it to a trust and, under
subpart E of part I of subchapter J of chapter 1 of subtitle A of the
Code (grantor trust rules), the contributing owner of the investment is
the deemed owner of the trust (grantor trust), the contribution to the
grantor trust is not an inclusion event. Similarly, a transfer of the
investment by the grantor trust to the trust's deemed owner is not an
inclusion event. For all purposes of the section 1400Z-2 regulations,
references to the term grantor trust mean the portion of the trust that
holds the qualifying investment in the QOF, and such a grantor trust,
or portion of the trust, is a wholly grantor trust as to the deemed
owner. Such contributions may include transfers by gift or any other
type of transfer between the grantor and the grantor trust that is a
nonrecognition event as a result of the application of the grantor
trust rules (that is, subpart E of part I of subchapter J of chapter 1
of subtitle A of the Code).
(ii) Changes in grantor trust status. In general, a change in the
income tax status of an existing trust owning a qualifying investment
in a QOF, whether the termination of grantor trust status or the
creation of grantor trust status, is an inclusion event.
Notwithstanding the previous sentence, the termination of grantor trust
status as the result of the death of the owner of a qualifying
investment is not an inclusion event, but the provisions of paragraph
(c)(4) of this section apply to distributions or dispositions by the
trust. If a qualifying investment is held in the grantor portion of an
electing small business trust (ESBT), as defined in section 1361(e)(1),
and the ESBT converts into a qualified subchapter S trust (QSST), as
defined in section 1361(d)(3), the beneficiary of which is the deemed
owner of the grantor portion of the ESBT, there has been no change in
the grantor trust status because the deemed owner continues to be
taxable under subtitle A of the Code on the income and gain from the
qualifying investment.
(iii) Conversions of QSSTs and ESBTs. With regard to conversions of
QSSTs and ESBTs, see paragraphs (c)(7)(i)(B) and (C) of this section.
For purposes of paragraph (c)(5)(ii) of this section, if a qualifying
investment is held by a QSST that converts to an ESBT, the beneficiary
of the QSST is the deemed owner of the grantor portion of the ESBT that
then holds the qualifying investment, and the deemed owner is not a
nonresident alien for purposes of this section (and thus
notwithstanding Sec. 1.1361-1(j)(8)), there has been no change in the
grantor trust status because the deemed owner continues to be taxable
under subtitle A of the Code on the income and gain from the qualifying
investment.
(6) Special rules for partners and partnerships--(i) Scope. Except
as otherwise provided in this paragraph (c)(6), in the case of a
partnership that is a QOF or a QOF partner, the inclusion rules of this
paragraph (c) apply to transactions involving any direct or indirect
partner of the QOF to the extent of that partner's share of any
eligible gain of the QOF.
(ii) Transactions that are not inclusion events--(A) In general.
Notwithstanding paragraphs (c)(1) and (2) of this section, and except
as otherwise provided in paragraph (c)(6) of this section, no
transaction described in paragraph (c)(6)(ii) of this section is an
inclusion event.
(B) Section 721 contributions. Subject to paragraph (c)(6)(v) of
this section, a contribution by a QOF owner (contributing partner), of
its qualifying QOF stock, qualifying QOF partnership interest, or
direct or indirect partnership interest in a qualifying investment to a
partnership (transferee partnership) to the extent the transaction is
governed by section 721(a) is not an inclusion event, provided the
interest transfer does not cause a partnership termination of a QOF
partnership, or the direct or indirect owner of a QOF, under section
708(b)(1). See paragraph (c)(6)(ii)(C) of this section for transactions
governed by section 708(b)(2)(A). The inclusion rules in paragraph (c)
of this section apply to any part of the transaction to which section
721(a) does not apply. The transferee partnership becomes subject to
section 1400Z-2 and the section 1400Z-2 regulations with respect to the
eligible gain associated with the contributed qualifying investment.
The transferee partnership must allocate and report the remaining
deferred gain that is associated with the contributed qualifying
investment to the contributing partner to the same extent that the
remaining deferred gain would have been allocated and reported to the
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contributing partner in the absence of the contribution. Additionally,
the transferee partnership must allocate the basis increases described
in section 1400Z-2(b)(2)(B)(iii) and (iv) to the contributing partner.
If a transferee partnership is a direct QOF owner, only the transferee
partnership may make the elections under section 1400Z-2(c) and the
regulations in this part under section 1400Z-2(c) of the Code with
respect to the contributed qualifying investment. See Sec. 1400Z2(c)-
1(b)(1)(ii) (election by transferee partnership).
(C) Section 708(b)(2)(A) mergers or consolidations--(1) Merger of a
partnership that is a QOF partner. Subject to paragraphs (c)(6)(iii)
and (v) of this section, a merger or consolidation of a partnership
that is a QOF partner (original partnership) with another partnership
in a transaction to which section 708(b)(2)(A) applies is not an
inclusion event to the extent section 721(a) applies to the merger. To
the extent the original partnership terminates in the merger, as
determined under Sec. 1.708-1(c)(1), the partnership that is a
continuation of the original partnership becomes subject to section
1400Z-2 and the section 1400Z-2 regulations to the same extent that the
original partnership was so subject prior to the transaction, and must
allocate and report any gain under section 1400Z-2(b) to the same
extent and to the same partners that the original partnership allocated
and reported such items prior to the transaction. Notwithstanding the
rules in this paragraph (c)(6)(ii)(C)(1), the general inclusion rules
of paragraph (c) of this section apply to the portion of the
transaction that is otherwise treated as a sale or exchange under
paragraph (c) of this section.
(2) Merger of QOF partnerships. Subject to paragraph (c)(6)(v) of
this section, a merger or consolidation of a QOF partnership with
another QOF partnership in a transaction to which section 708(b)(2)(A)
applies is not an inclusion event under paragraph (c)(2)(i) of this
section if, immediately after the merger or consolidation, the
resulting partnership is a QOF. The continuing partnership, as
determined under Sec. 1.708-1(c)(1), becomes subject to section 1400Z-
2 and the section 1400Z-2 regulations to the same extent that the
terminated partnership was so subject prior to the transaction, and
must allocate and report any gain under section 1400Z-2(b) to the same
extent and to the same partners that the terminated partnership would
have allocated and reported such items prior to the transaction.
Notwithstanding the rules in this paragraph (c)(6)(ii)(C)(2), the
general inclusion rules of paragraph (c) of this section apply to the
portion of the transaction that is otherwise treated as a sale or
exchange under paragraph (c) of this section.
(D) Example. The following example illustrates the rules of this
paragraph (c)(6)(ii).
(1) Example--(i) Facts. In 2019, taxpayer A contributes $100 of
eligible gain to a QOF partnership, X, in exchange for a qualifying
QOF partnership interest in X, and taxpayer B contributes $100 of
eligible gain to another QOF partnership, Y, in exchange for a
qualifying QOF partnership interest in Y. In 2021, in transactions
governed by section 721(a), A contributes her qualifying QOF
partnership interest in X, and B contributes her qualifying QOF
partnership interest in Y, to a newly formed partnership, UTP. In
2024, C receives a profits interest in UTP for services that she
will provide to UTP. In 2031, X sells a non-inventory asset and
allocates X's distributive share of the gain to UTP. No
distributions are ever made from X, Y, or UTP.
(ii) Analysis. On December 31, 2026, UTP recognizes $170 of
remaining deferred gain relating to the QOF interests. Of that gain,
A is allocated the $85 of gain relating to the $100 of eligible gain
that she invested in X, and B is allocated the $85 of gain relating
to the $100 of eligible gain that she invested in Y. C recognizes no
gain at this time. In 2031, because UTP's holding period in X
includes A's holding period in X, UTP has a holding period in X that
exceeds 10 years, and may make an election under Sec. 1.1400Z2(c)-
1(b)(2)(ii) to exclude the gain from X's asset sale. Even though A
was the original investor in X, she may not make the election. If
UTP makes the election, UTP will exclude its distributive share of
gain from the sale of the X asset.
(2) [Reserved]
(iii) Partnership distributions. Subject to paragraph (c)(6)(v) of
this section, an actual or deemed distribution of property, including
cash, by a QOF partnership to a partner with respect to its qualifying
investment is an inclusion event only to the extent that the
distributed property has a fair market value in excess of the partner's
basis in its qualifying investment. For purposes of this paragraph
(c)(6)(iii), in the case of a merger or consolidation of a QOF
partnership with another QOF partnership in a transaction to which
section 708(b)(2)(A) applies, the fair market value of the distributed
property is reduced by the fair market value of the QOF partnership
interest received in the merger or consolidation. A distribution from a
partnership that directly or indirectly owns a QOF is an inclusion
event only if the distribution is a liquidating distribution. For
purposes of this paragraph (c)(6)(iii), the distribution is not in
complete liquidation if the partnership making the distribution is a
partnership that terminates in a partnership merger or consolidation
under Sec. 1.708-1(c), the continuing partnership in the merger or
consolidation continues to directly or indirectly own an interest in
the QOF, and the distributee is distributed an interest in the
resulting partnership as part of the merger or consolidation. See
paragraph (c)(6)(iv) of this section for special rules relating to
mixed-funds investments.
(iv) Special rules for mixed-funds investments--(A) In general. The
rules of this paragraph (c)(6)(iv) apply solely for purposes of section
1400Z-2. A partner that holds a mixed-funds investment in a QOF
partnership (a mixed-funds partner) shall be treated as holding two
separate interests in the QOF partnership, one a qualifying investment
and the other a non-qualifying investment (separate interests). The
basis of each separate interest is determined under the rules described
in paragraphs (c)(6)(iv)(B) and (g) of this section as if each interest
were held by different taxpayers.
(B) Allocations and distributions. All section 704(b) allocations
of income, gain, loss, and deduction, all section 752 allocations of
debt, and all distributions made to a mixed-funds partner will be
treated as made to the separate interests based on the allocation
percentages of those interests as defined in paragraph (c)(6)(iv)(D) of
this section. For purposes of this paragraph (c)(6)(iv)(B), in
allocating income, gain, loss, or deduction between these separate
interests, section 704(c) principles apply to account for any value-
basis disparities attributable to the qualifying investment or non-
qualifying investment. Any distribution (whether actual or deemed) to
the holder of a qualifying investment is subject to the rules of
paragraphs (c)(6)(iii) and (v) of this section, without regard to the
presence or absence of gain under other provisions of subchapter K of
chapter 1 of subtitle A of the Internal Revenue Code.
(C) Subsequent contributions. In the event of an increase in a
partner's qualifying or non-qualifying investment, as for example, in
the case of an additional contribution for a qualifying investment or
for an interest that is a non-qualifying investment or a change in
allocations for services rendered, the partner's interest in the
separate interests must be valued immediately prior to the event and
the allocation percentages adjusted to reflect the relative values of
these separate interests and the additional contribution, if any.
(D) Allocation percentages. The allocation percentages of the
separate
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interests will be determined based on the relative capital
contributions attributable to the qualifying investment and the non-
qualifying investment. In the event a partner receives a profits
interest in the QOF partnership for services provided to or for the
benefit of the QOF partnership, the allocation percentage with respect
to the profits interest is 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.
(E) Examples. The following examples illustrate the rules of this
paragraph (c)(6)(iv).
(1) Example 1. Allocation of residual profits for which there is
no reasonable likelihood of application--(i) Facts. A realizes $100
of eligible gain and B realizes $900 of eligible gain. A and B form
Q, a QOF partnership. B contributes $900 to Q in exchange for a
qualifying QOF partnership interest (B's capital interest). A
contributes $100 to Q in exchange for a qualifying QOF partnership
interest (A's capital interest and, with B's capital interest, the
capital interests) and agrees to provide services to Q in exchange
for a profits interest in Q (A's profits interest). Q's partnership
agreement provides that Q's profits are first allocated to the
capital interests until the capital interest holders receive a 10
percent preferred return with respect to those interests. Next, Q's
profits are allocated 15 percent to A with respect to A's profits
interest, 10 percent to A with respect to A's capital interest, and
75 percent to B until the capital interests receive a 1,000%
preferred return. Thereafter, Q's profits are allocated 1 percent to
A's profits interest and 99 percent to the capital interests. There
is not a reasonable likelihood that Q's profits will be sufficient
to result in an allocation in the last tranche.
(ii) Analysis. Under paragraph (c)(6)(iv)(D) of this section,
the allocation percentage with respect to A's profits interest is
calculated based on the share of residual profits that A would
receive with respect to A's profits interest, disregarding any
allocation of residual profits that has no reasonable likelihood of
being achieved. Under Q's partnership agreement, A's share of Q's
residual profits with respect to A's profits interest is 1 percent.
However, there is no reasonable likelihood that this 1 percent
allocation will apply because it is unlikely that the capital
interests will receive a 1,000% preferred return. Therefore, under
paragraph (c)(6)(iv)(D) of this section, A's share of Q's residual
profits with respect to A's profits interest is 15 percent, the
final allocation of Q's profits to A's profits interest that is
reasonably likely to apply. The allocation percentage for A's
capital interest in Q is 10 percent under paragraph (c)(6)(iv)(D) of
this section. Thus, allocations and distributions made to A are
treated as made 60 percent (15/25) to A's non-qualifying profits
interest and 40 percent (10/25) to A's qualifying QOF partnership
interest.
(2) Example 2. Separate entity holding profits interest--(i)
Facts. The facts are the same as in paragraph (c)(6)(iv)(E)(1) of
this section (Example 1), except that A is a partnership that has no
eligible gain and P, a partnership that is owned by the same
taxpayers who own A, realizes $100 of eligible gain and contributes
$100 to Q for its qualifying investment.
(ii) Analysis. Under paragraph (c)(6)(iv)(D) of this section,
A's profits interest is a non-qualifying investment in Q. Because P
directly holds only a qualifying QOF partnership interest in Q, P is
not a mixed-funds partner in Q, and 100 percent of the allocations
and distributions made to P are attributable to P's qualifying QOF
partnership interest.
(v) Remaining deferred gain reduction rule. An inclusion event
occurs when and to the extent that a transaction has the effect of
reducing:
(A) The amount of remaining deferred gain of one or more direct or
indirect partners; or
(B) The amount of gain that would be recognized by such partner or
partners under paragraph (e)(4)(ii) of this section to the extent that
such amount would reduce such gain to an amount that is less than the
remaining deferred gain.
(7) Special rules for S corporations--(i) In general. Except as
provided in paragraphs (c)(7)(ii), (iii), and (iv) of this section,
none of the following is an inclusion event:
(A) An election, revocation, or termination of a corporation's
status as an S corporation under section 1362;
(B) A conversion of a QSST to an ESBT, but only if the QSST
beneficiary is the deemed owner of the grantor portion of the ESBT that
receives the qualifying investment and if the deemed owner is not a
nonresident alien;
(C) A conversion of an ESBT to a QSST, where the qualifying
investment is held in the grantor portion of the ESBT and the QSST
beneficiary is the deemed owner of the grantor portion of the ESBT; and
(D) A valid modification of a trust agreement of an S-corporation
shareholder whether by an amendment, a decanting, a judicial
reformation, or a material modification.
(ii) Distributions by QOF S corporation--(A) General rule. An
actual or constructive distribution of property by a QOF S corporation
to a QOF shareholder with respect to its qualifying investment is an
inclusion event to the extent that the distribution is treated as gain
from the sale or exchange of property under section 1368(b)(2) and (c).
For the treatment of a distribution by a QOF S corporation to which
section 305(a) applies, see paragraph (c)(8)(ii). For the treatment of
a distribution to which section 302(d) or section 306(a)(2) applies,
see paragraph (c)(9)(ii) of this section.
(B) Spill-over rule. For purposes of applying paragraph (c)(7)(ii)
of this section to the adjusted basis of a qualifying investment, or
non-qualifying investment, as appropriate, in a QOF S corporation, the
second sentence of Sec. 1.1367-1(c)(3) applies--
(1) With regard to multiple qualifying investments, solely to the
respective bases of such qualifying investments, and does not take into
account the basis of any non-qualifying investment; and
(2) With regard to multiple non-qualifying investments, solely to
the respective bases of such non-qualifying investments, and does not
take into account the basis of any qualifying investment.
(iii) Conversion from S corporation to partnership or disregarded
entity--(A) General rule. Notwithstanding paragraph (c)(7)(i) of this
section, and except as provided in paragraph (c)(7)(iii)(B) of this
section, a conversion of an S corporation to a partnership or an entity
disregarded as separate from its owner under Sec. 301.7701-3(b)(1)(ii)
of this chapter is an inclusion event.
(B) Exception for qualifying section 381 transaction. A conversion
described in paragraph (c)(7)(iii)(A) of this section is not an
inclusion event if the conversion comprises a step in a series of
related transactions that together qualify as a qualifying section 381
transaction.
(iv) Treatment of separate blocks of stock in mixed-funds
investments. With regard to a mixed-funds investment in a QOF S
corporation, if different blocks of stock are created for separate
qualifying investments to track basis in such qualifying investments,
the separate blocks are not treated as different classes of stock for
purposes of S corporation eligibility under section 1361(b)(1).
(v) Applicability. Paragraph (c)(7) of this section applies
regardless of whether the S corporation is a QOF or a QOF shareholder.
(8) Distributions by a QOF corporation--(i) General rule for
distributions by a QOF C corporation. If a QOF C corporation
distributes property to a QOF shareholder with respect to a qualifying
investment, only the amount of the distribution to which section
301(c)(3) or 1059(a)(2) applies gives rise to an inclusion event. For
purposes of this paragraph (c)(8)(i), a distribution of property
includes a distribution of stock in the QOF C corporation making the
distribution (or rights to acquire such stock) if the distribution is
treated as a distribution
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of property to which section 301 applies pursuant to section 305(b).
(ii) Section 305(a) distributions. A distribution with respect to
qualifying QOF stock to which section 305(a) applies is not an
inclusion event. QOF stock received in such a distribution is
qualifying QOF stock. The shareholder's remaining deferred gain is
allocated pro rata between the new qualifying QOF stock received and
the qualifying QOF stock with respect to which the distribution was
made in proportion to the fair market values of each on the date of
distribution. See Sec. 1.307-1(a).
(9) Dividend-equivalent redemptions and redemptions of section 306
stock.--(i) Redemptions by QOF C corporations--(A) In general. Except
as provided in paragraph (c)(9)(i)(B) of this section, if a QOF C
corporation redeems its stock from a QOF shareholder in a transaction
described in section 302(d) or section 306(a)(2), the full amount of
such redemption gives rise to an inclusion event.
(B) Redemptions of stock of wholly owned QOF C corporation and pro
rata redemptions. Paragraph (c)(8)(i) of this section applies to a
redemption described in paragraph (c)(9)(i)(A) of this section if, at
the time of such redemption--
(1) All stock in the QOF C corporation is held directly by a single
shareholder, or directly by members of a single consolidated group; or
(2) The QOF C corporation has outstanding only one class of stock,
as defined in section 1361 and Sec. 1.1361-1(l), and the redemption is
pro rata as to all shareholders of the redeeming QOF C corporation.
(ii) Redemptions by QOF S corporations. If a QOF S corporation
redeems its stock from a QOF shareholder in a transaction described in
section 302(d) or section 306(a)(2), the amount that gives rise to an
inclusion event is the amount by which the distribution exceeds basis
in the QOF stock as adjusted under paragraph (c)(7)(ii) of this
section.
(10) Qualifying section 381 transactions--(i) Assets of a QOF are
acquired--(A) In general. Except to the extent provided in paragraph
(c)(10)(i)(C) of this section, if the assets of a QOF corporation are
acquired in a qualifying section 381 transaction, and if the acquiring
corporation is a QOF immediately after the acquisition, then the
transaction is not an inclusion event.
(B) Determination of acquiring corporation's status as a QOF. For
purposes of paragraph (c)(10)(i)(A) of this section, the acquiring
corporation is treated as a QOF immediately after the qualifying
section 381 transaction if the acquiring corporation satisfies the
certification requirements in Sec. 1.1400Z2(d)-1 immediately after the
transaction and holds at least 90 percent of its assets in qualified
opportunity zone property on the first testing date after the
transaction. See section 1400Z-2(d)(1) and Sec. 1.1400Z2(d)-1.
(C) Receipt of boot by QOF shareholder in qualifying section 381
transaction. This paragraph (c)(10)(i)(C) applies if assets of a QOF
corporation are acquired in a qualifying section 381 transaction and an
eligible taxpayer that is a QOF shareholder receives boot with respect
to its qualifying investment. If this paragraph (c)(10)(i)(C) applies,
the QOF shareholder has an inclusion event and is treated as disposing
of a portion of its qualifying investment that bears the same
proportion to the QOF shareholder's total qualifying investment
immediately before the inclusion event as the fair market value of the
boot received by the QOF shareholder with respect to its qualifying
investment in the qualifying section 381 transaction bears to the fair
market value of the total consideration received by the QOF shareholder
with respect to its qualifying investment in the qualifying section 381
transaction.
(ii) Assets of a QOF shareholder are acquired--(A) In general.
Except to the extent provided in paragraph (c)(10)(ii)(B) of this
section, a qualifying section 381 transaction in which the assets of a
QOF shareholder are acquired is not an inclusion event with respect to
the qualifying investment and the acquiring corporation succeeds to the
target corporation's status as the QOF shareholder with respect to the
qualifying investment.
(B) Qualifying section 381 transaction in which QOF shareholder's
qualifying investment is not completely acquired. If the assets of a
QOF shareholder are acquired in a qualifying section 381 transaction in
which the acquiring corporation does not acquire all of the QOF
shareholder's qualifying investment, the QOF shareholder has an
inclusion event and is treated as disposing of the portion of its
qualifying investment that is not transferred to the acquiring
corporation.
(11) Section 355 transactions--(i) Distribution by a QOF--(A) In
general. Except as provided in paragraph (c)(11)(i)(B) of this section,
if a QOF corporation distributes stock or securities of a controlled
corporation to a QOF shareholder with respect to a qualifying
investment in the QOF corporation in a transaction to which section 355
(or so much of section 356 as relates to section 355) applies, the QOF
shareholder has an inclusion event and is treated as disposing of a
portion of its qualifying investment equal in value to the fair market
value of the shares of the controlled corporation and the fair market
value of any boot received by the QOF shareholder in the distribution
with respect to its qualifying investment.
(B) Controlled corporation becomes a QOF--(1) In general. Except as
provided in paragraph (c)(11)(i)(B)(3) of this section, if a QOF
corporation distributes stock or securities of a controlled corporation
in a transaction to which section 355, or so much of section 356 as
relates to section 355, applies, and if both the distributing
corporation and the controlled corporation are QOFs immediately after
the final distribution (qualifying section 355 transaction), then the
distribution is not an inclusion event with respect to a QOF
shareholder's qualifying investment in the distributing QOF corporation
or the controlled QOF corporation. This paragraph (c)(11)(i)(B) does
not apply unless the distributing corporation distributes all of the
stock and securities in the controlled corporation held by it
immediately before the distribution within a 30-day period. For
purposes of this paragraph (c)(11)(i)(B), the term final distribution
means the last distribution that satisfies the preceding sentence.
(2) Determination of distributing corporation's and controlled
corporation's status as QOFs. For purposes of paragraph
(c)(11)(i)(B)(1) of this section, each of the distributing corporation
and the controlled corporation is treated as a QOF immediately after
the final distribution if the corporation satisfies the certification
requirements in Sec. 1.1400Z2(d)-1 immediately after the final
distribution and holds at least 90 percent of its assets in qualified
opportunity zone property on the first testing date after the final
distribution. See section 1400Z-2(d)(1) and Sec. 1.1400Z2(d)-1.
(3) Receipt of boot. If a QOF shareholder receives boot in a
qualifying section 355 transaction with respect to its qualifying
investment, and if section 356(a) applies to the transaction, paragraph
(c)(10)(i)(C) of this section applies. If a QOF shareholder receives
boot in a qualifying section 355 transaction with respect to its
qualifying investment, and if section 356(b) applies to the
transaction, paragraph (c)(8)(i) of this section applies.
(4) Treatment of controlled corporation stock as qualified
opportunity zone stock. If stock or securities of a controlled
corporation are
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distributed in a qualifying section 355 transaction, and if the
distributing corporation retains a portion of the controlled
corporation stock after the initial distribution, the retained stock
will not cease to qualify as qualified opportunity zone stock in the
hands of the distributing corporation solely as a result of the
qualifying section 355 transaction. This paragraph (c)(11)(i)(B)(4)
does not apply unless the distributing corporation distributes all of
the stock and securities in the controlled corporation held by it
immediately before the distribution within a 30-day period.
(ii) Distribution by a QOF shareholder. If a QOF shareholder
distributes stock or securities of a controlled QOF corporation in a
transaction to which section 355 applies, then for purposes of section
1400Z-2(b)(1) and paragraph (b) of this section, the QOF shareholder
has an inclusion event and is treated as disposing of the portion of
its qualifying QOF stock over which it no longer has direct Federal
income tax ownership.
(12) Recapitalizations and section 1036 transactions--(i) In
general. Except as otherwise provided in paragraph (c)(12)(ii) of this
section, if a QOF corporation engages in a transaction that qualifies
as a reorganization described in section 368(a)(1)(E) (a
recapitalization), or if a QOF shareholder engages in a transaction
that is described in section 1036 (a section 1036 exchange), the
transaction is not an inclusion event.
(ii) Receipt of property or boot by QOF shareholder. If a QOF
shareholder receives property or boot, or is treated as having received
property or boot, with respect to its qualifying investment in a
recapitalization, then the property or boot is treated as property or
boot to which section 301 or section 356(a) or (c) applies, as
determined under general Federal income tax principles. If, in a
section 1036 exchange, a QOF shareholder receives property with respect
to its qualifying investment that is not permitted to be received
without the recognition of gain, then, for purposes of this section,
the receipt of the property is treated in a similar manner as the
receipt of such property or boot in a recapitalization. Paragraph
(c)(8)(i) of this section applies to property to which section 301
applies. Paragraph (c)(10)(i)(C) of this section applies to boot to
which section 356(a) or (c) applies.
(13) Section 304 transactions. If a QOF shareholder transfers its
qualifying investment in a transaction described in section 304(a), the
full amount of the consideration gives rise to an inclusion event.
(14) Deduction for worthlessness. If an eligible taxpayer claims a
loss for worthless stock under section 165(g) or otherwise claims a
worthlessness deduction with respect to all or a portion of its
qualifying investment, then for purposes of section 1400Z-2 and the
section 1400Z-2 regulations, the eligible taxpayer has an inclusion
event and is treated as having disposed of that portion of its
qualifying investment on the date it became worthless. Thus, neither
section 1400Z-2(b)(2)(B)(iii) or (iv) nor section 1400Z-2(c) applies to
that portion of the eligible taxpayer's qualifying investment after the
date it became worthless.
(15) Decertification of a QOF. The decertification of a QOF,
whether a self-decertification pursuant to Sec. 1.1400Z2(d)-1(a)(3) or
an involuntary decertification pursuant to Sec. 1.1400Z2(d)-1(a)(4),
is an inclusion event.
(16) Other inclusion and non-inclusion events. Notwithstanding any
other provision of this paragraph (c), the Commissioner may determine
in guidance published in the Internal Revenue Bulletin (see Sec.
601.601(d)(2) of this chapter) that a type of transaction is or is not
an inclusion event.
(d) Holding periods--(1) Holding period for qualifying investment--
(i) In general. Solely for purposes of section 1400Z-2(b)(2)(B),
section 1400Z-2(c), and the section 1400Z-2 regulations, and except as
otherwise provided in this paragraph (d)(1), the length of time a
qualifying investment has been held is determined without regard to the
period for which the eligible taxpayer had held property exchanged for
such investment (even if such period would be relevant for determining
the length of time for other Federal income tax purposes).
(ii) Holding period for qualifying investment received in certain
transactions with respect to QOFs. For purposes of section 1400Z-
2(b)(2)(B), section 1400Z-2(c), and the section 1400Z-2 regulations,
the principles of section 1223(1) or (4) apply to determine the holding
period for a qualifying investment received by a QOF owner in--
(A) A distribution described in paragraph (c)(2)(ii)(B) of this
section;
(B) A distribution to which section 305(a) applies;
(C) A qualifying section 381 transaction described in paragraph
(c)(10)(i) or (ii) of this section;
(D) A qualifying section 355 transaction described in paragraph
(c)(11)(i)(B) of this section;
(E) A recapitalization or a section 1036 exchange described in
paragraph (c)(12) of this section;
(F) A contribution of a QOF interest to a partnership to the extent
section 721(a) applies to the transfer; or
(G) A distribution of a QOF interest to the extent the interest was
received in a merger of two or more QOF partnerships in a transaction
described in section 708(b)(2)(A).
(iii) Tacking with deceased owner or deemed owner of a grantor
trust. For purposes of section 1400Z-2(b)(2)(B), section 1400Z-2(c),
and the section 1400Z-2 regulations, the holding period of a qualifying
investment held by an eligible taxpayer who received that qualifying
investment by reason of the prior owner's death includes the time
during which that qualifying investment was held by the deceased owner.
The rule in the preceding sentence also applies to allow a grantor
trust to tack the holding period of the deemed owner if the grantor
trust acquires the qualifying investment from the deemed owner in a
transaction that is not an inclusion event.
(2) Status of QOF assets as qualified opportunity zone property.
For purposes of section 1400Z-2(d) and the section 1400Z-2 regulations,
including for purposes of determining whether the original use of
qualified opportunity zone business property commences with the
acquiring corporation or partnership, qualified opportunity zone
property does not lose its status as qualified opportunity zone
property solely as a result of--
(i) Its transfer by the transferor corporation to the acquiring
corporation in a qualifying section 381 transaction described in
paragraph (c)(10)(i) of this section;
(ii) Its transfer by the distributing corporation to the controlled
corporation in a qualifying section 355 transaction described in
paragraph (c)(11)(i)(B) of this section; or
(iii) Its transfer by the transferor partnership to the acquiring
partnership in a transaction to which section 708(b)(2)(A) applies, but
only to the extent section 721(a) applies to the transaction.
(e) Amount includible. Except as provided in Sec. Sec.
1.1400Z2(a)-1(b)(7) and 1.1400Z2(f)-1(b), the amount of gain included
in gross income under section 1400Z-2(a)(1)(B) and this section on a
date described in paragraph (b) of this section is determined under
this paragraph (e).
(1) In general. Except as provided in paragraphs (e)(2) and (4) of
this section, and subject to paragraph (e)(5) of this section, in the
case of an inclusion
[[Page 1970]]
event, the amount of gain included in gross income is equal to the
excess of the amount described in paragraph (e)(1)(i) of this section
over the eligible taxpayer's basis in the portion of the qualifying
investment that is disposed of in the inclusion event. See paragraph
(c) of this section for rules regarding the amount that gave rise to
the inclusion event, and see paragraph (g) of this section for
applicable ordering rules.
(i) The amount described in this paragraph (e)(1)(i) is equal to
the lesser of--
(A) An amount which bears the same proportion to the remaining
deferred gain, as--
(1) The fair market value of the portion of the qualifying
investment that is disposed of in the inclusion event bears to--
(2) The fair market value of the total qualifying investment
immediately before the inclusion event; or
(B) The fair market value of the portion of the qualifying
investment that is disposed of in the inclusion event.
(ii) For purposes of paragraph (e)(1)(i) of this section, the fair
market value of the portion of the qualifying investment that is
disposed of in the inclusion event is determined by multiplying the
fair market value of the eligible taxpayer's entire qualifying
investment in the QOF, determined as of the date of the inclusion
event, by the percentage of the eligible taxpayer's qualifying
investment that is represented by the portion that is disposed of in
the inclusion event.
