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November 6, 2018

Stroock Special Bulletin

By: Richard G. Madris, Jeffrey D. Uffner

The tax reform legislation of December 2017 added new provisions offering tax benefits to investors reinvesting taxable gain into designated Qualified Opportunity Zones (“QOZs,” and the new provisions, as modified by recent proposed regulations and Revenue Ruling 2018-29, the “QOZ Rules”[1]).  The QOZ provisions have already garnered significant interest among investors and sponsors alike, but practitioners and commentators have raised a number of fundamental issues with respect to both the drafting and application of the statute.  The Treasury Department released proposed regulations on Oct. 19, 2018 (the “Proposed Regulations”), which provide guidance on certain aspects of the QOZ Rules; however, there are still many questions left unanswered, and the Treasury Department has promised further guidance in the “near future.”  We previously gave our initial take on the Proposed Regulations in a Stroock Special Bulletin issued the day such Proposed Regulations were released.[2]  This Stroock Special Bulletin provides background and analysis regarding the current state of the QOZ Rules, focusing on significant questions and issues still left outstanding.
QOZ Investor Requirements and Benefits
An investor that would otherwise recognize taxable gain on a sale occurring between 2018 and 2026 (inclusive) may reinvest up to the amount of such gain (the “rollover gain”) into a Qualified Opportunity Fund (“QOF”)[3] within 180 days of the sale.  The investor may thereby defer recognizing the rollover gain as income until Dec. 31, 2026, assuming the investor continues to hold the interest in the QOF.  In addition:

  • If the investor holds the interest in the QOF for 5 years, the investment’s basis increases by 10% of the amount of the rollover gain.


  • If the investor holds the interest in the QOF for 7 years, the investment’s basis will increase by an additional 5% for a total of 15%.[4]  Such basis increases reduce the deferred gain amount ultimately subject to tax.


  • An investor holding the QOF interest for 10 years or more qualifies for a special rule by which the investor may elect, on a subsequent disposition of the QOF interest,[5] not to recognize taxable gain with respect to any post-acquisition appreciation (thereby limiting the total gain recognized to the amount of the rollover gain, potentially reduced by up to 15%).

The Proposed Regulations clarify that:
(1) only capital gains (and not ordinary income or certain recapture ‘gain’) are eligible for rollover reinvestment;
(2) either a partnership (if it so elects) or a partner in such partnership (if the partnership does not elect) may rollover gains recognized through the partnership;
(3) if a partner recognizes gains through a partnership, the 180-day period in which to rollover such gains begins at the end of the partnership’s taxable year (unless the partner elects to use the partnership’s 180-day period beginning on the date the respective asset was sold); and
(4) investors may continue to hold their QOZ investments (for purposes of the special 10-year rule above) until Dec. 31, 2047 (and still not pay tax on any post-acquisition appreciation prior to the date of disposition).
QOF Requirements
An entity must meet certain requirements, separate from the investor-specific requirements above, to qualify as a QOF.  Specifically, a QOF must meet a test (the “90% Asset Test”) whereby 90% of its assets, measured every 6 months and averaged for each year, must be qualifying “QOZ Property.”  To meet this requirement, a QOF may (i) directly own “QOZ Business Property” or (ii) may own a QOZ Business that in turn owns QOZ Business Property.  A QOF may not, however, own (as a qualifying asset) an interest in another QOF.
A QOZ Business must (i) have “substantially all” of its tangible assets invested in QOZ Business Property, (ii) meet certain requirements under Section 1397C regarding permissible assets (including a general prohibition against owning more than 5% nonqualified financial assets such as cash),[6] and (iii) comport with certain “sin business” prohibitions under Section 144(c)(6)(B).
QOZ Business Property means, in general, tangible property acquired by purchase from an unrelated party,[7] which property either is “originally used” in the QOZ by the QOF or QOZ Business, or is “substantially improved” by the QOF or QOZ Business (meaning, generally, improvements over a period of 30 months that result in a 100% increase to the adjusted basis of the property).
The Proposed Regulations provide that:
(1) a QOF may be formed as an LLC;
(2) the working capital safe harbor from Section 1397C applies to the assets of QOZ Businesses for a period of up to 31 months;[8]
(3) for the “substantially all” test, only 70% of the tangible assets of a QOZ Business must constitute QOZ Business Property;[9] and
(4) if a QOF or QOZ Business purchases property consisting of land and a building, the “substantial improvement” prong of the QOZ Business Property test is met with respect to such property if the building’s adjusted basis is doubled, without any need to increase the basis of the land.
Despite this guidance, however, there remain many open questions.  Specifically, we think the following six burning questions are at the forefront of the analytical discussion surrounding the Proposed Regulations and are significant points that the Treasury Department should address in future guidance.
The QOZ Zero-Basis Rule:  How Does the Rule Interact With Other Basis Adjustments and Potential Distributions?

