Full Breakdown: The Second Round of Qualified Opportunity Zone Regulations

On May 1, 2019, the IRS posted the second round of proposed Qualified Opportunity Zone (QOZ) regulations to the Federal Register. Like others in the tax community, I analyzed the provisions of the New Proposed Regulations pretty carefully upon release. In the ensuing few weeks, though, I began to realize that I should revise my initial take on how important (or unimportant) certain aspects of the New Proposed Regulations actually were. In this post, I describe the notable changes in the New Proposed Regulations and what kind of impact I think they'll have on Qualified Opportunity Funds (QOFs) and their investors.

This article assumes basic familiarity with the QOZ program and the first round of proposed regulations, which I broke down here. Ever since the release of the Tax Cuts and Jobs Act, the legislation which birthed the QOZ program, I've spoken at dozens of events large and small to educate clients, centers of influence, and investors about its contents. For the most part, I feel many observers have moved on from introductory descriptions of the QOZ program and how it works. To put on a compelling QOZ seminar for the remainder of 2019 (and perhaps beyond), event organizers will need to present innovative content about creative planning under the QOZ program. To that end, I plan on releasing in the near future an article about some of the nifty ways tax practitioners can leverage the QOZ program to make the tax benefits even stronger for their clients.

What are the top five changes within the New Proposed Regulations that I need to know?

1. Net Section 1231 gain is now a trap for the unwary.

I can feel the non-tax folks collectively thinking, "What on Earth is net Section 1231 gain?" This calls for a bit of background. I always find tax law is best understood by asking "why" rather than asking "what," so here's why net Section 1231 gain even exists at all.

Section 1221 (twenty-one, not thirty-one) sets forth the definition of a capital asset. Capital assets are defined not by what they are, but rather by what they aren't. One of the categories of property that is not a capital asset is "property used in [a] trade or business" and subject to depreciation. This description includes real estate used in any trade or business.

Look to the case law and you'll see that the general category of "real estate used in a trade or business" is pretty broad. It includes hotel buildings, office buildings, multi-family apartment buildings, and industrial properties. In fact, it's such a broad category that it might be better defined by what certainly isn't included: triple-net leased and double-net leased property, raw and undeveloped land held for speculation, and any other real estate not being developed or held out for rent to unrelated tenants, such as property that has sat vacant or abandoned for awhile.

As yet another example of how real estate is one of the five lobbies that wrote the modern Internal Revenue Code (along with energy, insurance, agriculture, and the financial industry), Section 1231 provides a cool carve-out for real estate used in a trade or business. In general, gains from the sale of Section 1231 property are treated as long-term capital gain if the property has been held for more than one year, and losses from the sale of Section 1231 property are treated as ordinary losses. This unique hybrid treatment does have its limits, though -- Section 1231 gains and losses have to be netted against each other before being netted against non-Section 1231 tax items to prevent abuse (namely, gross Section 1231 losses getting netted against non-Section 1231 ordinary gain as opposed to Section 1231 capital gain, resulting in a windfall for the taxpayer). The netting of Section 1231 gains and losses occurs at the end of each taxable year.

Before the New Proposed Regulations came out, most tax planners (as opposed to tax preparers) didn't have to pay close attention to the difference between Section 1221 and Section 1231 real estate because the outcome didn't make much of a difference; for planning purposes, the gain upon sale would be capital in either scenario. But the New Proposed Regulations changed that in a big way: a provision specifies that since a taxpayer won't know net Section 1231 gain until the end of the year, the clock for QOZ deferral of net Section 1231 gain cannot start until December 31 of the taxable year... no matter what. Unlike the special election for K-1 gain deferral to start on either the date of recognition or December 31, net Section 1231 gain will not offer the same timing flexibility.

This presents two issues: the backward-looking issue and the forward-looking issue. The backward-looking issue is what taxpayers are supposed to do with the net Section 1231 gain they deferred within 180 days of the recognition date prior to the release of the New Proposed Regulations. Let's begin by tackling this one.

I don't think the New Proposed Regulations should cause any panic for taxpayers who already deferred net Section 1231 gain using the recognition date as the starting point, because the plain language of the statute allowed these taxpayers to do so. Even the IRS seems to agree with that take.