(2) Property received from a QOF in certain transactions. In the
case of an inclusion event described in paragraph (c)(6)(iii) or (v),
(c)(7)(ii), (c)(8)(i), or (c)(9) or (13) of this section (or in
paragraph (c)(11) or (12) of this section, to the extent the rules in
paragraph (c)(8)(i) of this section apply to the inclusion event), the
amount of gain included in gross income is equal to the lesser of--
(i) The remaining deferred gain; or
(ii) The amount that gave rise to the inclusion event.
(3) Gain recognized on December 31, 2026. The amount of gain
included in gross income on December 31, 2026 is equal to the excess
of--
(i) The lesser of--
(A) The remaining deferred gain; and
(B) The fair market value of the qualifying investment held on
December 31, 2026; over
(ii) The eligible taxpayer's basis in the qualifying investment as
of December 31, 2026, taking into account only section 1400Z-
2(b)(2)(B).
(4) Special amount includible rule for partnerships and S
corporations. For purposes of paragraphs (e)(1) and (3) of this
section, in the case of an inclusion event involving a qualifying
investment in a QOF partnership or S corporation, or in the case of a
qualifying investment in a QOF partnership or S corporation held on
December 31, 2026, the amount of gain included in gross income is equal
to the lesser of--
(i) The product of--
(A) The percentage of the qualifying investment that gave rise to
the inclusion event; and
(B) The remaining deferred gain, less any basis adjustments
pursuant to section 1400Z-2(b)(2)(B)(iii) and (iv); or
(ii) The gain that would be recognized on a fully taxable
disposition at fair market value of the qualifying investment that gave
rise to the inclusion event.
(5) Limitation on amount of gain included after statutory five-year
and seven-year basis increases. The total amount of gain included in
gross income under this paragraph (e) is limited to the amount deferred
under section 1400Z-2(a)(1) and the section 1400Z-2 regulations,
reduced by any increase in the basis of the qualifying investment made
pursuant to section 1400Z-2(b)(2)(B)(iii) and (iv). See paragraph
(g)(2) of this section for limitations on the amount of basis
adjustments under section 1400Z-2(b)(2)(B)(iii) and (iv).
(f) Examples. The following examples illustrate the rules of
paragraphs (c), (d) and (e) of this section. For purposes of the
following examples: A, B, C, W, X, Y, and Z are C corporations that do
not file a consolidated Federal income tax return; Q is a QOF
corporation or a QOF partnership, as specified in each example; and
each divisive corporate transaction satisfies the requirements of
section 355.
(1) Example 1. Determination of basis, holding period, and
qualifying investment --(i) Facts. A wholly and directly owns Q, a
QOF corporation. On May 31, 2019, A sells a capital asset to an
unrelated party and realizes $500 of capital gain. On October 31,
2019, A transfers unencumbered asset N to Q in exchange for a
qualifying investment. Asset N, which A has held for 10 years, has a
basis of $500 and a fair market value of $500. A elects to defer the
inclusion of $500 in gross income under section 1400Z-2(a) and Sec.
1.1400Z2(a)-1.
(ii) Analysis. Under Sec. 1.1400Z2(a)-1(c)(6)(ii)(B)(1), A made
a qualifying investment of $500. Under section 1400Z-2(b)(2)(B)(i),
A's basis in its qualifying investment in Q is $0. For purposes of
sections 1400Z-2(b)(2)(B) and 1400Z-2(c), A's holding period in its
new investment in Q begins on October 31, 2019. See paragraph
(d)(1)(i) of this section. Other than for purposes of applying
section 1400Z-2, A has a 10-year holding period in its new Q
investment as of October 31, 2019.
(iii) Transfer of built-in gain property. The facts are the same
as in paragraph (f)(1)(i) of this section (this Example 1), but A's
basis in transferred asset N is $200. Under Sec. 1.1400Z2(a)-
1(c)(6)(ii)(B)(1), A made a qualifying investment of $200 and a non-
qualifying investment of $300.
(2) Example 2. Transfer of qualifying investment--(i) Facts. On
May 31, 2019, taxpayer A sells a capital asset to an unrelated party
and realizes $500 of capital gain. On October 31, 2019, A transfers
$500 to newly formed Q, a QOF corporation, in exchange for a
qualifying investment. On February 29, 2020, A transfers 25 percent
of its qualifying investment in Q to newly formed Y in exchange for
100 percent of Y's stock in a transfer to which section 351 applies
(Transfer), at a time when the fair market value of A's qualifying
investment in Q is $800.
(ii) Analysis. Under Sec. 1.1400Z2(a)-1(c)(6)(ii)(A), A made a
qualifying investment of $500 on October 31, 2019. In the Transfer,
A exchanged 25 percent of its qualifying investment for Federal
income tax purposes, which reduced A's direct qualifying investment.
Under paragraph (c)(1)(i) of this section, the Transfer is an
inclusion event to the extent of the reduction in A's direct
qualifying investment. Under paragraph (e)(1) of this section, A
therefore includes in income an amount equal to the excess of the
amount described in paragraph (e)(1)(i) of this section over A's
basis in the portion of the qualifying investment that was disposed
of, which in this case is $0. The amount described in paragraph
(e)(1)(i) is the lesser of $125 ($500 x ($200/$800)) or $200. As a
result, A must include $125 of its deferred capital gain in income
in 2020. After the Transfer, the Q stock is not qualifying Q stock
in Y's hands.
(iii) Disregarded transfer. The facts are the same as in
paragraph (f)(2)(i) of this section (this Example 2), except that Y
elects to be treated as an entity that is disregarded as an entity
separate from its owner for Federal income tax purposes effective
prior to the Transfer. Since the Transfer is disregarded for Federal
income tax purposes, A's transfer of its qualifying investment in Q
is not treated as a reduction in direct tax ownership for Federal
income tax purposes, and the Transfer is not an inclusion event with
respect to A's qualifying investment in Q for purposes of section
1400Z-2(b)(1) and paragraph (b) of this section. Thus, A is not
required to include in income any portion of its deferred capital
gain.
(iv) Election to be treated as a corporation. The facts are the
same as in paragraph (f)(2)(iii) of this section (this Example 2),
except that Y (a disregarded entity) subsequently elects to be
treated as a corporation for Federal income tax purposes. A's deemed
transfer of its qualifying investment in Q to Y under Sec.
301.7701-3(g)(1)(iv) of this chapter is an inclusion event for
purposes of section 1400Z-2(b)(1) and paragraph (b) of this section.
(3) Example 3. Part sale of qualifying QOF partnership interest
in Year 6 when value of the QOF partnership interest has increased--
[[Page 1971]]
(i) Facts. In October 2018, A and B each realize $200 of eligible
gain, and C realizes $600 of eligible gain. On January 1, 2019, A,
B, and C form Q, a QOF partnership. A contributes $200 of cash, B
contributes $200 of cash, and C contributes $600 of cash to Q in
exchange for qualifying QOF partnership interests in Q. A, B, and C
hold 20 percent, 20 percent, and 60 percent interests in Q,
respectively. On January 30, 2019, Q obtains a nonrecourse loan from
a bank for $1,000. Under section 752, the loan is allocated $200 to
A, $200 to B, and $600 to C. On February 1, 2019, Q purchases
qualified opportunity zone business property for $2,000. On July 31,
2024, A sells 50 percent of its qualifying QOF partnership interest
in Q to B for $400 cash. Prior to the sale, there were no inclusion
events, distributions, partner changes, income or loss allocations,
or changes in the amount or allocation of debt outstanding. At the
time of the sale, the fair market value of Q's qualified opportunity
zone business property is $5,000.
(ii) Analysis. Because A held its qualifying QOF partnership
interest for at least five years, A's basis in its partnership
interest at the time of the sale is $220 (the original zero basis
with respect to the contribution, plus the $200 debt allocation,
plus the 10% increase for interests held for five years). The sale
of 50 percent of A's qualifying QOF partnership interest to B
requires A to recognize $90 of gain, the lesser of $90, which is 50
percent of $180 (the $200 remaining deferred gain less the $20 five-
year basis adjustment), or $390, which is the gain that would be
recognized on a taxable sale of 50 percent of the interest. A also
recognizes $300 of gain relating to the appreciation of its interest
in Q.
(4) Example 4. Sale of qualifying QOF partnership interest when
value of the QOF partnership interest has decreased--(i) Facts. The
facts are the same as in paragraph (f)(3) of this section (Example
3), except that A sells 50 percent of its qualifying QOF partnership
interest in Q to B for cash of $50, and at the time of the sale, the
fair market value of Q's qualified opportunity zone business
property is $1,500.
(ii) Analysis. Because A held its qualifying QOF partnership
interest for at least five years, A's basis at the time of the sale
is $220. Under section 1400Z-2(b)(2)(A), the sale of 50 percent of
A's qualifying QOF partnership interest to B requires A to recognize
$40 of gain, the lesser of $90 (50 percent of the excess of A's $200
remaining deferred gain over A's $20 five-year adjustment) or $40
(the gain that would be recognized by A on a sale of 50 percent of
its QOF interest). A's remaining basis in its qualifying QOF
partnership interest is $110.
(5) Example 5. Amount includible on December 31, 2026--(i)
Facts. The facts are the same as in paragraph (f)(3) of this section
(Example 3), except that no sale of QOF interests takes place in
2024. Prior to December 31, 2026, there were no inclusion events,
distributions, partner changes, income or loss allocations, or
changes in the amount or allocation of debt outstanding.
(ii) Analysis. For purposes of calculating the amount includible
on December 31, 2026, each of A's basis and B's basis is increased
by $30 to $230, and C's basis is increased by $90 to $690 because
they held their qualifying QOF partnership interests for at least
seven years. Each of A and B is required to recognize $170 of gain,
and C is required to recognize $510 of gain.
(iii) Sale of qualifying QOF partnership interests. The facts
are the same as in paragraph (f)(5)(i) of this section (this Example
5), except that, on March 2, 2030, C sells its entire qualifying QOF
partnership interest in Q to an unrelated buyer for cash of $4,200.
Assuming an election under section 1400Z-2(c) is made, the basis of
C's Q interest is increased to its fair market value immediately
before the sale by C. C is treated as purchasing the interest
immediately before the sale and the bases of the partnership's
assets are increased in the manner they would be if the partnership
had an election under section 754 in effect.
(6) Example 6. Mixed-funds investment--(i) Facts. On January 1,
2019, A and B form Q, a QOF partnership. A contributes $200 to Q,
$100 of which is in exchange for a qualifying investment, and B
contributes $200 to Q in exchange for a qualifying investment. All
the cash is used to purchase qualified opportunity zone property. Q
has no liabilities. On March 30, 2023, when the values and bases of
the qualifying investments remain unchanged, Q distributes $50 to A.
(ii) Analysis. Under paragraph (c)(6)(iv) of this section, A is
a mixed-funds partner holding two separate interests, a qualifying
investment and a non-qualifying investment. One half of the $50
distribution is treated under that provision as being made with
respect to A's qualifying investment. For the $25 distribution made
with respect to the qualifying investment, A is required to
recognize $25 of gain.
(iii) Basis adjustments. Under paragraph (g)(1)(ii)(B) of this
section, prior to determining the tax consequences of the
distribution, A increases its basis in its qualifying QOF
partnership interest by $25 under section 1400Z-2(b)(2)(B)(ii). The
distribution of $25 results in no gain under section 731. After the
distribution, A's basis in its qualifying QOF partnership interest
is $0 ($25-$25).
(7) Example 7. Qualifying section 381 transaction of a QOF
corporation--(i) Facts. X wholly and directly owns Q, a QOF
corporation. On May 31, 2019, X sells a capital asset to an
unrelated party and realizes $500 of capital gain. On October 31,
2019, X contributes $500 to Q in exchange for a qualifying
investment. In 2020, Q merges with and into unrelated Y (with Y
surviving) in a transaction that qualifies as a reorganization under
section 368(a)(1)(A) (Merger). X does not receive any boot in the
Merger with respect to its qualifying investment in Q. Immediately
after the Merger, Y satisfies the requirements for QOF status under
section 1400Z-2(d)(1) (see paragraph (c)(10)(i)(B) of this section).
(ii) Analysis. The Merger is not an inclusion event for purposes
of section 1400Z-2(b)(1) and paragraph (b) of this section. See
paragraph (c)(10)(i)(A) of this section. Accordingly, X is not
required to include in income in 2020 its $500 of deferred capital
gain as a result of the Merger. For purposes of section 1400Z-
2(b)(2)(B) and (c), X's holding period for its investment in Y is
treated as beginning on October 31, 2019. For purposes of section
1400Z-2(d), Y's holding period in its assets includes Q's holding
period in its assets, and Q's qualified opportunity zone business
property continues to qualify as such. See paragraph (d)(2) of this
section.
(iii) Merger of QOF shareholder. The facts are the same as in
paragraph (f)(7)(i) of this section (this Example 7), except that,
in 2020, X (rather than Q) merges with and into Y in a section 381
transaction in which Y acquires all of X's qualifying investment in
Q, and Y does not qualify as a QOF immediately after the merger. The
merger transaction is not an inclusion event for purposes of section
1400Z-2(b)(1) and paragraph (b) of this section. See paragraph
(c)(10)(ii) of this section.
(iv) Receipt of boot. The facts are the same as in paragraph
(f)(7)(i) of this section (this Example 7), except that the value of
X's qualifying investment immediately before the Merger is $1,000, X
receives $100 of cash in addition to Y stock with a fair market
value of $900 in the Merger in exchange for its qualifying
investment, and neither Q nor Y has any earnings and profits. Under
paragraph (c)(10)(i)(C) of this section, X is treated as disposing
of 10 percent ($100/$1000) of its qualifying investment. Under
paragraph (e)(1) of this section, X is required to include $50 ($500
x ($100/$1000)) of its deferred capital gain in income in 2020.
(8) Example 8. Section 355 distribution by a QOF--(i) Facts. A
wholly and directly owns Q, a QOF corporation, which wholly and
directly owns Y, a corporation that is a qualified opportunity zone
business. On May 31, 2019, A sells a capital asset to an unrelated
party and realizes $500 of capital gain. On October 31, 2019, A
contributes $500 to Q in exchange for a qualifying investment. On
June 26, 2025, Q distributes all of the stock of Y to A in a
transaction in which no gain or loss is recognized under section 355
(Distribution). Immediately after the Distribution, each of Q and Y
satisfies the requirements for QOF status. (See paragraph
(c)(11)(i)(B)(2) of this section.)
(ii) Analysis. Because each of Q, the distributing corporation,
and Y, the controlled corporation, is a QOF immediately after the
Distribution, the Distribution is a qualifying section 355
transaction. Thus, the Distribution is not an inclusion event for
purposes of section 1400Z-2(b)(1) and paragraph (b) of this section.
See paragraph (c)(11)(i)(B) of this section. Accordingly, A is not
required to include in income in 2025 any of its $500 of deferred
capital gain as a result of the Distribution. For purposes of
section 1400Z-2(b)(2)(B) and (c), A's holding period for its
qualifying investment in Y is treated as beginning on October 31,
2019. See paragraph (d)(1)(ii) of this section.
(iii) Section 355 distribution by a QOF shareholder. The facts
are the same as in paragraph (f)(8)(i) of this section (this Example
8), except that A distributes 80 percent of the stock of Q, all of
which is a qualifying investment in the hands of A, to A's
shareholders in a transaction in which no
[[Page 1972]]
gain or loss is recognized under section 355. At the time of the
distribution, the fair market value of A's Q stock exceeds $500. The
distribution is an inclusion event for purposes of section 1400Z-
2(b)(1) and paragraph (b) of this section, and A is required to
include in income $400 (80 percent of its $500 of deferred capital
gain) as a result of the distribution. See paragraphs (c)(1) and
(c)(11)(ii) of this section.
(iv) Distribution of boot. The facts are the same as in
paragraph (f)(8)(i) of this section (this Example 8), except that A
receives boot in the Distribution. Under paragraphs (c)(8)(i) and
(c)(11)(i)(B)(3) of this section, the receipt of boot in the
Distribution is an inclusion event for purposes of section 1400Z-
2(b)(1) and paragraph (b) of this section to the extent of gain
recognized pursuant to section 301(c)(3).
(v) Section 355 split-off. The facts are the same as in
paragraph (f)(8)(i) of this section (this Example 8), except that Q
stock is directly owned by both A and B (each of which has made a
qualifying investment in Q), and Q distributes all of the Y stock to
B in exchange for B's Q stock in a transaction in which no gain or
loss is recognized under section 355. The distribution is a
qualifying section 355 transaction and is not an inclusion event for
purposes of section 1400Z-2(b)(1) and paragraph (b) of this section.
Neither A nor B is required to include its deferred capital gain in
income in 2025 as a result of the distribution.
(vi) Section 355 split-up. The facts are the same as in
paragraph (f)(8)(v) of this section (this Example 8), except that Q
wholly and directly owns both Y and Z; Q distributes all of the Y
stock to A in exchange for A's Q stock and distributes all of the Z
stock to B in exchange for B's Q stock in a transaction in which no
gain or loss is recognized under section 355; Q then liquidates; and
immediately after the Distribution, each of Y and Z satisfies the
requirements for QOF status. The distribution is a qualifying
section 355 transaction and is not an inclusion event for purposes
of section 1400Z-2(b)(1) and paragraph (b) of this section. Neither
A nor B is required to include its deferred capital gain in income
in 2025 as a result of the transaction.
(vii) Section 355 split-off with boot. The facts are the same as
in paragraph (f)(8)(v) of this section (this Example 8), except that
B also receives boot. Under paragraph (c)(11)(i)(B)(3) of this
section, B has an inclusion event and is treated as disposing of a
portion of its qualifying investment that bears the same proportion
to B's total qualifying investment immediately before the inclusion
event as the fair market value of the boot bears to the fair market
value of the total consideration received by B.
(9) Example 9. Recapitalization--(i) Facts. On May 31, 2019,
each of A and B sells a capital asset to an unrelated party and
realizes $500 of capital gain. On October 31, 2019, A contributes
$500 to newly formed Q in exchange for 50 shares of class A stock of
Q (A's qualifying investment) and B contributes $500 to Q in
exchange for 60 shares of class B stock of Q (B's qualifying
investment). A and B are the sole shareholders of Q. In 2020, B
exchanges all of its class B stock of Q for 40 shares of class A
stock of Q as well as other property in a transaction that qualifies
as a reorganization under section 368(a)(1)(E).
(ii) Analysis. Because A did not receive any boot in the
transaction, A does not have an inclusion event with respect to its
qualifying investment in Q. See paragraph (c)(12)(i) of this
section. Therefore, A is not required to include any of its deferred
gain in income as a result of this transaction. However, under
paragraph (c)(12)(ii) of this section, B has an inclusion event. If
section 301 applies to the boot received by B, B has an inclusion
event to the extent of its section 301(c)(3) gain. If section 356(a)
or (c) applies to the boot received by B, B is treated as disposing
of a portion of its qualifying investment that bears the same
proportion to B's total qualifying investment immediately before the
inclusion event as the fair market value of the boot bears to the
fair market value of the total consideration received by B.
(10) Example 10. Debt financed distribution--(i) Facts. On
September 24, 2019, A and B form Q, a QOF partnership, each
contributing $200 that is deferred under the section 1400Z-2(a)
election to Q in exchange for a qualifying investment. On November
18, 2022, Q obtains a nonrecourse loan from a bank for $300. Under
section 752, the loan is allocated $150 to A and $150 to B. On
November 30, 2022, when the values and bases of the investments
remain unchanged, Q distributes $50 to A.
(ii) Analysis. A is not required to recognize gain under
paragraph (c) of this section because A's basis in its qualifying
investment is $150 (the original zero basis with respect to the
contribution, plus the $150 debt allocation). The distribution
reduces A's basis to $100.
(11) Example 11. Debt financed distribution in excess of basis--
(i) Facts. The facts are the same as in paragraph (f)(10) of this
section (Example 10), except that the loan is entirely allocated to
B under section 752. On November 30, 2024, when the values of the
investments remain unchanged, Q distributes $50 to A.
(ii) Analysis. Under paragraph (c)(6)(iii) of this section, A is
required to recognize $30 of eligible gain under paragraph (c) of
this section because the $50 distributed to A exceeds A's $20 basis
in its qualifying investment (the original zero basis with respect
to its contribution, plus $20 with regard to section 1400Z-
2(b)(2)(B)(iii)).
(g) Basis adjustments--(1) Basis adjustments under section 1400Z-
2(b)(2)(B)(ii) resulting from the inclusion of deferred gain--(i) In
general. Except as provided in paragraph (g)(1)(ii) of this section,
basis adjustments under section 1400Z-2(b)(2)(B)(ii) are made
immediately after the amount of gain determined under section 1400Z-
2(b)(2)(A) is included in income under section 1400Z-2(b)(1). If the
basis adjustment under section 1400Z-2(b)(2)(B)(ii) is being made as a
result of an inclusion event, then the basis adjustment is made before
determining the other Federal income tax consequences of the inclusion
event.
(ii) Specific application to section 301(c)(3) gain, section
1059(a)(2) gain, S corporation shareholder gain, or partner gain--(A)
Applicability. This paragraph (g)(1)(ii) applies if a QOF makes a
distribution to its owner, and if, without regard to any basis
adjustment under section 1400Z-2(b)(2)(B)(ii), at least a portion of
the distribution would be characterized as gain under section
301(c)(3), section 1059(a)(2), or paragraphs (c)(6)(iii) and (c)(7)(ii)
of this section with respect to the owner's qualifying investment in
the QOF.
(B) Ordering rule. If paragraph (g)(1)(ii) of this section applies,
an eligible taxpayer is treated as having an inclusion event to the
extent provided in paragraph (c)(6)(iii), (c)(7)(ii), or (c)(8), (9),
(11), (12), or (13) of this section, as applicable. Then, the eligible
taxpayer increases its basis under section 1400Z-2(b)(2)(B)(ii) before
determining the Federal income tax consequences of the distribution.
(iii) Shares in QOF C corporations to which section 1400Z-
2(b)(2)(B)(ii) adjustments are made. If a shareholder of a QOF C
corporation disposes of qualifying QOF stock in an exchange subject to
section 1001, basis adjustments under section 1400Z-2(b)(2)(B)(ii) are
made only to the portion of the qualifying investment that is disposed
of in the inclusion event.
(2) Amount of basis adjustment under section 1400Z-2(b)(2)(B)(iii)
and (iv). The increases in basis under section 1400Z-2(b)(2)(B)(iii)
and (iv) are limited to 10 percent and 5 percent, respectively, of the
remaining deferred gain with respect to a qualifying investment as of
the dates on which basis is increased under that section.
(3) Examples. The following examples illustrate the rules of
paragraphs (g)(1) and (2) of this section.
(i) Example 1--(A) Facts. On May 31, 2019, A, a C corporation,
sells a capital asset to an unrelated party and realizes $500 of
capital gain. On October 31, 2019, A contributes $500 to Q, a newly
formed QOF C corporation, in exchange for all of the outstanding Q
common stock and elects to defer the recognition of $500 of capital
gain under section 1400Z-2(a) and Sec. 1.1400Z2(a)-1. In 2020, when
Q has $40 of earnings and profits, Q distributes $100 to A
(Distribution).
(B) Recognition of gain. Under paragraph (g)(1)(ii)(B) of this
section, the Distribution is first evaluated without regard to any
basis adjustment under section 1400Z-2(b)(2)(B)(ii). Of the $100
distribution, $40 is treated as a dividend and $60 is treated as
gain from the sale or exchange of property under section 301(c)(3),
because A's basis in its Q stock is $0 under section 1400Z-
2(b)(2)(B)(i). Under paragraphs (c)(8)(i) and
[[Page 1973]]
(e)(2) of this section, $60 of A's gain that was deferred under
section 1400Z-2(a) and Sec. 1.1400Z2(a)-1 is recognized in 2020.
Pursuant to Sec. 1.312-6(b), A's earnings and profits increase by
$60.
(C) Basis adjustments. Under paragraph (g)(1)(ii)(B) of this
section, prior to determining the further tax consequences of the
Distribution, A increases its basis in its Q stock by $60 in
accordance with section 1400Z-2(b)(2)(B)(ii). As a result, the
Distribution is characterized as a dividend of $40 under section
301(c)(1) and a return of basis of $60 under section 301(c)(2).
Therefore, after the section 301 distribution, A's basis in Q is $0
($60-$60).
(ii) Example 2--(A) Facts. The facts are the same as in
paragraph (g)(3)(i) of this section (Example 1), except that,
instead of receiving a distribution, A sells half of the Q stock for
$250 in 2020. A continues to hold the remainder of its Q stock
through 2024.
(B) Recognition of gain and basis adjustments in 2020. Under
paragraphs (c)(1) and (e)(1) of this section, $250 of A's gain that
was deferred under section 1400Z-2(a) and Sec. 1.1400Z2(a)-1 is
recognized in 2020. Under paragraphs (g)(1)(i) and (iii) of this
section, A increases its basis to $250 in the sold shares in
accordance with section 1400Z-2(b)(2)(B)(ii) immediately before the
sale. Accordingly, A has no gain or loss on the sale ($250-$250).
Pursuant to Sec. 1.312-6(b), A's earnings and profits increase by
$250. A's basis in its remaining shares of Q stock remains $0.
(C) Basis adjustment in 2024. Under paragraph (g)(2) of this
section, A increases its basis in its remaining shares of Q stock in
accordance with section 1400Z-2(b)(2)(B)(iii). Pursuant to Sec.
1.312-6(b), A's earnings and profits are increased by the amount of
the basis adjustment.
(4) Special partnership rules--(i) General rule. The initial basis
under section 1400Z-2(b)(2)(B)(i) of a qualifying investment in a QOF
partnership is zero, as adjusted to take into account the contributing
partner's share of partnership debt under section 752.
(ii) Treatment of basis adjustments. Any basis adjustment to a
qualifying investment in a QOF partnership described in section 1400Z-
2(b)(2)(B)(iii) and (iv) and section 1400Z-2(c) is basis for all
purposes, including for purposes of suspended losses under section
704(d).
(iii) Tiered arrangements. Any basis adjustment described in
section 1400Z-2(b)(2)(B)(iii) and (iv) and section 1400Z-2(c) (basis
adjustment rules) will be treated as an item of income described in
section 705(a)(1) and must be reported in accordance with the
applicable forms and instructions. Any amount to which the basis
adjustment rules or to which section 1400Z-2(b)(1) applies will be
allocated to the owners of the QOF, and to the owners of any
partnership that directly or indirectly (solely through one or more
partnerships) owns the eligible interest, and will track to the owners'
interests, based on their shares of the remaining deferred gain to
which such amounts relate.
(5) Basis adjustments in S corporation stock--(i) Treatment of
basis adjustments. Any basis adjustment to a qualifying investment in a
QOF S corporation described in section 1400Z-2(b)(2)(B)(iii) and (iv)
and section 1400Z-2(c) is basis for all purposes, including for
purposes of suspended losses under section 1366(d).
(ii) S corporation investor in QOF--(A) S corporation. If an S
corporation is an investor in a QOF, the S corporation must adjust the
basis of its qualifying investment as set forth in this paragraph (g).
The rule in this paragraph (g)(5)(ii)(A) does not affect adjustments to
the basis of any other asset of the S corporation.
(B) S corporation shareholder--(1) In general. The S corporation
shareholder's pro-rata share of any recognized capital gain that has
been deferred at the S corporation level will be separately stated
under section 1366 when recognized and will adjust the shareholders'
stock bases under section 1367 at that time.
(2) Basis adjustments to qualifying investments. Any adjustment
made to the basis of an S corporation's qualifying investment under
section 1400Z-2(b)(2)(B)(iii) or (iv), or section 1400Z-2(c), will not:
(i) Be separately stated under section 1366; or
(ii) Until the date on which an inclusion event with respect to the
S corporation's qualifying investment occurs, adjust the shareholders'
stock bases under section 1367.
(3) Basis adjustments resulting from inclusion events. If the basis
adjustment under section 1400Z-2(b)(2)(B)(ii) is being made as a result
of an inclusion event, then the basis adjustment is made before
determining the tax consequences of the inclusion event other than the
computation of the tax on the deferred gain.
(iii) QOF S corporation--(A) Transferred basis of assets received.
If a QOF S corporation receives an asset in exchange for a qualifying
investment, the basis of the asset shall be the same as it would be in
the hands of the transferor, increased by the amount of the gain
recognized by the transferor on such transfer.
(B) Basis adjustments resulting from inclusion events. If the basis
adjustment under section 1400Z-2(b)(2)(B)(ii) for the shareholder of
the QOF S corporation is being made as a result of an inclusion event,
then the basis adjustment is made before determining the tax
consequences of the inclusion event other than the computation of the
tax on the deferred gain.
(6) Basis in the hands of a taxpayer who received a qualifying
investment in a QOF by reason of the prior owner's death--(i) In
general. The basis of a qualifying investment in a QOF, transferred by
reason of a decedent's death in a transfer that is not an inclusion
event, is zero under section 1400Z-2(b)(2)(B)(i), as adjusted for
increases in basis as provided under section 1400Z-2(b)(2)(B)(ii)
through (iv) and (c). See paragraph (c)(4) of this section.
(ii) Examples. The following examples illustrate the rule of
this paragraph (g)(6).
(A) Example 1. Taxpayer A, an individual, contributed $50X to a
QOF in exchange for a qualifying investment in the QOF in January
2019. This $50X was capital gain that was excluded from A's gross
income under section 1400Z-2(a)(1)(A). A's basis in the qualifying
investment is zero. As of January 2024, A's basis in the QOF is
increased by an amount equal to 10 percent of the amount of gain
deferred by reason of section 1400Z-2(a)(1)(A), so that A's adjusted
basis in 2024 is $5X. A dies in 2025 and A's heir inherits this
qualifying investment in the QOF. A's death is not an inclusion
event for purposes of section 1400Z-2. The heir's basis in the
qualifying investment is $5X.
(B) Example 2. The facts are the same as in paragraph
(g)(6)(ii)(A) of this section (Example 1), except that A dies in
November 2027, when the fair market value of the qualifying
investment was $75X. A was required to pay the tax on the excess of
the deferred capital gain over A's basis as part of A's 2026 income.
Therefore, at the time of A's death, A's basis in the qualifying
investment is the sum of three basis adjustments: The adjustment
made in January 2024 described in paragraph (g)(6)(ii)(A) (Example
1) ($5X); an additional adjustment made as of January 2026 equal to
5 percent of the amount of gain deferred by reason of section 1400Z-
2(a)(1)(A) ($2.5X); and the adjustment as of December 31, 2026, by
reason of section 1400Z-2(b)(1)(B) and (b)(2)(B)(ii) ($42.5X).
Accordingly, the basis of the qualifying investment in the hands of
A's heir is $50X.
(h) Notifications by partners and partnerships, and shareholders
and S corporations--(1) Notification of deferral election. A
partnership that makes a deferral election must notify all of its
partners of the deferral election and state each partner's distributive
share of the deferred gain in accordance with applicable forms and
instructions.
(2) Notification of deferred gain recognition by indirect QOF
owner. If an indirect owner of a QOF partnership sells or otherwise
disposes of all or a portion of its indirect interest in the QOF
partnership in a transaction that is an inclusion event under paragraph
(c)
[[Page 1974]]
of this section, such indirect owner must provide to the QOF owner
notification and information sufficient to enable the QOF owner, in a
timely manner, to recognize an appropriate amount of deferred gain.
(3) Notification of section 1400Z-2(c) election. A QOF partner or
QOF S corporation shareholder must notify the QOF partnership or QOF S
corporation, as appropriate, of an election under section 1400Z-2(c) to
adjust the basis of the qualifying QOF partnership interest or
qualifying QOF stock, as appropriate, that is disposed of in a taxable
transaction. Notification of the section 1400Z-2(c) election, and the
adjustments to the basis of the qualifying QOF partnership interest(s)
or qualifying QOF stock disposed of, or to the QOF partnership asset(s)
or QOF S corporation asset(s) disposed of, as appropriate, is to be
made in accordance with applicable forms and instructions.
