In a prior Memorandum, we described the potential benefits to investors and challenges to sponsors of qualified opportunity funds (“QOFs”). QOFs are unique tax-advantaged investment vehicles that invest in real estate or other businesses located in certain geographic areas that have been designated as qualified opportunity zones. Certain private equity and real estate funds may qualify as QOFs. This Memorandum updates our prior coverage, summarizing certain key points from recently released proposed Treasury regulations (the “Regulations”). Generally, the Regulations provide flexibility to QOFs and to their investors and sponsors.
1. Exit Considerations
The Regulations address an integral aspect of structuring a QOF: exiting investments and fund wind-up. Prior to these Regulations, we were concerned that gain from the sale by a QOF of portfolio investments would trigger gain recognition (that investors would pick up on their Schedule K-1s) and that the ’10-year tax-free gains’ benefit may not be fully available in such cases.
These Regulations provide that direct partners in an LP-QOF (a QOF that is structured as a partnership or LLC taxed as a partnership) may make a special election to exclude gains that are reported on a Schedule K-1. To make this election, the investor in the QOF must meet a 10-year holding period requirement with respect to his investment in the QOF. The election may be made on an asset-by-asset basis to the extent that a Schedule K-1 separately states capital gains arising from the dispositions of particular assets.
Similar rules exist for shareholders in a QOF that is classified as an S corporation or a REIT.
2. Flexibility in Deploying Capital
The Regulations provide QOFs flexibility in deploying capital in several ways. Generally, QOFs must invest at least 90% of its assets in qualified assets (the “90% Assets Test”) or risk tax penalties. The Regulations provide taxpayer friendly guidance for satisfying the 90% Assets Test.
First, QOFs can exclude from the 90% Assets Test any contributions received from investors in the prior six months. Second, cash proceeds from the sale of a qualified asset will be treated as a qualified asset for purposes of the 90% Assets Test for 12 months following the sale. During this 12-month period, the cash can be reinvested or distributed to investors. Third, the Regulations clarify various defined terms (e.g., “substantially all” and “qualified opportunity zone business property”) that should help QOF managers determine whether an investment will be a qualified asset under the 90% Assets Test. In sum, the Regulations offer flexibility and meaningful guidance to QOFs.
3. Interaction with Partnership Tax Rules
An LP-QOF continues to be subject to the partnership taxation rules (i.e., Subchapter K of the Internal Revenue Code). The Regulations provide limited, albeit helpful, guidance in coordinating the application of the QOF rules and the partnership taxation rules of Subchapter K. While the granular details of these aspects of the Regulations are beyond the scope of this Memorandum, we offer the following observations:
- Carried interest items will not be eligible for the benefits generally arising from an investment in an LP-QOF. However, the capital interest of a general partner in a QOF may be treated as a QOF investment if certain requirements are met.
- Subsequent closings or deferred capital calls may require the LP-QOF to revalue its assets.
- Certain distributions, including distributions of refinancing proceeds in certain instances, from LP-QOFs may accelerate the recognition of deferred gains (i.e., gains that were deferred by partners upon their investment in the QOF).
- Allocations of items of income, gains, losses, deduction and credit with respect to QOF partners are generally required to be based on relative capital contributions.
- Special rules apply to “mixed-funds partners” for purposes of determining the QOF attributes relating to such partners’ interest in the QOF (e.g., basis, tax accounting and income inclusions). “Mixed-funds partners” include partners that invest both deferred gains and other funds into the QOF, service partners and partners that contribute appreciated property to the QOF.
Both the QOF and partnership taxation rules are quite complex and, as such, the IRS is continually examining ways to simplify these rules. Similar rules apply in the context of S corporation QOFs.
4. QOF Interests and Estate Planning
QOFs present potentially significant estate planning opportunities, and the Regulations provide flexibility in this regard. Due to the long-term investment horizons associated with investing in QOFs, the Regulations also address the treatment of transfers of QOF interests by gift, charitable contribution and death.
Generally, gains that were deferred when an investor originally invested in a QOF are required to be recognized at the sooner of either the sale, exchange or disposition of the QOF interest or December 31, 2026. The Regulations clarify that transfers by gift and charitable contributions that occur before December 31, 2026 will be an income inclusion event to the extent of deferred gains. In other words, the QOF investor will first recognize any deferred gains before determining the income tax consequences of the gift or charitable contribution. The donee or receiving charity generally will not be eligible for the ’10-year tax-free gain’ benefit accorded to investors in a QOF.
Transfers to grantor trusts will not constitute an income inclusion event, although a change in status of the trust (other than by death of the grantor) generally will be.
Death of an investor in a QOF is generally not an inclusion event to the extent of deferred gains. This includes situations in which grantor trust status is terminated upon the death of the grantor. In these cases, the estate, trust or the beneficiaries will be required to include the gains deferred by the deceased upon his initial investment in the QOF upon a later inclusion event.
5. Anti-Abuse Rules
The IRS has the authority to recast transactions that are determined to be abusive if the significant purpose of a given transaction is to achieve a tax result that is inconsistent with the purposes of the QOF regime. The preamble to the Regulations specifically notes the application of this anti-abuse rule in the context of real estate investments. The IRS appears to be concerned with the purchase of unimproved land, including agricultural land, that is not used in a trade or business. This may be an area of future guidance.
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The Regulations and existing guidance relating to QOFs are complex. We are actively monitoring developments in this area of tax law, along with developments relating to QOFs in the investment funds context. For additional information on your tax compliance obligations, please contact Jonathan P. Brose (212-574-1615), James C. Cofer (212-574-1688), Ronald P. Cima (212-574-1471), Peter E. Pront (212-574-1221), Daniel C. Murphy (212-574-1210), or Brett R. Cotler (212-574-1269).