The forward-looking issue is what to do with net Section 1231 gain occurring after the publication date of the New Proposed Regulations (May 1, 2019). If you're feeling aggressive, you can go against the regulations and use the sale date as the beginning of the 180-day timer, and I'd feel somewhat comfortable with that approach for two reasons. First, Estate of True and other cases established the principle that Proposed Treasury Regulations are afforded "no more weight than a mere litigating position" of the IRS in court, meaning regulations that have not been finalized will not be persuasive before a judge. Second, it's a long-standing principle of administrative law that regulatory bodies such as the IRS do not have the power to pass regulations in contravention of the corresponding statute. Astute readers may have already noticed that the net Section 1231 gain principle is a major departure from the plain language of Section 1400Z-2(a)(1)(A), which specifies the deferral date as beginning "on the date of such sale or exchange." While the first round of Proposed Regulations provided a welcome departure from the statute for K-1 gains that probably doesn't line up with the statute either, taxpayer-friendly regulations don't tend to get challenged in court. The net Section 1231 gain rule, if finalized, ought to be the subject of litigation later on -- and I wouldn't bet on the government's chances when it happens. If you're a tax advisor, you may have to make a judgment call as to whether Form 8275 is required on the corresponding tax return, but I don't think Form 8275-R (which basically guarantees human review) is required unless the net Section 1231 gain provision is included in final regulations. Even then, taxpayers with an aggressive risk tolerance and a good war chest can go against the regulations and hunker down in preparation for litigation.

If you skew conservative, though, you'll advise clients to line up with the New Proposed Regulations on future net Section 1231 gain unless critical business exigencies make compliance impossible (this should probably be your initial advice anyway). For some clients, the net Section 1231 gain rule could prove cumbersome, so you'll need to have a lengthy discussion with them to figure out the best path forward. But regardless of which way you and your clients are leaning, don't let the net Section 1231 gain issue catch you off-guard.

2. Master leases are officially a way for clients who already own property in a QOZ to take advantage of the program's tax benefits.

Arguably the biggest question about QOZ tax planning, even after the release of the first round of Proposed Regulations, was what taxpayers should do if they owned real property in a QOZ prior to December 31, 2017 (the effective date of the statute). This property was ineligible for QOZ tax benefits, which seemed a bit unfair. As a law firm, we advised clients of two potential strategies, both of which came with substantial risk: the Sale-Reinvestment Strategy and the Master Lease Strategy.

The Sale-Reinvestment Strategy was based on literal compliance with the related-party rules. Since taxpayers couldn't "churn" their existing real property by selling it to a related QOF, taxpayers would instead sell to an unrelated QOF. The threshold for relatedness is 20% common ownership, so the taxpayer and his or her relatives would take slightly less than a 20% aggregate stake in the purchasing QOF, and the purchasing QOF would then develop or renovate the purchased property in compliance with either the original use or substantial improvement rules. Employees of the IRS and Treasury informally commented that the Sale-Reinvestment Strategy is not abusive, which is pretty comforting, but the obvious wart with the Sale-Reinvestment Strategy is the limitation on the original owner's stake in the purchasing QOF. The 20% upper limit for the taxpayer's membership in a QOF LLC or shareholding in a QOF corporation was an economic deal-breaker most of the time.

Enter the Master Lease strategy, in which a taxpayer would lease existing land or an existing structure (or both) to a related QOF, which would then develop the land, raze the existing structure and build a new one, or renovate the existing structure (in accordance with the substantial improvement requirement). Before the release of the New Proposed Regulations, the potential issue with the Master Lease strategy was whether it was an abusive circumvention of the related party rules. The IRS (rightly, in my opinion) decided the Master Lease strategy was OK because it encouraged new economics for the QOZ, whereas disallowing the Master Lease strategy would risk the adverse outcome of pre-existing property continuing to sit vacant or otherwise unaltered.

The provisions blessing the Master Lease strategy are simple and sensible. The Master Lease must begin after December 31, 2017, and leased property must be used in a QOZ substantially all of the time (never an issue for real estate). Leases between related parties must be at fair market value with no prepayments allowed, and master leases cannot be used to circumvent the substantial improvement requirement. Options to purchase at less than fair market value will be considered abusive per se.