(i) [Reserved]
(j) Applicability dates--(1) In general. The provisions of this
section are applicable for taxable years beginning after March 13,
2020.
(2) Prior periods. With respect to 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, a taxpayer may choose either--
(i) To apply section 1400Z-2 regulations, if applied in a
consistent manner for all such taxable years; or
(ii) To rely on the rules in proposed Sec. 1.1400Z2(b)-1 contained
in the notice of proposed rulemaking (REG-120186-18) published on May
1, 2019, but only if applied in a consistent manner for all such
taxable years.
0
Par. 5. Section 1.1400Z2(c)-1 is added to read as follows:
Sec. 1.1400Z2(c)-1 Investments held for at least 10 years.
(a) Scope. This section provides rules under section 1400Z-2(c) of
the Internal Revenue Code regarding the election to adjust the basis in
a qualifying investment in a QOF or in certain eligible property held
by the QOF. See Sec. 1.1400Z2(b)-1(d) for rules for determining the
holding period of a qualifying investment for purposes of this section.
(b) Investment for which an election can be made--(1) In general--
(i) Election by taxpayer. An eligible taxpayer who makes a deferral
election with respect to, or acquires by reason of a transaction that
is not an inclusion event, a qualifying investment in a QOF, recognizes
gain (if any) on December 31, 2026, of an amount determined under Sec.
1.1400Z2(b)-1(e)(3) (and so much of Sec. 1.1400Z2(b)-1(e)(4) as
relates to Sec. 1.1400Z2(b)-1(e)(3)) with respect to that qualifying
investment, and whose holding period in that qualifying investment is
at least ten years, is eligible to make an election described in
section 1400Z-2(c) on the sale or exchange of that qualifying
investment. Except as otherwise provided in this paragraph (b)(1), to
the extent a taxpayer described in the preceding sentence has an
inclusion event described in Sec. 1.1400Z2(b)-1(c) with respect to any
portion of a qualifying investment, that portion is no longer a
qualifying investment and the taxpayer is not eligible to make an
election pursuant to section 1400Z-2(c) and this section with respect
to that portion. See Sec. 1.1400Z2(c)-1(b)(2) for special election
rules for QOF partnerships and QOF S corporations.
(ii) Transferee partnership to make an election under section
1400Z-2(c)--(A) In general. This paragraph (b)(1)(ii)(A) applies if an
eligible taxpayer (transferor) transfers its qualifying investment to a
transferee in a transaction described in Sec. 1.1400Z2(b)-1(c)(6)(ii)
to the extent governed by section 721(a). If this paragraph
(b)(1)(ii)(A) applies, and if the transferee sells or exchanges a
qualifying investment that has a holding period of at least 10 years
under Sec. 1.1400Z2(b)-1(d)(1)(ii)(F), then the transferee can make an
election described in section 1400Z-2(c) on the sale or exchange of the
qualifying investment. See Sec. 1.1400Z2(b)-1(c)(6)(ii)(B) (transferee
partnership makes section 1400Z-2(c) election regarding contributed
qualifying investment).
(B) Conditions for transferee partnership or merged partnership to
make an election described in section 1400Z-2(c). A transferee referred
to in paragraph (b)(1)(ii)(A) of this section is eligible to make an
election described in section 1400Z-2(c) with respect to a qualifying
investment only if the transferee:
(1) Files a statement, at the time and in the manner that the
Commissioner of Internal Revenue may prescribe by Internal Revenue
Service forms and instructions or by publication in the Internal
Revenue Bulletin (see Sec. 601.601(d)(ii)(b) of this chapter),
providing the name of the transferor, the date of the transfer, and the
transferor's holding period in the transferred qualifying investment
immediately before the transfer; and
(2) Files form 8997, Initial and Annual Statement of Qualified
Opportunity Fund (QOF) Investments, with the transferee's timely filed
Federal Tax Return.
(iii) Limitation on the 10-year rule. As required by section 1400Z-
2(e)(1) (treatment of investments with mixed funds), section 1400Z-2(c)
applies only to the portion of an investment in a QOF that is a
qualifying investment. For rules governing the application of section
1400Z-2(c) to the portion of an investment in a QOF for which a loss
has been claimed under section 165(g) or otherwise, see Sec.
1.1400Z2(b)-1(c)(14).
(iv) Transactions to which section 301(c)(3), section 1059(a)(2),
or section 1368(b)(2) or (c)(3) applies. The receipt of amounts treated
as gain from the sale or exchange of property under section 301(c)(3),
section 1059(a)(2), or section 1368(b)(2) or (c)(3) with respect to
qualifying QOF stock in a transaction treated as an inclusion event
under Sec. 1.1400Z2(b)-1(c) does not prevent the QOF shareholder from
making a subsequent election described in section 1400Z-2(c) with
respect to that qualifying QOF stock.
(v) Partnership distributions in excess of basis. The occurrence of
an inclusion event described in Sec. 1.1400Z2(b)-1(c)(6)(iii), which
addresses a distribution of property by a QOF partnership to a QOF
partner where the distributed property has a fair market value in
excess of the QOF partner's basis in its qualifying investment, does
not prevent the QOF partner from making a subsequent election described
in section 1400Z-2(c) with respect to the QOF partner's qualifying QOF
partnership interest.
(2) Special election rules for QOF partnerships and QOF S
corporations--(i) Dispositions of qualifying QOF partnership interests.
If a QOF partner's basis in a qualifying QOF partnership interest is
adjusted under section 1400Z-2(c) upon the disposition of a qualifying
investment, then the basis of the QOF partnership interest is adjusted
to an amount equal to the net fair market value of the interest, plus
the QOF partner's share of QOF partnership indebtedness under section
752 with respect to that interest, and immediately prior to the sale or
exchange, the bases of the assets of the QOF partnership and of any
partnership owned directly or indirectly by the QOF partnership solely
through one or more partnerships are also adjusted with respect to the
disposed-of qualifying investment. For purposes of this paragraph
(b)(2)(i), section 7701(g) will apply in determining the value of a
qualifying investment in a QOF partnership. The adjustments in this
paragraph (b)(2)(i) are calculated in a manner similar to the section
743(b) adjustments that would
[[Page 1975]]
have been made if the transferor QOF partner had purchased its interest
in the QOF partnership for cash equal to the fair market value of the
interest immediately prior to the sale or exchange, assuming that valid
section 754 elections had been in place with respect to the QOF
partnership and any partnerships directly or indirectly owned by the
QOF partnership, whether or not an actual section 754 election is in
place for any of the partnerships. This paragraph (b)(2)(i) applies
without regard to the amount of deferred gain that was included under
section 1400Z-2(b)(1) or the timing of that inclusion.
(ii) Sales or exchanges of QOF property by QOF partnerships or QOF
S corporations--(A) Election to exclude gains and losses. If a taxpayer
has held a qualifying investment in a QOF partnership or QOF S
corporation for at least 10 years, as determined under Sec.
1.1400Z2(b)-1(d), and the QOF partnership or QOF S corporation or any
partnership that is owned directly, or indirectly solely through one of
more partnerships, by the QOF partnership or QOF S corporation sells or
exchanges property, the taxpayer may make an election under this
paragraph (b)(2)(ii)(A) to exclude from the taxpayer's income all gains
and losses allocable to the qualifying investment that arise from all
such sales or exchanges for the QOF partnership's or QOF S
corporation's taxable year. In order for the election to be valid, the
requirements set forth in paragraph (b)(2)(ii)(B) of this section must
be satisfied. For purposes of paragraph (b)(2)(ii) of this section,
gains and losses include all gains and losses other than gains or
losses from the sale or exchange of any item of inventory, as defined
in section 1221(a)(1), in the ordinary course of business.
(B) Deemed distribution and recontribution--(1) In general. If any
partner of a QOF partnership, or shareholder of a QOF S corporation,
makes an election under paragraph (b)(2)(ii)(A) of this section, the
taxpayer is treated as receiving a distribution of cash as calculated
under paragraph (b)(2)(ii)(B)(2) of this section, from the QOF
partnership or QOF S corporation at the end of the QOF partnership's or
QOF S corporation's taxable year and immediately recontributing the
cash to the QOF partnership or QOF S corporation in exchange for a non-
qualifying investment in the QOF partnership or QOF S corporation. In
determining the post-contribution qualifying investment and non-
qualifying investment, the QOF will value each interest based on the
underlying values of the QOF's assets determined at the end of its
taxable year in accordance with the principles of Sec. 1.704-
1(b)(2)(iv) (in the case of a QOF partnership) or fair market value (in
the case of a QOF S corporation). If the QOF partner or QOF S
corporation shareholder is a mixed-funds partner or shareholder prior
to the sale or exchange, the deemed distribution will be treated as
made proportionately with respect to the partner's or shareholder's
qualifying investment and non-qualifying investment in the QOF
partnership in accordance with Sec. 1400Z2(b)-1(c)(6)(iv)(B), or the
QOF S corporation. The distribution and recontribution rule of
paragraph (b)(2)(ii)(B) of this section is solely for purposes of
determining the taxpayer's interests in the QOF partnership or QOF S
corporation that constitute a qualifying investment and a non-
qualifying investment, and has no other Federal income tax consequence
(for example, the rule does not affect the accumulated adjustments
account of an S corporation and cannot be treated as a disproportionate
distribution by an S corporation).
(2) Amount of deemed distribution and re-contribution. The amount
of cash referred to in paragraph (b)(2)(ii)(B)(1) of this section that
is deemed distributed by and recontributed to the QOF partnership or
QOF S corporation is equal to--
(i) The partner's or shareholder's share of net proceeds from all
sales and exchanges of property described in paragraph (b)(2)(ii)(A) of
this section (other than sales of inventory in the ordinary course of
business) for the taxable year for which the election under paragraph
(b)(2)(ii)(A) is made (calculated without regard to whether any gain or
loss is recognized with regard to such property); less
(ii) All actual distributions of cash by the QOF partnership or QOF
S corporation with respect to any such sale or exchange that is made
within 90 days of the sale or exchange.
(3) Meaning of net proceeds--(i) QOF partnerships. For purposes of
paragraph (b)(2)(ii)(B)(2)(i) of this section, with respect to QOF
partnerships, the term ``net proceeds'' means the amount realized from
the sale of property described in paragraph (b)(2)(ii)(A) of this
section less any indebtedness included in the amount realized that
would constitute a qualified liability under Sec. 1.707-5(a)(6) if the
sold or exchanged property had been contributed to a lower-tier
partnership subject to the debt.
(ii) QOF S corporations. For purposes of paragraph
(b)(2)(ii)(B)(2)(i) of this section, with respect to QOF S
corporations, the term ``net proceeds'' means the amount realized from
the sale of property described in paragraph (b)(2)(ii)(A) of this
section less any indebtedness included in the amount realized that
would constitute a qualified liability under the principles of Sec.
1.707-5(a)(6).
(C) Treatment as exempt income--(1) General rule. With respect to
the taxpayer making an election under paragraph (b)(2)(ii) of this
section, the excess of any gains over losses excluded from income under
paragraph (b)(2)(ii) of this section is treated as income of the
partnership or S corporation that is exempt from tax under the Internal
Revenue Code for purposes of section 705(a)(1)(B) or section
1367(a)(1)(A). Section 265 or any similar provisions do not apply to
disallow any deductions otherwise allowable under subtitle A for
amounts paid or incurred by a taxpayer that are allocable to any gain
excluded from income under paragraph (b)(2)(ii) of this section.
(2) Special rule regarding accumulated adjustments account. Solely
for purposes of determining whether an adjustment must be made to the
accumulated adjustments account of an S corporation, the excess amount
described in paragraph (b)(2)(ii)(C)(1) of this section is not treated
as tax exempt income.
(D) Time and manner of making the election to exclude gain. An
election under paragraph (b)(2)(ii)(A) of this section is made by
filing the applicable form with the taxpayer's timely filed income tax
return, without extensions, for its taxable year that includes the
taxable year end of the QOF partnership or QOF S corporation. A
taxpayer must make the election under paragraph (b)(2)(ii)(A) of this
section for each taxable year in which it wishes to exclude gains and
losses of a QOF partnership or QOF S corporation.
(3) Basis adjustments upon sale or exchange of qualifying QOF
stock--(i) In general. Except as provided in paragraph (b)(3)(ii) of
this section, if a QOF shareholder's basis in qualifying QOF stock is
adjusted under section 1400Z-2(c), then the basis of the qualifying QOF
stock is adjusted to an amount equal to the fair market value of the
qualifying QOF stock immediately prior to the sale or exchange. This
paragraph (b)(3)(i) applies without regard to the amount of deferred
gain that was included under section 1400Z-2(b)(1) or the timing of
that inclusion.
(ii) Specific application to transactions to which section
301(c)(3), section 1059(a)(2), or section 1368(b)(2) or (c)(3)
applies--(A) Applicability. This paragraph (b)(3)(ii) applies if a QOF
[[Page 1976]]
corporation makes a distribution to a QOF shareholder, at least a
portion of the distribution would be characterized as gain from a sale
or exchange under section 301(c)(3), section 1059(a)(2), or section
1368(b)(2) or (c)(3) with respect to the QOF shareholder's qualifying
QOF stock without regard to any basis adjustment under section 1400Z-
2(c), and the QOF shareholder elects to adjust the basis of its
qualifying QOF stock under section 1400Z-2(c).
(B) Ordering rule. If paragraph (b)(3)(ii) of this section applies
with respect to a QOF corporation, the QOF shareholder increases its
basis by the lesser of the amount of the distribution characterized as
gain from a sale or exchange or the fair market value of the QOF
shareholder's qualifying QOF stock before determining the Federal
income tax consequences of the distribution.
(c) Extension of availability of the election described in section
1400Z-2(c). The ability to make an election under section 1400Z-2(c)
for investments held for at least 10 years is not impaired solely
because, under section 1400Z-1(f), the designation of one or more
qualified opportunity zones ceases to be in effect. The preceding
sentence does not apply to elections under section 1400Z-2(c) that are
related to dispositions occurring after December 31, 2047.
(d) Examples. The following examples illustrate the principles of
paragraphs (a) through (c) of this section.
(1) Example 1--(i) Facts. In 2020, taxpayer A invests $100 in
QOF S, a QOF S corporation, in exchange for a qualifying investment
and defers $100 of gain. At the end of 2028, the qualified
opportunity zone designation expires for the population census tract
in which QOF S primarily conducts its trade or business. In 2031, A
sells all of its QOF S shares, realizes gain, and makes an election
to increase the qualifying basis in its QOF S shares to fair market
value. But for the expiration of the designated zones in section
1400Z-1(f), QOF S and A's conduct is consistent with continued
eligibility to make the election under section 1400Z-2(c).
(ii) Analysis. Under paragraph (c) of this section, although the
designation expired on December 31, 2028, the expiration of the
zone's designation does not, without more, invalidate A's ability to
make an election under section 1400Z-2(c). Accordingly, pursuant to
that election, A's basis in the QOF stock is increased to its fair
market value and A recognizes no gain or loss on the sale.
(2) Example 2--(i) Facts. In 2019, taxpayer A realizes $100 of
eligible gain and contributes $100 to a QOF partnership, X, in
exchange for a qualifying QOF partnership interest in X, and
taxpayer B contributes $100 of eligible gain to another QOF
partnership, Y, in exchange for a qualifying QOF partnership
interest in Y. In 2021, in transactions governed by section 721(a),
A contributes her qualifying QOF partnership interest in X, and B
contributes her qualifying QOF partnership interest in Y, to a newly
formed partnership, UTP. In 2024, C receives a profits interest in
UTP for services that she will provide to UTP. In 2031, X sells a
non-inventory asset and allocates X's distributive share of the gain
to UTP. No distributions are ever made from X, Y, or UTP.
(ii) Analysis. On December 31, 2026, UTP recognizes $170 of
remaining deferred gain relating to the QOF interests. Of that gain,
A is allocated the $85 of gain relating to the $100 of eligible gain
that she invested in X, and B is allocated the $85 of gain relating
to the $100 of eligible gain that she invested in Y. C recognizes no
gain at this time. In 2031, because UTP's holding period in X
includes A's holding period in X, UTP has a holding period in X that
exceeds 10 years, and may make an election under Sec. 1.1400Z2(c)-
1(b)(2)(ii)(A) to exclude the gain from X's asset sale. Even though
A was the original investor in X, she may not make the election. If
UTP makes the election, UTP will exclude its distributive share of
gain from the sale of the X asset.
(3) Example 3--(i) Facts. In 2019, taxpayer B invests $100 in P,
a QOF partnership, in exchange for a qualifying investment and
properly makes an election under section 1400Z-2(a) to defer $100 of
eligible gain. B's interest in the partnership is 50 percent. In
2030, when B's interest in P has a value of $130 and a basis of
$100, B sells the interest, recognizing $30 of gain, $15 of which is
attributable to inventory assets of P. B makes an election under
section 1400Z-2(c) with respect to the sale.
(ii) Analysis. Because B's election under section 1400Z-2(c) is
in effect with respect to the sale, the bases of B's interest in P
and of P's assets with respect to the interest sold are adjusted to
fair market value immediately before B's sale under paragraph
(b)(2)(i) of this section, and B recognizes no gain or loss on the
sale.
(4) Example 4--(i) Facts. The facts are the same as in paragraph
(d)(3) of this section (Example 3), except that P sells qualified
opportunity zone property that is not inventory sold in the ordinary
course of business and distributes all of the proceeds from the sale
to partners within 90 days of the sale (the qualified opportunity
zone property was the only property sold by P in the taxable year).
The sold property has a value of $60 and a basis of $40. P
recognizes $20 of gain, $10 of which is allocable to B, and B makes
an election under paragraph (b)(2)(ii)(A) of this section for the
year in which B's allocable share of the partnership's recognized
gain would be included in B's gross income.
(ii) Analysis. Because B's election under paragraph
(b)(2)(ii)(A) of this section is in effect, B will exclude its
entire $10 allocable share of the partnership's $20 of recognized
gain. Because $10 of the sale proceeds were actually distributed to
B within 90 days of the sale, P is not treated as making a deemed
distribution and receiving a recontribution under paragraph
(b)(2)(ii)(B) of this section with respect to B.
(5) Example 5--(i) Facts. In 2019, taxpayer C invests $100 in Q,
a QOF partnership, in exchange for a qualifying investment and
properly makes an election under section 1400Z-2(a) to defer $100 of
eligible gain. C's interest in Q is 50%. Q's taxable year ends on
December 31. In 2025, Q purchases three qualified opportunity zone
properties, X, Y, and Z. On January 22, 2031, Q sells property X for
$200, recognizing $140 of gain. On July 31, 2031, Q sells property Y
for $80, recognizing $20 of loss. Q makes no distributions to its
partners in 2031, has no indebtedness, and has no other gain or loss
other than from the sales of properties X and Y. Property Z has a
value of $280 at all times throughout 2031. C's share of Q's gain
and loss is $70 and $10, respectively, for a net gain of $60, and C
makes an election under paragraph (b)(2)(ii)(A) of this section to
exclude the gains and losses from its income.
(ii) Analysis. Because C has made an election under paragraph
(b)(2)(ii)(A) of this section, under paragraph (b)(2)(ii)(B) of this
section, C is treated as receiving a cash distribution of $140 from
Q, C's share of the net proceeds from the sales of properties X and
Y, on December 31, 2031, and immediately recontributing $140 to Q in
exchange for a non-qualifying investment in Q. Beginning on January
1, 2032, 50 percent of A's interest in Q is a qualifying investment,
and 50 percent of A's investment in Q is a non-qualifying
investment. This amount is calculated as a fraction, the numerator
of which is $140, the amount deemed distributed and recontributed,
and the denominator of which is $280, the value of C's interest
prior to the deemed distribution.
(6) Example 6--(i) Facts. The facts are the same as in paragraph
(d)(5) of this section (Example 5), except that Q distributes all of
the proceeds from the sale of property X to its partners on March
30, 2031. Q does not make any distribution of proceeds from the sale
of property Y.
(ii) Analysis. Under paragraph (b)(2)(iii)(B)(2)(ii) of this
section, the actual distribution of cash to C on March 30, 2031,
reduces the amount of the deemed distribution and recontribution
with respect to C on December 31, 2031. Accordingly, the amount of
C's deemed distribution and recontribution is $40, which increases
C's non-qualifying investment to 22 percent. This amount is
calculated as a fraction, the numerator of which is $40, the amount
deemed distributed and recontributed, and the denominator of which
is $180, the value of C's interest.
(7) Example 7. Section 301(c)(3) gain--(i) Facts. In 2020,
taxpayer X makes an investment in Q, a QOF corporation, in exchange
for a qualifying investment. In 2031, when X's qualifying Q stock is
worth $1000x, Q makes a distribution to X with respect to X's
qualifying QOF stock, $500x of which is treated as gain from a sale
or exchange under section 301(c)(3). In 2032, X disposes of all of
its qualifying QOF stock in Q.
(ii) Analysis--(A) Section 301(c)(3) distribution. X is eligible
to make an election described in section 1400Z-2(c) in 2031 with
respect to its $500x gain. Under paragraph (b)(3)(ii) of this
section, the basis adjustment is $500x, the lesser of $500x, the
amount of
[[Page 1977]]
the distribution treated as gain from the sale or exchange of
property, and $1000x, the fair market value of the qualifying QOF
stock before the distribution. As a result of the election, X
increases its basis in its qualifying QOF stock in Q by $500x
immediately before the distribution; consequently, the $500x is
treated as a return of basis under section 301(c)(2).
(B) Disposition of qualifying QOF stock. X is eligible to make
an election described in section 1400Z-2(c) in 2032 with respect to
all of its qualifying QOF stock in Q, notwithstanding X's receipt of
a section 301(c)(3) distribution in 2031. See paragraph (b)(1)(iv)
of this section.
(e) Capital gain dividends paid by a QOF RIC or QOF REIT that some
shareholders may be able to elect to receive tax free under section
1400Z-2(c)--(1) Eligibility. For purposes of paragraph (b) of this
section, if a shareholder of a QOF RIC or QOF REIT receives a capital
gain dividend identified with a date, as defined in paragraph (e)(2) of
this section, then, to the extent that the shareholder's shares in the
QOF RIC or QOF REIT paying the capital gain dividend are a qualifying
investment in the QOF RIC or QOF REIT--
(i) The shareholder may treat the capital gain dividend, or part
thereof, as gain from the sale or exchange of a qualifying investment
on the date that the QOF RIC or QOF REIT identified with the dividend;
and
(ii) If, on the date identified, the shareholder had held that
qualifying investment in the QOF RIC or QOF REIT for at least 10 years,
then the shareholder may exclude that capital gain dividend, or part
thereof, from its taxable income for the taxable year.
(2) Definition of capital gain dividend identified with a date. A
capital gain dividend identified with a date means an amount of a
capital gain dividend, as defined in section 852(b)(3)(C) or
857(b)(3)(B), or part thereof, and a date that the QOF RIC reports or
QOF REIT designates in a notice provided to the shareholder not later
than one week after the QOF RIC reports or QOF REIT designates the
capital gain dividend pursuant to section 852(b)(3)(C) or 857(b)(3)(B).
The notice must be mailed to the shareholder unless the shareholder has
provided the QOF RIC or QOF REIT with an email address to be used for
this purpose. In the manner and at the time determined by the
Commissioner, the QOF RIC or QOF REIT must provide the Commissioner all
data that the Commissioner specifies with respect to the amounts of
capital gain dividends and the dates reported or designated by the QOF
RIC or QOF REIT for each shareholder.
(3) General limitations on the amounts of capital gain with which a
date may be identified--(i) No identification in the absence of any
capital gains with respect to qualified opportunity zone property. If,
during its taxable year, the QOF RIC or QOF REIT did not recognize
long-term capital gain on any sale or exchange of qualified opportunity
zone property, then no date may be identified with any capital gain
dividends, or parts thereof, with respect to that year.
(ii) Proportionality. Reportings and designations of capital gain
dividends identified with a date must be proportional for all capital
gain dividends paid with respect to the taxable year. See section
857(g)(2). Greater than de minimis violation of proportionality
invalidates all of the purported identifications for a taxable year.
(iii) Undistributed capital gains. If section 852(b)(3)(D)(i) or
857(b)(3)(C)(i) requires a shareholder of a QOF RIC or QOF REIT to
include a reported or designated amount in the shareholder's long-term
capital gain for a taxable year, then inclusion of this amount in this
manner is treated as receipt of a capital gain for purposes of this
paragraph (e) and may be identified with a date.
(iv) Gross gains. The amount determined under paragraph (e)(4) of
this section is determined without regard to any losses that may have
been recognized on other sales or exchanges of qualified opportunity
zone property. The losses do, however, limit the total amount of
capital gain dividends that may be reported or designated under section
852(b)(3) or section 857(b)(3).
(4) Determination of the amount of capital gain with which a date
may be identified. A QOF RIC or QOF REIT may choose to identify the
date for an amount of capital gain in one of the following manners:
(i) Simplified determination. If, during its taxable year, the QOF
RIC or QOF REIT recognizes long-term capital gain on one or more sales
or exchanges of qualified opportunity zone property, then the QOF RIC
or QOF REIT may identify the first day of that taxable year as the date
identified with each reported or designated amount with respect to the
capital gain dividends for that taxable year. A reported or designated
identification is invalid in its entirety if the amount of gains that
the QOF RIC or QOF REIT identifies with that date exceeds the aggregate
long-term capital gains recognized on those sales or exchanges for that
taxable year.
(ii) Sale date determination--(A) In general. If, during its
taxable year, the QOF RIC or QOF REIT recognizes long-term capital gain
on one or more sales or exchanges of qualified opportunity zone
property, then the QOF RIC or QOF REIT may identify capital gain
dividends, or a part thereof, with the latest date on which there was
such a recognition. The amount of capital gain dividends so identified
must not exceed the aggregate long-term capital gains recognized on
that date from sales or exchanges of qualified opportunity zone
property. A reported or designated identification is invalid in its
entirety if the amount of gains that the QOF RIC or QOF REIT identifies
with that date violates the preceding sentence.
(B) Iterative application. The process described in paragraph
(e)(4)(ii)(A) of this section is applied iteratively to increasingly
earlier transaction dates (from latest to earliest) until all capital
gain dividends are identified with dates or there are no earlier dates
in the taxable year on which the QOF RIC or QOF REIT recognized long-
term capital gains with respect to a sale or exchange of qualified
opportunity zone property, whichever comes first.
(f) Applicability dates. The provisions of this section are
applicable for taxable years beginning after March 13, 2020.
0
Par. 6. Section 1.1400Z2(d)-1 is added to read as follows:
Sec. 1.1400Z2 (d)-1 Qualified opportunity funds and qualified
opportunity zone businesses.
(a) Overview. This section provides rules that an eligible entity
(as defined in paragraph (a)(1) of this section) must satisfy to be a
qualified opportunity fund (QOF) or a qualified opportunity zone
business. Paragraphs (a)(2) through (4) of this section provide rules
that eligible entities must follow to be certified as QOFs, as well as
rules for the de-certification of QOFs. Paragraph (b) of this section
provides rules for determining whether the property held by a QOF
satisfies the 90-percent investment standard of section 1400Z-2(d)(1)
or the property held by a qualified opportunity zone business satisfies
the 70-percent tangible property standard of section 1400Z-
2(d)(3)(A)(i). Paragraph (c) of this section provides rules regarding
qualified opportunity zone property that a QOF must hold to satisfy the
90-percent investment standard. Paragraph (d) of this section provides
rules that an eligible entity must satisfy to be a qualified
opportunity zone business that is owned, in whole or in part, by one or
more QOFs. Paragraph (e) of this section provides applicability dates
for this section. See Sec. 1.1400Z2(d)-2 for rules that must be
satisfied for tangible property of an eligible entity to be
[[Page 1978]]
treated as qualified opportunity zone business property.
(1) Eligible entity--(i) In general. Except as provided in
paragraph (a)(1)(ii) of this section, the term eligible entity means an
entity that is classified as a corporation or partnership for Federal
income tax purposes. In order to be treated as a QOF, an eligible
entity must self-certify on an annual basis that it satisfies the
requirements of paragraphs (b) and (c) of this section, as appropriate.
An eligible entity is a qualified opportunity zone business if it
satisfies the requirements of paragraph (d) of this section.
(ii) Exceptions based on where an entity is created, formed, or
organized--(A) QOFs. An entity classified as a corporation or
partnership for Federal income tax purposes (an entity) but that is not
organized under the law of the United States or the law of one of the
50 states, a government of a federally recognized tribe (Indian tribal
government), the District of Columbia, or a U.S. territory, is not an
eligible entity and is ineligible to be a QOF. An entity described in
the preceding sentence is also ineligible to be a qualified opportunity
zone business, and therefore an equity interest in the entity is
neither qualified opportunity zone stock nor a qualified opportunity
zone partnership interest for purposes of section 1400Z-2(d)(2).
(B) Entities organized in a U.S. territory--(1) In general. If an
entity is organized in a U.S. territory but not in one of the 50 States
or the District of Columbia, the entity may be a QOF only if the entity
is organized for investing in qualified opportunity zone property that
relates to a trade or business operated in the U.S. territory in which
the entity is organized. If an entity is organized in a U.S. territory
but not in one of the 50 States or the District of Columbia, an equity
interest in the entity may be qualified opportunity zone stock or a
qualified opportunity zone partnership interest, as the case may be,
only if the entity conducts a qualified opportunity zone business in
the U.S. territory in which the entity is organized. An entity
described in the preceding sentence is treated as satisfying the
requirement, as applicable, of being a domestic corporation for
purposes of section 1400Z-2(d)(2)(B)(i) or of being a domestic
partnership for purposes of section 1400Z-2(d)(2)(C).
(2) U.S. territory defined. For purposes of this paragraph (a)(1),
the term U.S. territory means American Samoa, Guam, the Commonwealth of
the Northern Mariana Islands, the Commonwealth of Puerto Rico, the U.S.
Virgin Islands, and any other territory not under the jurisdiction of
one of the 50 States, an Indian tribal government, or the District of
Columbia where a qualified opportunity zone has been designated under
section 1400Z-1.
(iii) Pre-existing entities. There is no legal barrier to a pre-
existing eligible entity qualifying as a QOF or a qualified opportunity
zone business, but the pre-existing eligible entity must satisfy all of
the applicable requirements of section 1400Z-2, this section, and Sec.
1.1400Z2(d)-2.
(2) Self-certification as a QOF. The following rules apply to the
required self-certification of an eligible entity as a QOF:
(i) Time, form, and manner. The self-certification must be timely-
filed and effected annually in such form and manner as may be
prescribed by the Commissioner of Internal Revenue (Commissioner) in
the Internal Revenue Service (IRS) forms or instructions, or in
publications or guidance published in the Internal Revenue Bulletin
(see Sec. Sec. 601.601(d)(2) and 601.602 of this chapter).
(ii) First taxable year. The self-certification must identify the
first taxable year for which the self-certification takes effect.
(iii) First month. The self-certification may identify the first
month (in that initial taxable year) in which the self-certification
takes effect.
(A) Failure to specify first month. If the self-certification fails
to specify the month in the initial taxable year that the self-
certification takes effect, then the self-certification is treated as
taking effect in the first month of that taxable year.
(B) Investments before entity's first month as QOF not eligible for
deferral. If an investment in eligible interests of an eligible entity
occurs prior to the eligible entity's first month as a QOF, any
election under section 1400Z-2(a)(1) made for that investment is
invalid and the investment is a non-qualifying investment.
(iv) Becoming a QOF in a month that is not the first month of the
taxable year. This paragraph (a)(2)(iv) applies to an eligible entity
if its self-certification as a QOF is first effective for a month that
is not the first month of that entity's taxable year.
(A) For purposes of applying section 1400Z-2(d)(1)(A) and (B) in
the first year of the QOF's existence, the phrase first six-month
period of the taxable year of the fund means the first six months each
of which is in the taxable year and in each of which the entity is a
QOF. Thus, if an eligible entity becomes a QOF in the seventh or later
month of a 12-month taxable year, the 90-percent investment standard in
section 1400Z-2(d)(1) takes into account only the QOF's assets on the
last day of the QOF's taxable year.