A major issue and concern presented by the QOZ Rules is the extent to which a QOF may distribute cash or proceeds it receives, whether from operating income or from a refinancing, without adverse tax consequences.  An investor is initially deemed to have a zero tax basis in the QOZ investment,[10] and accordingly, there is a twofold concern: first, that any amounts distributed to the investor would potentially be taxable, and second, that under certain tax rules a distribution might be treated as the constructive disposition of all or a portion of the distributee’s interest in the entity – which, in the case of an interest in a QOF, would trigger the deferred gain and render the interest holder ineligible for future QOZ benefits.

This issue may be particularly complicated in the context of a QOF formed as a tax partnership.  The Proposed Regulations provide that a partner in a QOF does not treat its share of debt under Section 752 as a QOZ investment, but this provision does not address whether the partner receives basis for its share of such debt (as would normally occur, absent the special zero-basis rule under the QOZ provisions).  In 2026, when the gain is included in income and the basis in the QOZ is accordingly adjusted (to equal the original rollover amount), the partner should be able to receive distributions against such basis without the recognition of taxable gain or the deemed disposition of the QOZ investment.  But would partners also receive basis for their share of debt incurred by the QOZ Fund over the life of the partnership, or would that amount, and thus the amount they could withdraw without immediate recognition of taxable income, be forever limited until the ultimate sale of their QOZ investment?

A technical reading of the Proposed Regulations implies that, as in the case of a non-QOF partnership, debt basis would be available to the holder of an interest in a QOZ Fund formed as a partnership.  While the provisions state that “any basis increase resulting from a deemed Section 752(a) contribution” is not taken into account in determining the portion of a partner’s investment subject to Section 1400Z-2(e)(1)(A)(i) or (ii), this language nevertheless appears to contemplate that such basis increase does occur,[11] and the nature of the provision generally appears to be favorable to taxpayers rather than restrictive.  On the other hand, if basis is received for the debt and is not treated as a separate investment, there is the potential that small rollover investments can, through the use of debt, turn into significant projects with significant appreciation, opening the potential for the 10-year rule to provide arguably disproportionate tax benefits on the ultimate sale of such projects.  Given the importance of leverage to many projects and businesses, we believe the Treasury Department should clarify these rules and provide guidance on the overall mechanics of debt basis in a QOZ project.

Another basis issue to consider is whether an investor partner in a QOF partnership would receive tax basis for taxable income allocated to that partner by the QOF partnership, such that a corresponding amount of cash may be distributed tax-free.  Although an allocation of income would normally result in a basis step-up, the zero-basis provision in the QOZ Rules suggests the possibility that this rule may not apply in the QOZ context.

Conversely, suppose there is cash flow in excess of taxable income (for example, as a result of tax depreciation at the QOZ Business level).  Can the QOF distribute this cash to its investors, or would this distribution jeopardize the QOZ investments as a result of the zero-basis rule?  If not, what can the QOF do with the cash?  Purchasing another QOZ asset is a possibility, but may be inconsistent with the economic objectives of the QOF, and may be difficult from a practical standpoint.  The QOF also may not want to retain the cash, as doing so may reduce the economic returns of the investors and, if there is too much cash, jeopardize the QOF’s ability to qualify under the 90% Asset Test.  There has not been any guidance thus far specifically addressing these points.

X is a 20% partner in QOF Partnership A, with his contribution to Partnership A consisting solely of a rollover investment such that his basis in Partnership A is zero (per the QOZ Rules).  Partnership A earns $100 of operating income in Year 1, of which X’s share is $20.  Assuming no offsetting losses, X will recognize $20 of taxable income which is his distributive share of the partnership’s income (note that the QOZ Rules do not address such ongoing partnership dynamics).