The big takeaway from this part of the New Proposed Regulations is that clients who want to develop or renovate property in a QOZ they owned prior to December 31, 2017 have a safe strategy to do so and reap all the tax benefits of the program.

3. Even more safe harbors provide much-needed reliability for QOFs and QOZBs.

After a first round of Proposed Regulations with some nice safe harbors, the IRS again displayed this administration's inclination to really encourage taxpayers to use the program by introducing even more safe harbors. The closest thing to a magic phrase in the tax law is "safe harbor," so this development in the New Proposed Regulations is most welcome. The safe harbors new to this edition of IRS guidance are as follows:

• Regarding the requirement that 50% of a QOZB's income be derived from within a QOZ, there are three safe harbors and a facts-and-circumstances test.

1. The "services performed" safe harbor stipulates that 50% of total services performed by a QOZB's employees or independent contractors must be within a QOZ. This allows businesses with a high volume of QOZ clients but a few large non-QOZ clients to qualify.
2. The "amounts paid" safe harbor stipulates that 50% of amounts paid for services performed by a QOZB's employees or independent contractors must be within a QOZ. This allows businesses with the opposite situation - a high volume of non-QOZ clients but a few large QOZ clients -- to qualify.
3. The "headquarters" safe harbor is a two-parter stipulating that both (a) 50% of a QOZB's tangible property and (b) 50% of its management and operations must be within a QOZ. This one will probably prove the most popular.
4. In the event a taxpayer doesn't meet any of the safe harbors, a facts-and-circumstances test will apply, so if you're relying on this one, get ready to have some good backup to prove your case.

• The "new cash safe harbor" allows a QOF, for purposes of the 90% Test, to ignore any cash contributed in the previous six months, which allows some more leeway for a QOF to invest new capital. Note this does not apply for property contributed to a QOF (see below for details).
• The working capital safe harbor already existed but received a boost in the New Proposed Regulations. The IRS clarified that the WCSH will apply to all real estate activities. The WCSH is also tolled for any governmental action (or lack thereof) delaying a project, so no need to fear whether a development can get done in the 31-month window because of zoning or permitting issues. Finally, the WCSH can be applied separately to different blocks of cash, so every capital contribution will come with its own timer for the WCSH. For instance, if an investor contributes $1 million to a QOF on January 1 of a given year, the 31-month timer for the WCSH will begin as of January 1 for that particular block of cash. But for the cash contributed by an investor on July 1 of the same year, the WCSH applies separately and begins on July 1. This is a nice accommodation for multi-asset funds and those that need to make capital calls.

4. The "inclusion events" trigger recognition of deferred capital gain before the statutory due date of December 31, 2026.

One of the major remaining ambiguities in the QOZ program was what happened to a QOF interest if a taxpayer disposed of it after acquisition. The New Proposed Regulations set forth tax consequences by introducing a category of "inclusion events," or types of transactions that will trigger recognition of the deferred capital gain prior to December 31, 2026, even if the QOF interest were not sold or exchanged.

The general rule is that any taxable disposition of a QOF (or any interest in an entity owning a QOF) will be an inclusion event, which does make intuitive sense, but the following events are non-taxable dispositions that will be inclusion events also:

