Investing in Qualified Opportunity Funds

 
CONTENT
Federal Register, Volume 84 Issue 84 (Wednesday, May 1, 2019)
[Federal Register Volume 84, Number 84 (Wednesday, May 1, 2019)]
[Proposed Rules]
[Pages 18652-18693]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2019-08075]
[[Page 18651]]
Vol. 84
Wednesday,
No. 84
May 1, 2018
Part II
Department of the Treasury
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Internal Revenue Service
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26 CFR Part 1
Investing in Qualified Opportunity Funds; Proposed Rule
Federal Register / Vol. 84 , No. 84 / Wednesday, May 1, 2018 /
Proposed Rules
[[Page 18652]]
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DEPARTMENT OF TREASURY
Internal Revenue Service
26 CFR Part 1
[REG-120186-18]
RIN 1545-BP04
Investing in Qualified Opportunity Funds
AGENCY: Internal Revenue Service (IRS), Treasury.
ACTION: Notice of proposed rulemaking; partial withdrawal of a notice
of proposed rulemaking.
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SUMMARY: This document contains proposed regulations that provide
guidance under new section 1400Z-2 of the Internal Revenue Code (Code)
relating to gains that may be deferred as a result of a taxpayer's
investment in a qualified opportunity fund (QOF), as well as special
rules for an investment in a QOF held by a taxpayer for at least 10
years. This document also contains proposed regulations that update
portions of previously proposed regulations under section 1400Z-2 to
address various issues, including: the definition of ``substantially
all'' in each of the various places it appears in section 1400Z-2; the
transactions that may trigger the inclusion of gain that a taxpayer has
elected to defer under section 1400Z-2; the timing and amount of the
deferred gain that is included; the treatment of leased property used
by a qualified opportunity zone business; the use of qualified
opportunity zone business property in the qualified opportunity zone;
the sourcing of gross income to the qualified opportunity zone
business; and the ``reasonable period'' for a QOF to reinvest proceeds
from the sale of qualifying assets without paying a penalty. These
proposed regulations will affect QOFs and taxpayers that invest in
QOFs.
DATES: Written (including electronic) comments must be received by July
1, 2019. Outlines of topics to be discussed at the public hearing
scheduled for July 9, 2019, at 10 a.m. must be received by July 1,
2019. The public hearing will be held at the New Carrollton Federal
Building at 5000 Ellin Road in Lanham, Maryland 20706.
ADDRESSES: Submit electronic submissions via the Federal eRulemaking
Portal at www.regulations.gov (indicate IRS and REG-120186-18) by
following the online instructions for submitting comments. Once
submitted to the Federal eRulemaking Portal, comments cannot be edited
or withdrawn. The Department of the Treasury (Treasury Department) and
the IRS will publish for public availability any comment received to
its public docket, whether submitted electronically or in hard copy.
Send hard copy submissions to: CC:PA:LPD:PR (REG-120186-18), room 5203,
Internal Revenue Service, PO Box 7604, Ben Franklin Station,
Washington, DC 20044. Submissions may be hand-delivered Monday through
Friday between the hours of 8 a.m. and 4 p.m. to CC:PA:LPD:PR (REG-
120186-18), Courier's Desk, Internal Revenue Service, 1111 Constitution
Avenue NW, Washington, DC 20224.
FOR FURTHER INFORMATION CONTACT: Concerning the proposed regulations,
Erika C. Reigle of the Office of Associate Chief Counsel (Income Tax
and Accounting), (202) 317-7006, and Kyle C. Griffin of the Office of
Associate Chief Counsel (Income Tax and Accounting), (202) 317-4718;
concerning the submission of comments, the hearing, or to be placed on
the building access list to attend the hearing, Regina L. Johnson,
(202) 317-6901 (not toll-free numbers).
SUPPLEMENTARY INFORMATION:
Background
    This document contains proposed regulations under section 1400Z-2
of the Code that amend the Income Tax Regulations (26 CFR part 1).
Section 13823 of the Tax Cuts and Jobs Act, Public Law 115-97, 131
Stat. 2054, 2184 (2017) (TCJA), amended the Code to add sections 1400Z-
1 and 1400Z-2. Sections 1400Z-1 and 1400Z-2 seek to encourage economic
growth and investment in designated distressed communities (qualified
opportunity zones) by providing Federal income tax benefits to
taxpayers who invest new capital in businesses located within qualified
opportunity zones through a QOF.
    Section 1400Z-1 provides the procedural rules for designating
qualified opportunity zones and related definitions. Section 1400Z-2
provides two main tax incentives to encourage investment in qualified
opportunity zones. First, it allows for the deferral of inclusion in
gross income of certain gain to the extent that a taxpayer elects to
invest a corresponding amount in a QOF. Second, it allows for the
taxpayer to elect to exclude from gross income the post-acquisition
gain on investments in the QOF held for at least 10 years.
Additionally, with respect to the deferral of inclusion in gross income
of certain gain invested in a QOF, section 1400Z-2 permanently excludes
a portion of such deferred gain if the corresponding investment in the
QOF is held for five or seven years.
    On October 29, 2018, the Department of the Treasury (Treasury
Department) and the IRS published in the Federal Register (83 FR 54279)
a notice of proposed rulemaking (REG-115420-18) providing guidance
under section 1400Z-2 of the Code for investing in qualified
opportunity funds (83 FR 54279 (October 29, 2018)). A public hearing on
83 FR 54279 (October 29, 2018) was held on February 14, 2019. The
Treasury Department and the IRS continue to consider the comments
received on 83 FR 54279 (October 29, 2018), including those provided at
the public hearing.
