(ii) Historic Boardwalk Guidance  In January 2014, Treasury and the IRS issued Revenue Procedure 2014-12, 2014-3 I.R.B. 414, which established a safe harbor for federal historic tax credit investments made within a single tier or through a master lease pass-through structure. This guidance was issued in response to the Third Circuit decision in Historic Boardwalk discussed earlier. Although the Revenue Procedure does not establish substantive tax law, it does create a safe harbor for structuring HTC-advantage transactions.^201.1

According to the revenue procedure, either an investor may hold a direct partnership interest in the lessor entity that holds fee ownership of the project or, where an election is made by a lessor to pass through the HTCs to the lessee of the project, an investor may hold an indirect partnership interest in the lessor through the lessee, provided, however, that the investor does not also hold any other interest in the lessor.

The guidance makes clear that there is no minimum amount of cash that is required to be distributed to the investor in order to be respected as a partner, so projects that do not generate substantial cash returns can satisfy the upside return requirement of the guidance even if the aggregate cash generated by the investment will not exceed the investor's capital contribution. The investor, however, must receive a reasonably anticipated value, exclusive of tax benefits, commensurate with the investor member's percentage interest in the partnership.

1. At least 20 percent of an investor's total expected capital contribution must be contributed to the partnership prior to placement in service of the project and maintained for the duration of the investor's ownership of an interest in the partnership. Moreover, at least 75 percent of the investor's expected capital contribution must be fixed before placement in service. The contribution of the “fixed” portion of the investor's investment may be subject to contingencies such as placement in service, stabilization, or receipt of a Part 3 approval from the NPS. This requirement is intended to establish “downside” risk.
2. Funded guaranties are prohibited, and there is a defined range of “impermissible” guaranties. Impermissible guaranties include any guaranty of partnership distributions or other economic return and any guaranty for which the guarantor agrees to maintain a minimum net worth. It is also impermissible for any guaranty of tax structural risk or other disallowance or recapture events that are not due to an act or omission of the managing member or its affiliate. Similarly, no person involved in the HTC-advantaged transaction may pay the investor's costs or indemnify the investor for expenses incurred with respect to an IRS challenge of the HTCs.
3. Unfunded guaranties may cover 100 percent of the amount of the HTCs or the capital contributed to the partnership with respect to the HTCs. Unfunded guaranties may also cover all of the loss due to failure to complete the project as well as environmental liabilities. Further, an operating deficit reserve not in excess of 12 months of operating expenses may be established, and an operating deficit guarantee capped at 12 months of operating expenses may be provided to the investor.
4. According to the guidance, although a managing member or its affiliates may not hold a “call” option to acquire the investor member's interest in the partnership, the investor may hold an option to “put” its interest to the managing member or its affiliate for an amount that does not exceed fair market value.

The revenue procedure does not address other types of federal or state credits or transactions that combine HTCs with federal low-income housing or federal new markets tax credit transactions.

The guidance provides that the value of the investors' interest may not be diluted by “disproportionate rights to distribute distributions.” Preferred returns and special tax distributions to investors are permitted and, if not paid currently, may accrue. There will need to remain some meaningful amount of variable cash distributions after payment of deferred returns.

The guidance authorizes “flips” in the partnership interest after the end of a five-year HTC recaptured period. At all times, however, the principal's interest must be at least 1 percent of each material item of partnership income, gain, loss, deduction, and credit, and the investor's interest in such must be at least 5 percent of the largest investment percentage of such material items in the tax year for which the investor's percentage interest is the largest.

(j) State Tax Credits (as renumbered)  p. 1012. Insert the following new paragraphs at the end of this subsection:

The Tax Court maintained this position when it decided SFW Real Estate, LLC v. Commissioner.^205.1 The case involved the sale of Virginia state tax credits, and the Court again determined that the sale of the Virginia state tax credits was a disguised sale and the taxpayer was appropriately taxed on the economic benefit of funds received from the sale of the Virginia state tax credits.^205.2

In Gateway Hotel Partners, LLC v. Commissioner,^205.3 the Tax Court determined that two of the transfers of Missouri Historic Preservation Tax Credits were partnership distributions, but that a portion of the third credit transfer was a taxable sale.^205.4 The Tax Court considered whether three transfers made by a partnership resulted in taxable sales under the disguised sale rules, substance over form principles, or otherwise.

In Gateway,^205.5 the Tax Court considered whether the transfer of tax credits to an indirect owner of the partnership constitutes income to the partnership. No disguised sale under § 707(a)(2)(B) was found where a partner (Washington Avenue Historic Developer (“WAHD”)) contributed the proceeds of a bridge loan to a partnership (Gateway Hotel Partners, LLC (“Gateway”)) formed to engage in a historic real property development project in exchange for a preferred interest in Gateway and later received a distribution of state tax credits generated by the project. IRS took the position that Gateway was the bridge loan borrower and Gateway repaid the bridge loan by transferring the tax credits. However, the Tax Court found that the borrower was an upper-tier entity that borrowed the funds and then contributed the proceeds to Gateway through several tiers of entities, including WAHD.

The Tax Court then held that the distribution of the tax credits was not a disguised sale because (i) the transfer was made after the two-year period during which transfers are presumed to be a sale under Reg. § 1.707-3(d), so there was a presumption against a disguised sale; and (ii) the facts and circumstances indicated that the transaction was not a sale. In so holding, the Tax Court rejected the IRS's argument that the transfer of the credits was a disguised sale. The Tax Court primarily focused on the fact that the timing and amount of the subsequent transfer of the tax credits was not reasonably certain at the time of the bridge loan contribution and that WAHD/HRI did not have a legally enforceable right to the tax credits: since Gateway could have satisfied WAHD's preferred return with cash, instead of distributing the credits, WAHD had no right to the credits, so its preferred return was subject to the entrepreneurial risks of Gateway's business.

The IRS has listed facts and circumstances, each of which indicates that a transaction is a disguised sale because, at the time of the earlier transfer, the later transfer was not dependent on “entrepreneurial risks” of partnership operations (and, conversely, if the facts and circumstances show that, at the time of the earlier transfer, the later transfer may or may not occur, the transaction will not be treated as a disguised sale):^205.6

• The timing and amount of a subsequent transfer are determinable with reasonable certainty at the time of the earlier transfer.^205.7
• The transferor has a legally enforceable right to the subsequent transfer.^205.8
• The partner's right to receive the transfer of money or other consideration is secured in any manner, taking into account the period during which it is secured.^205.9
• Any person has made or is legally obligated to make contributions to the partnership so it can make the transfer of money or other consideration.^205.10
• Any person has loaned or agreed to loan the partnership the money or other consideration it needs to make the transfer, taking into account whether any such lending obligation is subject to contingencies related to partnership operations.^205.11
• The partnership has incurred or is obligated to incur debt to acquire the money or other consideration needed to make the transfer, taking into account the likelihood that the partnership will be able to incur the debt (including factors such as whether any person has agreed to guarantee or otherwise assume personal liability for the debt).^205.12
• The partnership holds money or other liquid assets beyond the reasonable needs of the business that are expected to be available to make the transfer (taking into account the income that will be earned from those assets).^205.13

In Gateway, even though WAHD had a disproportionately large allocation of the tax credits and did not have to return the tax credits to the partnership, the transaction was not a disguised sale (i.e., the transaction was not a disguised sale because, at the time of the earlier transfer, the later transfer was dependent on “entrepreneurial risks” of partnership operations).

