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IRS Issues Proposed Regs on Investments in Qualified Opportunity Zones

(Parker Tax Publishing April 2019)

The IRS issued proposed regulations that provide guidance under Code Sec. 1400Z-2 relating to gains that may be deferred as a result of a taxpayer's investment in a qualified opportunity fund (QOF), as well as special rules for an investment in a QOF held by a taxpayer for at least 10 years. The proposed regulations update portions of previously proposed regulations in REG-115420-18 to address various issues, including (1) the definition of "substantially all" in Code Sec. 1400Z-2, (2) the transactions that may trigger the inclusion of gain that a taxpayer has elected to defer, and (3) the timing and amount of the recognition of deferred gain. REG-120186-18.

The Tax Cuts and Jobs Act of 2017 added Code Sec. 1400Z-1 and Code Sec. 1400Z-2 to encourage economic growth and investment in designated distressed communities called "qualified opportunity zones" by providing federal income tax benefits to taxpayers who invest new capital in businesses located within qualified opportunity zones through a qualified opportunity fund (QOF).

In October 2018, the IRS issued proposed regulations in REG-115420-18 providing guidance under Code Sec. 1400Z-2 for investing in QOFs. After holding a hearing and considering comments, the IRS has issued additional proposed regulations in REG-120186-18 to describe and clarify requirements relating to investing in QOFs. Among other issues, the proposed regulations address the deferral of gain invested in a QOF and the definition of "substantially all" as used in Code Sec. 1400Z-2.

The proposed regulations allow the deferral of all or part of a gain that is invested into a QOF that would otherwise be includible in income. The gain is deferred until the investment is sold or exchanged or until December 31, 2026, whichever is earlier. If the investment is held for at least 10 years, investors may be able to permanently exclude from income gain from the sale or exchange of an investment in a QOF.

Qualified opportunity zone business property is tangible property used in a trade or business of the QOF if the property was purchased after December 31, 2017. The proposed regulations permit tangible property acquired after December 31, 2017, under a market rate lease to qualify as "qualified opportunity zone business property" if, during "substantially all" of the holding period of the property, substantially all of the use of the property was in a qualified opportunity zone.

The proposed regulations clarify the "substantially all" requirements in Code Sec. 1400Z-2 for the holding period and use of the tangible business property as follows:

(1) For purposes of determining whether an entity is a qualified opportunity zone business, a trade or business satisfies the "substantially all" test in Code Sec. 1400Z-2(d)(3) if at least 70 percent of the tangible property owned or leased by the trade or business is qualified opportunity zone business property.

(2) For determining the holding period of the property under Code Sec. 1400Z-2(d)(2)(D), tangible property must be qualified opportunity zone business property for at least 90 percent of the holding period of the QOF or qualified opportunity zone business.

(3) Under Code Sec. 1400Z-2(d)(2)(B), the partnership or corporation must be a qualified opportunity zone business for at least 90 percent of the QOF's holding period.

The proposed regulations note that, under Code Sec. 1400Z-2(b), there are situations where deferred gains may become taxable if an investor transfers an interest in a QOF. For example, if the transfer is done by gift, the deferred gain may become taxable. However, the proposed regulations provide that inheritance by a surviving spouse is not a taxable transfer, nor is a transfer, upon death, of an ownership interest in a QOF to an estate or a revocable trust that becomes irrevocable upon death.

The IRS stated that it expects to address the administrative rules under Code Sec. 1400Z-2(f) applicable to a QOF that fails to maintain the required 90 percent investment standard of Code Sec. 1400Z-2(d)(1), as well as information reporting requirements for an eligible taxpayer under Code Sec. 1400Z-2, in separate regulations, forms, or publications.

The IRS also anticipates revising Form 8996, Qualified Opportunity Fund, for tax years 2019 and following. As provided in the October 2018 proposed regulations, a QOF must file a Form 8996 with its federal income tax return for initial self-certification and for annual reporting of compliance with the 90-percent asset test in Code Sec. 1400Z-2(d)(1),

Observation: The IRS also issued a notice and request for information to seek public input on the development of public information collection and tracking related to the investment in QOFs.

While the proposed regulations generally apply to tax years ending after the date the regulations are published as final regulations, the IRS said that taxpayers may generally rely on the proposed regulations before they are finalized.

For a discussion of the tax treatment of gains from an investment in a QOF, see Parker Tax ¶110,150.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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