• Gifts and charitable contributions: this one is not so intuitive at first blush. Putting charitable contributions on the list of inclusion events is designed to prevent a windfall. As an example, suppose a taxpayer defers $1 million of short-term capital gain through investment in a QOF. The taxpayer then contributes the QOF interest to a public charity prior to December 31, 2026. If the contribution is not a recognition event, the taxpayer gets a $1 million (or greater) ordinary deduction for the charitable contribution and escapes taxation on $1 million of short-term capital gain. That's too much of a tax benefit of the IRS to allow, and rightly so. The prohibition on gifting, though, is to prevent manipulation of tax consequences when the capital gain does have to be recognized. For example, suppose the same taxpayer deferred only $100,000 of short-term capital gain through investment in a QOF. On December 30, 2026, the taxpayer gifts her QOF interest to her daughter, who is a 21-year-old college student with no other income. The original taxpayer would've paid a much higher marginal rate on the $100,000 than the 21-year-old college student. The IRS rightfully considers this outcome abusive.
• Reorganizations reducing a taxpayer's beneficial equity interest in a QOF: Same principle as a gift -- the IRS does not want abusive shifting of responsibility for the deferred capital gain from one taxpayer to another.
• Section 332 liquidations: This one surprised me. Any liquidation of a QOF corporate subsidiary into a corporate parent would be an inclusion event for reasons I still don't entirely understand. If anyone knows the abuse the IRS was looking to prevent here, I'd welcome discussion in the comments.
• Certain S-Corp ownership changes: If a shareholder in an S-Corp owning a QOF disposes of greater than 25% of the ownership interests, the entire deferred capital gain will be included in the transferor's income. Again, this one is meant to prevent shifting the burden of recognition too far toward a different taxpayer, though there's some breathing room to switch ownership before the inclusion event kicks in.
• Distributions in excess of basis: This one's intuitive -- it's a recognition event anyway, so the deferred capital gain will be recognized dollar-for-dollar as these distributions are made. The major exception for cash-out refinances is discussed below.

The following transactions are exceptions from the inclusion event rule:

• The general rule is that any non-recognition transaction that does not reduce a taxpayer's beneficial equity interest in a QOF (and thereby not changing the taxpayer's responsibility for the deferred capital gain) will be considered OK under the inclusion event rules.
• Most partnership and corporate reorganizations are exceptions, so long as the taxpayer's beneficial equity interest in the QOF has not changed.
• Disregarded entity transactions are OK because the federal income tax law ignores these transactions entirely.
• Corporate conversions from S-Corp to C-Corp and vice-versa: This one is mildly surprising due to the differentials in marginal income tax rates, but there are anti-abuse rules already codified in Subchapters C and S to prevent taxpayers from abusing conversions, so this shouldn't present any issues.
• Grantor trust transactions: This one has two interesting wrinkles. First, the regulations phrase the exception as "contributions" to grantor trusts, which are not as common as sales to grantor trusts. All estate and gift tax practitioners are generally familiar with Revenue Ruling 85-13, which provides the IRS will ignore for federal income tax purposes (not estate/gift tax purposes) any transactions between a grantor trust and its grantor (who may not necessarily be the settlor). I have to think that under the principle of Revenue Ruling 85-13, sales to grantor trusts will not be inclusion events, but the regulatory language is not entirely clear about that. The second curious aspect of the New Proposed Regulations regarding this issue is the treatment of ESBT/QSST conversions. As all trust tax practitioners know, QSSTs are simple trusts that are grantor trusts under Section 678(a)(1), but ESBTs are very nearly always complex non-grantor trusts. This means ESBT/QSST conversions could change grantor trust status and, therefore, ultimate responsibility for the deferred capital gain. Expect this second wrinkle to get changed prior to finalization.
• Death and estate administration: While dying will not be an inclusion event, the obligation to pay deferred capital gain apparently "follows" the QOF interest to the next owner through treatment as Section 691 IRD (income in respect of a decedent). What the IRS still has not clarified completely is whether the QOF interest still gets a Section 1014 basis adjustment, which I believe it does.
• The mere payment of corporate dividends will not be an inclusion event, which is a relief for REITs.
• Finally, the biggest exception of all: cash-out refinances for QOFs taxed as partnerships are generally not inclusion events, but they need to meet certain criteria. First, the distributions of refinance proceeds cannot exceed basis, which is academic. Second, the refinance will be analyzed under the disguised sale regulations (1.707-5(b)) and the QOZ anti-abuse regulations, so cheeky maneuvers like cashing out equity investors immediately after capital contributions will be a big no-no. Generally, QOF sponsors should wait until after stabilization of a real estate investment to refinance, which is part of most business plans anyhow; for operating businesses, it appears two years will be the waiting period for debt-financed distributions.

5. Sales within a QOF have regular income tax consequences, but careful planning can navigate around the issue.

The New Proposed Regulations concluded that the IRS could not find the authority to make transactions within QOFs exempt from federal income tax consequences, meaning any QOF's sale or exchange of QOZP would be taxable as normal unless some other non-recognition provision applied. This dashed the hopes of some QOF sponsors that internal "asset churn" would be tax-free, and many concluded QOFs had no choice but to hold their QOZP for ten years or more to truly reap maximum benefits under the program. I think this view is shortsighted and discounts the possibilities available with careful tax planning.