So long as developers of historic rehabilitation projects recognize the importance of proper documentation and adherence to contractual arrangements, the Gateway decision should provide comfort to developers that their tax reporting of such credits is likely to be respected.^205.14 Further note that to avoid recharacterization of such a transfer of tax credits as a disguised sale under the disguised sale rules, real estate partnerships should ensure that partners do not have a right to receive tax credits specifically at a particular point in time.

However, the Tax Court determined that Gateway had sold excess tax credits with respect to a certain portion of the credits transferred. Gateway was not entitled to rescind the transaction since it did not attempt the rescission until the subsequent year. Accordingly, Gateway was required to include as income the proceeds from this transfer. It should be noted that the court imposed a 20 percent negligence penalty with regard to this small portion of the credits determined to have been sold by the taxpayer. The court's determination that the proceeds should have been applied to partnership's income deemed unreported is a warning to taxpayers as to what can happen when the documentation is not complete.

(i) Qualified Active Low-Income Community Business  p. 1036. Insert the following at the end of this subsection:

(i) Tax Issues: Use of the A and B Notes by For-Profit QALICBs

(ii) Multiple Roles

(B) AS QALICB

page 1071. Insert the following after the last Example:

Nonprofit QALICBs, in contrast to for-profit QALICBs, are more likely to produce human capital amenities including employment training centers, childcare centers, school facilities, and, most frequently, healthcare facilities. Park, open space, and recreation and community centers are the most common quality-of-life amenities, followed by art museums, cultural institutions, and public libraries, all of which are more likely to be provided by nonprofit QALICBs. Project improvements to public infrastructure most often include parking lots and garages sponsored by for-profit QALICBs.^374.1

(iii) Board Approval  p. 1074. Add the following after the Caveat under this subsection:

Traps for the Unwary. Finally, the board of the charity needs to be educated by counsel with regard to five possible traps for the unwary involving UBIT, an advance agreement to forgive the leveraged loan, the CDE fee structure, the allocation of COD income, and the use of a “straw party” as a party to the unwind.

1. There is a potential UBIT concern on exit by the nonprofit charity, after the seven-year compliance period expires, if the project is not “substantially related” to the exempt function of the organization, such as relief of the poor or underprivileged or relieving the burdens of the government. The location in a QCT isn't enough.^381.1
2. It is critical that there is no agreement in advance that the leveraged loan will be forgiven at the end of the compliance period; otherwise, the basic structure of the NMTC may be defective.
3. In most cases, there may be a need for multiple CDEs in order to direct their allocations to the project; it is important that the board of the nonprofit examine the proposed CDE fees because the fees fluctuate and in certain cases may be above market.
4. If the QALICB is structured as an LLC with multiple parties or members, including a nonprofit, and is taxed as a partnership, the operating agreement should contain specific language covering the allocation among the partners of the COD income, if any. It is important to define narrowly the section on “Refinancing Proceeds” relative to exercise of a put.
5. A straw party should not be used by a QALICB to acquire the equity interest pursuant to the exercise of the put or call. The approach may backfire on the QALICB under the related-party rules (i.e., direct or indirect acquisition of debt, which could generate COD income for the taxpayer).^381.2

p. 1075. Delete the last two sentences of the first full paragraph on this page and add the following new subsections after subsection (iv):

(v) Questions a Nonprofit Board Should Consider in the Context of New Market Tax Financing.^382.1

1. What capital investments is the organization planning over the next 12 to 18 months?
   • Real estate development/construction
   • Asset purchases
   • New lines of business/service
   • Capital investments in the ordinary course of business
2. Does the organization plan on increasing headcount or services over the next 12 to 24 months?
3. Does the organization plan any potential reduction in community services issues over the next 12 months due to lack of funding?
4. Does the organization have projects/services that have been postponed or canceled due to capital costs and lack of funding through traditional capital campaign activities?
5. The board needs to examine the following issues before approving the structure:
   • What is the minimum deal size that is practicable, considering overall costs and recognizing that leveraged funds are difficult to obtain?
   • How does the organization go about attracting allocation?
   • Deals can take six months or longer, so it may be beneficial to begin as long as a year in advance of an allocation to “market” with prospective CDEs and equity investors.
   • Will there be continuity in management during the project development period and compliance period (seven years)?
   • Donors to a 501(c)(3) QALICB may want to have certain controls over the project and site selection.
   • There is often a perception that pledges are to be used to pay interest rather than providing a new service consistent with the exempt function of the charity.

(vi) Using a Title-Holding Corporation as a QALICB.^382.1  A QALICB charter school may use a title-holding corporation both as an asset protection vehicle and as a means of obtaining financing from a CDE in connection with an NMTC transaction.

To finance improvements on the property, the title-holding corporation may borrow funds from a third-party lender. If the title-holding corporation otherwise qualifies as a QALICB, it may borrow the required funds from a CDE as part of an NMTC transaction. The title-holding corporation may use a portion of the rent it receives from Charity A to repay the loan from the CDE. Despite the limitations imposed by § 501(c)(2) of the Code, the activities undertaken by the title-holding corporation in this example—holding a leasehold interest in improved real property in a low-income area, using loan proceeds to improve that property, leasing that property to another party, and paying all remaining income over to Charity A—are consistent with its qualifications both as a tax-exempt organization described in § 501(c)(2) of the Code and as a QALICB described in § 45D(2) of the Code.

p. 1075. Add the following new subsections (x) and (y), after subsection (w):

(x) CDFI Fund Frequently Asked Questions (FAQs)  The CDFI Fund has issued a series of New Markets Tax Credit Compliance and Monitoring Frequently Asked Questions (FAQs) since September 2011, by adding, revising, or updating select questions, some of which are highlighted here:^382.3

1. When a CDE has received principal repayments on a QLICI and reinvests those proceeds in a new QLICI, the new QLICI is subject to the same requirements found in § 3.2 of the allocation agreement (i.e., types of QLICIs, service area, etc.).

   To the extent a CDE reinvests repayments of principal as new QLICIs, the CDFI Fund is required to check compliance for all reported QLICIs against the requirements specified in the allocation agreement.

2. The six-month cure period is available to correct a CDE's or subsidiary CDE's failure to invest substantially all of its QEI proceeds.

   The six-month cure period^382.4 is available to correct a CDE's or subsidiary CDE's failure to invest substantially all of its QEI proceeds in QLICIs within the 12-month period.^382.5

   However, the six-month cure period is not automatically added to the 12-month period. The rules state that the six-month cure period begins on the date the CDE becomes aware (or reasonably should have become aware) of the failure to invest substantially all of the QEI proceeds in a QLICI within the 12-month period. (See FAQ 17.)

3. Supporting documentation that an allocatee needs to retain in order to demonstrate compliance with investing in areas of higher distress as reflected in § 3.2(h).

   In addition to CIMS, which provides non-metropolitan status, poverty rate, median family income (MFI) percentages, and unemployment rates, the CDFI Fund has provided several links on its website to assist allocations. (See the “Compliance Monitoring and Evaluation” link for details.)

   Allocatees are advised to retain all relevant information in support of its decision to invest in such areas. Supporting documentation for the areas of higher distress requirement may include statistical indices of economic distress such as poverty rates, median family income, or unemployment rates at the census tract level based on the 2006–2010 ACS; materials from other government programs (e.g., HUD Renewal Communities or EPA Brownfields) demonstrating the area qualified for assistance under those programs; and others.