    As is more fully explained in the Explanation of Provisions, the
proposed regulations contained in this notice of proposed rulemaking
describe and clarify requirements relating to investing in QOFs not
addressed in 83 FR 54279 (October 29, 2018). Specifically, and as was
indicated in 83 FR 54279 (October 29, 2018), these proposed regulations
address the meaning of ``substantially all'' in each of the various
places where it appears in section 1400Z-2; the reasonable period for a
QOF to reinvest proceeds from the sale of qualifying assets without
paying a penalty pursuant to section 1400Z-2(e)(4)(B); the transactions
that may trigger the inclusion of gain that has been deferred under a
section 1400Z-2(a) election; and other technical issues with regard to
investing in a QOF. Because portions of 83 FR 54279 (October 29, 2018)
contained certain placeholder text, included less detailed guidance in
certain areas that merely cross-referenced statutory rules, or lacked
sufficient detail to address these issues, this notice of proposed
rulemaking withdraws paragraphs (c)(4)(i), (c)(5) and (6),
(d)(2)(i)(A), (d)(2)(ii) and (iii), (d)(5)(i), and (d)(5)(ii)(B) of
proposed Sec.  1.1400Z2(d)-1 of 83 FR 54279 (October 29, 2018), and
proposes in their place new paragraphs (c)(4)(i), (c)(5) and (6),
(d)(2)(i)(A), (d)(2)(ii) and (iii), (d)(5)(i), and (d)(5)(ii)(B) of
proposed Sec.  1.1400Z2(d)-1.
    The Treasury Department and the IRS welcome suggestions as to other
issues that should be addressed to further clarify the rules under
section 1400Z-2, as well as comments on all aspects of these proposed
regulations.
    Within a few months of the publication of these proposed
regulations, the Treasury Department and the IRS expect to address the
administrative rules under section 1400Z-2(f) applicable to a QOF that
fails to maintain the required 90 percent
[[Page 18653]]
investment standard of section 1400Z-2(d)(1), as well as information-
reporting requirements for an eligible taxpayer under section 1400Z-2,
in separate regulations, forms, or publications.
    In addition, the Treasury Department and the IRS anticipate
revising the Form 8996 (OMB Control number 1545-0123) for tax years
2019 and following. As provided for under the rules set forth in 83 FR
54279 (October 29, 2018), a QOF must file a Form 8996 with its Federal
income tax return for initial self-certification and for annual
reporting of compliance with the 90-Percent Asset Test in section
1400Z-2(d)(1). Subject to tax administration limitations, the Paperwork
Reduction Act of 1995 (44 U.S.C. 3507(d)), and other requirements under
law, it is expected that proposed revisions to the Form 8996 could
require additional information such as (1) the employer identification
number (EIN) of the qualified opportunity zone businesses owned by a
QOF and (2) the amount invested by QOFs and qualified opportunity zone
businesses located in particular Census tracts designated as qualified
opportunity zones. In that regard, consistent with Executive Order
13853 of December 12, 2018, Establishing the White House Opportunity
and Revitalization Council (E.O. 13853), published in the Federal
Register (83 FR 65071) on December 18, 2018, and concurrent with the
publication of these proposed regulations, the Treasury Department and
the IRS are publishing a request for information (RFI) under this
subject in the Notices section of this edition of the Federal Register,
with a docket for comments on www.regulations.gov separate from that
for this notice of proposed rulemaking, requesting detailed comments
with respect to methodologies for assessing relevant aspects of
investments held by QOFs throughout the United States and at the State,
Territorial, and Tribal levels, including the composition of QOF
investments by asset class, the identification of designated qualified
opportunity zone Census tracts that have received QOF investments, and
the impacts and outcomes of the investments in those areas on economic
indicators, including job creation, poverty reduction, and new business
starts. E.O. 13853 charges the White House Opportunity and
Revitalization Council, of which the Treasury Department is a member,
to determine ``what data, metrics, and methodologies can be used to
measure the effectiveness of public and private investments in urban
and economically distressed communities, including qualified
opportunity zones.'' See the requests for comments in the RFI regarding
these or other topics regarding methodologies for assessing the impacts
of sections 1400Z-1 and 1400Z-2 on qualified opportunity zones
throughout the Nation.
Explanation of Provisions
I. Qualified Opportunity Zone Business Property
A. Definition of Substantially All for Purposes of Sections 1400Z-
2(d)(2) and (d)(3)
    The proposed rule published at 83 FR 54279 (October 29, 2018)
clarified that, for purposes of section 1400Z-2(d)(3)(A)(i), for
determining whether an entity is a qualified opportunity zone business,
the threshold to determine whether a trade or business satisfies the
substantially all test is 70 percent. See 83 FR 54279, 54294 (October
29, 2018). If at least 70 percent of the tangible property owned or
leased by a trade or business is qualified opportunity zone business
property (as defined in section 1400Z-2(d)(3)(A)(i)), proposed Sec.
1.1400Z2(d)-1(d)(3)(i) in 83 FR 54279 (October 29, 2018) provides that
the trade or business is treated as satisfying the substantially all
requirement in section 1400Z-2(d)(3)(A)(i).