In the preamble to the New Proposed Regulations, the IRS notes that there are other non-recognition provisions QOFs could freely use to avoid federal income tax recognition on their QOZP transactions. One of the provisions cited was Section 1031, but the preamble conspicuously left out Section 1045, which I think is just as important. I discuss both strategies below.

• The Section 1031 strategy entails a QOF or QOZB selling real property in a QOZ meeting the qualified use requirement and exchanging into other QOZ real property also meeting the qualified use requirement. The first counterpoint I hear in response to proposing the Section 1031 strategy is how a like-kind exchange would sync with the substantial improvement requirement under the QOZ program. I see at least two avenues to achieve compliance. First, a QOF could complete an exchange into QOZ real property and combine either a capital call or new construction financing to meet the substantial improvement requirement. Second, a QOF could use the Section 1031 funds to enact a non-safe harbor parking exchange under the recent Estate of Bartell v. Commissioner case, in which the U.S. Tax Court ruled that a Section 1031 parking exchange entailing well over the normal six-month exchange period for development was compliant with the statute and regulations. I note Bartell-style non-safe harbor parking exchanges come with substantial risk for various technical reasons, including an IRS non-acquiescence to the decision and an explicit intent to continue challenging other transactions like it. But for QOFs looking to take advantage of Section 1031 while avoiding the necessity to make a capital call, the Bartell option is a viable strategy.
• As much as I love Section 1031 because it was the first major income tax concept I ever felt comfortable enough to advise clients about (and I owe a huge debt of gratitude to Professor Bradley T. Borden at Brooklyn Law School for that), I find the Section 1045 strategy even more powerful for QOFs. Some background: many of you might be familiar, at least on the surface, with Section 1202 and Qualified Small Business Stock (QSBS). If you're not, check out this article I wrote with the absolutely brilliant Caryn Friedman of Ernst & Young LLP's national office. Not only does Section 1202 confer a really nifty tax break in and of itself, but the QSBS program also provides a tax-deferred exchange of its own in Section 1045. In essence, Section 1045 provides that any sale of stock qualifying as QSBS can be exchanged for other stock qualifying as QSBS within six months of sale, and taxes from the original sale will be deferred through carrying over basis to the new investment (think of it as a Section 1031 exchange for business stock). For QOFs, this means that their QOZBs running operating businesses should be C-Corps, which would allow an early exit strategy if the QOF has no issues reinvesting the proceeds into other QSBS. Better yet, so long as the QOF is invested in the QSBS directly and the corporation doesn't have a tiered structure, the QOF doesn't even need to actively participate in the operating business itself.

In general, what you should know is that both Sections 1031 and 1045 provide viable ways for QOFs to make investments of less than ten years and still keep the gravy train rolling for tax-free appreciation. These strategies illustrate the general principle that the QOZ program can be made even more powerful if you're aware of several other companion strategies, all of which I plan on describing in a follow-up post.

What else do taxpayers need to know about the New Proposed Regulations?