(B) The computation of any penalty under section 1400Z-2(f)(1) does
not take into account any months before the first month in which an
eligible entity is a QOF.
(3) Self-decertification of a QOF. If a QOF chooses to self-
decertify as a QOF, the following rules apply:
(i) Form and manner. The self-decertification must be effected in
such form and manner as may be prescribed by the Commissioner in IRS
forms or instructions or in publications or guidance published in the
Internal Revenue Bulletin (see Sec. Sec. 601.601(d)(2) and 601.602 of
this chapter).
(ii) Time. The self-decertification becomes effective at the
beginning of the month following the month specified by the taxpayer,
which month must not be earlier than the month in which the taxpayer
files its self-decertification as provided in paragraph (a)(3)(i) of
this section.
(4) [Reserved]
(b) Valuation of property for purposes of the 90-percent investment
standard and the 70-percent tangible property standard--(1) In general.
An eligible entity may value its owned or leased property using the
valuation methods provided in paragraphs (b)(3) and (4) of this section
to determine whether--
(i) In the case of an eligible entity that has self-certified as a
QOF, the assets owned or leased by the QOF satisfy the 90-percent
investment standard in section 1400Z-2(d)(1); and
(ii) In the case of an eligible entity that has issued qualified
opportunity zone partnership interests or qualified opportunity zone
stock to a QOF, the tangible property owned or leased by the eligible
entity satisfies the 70-percent tangible property standard in section
1400Z-2(d)(3)(A)(i).
(2) Special rules--(i) QOFs--(A) In general. To meet the 90-percent
investment standard in section 1400Z-2(d)(1), on a semiannual basis, a
QOF may value its assets using the applicable financial statement
valuation method set forth in paragraph (b)(3) of this section, if the
QOF has an applicable financial statement within the meaning of Sec.
1.475(a)-4(h), or the alternative valuation method set forth in
paragraph (b)(4) of this section. During each taxable year, a QOF must
apply consistently the valuation method that it selects under paragraph
(b) of this section to all assets valued with respect to the taxable
year.
(B) Option for QOFs to disregard recently contributed property. A
QOF
[[Page 1979]]
may choose to determine compliance with the 90-percent investment
standard by excluding from both the numerator and denominator of the
test any property that satisfies all the criteria in paragraphs
(b)(2)(i)(B)(1) through (3) of this section. A QOF need not be
consistent from one semiannual test to another in whether it avails
itself of the option in this paragraph (b)(2)(i)(B).
(1) The amount of the property was received by the QOF partnership
as a contribution or by the QOF corporation solely in exchange for
stock of the corporation;
(2) The contribution or exchange occurred not more than 6 months
before the test from which it is being excluded; and
(3) Between the date of the fifth business day after the
contribution or exchange and the date of the semiannual test, the
amount was held continuously in cash, cash equivalents, or debt
instruments with a term of 18 months or less.
(C) Safe harbor for QOFs to determine whether equity in an entity
is qualified opportunity zone property. A QOF may choose to determine
compliance with the 90-percent investment standard for each semiannual
testing date of the QOF by including in both the numerator and
denominator of the test the equity of each entity the QOF holds on that
testing date that satisfies all the criteria in paragraph
(b)(2)(i)(C)(1) or (2) of this section.
(1) The entity was a qualified opportunity zone business for at
least 90 percent of the QOF's cumulative holding period for that equity
of the entity--
(i) Beginning on the date the QOF's self-certification as a QOF is
first effective; and
(ii) Ending on the last day of the entity's most recent taxable
year ending on or before the semiannual testing date of the QOF.
(2) An entity that would not be a qualified opportunity zone
business as of the end of its last taxable year ending on or before a
semiannual testing date of the QOF is a qualified opportunity zone
business with respect to the QOF for that taxable year of the entity
if--
(i) A cure is achieved for the entity under paragraph (d)(6) of
this section; and
(ii) The QOF files its Federal income tax return for the taxable
year of the QOF containing the testing date on a date that is timely
(taking extensions into account) and that is not later than when that
cure is achieved.
(ii) Qualified opportunity zone businesses--(A) In general. For
purposes of the fraction set forth in paragraph (d)(2)(ii)(A) of this
section, the owned or leased tangible property of a qualified
opportunity zone business may be valued using the applicable financial
statement valuation method set forth in paragraph (b)(3) of this
section, if the qualified opportunity zone business has an applicable
financial statement within the meaning of Sec. 1.475(a)-4(h), or the
alternative valuation method set forth in paragraph (b)(4) of this
section. During each taxable year, the valuation method selected under
this paragraph (b) must be applied consistently to all tangible
property valued with respect to the taxable year.
(B) Five-percent zone taxpayer. If a taxpayer both has self-
certified as a QOF and holds an equity interest in an eligible entity
that is tested as a qualified opportunity zone business, then that
taxpayer may value the eligible entity's tangible property for purposes
of satisfying the 70-percent tangible property standard using the same
valuation methodology under this paragraph (b) that the taxpayer uses
for determining its own compliance with the 90-percent investment
standard (compliance methodology), provided that no other equity holder
in the eligible entity is a five-percent zone taxpayer. If two or more
taxpayers that have self-certified as QOFs hold equity interests in the
eligible entity and at least one of them is a five-percent zone
taxpayer, then the values of the eligible entity's tangible property
may be calculated using the compliance methodology that both is used by
a five-percent zone taxpayer and that produces the highest percentage
of qualified opportunity zone business property for the eligible entity
for purposes of the 70-percent tangible property standard. A five-
percent zone taxpayer is a taxpayer that has self-certified as a QOF
and that holds stock in the entity (if it is a corporation)
representing at least 5 percent in voting rights and value or holds an
interest of at least 5 percent in the profits and capital of the entity
(if it is a partnership).
(1) Example. The example in paragraph (b)(2)(ii)(B)(2) of this
section illustrates the principles of paragraph (b)(2)(ii)(B) of this
section.
(2) Example. Entity JH is a corporation that has issued only one
class of stock and that conducts a trade or business. Taxpayer X
holds 94% of the JH stock, and Taxpayer Y holds the remaining 6% of
that stock. (Thus, both X and Y are five percent zone taxpayers
within the meaning of paragraph (b)(2)(ii)(B) of this section.) JH
does not have an applicable financial statement, and, for that
reason, a determination of whether JH is conducting a qualified
opportunity zone business may employ the compliance methodology of X
or Y. X and Y use different compliance methodologies permitted under
paragraph (b)(2)(i)(A) of this section for purposes of satisfying
the 90-percent investment standard of section 1400Z-2(d)(1). Under
X's compliance methodology (which is based on X's applicable
financial statement), 65% of the tangible property owned or leased
by JH's trade or business is qualified opportunity zone business
property. Under Y's compliance methodology (which is based on Y's
cost), 73% of the tangible property owned or leased by JH's trade or
business is qualified opportunity zone business property. Because
Y's compliance methodology would produce the higher percentage of
qualified opportunity zone business property for JH (73%), both X
and Y may use Y's compliance methodology to value JH's owned or
leased tangible property. If JH's trade or business satisfies all
additional requirements in section 1400Z-2(d)(3), the trade or
business is a qualified opportunity zone business. Thus, if all of
the additional requirements in section 1400Z-2(d)(2)(B) are
satisfied, stock in JH is qualified opportunity zone stock in the
hands of a taxpayer that has self-certified as a QOF.
(iii) Inventory. In determining whether the 90-percent investment
standard in section 1400Z-2(d)(1) or the 70-percent tangible property
standard in section 1400Z-2(d)(3)(A)(i) is satisfied, an eligible
entity may choose to exclude from both the numerator and denominator of
the applicable test the value of all inventory (including raw
materials) of the trade or business, if applied consistently within a
taxable year of the eligible entity.
(3) Applicable financial statement valuation method--(i) In
general. Under the applicable financial statement valuation method set
forth in this paragraph (b)(3), the value of each property that is
owned or leased by an eligible entity is the value of that asset as
reported on the eligible entity's applicable financial statement for
the relevant reporting period.
(ii) Requirement for selection of method. An eligible entity may
select the applicable financial statement valuation method set forth in
this paragraph (b)(3) to value an asset leased by the eligible entity
only if the applicable financial statement of the eligible entity is
prepared according to U.S. generally accepted accounting principles
(GAAP) and requires an assignment of value to the lease of the asset.
(4) Alternative valuation method--(i) In general. Under the
alternative valuation method set forth in this paragraph (b)(4), the
value of the property owned by an eligible entity is calculated under
paragraph (b)(4)(ii) of this section, and the value of the property
leased by an eligible entity is
[[Page 1980]]
calculated under paragraph (b)(4)(iii) of this section.
(ii) Property owned by an eligible entity--(A) Property purchased
or constructed. The value of each property owned by an eligible entity
that is acquired by purchase for fair market value or constructed for
fair market value is the eligible entity's unadjusted cost basis of the
asset under section 1012 or section 1013.
(B) Other property. The value of each item of property owned by an
eligible entity that is not purchased or constructed for fair market
value is the item of property's fair market value, determined on the
last day of the first 6 month period of the taxable year and on the
last day of the taxable year.
(iii) Property leased by an eligible entity--(A) In general. The
value of each property that is leased by an eligible entity is equal to
the present value of the leased property as defined in paragraph
(b)(4)(iii)(C) of this section.
(B) Discount rate. For purposes of calculating present value under
paragraph (b)(4)(iii) of this section, the discount rate is the short-
term applicable Federal rate under section 1274(d)(1), based on
semiannual compounding, for the month in which the eligible entity
enters into the lease. For purposes of the preceding sentence, the
three month rule in section 1274(d)(2) does not apply to determine the
applicable Federal rate.
(C) Present value. For purposes of paragraph (b)(4)(iii) of this
section, present value of a leased property--
(1) Is equal to the sum of the present values of each payment under
the lease for the property;
(2) Is calculated at the time the eligible entity enters into the
lease for the property; and
(3) Once calculated, is used as the value for the property by the
eligible entity for all testing dates during the term of the lease for
purposes of the 90-percent investment standard or the 70-perecent
tangible property standard.
(D) Term of a lease. For purposes of paragraph (b)(4)(iii) of this
section, the term of a lease includes periods during which the lessee
may extend the lease at a pre-defined market rate rent. For
nonresidential real property or residential real property, pre-defined
rent does not include the option to renew at fair market value,
determined at the time of renewal. The terms of the pre-defined rent
must satisfy the following criteria:
(1) General rule. The terms of the pre-defined rent are market rate
(that is, the terms of the pre-defined rent reflect common, arms-length
market pricing in the locale that includes the qualified opportunity
zone as determined under section 482 and all section 482 regulations in
this chapter) at the time the lease is entered into.
(2) Rebuttable presumption regarding leases not between related
persons. There will be a rebuttable presumption that the terms of the
extension of the lease are market rate for leases not between related
persons (within the meaning of section 1400Z-2(e)(2)), and thus, the
parties to the lease are not required to perform a section 482
analysis.
(3) Exception for state, local, and Indian tribal governments. For
purposes of this paragraph (b)(4)(iii)(D), 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 person.
(c) Qualified opportunity zone property--(1) In general. Pursuant
to section 1400Z-2(d)(2)(A), the following property is qualified
opportunity zone property:
(i) Qualified opportunity zone stock as defined in paragraph (c)(2)
of this section;
(ii) Qualified opportunity zone partnership interest as defined in
paragraph (c)(3) of this section; and
(iii) Qualified opportunity zone business property as defined in
Sec. 1.1400Z2(d)-2.
(2) Qualified opportunity zone stock--(i) In general. Except as
provided in paragraph (c)(2)(ii) of this section, if an eligible entity
is classified as a corporation for Federal income tax purposes
(corporation), then an equity interest (stock) in the eligible entity
is qualified opportunity zone stock if the requirements described in
this paragraph (c)(2)(i) are satisfied:
(A) Date of acquisition. The stock is acquired by a QOF after
December 31, 2017, at its original issue (directly or through an
underwriter) from the corporation solely in exchange for cash;
(B) Qualified opportunity zone business. As of the time the stock
was issued, the corporation was a qualified opportunity zone business
as defined in section 1400Z-2(d)(3) and paragraph (d) of this section
(or, in the case of a new corporation, the corporation was being
organized for purposes of being such a qualified opportunity zone
business); and
(C) 90-percent qualified opportunity zone property holding period--
(1) Cumulative holding period test. During at least 90 percent of the
QOF's holding period for the corporation's stock, determined on a
cumulative basis in accordance with paragraph (c)(2)(i)(C)(2) of this
section, the corporation qualified as a qualified opportunity zone
business.
(2) Semiannual qualified opportunity zone business test. For
purposes of determining satisfaction of the cumulative 90-percent
qualified opportunity zone property holding period test described in
paragraph (c)(2)(i)(C)(1) of this section, the determination of whether
a corporation engaged in a trade or business qualifies as a qualified
opportunity zone business is made by the QOF on a semiannual basis
pursuant to section 1400Z-2(d)(1). However, a QOF may choose to apply
the safe harbor rule in paragraph (b)(2)(i)(C) of this section to make
this determination.
(ii) Redemptions of stock. Pursuant to section 1400Z-
2(d)(2)(B)(ii), the following rules apply for purposes of determining
whether stock in a corporation qualifies as qualified opportunity zone
stock:
(A) Redemptions from taxpayer or related person. Stock acquired by
a QOF is not treated as qualified opportunity zone stock if, at any
time during the 4-year period beginning on the date 2 years before the
issuance of the stock, the corporation issuing the stock purchased
either directly or indirectly any of its stock from the QOF or from a
person related (within the meaning of section 1400Z-2(e)(2)) to the
QOF. Even if the purchase occurs after the issuance, the stock was
never qualified opportunity zone stock.
(B) Significant redemptions--(1) In general. Stock issued by a
corporation is not treated as qualified opportunity zone stock if, at
any time during the 2-year period beginning on the date one year before
the issuance of the stock, the corporation made one or more purchases
of more than a de minimis amount of its stock and the purchased stock
has an aggregate value (as of the time of the respective purchases)
exceeding 5 percent of the aggregate value of all of its stock as of
the beginning of the 2-year period. The aggregate value is determined
as of the time of the stock purchases. Even if one or more of the
disqualifying purchases occurs after the issuance, the stock was never
qualified opportunity zone stock.
(2) De minimis amount. For purposes of this paragraph
(c)(2)(ii)(B), stock acquired from the taxpayer or a related person
exceeds a de minimis amount only if the aggregate amount paid for the
stock exceeds $10,000 and more than 2 percent of the stock held by the
taxpayer and related persons (within the meaning of section 1400Z-
2(e)(2)) is acquired. The rules in the following sentences of this
paragraph (c)(2)(ii)(B)(2) apply for purposes of determining whether
the 2-
[[Page 1981]]
percent limit is exceeded. The percentage of stock acquired in any
single purchase is determined by dividing the stock's value (as of the
time of purchase) by the value (as of the time of purchase) of all
stock held (directly or indirectly) by the taxpayer and related persons
immediately before the purchase. The percentage of stock acquired in
multiple purchases is the sum of the percentages determined for each
separate purchase.
(C) Treatment of certain transactions. If any transaction is
treated under section 304(a) as a distribution in redemption of the
stock of any corporation, for purposes of paragraphs (c)(2)(ii)(A) and
(B) of this section, that corporation is treated as purchasing an
amount of its stock equal to the amount that is treated as such a
distribution under section 304(a).
(D) Principles of Sec. 1.1202-2(c) and (d). The principles of
Sec. 1.1202-2(c) and (d) apply in determining whether stock is
redeemed or purchased for purposes of paragraph (c)(2)(ii) of this
section.
(iii) Reorganizations of corporations otherwise qualifying as
qualified opportunity zone businesses--(A) Qualification as qualified
opportunity zone stock. Stock that meets all of the requirements of
paragraph (c)(2)(i) of this section except for the requirement in
paragraph (c)(2)(i)(A) of this section is qualified opportunity zone
stock if it is received solely in exchange for qualified opportunity
zone stock in a transaction described in section 381(a)(2). The
requirements in paragraphs (c)(2)(i)(B) and (C) of this section must be
met with respect to both the stock held before such transaction and the
stock for which it is exchanged in such transaction.
(B) Satisfaction of original use and substantial improvement tests.
The requirements of Sec. 1.1400Z2(d)-2 apply to property of a
qualified opportunity zone business acquired from a qualified
opportunity zone business in a transaction described in section
381(a)(2) as if the acquiring corporation had held the property during
the period in which the target corporation held the property. For
example, an item of property must be substantially improved by the same
date by which the target corporation was required to satisfy the
substantial improvement test for such property.
(C) Reorganizations of qualified opportunity zone businesses within
a consolidated group. See Sec. Sec. 1.1502-14Z and 1.1504-3 for
special rules applicable to consolidated groups.
(3) Qualified opportunity zone partnership interest--(i) In
general. If an eligible entity is classified as a partnership for
Federal tax purposes (partnership), any capital or profits interest
(partnership interest) in the eligible entity is a qualified
opportunity zone partnership interest if--
(A) Date of acquisition. The partnership interest is acquired by a
QOF after December 31, 2017, from the partnership solely in exchange
for cash;
(B) Qualified opportunity zone business. As of the time the
partnership interest was acquired, the partnership was a qualified
opportunity zone business as defined in section 1400Z-2(d)(3) and
paragraph (d) of this section (or, in the case of a new partnership,
the partnership was being organized for purposes of being a qualified
opportunity zone business); and
(C) 90-percent qualified opportunity zone property holding period--
(1) Cumulative holding period test. During at least 90-percent of the
QOF's holding period for the partnership interest, determined on a
cumulative basis in accordance with paragraph (c)(3)(i)(C)(2) of this
section, the partnership qualified as a qualified opportunity zone
business.
(2) Semiannual qualified opportunity zone business test. For
purposes of determining satisfaction of the cumulative 90-percent
qualified opportunity zone property holding period test described in
paragraph (c)(3)(i)(C)(1) of this section, the determination of whether
a partnership engaged in a trade or business qualifies as a qualified
opportunity zone business is made by the QOF on a semiannual basis
pursuant to section 1400Z-2(d)(1). However, a QOF may choose to apply
the safe harbor rule in paragraph (b)(2)(i)(C) of this section to make
this determination.
(ii) Reorganizations of partnerships otherwise qualifying as
qualified opportunity zone businesses--(A) Qualification as a qualified
opportunity zone partnership interest. A partnership interest that
meets all of the requirements of paragraph (c)(3)(i) of this section
except for the requirement in paragraph (c)(3)(i)(A) of this section is
a qualified opportunity zone partnership interest if it is received
solely in exchange for a qualified opportunity zone partnership
interest in a merger or consolidation transaction described in section
708(b)(2)(A). The requirements in paragraphs (c)(3)(i)(B) and (C) of
this section must be met with respect to both the partnership interest
held before the transaction and the partnership interest for which it
is exchanged in the transaction.
(B) Satisfaction of original use and substantial improvement tests.
The requirements of Sec. 1.1400Z2(d)-2 apply to property of a
qualified opportunity zone business acquired from a qualified
opportunity zone business in a transaction described in section
708(b)(2)(A) as if the resulting partnership had held the property
during the period in which the merging or consolidating partnership
held the property. For example, an item of property must be
substantially improved by the same date by which the merging or
consolidating partnership was required to satisfy the substantial
improvement test for such property.
(d) Qualified opportunity zone business--(1) In general. An
eligible entity engaged in a trade or business within the meaning of
section 162 is a qualified opportunity zone business if the entity
satisfies, as determined at the end of its taxable year, all the
criteria in paragraphs (d)(1)(i) through (iii) of this section. An
eligible entity's status as a qualified opportunity zone business
applies for the entire taxable year of the entity.
(i) Pursuant to section 1400Z-2(d)(3)(A)(i), the eligible entity
engaged in the trade or business satisfies the 70-percent tangible
property standard with respect to its tangible property, as provided in
paragraph (d)(2) of this section;
(ii) Pursuant to section 1400Z-2(d)(3)(A)(ii), the eligible entity
engaged in the trade or business satisfies the requirements of section
1397C(b)(2), (4), and (8), as provided in paragraph (d)(3) of this
section; and
(iii) Pursuant to section 1400Z-2(d)(3)(A)(iii), the eligible
entity engaged in the trade or business is not described in section
144(c)(6)(B) as provided in paragraph (d)(4) of this section.
(2) Satisfaction of 70-percent tangible property standard--(i) In
general. A trade or business of an eligible entity satisfies the 70-
percent tangible property standard if at least 70 percent of the
tangible property owned or leased by the trade or business is qualified
opportunity zone business property (as defined in Sec. 1.1400Z2(d)-2).
(ii) Calculating percent of tangible property owned or leased in a
trade or business--(A) In general. Whether a trade or business of the
eligible entity satisfies the 70-percent tangible property standard set
forth in paragraph (d)(2)(i) of this section is determined by a
fraction--
(1) The numerator of which is the total value of all tangible
property owned or leased by the qualified opportunity zone business
that is qualified opportunity zone business property; and
[[Page 1982]]
(2) The denominator of which is the total value of all tangible
property owned or leased by the qualified opportunity zone business,
whether located inside or outside of a qualified opportunity zone.
(B) Valuation. See paragraph (b)(2)(ii) of this section for rules
regarding the valuation of tangible property for purposes of the 70-
percent tangible property standard.
(3) Operation of section 1397C requirements adopted by reference--
(i) Gross income requirement. Section 1400Z-2(d)(3)(A)(ii) incorporates
section 1397C(b)(2), requiring that for each taxable year at least 50
percent of the gross income of a qualified opportunity zone business is
derived from the active conduct of a trade or business in the qualified
opportunity zone (or in multiple qualified opportunity zones). A trade
or business meets the 50-percent gross income requirement in the
preceding sentence if the trade or business satisfies any one of the
four criteria described in paragraph (d)(3)(i)(A), (B), (C), or (D) of
this section, or any criteria identified in published guidance issued
by the Commissioner under Sec. 601.601(d)(2) of this chapter.
(A) Services performed in qualified opportunity zone based on
hours. At least 50 percent of the services performed for the trade or
business are performed in a qualified opportunity zone, determined by
the fraction described in paragraphs (d)(3)(i)(A)(1) and (2) of this
section. Amounts paid to partners that provide services to the trade or
business of a partnership are taken into account in the numerator and
denominator set forth in paragraphs (d)(3)(i)(A)(1) and (2) of this
section only to the extent the amounts paid to the partners are
guaranteed payments for services provided to the partnership within the
meaning of section 707(c).
(1) The numerator of the fraction is the total number of hours of
services performed for the trade or business in a qualified opportunity
zone during the taxable year by employees, partners that provide
services to a partnership, independent contractors, and employees of
independent contractors; and
(2) The denominator of the fraction is the total number of hours of
services performed for the trade or business during the taxable year by
employees, partners that provide services to a partnership, independent
contractors, and employees of independent contractors.
(B) Services performed in qualified opportunity zone based on
amounts paid for services. At least 50 percent of the services
performed for the trade or business are performed in a qualified
opportunity zone, determined by the fraction described in paragraphs
(d)(3)(i)(B)(1) and (2) of this section. Amounts paid to partners that
provide services to the trade or business of a partnership are taken
into account in the numerator and denominator set forth in paragraphs
(d)(3)(i)(B)(1) and (2) of this section only to the extent the amounts
paid to the partners are guaranteed payments for services provided to
the partnership within the meaning of section 707(c).
(1) The numerator of the fraction is the total amount paid by the
entity for services performed in a qualified opportunity zone during
the taxable year, whether by employees, partners that provide services
to a partnership, independent contractors, or employees of independent
contractors; and
(2) The denominator of the fraction is the total amount paid by the
entity for services performed during the taxable year, whether by
employees, partners that provide services to a partnership, independent
contractors, or employees of independent contractors.
(C) Necessary tangible property and business functions. The
tangible property of the trade or business located in a qualified
opportunity zone and the management or operational functions performed
in a qualified opportunity zone are each necessary for the generation
of at least 50 percent of the gross income of the trade or business.
(D) Facts and circumstances. Based on all the facts and
circumstances, at least 50 percent of the gross income of a qualified
opportunity zone business is derived from the active conduct of a trade
or business in a qualified opportunity zone.
(E) Examples. The following examples illustrate the principles of
paragraphs (d)(3)(i)(C) and (D) of this section.
(1) Example 1. A landscaping business has its headquarters in a
qualified opportunity zone, its officers and employees manage the
daily operations of the business (inside and outside the qualified
opportunity zone) from its headquarters, and all its equipment and
supplies are stored in the headquarters facilities. The activities
occurring and the storage of equipment and supplies in the qualified
opportunity zone are, taken together, necessary for the generation
of the income of the business.
(2) Example 2. A trade or business is formed or organized under
the laws of the jurisdiction within which a qualified opportunity
zone is located, and the business has a P.O. Box located in the
qualified opportunity zone. The mail received at that P.O. Box is
fundamental to the income of the trade or business, but there is no
other basis for concluding that the income of the trade or business
is derived from activities in the qualified opportunity zone. The
mere location of the P.O. Box is not necessary for the generation of
gross income by the trade or business.
(3) Example 3. In 2019, Taxpayer X realized $w million of
capital gains and within the 180-day period invested $w million in
QOF Y, a qualified opportunity fund. QOF Y immediately acquired from
partnership P a partnership interest in P, solely in exchange for $w
million of cash. P is a real estate developer that has written plans
to acquire land in a qualified opportunity zone on which it plans to
construct a commercial building for lease to other trades or
businesses. In 2023, P's commercial building is placed in service
and is fully leased up to other trades or businesses. For the 2023
taxable year, at least 50 percent of P's gross income is derived
from P's rental of its tangible property in the qualified
opportunity zone. Thus, under P's facts and circumstances, P
satisfies the gross income test under section 1397C(b)(2).
(ii) Use of intangible property requirement--(A) In general.
Section 1400Z-2(d)(3)(A)(ii) incorporates section 1397C(b)(4),
requiring that, with respect to any taxable year, a substantial portion
of the intangible property of a qualified opportunity zone business is
used in the active conduct of a trade or business in a qualified
opportunity zone. For purposes of section 1400Z-2(d)(3)(A)(ii) and the
preceding sentence, the term substantial portion means at least 40
percent.
(B) Use of intangible property. For purposes of section 1400Z-
2(d)(3)(A)(ii) and paragraph (d)(3)(ii)(A) of this section, intangible
property of a qualified opportunity zone business is used in the active
conduct of a trade or business in a qualified opportunity zone if--
(1) The use of the intangible property is normal, usual, or
customary in the conduct of the trade or business; and
(2) The intangible property is used in the qualified 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.
(iii) Active conduct of a trade or business--(A) Operating real
property. Solely for purposes of section 1400Z-2(d)(3)(A), the
ownership and operation (including leasing) of real property is the
active conduct of a trade or business.
(B) Lessee is responsible for certain costs. Merely entering into a
triple-net-lease with respect to real property owned by a taxpayer does
not constitute the active conduct of a trade or business by such
taxpayer.
(C) Examples. The following examples illustrate the rules of
paragraph (d)(3)(iii) of this section.
[[Page 1983]]
(1) Example 1. Mere triple-net-lease not active conduct of trade
or business--(i) Facts. Company N constructs and places into service
a new, three-story office building in a qualified opportunity zone
and leases the entire building to tenant X, an unrelated person,
which uses the building as office space for its software development
firm. This building is the only property owned by Company N. The
lease agreement between Company N and tenant X is a triple-net-lease
under which tenant X is responsible for all of the costs relating to
the office building (for example, paying all taxes, insurance, and
maintenance expenses) in addition to paying rent. Company N also
maintains an office in the building with staff members to address
any issues that may arise with respect to the triple-net-lease.
(ii) Analysis. Solely for purposes of section 1400Z-2(d)(3)(A),
Company N is treated as not engaged in the active conduct of a trade
or business with respect to the leased office building. Company N
leases the building to tenant X under a triple-net-lease, and
therefore the employees of Company N do not meaningfully participate
in the management or operations of the building. The fact that
Company N maintains an office in the leased building with staff
members to address any issues that may arise with respect to the
triple-net-lease does not alter this result. Therefore, Company N
does not conduct an active trade or business in a qualified
opportunity zone.
(2) Example 2. Triple-net-lease and managerial and operational
activities can constitute active conduct of trade or business--(i)
Facts. Company N constructs and places into service a new, three-
story mixed-use building in a qualified opportunity zone and leases
a floor to each of unrelated tenants X, Y, and Z, respectively. This
building is the only property owned by Company N. The lease
agreement between Company N and tenant X is a triple-net-lease under
which tenant X is responsible for all of the costs relating to the
third floor of the building (for example, paying all such taxes,
insurance, and maintenance expenses) in addition to paying rent. The
lease agreement between Company N and tenant Y is not a triple-net-
lease and employees of Company N manage and operate the second floor
of the building. Likewise, the lease agreement between Company N and
tenant Z is not a triple-net-lease and employees of Company N manage
and operate the first floor of the building. Company N maintains an
office in the building, which the employees regularly use to carry
out their managerial and operational duties with respect to the
first and second floors, and address any other issues that may arise
with respect to the three leases.
(ii) Analysis. Solely for purposes of section 1400Z-2(d)(3)(A),
Company N is treated as engaged in the active conduct of a trade or
business with respect to the leased mixed-use building. While
Company N leases the third floor of the building to tenant X merely
under a triple-net-lease, and therefore the employees of Company N
do not meaningfully participate in the management or operations of
that floor, the employees of Company N meaningfully participate in
the management and operations of the first and second floors of the
leased building. Therefore, in carrying out the overall leasing
business of Company N with respect to the mixed-use building,
employees of Company N conduct meaningful managerial and operational
activities. As a result, Company N conducts an active trade or
business in a qualified opportunity zone.
(iv) Nonqualified financial property limitation. Section 1400Z-
2(d)(3)(A)(ii) incorporates section 1397C(b)(8), which requires that in
each taxable year less than 5 percent of the average of the aggregate
unadjusted bases of the property of a qualified opportunity zone
business is attributable to nonqualified financial property. Section
1397C(e)(1), which defines the term nonqualified financial property for
purposes of section 1397C(b)(8), excludes from that term reasonable
amounts of working capital held in cash, cash equivalents, or debt
instruments with a term of 18 months or less (working capital assets)
and debt instruments described in section 1221(a)(4).
(v) Safe harbor for reasonable amount of working capital. Solely
for purposes of applying section 1397C(e)(1) to the definition of a
qualified opportunity zone business under section 1400Z-2(d)(3),
working capital assets are treated as reasonable in amount for purposes
of sections 1397C(b)(2) and 1400Z-2(d)(3)(A)(ii), if all of the
requirements in paragraphs (d)(3)(v)(A) through (C) of this section are
satisfied.
(A) Designated in writing. These amounts are designated in writing
for the development of a trade or business in a qualified opportunity
zone (as defined in section 1400Z-1(a)), including when appropriate the
acquisition, construction, and/or substantial improvement of tangible
property in such a zone.
(B) Reasonable written schedule. There is a written schedule
consistent with the ordinary start-up of a trade or business for the
expenditure of the working capital assets. Under the schedule, the
working capital assets must be spent within 31 months of the receipt by
the business of the assets.
(C) Property consumption consistent. The working capital assets are
actually used in a manner that is substantially consistent with the
writing and written schedule described in paragraphs (d)(3)(v)(A) and
(B) of this section. If consumption of the working capital assets is
delayed by waiting for governmental action the application for which is
complete, that delay does not cause a failure of this paragraph
(d)(3)(v)(C).