   The “Compliance Monitoring and Evaluation” section on the CDFI Fund's website has links to the following sites:^382.6

   • Federally Designated Empowerment Zones, Enterprise Communities, or Renewal Communities
   • Brownfield Sites
   • SBA-Designated HUB Zones
   • Medically Underserved Areas (Department of Health and Human Services)
   • Food Desert
   • Promise Zone
4. All allocatees are required to invest substantially all (generally 85 percent) of their QEIs as QLICIs. Section 3.2(j) of the allocation agreement may require an allocatee to invest an even higher percentage of QEIs (e.g., 95 percent or 100 percent) as QLICIs, based on representations made by the allocatee in its allocation application.
   1. All allocatees must be able to demonstrate that they initially made QLICIs in the amount specified in their allocation agreements.
   2. If an allocatee subsequently receives repayments of principal from the QLICIs (e.g., amortizing loan payments), but consistent with applicable IRS regulations does not reinvest these proceeds into other QLICIs, then the allocatee will be treated as fulfilling the requirements of § 3.2(j)—notwithstanding the fact that the allocatee is no longer “fully invested” at the initial percentage.
   3. If an allocatee subsequently receives repayments of principal from the QLICIs that are sufficient enough to trigger reinvestment requirements under the IRS regulations, the allocatee is required to reinvest those proceeds in the same percentage as is required in the allocation agreement.
5. Section 6.9 of the allocation agreement requires CDEs to report Material Events to the CDFI Fund within 20 days of the occurrence.

   An updated Material Events Form can be found on the CDFI Fund's website. An allocatee should use this form to identify the nature of the event so that the CDFI Fund can determine whether it is material and affects the CDE's ability to retain certification as a CDE or remain compliant with its Allocation Agreement.^382.8

   The CDFI Fund defines a “Material Event” as an occurrence that affects an organization's strategic direction, mission, or business operation and, thereby, its status as a certified Community Development Financial Institution (CDFI) or Community Development Entity (CDE), and/or its compliance with the terms and conditions of the Allocation Agreement. The following list provides examples of Material Events that should be reported to the CDFI Fund on the Certification of Material Event Form.

   • An Event of Default as that term is defined in Section 8.1 of the allocation agreement, or any event that upon notice or lapse of time, or both, would constitute an Event of Default.
   • A merger, acquisition, or consolidation with another entity.
   • A change in the Controlling Entity identified in any allocation agreement or where the Controlling Entity will no longer have any ownership or management interest in the Allocatee and/or will no longer have control over the day-to-day management and operations (including investment decisions) of the Allocatee.
   • A change in the organization legal status (e.g., dissolution or liquidation of the organization, bankruptcy proceedings, receivership, etc.).
   • An event that materially changes the strategic direction, mission, or business of the organization such that the organization no longer meets one or more CDFI or CDE certification requirements such as no longer providing loans or equity investments.
   • Changes in business strategy that might have influenced the merits of awarding the application to the extent that such changes result in the allocation use being generally inconsistent with the strategies (including, but not limited to, the proposed product offerings and markets served) set forth in the Allocation Application.
   • An event that materially changes the organization's tax and/or corporate structure (e.g., changing from for-profit to nonprofit status).
   • An event that results in a change in control of the organization (e.g., control by, controlling relationships, loss of control—as such term is defined in the allocation agreement—by any entity that is a party thereto).
   • A change in the composition of the organization's Board of Directors (or other governing body) such that the percentage of the governing or advisory board members representing the organization's Service Area is diminished or altered.
   • Relocation of the organization's primary office to another state, which alters the organization's ability to serve or be accountable to its Service Area (based on its most recent certification prior to the relocation).
   • A proceeding or enforcement action instituted against the allocatee in, by, or before any court or governmental or administrative body or agency, which proceeding or its outcome could have a material adverse effect on the financial condition or business operations of the allocatee.
   • A proceeding instituted against a regulated Affiliate of an allocatee by or before any court or governmental or administrative body or agency, which proceeding or its outcome could have a material adverse effect on the financial condition or business operations of the allocatee.
   • A material adverse change in the condition, financial or otherwise, or operations of the allocatee that would impair the allocatee's ability to carry out the authorized uses of the allocation.
   • The debarment, suspension, exclusion, or disqualification by the Department of Treasury, or any other federal department or agency, of any individual or entity (or principal thereof) that received any portion of the allocation in a procurement or nonprocurement transaction, as defined in 31 C.F.R. § 19.970.
   • The replacement of any key management official(s) (e.g., the Executive Director, the Chief Financial Officer, the Board Chairperson, or their equivalents) who had been named in the Allocation Application.
   • The receipt of an Adverse Opinion, Qualified Opinion, or Disclaimer of Opinion in audited financial statements of the allocatee.
6. An allocatee may request an amendment to its allocation agreement.

   An allocatee may request an amendment to its allocation agreement by submitting a written request on the CDE's letterhead to the CDFI Fund. The request, at a minimum, must:^382.9

   1. identify the name and control number of the allocatee;
   2. identify the portion(s) of the allocation agreement that needs to be modified;
   3. state the reasons why the allocatee is making the request; and
   4. explain the extent to which the proposed modifications are consistent with what the allocatee had proposed in its initial application to the CDFI Fund, and will help to further the goals of the New Markets Tax Credit Program.

      The request can be submitted by email to [email protected] with subject line: NMTC: Allocation Agreement Amendment Request. The request can also be submitted by mail to:

   • Attention: Compliance
   • U.S. Department of the Treasury
   • Community Development Financial Institutions Fund
   • 1500 Pennsylvania Avenue, NW

     Washington, DC 20220

     Justification for approving an amendment to an allocation agreement includes, but is not limited to, a determination that the amendment request is:

   1. consistent with the intent of the NMTC Program statute and regulations and furthers the goals of the NMTC Program;
   2. consistent with (or not a substantive departure from) the business strategy proposed in the initial application for an allocation; and
   3. sufficiently narrow in scope that it does not disadvantage other allocatees or other applicants from the same allocation round.

      Although an amendment request can be submitted at any time, it must be submitted no later than 90 calendar days before the allocatee needs the determination.

7. There are new QALICB use restrictions that relate to QLICI proceeds being used to repay or refinance any debt or equity provider (or an affiliate of any debt or equity provider). Beginning with the CY 2015–2016 round, any debt or equity provider, or affiliate of any debt or equity provider, whose capital was used, directly or indirectly, to fund a QEI may receive QLICI proceeds to repay or refinance reasonable expenditures that are incurred by the debt or equity provider (or affiliate) and that are directly attributable to the qualified business of the QALICB if the expenditures (i) were incurred no more than 24 months prior to the date on which the QLICI transaction closes or (ii) represent no more than 5 percent of the total QLICI proceeds from the QEI.^382.10

In summary, of the $1.7 million in documented, reasonable expenditures directly attributable to the qualified business of the QALICB incurred by A, the QALICB may elect to either reimburse the full amount of reasonable expenditures incurred within 24 months of the QLICI closing date ($1 million) or reimburse reasonable expenditures that represent up to 5 percent of the QLICI proceeds incurred at any time prior to the QLICI closing date ($500,000). It may not do both.

The CDFI Fund will need to monitor the restriction on the use of QLICI proceeds to directly or indirectly repay or refinance any debt or equity provider, or affiliate to any debt or equity provider, whose capital was used, directly or indirectly, to fund the QEI required under the CY 2015–2016 NMTC application.^382.11

A QALICB may use QLICI proceeds to repay or refinance any debt or equity provider, or affiliate of any debt or equity provider, and to monetize an asset owned by, contributed, sold, or otherwise transferred to the QALICB (or an affiliate of a QALICB) but not including the accreted value of an asset.