Ordinarily, X’s basis in Partnership A would be increased by this $20 income amount – such that the $20 of corresponding cash could be distributed to X without incurring further tax (as he has already been taxed on this $20 through the partnership).  But if the QOZ Rules operate to deny this basis increase, keeping the basis at zero, X cannot take a cash distribution without a second layer of tax (due to a distribution in excess of basis), and risking the possibility of being treated as having disposed of a portion of his QOZ investment.

Alternatively, suppose Partnership A has $100 of operating cash flow, but no taxable income as a result of depreciation.[12]  X would continue to have a zero basis and accordingly could not receive a cash distribution without incurring the potential adverse consequences above.

The same potential issue arises with respect to a refinancing.  If the refinancing does not create tax basis for X, a distribution of the refinancing proceeds would result in immediate tax and a potential recapture of the deferred gain.

Additionally, the issue may arise outside the partnership context.  May a QOF formed as a corporation make distributions to its rollover-investor shareholders?  There is no “debt basis” concept in corporate taxation, so there remains a significant concern that any such distributions would be treated as a taxable disposition of the QOZ investment and prevent further QOZ benefits.

Investors, developers and sponsors will need to know the answers to these questions, particularly as refinancing distributions are a significant part of real estate development and other investment strategies.  The inability to distribute refinancing proceeds prior to (or even after) 7 years would represent either a drag on the ability of investors to put their capital back to work in the market or, more likely, a drag on the carried interest of the developer as additional IRR accrues on such capital.  Conversely, the ability to receive debt basis without affecting the underlying rollover investment would be a significant boon to such strategies.

Working Capital Safe Harbor: Which Entity?

A significant question regarding the new working capital safe harbor is whether a QOF that owns a QOZ Business may hold such capital at the QOF level, or whether the QOF must contribute such working capital to the QOZ Business to be held at this “lower level.”  The latter outcome could result in a drag on investment returns at the QOZ Business level, as cash would remain stagnant in the QOZ Business entity before such cash would actually be needed – potentially a significant amount in excess of current construction expenditures.

Logically, it makes sense for the QOF to be able to hold the capital at the upper tier level until such capital is needed at the QOZ Business level – why should the QOZ Business require capital significantly  in excess of its needs at such an early point in time?[13]