• In a bummer for the QOF sponsors, the New Proposed Regulations clarified that any QOF equity received in exchange for services is not eligible for QOZ tax benefits. This means QOF carried interests are always taxable, even if they're held for ten years or more. Recall that QOZBs cannot issue interests in exchange for services because of the requirement that QOZB equity be issued in exchange solely for cash.
• As an exit strategy for multi-asset funds, the New Proposed Regulations contain a new election for QOF equity holders to exclude from capital gain the sale of QOF assets. This election, the procedure for which has not yet been finalized, would occur on the QOF equity holder's K-1. Curiously, this election excludes only the capital gain from the sale of QOF assets, meaning the strategy is less effective for any assets with depreciation recapture or other characteristics giving rise to ordinary income. We'll see whether the IRS addresses this when the regulations have been finalized.
• The New Proposed Regulations made clear the anti-abuse rules will be applied when a project goes against the statutory purpose of "encouraging economic growth and development in QOZs." Below, I discuss how OpCo-PropCo structures and HoldCos can run afoul of the anti-abuse rules because they run counter to the intent of the statute.
• The IRS considered the comments about the use of the phrase "substantially all" in the statute and released some numerical testing in the New Proposed Regulations. When QOZBP must be used within the QOZ substantially all of the time, that means at least 70% of the time, but I discuss below how this presents an ambiguity for QOZBs operating enterprises with mobile property. When QOZBP must qualify as such for substantially all of a QOF or QOZB's holding period, that means at least 90% of the holding period, which shouldn't be much of an issue most of the time.
• The New Proposed Regulations also fleshed out some aspects of "original use," the alternative way for QOZBP to be eligible under the 70% Test or 90% Test. A major misinterpretation among the general public was the idea that original use meant the QOF or QOZB had to be the first to use the QOZBP at all. The New Proposed Regulations dispel that notion and clarify original use means the QOF or QOZB has to be the first to use the QOZBP in the QOZ. If the QOF or QOZB is the first to use the QOZBP in the particular QOZ where it lies, the QOZBP meets the original use requirement. "Use" will be measured through placement into service for purposes of depreciation or amortization. This means relocations of operating businesses into QOZs will be eligible for tax benefits. Furthermore, the New Proposed Regulations clarify that any property that has sat vacant or abandoned for five or more years will qualify for original use if a QOF or QOZB re-deploys the property (again, for purposes of depreciation or amortization). Interestingly, this opens up the "build and sell" strategy, in which a taxpayer can sell a building to a QOF or QOZB that has not ever been depreciated before, and the QOF or QOZB can claim original use without having to substantially improve the structure.
• Land must be used in a Section 162 trade or business to be excluded from compliance testing, so for all of you who wanted to use the QOZ program for land speculation, this provision and the anti-abuse rules will dash your hopes forever. For good measure, the IRS codified the "cupcake rule," which disallows land speculation through the construction of a proverbial "cupcake" on top of a vast swath of QOZ land.
• The IRS allowed investment of property into QOFs, not just cash, but the major difference is that property investments into QOFs will only get capital gain deferral credit to the extent of basis, not fair market value. For instance, if I have $100 of long-term capital gain and property with a basis of $50 and a fair market value of $100, a contribution of the property into the QOF will only get me $50 of deferral credit, not $100. The $50 differential between basis and FMV is treated as a "mixed investment" ineligible for QOZ tax benefits. This puts my accountant into the nightmare territory of dealing with how the New Proposed Regulations reconcile the QOZ program with the partnership tax rules and consolidated return rules, and the IRS effectively shrugged its shoulders and said, "Well, these parts of the Code don't mix, but we'll kinda mishmash the whole thing together and give it a whirl." While some have said all these problems would prevent taxpayers from deferring through property contributions into QOFs, I have advised clients to use the strategy in appropriate circumstances -- but note the property itself is still subject to compliance testing post-contribution.
• In recognition of the idea QOFs should have a secondary market, the IRS allowed taxpayers to get investment credit into a QOF for buying an interest from an existing owner, not just making a capital contribution in exchange for a new interest. Expect this approach to become more popular with time.
• We received confirmation that when a taxpayer sells a QOF equity interest after ten years, the sale comes completely free of income tax, including ordinary income (via Section 751 or otherwise) and any outstanding indebtedness (including debt in excess of basis, a/k/a negative capital accounts).
• We also received confirmation that Section 752(a) basis shares are not counted as investments in a QOF, so taxpayers still can't "boot net" through the QOZ program. For many real estate sellers, Section 1031 exchanges will still be the way to go when leveraging tax-advantaged strategies.

What ambiguities remain in the QOZ program, even after passage of the New Proposed Regulations?