Under the CY 2015–2016 round, a QALICB is permitted to use QLICI proceeds only to repay or refinance a debt or equity provider (or affiliate of a debt or equity provider) whose capital was used directly or indirectly to fund the QEI, subject to the provisions referenced in this section. The QALICB may use QLICI proceeds to repay or refinance expenditures incurred by the debt or equity provider (or their affiliate) for the acquisition of any asset contributed, sold, or otherwise transferred to the QALICB to the extent such asset represents a reasonable expenditure directly attributable to the qualified business for the QALICB. However, the amount that can be repaid or refinanced for such an asset is limited to the asset's original cost and not to any accreted value obtained by appraisal or other valuation methods. Such transactions remain subject to the aforesaid 24-month rule or 5 percent rule.

(y) Future of the NMTC Program

(a) Introduction

The 2017 Tax Act allows individuals and corporate investors to defer capital gains on the sale of stock business assets or other property (wherever located) by investing in a qualified opportunity zone (which must invest at least 90 percent of its assets, directly or indirectly, in businesses located in designated opportunity zones, i.e., low-income communities). But the deferral does not apply to gains generated on the sale to the fund itself.

The proceeds must be invested within 180 days beginning from the initial sale or exchange in the amount equal to the gain to be deferred. Moreover, there is partial forgiveness of the deferred capital gain if held for five or seven years; and furthermore, any future gain on the investment in an opportunity fund may be excluded if the investment is held for ten years.⁴³²

The deferred portion of the gain is taxable when the investment in the opportunity fund is sold or, if sooner, on December 31, 2026, unless the date is subsequently extended. So if the opportunity fund investment is held for 10 years, beyond 2026, the tax basis of the new investment is deemed to be its fair market value on sale. In effect, further appreciation on the investment, but not the deferred gain, is eliminated permanently. As a result, leveraged investments generating depreciation during the hold may not be recaptured. It is important to note that the original property sold need not be located in or connected in any way with a qualified census tract.

This is a remarkable opportunity for high-net-worth individuals to defer gain and subsequently exclude further gain based upon the appreciation of their investment in an opportunity zone. Moreover, and most important, it allows and incentivizes investments in qualified census tracts.

(b) Operations of QOZ Business

An opportunity fund may be sponsored by CDFIs as well as banks that are presently involved in the new market tax credit program as well as other individuals, corporations, or nonprofits. The opportunity fund needs to invest in qualified opportunity zone property (“OZP”), which would include qualified stock, partnership interests, and business property. In all cases, to qualify as an opportunity zone business, substantially all of the tangible assets of the business must be used in an opportunity zone. A qualified opportunity fund must hold at least 90 percent of its assets in qualified opportunity zone properties (which does not include another opportunity fund). The 90 percent requirement is determined by the average percentage of two OZP held by the Fund measured on the last day of the first six-month period of the taxable year of the Opportunity Fund and the last day of the taxable year (for calendar year taxpayer would be June 30 and December 31, but there could be a short-year issue). If the Fund fails the 90 percent test in any year, it is not disqualified but is required to pay a penalty for each month it fails to meet the requirement in an amount equal to the excess of the 90 percent of its aggregate assets over the amount of qualified opportunity zone property held by the Fund multiplied by the underpayment rate under § 6621(a)(2) of the Code. If the opportunity fund is a partnership or a pass-through entity, each partner must pay his proportionate share of the penalty. There is an exception if the opportunity fund can demonstrate that its failure to meet the 90 percent test is due to reasonable cause.

The qualified opportunity zone stock or partnership interest must be acquired from the corporation or partnership by the fund after December 31, 2017, solely in exchange for cash. (It is an equity investment structure.) During substantially all of the holding period of the qualified opportunity stock or partnership interest, the corporation or partnership must continue to qualify as an opportunity zone business.

Similar limitations with regard to the qualified opportunity zone business are based upon the new market tax credit rules relative to active businesses such as the 50 percent of gross income and the limitation on intangibles and nonqualified financial property and “sin” uses. See subsection 13.6(i).

Investments in qualified opportunity zone business property must be tangible property used in a trade or business acquired by purchase (see § 179(d)(2)) in which the related party rules apply, but substitute a 20 percent test instead of 50 percent). Second, and most important, the original use in the qualified opportunity zone must commence with the zone business or the business must substantially improve the property, which means during any 30-month period beginning after the acquisition of the property, additions to basis of the property must exceed an amount equal to the adjusted basis of the property at the beginning of the period. In effect, the improvements must exceed the adjusted basis of the purchase of the property.

(i) Combining with Other Tax Incentives.⁴³³

(c) Pairing Opportunity Zone Incentives with NMTCs

Through the NMTC structure, the investor can take advantage of the leveraging structure and generate tax credits over a seven-year period. So not only can the capital gains be deferred for a seven-year period, including an increase in basis with partial forgiveness after five- and seven-year holding periods, but the taxpayer can receive incremental benefit through the tax credit regime. However, the investor is likely to be a C corporation in view of the AMT, which was retained in the 2017 Tax Act as to individuals. Nevertheless, sufficient basis is needed to absorb the required NMTC basis adjustment. Accordingly, the OZ deferral election will generally be limited to the QEI less the sub-CDE fees and the NMTCs that are generated.

(d) Use by Tax-Exempt Organizations: Win-Win

Opportunity funds may be purchased and sold similar to mutual funds. A fund could invest in all aspects of mixed-use development in designated qualified census tracts beneficial to low-income exempt organizations. It incentivizes urban renewal as well as rural development, allowing developers to create and expand communities with new multifamily housing and retail venues.

It may also attract “angel” investors and incubators, along with venture capitalists, thereby attracting companies to locate in opportunity zones, where, after a 10-year hold, a liquidation may generate millions of dollars in capital gains with permanent exclusion from taxation.

There are many reasons why a nonprofit should form joint ventures or a for-profit subsidiary to directly partner with the OZF to operate in the designated low-income high-unemployment zones, consistent with its exempt function. Because the law favors new businesses, new construction, startups, and incubators may be motivated by the incentives. Thus, an opportunity fund could operate or fund a new technology or healthcare business in the zone. A successful tech startup could experience significant growth over a decade, allowing the investor a large permanent exclusion from taxation. Community healthcare and food deserts are also sorely needed in many low-income communities, and walk-in clinics and urgent care facilities, already growing in popularity, may also be attractive projects for opportunity funds.⁴³⁴

(e) Preliminary Steps in Formation of Opportunity Fund

1. Formation of Opportunity Zone Fund (OZF) as a corporation or a partnership for purposes of investing in Qualified Opportunity Zone Property (“QOZF”): use of an LP/Query: will an LLC qualify as an OZF?
2. General Partner of the LP: formation of the limited liability company; operations of OZF. (See 90 percent test, discussed in subsection 13.11(b).)
3. Management Company: formation of the limited liability company that will act as a management company.
4. Terms of the Investment Management Agreement.
5. Overall fee structure, which needs to be competitive in the marketplace, with return of capital and preferred annual distributions; minimum ten year hold, claw back, etc.
6. Confirmation of designation as QCT by Governors, approved by Treasury.
7. Self-certification of OZF based upon IRS Frequently Asked Questions. To self-certify, a taxpayer merely completes a form (to be released in summer 2018), which is attached to taxpayer's federal income tax return.
8. Preparation of OZF Business Plan (to be reviewed by counsel), including land and building acquisition, timing. Need to “tie-up” properties within designated zones.
9. Draft of private placement memorandum.
10. Draft of the subscription agreement.
11. Review of exemptions under the Securities Act, state blue sky laws, and the Investment Advisers Act.
12. Proposed liquidation of fund, cash-out of investors, redemption, etc., after ten years.