    The phrase substantially all is also used throughout section 1400Z-
2(d)(2). The phrase appears in section 1400Z-2(d)(2)(D)(i)(III), which
establishes the conditions for property to be treated as qualified
opportunity zone business property (``during substantially all of the
qualified opportunity fund's holding period for such property,
substantially all of the use of such property was in a qualified
opportunity zone''). The phrase also appears in sections 1400Z-
2(d)(2)(B)(i)(III) and 1400Z-2(d)(2)(C)(iii), which require that during
substantially all of the QOF's holding period for qualified opportunity
zone stock or qualified opportunity zone partnership interests, such
corporation or partnership qualified as a qualified opportunity zone
business.
    The proposed rule published at 83 FR 54279 (October 29, 2018)
reserved the proposed meaning of the phrase substantially all as used
in section 1400Z-2(d)(2). The statute neither defines the meaning of
substantially all for the QOF's holding period for qualified
opportunity zone stock, qualified opportunity zone partnership
interests, and qualified opportunity zone business property, nor
defines it for purposes of testing the use of qualified opportunity
zone business property in a qualified opportunity zone. The Treasury
Department and the IRS have received numerous questions and comments on
the threshold limits of substantially all for purposes of section
1400Z-2(d)(2). Many commenters suggested that a lower threshold for the
use requirement of section 1400Z-2(d)(2)(D)(i)(III) would allow a
variety of businesses to benefit from qualifying investments in QOFs.
Other commentators suggested that too low a threshold would negatively
impact the low-income communities that section 1400Z-2 is intended to
benefit, because the tax-incentivized investment would not be focused
sufficiently on these communities.
    Consistent with 83 FR 54279 (October 29, 2018) these proposed
regulations provide that, in testing the use of qualified opportunity
zone business property in a qualified opportunity zone, as required in
section 1400Z-2(d)(2)(D)(i)(III), the term substantially all in the
context of ``use'' is 70 percent. With respect to owned or leased
tangible property, these proposed regulations provide identical
requirements for determining whether a QOF or qualified opportunity
zone business has used substantially all of such tangible property
within the qualified opportunity zone within the meaning of section
1400Z-2(d)(2)(D)(i)(III). Whether such tangible property is owned or
leased, these proposed regulations propose that the substantially all
requirement regarding ``use'' is satisfied if at least 70 percent of
the use of such tangible property is in a qualified opportunity zone.
    As discussed in the preamble to 83 FR 54279 (October 29, 2018) a
compounded use of substantially all must be interpreted in a manner
consistent with the intent of Congress. Consequently, the Treasury
Department and the IRS have determined that a higher threshold is
necessary in the holding period context to preserve the integrity of
the statute and for the purpose of focusing investment in designated
qualified opportunity zones. Thus, the proposed regulations provide
that the term substantially all as used in the holding period context
in sections 1400Z-2(d)(2)(B)(i)(III), 1400Z-2(d)(2)(C)(iii), and 1400Z-
2(d)(2)(D)(i)(III) is defined as 90 percent. Using a percentage
threshold that is higher than 70-percent in the holding period context
is warranted as taxpayers are more easily able to control and determine
the period for which they hold property. In addition, given the lower
70-percent thresholds for testing both the use of tangible property in
the qualified opportunity zone and the amount of owned and leased
tangible property of a qualified opportunity zone business
[[Page 18654]]
that must be qualified opportunity zone business property, applying a
70-percent threshold in the holding period context can result in much
less than half of a qualified opportunity zone business's tangible
property being used in a qualified opportunity zone. Accordingly, the
Treasury Department and the IRS have determined that using a threshold
lower than 90 percent in the holding period context would reduce the
amount of investment in qualified opportunity zones to levels
inconsistent with the purposes of section 1400Z-2.
    The Treasury Department and the IRS request comments on these
proposed definitions of substantially all for purposes of section
1400Z-2(d)(2).
B. Original Use of Tangible Property Acquired by Purchase
    In 83 FR 54279 (October 29, 2018) the Treasury Department and the
IRS specifically solicited comments on the definition of the ``original
use'' requirement in section 1400Z-2(d)(2)(D)(i)(II) for both real
property and tangible personal property and reserved a section of the
proposed regulations to define the phrase original use. The requirement
that tangible property acquired by purchase have its ``original use''
in a qualified opportunity zone commencing with a qualified opportunity
fund or qualified opportunity zone business, or be substantially
improved, in order to qualify for tax benefits is also found in other
sections of the Code. Under the now-repealed statutory frameworks of
both section 1400B (related to the DC Zone) and section 1400F (related
to Renewal Communities), qualified property for purposes of those
provisions was required to have its original use in a zone or to meet
the requirements of substantial improvement as defined under those
provisions. The Treasury Department and the IRS have received numerous
questions on the meaning of ``original use.'' Examples of these
questions include: May tangible property be previously used property,
or must it be new property? Does property previously placed in service
in the qualified opportunity zone for one use, but now placed in
service for a different use, qualify? May property used in the
qualified opportunity zone be placed in service in the same qualified
opportunity zone by an acquiring, unrelated taxpayer?
    After carefully considering the comments and questions received,
the proposed regulations generally provide that the ``original use'' of
tangible property acquired by purchase by any person commences on the
date when that person or a prior person first places the property in
service in the qualified opportunity zone for purposes of depreciation
or amortization (or first uses the property in the qualified
opportunity zone in a manner that would allow depreciation or
amortization if that person were the property's owner). Thus, tangible
property located in the qualified opportunity zone that is depreciated
or amortized by a taxpayer other than the QOF or qualified opportunity
zone business would not satisfy the original use requirement of section
1400Z-2(d)(2)(D)(i)(II) under these proposed regulations. Conversely,
tangible property (other than land) located in the qualified
opportunity zone that has not yet been depreciated or amortized by a
taxpayer other than the QOF or qualified opportunity zone business
would satisfy the original use requirement of section 1400Z-
2(d)(2)(D)(i)(II) under these proposed regulations. However, the
proposed regulations clarify that used tangible property will satisfy
the original use requirement with respect to a qualified opportunity
zone so long as the property has not been previously used (that is, has
not previously been used within that qualified opportunity zone in a
manner that would have allowed it to be depreciated or amortized) by
any taxpayer. (For special rules concerning the original use
requirement for assets acquired in certain transactions to which
section 355 or section 381 applies, see proposed Sec.  1.1400Z2(b)-
1(d)(2) in this notice of proposed rulemaking.)