Nevertheless, the language of the Proposed Regulations and the underlying examples imply that the working capital safe harbor must be applied at the QOZ Business level only – the provisions clearly specify Section 1400z-2(d)(3).  The rationale for this provision, despite the above policy-driven concerns, is that a QOZ Business must meet a requirement that a QOF need not: the requirement under Section 1397C(b)(8) that less than 5% of the average aggregate unadjusted bases of the entity’s property be attributable to nonqualified financial property.  This requirement is entirely separate from the requirement that “substantially all” of the QOZ Business’s tangible property be QOZ Business Property,[14] and accordingly works in tandem with the 70% threshold set forth in the Proposed Regulations under which the “substantially all” prong is met.
An interesting corollary, however, is that the QOF may not need to satisfy the requirements of Sections 1397C(b)(2), (4) and (8); the language of the QOZ statute provides only that QOZ Businesses must meet such requirements.  Accordingly, it would seem that up to 10% of the QOF’s assets (i.e., all but the 90% that must be QOZ Property) could be cash or financial instruments without violating the QOZ Rules.  Furthermore, the prohibition on “sin businesses” from Section 144(c)(6)(B) also appears as a technical matter only to apply to QOZ Businesses and not QOFs, and thus a QOF could potentially operate such a business.  It is unclear whether this result is intended, and it is possible that future clarifications (whether statutory or regulatory) would extend all of the QOZ Business provisions to QOFs generally – which could include the working capital safe harbor.
Multiple Asset QOFs:  Will There Be Any Flexibility to Invest or Ultimately Sell Through Tiered Entities?
Two related issues that have yet to be clarified by regulations involve the structuring of QOFs where multiple assets are concerned.  An investor must exit a QOF by selling its interest in the QOF in order to obtain QOZ benefits,[15] but this form of exit may be complicated and unattractive if the QOF owns multiple properties.  An alternative may be to form multiple QOFs, one for each property, but (assuming each QOF owns the property through a QOZ Business, which may be a partnership with a developer involving management provisions and a carried interest waterfall) there is no way to consolidate these multiple QOFs under a single umbrella, as a QOF may not own another QOF as a qualifying asset.  Accordingly, commentators have requested clarification about whether taxpayers may generally invest into a QOF through a separate entity such as a feeder or aggregator.[16]
Rollover from QOZ Investment to New QOZ Investment:  Does the Holding Period Tack?
The Proposed Regulations provide that a taxpayer who disposes of a QOF interest prior to December 31, 2026 may reinvest the deferred gain (that would otherwise be included in income in the year of such disposition) into a new QOZ investment.  What is unclear, however, is whether the new QOZ investment would tack the holding period of the old investment for purposes of the 5-year, 7-year and 10-year rules.
Absent further guidance, the technical reading of the Proposed Regulations would not permit a tacking of the holding period.  The Proposed Regulations merely clarify when the 180-day period begins for investors wishing to do so, and support the general concept that the deferred gain may be rolled over again (despite the statutory language suggesting that it would be “included in income”).  Nothing in the Proposed Regulations appears to indicate that the new QOZ investment would be treated as a continuation of the old one.  Accordingly, investors should anticipate this restriction in determining the availability of QOZ benefits with respect to their investments.
New Provisions Regarding Land:  Does Land Count as a 90% Asset Even If Not Improved?  Must (Entirely) Vacant Land Be Substantially Improved?
The Proposed Regulations provide that for purposes of the “substantial improvement” prong of the test for qualifying QOZ Business Property, a QOF (or QOZ Business) that purchases a building located on land within a QOZ is not required to improve the land, only the building (i.e., it may effectively ignore the cost of the land for substantial improvement purposes).  Revenue Ruling 2018-29, issued the same day as the Proposed Regulations, elaborates on this rule by, among other items, (i) noting that land, by its very nature, never has an original use in a QOZ by a QOF, and (ii) providing an example in which a QOF acquires land with a building and improves (only) the building.  There are several uncertainties here, however.
First, it is unclear whether the land is treated as a qualifying asset for purposes of the 90% Asset Test.  The statutory provisions do not exclude land from the 90% calculation – but they also do not exclude land from the “substantial improvement” test (which both the Proposed Regulations and Revenue Ruling 2018-29 do).[17]  Accordingly, it is possible that the guidance to date contemplates land as automatically a qualifying asset.  On the other hand, it is possible to construe the provisions of the Proposed Regulations and Revenue Ruling as simply ignoring land for the 90% Asset Test (i.e., treating the land at a zero value, to effectively remove it from both the numerator and the denominator) and basing such test solely on the substantial improvement of the building.  It is even possible that the land could remain a non-qualifying asset, and only the building would qualify, although this reading would appear to vitiate the intent of the provision (and as the example in the Revenue Ruling involves 60% land, the QOF in the example would appear not to meet the 90% Asset Test if the land were a non-qualifying asset).
The proper treatment of vacant land is also unclear under the Proposed Regulations and Revenue Ruling.  There is no requirement, in either the Proposed Regulations or the Revenue Ruling (where land and a building are purchased together, as in the Revenue Ruling’s example), that the building have any minimum value in order for the land to be excluded from the substantial improvement requirement.  Accordingly, the implication is that the value of the building could be de minimis or zero.  If so, then vacant land should also qualify as “substantially improved” under the Proposed Regulations and Revenue Ruling, even without any improvement at all!  Note that if this were not the case, then (absent any anti-abuse restrictions), a seller could simply improve vacant land with a simple small building prior to selling it to a QOF, so that the QOF purchasing it would be able to effortlessly meet the substantial improvement requirement and thereby avoid the issue.  Even if this result may follow logically, it is unclear whether it is intended or whether this result would be considered abusive.  The Treasury Department should clarify the intent of the Proposed Regulations on this point and, if necessary, provide for a building-to-land-value ratio below which the land would have to be substantially improved regardless of any building.
QOZ Land Acquired by a QOZ Prior to 2018:  Will There Be Any Guidance to Facilitate the Development of Such Land?
The Proposed Regulations do not address whether there is any ability for a taxpayer to utilize land it already owns (i.e., prior to 2018).  From a public policy perspective, it would make sense for taxpayers to be able to build ground-up developments (i.e., new acquisitions of buildings and improvements) on land they already own, and many believe this should be expressly permitted.  As noted previously, the Proposed Regulations provide that acquired land may be effectively disregarded from a substantial improvement perspective; the question is whether the Treasury Department might add a similar provision to permit a QOF to disregard land it already owned provided there will be qualifying improvements with original use on such land.
The Future
As noted, the Treasury Department has promised further guidance in the “near future,” including at least some guidance before the end of 2018.  The Proposed Regulations were published in the Federal Register on Oct. 29, and there is a 60-day comment period during which the Treasury Department will receive input from practitioners and industry groups.  Future guidance will hopefully address some or all of the major issues identified above; in the meantime, transactions that are less affected by such issues are likely to proceed in light of the clarifications provided thus far and the Treasury Department’s more active role in addressing the QOZ Rules generally.
Stroock remains committed to being one of the leaders among practitioners in the QOZ space.  As always, please contact the Stroock QOZ team if you have any questions about the QOZ Rules (whether as a sponsor, investor, or otherwise) or would like to draw upon our expertise.