(f) Treasury Publishes Opportunity Zone Proposed Regulations

The First Important Step in the Structuring of OZ Funds. As part of the 2017 Tax Act, a new tax incentive program was created to spur economic growth and investment in designated distressed communities (each an “opportunity zone” or “OZ”). Not only does the OZ incentive program allow for the deferral of certain capital gains to the extent that such gain is invested in a qualified opportunity fund (“QOF”), but it also allows for income exclusion for gains on investments in QOFs that are held for at least ten years. While the OZ incentive program was well-received, both practitioners and potential investors had many questions about the program that seemed to be unanswered by the initial provisions provided for in the Tax Act.

As such, on October 19, 2018, the Treasury Department issued additional guidance for the OZ incentive program. Specifically, the Treasury Department issued a set of proposed regulations and a revenue ruling, both of which can be relied on by taxpayers. In addition to the proposed regulations and the revenue ruling, the Treasury Department provided a draft Form 8996, the self-certification form for QOFs, and corresponding instructions for the form. Although the additional guidance answers many questions that investors and practitioners have about the OZ incentive program, there were still a number of unanswered questions, some of which were addressed in the second tranche of guidance issued from the Treasury Department in April 2019.⁴³⁵

A highlight of the guidance from the proposed regulations is as follows:

1. Eligible Taxpayers. Taxpayers who are eligible to defer gain under the OZ incentive program are those that recognize “capital gain” for federal income tax purposes. As such, individuals, C corporations (including REITs and RICs), partnerships, common trust funds, qualified settlement funds, disputed ownership funds, and certain other types of entities should qualify.
2. Gain Issues. The OZ incentive program provides gain deferral for capital gains only; however, unrecaptured 1250 gain (depreciation recapture) should be eligible for deferral. More IRS guidance is needed to clarify this issue. The gain to be deferred must be gain that would have been recognized (assuming that deferrals under the OZ incentive program were not permitted) no later than December 31, 2026. In the case of a taxpayer who made an election to defer with respect to some but not all eligible gains, the term “eligible gain” includes the portion of the eligible gain for which no election has been made.

   The gain to be deferred must not arise from a sale or exchange with certain related persons. Generally, the OZ incentive program adopts the related-party rules found in § 267(b) and § 707(b)(1) of the Internal Revenue Code (the “Code”), except that it substitutes “20 percent” in place of “50 percent” each place it occurs in § 267(b) or § 707(b)(1). For example, a partnership and a person owning, directly or indirectly, more than 20 percent of the capital interest, or the profits interest of such partnership, are considered to be related parties.

   Except as otherwise provided for in provisions of the OZ incentive program, the first day of the 180-day period during which an investment of capital gains must be made into a QOF is the date on which the gain would be recognized for federal income tax purposes.

3. Gains of Partnerships and Other Pass-Through Entities. A partnership may elect to defer all or part of a capital gain to the extent that it makes an eligible investment in a QOF. If so, no part of the deferred gain is required to be included in the distributive shares of the partners. If the partnership does not elect to defer capital gain, a partner may elect to defer gain with respect to its distributive share under the OZ incentive regime (provided that all other requirements have been met). A partner's 180-day period generally begins on the last day of the partnership's taxable year. A partner may also choose to begin its own 180-day period on the same date as the start of the partnership's 180-day period (in situations in which the partner knows both the date of the partnership's gain and the partnership's decision not to elect deferral).
4. Inclusion in Income When Deferral Ends. All of the deferred gain's tax attributes are preserved through the deferral period and are taken into account when the gain is included. If a taxpayer disposes of less than all of its fungible interests in a QOF, the interests that are disposed of are identified using a first-in, first-out method.
5. QOF Qualification. A QOF must be classified as a corporation or partnership for federal income tax purposes. Thus, it seems that limited liability companies also should qualify, since Reg. § 1.1400Z-2(d)-1(a) states that it is “qualified as a corporation or partnership for federal tax purposes.” A QAOF must be created or organized in one of the 50 states, the District of Columbia, or a U.S. possession. If organized in a U.S. possession, then an entity must be organized for the purpose of investing in qualified opportunity zone property that relates to a trade or business operated in the possession in which the entity is organized. There is no prohibition to using a “preexisting” entity as a QOF, provided that all other requirements of the OZ incentive program are satisfied, including that QOZ property is acquired after December 31, 2017.
6. Investment in QOF. To qualify for the OZ incentive program, an investment in a QOF must be an equity interest in the QOF, including preferred stock or a partnership interest with special allocations (i.e., such investment cannot be a debt instrument within the meaning of § 1275(a) and Reg. § 1.1275-1(d)). Thus, convertible debt should not qualify for the OZ incentive program, but query whether certain types of debt instruments may also qualify, as some of these instruments may be classified as equity for federal tax purposes. Provided that the eligible taxpayer is the owner of the equity interest, status as such is not impaired by the taxpayer's use of the interest as collateral for a loan. Deemed contributions of money under § 752(a) of the Code do not qualify as an investment in a QOF, which is a beneficial result.
7. Designating When a QOF Begins. It is expected that Form 8996, the self-certification form, will be attached to a QOF's federal income tax return for the relevant tax years. On Form 8996, it appears that the penalty for nonqualification is calculated monthly, but such penalty does not apply to any months before the first month in which an eligible entity is a QOF. On Form 8996, a QOF is allowed to identify both (1) the taxable year and (2) the first month in that year in which the entity becomes a QOF. If an eligible entity fails to specify the first month it is a QOF, then the first month of its initial tax year as a QOF is designated as the first month that the eligible entity is a QOF. The “first six-month period of the taxable year of the fund” under the 90 percent test means the first six-month period composed entirely of months that are within the taxable year and during which the entity is a QOF. For example, if a calendar-year entity was created in February and chooses April as its first month as a QOF, then the 90 percent test dates are the end of September (which is six months from April 1) and the end of December. This means that if a calendar-year QOF chooses a month after June as its first month as a QOF, then the only testing date for that first taxable year is the last day of the QFO's taxable year. But see the second tranche under subsection (g).
8. Valuation Method for Applying the 90 Percent Asset Test. For purposes of the 90 percent asset test of a QOF, the QOF is required to use the asset values that are reported on the QOF's applicable financial statement for the taxable year (namely, a financial statement within the meaning of Reg. § 1.475(a)-4(h), which, generally, includes a financial statement filed with the SEC or one that has significant business use). (But see modification in the second tranche of proposed regulations under subsection (g).) This may present a problem for certain QOFs if GAAP financial statements are used, since GAAP accounting takes into account impairment, depreciation, and so forth, which could strain the 90 percent asset test. If there is no applicable financial statement, then the QOF should use “cost of the asset.” Presumably, this means the original cost basis, without regard for depreciation.
9. Working Capital Safe Harbor. A new working capital safe harbor is established for QOF investments in QOZ businesses that acquire, construct, or rehabilitate tangible business property, which includes both real property and other tangible property used in a business operating in an OZ. The safe harbor allows QOZ businesses to hold a reasonable amount of working capital (generally, cash, cash equivalents, or debt instruments with a term of 18 months or less) for 31 months if (1) there is a written plan that identifies the financial property as property held for the acquisition, construction, or substantial improvement of tangible property in the OZ, (2) there is a written schedule consistent with the ordinary business operations of the business that the property will be used within 31 months, and (3) the QOZ business complies with such schedule. Solely for purposes of applying the 50 percent “active” conduct test in § 1397C(b)(2), as required by the definition of a QOZ business, if any gross income is derived from a reasonable amount of working capital, then such gross income is counted toward satisfaction of such 50 percent test.
10. Basis Step-Up Election. Taxpayers may make the election for a step-up in their QOF investments after the QOZ designation expires. Specifically, such election is preserved until December 31, 2047 (essentially allowing all QOF investments to qualify for the step-up).
11. QOZ Business Qualification. Generally, to qualify as a QOZ business, “substantially all” of a corporation or partnership's tangible property owned or leased must be QOZ business property. In this context, “substantially all” means at least 70 percent. Note that this means that if $100 were invested in a QOF, and the QOF decided to invest through a partnership or corporation, the proposed regulations dictate that a minimum of $63 must be QOZ business property (90 percent × 70 percent × $100). If the QOF operates a trade or business directly and does not invest equity in any QOZ business, then the 90 percent asset test would apply (i.e., $90 must be QOZ property). Thus, there is an incentive for QOFs to invest in a QOZ business rather than holding QOZ business property directly.
12. QOZ Stock. Certain redemption transactions will cause stock acquired by a QOF to not be treated as QOZ stock. For example, stock issued by a corporation is not treated as QOZ stock if, at any time during the two-year period beginning on the date one year before the issuance of such stock, the corporation made one or more purchases of its stock with an aggregate value exceeding 5 percent of the aggregate value of all of its stock as of the beginning of the two-year period.
13. Revenue Ruling: Exclude Basis of Land. New Revenue Ruling 2018-29 primarily addresses the concept of “original use” as follows:

If a QOF purchases an existing building located on land that is wholly within a QOZ, the original use of the building in the QOZ is not considered to have commenced with the QOF, and the requirement that the original use of the tangible property in the QOZ commence with a QOF is not applicable to the land on which the building is located. If a QOF purchases a building wholly within a QOZ, a substantial improvement to the building is measured by the QOF's additions solely to the adjusted basis of the building. Measuring a substantial improvement to the building by additions to the QOF's adjusted basis of the building does not require the QOF to separately improve the land upon which the building is located.

By excluding the basis of land, the rules facilitate repurposing vacant buildings in QOZs. But see the second tranche of proposed regulations under subsection (g).

1. Key Issues Not Addressed. Key issues not addressed in the initial October 2018 guidance include many critical subjects that are described below. There has been further clarification, however, in the second tranche referenced in subsection (g):
   • The term “substantially all” is used in various places of the OZ incentive program. For example, for property to qualify as QOZ business property, during substantially all of the QOF's holding period for such property, substantially all of the use of such property must be in a QOZ. Further, for definitions of “qualified opportunity zone stock” and “qualified opportunity zone partnership interest” during substantially all of the QOF's holding period for such interest, such interest is qualified as a QOZ business. What does this term “substantially all” mean as it is used in these other references? See subsection (g), infra.
   • How long is the “reasonable period” for a QOF to reinvest proceeds from the sale of qualifying assets without paying a penalty? The OZ incentive program provides that a QOF has “a reasonable period of time to reinvest the return of capital from investments in qualified opportunity zone stock and qualified opportunity zone partnership interests, and to reinvest proceeds received from the sale or disposition of qualified opportunity zone business property.” For example, if a QOF sells QOZ property shortly before a testing date, such QOF should have a reasonable amount of time in which to bring itself into compliance with the 90 percent asset test. See subsection (g), infra.
   • In calculating the value of a QOF's assets, Form 8996's instructions allow the use of a certified audited financial statement that is prepared in accordance with GAAP. However, the proposed regulations' requirements are a bit more complex. Additional guidance was necessary to reconcile this conflicting guidance. See subsection (g), infra.
   • Will there be any relief for a taxpayer who fails to reinvest eligible gain into a QOF within 180 days of the transaction that produced such gain? Currently, there is no such relief.
   • Do section 1231 gains need to be aggregated with section 1231 losses in order to be an “eligible gain”? Section 1231 gains are only capital gains to the extent that they exceed section 1231 losses. See subsection (g), infra.
   • There does not appear to be guidance on whether a new building built on unimproved land satisfies the “original use” and “substantial improvement” requirements for QOZ business property. See subsection (g), infra.
   • The additional guidance does not appear to address leased property. How such property is accounted for may put pressure on the 90 percent asset test. This subject is discussed in subsection (g), infra.
   • How are interim gains—that is, gains recognized at the QOF level—treated? For example, will such gains be eligible for deferral to the extent that they are invested? This subject is answered favorably in the second tranche. See subsection (g), infra.
   • Is carried interest a qualifying investment in a QOF? Currently, there is no distinction for interest received for cash versus services. See subsection (g), infra.
   • What other information reporting requirements are necessary under the OZ incentive program? For example, what are the forms and instructions by which an eligible taxpayer may elect to defer eligible gains?
   • What are some examples that will lead to an entity's decertification as a QOF?

(g) Treasury Publishes the Second Tranche of Proposed Opportunity Zone Regulations

On April 17, 2019, the Treasury Department issued a second tranche of proposed regulations, which again can be relied on by taxpayers. This additional guidance provides answers to open issues related to the definition of “substantially all,” the use of qualified OZ business property, the treatment of leased tangible property, the sourcing of gross income in a QOZ, a reasonable period for a QOF to reinvest proceeds from the sale of a qualifying asset without paying a penalty, and various other topics. However, as was the case with the first set of regulations, there are still a number of unanswered questions (some of which the Treasury Department solicited additional comments on).

A highlight of the guidance from the second tranche of proposed regulations is as follows:

1. Qualified Opportunity Zone Business Property. Definition of “Substantially All” for Purposes of Code Sections 1400Z-2(d)(2) and (d)(3). After the first tranche of proposed regulations, the term “substantially all” remained undefined in a number of places in the OZ incentive program. “Substantially all” is clarified to mean (i) 70 percent as it relates to usage of tangible property in an OZ and (ii) 90 percent as it relates to the holding period of tangible property used in an OZ, an interest in stock, or a partnership interest (which qualifies as qualified OZ stock or qualified OZ partnership, respectively).
2. Special Rules for Section 1231 Gains (Depreciable Real Estate Held Over One Year). Only net section 1231 gains are eligible for the deferral under the OZ incentive program. The 180-day period for investing capital gain income from section 1231 property in an QOF begins on the last day of the taxable year. This rule may present a trap for unwary taxpayers, since gain on the sale of depreciable real estate held for more than one year is a 1231 gain treated as a long-term capital gain. But the IRS stated that it is necessary to wait for the end of the taxable year to open the 180-day period for investment, in order to see if such gains are reduced by netting against 1231 losses during the year (attributable to the taxpayer; e.g., an individual may have such losses through other partnerships or individually). A delay in receiving a Form K-1 could also create difficulties for a partner in a partnership wanting to roll over gain allocated to him from a partnership. There is no election provided as in subsection (f)(iii) in the partnership context.
3. Original Use of Tangible Property by Purchase. The “original use” of tangible property acquired by purchase starts on the date when that person (or a prior person) first places the property in service in a qualified OZ for purposes of depreciation of amortization (i.e., tangible property located in a qualified OZ that is depreciated or amortized by a taxpayer other than the QOF or qualified OZ business would not be of “original use”). Tangible property (other than land) located in a qualified OZ that has not yet been depreciated or amortized by a taxpayer (other than a QOF or qualified OZ business) would satisfy the original use requirement.

   Improvements made by a lessee to leased property would satisfy the original use requirement and are considered purchased property for the amount of the unadjusted cost basis. The determination of whether the substantial improvement requirement is satisfied for tangible property that is purchased is made on an asset-by-asset basis and not on an “aggregate” basis. The IRS indicated that it is considering applying the rule on an aggregate basis, but it has not done so at this point. This may raise critical issues for many businesses.