    The Treasury Department and the IRS have also studied the extent to
which usage history of vacant structures or other tangible property
(other than land) purchased after 2017 but previously placed in service
within the qualified opportunity zone may be disregarded for purposes
of the original use requirement if the structure or other property has
not been utilized or has been abandoned for some minimum period of time
and received multiple public comments regarding this issue. Several
commenters suggested establishing an ``at least one-year'' vacancy
period threshold similar to that employed in Sec.  1.1394-1(h) to
determine whether property meets the original use requirement within
the meaning of section 1397D (defining qualified zone property) for
purposes of section 1394 (relating to the issuance of enterprise zone
facility bonds). Given the different operation of those provisions and
the potential for owners of property already situated in a qualified
opportunity zone to intentionally cease occupying property for 12
months in order to increase its marketability to potential purchasers
after 2017, other commenters proposed longer vacancy thresholds ranging
to five years. The Treasury Department and the IRS are proposing that
where a building or other structure has been vacant for at least five
years prior to being purchased by a QOF or qualified opportunity zone
business, the purchased building or structure will satisfy the original
use requirement. Comments are requested on this proposed approach,
including the length of the vacancy period and how such a standard
might be administered and enforced.
    In addition, in response to questions about a taxpayer's
improvements to leased property, the proposed regulations provide that
improvements made by a lessee to leased property satisfy the original
use requirement and are considered purchased property for the amount of
the unadjusted cost basis of such improvements as determined in
accordance with section 1012.
    As provided in Rev. Rul. 2018-29, 2018 I.R.B 45, and these proposed
regulations, if land that is within a qualified opportunity zone is
acquired by purchase in accordance with section 1400Z-2(d)(2)(D)(i)(I),
the requirement under section 1400Z-2(d)(2)(D)(i)(II) that the original
use of tangible property in the qualified opportunity zone commence
with a QOF is not applicable to the land, whether the land is improved
or unimproved. Likewise, unimproved land that is within a qualified
opportunity zone and acquired by purchase in accordance with section
1400Z-2(d)(2)(D)(i)(I) is not required to be substantially improved
within the meaning of section 1400Z-2(d)(2)(D)(i)(II) and
(d)(2)(D)(ii). Multiple public comments were received suggesting that
not requiring the basis of land itself to be substantially improved
within the meaning of section 1400Z-2(d)(2)(D)(i)(II) and (d)(2)(D)(ii)
would lead to speculative land purchasing and potential abuse of
section 1400Z-2.
    The Treasury Department and the IRS have considered these comments.
Under section 1400Z-2(d)(2)(D)(i)(II) and these proposed regulations,
land can be treated as qualified opportunity zone business property for
purposes of section 1400Z-2 only if it is used in a trade or business
of a QOF or qualified opportunity zone business. As described in part
III.D. of this Explanation of Provisions, only activities giving rise
to a trade or business within the meaning of section 162 may qualify as
a trade or business for purposes of section 1400Z-
[[Page 18655]]
2; the holding of land for investment does not give rise to a trade or
business and such land could not be qualified opportunity zone business
property. Moreover, land is a crucial business asset for numerous types
of operating trades or businesses aside from real estate development,
and the degree to which it is necessary or useful for taxpayers seeking
to grow their businesses to improve the land that their businesses
depend on will vary greatly by region, industry, and particular
business. In many cases, regulations that imposed a requirement on all
types of trades or businesses to substantially improve (within the
meaning of section 1400Z-2(d)(2)(D)(i)(II) and (d)(2)(D)(ii)) land that
is used by them may encourage noneconomic, tax-motivated business
decisions, or otherwise effectively prevent many businesses from
benefitting under the opportunity zone provisions. Such rules also
would inject a significant degree of additional complexity into these
proposed regulations.
    Nevertheless, the Treasury Department and the IRS recognize that,
in certain instances, the treatment of unimproved land as qualified
opportunity zone business property could lead to tax results that are
inconsistent with the purposes of section 1400Z-2. For example, a QOF's
acquisition of a parcel of land currently utilized entirely by a
business for the production of an agricultural crop, whether active or
fallow at that time, potentially could be treated as qualified
opportunity zone business property without the QOF investing any new
capital investment in, or increasing any economic activity or output
of, that parcel. In such instances, the Treasury Department and the IRS
have determined that the purposes of section 1400Z-2 would not be
realized, and therefore the tax incentives otherwise provided under
section 1400Z-2 should not be available. If a significant purpose for
acquiring such unimproved land was to achieve that inappropriate tax
result, the general anti-abuse rule set forth in proposed Sec.
1.1400Z2(f)-1(c) (and described further in part X of this Explanation
of Provisions) would apply to treat the acquisition of the unimproved
land as an acquisition of non-qualifying property for section 1400Z-2
purposes. The Treasury Department and the IRS request comments on
whether anti-abuse rules under section 1400Z-2(e)(4)(c), in addition to
the general anti-abuse rule, are needed to prevent such transactions or
``land banking'' by QOFs or qualified opportunity zone businesses, and
on possible approaches to prevent such abuse.