(D) Federally declared disasters. If the qualified opportunity zone
business is located in a qualified opportunity zone within a federally
declared disaster (as defined in section 165(i)(5)(A)), the qualified
opportunity zone business may receive up to an additional 24 months to
consume its working capital assets, as long as it otherwise meets the
requirements of paragraph (d)(3)(v) of this section.
(E) Ability of a single business to benefit from more than a single
application of the safe harbor. A business may benefit from multiple
overlapping or sequential applications of the working capital safe
harbor, provided that each application independently satisfies all of
the requirements in paragraphs (d)(3)(v)(A) through (C) of this
section.
(F) Ability of tangible property to benefit from more than a single
application of the safe harbor. Tangible property may benefit for an
additional 31-month period, for a total of 62 months, in the form of
multiple overlapping or a sequential application of the working capital
safe harbor, provided that each application independently satisfies all
of the requirements in paragraphs (d)(3)(v)(A) through (C) of this
section, the working capital assets from an expiring 31-month period
were expended in accordance with the requirements in paragraphs
(d)(3)(v)(A) through (C) of this section, and the subsequent infusions
of working capital assets form an integral part of the plan covered by
the initial working capital safe harbor period. An overlapping or
sequential application of the working capital safe harbor must include
a substantial amount of working capital assets (which may include debt
instruments described in section 1221(a)(4)).
(G) Examples. The following examples illustrate the rules of
paragraph (d)(3)(v) of this section.
(1) Example 1. General application of working capital safe
harbor--(i) Facts. QOF F creates a domestic C corporation E to open
a fast-food restaurant and acquires almost all of the equity of E in
exchange for cash. E has a written plan and a 20-month schedule for
the use of this cash to establish the restaurant. Among the planned
uses for the cash are identification of favorable locations in the
qualified opportunity zone, leasing a building suitable for such a
restaurant, outfitting the building with appropriate equipment and
furniture (both owned and leased), necessary security deposits,
obtaining a franchise and local permits, and the hiring and training
of kitchen and wait staff. Not-yet-disbursed amounts were held in
assets described in section 1397C(e)(1), and these assets were
eventually expended in a manner consistent with the plan and
schedule.
[[Page 1984]]
(ii) Analysis. E's use of the cash qualifies for the working
capital safe harbor described in paragraph (d)(3)(v) of this
section.
(2) Example 2. Multiple applications of working capital safe
harbor--(i) Facts. QOF G creates a domestic C corporation H to start
a new technology company and acquires equity of H in exchange for
cash on Date 1. In addition to H's rapid deployment of capital
received from other equity investors, H writes a plan with a 30-
month schedule for the use of the Date 1 cash. The plan describes
use of the cash to research and develop a new technology
(Technology), including paying salaries for engineers and other
scientists to conduct the research, purchasing, and leasing
equipment to be used in research and furnishing office and
laboratory space. Approximately 18 months after Date 1, on Date 2, G
acquires additional equity in H for cash, and H writes a second
plan. This new plan has a 25-month schedule for the development of a
new application of existing software (Application), to be marketed
to government agencies. Among the planned uses for the cash received
on Date 2 are paying development costs, including salaries for
software engineers, other employees, and third-party consultants to
assist in developing and marketing the new application to the
anticipated customers. Not-yet-disbursed amounts that were scheduled
for development of the Technology and the Application were held in
assets described in section 1397C(e)(1), and these assets were
eventually expended in a manner substantially consistent with the
plans and schedules for both the Technology and the Application.
(ii) Analysis. H's use of both the cash received on Date 1 and
the cash received on Date 2 qualifies for the working capital safe
harbor described in paragraph (d)(3)(v) of this section.
(3) Example 3. General application of working capital safe
harbor--(i) Facts. In 2019, Taxpayer H realized $w million of
capital gains and within the 180-day period invested $w million in
QOF T, a qualified opportunity fund. QOF T immediately acquired from
partnership P a partnership interest in P, solely in exchange for $w
million of cash. P immediately placed the $w million in working
capital assets, which remained in working capital assets until used.
P had written plans to acquire land in a qualified opportunity zone
on which it planned to construct a commercial building. Of the $w
million, $x million was dedicated to the land purchase, $y million
to the construction of the building, and $z million to ancillary but
necessary expenditures for the project. The written plans provided
for purchase of the land within a month of receipt of the cash from
QOF T and for the remaining $y and $z million to be spent within the
next 30 months on construction of the building and on the ancillary
expenditures. All expenditures were made on schedule, consuming the
$w million. During the taxable years that overlap with the first 31-
month period, P had no gross income other than that derived from the
amounts held in those working capital assets. Prior to completion of
the building, P's only assets were the land it purchased, the
unspent amounts in the working capital assets, and P's work in
process as the building was constructed.
(ii) Analysis--P met the three requirements of the safe harbor
provided in paragraphs (d)(3)(v)(A) through (C) of this section. P
had a written plan to spend the $w received from QOF T for the
acquisition, construction, and/or substantial improvement of
tangible property in a qualified opportunity zone, as defined in
section 1400Z-1(a). P had a written schedule consistent with the
ordinary start-up for a business for the expenditure of the working
capital assets. And, finally, P's working capital assets were
actually used in a manner that was substantially consistent with its
written plan and the ordinary start-up of a business. First, the $x
million, the $y million, and the $z million are treated as
reasonable in amount for purposes of sections 1397C(b)(2) and 1400Z-
2(d)(3)(A)(ii). Second, because P had no other gross income during
the 31 months at issue, 100 percent of P's gross income during that
time is treated as derived from an active trade or business in the
qualified opportunity zone for purposes of satisfying the 50-percent
test of section 1397C(b)(2). Third, for purposes of satisfying the
requirement of section 1397C(b)(4), during the period of land
acquisition and building construction a substantial portion of P's
intangible property is treated as being used in the active conduct
of a trade or business in the qualified opportunity zone. Fourth,
all of the facts described are consistent with QOF T's interest in P
being a qualified opportunity zone partnership interest for purposes
of satisfying the 90-percent investment standard in section 1400Z-
2(d)(1).
(iii) Analysis if P had purchased an existing building. The
conclusions would also apply if P's plans had been to buy and
substantially improve a pre-existing commercial building. In
addition, the fact that P's basis in the building has not yet
doubled would not cause the building to fail to satisfy section
1400Z-2(d)(2)(D)(i)(III).
(vi) Safe harbor for gross income derived from the active conduct
of business. Solely for purposes of applying the 50-percent test in
section 1397C(b)(2) to the definition of a qualified opportunity zone
business in section 1400Z-2(d)(3), if any gross income is derived from
property that paragraph (d)(3)(v) of this section treats as a
reasonable amount of working capital, then that gross income is counted
toward satisfaction of the 50-percent test.
(vii) Safe harbor for use of intangible property. Solely for
purposes of applying the use requirement in section 1397C(b)(4) to the
definition of a qualified opportunity zone business under section
1400Z-2(d)(3), intangible property purchased or licensed by the trade
or business, pursuant to the reasonable written plan with a written
schedule for the expenditure of the working capital, satisfies the use
requirement during any period in which the business is proceeding in a
manner that is substantially consistent with paragraphs (d)(3)(v)(A)
through (C) of this section.
(viii) Safe harbor for property on which working capital is being
expended--(A) In general. If paragraph (d)(3)(v) of this section treats
property that would otherwise be nonqualified financial property as
being a reasonable amount of working capital because of compliance with
the three requirements of paragraphs (d)(3)(v)(A) through (C) of this
section and if the tangible property referred to in paragraph
(d)(3)(v)(A) is expected to satisfy the requirements of section 1400Z-
2(d)(2)(D)(i) as a result of the planned expenditure of those working
capital assets, then tangible property purchased, leased, or improved
by the trade or business, pursuant to the written plan for the
expenditure of the working capital assets, is treated as qualified
opportunity zone business property satisfying the requirements of
section 1400Z-2(d)(2)(D)(i), during that and subsequent working capital
periods the property is subject to, for purposes of the 70-percent
tangible property standard in section 1400Z-2(d)(3).
(B) Example. Multiple applications of working capital safe
harbor to tangible property--(i) Facts. B also borrows cash and
forms a domestic C corporation B to develop a large mixed-use real
estate development that will consist of commercial and residential
real property, owning almost all of the equity of B in exchange for
cash. QOF A has a master written plan for the completion of the
commercial and residential real property over a 55 month period. The
plan provides that the commercial real property will be completed
over a 30 month schedule and subsequently, the residential real
property will be completed over a 25 month schedule. The plan
further provides that a portion of the commercial real property is
unable to be used in a trade or business after the completion of the
commercial real property since that portion of the commercial real
property will be unusable during the residential construction phase.
Pursuant to B's original master plan for the completion of the real
estate development, QOF A acquires additional equity in B for cash
after the completion of the commercial development phase, and B
commences use of those working capital assets for residential
development phase.
(ii) Analysis. B's use of the cash for the commercial and
residential phase qualified for the working capital safe harbor
described in paragraph (d)(3)(v) of this section. In addition, all
of B's commercial real property developed pursuant to B's original
master plan is treated as qualified opportunity zone business
property under paragraph (d)(3)(viii) of this section.
(ix) Real property straddling a qualified opportunity zone. For
purposes of satisfying the requirements in this paragraph (d)(3) in the
case of
[[Page 1985]]
real property that straddles a qualified opportunity zone, a qualified
opportunity zone is the location of services, tangible property, or
business functions if--
(A) The trade or business uses the portion of the real property
located within a qualified opportunity zone in carrying out its
business activities;
(B) The trade or business uses the real property located outside of
a qualified opportunity zone in carrying out its business activities;
(C) The amount of the real property located within a qualified
opportunity zone is substantial compared to the amount of real property
located outside of a qualified opportunity zone; and
(D) The real property located in the qualified opportunity zone is
contiguous to part, or all, of the real property located outside of the
qualified opportunity zone.
(E) In general, one of the two methods in paragraph
(d)(3)(ix)(E)(1) and (2) of this section may be chosen to determine
whether the amount of real property located in the qualified
opportunity zone is substantial compared to the amount of real property
located outside the qualified opportunity zone.
(1) Square footage test. If the amount of real property based on
square footage located within the qualified opportunity zone is greater
than the amount of real property based on square footage outside of the
qualified opportunity zone, and the real property outside of the
qualified opportunity zone is contiguous to part or all of the real
property located inside the qualified opportunity zone, then all of the
property is deemed to be located within a qualified opportunity zone.
The test in this paragraph (d)(3)(ix)(E)(1) is carried out at the time
at which the subject real property is acquired.
(2) Unadjusted cost test. If the unadjusted cost of the real
property located inside a qualified opportunity zone is greater than
the unadjusted cost of the real property outside the qualified
opportunity zone, and the real property outside of the qualified
opportunity zone is contiguous to all or part of the real property
located inside the qualified opportunity zone, then all of the property
is deemed to be located within a qualified opportunity zone. The
unadjusted cost basis of property acquired as a single tract is
presumed to be allocated on the basis of the square footage of the
property. The test in this paragraph (d)(3)(ix)(E)(2) is carried out at
the time at which the subject real property is acquired.
(F) For purposes of the two tests described in paragraph
(d)(3)(ix)(E)(1) and (2) of this section, two or more tracts or parcels
of land are contiguous if they share common boundaries or would share
common boundaries but for the interposition of a road, street,
railroad, stream or similar property. Tracts or parcels of land which
touch only at a common corner are not contiguous.
(x) Example. The following example illustrates the rules of
paragraph (d)(3) of this section--
(A) Facts. In 2019, Taxpayer H realized $w million of capital
gains and within the 180-day period invested $w million in QOF T, a
qualified opportunity fund. QOF T immediately acquired from
partnership P a partnership interest in P, solely in exchange for $w
million of cash. P immediately placed the $w million in working
capital assets, which remained in working capital assets until used.
P had written plans to acquire land in a qualified opportunity zone
on which it planned to construct a commercial building. Of the $w
million, $x million was dedicated to the land purchase, $y million
to the construction of the building, and $z million to ancillary but
necessary expenditures for the project. The written plans provided
for purchase of the land within a month of receipt of the cash from
QOF T and for the remaining $y and $z million to be spent within the
next 30 months on construction of the building and on the ancillary
expenditures. All expenditures were made on schedule, consuming the
$w million. During the taxable years that overlap with the first 31-
month period, P had no gross income other than that derived from the
amounts held in those working capital assets. Prior to completion of
the building, P's only assets were the land it purchased, the
unspent amounts in the working capital assets, and P's work in
process as the building was constructed.
(B) Analysis--(1) P met the three requirements of the safe
harbor provided in paragraph (d)(3)(v) of this section. P had a
written plan to spend the $w received from QOF T for the
acquisition, construction, and/or substantial improvement of
tangible property in a qualified opportunity zone, as defined in
section 1400Z-1(a). P had a written schedule consistent with the
ordinary start-up for a business for the expenditure of the working
capital assets. And, finally, P's working capital assets were
actually used in a manner that was substantially consistent with its
written plan and the ordinary start-up of a business. Therefore, the
$x million, the $y million, and the $z million are treated as
reasonable in amount for purposes of sections 1397C(b)(2) and 1400Z-
2(d)(3)(A)(ii).
(2) Because P had no other gross income during the 31 months at
issue, 100 percent of P's gross income during that time is treated
as derived from an active trade or business in the qualified
opportunity zone for purposes of satisfying the 50-percent test of
section 1397C(b)(2).
(3) For purposes of satisfying the requirement of section
1397C(b)(4), during the period of land acquisition and building
construction a substantial portion of P's intangible property is
treated as being used in the active conduct of a trade or business
in the qualified opportunity zone.
(4) All of the facts described are consistent with QOF T's
interest in P being a qualified opportunity zone partnership
interest for purposes of satisfying the 90-percent investment
standard in section 1400Z-2(d)(1).
(C) Analysis if P had purchased an existing building. The
conclusions in paragraph (d)(3)(x)(B) of this section would also
apply if P's plans had been to buy and substantially improve a pre-
existing commercial building. In addition, the fact that P's basis
in the building has not yet doubled would not cause the building to
fail to satisfy section 1400Z-2(d)(2)(D)(i)(III).
(4) Trade or businesses described in section 144(c)(6)(B) not
eligible--(i) Pursuant to section 1400Z-2(d)(3)(A)(iii), the following
trades or businesses, and businesses leasing more than a de minimis
amount of property to the following trades or businesses, cannot
qualify as a qualified opportunity zone business:
(A) Any private or commercial golf course;
(B) Country club;
(C) Massage parlor;
(D) Hot tub facility;
(E) Suntan facility;
(F) Racetrack or other facility used for gambling; or
(G) Any store the principal business of which is the sale of
alcoholic beverages for consumption off premises.
(ii) De minimis amounts of gross income attributable to a business
described in section 144(c)(6)(B) will not cause a trade or business to
fail to be a qualified opportunity zone business.
(iii) The term de minimis amount of property, used in paragraph
(d)(4)(i) of this section, means less than 5 percent of the net
rentable square feet for real property and less than 5 percent of the
value for all other tangible property. The term de minimis amount of
gross income, used in paragraph (d)(4)(ii) of this section, means less
than 5 percent of the gross income of the qualified opportunity zone
business may be attributable to the types of business described in
section 144(c)(6)(B).
(iv) The following examples illustrate the rules of paragraph
(d)(4) of this section:
(A) Example 1. Entity A is a QOF that meets the requirements of
section 1400Z-2(d)(1). Entity A owns qualified opportunity zone
stock in a domestic corporation described in section 1400Z-
2(d)(2)(B), which operates a hotel located in a qualified
opportunity zone that qualifies as a trade or business. As part of
that trade or business, the hotel operates a spa that provides
massages and other therapies. Less than 5 percent of the hotel's
total gross income is
[[Page 1986]]
attributable to the spa, and less than 5 percent of the net rentable
square feet for real property and less than 5 percent of the value
for all other tangible property is attributable to the spa. As a
result, the operation of the spa, which is a business described in
section 144(c)(6)(B), will not prevent the operation of the hotel
from qualifying as a qualified opportunity zone business.
(B) Example 2--(1) Facts. Entity B is a qualified opportunity
zone business that meets the requirements of section 1400Z-2(d)(3).
Entity B plans to acquire a commercial golf course that consists of
land and other related buildings and equipment in a qualified
opportunity zone, that will satisfy each requirement for qualified
opportunity zone business property set forth in section 1400Z-
2(d)(2)(D). Instead of directly managing and operating the
commercial golf course business, Entity B will lease the land and
other related buildings and equipment to a third party to manage and
operate the commercial golf course. The leased real property
represents more than 5 percent of the net rentable square feet of
Entity B's real property and the leased and other tangible property
represents more than 5 percent of the value for all other tangible
property of Entity B.
(2) Analysis. Because a golf course is prohibited from being a
qualified trade or business under section 1400Z-2(d)(3)(A)(iii), the
leasing arrangement will cause Entity B to fail to be a qualified
opportunity zone business regardless of the satisfaction of each
requirement set forth in section 1400Z-2(d)(2)(D).
(C) Example 3--(1) Facts. Entity B meets the explicit
requirements of section 1400Z-2(d)(1) and has certified itself as a
QOF. Entity B owns a commercial golf course that consists of land
and other related buildings and equipment in a qualified opportunity
zone, and the land and buildings satisfy all explicit requirements
(in section 1400Z-2(d)(2)(D)) to be qualified opportunity zone
business property. Entity B manages and operates the commercial golf
course business, but does not manage or operate any other trade or
business not described in section 144(c)(6)(B) (listing businesses
not eligible to be a qualified opportunity zone business pursuant to
section 1400Z-2(d)(3)(A)(iii)). Entity B chose to operate the
commercial golf course through Entity B, rather than through a
qualified opportunity zone business, in order to avoid the
requirement in section 1400Z-2(d)(3)(A)(iii), which provides that a
qualified opportunity zone business cannot operate a commercial golf
course due to the inclusion of that trade or business in section
144(c)(6)(B).
(2) Analysis. The ownership and operation of the golf course at
the QOF level will not disqualify the QOF because the prohibition on
businesses described in section 144(c)(6)(B) is not applicable at
the QOF level. In addition, if each requirement set forth in section
1400Z-2(d)(2)(D) is satisfied, the property used in the commercial
golf course will qualify as qualified opportunity zone business
property held by Entity B for purposes of section 1400Z-2(d)(2)(A).
(5) Tangible property of a qualified opportunity zone business that
ceases to be qualified opportunity zone business property. For
qualified opportunity zone businesses, tangible property that ceases to
be qualified opportunity zone business property shall continue to be
treated as qualified opportunity zone business property for the lesser
of five years after the date on which such tangible property ceases to
be so qualified or the date on which such tangible property is no
longer held by the qualified opportunity zone business. However,
tangible property is not eligible for the benefits provided in this
paragraph (d)(5) unless the tangible property ceasing to qualify as
qualified opportunity zone business property was qualified opportunity
zone business property used by a qualified opportunity zone business in
a qualified opportunity zone for two years. For purposes of this
paragraph (d)(5), tangible property purchased, leased, or improved by a
trade or business, that is treated as satisfying the requirements of
section 1400Z-2(d)(2)(D)(i) during that working capital safe harbor
period pursuant to paragraph (d)(3)(v) of this section or that 30-month
substantial improvement period described in Sec. 1.1400Z2(d)-2(b)(4),
is not treated as used by a qualified opportunity zone business in a
qualified opportunity zone for any portion of the two year period
described in this paragraph (d)(5).
(6) Cure period for qualified opportunity zone businesses. (i) For
purposes of the 90-percent qualified opportunity zone business holding
period requirements set forth in sections 1400Z-2(d)(2)(B)(i)(III),
1400Z-2(d)(2)(C)(iii), and 1400Z-2(d)(2)(D)(i)(III), if a trade or
business causes the QOF to fail the 90-percent investment standard on a
semiannual testing date, the QOF may treat the stock or partnership
interest in that business as qualified opportunity zone property for
that semiannual testing date provided the business corrects the failure
within 6 months of the date on which the stock or partnership interest
lost its qualification.
(ii) If the failure occurs on the last testing date of the taxable
year, the six-month cure period described in paragraph (d)(6)(i) of
this section is available to the QOF only if the QOF files a valid
application for an extension of time to file its tax return.
(iii) Each QOF is permitted only one correction pursuant to
paragraph (d)(6) of this section. If the entity, at the end of the
additional six-month cure period, fails to qualify as a qualified
opportunity zone business, then the QOF becomes subject to the penalty
under section 1400Z-2(f)(1) for each month the entity failed to qualify
as a qualified opportunity zone business beginning with the first month
following the last month that the QOF met the 90-percent investment
standard.
(e) Applicability dates--(1) In general. The provisions of this
section are applicable for taxable years beginning after March 13,
2020.
(2) Prior periods. With respect to 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, a taxpayer may choose either--
(i) To apply the section 1400Z-2 regulations, if applied in a
consistent manner for all such taxable years; or
(ii) To rely on the rules in proposed Sec. 1.1400Z2(d)-1 contained
in the notice of proposed rulemaking (REG-115420-18) published on
October 29, 2018, as amplified by the notice of proposed rulemaking
(REG-120186-18) published on May 1, 2019, but only if applied in a
consistent manner for all such taxable years.
0
Par. 7. Section 1.1400Z2(d)-2 is added to read as follows:
Sec. 1.1400Z2(d)-2 Qualified opportunity zone business property.
(a) Qualified opportunity zone business property--(1) In general.
This section provides rules for determining whether owned or leased
tangible property held by an eligible entity (within the meaning of
Sec. 1.1400Z2(d)-1(a)(1)) is qualified opportunity zone business
property within the meaning of section 1400Z-2(d)(2)(D). Paragraph
(a)(2) of this section provides general requirements that tangible
property must satisfy to be qualified opportunity zone business
property. Paragraph (b) of this section provides rules related to owned
tangible property. Paragraph (c) of this section provides rules related
to leased tangible property (that is, tangible property that the
eligible entity acquires by lease from a lessor). Paragraph (d) of this
section provides rules related to the 90-percent qualified opportunity
zone business property holding period requirement and the 70-percent
use test of section 1400Z-2(d)(2)(D)(i)(III). Paragraph (e) of this
section provides the dates of applicability of this section.
(2) Qualified opportunity zone business property requirements. The
term qualified opportunity zone business property means tangible
property owned or leased by an eligible entity (as defined in Sec.
1.1400Z2(d)-1(a)(1)) that--
(i) Is used by the eligible entity in a trade or business within
the meaning of section 162; and
[[Page 1987]]
(ii) Satisfies the requirements of paragraphs (b), (c), and (d) of
this section, as applicable.
(b) Tangible property owned by an eligible entity--(1) Purchase
requirement--(i) In general. In the case of tangible property that is
owned by an eligible entity, the tangible property must be acquired by
the eligible entity after December 31, 2017, by purchase as defined by
section 179(d)(2) from a person that is not a related person within the
meaning of section 1400Z-2(e)(2) (providing that persons are related to
each other if such persons are described in section 267(b) or section
707(b)(1), determined by substituting ``20 percent'' for ``50 percent''
each place it appears in such sections).
(ii) Plan, intent, or expectation for seller to repurchase acquired
property. In the case of real property that is purchased by an eligible
entity, if, at the time of the purchase, there was a plan, intent, or
expectation for the acquired real property to be repurchased by the
seller of the real property for an amount of consideration other than
the fair market value of the real property, determined at the time of
the repurchase by the seller, the purchased real property is not
qualified opportunity zone business property.
(iii) Property manufactured, constructed, or produced for use in a
qualified opportunity zone--(A) In general. In the case of tangible
property manufactured, constructed, or produced by an eligible entity,
if the property is manufactured, constructed, or produced for use by an
eligible entity with the intent to use such property in a trade or
business in a qualified opportunity zone, then such property satisfies
the requirements of paragraph (b)(1)(i) of this section if the
manufacture, construction, or production begins after December 31,
2017. The materials and supplies used to manufacture, construct, or
produce qualified opportunity zone business property by the eligible
entity must also be qualified opportunity zone business property.
(B) Time when manufacture, construction or production considered to
begin. For purposes of paragraph (b)(1)(iii) of this section, the
acquisition date of such property is the date on which the manufacture,
construction, or production of property (as defined in paragraph
(b)(1)(iii) of this section) begins. The manufacture, construction, or
production of property begins when physical work of a significant
nature begins. Physical work does not include preliminary activities
such as planning or designing, securing financing, exploring or
researching. The determination of when physical work of a significant
nature begins depends on the facts and circumstances. For example, if a
factory is to be constructed on-site, construction begins when physical
work of a significant nature commences at the site; this could occur,
for example, when work begins on the excavation of footings, or the
pourings of pads for the factory. Preliminary work, such as clearing or
testing of soil condition, does not constitute the beginning of
construction.
(C) Safe harbor. For purposes of paragraph (b)(1)(iii)(B) of this
section, a taxpayer may choose to determine when physical work of a
significant nature begins in accordance with this paragraph
(b)(1)(iii)(C). Physical work of a significant nature will not be
considered to begin before the taxpayer incurs or pays more than 10
percent of the total cost of the property (excluding the cost of any
land and preliminary activities such as planning or designing, securing
financing, exploring, or researching).
(2) Original use or substantial improvement requirement--(i) In
general. In the case of tangible property owned by the eligible entity
either--
(A) The original use of the owned tangible property in the
qualified opportunity zone, within the meaning of paragraph (b)(3) of
this section, must commence with the eligible entity; or
(B) The eligible entity must substantially improve the owned
tangible property within the meaning of paragraph (b)(4) of this
section (which defines substantial improvement in this context).
(ii) Inventory. Inventory (including raw materials) of a trade or
business produced by an eligible entity after December 31, 2017, is
deemed to satisfy the requirements set forth in paragraphs (b)(1) and
(b)(2)(i) of this section.
(3) Original use of tangible property acquired by purchase--(i)
Original use--(A) In general. For purposes of paragraph (b)(2) of this
section, the original use of tangible property in a qualified
opportunity zone commences on the date any person first places the
property in service in the qualified opportunity zone for purposes of
depreciation or amortization, or first uses it in a manner that would
allow depreciation or amortization if that person were the property's
owner.
(B) Commencement of original use of vacant property. For purposes
of this paragraph (b)(3), if real property, including land and
buildings, has been vacant for an uninterrupted period of at least one
calendar year beginning on a date prior to the date on which the
qualified opportunity zone in which the property is located is listed
as a designated qualified opportunity zone in a QOZ designation notice
and the property has remained vacant through the date on which the
property was purchased by the eligible entity, or if the property has
been vacant for an uninterrupted three calendar year period beginning
on a date after the date of publication of the QOZ designation notice
that lists as designated the qualified opportunity zone in which the
property is located and the property has remained vacant through the
date on which the property was purchased by the eligible entity,
original use in the qualified opportunity zone commences on the date
after that period when any person first so uses or places the property
in service in the qualified opportunity zone. Such property must
satisfy the definition of vacancy under paragraph (b)(3)(iii) of this
section.
(C) Used tangible property. Used tangible property satisfies the
original use requirement if the property has not been previously so
used or placed in service in the qualified opportunity zone. If the
tangible property had been so used or placed in service in the
qualified opportunity zone before it is acquired by purchase, it must
be substantially improved in order to satisfy the requirements of
section 1400Z-2(d)(2)(D)(i)(II).
(D) Example. The following example illustrates the principles of
paragraph (b)(3)(i)(A) of this section.
(1) Facts. On January 1, 2019, QOF A purchases from a developer
a newly constructed hotel building located in a qualified
opportunity zone for $10 million. The developer purchased a parcel
of land in that qualified opportunity zone, and constructed the
hotel building thereon, with the intent and expectation to sell the
building to a QOF. As of the time of the purchase, the developer had
not placed the hotel building in service in the qualified
opportunity zone for purposes of depreciation. Other than the
original use requirement, assume that the hotel building satisfies
all requirements under section 1400Z-2(d)(2)(D). In addition, assume
that, at the time of the purchase, the developer had no plan,
intent, or expectation to repurchase the hotel building.
(2) Analysis. At the time of QOF A's purchase of the hotel
building, the original use of the hotel building had not commenced
because the developer had not yet placed the hotel building into
service for purposes of depreciation in a qualified opportunity
zone. See paragraph (b)(3)(i)(A) of this section. Therefore, the
original use of the hotel building in the qualified opportunity zone
in which the building is located is treated as commencing with QOF
A. See paragraph (b)(3)(i)(A) of this section. As a result, the
hotel building purchased by QOF A is treated as satisfying the
original use requirement of section 1400Z-2(d)(2)(D)(i)(II).
[[Page 1988]]
(ii) Lessee improvements to leased property. Improvements made by a
lessee to leased property satisfy the original use requirement in
section 1400Z-2(d)(2)(D)(i)(II) as purchased property for the amount of
the unadjusted cost basis under section 1012 of such improvements.
(iii) Vacancy. Solely for purposes of meeting the requirements of
section 1400Z-2, real property, including land and buildings, is
considered to be in a state of vacancy if the property is significantly
unused. A building or land will be considered significantly unused if
more than 80 percent of the building or land, as measured by the square
footage of useable space, is not currently being used.
(iv) Brownfield sites. An eligible entity that purchases a parcel
of land that is a brownfield site, as defined by section 101 of the
Comprehensive Environmental Response, Compensation, and Liability Act
of 1980 (42 U.S.C. 9601) (brownfield site), may treat all property
composing the brownfield site (including the land and structures
thereon) as satisfying the original use requirement of section 1400Z-
2(d)(2)(D)(i)(II), if, within a reasonable period, the eligible entity
makes investments in the brownfield site to ensure that all property
composing the brownfield site meets basic safety standards for both
human health and the environment.
(v) Property involuntarily transferred to local government. An
eligible entity that purchases real property from a local government
that the local government holds as the result of an involuntary
transfer (including through abandonment, bankruptcy, foreclosure, or
receivership) may treat all property composing the real property
(including the land and structures thereon) as satisfying the original
use requirement of section 1400Z-2(d)(2)(D)(i)(II).
(4) Substantial improvement of tangible property acquired by
purchase--(i) In general. Except as provided in paragraph (b)(4)(iv) of
this section, for purposes of paragraph (b)(2) of this section,
tangible property is treated as substantially improved by an eligible
entity only if it meets the requirements of section 1400Z-
2(d)(2)(D)(ii) during the 30-month substantial improvement period. The
property has been substantially improved when the additions to basis of
the property in the hands of the QOF exceed an amount equal to the
adjusted basis of such property at the beginning of such 30-month
period in the hands of the QOF (substantial improvement requirement).
(ii) Treatment of property in the 30-month substantial improvement
period. For purposes of the 90-percent investment standard under
section 1400Z-2(d)(1), 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 by the eligible entity
or used in the eligible entity's trade or business is treated as
satisfying the requirements of section 1400Z-2(d)(2)(D)(i) and
paragraph (b)(2) of this section for the 30-month substantial
improvement period with respect to that property provided the eligible
entity reasonably expects that the property will be substantially
improved as defined in paragraph (b)(4)(i) of this section and used in
the eligible entity's trade or business in a qualified opportunity zone
by the end of such 30-month period. Tangible property described in the
preceding sentence is not considered qualified opportunity zone
business property for purposes of the special rule in section 1400Z-
2(d)(3)(B) unless the tangible property is qualified opportunity zone
business property for at least two years without regard to this
paragraph (b)(4)(ii).
(iii) Aggregation of original use property that improves the
functionality of non-original use property--(A) General rule. The cost
of purchased property that would otherwise qualify as qualified
opportunity zone business property may be taken into account in
determining whether additions to the basis of non-original use property
acquired by purchase satisfy the substantial improvement requirement
under section 1400Z-2(d)(2)(D)(ii), so long as the purchased property
is located in the same qualified opportunity zone (or a contiguous
qualified opportunity zone) as the non-original use property, is used
in the same trade or business as the non-original use property, and
improves the functionality of the non-original use property.