• The substantial improvement provisions stated the requirement will be assessed on an asset-by-asset basis, but there were no further details about how the evaluation would apply. For instance, suppose I buy a parcel of QOZ real estate with an existing building, but I construct two adjacent buildings of equal size and value. If substantial improvement applies separately to the existing building, I'm probably out of compliance, even though I brought tremendous new economics to the QOZ. But if substantial improvement applies to the parcel of real property as a whole, I should be in good shape. Further clarity is necessary for investors to proceed with confidence in situations like this.
• As stated above, the requirement that QOZBP remain in a QOZ for "substantially all" of the holding period means 70% of the time. But how does the IRS plan on tracking this for mobile property, and what burden will taxpayers have to show they've met this requirement? Suppose my QOZB rents trucks. Do I have to track where the trucks go each time I rent them? What about construction businesses taking equipment to off-site jobs? This seems to cry out for another safe harbor, but the final regulations will reveal what (if anything) the IRS does to address this barrier to business activity.
• One of the most common questions I get is whether OpCo/PropCo structures or pure HoldCo structures will work for the QOZ program. The concept is pretty simple: in either case, the PropCo or HoldCo will simply own intellectual property, real estate, heavy equipment, or other business/investment assets. For OpCo/PropCo structures, the PropCo will lease the assets at fair market value to the OpCo, which will use the assets to run an operating business. Taxpayers will need to watch out for many risks involved in these structures, including whether the PropCo or HoldCo is conducting a Section 162 trade or business (required of all QOZBs), whether intangible property is used in a trade or business (there's a 40% threshold for this in the New Proposed Regulations), and whether the anti-abuse rules should apply. If the OpCo is outside a QOZ, expect the anti-abuse rules to zap out tax benefits upon IRS examination. If the PropCo or HoldCo has merely token operations and staff to justify economic benefits for investment assets, especially intangibles, I would give the structure a low chance of survival in the event of an audit or litigation.
• Treasury Secretary Mnuchin said in May that marijuana business shouldn't get QOZ benefits. I have advised marijuana clients not to be deterred. The narrow list of "sin businesses" does not include any reference to marijuana, and neither do any of the proposed regulations; by the time marijuana businesses are claiming their ten-year benefits, Mr. Mnuchin will no longer be Secretary of the Treasury, and the federal government may well have followed the lead of several states in legalizing marijuana. Regardless of whether marijuana operating businesses will qualify, carving out a separate entity for the real estate holding companies should ensure the real property element will qualify. My personal view is that marijuana businesses planning to use the QOZ program should go full steam ahead.
• Finally, states and localities have taken a wide range of stances about whether they will conform to the QOZ program. Confounding matters is the impact of the Tax Cuts and Jobs Act as a whole on coastal states and Illinois, where the $10,000 broad limit on state and local tax (SALT) deductions has had a particularly negative effect on local residents. The disproportionately large impact on high-tax jurisdictions led many of these states to "decouple" from the federal government when it came to determining tax liability, meaning many places now to have affirmatively adopt the QOZ program locally. New York State and New York City have conformed, California has not yet conformed, and Massachusetts just recently released a hybrid approach that treats individuals differently from businesses. When modeling the financial returns of a QOZ project, don't forget to investigate how it'll be treated under local law. Novogradac & Co. has a nice resource you can find here.

In various public pronouncements, the IRS and Treasury have made clear that this is the last round of proposed regulations unless future issues compel new ones. Most likely, any future IRS guidance will come via Revenue Rulings, Revenue Procedures, Notices, and new informational forms to file.

The other cool aspect of the New Proposed Regulations is how you can see the IRS takes suggestions from the comment letters. I submitted my own comment letter (you can find it on the Internet at regulations.gov), and the IRS appeared to agree with at least three points I made. First, they inserted the provision described above tolling the WCSH in the event of government action or inaction. Second, they provided exceptions to inclusion events for QOF non-recognition transactions that do not change a taxpayer's beneficial interest in a QOF. Third, they followed my suggestion for anti-abuse rules governing cash-out refinances almost to the letter. I plan on submitting another comment letter with observations about the New Proposed Regulations before the July 1 deadline.

If you'd like to discuss this post or any other aspect of the QOZ program, you can contact me by private message on LinkedIn or by e-mail at [email protected]. Please refrain from calling my office if at all possible to prevent overloading the firm's switchboard; unless you are a current client, it's not the best way to reach me.

Note that the above does not constitute tax or legal advice. Please consult your own legal or tax advisor about your specific facts and circumstances. This article may be considered Attorney Advertising under the New York Rules of Professional Conduct.