    Conversely, if real property, other than land, that is acquired by
purchase in accordance with section 1400Z-2(d)(2)(D)(i)(I) had been
placed in service in the qualified opportunity zone by a person other
than the QOF or qualified opportunity zone business (or first used in a
manner that would allow depreciation or amortization if that person
were the property's owner), it must be substantially improved to be
considered qualified opportunity zone business property. Substantial
improvement by the QOF or qualified opportunity zone business for real
property, other than land, is determined by applying the requirements
for substantial improvement of tangible property acquired by purchase
set forth in section 1400Z-2(d)(2)(D)(ii).
    The Treasury Department and the IRS request comments on these
proposed rules regarding the original use requirement generally,
including whether certain cases may warrant additional consideration.
Comments are also requested as to whether the ability to treat such
prior use as disregarded for purposes of the original use requirement
should depend on whether the property has been fully depreciated for
Federal income tax purposes, or whether other adjustments for any
undepreciated or unamortized basis of such property would be
appropriate. The Treasury Department and the IRS are also studying the
circumstances under which tangible property that had not been purchased
but has been overwhelmingly improved by a QOF or a qualified
opportunity zone business may be considered as satisfying the original
use requirement and request comment regarding possible approaches.
    Under these proposed regulations, the determination of whether the
substantial improvement requirement of section 1400Z-2(d)(2)(D)(ii) is
satisfied for tangible property that is purchased is made on an asset-
by-asset basis. The Treasury Department and the IRS have considered the
possibility, however, that an asset-by-asset approach might be onerous
for certain types of businesses. For example, the granular nature of an
asset-by-asset approach might cause operating businesses with
significant numbers of diverse assets to encounter administratively
difficult asset segregation and tracking burdens, potentially creating
traps for the unwary. As an alternative, the Treasury Department and
the IRS have contemplated the possibility of applying an aggregate
standard for determining compliance with the substantial improvement
requirement, potentially allowing tangible property to be grouped by
location in the same, or contiguous, qualified opportunity zones. Given
that an aggregate approach could provide additional compliance
flexibility, while continuing to incentivize high-quality investments
in qualified opportunity zones, the Treasury Department and the IRS
request comments on the potential advantages, as well as disadvantages,
of adopting an aggregate approach for substantial improvement.
    Additional comments are requested regarding the application of the
substantial improvement requirement with respect to tangible personal
property acquired by purchase that is not capable of being
substantially improved (for example, equipment that is nearly new but
was previously used in the qualified opportunity zone and the cost of
fully refurbishing the equipment would not result in a doubling of the
basis of such property). Specifically, comments are requested regarding
whether the term ``property'' in section 1400Z-2(d)(2)(D)(ii) should be
interpreted in the aggregate to permit the purchase of items of non-
original use property together with items of original use property that
do not directly improve such non-original use property to satisfy the
substantial improvement requirement. In that regard, comments are
requested as to the extent to which such treatment may be appropriate
given that such treatment could cause a conflict between the
independent original use requirement of section 1400Z-2(d)(2)(D)(i)(II)
and the independent substantial improvement requirement of section
1400Z-2(d)(2)(D)(i)(II) by reason of the definition of substantial
improvement under section 1400Z-2(d)(2)(D)(ii). Comments are also
requested regarding the treatment of purchases of multiple items of
separate tangible personal property for purposes of section 1400Z-
2(d)(2)(D)(i)(II) that have the same applicable depreciation method,
applicable recovery period, and applicable convention, and which are
placed in service in the same year by a QOF or qualified opportunity
zone business in one or more general asset accounts within the meaning
of section 168(i) and Sec.  1.168(i)-1.
C. Safe Harbor for Testing Use of Inventory in Transit
    Section 1400Z-2(d)(2)(D)(i)(III) provides that qualified
opportunity zone business property means tangible property used in a
trade or business of the QOF if, during substantially all of
[[Page 18656]]
the QOF's holding period for such property, substantially all of the
use of such property was in a qualified opportunity zone. Commentators
have inquired how inventory will be treated for purposes of determining
whether substantially all of the tangible property is used in the
qualified opportunity zone. Commentators expressed concern that
inventory in transit on the last day of the taxable year of a QOF would
be counted against the QOF when determining whether the QOF has met the
90-percent ownership requirement found in section 1400Z-2(d)(1) (90-
percent asset test).
    The proposed regulations clarify that inventory (including raw
materials) of a trade or business does not fail to be used in a
qualified opportunity zone solely because the inventory is in transit
from a vendor to a facility of the trade or business that is in a
qualified opportunity zone, or from a facility of the trade or business
that is in a qualified opportunity zone to customers of the trade or
business that are not located in a qualified opportunity zone. Comments
are requested as to whether the location of where inventory is
warehoused should be relevant and whether inventory (including raw
materials) should be excluded from both the numerator and denominator
of the 70-percent test for QOZBs.
    The Treasury Department and the IRS request comments on the
proposed rules regarding the determination of whether inventory, as
well as other property, is used in a qualified opportunity zone,
including whether certain cases or types of property may warrant
additional consideration.