(B) Improvement of non-original use real property. If an eligible
entity chooses to apply this paragraph (b)(4)(iii) to non-original use
real property, the eligible entity must improve the non-original use
real property by more than an insubstantial amount within the meaning
of paragraph (b)(4)(iv)(C) of this section.
(C) Effect on purchased property. If an eligible entity chooses to
apply this paragraph (b)(4)(iii), the purchased property that would
otherwise qualify as qualified opportunity zone business property will
not be treated as original use property, and instead the basis of that
purchased property will be taken into account in determining whether
additions to the basis of the non-original use property satisfy the
requirements under section 1400Z-2(d)(2)(D)(i)(II) and (d)(2)(D)(ii).
(D) Examples. The following examples illustrate the principles of
paragraph (b)(4)(iii) of this section.
(1) Example 1--(i) Facts. On January 1, 2019, QOF A purchases
the assets of a hotel business located in a qualified opportunity
zone for $5 million. The purchased assets include land, a building,
linens, furniture and other fixtures attached to the building. $1
million of the purchase price is allocated to land and the remaining
$4 million is allocated to the building, furniture and fixtures.
During the course of renovations over the 30-month substantial
improvement period, the QOF spent $1 million replacing linens,
mattresses and furniture, $500,000 on the purchase of new exercise
equipment for a gym located in the hotel building, $1 million on
renovations for a restaurant (including restaurant equipment)
attached to the hotel, and $1.5 million on structural renovations to
the hotel. The QOF chooses to apply paragraph (b)(4)(iii) of this
section to determine whether the substantial improvement requirement
in section 1400Z-2(d)(2)(D)(ii) is met.
(ii) Analysis. In order for the hotel to be considered qualified
opportunity zone business property, QOF A must substantially improve
the hotel as the hotel had previously been placed in service in the
qualified opportunity zone. (QOF A was not required to substantially
improve the land on which the hotel was located pursuant to
paragraph (b)(4)(iv) of this section.) Because the amount of basis
allocated to the hotel was $4 million, QOF A must expend $4 million
to improve the hotel within the 30-month substantial improvement
period provided in section 1400Z-2(d)(2)(D)(ii). The new linens,
mattresses and furniture, new exercise equipment, and new restaurant
equipment all qualify as original use assets under section 1400Z-
2(d)(2)(D)(i)(II). QOF A also substantially improved the hotel,
which was the asset that needed to be improved under section 1400Z-
2(d)(2)(D)(i)(II). QOF A chose, at the start of the 30-month period,
to include the costs of the newly purchased assets that improve the
functionality of the hotel to the basis of the hotel. Thus, the cost
of these items is eligible to be added to the hotel's basis pursuant
to paragraph (b)(4)(iii) of this section. Therefore, QOF A has met
the substantial improvement requirement under section 1400Z-
2(d)(2)(D)(i)(II) by doubling its basis in the hotel and its
fixtures within the 30-month substantial improvement period. The
amounts spent replacing linens, mattresses, furniture, exercise
equipment, and new restaurant equipment that were counted toward the
substantial improvement requirement for the hotel are not considered
original use assets for purposes of the 90-percent investment
standard.
(2) Example 2--(i) Purchase of unrelated property. The facts are
the same as in paragraph (b)(4)(iii)(D)(1)(i) of this section,
except that in addition to purchasing the
[[Page 1989]]
hotel and the related land, QOF A also purchases an apartment
building one block away from the hotel for $10 million. The
apartment building is located in the same qualified opportunity zone
as the hotel.
(ii) Analysis. QOF A may not include any improvements made to
the apartment building, including purchased property that improves
the functionality of the apartment building, to the basis of the
hotel. QOF A may choose, under paragraph (b)(4)(iii) of this
section, to include the purchased property that improves the
functionality of the apartment building in the basis of the
apartment building for purposes of the substantial improvement
requirement under section 1400Z-2(d)(2)(D)(i)(II).
(iv) Special rules for land and improvements on land--(A) Buildings
located in a qualified opportunity zone. In accordance with the rules
set forth in this paragraph (b)(4)(iv)(A), if an eligible entity
purchases a building located on a parcel of land within the geographic
borders of a qualified opportunity zone, for purposes of section 1400Z-
2(d)(2)(D)(ii), a substantial improvement to the building is measured
by the eligible entity's additions to the basis of the building, as
determined under section 1012.
(B) Unimproved land. Unimproved land that is within a qualified
opportunity zone and acquired by purchase in accordance with section
1400Z-2(d)(2)(D)(i)(I) is not required to be substantially improved
within the meaning of section 1400Z-2(d)(2)(D)(i)(II) and
(d)(2)(D)(ii).
(C) Exception for insubstantially improved land. Notwithstanding
paragraph (b)(4)(iv)(B) of this section, if the land is unimproved or
minimally improved and the eligible entity purchases the land with an
expectation or an intention to not improve the land by more than an
insubstantial amount within 30 months after the date of purchase,
paragraph (b)(4)(iv)(B) of this section does not apply with respect to
such land and such land is not considered qualified opportunity zone
business property unless it is substantially improved within the
meaning of sections 1400Z-2(d)(2)(D)(i)(II) and (d)(2)(D)(ii). In
determining whether an eligible entity had an expectation or an
intention to improve the land by more than an insubstantial amount,
improvements to the land by the eligible entity (including grading,
clearing of the land, remediation of the contaminated land, or
acquisition of related qualified opportunity zone business property
that facilitates the use of the land in a trade or business of the
eligible entity) will be taken into account.
(D) Remediation of contaminated land. Betterments to land within
the meaning of Sec. 1.263(a)-3(j)(1)(i) may be added to the basis of
the purchased land and included for purposes of section 1400Z-
2(d)(2)(D)(ii) if the betterments are paid for by the eligible entity.
(E) Separate improvement to underlying land not required. In
determining whether the substantial improvement test under section
1400Z-2(d)(2)(D) has been met with respect to a building, there is no
requirement that the eligible entity separately substantially improve
the land upon which the building is located.
(v) Aggregation of purchased buildings--(A) Substantial improvement
requirement for eligible building group. For purposes of applying the
substantial improvement requirement under sections 1400Z-
2(d)(2)(D)(i)(II) and 1400Z-2(d)(2)(D)(ii), an eligible entity may
apply paragraph (b)(4)(v)(D) of this section with respect to two or
more buildings located within a qualified opportunity zone or a single
series of contiguous qualified opportunity zones, as described in
paragraph (b)(4)(v)(B) or (C) of this section (eligible building
group), respectively.
(B) Eligible building group located entirely within parcel of land
described in single deed. All buildings comprising an eligible building
group may be treated as a single property as that term is used in
section 1400Z-2(d)(2)(D)(ii) (single property), if each building
comprising the eligible building group is located entirely within the
geographic borders of a parcel of land described in a single deed.
(C) Eligible building group spanning contiguous parcels of land
described in separate deeds. An eligible entity may treat all buildings
comprising an eligible building group located entirely within the
geographic borders of contiguous parcels of land described in separate
deeds as a single property to the extent each building is operated as
part of one or more trades or businesses that--
(1) Are operated exclusively by the eligible entity;
(2) Share facilities or share significant centralized business
elements, such as personnel, accounting, legal, manufacturing,
purchasing, human resources, or information technology resources; and
(3) Are operated in coordination with, or reliance upon, one or
more of the trades or businesses (for example, supply chain
interdependencies or mixed-use facilities).
(D) Calculation of aggregate building basis and additions to basis
of single property--(1) In general. For purposes of the substantial
improvement requirement under section 1400Z-2(d)(2)(D)(ii), the amount
of basis required to be added to the portion of an eligible building
group treated as a single property equals the total amount of basis
calculated by adding the basis of each building comprising the single
property at the beginning of the 30-month period and additions to the
basis of each building comprising the single property are aggregated to
determine satisfaction of the substantial improvement requirement.
(2) Aggregation of original use property that improves the
functionality of single property. In applying paragraph (b)(4)(v)(D)(1)
of this section, purchased property that would otherwise qualify as
qualified opportunity zone business property may be taken into account
in determining whether additions to the basis of a single property
described in paragraph (b)(4)(v)(B) or (C) of this section satisfy the
substantial improvement requirement under section 1400Z-2(d)(2)(D)(ii).
(c) Tangible property leased by an eligible entity. In the case of
tangible property with respect to which an eligible entity is a
lessee--
(1) Qualifying acquisition of possession. The tangible property
must be acquired by the eligible entity under a lease entered into
after December 31, 2017.
(2) Arms-length terms--(i) General rule. The terms of the lease
must be market rate (that is, the terms of the lease reflect common,
arms-length market pricing in the locale that includes the qualified
opportunity zone as determined under section 482 and all section 482
regulations in this chapter) at the time that the lease was entered
into.
(ii) Rebuttable presumption regarding unrelated persons. There will
be a rebuttable presumption that the terms of the lease were market
rate for leases between persons not related within the meaning of
section 1400Z-2(e)(2) (unrelated persons), and thus, the parties to the
lease are not required to perform a section 482 analysis.
(iii) Exception for state, local, and Indian tribal governments.
For purposes of this paragraph (c)(2), 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
person within the meaning of section 1400Z-2(e)(2) (related person).
(3) Additional requirements for tangible property leased from a
related person. If the lessor is a related person with respect to an
eligible entity that is the lessee of tangible property, the
requirements of paragraphs (c)(3)(i) and (ii) of this section, as
applicable, must
[[Page 1990]]
be satisfied in order for the tangible property to be treated as
qualified opportunity zone business property.
(i) Prepayments of not more than one year. The lessee at no time
makes any prepayment in connection with the lease relating to a period
of use of the tangible property that exceeds 12 months.
(ii) Purchase of other qualified opportunity zone business
property. In the case of leased tangible property that is personal
property, if the original use of the leased tangible personal property
in a qualified opportunity zone (within the meaning of paragraph
(c)(3)(iii) of this section) does not commence with the lessee, the
property is not qualified opportunity zone business property unless,
during the relevant testing period (as defined in paragraph (c)(3)(iv)
of this section), the lessee becomes the owner of tangible property
that is qualified opportunity zone business property having a value not
less than the value of that leased tangible personal property. There
must be substantial overlap of the qualified opportunity zone(s) in
which the owner of the tangible property so acquired uses it and the
qualified opportunity zone(s) in which that person uses the leased
tangible personal property.
(iii) Original use of leased tangible property--(A) In general. For
purposes of paragraph (c)(3)(ii) of this section, the original use of
leased tangible property in a qualified opportunity zone commences on
the date any person first places the property in service in the
qualified opportunity zone for purposes of depreciation (or first uses
the property in the qualified opportunity zone in a manner that would
allow depreciation or amortization if that person were the property's
owner).
(B) Used leased tangible property. Used leased tangible personal
property can satisfy the original use requirement if the property has
not been previously so used or placed in service in the qualified
opportunity zone.
(iv) Relevant testing period. For purposes of paragraph (c)(3)(ii)
of this section, the relevant testing period is the period that begins
on the date that the lessee receives possession under the lease of the
leased tangible personal property and ends on the earlier of--
(A) The date 30-months after the date the lessee receives
possession of the leased tangible personal property under the lease; or
(B) The last day of the term of the lease (within the meaning of
Sec. 1.1400Z2(d)-1(b)(4)(iii)(D)).
(4) Plan, intent, or expectation for purchases not for fair market
value. In the case of real property that is leased by an eligible
entity, if, at the time the lease is entered into, there was a plan,
intent, or expectation for the real property to be purchased by the
eligible entity for an amount of consideration other than the fair
market value of the real property determined at the time of the
purchase without regard to any prior lease payments, the leased real
property is not qualified opportunity zone business property.
(d) Holding period and use within a qualified opportunity zone of
owned or leased tangible property--(1) In general. In the case of
tangible property that is owned or leased by an eligible entity, during
substantially all of the eligible entity's holding period for the
tangible property, substantially all of the use of the tangible
property must be in a qualified opportunity zone.
(2) Valuation of owned and leased property. For purposes of the 70-
percent use test in paragraph (d)(4) of this section, the value of
owned and leased property is required to be determined in accordance
with the valuation methodologies provided in Sec. 1.1400Z2(d)-1(b),
and such value in the case of leased tangible personal property is to
be determined on the date the lessee receives possession of the
tangible personal property under the lease.
(3) Substantially all of an eligible entity's holding period for
owned or leased tangible property--(i) In general. For purposes of
determining whether the holding period requirement in paragraph (d)(1)
of this section is satisfied, the term substantially all means at least
90 percent. The holding period requirement is applied on a semiannual
basis, based on the entire amount of time the eligible entity has owned
or leased such property. Thus, on each semiannual testing date of the
eligible entity, the tangible property satisfies the 90-percent
qualified opportunity zone business property holding period requirement
of section 1400Z-2(d)(2)(D)(i)(III) only if, during at least 90 percent
of the period during which the QOF has owned or leased the property,
the property has satisfied the 70-percent use test in paragraph (d)(4)
of this section.
(ii) Semiannual qualified opportunity zone business test. For
purposes of determining satisfaction of the 90-percent qualified
opportunity zone business property holding period test described in
paragraph (d)(3)(i) of this section in the case of a QOF, the
determination of whether property satisfies the 70-percent use test is
made on a semiannual basis pursuant to section 1400Z-2(d)(1) and
paragraph (d)(4) of this section.
(4) Substantially all of the use of owned or leased tangible
property in a qualified opportunity zone--(i) 70-percent use test.
Tangible property used in a trade or business of an eligible entity
satisfies the substantially all requirement of paragraph (d)(2)(i) of
this section (that is, the 70-percent use test) if and only if the
tangible property is qualified tangible property. Qualified tangible
property is tangible property that satisfies the requirements of
paragraph (d)(4)(ii), (iii) (subject to the limitation in paragraph
(d)(4)(iv) of this section), or (v) of this section.
(ii) Qualified tangible property. Tangible property held by a trade
or business is qualified tangible property to the extent, based on the
number of days between two consecutive semiannual testing dates, not
less than 70 percent of the total utilization of the tangible property
by the trade or business occurs at a location within the geographic
borders of a qualified opportunity zone.
(iii) Safe harbor for tangible property utilized in rendering
services inside and outside of a qualified opportunity zone. Subject to
the limitation described in paragraph (d)(4)(iv) of this section,
tangible property utilized by a trade or business in rendering services
both inside and outside of the geographic borders of a qualified
opportunity zone may be treated as qualified tangible property if--
(A) The tangible property utilized in rendering the service
directly generates gross income for the trade or business both inside
and outside of the geographic borders of a qualified opportunity zone;
(B) The trade or business has an office or other facility located
within the geographic borders of a qualified opportunity zone (QOZ
office);
(C) The tangible property is operated by employees of the trade or
business who--
(1) Regularly use a QOZ office of the trade or business in the
course of carrying out their duties; and
(2) Are managed directly, actively, and substantially on a day-to-
day basis by one or more employees of the trade or business who carry
out their duties at a QOZ office; and
(D) The tangible property is not operated exclusively outside of
the geographic borders of a qualified opportunity zone for a period
longer than 14 consecutive days for the generation of gross income for
the trade or business.
(iv) Limitation. For purposes of the 70-percent tangible property
standard, the safe harbor provided in paragraph (d)(4)(iii) of this
section may not be used
[[Page 1991]]
to treat more than 20 percent of the tangible property of the trade or
business as qualified tangible property.
(v) Safe harbor for tangible property owned by leasing businesses
with QOZ offices. Tangible property of a trade or business, the
employees of which use a QOZ office of the trade or business to
regularly lease such tangible property to customers of the trade or
business, may be treated as qualified tangible property if--
(A) Consistent with the normal, usual, or customary conduct of the
trade or business, when not subject to a lease to a customer of the
trade or business, the tangible property is parked or otherwise stored
at a QOZ office; and
(B) No lease under which a customer of the trade or business
acquires possession of the tangible property is for a duration
(including extensions) longer than 30 consecutive days.
(vi) Use of tangible property in one or more qualified opportunity
zones. In accordance with paragraphs (d)(4)(ii) through (v) of this
section, if qualified tangible property is utilized by the trade or
business in one or more qualified opportunity zones, satisfaction of
the 70-percent use test is determined by aggregating the number of days
the tangible property is utilized by the trade or business in each
qualified opportunity zone.
(vii) Real property straddling a qualified opportunity zone. For
purposes of satisfying the requirements in this paragraph (d), the
rules of Sec. 1.1400Z2(d)-1(d)(3)(ix) apply to a QOF or qualified
opportunity zone business for determining whether real property is
situated in a qualified opportunity zone.
(viii) Safe harbor for inventory in transit--(A) In general. In
determining whether tangible property is used in a qualified
opportunity zone for purposes of applying the 70-percent use test under
paragraph (d)(4) of this section, inventory (including raw materials)
of a trade or business does not fail to be used in a qualified
opportunity zone solely because the inventory is in transit--
(1) From a vendor to a facility of the trade or business that is in
a qualified opportunity zone; or
(2) From a facility of the trade or business that is in a qualified
opportunity zone to customers of the trade or business that are not
located in a qualified opportunity zone.
(B) No effect from certain events in transit. The distance traveled
by the inventory while it is in transit, or the fact that the inventory
is briefly warehoused while in transit, does not affect the application
of the safe harbor described in paragraph (d)(4)(viii) of this section.
(e) Applicability dates--(1) In general. The provisions of this
section are applicable for taxable years beginning after March 13,
2020.
(2) Prior periods. With respect to 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, a taxpayer may choose either--
(i) To apply the section 1400Z-2 regulations, if applied in a
consistent manner for all such taxable years; or
(ii) To rely on the rules in proposed Sec. 1.1400Z2(d)-1 contained
in the notice of proposed rulemaking (REG-115420-18) published on
October 29, 2018, as amplified by the notice of proposed rulemaking
(REG-120186-18) published on May 1, 2019, but only if applied in a
consistent manner for all such taxable years.
Sec. 1.1400Z2(e)-1 [Added and Reserved]
0
Par. 8. Reserved Sec. 1.1400Z2(e)-1 is added.
0
Par. 9. Section 1.1400Z2(f)-1 is added to read as follows:
Sec. 1.1400Z2(f)-1 Administrative rules- penalties, anti-abuse, etc.
(a) In general. Except as provided by Sec. 1.1400Z2(d)-
1(a)(2)(iv)(B) with respect to a taxpayer's first taxable year as a
QOF, if a QOF fails to satisfy the 90-percent investment standard in
section 1400Z-2(d)(1), then the QOF must pay the statutory penalty set
forth in section 1400Z-2(f) for each month it fails to meet the 90-
percent investment standard.
(b) Time period for a QOF to reinvest certain proceeds--(1) In
general. If a QOF receives proceeds from the return of capital or the
sale or disposition of some or all of its qualified opportunity zone
property within the meaning of section 1400Z-2(d)(2)(A), and if the QOF
reinvests some or all of the proceeds in qualified opportunity zone
property by the last day of the 12-month period beginning on the date
of the distribution, sale, or disposition, then the proceeds, to the
extent that they are so reinvested, are treated as qualified
opportunity zone property for purposes of the 90-percent investment
standard in section 1400Z-2(d)(1), but only to the extent that prior to
the reinvestment in qualified opportunity zone property the proceeds
are continuously held in cash, cash equivalents, or debt instruments
with a term of 18 months or less. If reinvestment of the proceeds is
delayed by waiting for governmental action the application for which is
complete, that delay does not cause a failure of the 12-month
requirement in this paragraph (b).
(2) Federally declared disasters. If the QOF's plan to reinvest
some or all of the proceeds described in paragraph (b)(1) of this
section in qualified opportunity zone property is delayed due to a
federally declared disaster (as defined in section 165(i)(5)(A)), the
QOF may receive up to an additional 12 months to reinvest such
proceeds, provided that the QOF invests such proceeds in the manner
originally intended before the disaster.
(c) Anti-abuse rules--(1) General anti-abuse rule. Pursuant to
section 1400Z-2(e)(4)(C), the rules of section 1400Z-2 and Sec. Sec.
1.1400Z2(a)-1 through 1.1400Z2(d)-(2), 1.1400Z2(f)-1, 1.1502-14Z, and
1.1504-3 must be applied in a manner consistent with the purposes of
section 1400Z-2 and the section 1400Z-2 regulations (as defined in
Sec. 1.1400Z2(a)-1(b)(41)). The purposes of section 1400Z-2 and the
section 1400Z-2 regulations are to provide specified Federal income tax
benefits to owners of QOFs to encourage the making of longer-term
investments, through QOFs and qualified opportunity zone businesses, of
new capital in one or more qualified opportunity zones and to increase
the economic growth of such qualified opportunity zones. Accordingly,
if a significant purpose of a transaction is to achieve a Federal
income tax result that is inconsistent with the purposes of section
1400Z-2 and the section 1400Z-2 regulations, a transaction (or series
of transactions) will be recast or recharacterized for Federal tax
purposes as appropriate to achieve tax results that are consistent with
the purposes of section 1400Z-2 and the section 1400Z-2 regulations.
This recasting and recharacterization may include, as appropriate,
treating an investment as other than a qualifying investment. A
determination of whether a Federal income tax result is inconsistent
with the purposes of section 1400Z-2 and the section 1400Z-2
regulations must be based on all facts and circumstances.
(2) Special anti-abuse rule for partnerships--(i) In general. In
addition to being subject to the general anti-abuse rule of paragraph
(c)(1) of this section, the application of the rules of section 1400Z-2
and Sec. Sec. 1.1400Z2(a)-1 through 1.1400Z2(d)-2, 1.1400Z2(f)-1,
1.1502-14Z, and 1.1504-3 to partnerships is also subject to the special
anti-abuse rule set forth in paragraph (c)(2)(ii) of this section.
(ii) Special partnership anti-abuse rule. If a partnership is
formed or availed of with a significant purpose of
[[Page 1992]]
avoiding the requirements of Sec. 1.1400Z2(a)-1(b)(11)(i)(B) that a
gain be subject to Federal income tax in order to be an eligible gain,
the partnership will be disregarded in whole or in part for purposes of
Sec. 1.1400Z2(a)-1(b)(11)(i)(B) and (b)(11)(ix)(B) to prevent the
creation of a qualifying investment by the partnership with respect to
any partner or partners that would not otherwise satisfy such
requirements.
(3) Examples. The following examples illustrate the anti-abuse rule
of paragraph (c) of this section.
(i) Example 1--(A) Facts. Two nonresident alien individuals
(collectively, the individuals) plan to sell stock at a gain of $50,
to invest the amount of the resulting capital gain in a QOF, and to
make a deferral election under section 1400Z-2(a). They make this
election with the intent of holding the QOF investment for 10 years
and then making an election to increase the qualifying basis to fair
market value under section 1400Z-2(c). A gain on a sale of the stock
by the individuals, however, would not be subject to Federal income
tax, and so the gain would not support their making a deferral
election as a result of the requirement in Sec. 1.1400Z2(a)-
1(b)(11)(i)(B). Instead of selling the stock themselves, the
individuals form a domestic partnership with a significant purpose
of using that partnership to make a deferral election with respect
to the stock under the exception in Sec. 1.1400Z2(a)-
1(b)(11)(ix)(B). The individuals contribute their stock to the
partnership in exchange for partnership interests, after which the
partnership sells the stock and invests the $50 gain in a QOF. Had
the partnership not made a deferral election, the individuals would
not be subject to tax on their allocated portion of the
partnership's recognized gain on the sale of the stock.
(B) Analysis. Based on these facts, the partnership is formed
and availed of with a significant purpose to avoid the requirements
of Sec. 1.1400Z2(a)-1(b)(11)(i)(B). Thus, under paragraph (c)(2) of
this section, the partnership is disregarded for purposes of
applying Sec. 1.1400Z2(a)-1(b)(11)(ix)(B) to the $50 gain, and
therefore the partnership's investment in the QOF is not a
qualifying investment.
(ii) Example 2--(A) Facts. The facts are the same as in
paragraph (c)(3)(i)(A) of this section (Example 1), except the
individuals contribute their stock to an existing partnership, the
sole partners of which are U.S. citizens, with a significant purpose
of the individuals' use of the partnership being to make an
investment in a QOF and a deferral election under the Sec.
1.1400Z2(a)-1(b)(11)(ix)(B) exception for partnerships. During the
year, the partnership sells property it owned before the
individuals' contribution, resulting in capital gain of $100, all of
which is eligible to be invested in a QOF. It also sells the stock
contributed by the individuals, resulting in $50 of capital gain.
The partnership invests $150 in a QOF and makes the requisite gain
deferral election.
(B) Analysis. Based on these facts, the partnership is availed
of by the individuals with a significant purpose to avoid the
requirements of Sec. 1.1400Z2(a)-1(b)(11)(i)(B). Thus, under
paragraph (c)(2) of this section, the partnership is disregarded for
purposes of applying Sec. 1.1400Z2(a)-1(b)(11)(i)(B) and
(b)(11)(ix)(B) with respect to the $50 capital gain from the sale of
the individuals' contributed stock and that gain fails to be
eligible gain. Under Sec. 1.1400Z2(a)-1(b), no section 1400Z-2(a)
election is available for that gain and the partnership will have a
mixed-funds investment, $100 of which is a qualifying investment and
$50 of which is a non-qualifying investment.
(iii) Example 3--(A) Facts. Entity C is a QOF that meets the
requirements of section 1400Z-2(d)(1). Entity C owns qualified
opportunity zone stock in a domestic corporation described in
section 1400Z-2(d)(2)(B) (Corporation C), which operates a qualified
opportunity zone business. Entity C also owns Corporation D stock,
which is not qualified opportunity zone stock, which stock is less
than 10% of the assets of Entity C. Under section 1400Z-2(e)(2),
these stock holdings cause Entity C to be related to both
Corporation C and Corporation D. On date 1, under section 1400Z-
2(e)(2), Individual S is not a related person with respect to Entity
C, Corporation C, or Corporation D. On that date, Individual S sells
tangible property to Corporation C for use in Corporation C's
qualified opportunity zone business and sells a second asset to
Corporation D. Both items sold were capital assets (as defined in
section 1221). As a result, Individual S realizes gain of $100 from
the sale to Corporation C and $75 from the sale to Corporation D. At
the time of the sale Individual S has a plan or intent to invest
$175 in Entity C and to make deferral elections under section 1400Z-
2(a)(1) with respect to the gain from the two sales. On date 2, for
$175 Individual S acquired an eligible interest in Entity C, an
acquisition that causes Individual S to become a related person with
respect to Entity C within the meaning of section 1400Z-2(e)(2).
(B) Analysis. Under paragraph (c)(1) of this section, Individual
S's $175 gain is not an eligible gain and cannot be the subject a
deferral election under section 1400Z-2(a)(1). The gain fails to
satisfy Sec. 1.1400Z2a-1(b)(11)(i)(C) because of Individual S's
plan to acquire sufficient equity in Entity C to become related to
Corporations C and D. Moreover, for the same reason, the tangible
property that Corporation C purchased from Individual S fails to
satisfy the requirement that a purchase of qualified opportunity
zone business property must be from an unrelated person. See
sections 1400Z-2(d)(2)(D)(i)(I) and 179(d)(2)(A).
(iv) Example 4--(A) Facts. Entity D is a QOF that meets the
requirements of section 1400Z-2(d)(1). Entity D owns a majority
qualified opportunity zone partnership interest in a domestic
partnership, Partnership D described in section 1400Z-2(d)(2)(C).
Entity D organized Partnership D for the purpose of being a
qualified opportunity zone business. Partnership D acquires a tract
of land located in a qualified opportunity zone. At the time of the
acquisition of that land, there was no plan or intent to develop or
otherwise utilize the land in a trade or business that would
increase substantially the economic productivity of the land.
Instead, there was a plan to pave the land for use as a parking lot.
Partnership D planned to install a gate to the paved parking area, a
small structure that would serve as an office for a parking
attendant, and two self-pay stations for use by customers. The
parking lot was not reasonably expected to expand significantly, and
the initial small number of employees was not reasonably expected
significantly to increase. A significant purpose for the acquisition
of the land was to sell the land at a profit and to exclude any gain
from appreciation by making an election under section 1400Z-2(c).
(B) Analysis. Under paragraph (c)(1) of this section, the
acquisition of the land is a transaction carried out to achieve a
tax result that is inconsistent with the purposes of section 1400Z-2
and the section 1400Z-2 regulations. Consequently, the land is not
qualified opportunity zone business property and gain from the sale
of the land will not be eligible to be excluded from gross income
under section 1400Z-2(c). This recharacterization of the
qualification of the land for Federal tax purposes is appropriate to
ensure that the tax results of the transaction, including the status
of Partnership D as a qualified opportunity zone business, are
consistent with the purposes of section 1400Z-2 and the section
1400Z-2 regulations. Partnership D fails to be a qualified
opportunity zone business unless other assets that it owns or leases
are qualified opportunity zone business property that satisfy
section 1400Z-2(d)(3)(A)(i), and the other requirements of section
1400Z-2 and the section 1400Z-2 regulations.
(v) Example 5--(A) Facts. The facts are the same as in paragraph
(c)(3)(iv) of this section, except that Partnership D, in year 1,
acquired a tract of land located in a qualified opportunity zone
that was previously used for hog and pig farming. On its Form 1065T
the previous owner, also a partnership, properly described those
activities with the principal business activity code 112210. During
the several-year period ending on the date of the acquisition of the
land, the value of the land had significantly increased and D
projected the land to continue to increase in value by ten-fold
during the following 10-year period. At the time of the acquisition,
Partnership D intended to conduct sheep and goat farming activities
on the land and, accordingly, planned to use principal business
activity code 112400 on its Form 1065. According to its plan,
Partnership D conducted sheep and goat farming activities on the
land during the 10-year period beginning on the date of acquisition
of the land. During the 10-year period, Partnership D made
significant capital improvements to the land, including improvements
to existing farm structures, construction of new farm structures,
and installation of a new irrigation system. As expected, the value
of the land substantially increased during the following decade. The
owners' entire interest in Partnership D was a qualifying
investment, and, after having held it for at least 10 years
[[Page 1993]]
the owners sold the entire interest at a large gain. As planned the
owners made an election under section 1400Z-2(c) in order to avoid
tax on the gain from the sale.
(B) Analysis. The modification of the land to suit sheep and
goat farming activity from its previous use of hog and pig farming
and the significant capital improvements made to land, is a
significant investment in the business activities on the land. Thus,
Partnership D did not hold the land solely for speculative
investment. As a result, under paragraph (c)(1) of this section, the
acquisition of the land, the activities conducted on the land, the
capital improvements made to the land, and the later disposition of
the land for a significant profit are not inconsistent with the
purposes of section 1400Z-2 and the section 1400Z-2 regulations.
(vi) Example 6--(A) Facts. Individuals intend to sell stock at a
capital gain and invest the resulting gain in a QOF pursuant to a
deferral election under section 1400Z-2(a). The individuals form
Entity F and file Form 8996 certifying that Entity F is a QOF
organized for the purpose of investing in qualified opportunity zone
property. Individuals have no intention of investing in qualified
opportunity zone property. Instead individuals intend to invest in
property other than qualified opportunity zone property hoping that
the property will appreciate substantially in value and the
individuals will be able to exclude any appreciation on their
investment from gross income by making an election under section
1400Z-2(c). Each year Entity F files Form 8996 and pays the
applicable penalty under section 1400Z-2(f). After holding their
interests in Entity F for 10 years, individuals sell their interest
in Entity F to an unrelated third party for a substantial gain and
make an election to exclude the appreciation on their investment
under section 1400Z-2(c).
(B) Analysis. A significant purpose of the transaction is to
achieve a tax result that is inconsistent with the purposes of
section 1400Z-2 and the section 1400Z-2 regulations, and the
transaction will be recast and recharacterized for Federal tax
purposes so that Entity F is not a QOF and the individuals are not
eligible for the elections under sections 1400Z-2(a) and (c).