   Safe Harbor for Testing Use of Inventory in Transit. Inventory (including raw materials) of a trade or business does not fail to be used in a qualified OZ solely because the inventory is in transit from a vendor to a facility in the trade or business that is in a qualified OZ, or from a facility of the trade or business that is in a qualified OZ to customers of the trade or business that are not located in a qualified OZ.

4. Treatment of Leased Tangible Property. Status as Qualified Opportunity Zone Business Property. Leased tangible property can satisfy the 90 percent asset test for a QOF and the “substantially all” requirement for a qualified OZ business if (1) such leased tangible property is acquired under a lease entered into after December 31, 2017, and (2) substantially all of the use of such leased tangible property is in a qualified OZ during substantially all of the period for which the business leases the property. There is no original use requirement with respect to leased tangible property. Further, leased tangible property can be leased from a related lessor (see below for additional limitations applied to related parties). All leases under which a QOF or qualified OZ business acquires rights with respect to any leased tangible property must be a “market rate lease,” as determined under the regulations under section 482.

   As noted above, the lessor and lessee of tangible property may be related. If a lessor and lessee are related, leased tangible property shall not be qualified OZ business property if, in connection with the lease, a QOF or qualified OZ business at any time makes a prepayment to the lessor (or a person related to the lessor) relating to a period of use of the leased tangible property that exceeds 12 months. Further, if a lessor and lessee are related, leased tangible property shall not be qualified OZ business property unless the lessee becomes the owner of other tangible property that is qualified OZ business property and that has a value not less than the value of the leased tangible property. Such acquisition must occur during a period that begins on the date that the lessee receives possession of the property under the lease and ends on the earlier of (1) the last day of the lease or (2) the end of the 30-month period beginning on the date that the lessee receives possession of the property under the lease.

5. Valuation of Lease Property. On an annual basis, leased tangible property may be valued using either an applicable financial statement method or an alternative valuation method. Once a QOF or qualified OZ business selects one of the valuation methods, it must apply such method consistently to all leased tangible property with respect to the taxable year.

   Under the alternative valuation approach, the value of leased tangible property is determined based on a calculation of the “present value” of such tangible property—that is, the sum of the present values of the payments to be made under the lease for such tangible property. For purposes of this calculation, the discount rate is the applicable federal rate under § 1274(d)(1). Under this alternative valuation approach, once the value of the leased property is fixed at the outset of the lease, it does not change over the course of the lease; under the GAAP method above, it is expected that the valuation of the leased property will decline over time.

6. Qualified Opportunity Zone Businesses. Real Property Straddling a Qualified Opportunity Zone. If the amount of real property based on square footage located within the qualified opportunity zone is substantial as compared to 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.
7. 50 Percent of Gross Income of a Qualified Opportunity Zone Business. There are three safe harbors and a facts and circumstances test for determining whether sufficient income is derived from a trade or business in a qualified OZ for purposes of the 50 percent test in Code section 1397C(b)(2).
   • Hours: The first safe harbor requires that at least 50 percent of the services performed (based on hours) for a business by its employees and independent contractors are performed within the qualified OZ.
   • Amounts Paid: The second safe harbor requires that at least 50 percent of the services performed, based on the amounts paid for such services, for the business by its employees and independent contractors are performed within the qualified OZ.
   • Tangible Property and Management: The third safe harbor provides that a trade or business may satisfy the 50 percent test if: (1) the tangible property of the business that is in a qualified OZ and (2) the management and operational functions performed for the business in the qualified OZ are each necessary to generate 50 percent of the gross income of the trade or business.
   • Facts and Circumstances Test: Finally, the 50 percent test may be satisfied if, based on all facts and circumstances, at least 50 percent of the gross income of a trade or business is derived from the active conduct of a trade or business in the qualified OZ.
8. Use of Intangibles (40 Percent). The term “substantial portion” as it relates to the usage of intangible assets in the active conduct of a trade or business in a qualified OZ means at least 40 percent.
9. Active Conduct of a Trade or Business. The ownership and operation (including leasing) of real property used in a trade or business is treated as the active conduct of a trade or business for purposes of the OZ incentive program. However, merely entering into a triple-net lease with respect to real property owned by a taxpayer is not the active conduct of a trade or business by such taxpayer. This provision will likely impact the conventional leasing of industrial properties.
10. Working Capital Safe Harbor. Expanding on the first tranche of the proposed regulations, the written designation for the planned use of working capital includes the development of a trade or business in the qualified OZ as well as the acquisition, construction, and/or substantial improvement of tangible property. There is an example of such a written plan to create a restaurant business, but without a specifically identified site yet. This example indicates that a QOF need not have “identified” the specific property within the qualified OZ in order to benefit from this working capital safe harbor.
11. Relief with Respect to the 90-Percent Asset Test. Relief for Newly Contributed Assets. A QOF may apply the 90 percent asset test without taking into account any investments received in the preceding six months.

    QOF Reinvestment Rule. Proceeds received by a QOF from the sale or disposition of: (1) qualified OZ business property, (2) qualified OZ stock, and (3) qualified OZ partnership interests are treated as qualified OZ property for purposes of the 90 percent requirement, so long as the QOF reinvests the proceeds received by the QOF from the distribution, sale, or disposition of such property during the 12-month period beginning on the date of such distribution, sale, or disposition. Such proceeds must be held in cash, cash equivalents, or debt instruments with a term of 18 months or less. A QOF may reinvest proceeds from a sale of an investment into another type of qualifying investment.

12. Amount of an Investment for Purposes of Making a Deferral Election. A taxpayer may make an investment for purposes of the gain deferral election under the OZ incentive program by transferring cash or property to a QOF. There are special rules for determining the amount of an investment for purposes of the deferral election if a taxpayer transfers property other than cash to a QOF in a carryover basis transaction. In such a case, the amount of the investment equals the lesser of (1) the taxpayer's adjusted basis in the equity received in the transaction or (2) the fair market value of the equity received in the transaction, both of which are determined immediately after the transaction. In the case of a contribution to a partnership QOF, the basis is calculated without regard to any liability that is allocated to the contributor under § 752(a).
13. Events That Cause Inclusion of Deferred Gain. In General. Generally, an inclusion event (i.e., an event that causes the recognition of gains deferred under the OZ incentive program) results from a transfer of a qualifying investment in a transaction to the extent the transfer reduces a taxpayer's equity interest in the qualifying investment. However, except as provided elsewhere in the regulations, a transaction is also an inclusion event to the extent a taxpayer receives property from a QOF in a transaction that is treated as a distribution for U.S. federal income tax purposes.

    Inclusion events include, but are not limited to:

    • A taxable disposition of all or part of a qualifying investment;
    • A taxable disposition of interests in an S corporation that is the direct investor of a QOF;
    • A transfer by gift of a qualifying investment;
    • A redemption of qualified QOF stock that is treated as an exchange of property for the redeemed qualifying QOF stock under Code Section 302;
    • A liquidation of a QOF corporation to which section 331 applies; and

      Certain nonrecognition transactions.

      Certain disregarded transfers and certain types of nonrecognition transactions (e.g., an acquisitive asset reorganization under Code section 381) are not inclusion events. Debt-financed distributions from a QOF partnership are generally not inclusion events, subject to two limitations:

      1. Such distribution will trigger inclusion of deferred gain to the extent the distribution exceeds the investor's basis (which includes such investor's share of liabilities); and
      2. If such distribution generally occurs within the first two years of an investor's contribution of cash/property to the QOF (or in some cases later), there are certain rules that could recharacterize the original contribution as an investment that does not qualify for the benefits of the OZ incentive program (under the “disguised sales” rules of Section 707(a)(2)(B)).