II. Treatment of Leased Tangible Property
    As noted previously, section 1400Z-2(d)(3)(A)(i) provides that a
qualified opportunity zone business is a trade or business in which,
among other things, substantially all (that is, at least 70 percent) of
the tangible property owned or leased by the taxpayer is ``qualified
opportunity zone business property'' within the meaning of section
1400Z-2(d)(2)(D), determined by substituting ``qualified opportunity
fund'' with ``qualified opportunity zone business'' each place that
such term appears. Taking into account this substitution, section
1400Z-2(d)(2)(D)(i) provides that qualified opportunity zone business
property is tangible property that meets the following requirements:
(1) The tangible property was acquired by the trade or business by
purchase (as defined in section 179(d)(2)) after December 31, 2017; (2)
the original use of such property in the qualified opportunity zone
commences with the qualified opportunity zone business, or the
qualified opportunity zone business substantially improves the
property; and (3) for substantially all of the qualified opportunity
zone business's holding period of the tangible property, substantially
all of the use of such property is in the qualified opportunity zone.
Commenters have expressed concern as to whether tangible property that
is leased by a qualified opportunity zone business can be treated as
satisfying these requirements. Similar questions have arisen with
respect to whether tangible property leased by a QOF could be treated
as satisfying the 90-percent asset test under section 1400Z-2(d)(1).
A. Status as Qualified Opportunity Zone Business Property
    The purposes of sections 1400Z-1 and 1400Z-2 are to increase
business activity and economic investment in qualified opportunity
zones. As a proxy for evaluating increases in business activity and
economic investment in a qualified opportunity zone, these sections of
the Code generally measure increases in tangible business property used
in that qualified opportunity zone. The general approach of the statute
in evaluating the achievement of those purposes inform the proposed
regulations' treatment of tangible property that is leased rather than
owned. The Treasury Department and the IRS also recognize that not
treating leased property as qualified opportunity zone business
property may have an unintended consequence of excluding investments on
tribal lands designated as qualified opportunity zones because tribal
governments occupy Federal trust lands and these lands are, more often
than not, leased for economic development purposes.
    Given the purpose of sections 1400Z-1 and 1400Z-2 to facilitate
increased business activity and economic investment in qualified
opportunity zones, these proposed regulations would provide greater
parity among diverse types of business models. If a taxpayer uses
tangible property located in a qualified opportunity zone in its
business, the benefits of such use on the qualified opportunity zone's
economy would not generally be expected to vary greatly depending on
whether the business pays cash for the property, borrows in order to
purchase the property, or leases the property. Not recognizing that
benefits can accrue to a qualified opportunity zone regardless of the
manner in which a QOF or qualified opportunity zone business acquires
rights to use tangible property in the qualified opportunity zone could
result in preferences solely based on whether businesses choose to own
or lease tangible property, an anomalous result inconsistent with the
purpose of sections 1400Z-1 and 1400Z-2.
    Accordingly, leased tangible property meeting certain criteria may
be treated as qualified opportunity zone business property for purposes
of satisfying the 90-percent asset test under section 1400Z-2(d)(1) and
the substantially all requirement under section 1400Z-2(d)(3)(A)(i).
The following two general criteria must be satisfied. First, analogous
to owned tangible property, leased tangible property must be acquired
under a lease entered into after December 31, 2017. Second, as with
owned tangible property, substantially all of the use of the leased
tangible property must be in a qualified opportunity zone during
substantially all of the period for which the business leases the
property.
    These proposed regulations, however, do not impose an original use
requirement with respect to leased tangible property for, among others,
the following reasons. Unlike owned tangible property, in most
circumstances, leased tangible property held by a lessee cannot be
placed in service for depreciation or amortization purposes because the
lessee does not own such tangible property for Federal income tax
purposes. In addition, in many instances, leased tangible property may
have been previously leased to other lessees or previously used in the
qualified opportunity zone. Furthermore, taxpayers generally do not
have a basis in leased property that can be depreciated, again, because
they are not the owner of such property for Federal income tax
purposes. Therefore, the proposed regulations do not impose a
requirement for a lessee to ``substantially improve'' leased tangible
property within the meaning of section 1400Z-2(d)(2)(D)(ii).
    Unlike tangible property that is purchased by a QOF or qualified
opportunity zone business, the proposed regulations do not require
leased tangible property to be acquired from a lessor that is unrelated
(within the meaning of section 1400Z-2(e)(2)) to the QOF or qualified
opportunity zone business that is the lessee under the lease. However,
in order to maintain greater parity between decisions to lease or own
tangible property, while also limiting abuse, the proposed regulations
provide one limitation as an alternative to imposing a related person
rule or a substantial improvement rule and two further limitations that
apply when the lessor and lessee are related.
[[Page 18657]]
    First, the proposed regulations require in all cases, that the
lease under which a QOF or qualified opportunity zone business acquires
rights with respect to any leased tangible property must be a ``market
rate lease.'' For this purpose, whether a lease is market rate (that
is, whether the terms of the lease reflect common, arms-length market
practice in the locale that includes the qualified opportunity zone) is
determined under the regulations under section 482. This limitation
operates to ensure that all of the terms of the lease are market rate.
    Second, if the lessor and lessee are related, the proposed
regulations do not permit leased tangible property to be treated as
qualified opportunity zone business property if, in connection with the
lease, a QOF or qualified opportunity zone business at any time makes a
prepayment to the lessor (or a person related to the lessor within the
meaning of section 1400Z-2(e)(2)) relating to a period of use of the
leased tangible property that exceeds 12 months. This requirement
operates to prevent inappropriate allocations of investment capital to
prepayments of rent, as well as other payments exchanged for the use of
the leased property.