(vii) Example 7--(A) Facts. Entity E treats itself as a QOF that
meets the requirements of section 1400Z-2(d)(1). Entity E owns all
of the stock in a domestic corporation, Corporation E, and Entity E
treats this stock as qualified opportunity zone stock. Corporation E
uses the majority of the cash invested by Entity E to purchase gold
bars from unrelated parties within the meaning of section 1400Z-
2(e)(2). The aggregate value of the gold bars is $1000. Corporation
E rents a safe deposit box in a qualified opportunity zone and hires
one employee to manage the purchase and sale of the gold bars. Each
year Corporation E purchases a small number of additional gold bars
and sells to customers a portion of the gold bars on hand. The
aggregate value of both the purchases and sales approximates half
the value of the bars held at the beginning of the year. Corporation
E seeks to treat the gold bars as qualified opportunity zone
business property within the meaning of section 1400Z-2(d)(3). At
the time that Corporation E began the gold bar business, it did not
reasonably expect the business to expand significantly, nor was the
number of employees reasonably expected to increase. Gold, however,
was reasonably expected to appreciate. Ten years after the formation
of Entity E, the investors in Entity E sell all of their interests
in the entity and seek to make an election under section 1400Z-2(c)
to exclude any gain from appreciation.
(B) Analysis. Under paragraph (c)(1) of this section, a
significant purpose of Corporation E's activities is to achieve a
tax result that is inconsistent with the purposes of section 1400Z-2
and the section 1400Z-2 regulations. The gold bar business carried
out by Corporation E was merely speculative in nature and was not
expected to increase economic activity in the subject qualified
opportunity zone in a manner consistent with the purposes of section
1400Z-2 and the section 1400Z-2 regulations. As a result,
Corporation E's activities are carried on to achieve tax results
that are inconsistent with the purposes of section 1400Z-2 and the
section 1400Z-2 regulations. Consequently, the gold bars are not
qualified opportunity zone property. Corporation E fails to be a
qualified opportunity zone business unless other assets that it owns
or leases are qualified opportunity zone business property that
satisfy section 1400Z-2(d)(3)(A)(i) (along with other requirements).
If Corporation E fails to be a qualified opportunity zone business,
Corporation E's stock fails to be qualified opportunity zone
property in the hands of Entity E.
(d) Applicability date--(1) In general. The provisions of this
section are applicable for taxable years beginning after March 13,
2020.
(2) Prior periods. With respect to the portion of a taxpayer's
first taxable year ending after December 21, 2017, that began on
December March 13, 2020, a taxpayer may choose either--
(i) To apply the section 1400Z-2 regulations, if applied in a
consistent manner for all such taxable years, or
(ii) To rely on the rules in proposed Sec. 1.1400Z2(f)-1 contained
in the notice of proposed rulemaking (REG-115420-18) published on
October 29, 2018, as amplified by the notice of proposed rulemaking
(REG-120186-18) published on May 1, 2019, but only if applied in a
consistent manner for all such taxable years.
0
Par. 10. Section 1.1502-14Z is added to read as follows:
Sec. 1.1502-14Z Application of opportunity zone rules to members of a
consolidated group.
(a) Scope and definitions--(1) Scope. This section provides rules
regarding the Federal income tax treatment of QOFs owned by members of
a consolidated group (as defined in Sec. 1.1502-1(b) and (h),
respectively). Rules in the section 1400Z-2 regulations (as defined in
Sec. 1.1400Z2(a)-1(b)(41)) apply to consolidated groups except as
modified in this section. Paragraph (b) of this section generally
provides rules regarding the effects of an election under Sec. 1.1504-
3(b)(2) to treat a subsidiary QOF C corporation as a member of a
consolidated group. Paragraph (c) of this section provides rules
regarding qualifying investments made by members of a consolidated
group (including an election to treat the investment by one member as a
qualifying investment by another member) and the application of Sec.
1.1502-13 to intercompany transfers of a qualifying investment.
Paragraph (d) of this section provides coordinating rules for basis
adjustments within a consolidated group. Paragraph (e) of this section
provides coordinating rules for Sec. 1.1502-36(d). Paragraph (f) of
this section provides elective transition relief to taxpayers that
consolidated a subsidiary QOF C corporation prior to May 1, 2019.
Paragraph (g) of this section provides rules regarding the consequences
of a deconsolidation of a QOF C corporation. Paragraph (h) of this
section provides instructions for making the elections provided by
paragraphs (c) and (f) of this section. Paragraph (i) of this section
is reserved. Paragraph (j) of this section provides examples. Paragraph
(k) of this section provides the applicability dates.
(2) Definitions--(i) In general. The definitions provided in
Sec. Sec. 1.1400Z2(a)-1(b) and 1.1400Z2(d)-1 apply for purposes of
this section.
(ii) Definitions for consolidated groups--(A) Day one. The term day
one means the date members of the consolidated group formed or acquired
section 1504 control of the pre-existing QOF sub. If a pre-existing QOF
sub was a member of the consolidated group prior to becoming a QOF C
corporation, day one is the first day of the first month in which the
member self-certified as, or is treated as, a QOF C corporation,
whichever is earlier.
(B) Election date. The term election date means the date on which
an election under paragraph (c) or (f) of this section is made.
(C) Pre-existing QOF sub. The term pre-existing QOF sub means a
subsidiary QOF C corporation that meets the affiliation requirements in
section 1504 (without regard to Sec. 1.1504-3(b)(1)) as of May 1,
2019.
(D) QOF investor member. The term QOF investor member means any
member holding a qualifying investment in the QOF member.
(E) QOF member. The term QOF member means a subsidiary QOF C
[[Page 1994]]
corporation that is treated as a member of a consolidated group
pursuant to an election in Sec. 1.1504-3(b)(2).
(F) QOF member stock. The term QOF member stock means the QOF stock
of a QOF member.
(G) QOF SAG. The term QOF SAG means, with respect to a QOF member,
the affiliated group that would be determined under section 1504(a) if
the QOF member were the common parent.
(H) Subsidiary QOF C corporation. The term subsidiary QOF C
corporation means a QOF C corporation that meets the requirements to be
a member of an affiliated group (as defined in section 1504(a)(1), and
without regard to Sec. 1.1504-3(b)(1)) other than the common parent of
such consolidated group.
(b) Subsidiary QOF C corporation treated as member of the
consolidated group--(1) Effects of election to treat a subsidiary QOF C
corporation as a member--(i) Determining whether a distribution is an
inclusion event. A distribution of property with respect to qualifying
QOF stock by a QOF member to a QOF investor member is an inclusion
event to the extent the distribution would create or increase an excess
loss account (ELA) in the qualifying QOF stock, without regard to any
inclusion resulting from application of this paragraph (b)(1)(i).
Solely for purposes of determining whether a distribution creates or
increases an ELA during a taxable year, investment adjustments
pertaining to a distribution on qualifying QOF stock by a QOF member
are made after all other investment adjustments under Sec. 1.1502-32
for that year.
(ii) Determining the amount of deferred gain includible by the QOF
investor member. The amount of gain included in gross income of a QOF
investor member under section 1400Z-2(a)(1)(B) on a date described in
Sec. 1.1400Z2(b)-1(b) (modified by paragraph (c)(3) of this section,
as applicable) is determined under this paragraph (b)(1)(ii). The
amount of gain included in gross income of the QOF investor member is
the lesser of:
(A) The product of:
(1) The percentage of the qualifying investment that gave rise to
the inclusion event; and
(2) The remaining deferred gain (see Sec. 1.1400Z2(a)-1(b)(40)),
less any basis adjustments pursuant to section 1400Z-2(b)(2)(B)(iii)
and (iv); or
(B) The gain that would be recognized on a fully taxable
disposition of the qualifying investment that gave rise to the
inclusion event.
(iii) Application of ELA rules on the disposition of QOF member
stock. When a QOF investor member disposes of a share of qualifying QOF
member stock, any ELA in the share is taken into account as income or
gain from the disposition under Sec. 1.1502-19(b)(1) before the basis
of the share is increased under section 1400Z-2(c), if applicable. See
paragraph (g)(3)(i) of this section for the general rule regarding the
treatment of an ELA upon the deconsolidation of a QOF member.
(iv) Transactions between the QOF member and other members of the
consolidated group--(A) In general. This paragraph (b)(1)(iv) governs
transactions between a member of the QOF SAG and other members of the
consolidated group.
(B) Sale or exchange of property. A sale or exchange of property
between a member of the QOF SAG and a member of the consolidated group
that is not a member of such QOF SAG is not treated as an intercompany
transaction (as defined in Sec. 1.1502-13(b)(1)) and is not subject to
the rules in Sec. 1.1502-13. In contrast, a sale or exchange of
property between members of the QOF SAG is an intercompany transaction
that is subject to the rules in Sec. 1.1502-13.
(C) Other transactions. Any transaction between a member of the QOF
SAG and a member of the consolidated group that is not a member of such
QOF SAG that is not a sale or exchange of property is an intercompany
transaction subject to the rules in Sec. 1.1502-13.
(v) Separate-entity application of QOF qualifying rules to QOF
member. A consolidated group is not treated as a single entity for
purposes of determining whether a QOF member or a qualified opportunity
zone business that is a consolidated group member satisfies the
investment standard rules in section 1400Z-2(d) and (f) and Sec. Sec.
1.1400Z2(d)-1 and 1.1400Z2(f)-1; instead, the rules in this paragraph
(b)(1)(v) apply on a separate-entity basis. Therefore, for example, the
QOF member's satisfaction of the requirements under section 1400Z-2(d)
is determined by taking into account only property (including qualified
opportunity zone stock or qualified opportunity zone partnership
interests) held by the QOF member, without regard to property
transferred by the QOF member to other members of the consolidated
group.
(2) Anti-avoidance rule. The purposes of section 1400Z-2 and the
section 1400Z-2 regulations are to provide specified tax benefits to
owners of QOFs to encourage the making of longer-term investments,
through QOFs and qualified opportunity zone businesses, of new capital
in one or more qualified opportunity zones and to increase the economic
growth of such qualified opportunity zones. If a transaction is engaged
in or structured with a view to avoid the application of the rules of
section 1400Z-2, the section 1400Z-2 regulations, or the regulations in
this part under section 1502 of the Code (including this section),
appropriate adjustments will be made to carry out the purposes of
section 1400Z-2 and the section 1400Z-2 regulations. For example, if a
consolidated group engages in a restructuring (such as a distribution
described in section 355) with a view to using stock basis adjustments
under Sec. 1.1502-32 resulting from increases in the basis of stock
under section 1400Z-2(b) in a sale or exchange transaction without
disposing of any part of the consolidated group's direct ownership of
the relevant qualifying investment, the transaction will be treated as
an inclusion event with regard to an appropriate amount of deferred
gain.
(c) Qualifying investments by members of a consolidated group--(1)
In general. Except as otherwise provided in this section or in Sec.
1.1400Z2(b)-1 (see, for example, Sec. 1.1400Z2(b)-1(c)(9)(i)(B)(1)),
section 1400Z-2 applies separately to each member of a consolidated
group. Therefore, for example, the same member of the consolidated
group generally must both engage in the sale of a capital asset giving
rise to eligible gain and timely invest an amount equal to some or all
of such gain in a QOF (as provided in section 1400Z-2(a)(1)) in order
to qualify for deferral of such gain under section 1400Z-2.
(2) Election to treat investment of one member as a qualifying
investment by another member--(i) Availability of election. If members
of a consolidated group satisfy the requirements of this paragraph
(c)(2), the consolidated group may elect to treat the investment by one
member as a qualifying investment by another member. The election
provided by this paragraph (c)(2) is available when a member of a
consolidated group (M1) has eligible gain and a second member (M2)
makes an investment in a QOF that would be a qualifying investment if
M1, rather than M2, had made the investment. For example, if M1 has
$100x of eligible gain but M2 has none, and M2 makes a $120x investment
in a QOF C corporation, only $100x of M2's investment in the QOF C
corporation is eligible for the election under this paragraph (c)(2).
See paragraph (h)(2) of this section for the form and manner of making
this election. If M2 has its own eligible gain, M2 may make a
qualifying investment on its own behalf and defer such eligible
[[Page 1995]]
gain under section 1400Z-2(a)(1)(A) and Sec. 1.1400Z2(a)-1.
(ii) Effect of election. If a consolidated group makes an election
under this paragraph (c)(2), then M1 is treated as having made the
investment in the QOF that is actually made by M2. M1 is then treated
as having immediately sold such investment to M2 for fair market value.
The deemed sale by M1 is subject to the rules in paragraph (c)(3) of
this section. The consolidated group must treat the deemed investment
by M1 and the deemed sale by M1 to M2 as having occurred for all
Federal income tax purposes.
(3) Intercompany transfers of a qualifying investment--(i) In
general. Except as otherwise provided in this paragraph (c)(3), when
one member (S) transfers its qualifying investment to another member
(B), the transaction is not treated as an intercompany transaction
within the meaning of Sec. 1.1502-13(b)(1) for purposes of applying
the rules of section 1400Z-2 and the section 1400Z-2 regulations.
Therefore, Sec. 1.1502-13(c) does not apply to treat S and B as
divisions of a single entity for purposes of section 1400Z-2. For
example, if S transfers its qualifying investment to B in a section 351
transaction, the transfer is an inclusion event for S under Sec.
1.1400Z2(b)-1(c). In addition, because the transfer is not an
intercompany transaction for purposes of section 1400Z-2, Sec. 1.1502-
13 does not apply to continue S's deferral under Sec. 1.1400Z2(b)-
1(b).
(ii) Application of Sec. 1.1502-13 to fully taxable intercompany
transfers of a qualifying investment--(A) Applicable transactions.
Notwithstanding paragraph (c)(3)(i) of this section, if S transfers its
qualifying investment to B in a fully taxable transaction, the
transaction is treated as an intercompany transaction, and Sec.
1.1502-13(c) applies to treat S and B as divisions of a single entity
for purposes of applying section 1400Z-2.
(B) Treatment of S's intercompany gain on its qualifying
investment. If a transaction is described in paragraph (c)(3)(ii)(A) of
this section, Sec. 1.1502-13(c)(6)(ii) is inapplicable in determining
the excludability of S's gain (or the treatment of such gain as tax-
exempt income) on the application of section 1400Z-2(b) and (c) to S
and B as a single entity. Thus, S's gain on the qualifying investment
(including the amount includible under Sec. 1.1400Z2(b)-1(e)) may be
redetermined to be excluded from gross income (or treated as tax-exempt
income), as appropriate, to achieve single-entity treatment between S
and B with regard to the ownership and disposal of the qualifying
investment. To qualify for benefits under section 1400Z-2, S and B must
otherwise satisfy the requirements of section 1400Z-2. See also Sec.
1.1502-13(j)(4) (concerning multiple or successive intercompany
transactions).
(C) Investment adjustments and adjustments to earnings and profits.
Income of S excluded under section 1400Z-2 by application of paragraphs
(c)(3)(ii)(A) and (B) of this section and Sec. 1.1502-13 results in
adjustments to S's earnings and profits and is treated as tax-exempt
income to S for purposes of Sec. 1.1502-32(b)(2)(ii).
(D) Election under section 1400Z-2(c). To the extent paragraph
(c)(3)(ii)(A) of this section applies to S's transfer of its qualifying
investment to B, B (and not S) is entitled to make the election under
section 1400Z-2(c) at the time when, treating S and B as divisions of a
single entity, the single entity would be entitled to make such an
election. For example, pursuant to Sec. 1.1502-13(c)(1)(ii), B takes
S's holding period into account in determining whether B is treated as
holding the transferred qualifying investment for 10 years. In
addition, the attributes of S's intercompany item on the transfer of
the qualifying investment may be redetermined based on B's election.
(4) Intercompany transfer as qualifying investment in a QOF member.
A transfer by a consolidated group member with an eligible gain to a
QOF member before January 1, 2027, is not treated as an intercompany
transaction within the meaning of Sec. 1.1502-13 and may constitute a
qualifying investment. But see Sec. 1.1504-3(b)(2) regarding
conditions for consolidating a QOF C corporation.
(5) Intercompany gain as eligible gain. When S sells property to B,
Sec. 1.1502-13 applies to determine if, and when, S's intercompany
gain and B's corresponding gain constitute eligible gain. S's gain and
B's gain are treated as eligible gain only to the extent such gain
would be eligible gain if S and B were divisions of a single entity.
For example, if S sells a piece of property to B at a gain, B
subsequently sells that property to an unrelated party at a further
gain, and the gains are treated as capital gain under Sec. 1.1502-
13(c)(1) and (4), then both S's gain and B's gain are eligible gains at
the time B sells the property to the unrelated party. In contrast, if S
sells a piece of property to B at a loss, and B subsequently sells that
property to an unrelated party at a gain, then B's corresponding gain
on the property is eligible gain only to the extent that S and B, if
treated as divisions of a single entity, would have eligible gain on
the sale of property to the unrelated party. See Sec. 1.1502-13(a)(1).
(d) Tiering-up of investment adjustments provided by section 1400Z-
2. Basis increases in a qualifying investment in a QOF under sections
1400Z-2(b)(2)(B)(iii), 1400Z-2(b)(2)(B)(iv), and 1400Z-2(c) are treated
as satisfying the requirements of Sec. 1.1502-32(b)(3)(ii)(A) and thus
qualify as tax-exempt income to the QOF owner. Therefore, if the QOF
owner is a member of a consolidated group and is owned by other members
of the same consolidated group (upper-tier members), the upper-tier
members increase their bases in the shares of the QOF owner under Sec.
1.1502-32(b)(2)(ii). However, there is no basis adjustment under Sec.
1.1502-32(b)(2)(ii) or (iii) in shares of upper-tier members with
regard to a basis adjustment under section 1400Z-2(c) and Sec.
1.1400Z2(c)-1 unless and until the basis of the qualifying investment
is adjusted to its fair market value, as provided in section 1400Z-2(c)
and Sec. 1.1400Z2(c)-1.
(e) Application of Sec. 1.1502-36(d). This paragraph (e) clarifies
how Sec. 1.1502-36(d) applies if a member (M) transfers a loss share
of another member (S) that is a QOF owner that owns a qualifying
investment. To determine S's attribute reduction amount under Sec.
1.1502-36(d)(3), S's basis in its qualifying investment is included in
S's net inside attribute amount to compute S's aggregate inside loss
under Sec. 1.1502-36(d)(3)(iii)(A). However, S's basis in the
qualifying investment is not included in S's Category D attributes
available for attribute reduction under Sec. 1.1502-36(d)(4). Thus,
S's basis in the qualifying investment cannot be reduced under Sec.
1.1502-36(d). If S's attribute reduction amount exceeds S's attributes
available for reduction, then to the extent of the lesser of S's basis
in the qualifying investment or the remaining attribute reduction
amount, the common parent is treated as making the election under Sec.
1.1502-36(d)(6) to reduce M's basis in the transferred loss S shares.
(f) Transition relief--(1) Overview. This paragraph (f) provides
options for elective relief to pre-existing QOF subs. An election under
this paragraph (f) is made in the manner provided in paragraph (h)(3)
of this section. If a timely election under this paragraph (f) is not
made, the pre-existing QOF sub is treated as deconsolidating on March
13, 2020.
(2) Reclassification election--(i) In general. A consolidated group
may make one of the alternative, irrevocable elections provided in
paragraphs (f)(2)(ii) through (iv) of this section for
[[Page 1996]]
its pre-existing QOF subs. All elective relief provided in this
paragraph (f)(2) is effective on day one.
(ii) Treatment as a QOF partnership--(A) Election. A consolidated
group may elect to treat certain pre-existing QOF subs as QOF
partnerships (electing QOF partnership). To be eligible for the
election in this paragraph (f)(2)(ii)(A), a pre-existing QOF sub must
have converted to an entity treated as a partnership for Federal income
tax purposes as of the election date.
(B) Effect of the QOF partnership election. As a result of making
the election under this paragraph (f)(2)(ii), the pre-existing QOF sub
is treated as a QOF partnership from day one. Consequently, the
consolidated group must file amended or superseding returns, as
applicable, to account for the electing QOF partnership's income, gain,
deduction, and loss; the electing QOF partnership also must file its
own partnership returns for taxable periods beginning on day one, as
applicable. The electing QOF partnership must include its self-
certification under Sec. 1.1400Z2(d)-1(a) with its own returns, and
the self-certification will be treated as timely so long as the
consolidated group filed a timely self-certification under Sec.
1.1400Z2(d)-1(a) for the pre-existing QOF sub. In addition, appropriate
adjustments must be made to account for the change in status of the
electing QOF partnership from day one, including modifications to
investment adjustments to the basis in members' stock made under Sec.
1.1502-32 and adjustments to members' earnings and profits made under
Sec. 1.1502-33.
(C) Pre-existing QOF sub with single owner. If a pre-existing QOF
sub is wholly owned by one member of a consolidated group, then for
purposes of making the election under this paragraph (f)(2)(ii), the
electing QOF partnership is deemed to have had a nominal partner from
day one until the date the electing QOF partnership is treated as a
partnership for Federal income tax purposes without regard to this
paragraph (f)(2)(ii).
(D) Example. The following example illustrates the election under
this paragraph (f)(2)(ii).
(1) Facts. P, the common parent of a consolidated group (P
group), wholly owns M1 and M2. On July 1, 2018, M1 and M2 each sell
an asset to an unrelated party and realize $70x and $30x of eligible
gain, respectively. On August 13, 2018, M1 and M2 form Q12 (a QOF C
corporation that was formed as a corporation under state law). Also
on August 13, 2018, M1 and M2 contribute $70x and $30x,
respectively, to Q12 in exchange for stock of Q12 and properly elect
to defer their respective eligible gains under section 1400Z-2(a)
and Sec. 1.1400Z2(a)-1. The P group also makes a timely self-
certification under Sec. 1.1400Z2(d)-(1)(a) for Q12. Following
March 13, 2020, the P group intends to timely elect under this
paragraph (f)(2)(ii) to treat Q12 as a QOF partnership.
(2) Analysis--(i) Eligibility to elect. For the P group to elect
to treat Q12 as a QOF partnership under this paragraph (f)(2)(ii),
by the date of the election, Q12 must either convert to a state law
partnership or another entity treated as a partnership for Federal
income tax purposes.
(ii) Consequences of the election. As a result of making the
election under this paragraph (f)(2)(ii), Q12 is treated as a QOF
partnership from August 13, 2018 (day one). The P group must file
amended or superseding returns, as applicable and as necessary, to
account for Q12's income, gain, deduction, and loss. In addition,
Q12 must file its own returns for the taxable period beginning on
August 13, 2018, as applicable. The returns must be filed within the
time frame provided in paragraph (h)(3)(iii) of this section.
Finally, because the P group filed a timely self-certification under
Sec. 1.1400Z2(d)-(1)(a) for Q12 as a QOF C corporation, Q12's self-
certification as a QOF partnership would be is considered timely
filed.
(3) Deemed nominal partner--(i) Facts. The facts are the same as
paragraph (f)(2)(iii)(D)(1) of this section, except that on July 1,
2018, only M1 sells an asset to an unrelated party and realizes $70x
of eligible gain. On August 13, 2018, M1 contributes cash of $70x to
Q12 in exchange for stock of Q12 and properly elects to defer the
eligible gain under section 1400Z-2(a) and Sec. 1.1400Z2(a)-1. As
of the date the election is made to treat Q12 as a partnership from
day one, a second party invests in Q12, and Q12 is an entity treated
as a partnership for Federal income tax purposes.
(ii) Analysis. The analysis is generally the same as in
paragraph (f)(2)(iii)(D)(2) of this section. In addition, because
Q12 is wholly owned by M1, solely for purposes of treating Q12 as a
QOF partnership from August 13, 2018, Q12 is deemed to have a
nominal partner from August 13, 2018 until the election date or the
date Q12 qualifies as a partnership, if earlier.
(iii) Treatment as a non-member QOF C corporation--(A) Election. A
consolidated group may elect to treat the pre-existing QOF sub as a QOF
C corporation that is not a member of the consolidated group.
(B) Effect of the non-member QOF C corporation election. As a
result of making the election under this paragraph (f)(2)(iii), the
pre-existing QOF sub is treated as not being a member of the
consolidated group from day one. Consequently, the consolidated group
must file amended or superseding returns, as applicable, to exclude all
of the pre-existing QOF sub's income, gain, deduction, and loss from
the consolidated returns; the pre-existing QOF sub also must file its
own returns for taxable periods beginning on day one, as applicable. In
addition, all adjustments resulting from the pre-existing QOF sub's
operations must be eliminated from the consolidated group, including
investment adjustments made under Sec. 1.1502-32 to basis in members'
stock (as well as stock in the pre-existing QOF sub) and adjustments
made under Sec. 1.1502-33 to members' earnings and profits.
(iv) Treatment as a non-QOF C corporation--(A) Election. A
consolidated group may elect to treat a pre-existing QOF sub as if it
never self-certified to be a QOF pursuant to Sec. 1.1400Z2(d)-1.
(B) Effect of the non-QOF C corporation election. As a result of
making the election under this paragraph (f)(2)(iv), the pre-existing
QOF sub is treated from day one as a member of the consolidated group
and not as a QOF. Therefore, section 1400Z-2 is not applicable, and
amended returns or superseding returns must be filed, as applicable, to
account for the eligible gain that was invested in the pre-existing QOF
sub. In addition, appropriate adjustments must be made to account for
the non-applicability of section 1400Z-2, including adjustments to
members' stock basis and earnings and profits under Sec. Sec. 1.1502-
32 and 1.1502-33, respectively.
(3) Election to continue treating pre-existing QOF sub as a member
of the consolidated group--(i) Election. A consolidated group may elect
to have a pre-existing QOF sub retain its QOF status and remain a
member of the consolidated group.
(ii) Effects of electing to remain a QOF and a member of the
consolidated group. As a result of making the election under this
paragraph (f)(3), the conditions and effects provided in Sec. 1.1504-
3(b)(2) and paragraph (b)(1) of this section will apply to the pre-
existing QOF sub and the consolidated group as of the effective date of
this election. See paragraph (h)(1) of this section for the effective
date of this election, and see paragraph (h)(3)(iii) of this section
regarding the timing for meeting the requirements in Sec. 1.1504-
3(b)(2)(ii).
(g) Deconsolidation rules--(1) In general. This paragraph (g)
provides rules applicable on any deconsolidation of a QOF C corporation
(deconsolidating QOF).
(2) Deconsolidation and inclusion event. A deconsolidation event is
not an inclusion event unless the deconsolidation is the result of an
actual transfer of the QOF member stock or a worthlessness event within
the meaning of Sec. 1.1502-80(c). For example, when a consolidated
group fails to meet the
[[Page 1997]]
conditions in Sec. 1.1504-3(b)(2) of this section and causes a QOF
member to deconsolidate, the deconsolidation event is not an inclusion
event solely as a result of the consolidated group's failure to meet
the requirements in Sec. 1.1504-3(b)(2) of this section.
(3) Basis in the deconsolidating QOF at time of deconsolidation--
(i) ELA in a deconsolidating QOF. Any ELA in stock of the
deconsolidating QOF at the time of the deconsolidation is taken into
account under the rules of Sec. 1.1502-19. See paragraph (b)(1)(iii)
of this section for rules coordinating the application of section
1400Z-2(c) with Sec. 1.1502-19.
(ii) Positive basis in the deconsolidating QOF resulting from Sec.
1.1502-32. Consolidated group members retain any positive basis in the
deconsolidating QOF resulting from investment adjustments under Sec.
1.1502-32 following its deconsolidation. However, following the
deconsolidation, for purposes of determining the amount includible
under Sec. 1.1400Z2(b)-1(e), the amount of basis referred to in
section 1400Z-2(b)(2)(A)(ii) is computed by applying only those rules
applicable to corporations that do not file a consolidated return (that
is, the basis rules under subchapter C and section 1400Z-2). Therefore,
any positive basis resulting from Sec. 1.1502-32 adjustments is not
taken into account in computing the includible amount under Sec.
1.1400Z2(b)-1(e).
(4) Deconsolidating QOF's earnings and profits--(i) Deconsolidation
on or before December 31, 2026. Notwithstanding Sec. 1.1502-33(e)(1),
if a deconsolidating QOF deconsolidates before December 31, 2026, the
deconsolidating QOF retains its earnings and profits under this
paragraph (g)(4)(i). Any earnings and profits of the deconsolidating
QOF that were taken into account by any other members under Sec.
1.1502-33 are eliminated from those members as of the end of the day on
which the deconsolidating QOF deconsolidates.
(ii) Deconsolidation after December 31, 2026. If the
deconsolidating QOF deconsolidates after December 31, 2026, the rules
under Sec. 1.1502-33(e) apply.
(5) Consequences under Sec. 1.1502-36. See Sec. 1.1502-
36(f)(10)(i)(B) for the treatment of a deconsolidation as a transfer of
all of the stock in the deconsolidating member held by other members of
the consolidated group.
(h) Form and manner of making an election under this section--(1)
In general. The elections provided in this section are irrevocable. The
information required for each election is provided in this paragraph
(h). A reclassification election under paragraph (f)(2) of this section
is effective as of day one. All other elections are effective on the
election date.
(2) Election under paragraph (c)(2) of this section to treat
investment by M2 as qualifying investment by M1--(i) Form of election.
The election under paragraph (c)(2) of this section must be made in the
form of a statement titled ``THIS IS AN ELECTION UNDER Sec. 1.1502-
14Z(c)(2) TO TREAT AN INVESTMENT BY [insert name and employer
identification number (E.I.N.) of M2] AS A QUALIFYING INVESTMENT BY
[insert name and E.I.N. of M1].'' The statement must be included with
the consolidated group's timely filed return (original, superseding, or
amended return, as applicable, including extensions). In addition, the
statement must include the information required under paragraph
(h)(2)(ii) of this section.
(ii) Required information. (A) The amount of M1's eligible gain;
(B) The amount of the investment M2 has made in a QOF, including
identification of the amount of the investment that is eligible for
treatment as a qualifying investment under paragraph (c)(2) of this
section and the amount (if any) that is not eligible for such
treatment; and
(C) The date on which M1 recognized its eligible gain, and the date
on which M2 made the investment in the QOF.
(3) Elections under paragraph (f) of this section for transition
relief--(i) Form of election. The elections under paragraph (f) of this
section must be made in the form of a statement titled ``THIS IS AN
ELECTION UNDER Sec. 1.1502-14Z(f) FOR [insert name and E.I.N. of pre-
existing QOF sub].'' All actions necessary to make these elections,
including the filing of an amended return (or superseding return, as
applicable), or filing an original return, as applicable, must be
completed within the time designated in paragraph (h)(3)(iii) of this
section. The statement must be included on or with any amended prior-
year consolidated return (or superseding or original return, as
applicable) and on or with the consolidated group's timely filed return
(original or amended if filed by the due date for the return, including
extensions) for the election year. In addition, the statement must
include the information required in paragraph (h)(3)(ii) of this
section.
(ii) Required information--(A) Reclassification election under
paragraph (f)(2)(ii) of this section. (1) A statement that the pre-
existing QOF sub is electing to be a QOF partnership;
(2) The election date;
(3) The effective date of the election;
(4) Specification of the appropriate adjustments required under
paragraph (f)(2)(ii) of this section made by the pre-existing QOF sub
and the consolidated group; and
(5) Certification that the appropriate change under state law or
the entity classification election under Sec. 301.7701-3 of this
chapter (as applicable) has been made, and the date of the change or
entity classification election.
(B) Reclassification election under paragraph (f)(2)(iii) or (iv)
of this section. (1) A statement that the pre-existing QOF sub is
changing its status;
(2) The pre-existing QOF sub's new status (either a non-member QOF
C corporation, under paragraph (f)(2)(iii) of this section, or a non-
QOF C corporation, under paragraph (f)(2)(iv) of this section);
(3) The election date;
(4) The effective date of the election; and
(5) Specification of the appropriate adjustments made the by pre-
existing QOF sub and the consolidated group pursuant to paragraph
(f)(2)(iii) or (iv) of this section, as applicable.
