Treasury has issued two rounds of generally taxpayer-friendly regulations with respect to opportunity zone tax incentives and the structuring of qualified opportunity funds (QOFs). However, there still remain important issues that are keeping investors, and large amounts of money, on the sidelines. The discussion below offers some suggestions to Treasury that, if adopted, would provide fund managers and investors with needed clarity, and thereby help kick the opportunity zone (OZ) program into high gear.
HOW IT GOT STARTED
When the OZ incentive was introduced as part of the 2017 Tax Cuts and Jobs Act, traditional real estate fund managers started to explore how to best structure and establish qualified opportunity funds to maximize the benefits of the new legislation. However, these initial efforts were largely stymied by a lack of clarity on how the new law would be implemented, especially with respect to large multi-asset funds that are a standard investment vehicle in many other areas of real estate and business investment. While the second round of proposed regulations issued in April 2019 provided helpful guidance on many key issues, there remain several challenges that need to be addressed before the full investment power of multi-asset funds will be unleashed.[1]
The OZ legislation provides investors with three primary tax benefits: deferral of eligible gain until Dec. 31, 2026 (unless there is an earlier inclusion event), reduction of up to 15% of any eligible gain invested into a qualified opportunity fund, and elimination of gain on a disposition of an investor’s QOF investment if the investor held the interest in the QOF for at least 10 years (10-Year Exclusion Benefit).
THE 10-YEAR EXCLUSION BENEFIT
This third benefit of the program is the one that will likely have the greatest economic impact, and is achieved through an election by the taxpayer to increase the tax basis of the investment to equal “the fair market value of such investment on the date the investment is sold or exchanged.”[2] Prior to issuance of the second round of regulations, this language was interpreted to mean that an investor would only get the exclusion benefit by selling the investor’s investment in a QOF. This obviously hindered the formation of multi-asset funds, since a single QOF set up to hold multiple assets would likely require the fund manager to find a single buyer interested in buying a QOF with multiple assets, as opposed to a separate buyer for each of the assets. In response, fund managers have been utilizing various other alternative fund structures, including the use of a REIT as the QOF or the establishment of a series of parallel partnerships each separately qualifying as a QOF, as explained in further detail below.
A REIT QOF
Pursuant to Code §562(b), REITs are entitled to a dividends paid deduction for all distributions made within 24 months of the adoption of a plan of liquidation.[3] Meanwhile, Code §331 treats amounts received by REIT shareholders pursuant to a liquidation as payment in exchange for the stock of the corporation.[4] This combination of rules allows for a QOF which has been set up as a REIT to adopt a plan of liquidation after the ten-year holding period has been met and then to make liquidating distributions (not taxed at the REIT level, and treated as deemed purchase payments at the shareholder level) as the REIT sells its assets over a 24-month period. However, because the distributions must be made within a two-year period, a fund with a large number of assets will not have much time to fully liquidate its portfolio. REITs have other limitations (such as investors having zero basis in their stock) and complications (i.e., asset and income requirements) that are beyond the scope of this article, making them a less effective choice than a typical partnership as a QOF vehicle.
PARALLEL QOF STRUCTURE
The unique rules described above applicable to REITs do not apply to partnerships, and so investors in a partnership QOF with multiple assets would presumedly need to sell their interests in the partnership QOF in order to obtain the 10-year exclusion benefit. This could be difficult to accomplish, since the selling partners would need to find a buyer interested in purchasing the entire partnership portfolio of assets. As an alternative, fund managers have utilized a parallel QOF structure whereby separate QOFs are used to invest (directly or indirectly) in each asset in the portfolio, so that each asset can be sold separately by selling the controlling QOF. Investors in this fund structure are obligated to invest into each QOF on a pro rata basis, meaning no cherry picking. The fund manager then looks to sell off each separate QOF after the 10-year holding period is reached, thereby preserving the 10-year exclusion benefit for investors. While this structure fits within the technical parameters of the existing provisions, it is administratively cumbersome and, among its many awkward consequences, requires a manager to issue separate K-1s to partners from each separate QOF.
AGGREGATOR PARTNERSHIPS
Treasury was aware of the challenges facing multi-asset fund formation and tried to address some of these issues in the second round of regulations. First, in a long list of events that would cause an investor to include its deferred gain into income, Treasury provided a rule that states that a contribution by QOF owners of qualifying QOF interests to a partnership in a transaction governed all or in part by Code §721(a) is not an inclusion event. This rule theoretically allows a fund with parallel QOF entities to have its investors contribute their QOF interests into an “aggregator” partnership after they invested their eligible gains into the parallel QOFs. It is believed that Treasury proposed this indirect and rather awkward “solution” due to a concern that it lacks regulatory authority to allow investors to invest directly into the aggregating partnership as the legislation requires investors to invest directly into a QOF.[5]
Given that funds may have many separate investors, this provision reduces substantially the compliance burden inherent in a parallel QOF structure by allowing investors to receive one K-1 from the aggregator partnership rather than a separate K-1 from each parallel QOF. However, it will be helpful if Treasury makes it clear that it will not apply the step-transaction doctrine in a situation where investors make a direct investment into multiple QOFs followed by a drop-down of those QOF interests into an aggregator partnership pursuant to a pre-determined plan.