    Third, also applicable when the lessor and lessee are related, the
proposed regulations do not permit leased tangible personal property to
be treated as qualified opportunity zone business property unless the
lessee becomes the owner of tangible property that is qualified
opportunity zone business property and that has a value not less than
the value of the leased personal property. This acquisition of this
property must occur during a period that begins on the date that the
lessee receives possession of the property under the lease and ends on
the earlier of the last day of the lease or the end of the 30-month
period beginning on the date that the lessee receives possession of the
property under the lease. There must be substantial overlap of zone(s)
in which the owner of the property so acquired uses it and the zone(s)
in which that person uses the leased property.
    Finally, the proposed regulations include an anti-abuse rule to
prevent the use of leases to circumvent the substantial improvement
requirement for purchases of real property (other than unimproved
land). In the case of real property (other than unimproved land) that
is leased by a QOF, if, at the time the lease is entered into, there
was a plan, intent, or expectation for the real property to be
purchased by the QOF for an amount of consideration other than the fair
market value of the real property determined at the time of the
purchase without regard to any prior lease payments, the leased real
property is not qualified opportunity zone business property at any
time.
    The Treasury Department and the IRS request comments on all aspects
of the proposed treatment of leased tangible property. In particular, a
determination under section 482 of whether the terms of the lease
reflect common, arms-length market practice in the locale that includes
the qualified opportunity zone takes into account the simultaneous
combination of all terms of the lease, including rent, term,
possibility of extension, presence of an option to purchase the leased
asset, and (if there is such an option) the terms of purchase. Comments
are requested on whether taxpayers and the IRS may encounter undue
burden or difficulty in determining whether a lease is market rate. If
so, how should the final regulations reduce that burden? For example,
should the final regulations describe one or more conditions whose
presence would create a presumption that a lease is (or is not) a
market rate lease? Comments are also requested on whether the
limitations intended to prevent abusive situations through the use of
leased property are appropriate, or whether modifications are
warranted.
B. Valuation of Leased Tangible Property
    Based on the foregoing, these proposed regulations provide
methodologies for valuing leased tangible property for purposes of
satisfying the 90-percent asset test under section 1400Z-2(d)(1) and
the substantially all requirement under section 1400Z-2(d)(3)(A)(i).
Under these proposed regulations, on an annual basis, leased tangible
property may be valued using either an applicable financial statement
valuation method or an alternative valuation method, each described
further below. A QOF or qualified opportunity zone business, as
applicable, may select the applicable financial statement valuation
method if they actually have an applicable financial statement (within
the meaning of Sec.  1.475(a)-4(h)). Once a QOF or qualified
opportunity zone business selects one of those valuation methods for
the taxable year, it must apply such method consistently to all leased
tangible property valued with respect to the taxable year.
Financial Statement Valuation Method
    Under the applicable financial statement valuation method, the
value of leased tangible property of a QOF or qualified opportunity
zone business is the value of that property as reported on the
applicable financial statement for the relevant reporting period. These
proposed regulations require that a QOF or qualified opportunity zone
business may select this applicable financial statement valuation only
if the applicable financial statement is prepared according to U.S.
generally accepted accounting principles (GAAP) and requires
recognition of the lease of the tangible property.
Alternative Valuation Method
    Under the alternative valuation method, the value of tangible
property that is leased by a QOF or qualified opportunity zone business
is determined based on a calculation of the ``present value'' of the
leased tangible property. Specifically, the value of such leased
tangible property under these proposed regulations is equal to the sum
of the present values of the payments to be made under the lease for
such tangible property. For purposes of calculating present value, the
discount rate is the applicable Federal rate under section 1274(d)(1),
determined by substituting the term ``lease'' for ``debt instrument.''
    These proposed regulations require that a QOF or qualified
opportunity zone business using the alternative valuation method
calculate the value of leased tangible property under this alternative
valuation method at the time the lease for such property is entered
into. Once calculated, these proposed regulations require that such
calculated value be used as the value for such asset for all testing
dates for purposes of the ``substantially all of the use'' requirement
and the 90-percent asset test.
    The Treasury Department and the IRS request comments on these
proposed rules regarding the treatment and valuation of leased tangible
property, including whether other alternative valuation methods may be
appropriate, or whether certain modifications to the proposed valuation
methods are warranted.
III. Qualified Opportunity Zone Businesses
A. Real Property Straddling a Qualified Opportunity Zone
    Section 1400Z-2(d)(3)(A)(ii) incorporates the requirements of
section 1397C(b)(2), (4), and (8) related to Empowerment Zones. The
Treasury Department and the IRS have received numerous comments on the
ability of a business that holds real property straddling multiple
Census tracts, where not all of the tracts are designated as a
[[Page 18658]]
qualified opportunity zone under section 1400Z-1, to satisfy the
requirements under sections 1400Z-2 and 1397C(b)(2), (4), and (8).
Commenters have suggested that the proposed regulations adopt a rule
that is similar to the rule used for purposes of other place-based tax
incentives (that is, the Empowerment Zones) enshrined in section
1397C(f). Section 1397C(f) provides that if the amount of real property
based on square footage located within the qualified opportunity zone
is substantial as compared to the amount of real property based on
square footage outside of the zone, and the real property outside of
the zone is contiguous to part or all of the real property located
inside the zone, then all of the property would be deemed to be located
within a qualified zone.
    These proposed regulations provide that in satisfying the
requirements of section 1400Z-2(d)(3)(A)(ii), section 1397C(f) applies
in the determination of whether a qualified opportunity zone is the
location of services, tangible property, or business functions
(substituting ``qualified opportunity zone'' for ``empowerment zone'').