(C) Election to continue treating the pre-existing QOF sub as a
subsidiary member of the consolidated group under paragraph (f)(3) of
this section. (1) A statement that the pre-existing QOF sub is electing
to retain its status as a QOF C corporation and remain a member of the
consolidated group;
(2) The election date; and
(3) Certification that the pre-existing QOF sub and the
consolidated group are in compliance with the conditions under Sec.
1.1504-3(b)(2)(ii) as of the date that the pre-existing QOF sub and the
consolidated group are in compliance with the conditions under Sec.
1.1504-3(b)(2)(ii).
(iii) Time for completing the elections under paragraph (f) of this
section. (A) If the pre-existing QOF sub is making an election under
paragraph (f)(2)(ii) or (f)(3) of this section, all actions necessary
to make such election must be completed by April 13, 2020.
Specifically, if the pre-existing QOF sub is making the election under
paragraph (f)(3) of this section, the conditions in Sec. 1.1504-
3(b)(2)(ii) must be met by April 13, 2020. In addition, the
consolidated group's amended return (or superseding return, as
applicable), taking into account the relevant changes, if applicable,
must be filed by May 12, 2020. Moreover, if the electing QOF
partnership had been a QOF partnership on day one and the electing QOF
partnership's return would have been
[[Page 1998]]
due, then such return also must be filed by May 12, 2020].
(B) If the pre-existing QOF sub is making a reclassification
election under paragraph (f)(2)(iii) or (iv) of this section, all
actions necessary to make such election, including the filing of the
pre-existing QOF sub's own return (if the return would have been due
had the pre-existing QOF sub not been included in the consolidated
group on day one), and the consolidated group's amended return (or
superseding return, as applicable), if applicable, must be completed by
April 13, 2020.
(iv) Extension of statute of limitations. If, as a result of making
a reclassification election in paragraph (f)(2) of this section, the
consolidated group is required to file an amended return, and the
electing QOF partnership is required to file a return by May 12, 2020
or the pre-existing QOF sub is required to file a return by April 13,
2020 (collectively, the related returns), then the consolidated group
(and the pre-existing QOF sub, if an election under paragraph
(f)(2)(iii) of this section is made) also must consent to extend the
period of limitations on assessment with respect to any issues arising
under section 1400Z-2 in the related returns of the consolidated group
(and the pre-existing QOF sub, if applicable). This consent must be
effected at such time and in such form and manner as may be prescribed
by the Commissioner of Internal Revenue in Internal Revenue Service
forms or instructions or in publications or guidance published in the
Internal Revenue Bulletin (see Sec. Sec. 601.601(d)(2) and 601.602 of
this chapter).
(i) [Reserved]
(j) Examples. The following examples illustrate the rules of this
section. For purposes of these examples, and unless otherwise stated: P
is the common parent of the P consolidated group (P group); S, B, and M
are members of the P group; Q is a QOF C corporation that is not a
member of the P group; and X is an unrelated party.
(1) Example 1: Distribution by a QOF member and inclusion
events--(i) Facts. P wholly owns S. In 2018, S sells an asset to an
unrelated party and realizes $500x of eligible gain. S forms a new
QOF C corporation Q2, contributes $500x to Q2 in exchange for stock
of Q2, and properly elects to defer the eligible gain under section
1400Z-2(a) and Sec. 1.1400Z2(a)-1. The P group elects under Sec.
1.1504-3(b)(2) to consolidate Q2. In 2024, Q2 distributes $20x to S
when S's basis in Q2 is $50x, the value of Q2 exceeds $500x, and Q2
has no earnings and profits. There are no other events in 2024 that
results in investment adjustments to Q2 stock.
(ii) Analysis. Under Sec. Sec. 1.1502-13(f)(2) and 1.1502-32,
the intercompany distribution from Q2 to S of $20x reduces S's basis
in Q2 to $30x ($50x-$20x). Under paragraph (b)(1)(i) of this
section, because the distribution does not create or increase an ELA
in Q2 stock, the distribution is not an inclusion event.
(iii) Distribution that creates an ELA. The facts are the same
as in paragraph (j)(1)(i) of this section except that in 2024 Q2
distributes $70x to S. Under Sec. Sec. 1.1502-13(f)(2) and 1.1502-
32, the intercompany distribution from Q2 to S of $70x reduces S's
basis in Q2 to $0 and creates an ELA of $20x ($50x-$70x). Under
paragraph (b)(1)(i) of this section, because an ELA is created in
Q2's stock, the distribution is an inclusion event to the extent of
the increase in the ELA. S therefore includes $20x of its deferred
gain into income in 2024. See Sec. 1.1400Z2(b)-1(e)(2). In
addition, under Sec. 1.1400Z2(b)-1(g)(1)(ii), the adjustment to S's
basis in Q2 under section 1400Z-2(b)(2)(B)(ii) is applied before
determining the other Federal income tax consequences of the
distribution. Therefore, as a result of the inclusion event, S's
basis in Q2 is first increased to $70x ($50x + $20x), and then S's
basis in Q2 is reduced by $70x (the amount of the distribution) to
$0 under Sec. 1.1502-32.
(2) Example 2: Basis adjustment when member owns qualifying QOF
stock--(i) Facts. P wholly owns S. In 2018, S sells an asset to an
unrelated party and realizes $500x of eligible gain. S contributes
$500x to Q in exchange for stock of Q and properly elects to defer
the eligible gain under section 1400Z-2(a) and Sec. 1.1400Z2(a)-1.
S does not otherwise own stock in Q. In 2026, the fair market value
of S's qualifying investment in Q exceeds $500x. In 2029, when S
still owns its qualifying investment in Q, P sells all of the stock
of S to X. S retains its stock in Q.
(ii) Analysis--(A) Five-year and seven-year basis increase and
Sec. 1.1502-32 tier-up. In 2023, when S has held the stock of Q for
five years, under section 1400Z-2(b)(2)(B)(iii), S increases its
basis in its Q stock by $50x (10 percent of $500x, the amount of
gain deferred by reason of section 1400Z-2(a)(1)(A)). The 10-percent
basis increase qualifies as tax-exempt income to S under paragraph
(d) of this section. Thus, P (an upper-tier member) increases its
basis in S's stock by $50x under Sec. 1.1502-32(b)(2)(ii).
Similarly, in 2025, when S has held the stock of Q for seven years,
under section 1400Z-2(b)(2)(B)(iv), S increases its basis in its Q
stock by an additional $25x (5 percent of $500x). The 5-percent
basis increase also qualifies as tax-exempt income to S under
paragraph (d) of this section, and P increases its basis in S's
stock by an additional $25x under Sec. 1.1502-32(b)(2)(ii).
(B) S's recognition of deferred capital gain in 2026. S did not
dispose of its Q stock prior to December 31, 2026. Therefore, under
section 1400Z-2(b)(1)(B) and Sec. 1.1400Z2(b)-1(b)(2), S's
remaining deferred gain is included in S's income on December 31,
2026. The amount of gain included under section 1400Z-2(b)(2)(A) and
Sec. 1.1400Z2(b)-1(e)(3) is $425x ($500x of remaining deferred gain
less S's $75x basis in Q). S's basis in Q is increased by $425x to
$500x, and P's basis in S also is increased by $425x under Sec.
1.1502-32(b)(2)(i).
(C) P's disposition of S. P's sale of S stock in 2029 results in
the deconsolidation of S. S retains its Q stock, and S is not
treated as selling or exchanging its Q stock for purposes of section
1400Z-2(c). Therefore, no basis adjustments under section 1400Z-2
are made as a result of P's sale of S stock.
(iii) S sells the stock of Q after 10 years. The facts are the
same as in paragraph (j)(2)(i) of this section, except that in 2029,
instead of P selling all of the stock of S, S sells all of the stock
of Q to X for its fair market value of $800x. At the time of the
sale, S has owned the Q stock for over 10 years, and S elects under
section 1400Z-2(c) to adjust its stock basis in Q from $500x (see
the analysis in paragraph (j)(2)(ii)(B) of this section) to $800x,
the fair market value of Q on the date of the sale. As a result of
the election, S has no gain on the sale of Q stock. Additionally,
the $300x basis increase in Q is treated as tax-exempt income to S
pursuant to paragraph (d) of this section. Thus, P increases its
basis in P's S stock by $300x under Sec. 1.1502-32(b)(2)(ii).
(3) Example 3: Intercompany sale of qualifying investment--(i)
Facts. In 2018, S sells an asset to an unrelated party and realizes
$100x of eligible gain. Also in 2018, S contributes $100x to Q in
exchange for Q stock and properly elects to defer the eligible gain
under section 1400Z-2(a) and Sec. 1.1400Z2(a)-1. S does not
otherwise own stock in Q. In 2021, S sells all of its Q stock to B
for $250x in a fully taxable transaction. In 2026, the fair market
value of Q is $300x. In 2030, B sells the Q stock to X for $800x.
(ii) Analysis--(A) Intercompany sale treated as an inclusion
event. In 2021, S's sale of its Q stock to B is an inclusion event
under section 1400Z-2(b)(1) and Sec. 1.1400Z2(b)-1(c). The amount
includible pursuant to Sec. 1.1400Z2(b)-1(e)(1) is $100x (the
lesser of the remaining deferred gain of $100x and the fair market
value of the qualifying investment of $250x, over S's basis in Q,
$0). As a result of the inclusion, S's basis in Q increases from $0
to $100x and S also realizes a capital gain of $150x ($250x of
amount realized less its $100x basis in the Q stock) from the
intercompany sale of Q to B. Because S's sale of its Q stock to B is
a fully taxable transaction, paragraph (c)(3)(ii) of this section
applies to treat the sale as an intercompany transaction and S's
intercompany gains are taken into under Sec. 1.1502-13(c)(2)(ii).
Thus, S defers the inclusion of its $100x of remaining deferred gain
and its $150x of capital gain in 2021. B has a $250x basis in its Q
stock.
(B) Five-year basis increase in 2023. Pursuant to paragraph
(c)(3)(ii) of this section, S and B are treated as divisions of a
single entity for purposes of applying section 1400Z-2. In 2023, the
single entity would have held the QOF investment for five years and
its basis in Q would be increased to $10x ($100x x 10%) under
section 1400Z-2(b)(2)(B)(iii). To achieve this single entity result,
$10x of S's $100x of remaining deferred gain is redetermined to be
tax-exempt income. See Sec. 1.1502-13(c)(1); see also paragraph
(c)(3)(ii)(B) of this section making Sec. 1.1502-13(c)(6)(ii)
inapplicable in
[[Page 1999]]
determining the excludability of S's intercompany gain. Therefore,
in 2023, S is treated as having $10x of tax-exempt income, S's
remaining deferred gain is $90x ($100x-$10x), while B's basis in Q
remains $250x.
(C) Seven-year basis increase in 2025. The same analysis in
paragraph (j)(3)(ii)(B) of this section applies for the year 2025.
Therefore, in 2025, S is treated as having $5x ($100x x 5%) of tax-
exempt income, S's remaining deferred gain is $85x ($90x-$5x), and
B's basis in Q remains $250x.
(D) Inclusion of S's remaining deferred gain in 2026. B
continues to own the Q stock through 2026, and, treating S and B as
divisions of a single entity for purposes of section 1400Z-2, the
single entity would include its remaining deferred gain in income on
December 31, 2026. See section 1400Z-2(b)(1), Sec. 1.1400Z2(b)-
1(b). On a single-entity basis, the amount includible pursuant to
Sec. 1.1400Z2(b)-1(e) is $85x (the lesser of the remaining deferred
gain of $100x and the fair market value of the qualifying investment
of $300x, over the single entity's basis in Q, $15x). B does not
otherwise have an income event with respect to its Q stock in 2026.
Therefore, under Sec. 1.1502-13(c), all $85x of S's remaining
deferred gain is taken into account in 2026. In addition, S's $150x
of capital gain on its Q stock sale continues to be deferred, and
B's basis in Q remains $250x.
(E) B sells the Q stock in 2030. In 2030, B sells all its Q
stock to X for $800x. Under paragraph (c)(3)(ii)(D) of this section,
B is entitled to make the election under section 1400Z-2(c) if,
treating S and B as a single entity, the single entity would be
eligible to make the election. Taking into account S's holding
period, B has held Q for over 10 years, and B is eligible for the
election when it sells Q to X in 2030. B makes the section 1400Z-
2(c) election at the time of sale. Following the election, if S and
B were divisions of a single entity, the single entity's basis in Q
would increase from $100x to its fair market value of $800x, causing
to be excluded the $700x of gain on the sale of Q stock. To achieve
this single entity result, Sec. 1.1502-13(c)(1) redetermines B's
$550x ($800x-$250x) of gain and S's deferred $150x of capital gain
to be tax-exempt income. See paragraph (c)(3)(ii)(B) of this section
making Sec. 1.1502-13(c)(6)(ii) inapplicable in determining the
excludability of S's intercompany gain. Therefore, as a result of
the sale of the Q stock and B making the section 1400Z-2(c)
election, S has $150x of tax-exempt income, and B has $550x of tax-
exempt income.
(4) Example 4: Intercompany sale of qualifying investment
followed by sale of QOF at a loss outside of the consolidated
group--(i) Facts. The facts are the same as in paragraph (j)(3)(i)
of this section, except that in 2030, B sells the stock of Q for
$225x to X.
(ii) Analysis. The analysis for tax years prior to 2030 is the
same as in paragraphs (j)(3)(ii)(A) through (D) of this section. In
addition, applying the analysis in paragraph (j)(3)(ii)(E) of this
section, B is entitled to make the election under section 1400Z-2(c)
and B makes the election. Following the election, if S and B were
divisions of a single entity, the single entity's basis in Q would
increase from $100x to $225x, causing to be excluded the $125x of
gain on the sale of Q stock. To achieve this single entity result,
Sec. 1.1502-13(c)(1) redetermines B's $25x ($225x-$250x) of loss to
be a noncapital, nondeductible expense and S's deferred $150x of
capital gain to be tax-exempt income. Therefore, as a result of the
sale of Q stock and B making the section 1400Z-2 election, S has
$150x of tax-exempt income, and B has $25x of noncapital,
nondeductible expense.
(5) Example 5: Intercompany section 351 transfer of qualifying
investment--(i) Facts. In 2018, M sells an asset to an unrelated
party and realizes $100x of eligible gain. Also in 2018, M
contributes $100x to Q in exchange for Q stock and properly elects
to defer the eligible gain under section 1400Z-2(a) and Sec.
1.1400Z2(a)-1. M does not otherwise own stock in Q. In 2021, when
the value of Q is $200x, M contributes all of its Q stock to S in
exchange for S stock in a transaction that qualifies under section
351.
(ii) Analysis. In 2021, M's contribution of its Q stock to S is
an inclusion event under section 1400Z-2(b)(1) and Sec.
1.1400Z2(b)-1(c). The amount includible pursuant to Sec.
1.1400Z2(b)-1(e) is $100x (the lesser of the remaining deferred gain
of $100x and the fair market value of the qualifying investment of
$200x, over S's basis in Q, $0). Because M's contribution of its Q
stock to S is not a fully taxable transaction, the general rule in
paragraph (c)(3)(i) of this section applies to treat the
contribution as not an intercompany transaction for purposes of
applying section 1400Z-2, and Sec. 1.1502-13 does not apply to
treat M and S as a single entity for purposes of section 1400Z-2.
Thus, as a result of the transfer, M takes its $100x of remaining
deferred gain into account, M's basis in S is $100x, and S's basis
in Q is $100x.
(6) Example 6: Intercompany sale of qualifying investment
followed by a tax-free transfer of the qualifying investment--(i)
Section 351 transfer to another member of the consolidated group--
(A) Facts. In 2018, S sells an asset to an unrelated party and
realizes $100x of eligible gain. Also in 2018, S contributes $100x
to Q in exchange for Q stock and properly elects to defer the
eligible gain under section 1400Z-2(a) and Sec. 1.1400Z2(a)-1. S
does not otherwise own stock in Q. In 2021, when the fair market
value of the Q stock is $250, S sells all of its Q stock to B for
$250x in a fully taxable transaction. In 2024, B transfers all its Q
stock to another member of the P group, B2, in a section 351
transaction. At such time, the fair market value of the Q stock is
$300x.
(B) Analysis--(1) Intercompany sale in 2021. In 2021, S's sale
of its Q stock to B is an inclusion event under section 1400Z-
2(b)(1) and Sec. 1.1400Z2(b)-1(c). The amount includible pursuant
to Sec. 1.1400Z2(b)-1(e) is $100x (the lesser of the remaining
deferred gain of $100x and the fair market value of the qualifying
investment of $250x, over S's basis in Q, $0). As a result of the
inclusion, S's basis in its Q stock increases from $0 to $100x and S
also realizes a capital gain of $150x ($250x of amount realized less
its $100x basis in the Q stock) from the intercompany sale of the Q
stock to B. Because S's sale of its Q stock to B is a fully taxable
transaction, paragraph (c)(3)(ii) of this section applies to treat
the sale as an intercompany transaction. Therefore, S's intercompany
gains are taken into account under Sec. 1.1502-13(c) and (d). Thus,
S defers the inclusion of its $100x of remaining deferred gain and
its $150x of capital gain in 2021. B has a $250x basis in its Q
stock.
(2) Five-year basis increase in 2023. Pursuant to paragraph
(c)(3)(ii) of this section, S and B are treated as divisions of a
single entity for purposes of applying section 1400Z-2. In 2023, the
single entity has held the QOF investment for five years and its
basis in the Q stock would be increased to $10x ($100x x 10%) under
section 1400Z-2(b)(2)(B)(iii). To achieve this single entity result,
$10x of S's $100x of remaining deferred gain is redetermined to be
tax-exempt income. See Sec. 1.1502-13(c)(1); see also paragraph
(c)(3)(ii)(B) of this section making Sec. 1.1502-13(c)(6)(ii)
inapplicable in determining the excludability of S's intercompany
gain. Therefore, in 2023, S is treated as having $10x of tax-exempt
income, S's remaining deferred gain is $90x ($100x-$10x), and B's
basis in the Q stock remains $250x.
(3) Intercompany transfer in a section 351 transaction. In 2024,
B's contribution of its Q stock to B2, a member of the P group, is
an inclusion event under section 1400Z-2(b)(1) and Sec.
1.1400Z2(b)-1(c). The amount includible pursuant to Sec.
1.1400Z2(b)-1(e) is $90x (the remaining deferred gain as determined
in paragraph (j)(6)(i)(B) of this section). Because B's contribution
of its Q stock to B2 is not a fully taxable transaction, the general
rule in paragraph (c)(3)(i) of this section applies to prevent the
contribution from being treated as an intercompany transaction for
purposes of section 1400Z-2. As a result, for purposes of section
1400Z-2, Sec. 1.1502-13 does not apply to treat B and B2 as a
single entity, and the application of Sec. 1.1502-13(j) is adjusted
accordingly. As a result of the section 351 transfer, S takes its
$90x of remaining deferred gain into account. B's basis in its B2
stock is $250x, and B's basis in its Q stock is $250x. However,
because S's $150x of capital gain from the intercompany sale of its
Q stock to B in 2021 is not an item related to section 1400Z-2, it
continues to be deferred under Sec. 1.1502-13 because B2 is a
member of the P group. See Sec. 1.1502-13(j)(4) regarding
successive intercompany transactions.
(ii) Section 351 transfer to a non-member--(A) Facts. The facts
are the same as in paragraph (j)(6)(i)(A) of this section, except
that B2 is not a member of the P group, and B contributes all its Q
stock to B2 in a transaction that qualifies under section 351.
(B) Analysis--(1) Intercompany sale in 2021 and five-year basis
increase in 2023. The analysis for the 2021 and 2023 tax years are
the same as in paragraphs (j)(6)(i)(B)(1) and (2) of this section.
(2) Transfer of Q to a non-member in a section 351 transaction.
In 2024, B's contribution of its Q stock to B2, a non-member of the
P group, is an inclusion event under section 1400Z-2(b)(1) and Sec.
1.1400Z2(b)-1(c). The amount includible
[[Page 2000]]
pursuant to Sec. 1.1400Z2(b)-1(e) is $90x (the remaining deferred
gain as determined in paragraph (j)(6)(ii)(B)(1) of this section).
S's deferred capital gain of $150x is taken into account in 2024
under the acceleration rule of Sec. 1.1502-13(d) because the Q
stock has left the P group. B2's holding period for the qualifying
investment does not include the time during which B and S held the
qualifying investment.
(iii) Section 721(a) transfer to a partnership--(A) Facts. The
facts are the same as in paragraph (j)(6)(i)(A) of this section,
except that B2 is a partnership, and an unrelated party is the other
partner in B2. B's transfer of all of its Q stock to B2 qualifies
for non-recognition treatment under section 721(a). In 2026, the
fair market value of Q is $330x.
(B) Analysis--(1) Intercompany sale in 2021 and five-year basis
increase in 2023. The analysis for the 2021 and 2023 tax years are
the same as in paragraphs (j)(6)(i)(B)(1) and (2) of this section.
(2) Transfer of Q stock to a partnership in a section 721(a)
transaction. In 2024, B transfers its Q stock to B2, a partnership,
in a section 721(a) transaction. Although a section 721(a)
transaction is not an inclusion event under Sec. 1.1400Z2(b)-
1(c)(7), under the acceleration rule of Sec. 1.1502-13(d), S must
take into account its $90x of remaining deferred gain because B2 has
benefited from an increased basis in the Q stock as a result of the
intercompany sale between S and B such that this is the appropriate
time to take the remaining deferred gain into account. S's deferred
capital gain of $150x is taken into account in 2024 for the same
reason.
(7) Example 7: Computation and application of the attribute
reduction amount under Sec. 1.1502-36(d) when S owns a QOF--(i)
Facts. In 2018, S sells an asset to an unrelated party and realizes
$5,000x of eligible gain. S contributes $5,000x to Q in exchange for
stock of Q and properly elects to defer the eligible gain under
section 1400Z-2(a) and Sec. 1.1400Z2(a)-1. In 2024, M sells all of
its S stock to X for its fair market value of $100x, and M's basis
in the stock of S is $300x. At the time of sale, S owns the Q stock
with a basis of $500x (S's basis in its Q stock was increased under
section 1400Z-2(b)(2)(B)(iii) to $500x in 2023), and S has a net
operating loss carryover of $50x. M's transfer of the S shares is a
transfer of loss shares under Sec. 1.1502-36. Assume that no basis
redetermination is required under Sec. 1.1502-36(b) and no basis
reduction is required under Sec. 1.1502-36(c).
(ii) Attribute reduction under Sec. 1.1502-36(d). Under Sec.
1.1502-36(d), S's attributes are reduced by S's attribute reduction
amount. Section 1.1502-36(d)(3) provides that S's attribute
reduction amount is the lesser of the net stock loss and S's
aggregate inside loss. The net stock loss is the excess of the $300x
aggregate basis of the transferred S shares over the $100x aggregate
value of those shares, or $200x. S's aggregate inside loss, which
includes the basis of the stock of Q as provided by paragraph (e) of
this section, is the excess of S's net inside attribute amount over
the value of the S share. S's net inside attribute amount is $550x,
computed as the sum of S's $50x loss carryover and its $500x basis
in Q. S's aggregate inside loss is therefore $450x ($550x net inside
attribute amount over the $100x value of the S share). Accordingly,
S's attribute reduction amount is the lesser of the $200x net stock
loss and the $450x aggregate inside loss, or $200x. Under Sec.
1.1502-36(d)(4), S's $200x attribute reduction is first allocated
and applied to reduce S's $50x loss carryover to $0. Under Sec.
1.1502-36(d)(4)(i)(D), S generally would be able to reduce the basis
of its category D assets (including stock in other corporations) by
the remaining attribute reduction amount ($150x). However, paragraph
(e) of this section provides that S's basis in the stock of Q is not
included in S's Category D attributes that are available for
reduction under Sec. 1.1502-36(d)(4), and the remaining $150x of
attribute reduction amount cannot be used to reduce the basis of Q
shares under Sec. 1.1502-36(d). Rather, under paragraph (e) of this
section, P is treated as making the election under Sec. 1.1502-
36(d)(6) to reduce M's basis in the transferred loss S shares by
$150x. As a result, P's basis in its M stock is also reduced by
$150x.
(k) Applicability dates--(1) In general. This section applies for
taxable years beginning after March 13, 2020.
(2) Prior periods. With respect to the portion of a consolidated
group'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, a consolidated group may
choose either--
(i) To apply the section 1400Z-2 regulations, if applied in a
consistent manner for all such taxable years; or
(ii) To rely on the rules in proposed Sec. 1.1400Z2(g)-1 contained
in the notice of proposed rulemaking (REG-120186-18) published on May
1, 2019, but only if applied in a consistent manner for all such
taxable years.
0
Par. 11. Section 1.1504-3 is added to read as follows:
Sec. 1.1504-3 Treatment of stock in a QOF C corporation for purposes
of consolidation.
(a) Scope and definitions--(1) Scope. This section provides rules
regarding the treatment of stock in a QOF C corporation for purposes of
determining whether such corporation can join in the filing of a
consolidated return. Paragraph (b) of this section generally prevents a
subsidiary QOF C corporation from joining in the filing of a
consolidated return, but it provides an election to consolidate a
subsidiary QOF C corporation (subject to certain conditions). Paragraph
(c) of this section provides instructions for making the election
provided by paragraph (b) of this section. Paragraph (d) of this
section provides an example. Paragraph (e) of this section provides the
applicability dates.
(2) Definitions. The definitions provided in Sec. Sec.
1.1400Z2(a)-1(b) and 1.1502-14Z(a)(2)(ii) apply for purposes of this
section.
(b) QOF stock not stock for purposes of affiliation--(1) In
general. Except as otherwise provided in paragraph (b)(2) of this
section, stock in a QOF C corporation (whether qualifying QOF stock or
otherwise) is not treated as stock under section 1504 for purposes of
determining whether the issuer may join in the filing of a consolidated
return under section 1501. Therefore, a QOF C corporation can be the
common parent of a consolidated group, and a QOF C corporation
generally can be a member of an affiliated group for purposes of
section 1504, but a QOF C corporation cannot join in the filing of a
consolidated return as a subsidiary member (except as provided in
paragraph (b)(2) of this section).
(2) Election to consolidate a subsidiary QOF C corporation--(i) In
general. Notwithstanding paragraph (b)(1) of this section, a
consolidated group may elect to consolidate a subsidiary QOF C
corporation that was formed, or section 1504 control of which was
acquired, by the consolidated group after May 1, 2019, and that
otherwise meets the affiliation requirements under section 1504. If a
pre-existing corporation was a member of the consolidated group prior
to becoming a QOF C corporation, a consolidated group may elect to
continue to consolidate such pre-existing corporation if it self-
certified to be a QOF after May 1, 2019. The consolidated group must
make the election under this paragraph (b)(2) with regard to the first
taxable year during which the subsidiary QOF C corporation otherwise
meets the section 1504 affiliation requirements (without regard to
paragraph (b)(1) of this section). See Sec. 1.1502-14Z(f)(3) for an
election available with regard to a subsidiary QOF C corporation that
met the section 1504 affiliation requirements as of May 1, 2019. The
election under this paragraph (b)(2) is effective on the later of May
1, 2019, or the first date on which the QOF C corporation otherwise
meets the requirements of section 1504. If a consolidated group makes
the election under this paragraph (b)(2), then the conditions in
paragraph (b)(2)(ii) of this section apply to the consolidated group
and to the QOF member. See paragraph (c) of this section for the form
and manner of making this election.
(ii) Conditions to consolidate a subsidiary QOF C corporation--(A)
Ownership status of QOF investor member. On and at all times after the
[[Page 2001]]
date of the investment, the common parent must directly or indirectly
own all shares of all classes of stock (including non-qualified
preferred stock) issued by any QOF investor member.
(B) Direct investment. Except as provided in Sec. 1.1502-14Z(c),
each QOF investor member must maintain direct ownership of its
qualifying investment (see, for example, Sec. 1.1400Z2(b)-1(c), which
generally treats transfers of a qualifying investment as an inclusion
event). See Sec. 1.1502-14Z(c)(4) for rules regarding the treatment of
intercompany transfers as qualifying investments in a QOF member. See
also Sec. 1.1502-14Z(c)(2) and (c)(3)(ii) for rules regarding actual
and deemed intercompany transfers of qualifying investments.
(3) Failure of continued qualification. Consolidation of a
subsidiary QOF C corporation is contingent upon continued satisfaction
of all of the conditions of paragraph (b)(2)(ii) of this section. The
requirements of paragraph (b)(2) of this section continue to apply
(with appropriate modifications to reflect single-entity treatment)
following any intercompany transfer of the QOF member stock that is
subject to Sec. 1.1502-14Z(c)(3)(ii). For example, following an
intercompany transfer of the QOF member stock that is subject to Sec.
1.1502-14Z(c)(3)(ii), the buying member must maintain a direct
investment in the QOF member. On the failure to satisfy any condition
of paragraph (b)(2), the QOF member will deconsolidate, and Sec.
1.1502-14Z(g) will apply with respect to such deconsolidation.
(c) Election under paragraph (b)(2) of this section to consolidate
a subsidiary QOF C corporation--(1) In general. The election under
paragraph (b)(2) of this section is irrevocable and is made in the form
provided in paragraph (c)(2) of this section.
(2) Form of election. The election under paragraph (b)(2) of this
section must be made in the form of a statement titled ``THIS IS AN
ELECTION UNDER Sec. 1.1504-3(b)(2) TO CONSOLIDATE [insert name and
employer identification number (E.I.N.) of subsidiary QOF C
corporation] as of [insert date].'' The statement must be included with
the consolidated group's timely filed return (original, superseding, or
amended return, as applicable, including extensions) for the year the
election under Sec. 1.1504-3(b)(2) is made.
(d) Example. The following example illustrates the treatment of QOF
stock as not stock for purposes of affiliation as described in
paragraph (b)(1) of this section.
(1) QOF stock as not stock for purposes of affiliation to join
in the filing of a consolidated return--(i) Facts. P wholly owns S,
which wholly owns corporation Q1. P, S, and Q1 are members of the P
group. In 2021, S sells an asset to an unrelated party and realizes
$500x of eligible gain. S contributes $500x to Q1 and properly
elects to defer the eligible gain under section 1400Z-2(a) and Sec.
1.1400Z2(a)-1. At such time, Q1 qualifies and elects to be treated
as a QOF, but the P group does not elect to consolidate Q1 under
paragraph (b)(2) of this section.
(ii) Analysis. Under paragraph (b)(1) of this section, stock of
a QOF C corporation (qualifying or otherwise) is not treated as
stock for purposes of determining whether the QOF C corporation may
join in the filing of a consolidated return. Thus, because no
election has been made under paragraph (b)(2) of this section, once
Q1 becomes a QOF, Q1 ceases to be affiliated with the P group
members for purposes of section 1501, and it deconsolidates from the
P group. See Sec. Sec. 1.1502-1 through -1.1502-100 generally for
the consequences of deconsolidation.
(2) [Reserved]
(e) Applicability dates--(1) In general. This section applies for
taxable years beginning after March 13, 2020.
(2) Prior periods. With respect to the portion of a consolidated
group'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, a consolidated group may
choose either--
(i) To apply the section 1400Z-2 regulations, if applied in a
consistent manner for all such taxable years; or
(ii) To rely on the rules in proposed Sec. 1.1400Z2(g)-1 contained
in the notice of proposed rulemaking (REG-120186-18) published on May
1, 2019, but only if applied in a consistent manner for all such
taxable years.
Sunita Lough,
Deputy Commissioner for Services and Enforcement.
Approved: December 18, 2019
David J. Kautter,
Assistant Secretary (Tax Policy).
[FR Doc. 2019-27846 Filed 12-31-19; 4:15 pm]
BILLING CODE 4830-01-P