[1] Sections 1400z-1 and 1400z-2.  Section references herein, unless otherwise indicated, refer to the Internal Revenue Code of 1986, as amended.
[3] In general, a QOF is a self-certifying entity (partnership or corporation) meeting certain requirements as to the ownership of its assets within a QOZ.
[4] Given the 2026 “sunset,” rollovers after 2019 cannot receive the additional 5% basis under the 7-year rule, and rollovers after 2021 cannot receive any increase in basis under either the 5- or 7-year rule.
[5] The exit from a QOF must generally be by sale of the QOF interest in order to take advantage of the QOZ benefits.
[6] Section 1397C generally governs the rules applicable to tax credits for so-called “enterprise zone businesses.”  Several of these provisions – Section 1397C(b)(2), (b)(4) and (b)(8) – are incorporated into the QOZ Rules by reference.
[7] “Relatedness” for this purpose is generally determined by a 20% or greater common ownership test with certain constructive ownership rules.
[8] Among other requirements, this safe harbor generally requires that there be a written plan identifying the entity’s financial property as property held for the acquisition, construction, or substantial improvement of qualifying QOZ Business Property.
[9]  The Proposed Regulations specifically observe that this means the QOF itself can potentially have as little as 63% (i.e., 90% of 70%) of its assets be QOZ Business Property.
[10] Section 1400Z-2(b)(2)(B) provides that, except as otherwise provided in such section (which includes, for example, the 10% basis step up after 5 years), the taxpayer’s basis in the investment shall be zero.
[11] Section 1.1400Z-2(e)-1(a)(2); see also Example in -1(a)(3).
[12] Some commentators have raised the possibility of a downward adjustment in the basis of the QOF’s (or QOZ Business’s) assets, similar to that in Section 743(b).  In this event, there would be no depreciation with respect to X’s interest in the QOF, and thus this particular sub-issue would be avoided.  However, the Treasury Department has not indicated whether it will follow such an approach.
[13] The preamble to the Proposed Regulations states that the working capital safe harbor is meant to aid QOFs in meeting the 90% Asset Test, but technically, if the safe harbor were only to apply to QOZ Businesses, then it would only aid QOZ Businesses in meeting the 70% test to qualify as a QOZ Business – which does benefit QOFs, but only indirectly.  This technical nuance in the preamble’s language, however, does not militate in favor of a different reading (given the strong argument in the following paragraph).
[14] Section 1400z-2(d)(3)(A)(ii) as opposed to -2(d)(3)(A)(i).
[15] This means that a QOF, as a general matter (except perhaps in certain contexts involving corporations), cannot sell its assets and liquidate (and still provide the QOZ benefits to its investors).
[16] As noted, the Proposed Regulations did clarify that gain recognized through a partnership is eligible for QOZ reinvestment by the partners, but the Proposed Regulations did not address any tiering with respect to the reinvestment itself.
[17] Sections 1400z-2(d)(1) and -2(d)(2)(D)(ii).