MERGERS AS A NON-INCLUSION EVENT
The second round of regulations contain a helpful provision clarifying that a merger or consolidation of upper-tier partnerships holding a qualifying investment is not an inclusion event.[6] Unfortunately, the second round of regulations do not address mergers of QOFs; it would be very helpful to confirm that a merger of two or more QOFs is not an inclusion event. Similar to the rule above with respect to aggregator partnerships, allowing for a merger of multiple QOFs into a single QOF would let funds issue one K-1 to investors from the merged QOF in place of a K-1 from each separate original QOF, greatly reducing the compliance burden for fund managers.
INVESTMENTS HELD FOR AT LEAST 10 YEARS
Prior to the issuance of the second round of regulations, the legislative language of §1400Z-2(c) was interpreted to mean that an investor would only get the 10-year exclusion benefit by selling the investor’s investment in the QOF entity. The updated regulations provided special election rules that broaden the scope of §1400Z-2(c) to apply to additional scenarios, including dispositions of qualified opportunity zone property (QOZP) by QOF partnerships or QOF S corporations, as well as to capital gain dividends paid by a QOF REIT.
Under the code, QOF partnerships and QOF S corporations that dispose of QOZP will allocate gain from the disposition to equity holders on a Schedule K-1. The second round of regulations allow investors to elect to exclude from gross income some or all of any capital gain to the extent that the gain relates to that portion of the taxpayer’s qualifying investment that the taxpayer has held for at least 10 years.[7] Unfortunately, these proposed rules do not apply to sales of qualified opportunity zone business property (QOZBP) by a qualified opportunity zone business (QOZB); it only applies to the QOF’s sale of the QOZB entity itself. Although institutional buyers of real estate may be accustomed to acquiring property through the acquisition of interests in an entity that owns the real estate, a typical real estate investor may not want to deal with the potential legal liabilities associated with acquiring an existing entity, thereby limiting the pool of potential buyers upon exit and/or requiring a discount in the sale price. Note also that this rule only allows for an exclusion of capital gain; to the extent there is any ordinary gain in connection with the sale, the investor will be required to recognize that gain. It would benefit QOF investors if the Treasury would allow for a full exclusion of all gain (not just capital gain) related to sales of assets at any level.
A QOF REIT that sells QOZP, on the other hand, would designate a portion of the distribution related to the gain on sale as a capital gain dividend, reported to shareholders on Form 1099-DIV. The second round of regulations contain a provision that allows shareholders of a QOF REIT to elect to apply a zero percent tax rate to capital gain dividends related to the sale of QOZP, as long as the shareholder has held its qualifying investment for at least 10 years. Note that while this would exempt capital gain dividend income from federal tax it would not necessarily exempt it from state tax (even in states that fully conform to federal opportunity zone rules) unless that particular state enacts a similar provision applying a zero percent state tax rate.
Overall, the above provisions for investments held at least 10 years can be very helpful to QOFs with multiple assets, as they would allow a QOF to sell its assets to different buyers over time while providing opportunity zone tax benefits to investors that invested eligible gains into the fund and held the fund interest for more than 10 years. However, in addition to the issues referenced above, the biggest limitation to these proposed rules is that taxpayers cannot rely upon these rules until they are issued as final regulations.
THE FUTURE OF MULTI-ASSET OPPORTUNITY FUNDS
Treasury favorably addressed in the second round of regulations several of the challenges to formation of multi-asset funds investing in opportunity zones, but ongoing uncertainty has had a chilling effect on investment decisions. Large, multi-asset opportunity funds will enhance the success of the opportunity zone program, as the ability of a multi-asset fund to diversify investment risk should help offset the inherent risk of investing in areas that have traditionally struggled to attract investor capital. Given the taxpayer-friendly guidance that Treasury has issued to date, one can hope that Treasury will likewise address favorably the issues raised in this article.
Sources:
[1] See IRS Proposed Rules (REG-120186-18, May 1, 2019) for the second set of regulations.
[2] IRC 400Z-2(c).
[3] IRC 62(b).
[4] IRC 31(a).
[5] IRC 400Z-2(a)(1)(A).
[6] Prop. Treas. Reg. 1400Z2(b)-1(c)(6)(ii)(C)
[7] Prop. Treas. Reg. 1400Z2(c)-1(b)(2)(ii).