The Qualified Opportunity Zone program was enacted through the Tax Cuts and Jobs Act of 2017. The Department of Treasury has provided guidance concerning the tax incentives available under this program through two tranches of Proposed Regulations released in 2018 and 2019. The Internal Revenue Code and Proposed Regulations have strongly encouraged that Opportunity Zone investments be structured using a two-tier approach: (1) an upper-tier Qualified Opportunity Fund (“QOF”) business entity which takes in deferred capital gain amounts; and (2) a lower-tier Qualified Opportunity Zone Business (“QOZB”) business entity which deploys the deferred capital gain amounts into a real estate project or operating business.
While the QOF and QOZB are permitted to be structured as corporations, it is much more common for these entities to be classified as partnerships for tax purposes, particularly in the context of real estate investments.
One of the tax incentives provided in I.R.C. § 1400Z-2 is the temporary deferral of capital gain amounts that are invested into a QOF until as late as tax year 2026. A second tax incentive is a reduction in the gain amount, which is accomplished through an increase in basis in the investment of either 10% (for investments held for at least 5 years) or 15% (for investments held for at least 7 years). A third tax incentive provides that in the case of an investment held for at least 10 years, any post-acquisition appreciation will be tax-free, which is accomplished through a basis step-up upon sale or exchange of the investment.
However, the mechanics of that gain deferral provide that the basis in the investment starts out at zero, and the 10% and 15% basis increases only become operative once gain is ultimately recognized (1) at the end of 2026; (2) upon disposition of the investment; or (3) upon other specified “inclusion events.”[1] Accordingly, the investment will have a zero basis throughout the deferral period absent an increase in basis through operating income or partnership liabilities.
This statutory and regulatory scheme directly impacts the proper drafting of distribution provisions in partnership and operating agreements in that these provisions must be drafted to ensure that no distributions in excess of basis will occur. While distributions in excess of basis will always give rise to capital gain, greater caution must be exercised in the case of QOF investments. A distribution in excess of basis, in the context of a QOF investment, may not only trigger a premature inclusion of the gain that is sought to be deferred, but such a gain may also render the gains ineligible for the 10% and 15% reductions depending on the timing of any such distributions. The current proposed regulations do not have similar provisions for the 10-year holding period, so it is not clear whether the Internal Revenue Service will consider distributions in excess of basis following the initial deferral period to cause other adverse tax consequences with regard to the 10-year basis step up.
Accordingly, additional language should be inserted into the distribution provisions for any venture in which a QOF is investing so that distributions to the QOF will be limited to its basis (inclusive of I.R.C. § 752 allocations of debt).
[1] I.R.C. § 1400Z-2(b)(2)(B)(i).
