Qualified Opportunity Funds
The Opportunity Zone tax incentive program allows taxpayers that invest in a Qualified Opportunity Fund to (i) defer paying taxes on the capital gain from the sale or exchange of appreciated assets; (ii) receive a permanent exclusion from taxation of up to 15% on that deferred gain, and (iii) for taxpayers that hold their investment for at least 10 years, a permanent exclusion from taxation for any appreciation in excess of the deferred gain.
On April 17, the Treasury Department released its second round of guidance on Opportunity Zone investments in the form of proposed regulations (the "New Proposed Regulations"). These newly proposed regulations supplement and in some cases revise the proposed regulations issued in October of 2018 (the "October Proposed Regulations"). To review our blog post regarding the October Proposed Regulations click here.
This is Part III of our series of blog posts on the New Proposed Regulations. This post addresses key issues relating to the requirements for Qualified Opportunity Funds ("Funds"). For Part II of this series, which addresses qualified opportunity zone businesses and qualified opportunity zone business property, please click here. For Part I of our explanation, which addresses qualified investments in qualified opportunity funds, please click here.
The New Proposed Regulations provide more flexibility in the way taxpayers can qualify for the benefits of the Opportunity Zone tax incentive program. With limited exceptions, taxpayers are permitted to rely on the New Proposed Regulations before they are finalized. These largely favorable regulations enhance scalability and are likely to lead to increased investment in Qualified Opportunity Zones.
A Tentative Step Toward Multi Asset Funds
Permanent Gain Exclusion Expanded to Apply to Capital Gain from Sale of Fund Assets
Currently, taxpayers that hold an interest in a Fund for at least 10 years must sell their interest in the Fund to achieve the permanent tax exclusion of gain on appreciation in their investment. In contrast, the sale or exchange by a Fund of Fund assets would give rise to taxable gain. As a result, many sponsors structure Opportunity Zone investments as single asset Funds to promote liquidity for investors, on the theory that potential purchasers who wish to purchase qualified opportunity zone property will be more willing to purchase interests in the Fund rather than Fund assets if each Fund has a single business and if the acquisition of 100% of that Fund would allow the purchaser a stepped up basis in the Fund's assets (similar to what a purchaser would get if they simply purchased a business from the Fund). This exit strategy is inconsistent with the way that most traditional investment funds operate.
The New Proposed Regulations would permit investors that hold an interest in a Fund for at least 10 years to elect to exclude capital gain allocated to them when the Fund sells its qualified opportunity zone property after such 10 year period. Although this change was intended to align the Opportunity Zone rules with the manner in which most investment funds operate it falls short in at least three important respects.
First, this provision is limited to a direct sale by the Fund of qualified opportunity zone property. In other words, a Fund that invests in a qualified opportunity stock or a qualified opportunity zone partnership interest must sell its equity in the lower tier entity in order to achieve permanent exclusion of capital gain. A sale of appreciated property by the lower tier entity would trigger the recognition of gain. In addition, although a Fund may hold up to 10% of its assets in the form of property that is not qualified opportunity zone property, gain from the sale of such "nonqualified" assets would not be eligible for exclusion.
Second, if a Fund generates ordinary income on the sale of assets, as would be the case upon the sale of depreciated personal property or the portion of a qualified opportunity zone partnership interest attributable to unrealized receivables and inventory items, such ordinary income does not appear to be excludable by the investor even if the investor has held its interest in the Fund for 10 years.
Third, and perhaps most importantly, unlike most other portions of the New Proposed Regulations, these 10 year rules cannot be relied upon until the New Proposed Regulations are finalized.
In light of the inability to rely on the 10 year rules until the New Proposed Regulations are finalized and the failure to extend the 10 year exclusion rule to (i) gain from all of the property of a Fund (not just the property that counts as "good" property for the 90% test), (ii) sales of property by lower tier entities, or (iii) ordinary income arising from the sale of qualified opportunity zone property, the single asset Fund structure is likely to continue to dominate the opportunity zone investment space.
Under the current guidance, investors cannot make their initial investment in a Fund through a feeder partnership. For the reasons described above, many Fund sponsors have chosen to form multiple single asset Funds with investors achieving diversity by investing in multiple single asset Funds managed by the same sponsor. Provisions in the New Proposed Regulations permit an investor in a Fund to contribute an interest in that Fund to a partnership without triggering the tax on deferred gain. This change will permit investors to contribute interests in multiple Funds into a single partnership managed by the same sponsor for more streamlined management.
Secondary Market for Interests in a Qualified Opportunity Fund
The New Proposed Regulations allow taxpayers to purchase an eligible interest in a Fund in the secondary market. Therefore, even if a Fund is no longer taking subscriptions or investments, investors can take advantage of the related tax benefits by purchasing an interest in the Fund in the secondary market. Similarly, investors that wish to exit from their investment prior to the sale of the underlying business will have a greater ability to attract buyers seeking Opportunity Zone tax benefits. Prior to the New Proposed Regulations, the statute was interpreted by many as limiting the benefits to direct investments in a Fund as opposed to the secondary market.
The New Proposed Regulations clarified that services rendered to a Fund are not an investment for which a taxpayer may receive an eligible interest. Thus, any person receiving a carried interest in a Fund will not be eligible for the opportunity zone tax incentives associated with holding an interest in a Fund with respect to their carried interest.
Six Months for Fund to Invest Capital
Under the New Proposed Regulations a Fund has six months to invest the capital it receives from investors provided that the capital assets are being held in cash, cash equivalents, or debt instruments with terms of 18 months or less. Further, the New Proposed Regulations allow a Fund to apply the six-month test on an investment by investment basis. This should allow funds more flexibility to accept capital contributions during the start-up period.
12 Month Reinvestment Rule
Prior to the New Proposed Regulations it was unclear how long a Fund had to reinvest the proceeds from the sale of qualified opportunity zone property without losing its status as a Fund. The New Proposed Regulations make clear that the Fund has twelve months to reinvest the proceeds in new Qualified Opportunity Zone property.
Debt Financed Distributions
The New Proposed Regulations make clear that a Fund that is taxable as a partnership may distribute loan proceeds to Investors in an amount that does not exceed the Investor's basis in its interest without the Investor recognizing taxable income. However, key exceptions in the New Proposed Regulations make clear that debt financed distributions within the first two years following an investment in the Fund and any other debt financed distributions treated as a disguised sale under Internal Revenue Code Section 707 will trigger recognition of deferred gain.
The New Proposed Regulations addressed a number of issues relating to investors and qualified investments in qualified opportunity funds as described in Part I of this series. For additional information please click here.
Qualified Opportunity Zone Businesses
As outlined in Part II of this series, the New Proposed Regulations additional flexibility and clarification on the requirements for a qualified opportunity zone business. For additional information, please click here.
Certain Challenges Still Remain
Despite the favorable provisions established by the New Proposed Regulations, certain challenges still exist, and it is not clear whether the IRS or Treasury intends to provide further guidance in the future. We will address additional issues under the New Proposed Regulations in future blog posts on the topics of consolidated return issues, reinvestment, taxable inclusion events and more.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.