         Timing of Basis Adjustments. The 10 percent and additional 5 percent basis step-up on a taxpayer's investment in a QOF as of the end of 2026 is basis for all purposes. The basis adjustment upon recognition of deferred gain is made immediately after the amount of deferred capital gain is taken into income. For dispositions after 10 years of qualifying QOF partnership interests, by the equity investor, the bases of the QOF partnership's assets are also adjusted with respect to the transferred qualifying QOF partnership interest, with such adjustments calculated in a manner similar to the adjustments that would have been made to the partnership's assets if the selling partner had purchased the interest for cash immediately prior to the transaction and the partnership had a valid section 754 election in effect. This treatment should prevent recapture of depreciation taken by the partner on assets of the QOF partnership over the ten-plus years of holding the investment. It is an important technical fix that should allow taxpayers to realize substantial benefits.

         Partnership and S Corporation Provisions. The transfer by a partner of all or a portion of its interest in a QOF partnership will generally be an inclusion event. However, a transfer in a transaction governed by Code § 721 or § 708(b)(2)(A) is generally not an inclusion event, provided there is no reduction in the amount of the remaining deferred gain that would be recognized by the transferring partners in a later inclusion event.

         The conversion of an S corporation that holds a qualifying investment in a QOF to a C corporation (or vice versa) is not an inclusion event. If an S corporation is an investor in a QOF, the S corporation must adjust the basis of its qualifying investment in the same manner as for C corporations, but this rule does not affect adjustments to the basis of any other asset of the S corporation. Solely for purposes of the OZ incentive program, an S corporation's qualifying investments in a QOF will be treated as disposed of if there is a greater than 25 percent change in ownership of the S corporation.

         For purposes of investments held for at least ten years, a taxpayer who is the holder of a direct qualifying QOF partnership interest or qualifying QOF stock of a QOF S corporation may make an election to exclude from gross income some or all of the capital gain from the disposition of qualified OZ property reported on Schedule K-1 of such entity, provided the disposition occurs after the taxpayer's ten-year holding period.

14. Treatment of Carried Interest. Where a partner receives a partnership interest in exchange for services (e.g., carried interest), such portion of such investment is not eligible for the benefits related to qualifying investments of the OZ incentive program. The first set of proposed regulations had stated that a partnership interest with special allocations was an eligible QOF investment, but these new proposed regulations would require restructuring in this area.
15. Consolidated Return Provisions. QOF stock is not stock for purposes of Code section 1504 affiliation. The provisions of the OZ incentive program apply separately to each member of a consolidated group.
16. General Anti-Abuse Rule. If a significant purpose of a transaction is to achieve a result that is inconsistent with the purposes of the OZ incentive program, the IRS may recast a transaction (or series of transactions) for federal tax purposes as appropriate to achieve the tax results that are consistent with the OZ incentive program.
17. Key Issues Still Not Addressed by the Second Tranche of Proposed Regulations.
    • Should prior use of fully depreciated/amortized property be disregarded for purposes of the original use requirement?
    • How should the OZ incentive program treat tangible personal property that is realistically not capable of being substantially improved?
    • Should inventory be excluded from the 70 percent test for qualified OZ businesses?
    • What are the specific mechanics by which the election for holders of a direct qualifying QOF partnership interest or qualifying QOF stock of a QOF S corporation can exclude from gross income some or all of the capital gain from the disposition of qualified OZ property?
18. Conclusion. The second tranche of proposed regulations is a significant step forward in providing guidance to QOF investors, developers, and fund managers. It provides clarity on a number of open questions that remained after the October 2018 publication of the initial set of proposed regulations by including the definition of substantially all, the use of qualified OZ business property, the treatment of leased tangible property, the sourcing of gross income in a QOF, a reasonable period for the QOF to invest proceeds for the sale of qualifying assets without paying a penalty, and restrictions as to triple-net leases and carried interests.

(h) Opportunity Zone Funds: Application of Final Regulations: The Opportunity Zone Tax Incentive Program in the Wake of the COVID-19 Pandemic (Revised)

In December 2019, the Treasury Department released final regulations for the opportunity zone (OZ) program to refine and clarify certain aspects of the first two sets of proposed regulations⁴³⁶ and to make the rules easier to follow and understand (the “Final Regulations”). The Final Regulations are examined in this section.

The OZ program is highlighted in light of the unprecedented economic challenges presented by the COVID-19 outbreak. Indeed, taxpayers with short-term or long-term capital gain income generated in 2019, or in early 2020, can use the OZ program to invest the qualified gains in a QOF for a period of time.

As some investors reevaluate their commitments to qualified opportunity zones in the face of the COVID-19 global pandemic, they may enjoy some level of favorable tax treatment in 2020 if they decide to liquidate their capital from the funds. While investors would likely consider multiple variables (i.e., the extent fund withdrawal is allowed, market stability, and investor ability to write off losses) before deciding to take money out of OZs, the Internal Revenue Code has some advantages for those seeking to opt out of funds.

To the extent individuals had deferred capital gains by committing them to QOFs in previous tax years, the gains would be recognized in 2020 if those investors decided to liquidate their investment in 2020. Such liquidation would result in those investors' ability to offset their capital losses generated in 2020, thereby reducing their tax liabilities. While such result may not be the original tax benefit investors were looking for when they invested in opportunity funds, it may be more beneficial than sustaining a capital loss in 2020 because those losses cannot be carried back.

The Final Regulations clarify that individuals would not be subject to interest or other kinds of penalties if they chose to liquidate their investments early.

• Given the market's current volatility, investors may be willing to realize losses in 2020 to offset previously deferred gains. Note that the IRS may challenge attempts to offset gains and losses by liquidating OZ investments to determine if those individuals lacked bona fide, good-faith intentions to follow through on those commitments in line with the anti-abuse provisions discussed hereinafter.⁴³⁷
• The OZ program was designed to offer tax relief for investments in low-income communities and does not levy interest-laden penalties on investors who choose to withdraw capital gains from funds. The OZ program also allows a restart on the clock on the 180-day window for reinvesting in other funds without losing out on the OZ program's favorable tax treatment.

Once the capital gains have been reinvested into a QOF and then dropped into a qualified opportunity zone business (“QOZB”), taxpayers have up to 62 months to reinvest the proceeds into various qualified opportunity zone projects. This extended reinvestment period is particularly useful in light of the uncertainty in the current markets.

The Final Regulations became effective March 16, 2020. The new rules give taxpayers increased flexibility and extension of time when it comes to determining when the 180-day capital gain reinvestment countdown begins for purposes of meeting the QOF deadline.

• COVID-19 Update: The IRS issued Notice 2020-23, which grants investors whose deadline falls between April 1 and July 15, 2020 automatic relief of the 180-day investment requirement. It followed with Notice 2020-39, which extended the 180-day requirement to December 31, 2020. The Notice also extended the 90 percent investment standard date to December 31, 2020 (as reasonable “cause”) and tolled the 30-month substantial improvement period (during April 1, 2020 through December 31, 2020).

Accordingly, QOFs are a remarkable opportunity for high-net-worth individuals to defer gain and subsequently exclude further gain based upon the appreciation of their investment in an opportunity zone. This summary highlights certain major clarifications and additional flexibility found in the Final Regulations. It also points out certain unresolved matters.