Real property located within the qualified opportunity zone should be
considered substantial if the unadjusted cost of the real property
inside a qualified opportunity zone is greater than the unadjusted cost
of real property outside of the qualified opportunity zone.
    Comments are requested as to whether there exist circumstances
under which the Treasury Department and the IRS could apply principles
similar to those of section 1397C(f) in the case of other requirements
of section 1400Z-2.
B. 50 Percent of Gross Income of a Qualified Opportunity Zone Business
    Section 1397C(b)(2) provides that, in order to be a ``qualified
business entity'' (in addition to other requirements found in section
1397C(b)) with respect to any taxable year, a corporation or
partnership must derive at least 50 percent of its total gross income
``from the active conduct of such business.'' The phrase such business
refers to a business mentioned in the preceding sentence, which
discusses ``a qualified business within an empowerment zone.'' For
purposes of application to section 1400Z-2, references in section 1397C
to ``an empowerment zone'' are treated as meaning a qualified
opportunity zone. Thus, the corporation or partnership must derive at
least 50 percent of its total gross income from the active conduct of a
business within a qualified opportunity zone.
    An area of concern for commenters is how the Treasury Department
and the IRS will determine whether this 50-percent gross income
requirement is satisfied. Commenters recommended that the Treasury
Department and the IRS provide guidance to clarify the requirements of
sections 1400Z-2(d)(3)(A)(ii) and 1397C(b)(2).
    The proposed regulations provide three safe harbors and a facts and
circumstances test for determining whether sufficient income is derived
from a trade or business in a qualified opportunity zone for purposes
of the 50-percent test in section 1397C(b)(2). Businesses only need to
meet one of these safe harbors to satisfy that test. The first safe
harbor in the proposed regulations requires that at least 50 percent of
the services performed (based on hours) for such business by its
employees and independent contractors (and employees of independent
contractors) are performed within the qualified opportunity zone. This
test is intended to address businesses located in a qualified
opportunity zone that primarily provide services. The percentage is
based on a fraction, the numerator of which is the total number of
hours spent by employees and independent contractors (and employees of
independent contractors) performing services in a qualified opportunity
zone during the taxable year, and the denominator of which is the total
number of hours spent by employees and independent contractors (and
employees of independent contractors) in performing services during the
taxable year.
    For example, consider a startup business that develops software
applications for global sale in a campus located in a qualified
opportunity zone. Because the business' global consumer base purchases
such applications through internet download, the business' employees
and independent contractors are able to devote the majority of their
total number of hours to developing such applications on the business'
qualified opportunity zone campus. As a result, this startup business
would satisfy the first safe harbor, even though the business makes the
vast majority of its sales to consumers located outside of the
qualified opportunity zone in which its campus is located.
    The second safe harbor is based upon amounts paid by the trade or
business for services performed in the qualified opportunity zone by
employees and independent contractors (and employees of independent
contractors). Under this test, if at least 50 percent of the services
performed for the business by its employees and independent contractors
(and employees of independent contractors) are performed in the
qualified opportunity zone, based on amounts paid for the services
performed, the business meets the 50-percent gross income test found in
section 1397C(b)(2). This test is determined by a fraction, the
numerator of which is the total amount paid by the entity for employee
and independent contractor (and employees of independent contractors)
services performed in a qualified opportunity zone during the taxable
year, and the denominator of which is the total amount paid by the
entity for employee and independent contractor (and employees of
independent contractors) services performed during the taxable year.
    For illustration, assume that the startup business described above
also utilizes a service center located outside of the qualified
opportunity zone and that more employees and independent contractor
working hours are performed at the service center than the hours worked
at the business' opportunity zone campus. While the majority of the
total hours spent by employees and independent contractors of the
startup business occur at the service center, the business pays 50
percent of its total compensation for software development services
performed by employees and independent contractors on the business'
opportunity zone campus. As a result, the startup business satisfies
the second safe harbor.
    The third safe harbor is a conjunctive test concerning tangible
property and management or operational functions performed in a
qualified opportunity zone, permitting a trade or business to use the
totality of its situation to meet the requirements of sections 1400Z-
2(d)(3)(A)(i) and 1397C(b)(2). The proposed regulations provide that a
trade or business may satisfy the 50-percent gross income requirement
if (1) the tangible property of the business that is in a qualified
opportunity zone and (2) the management or operational functions
performed for the business in the qualified opportunity zone are each
necessary to generate 50 percent of the gross income of the trade or
business. Thus, for example, if a landscaper's headquarters are in a
qualified opportunity zone, its officers and employees manage the daily
operations of the business (occurring within and outside the qualified
opportunity zone) from its headquarters, and all of its equipment and
supplies are stored within the headquarters facilities or elsewhere in
the qualified opportunity zone, then the management activity and the
storage of equipment and supplies in the qualified opportunity zone are
[[Page 18659]]
each necessary to generate 50 percent of the gross income of the trade
or business. Conversely, the proposed regulations provide that if a
trade or business only has a PO Box or other delivery address located
in the qualified opportunity zone, the presence of the PO Box or other
delivery address does not constitute a factor necessary to generate
gross income by such business.
    Finally, taxpayers not meeting any of the other safe harbor tests
may meet the 50-percent requirement based on a facts and circumstances
test if, based on all the facts and circumstances, at least 50 percent
of the gross income of a trade or business is derived from the active
conduct of a trade or business in the qualified opportunity zone.
    The Treasury Department and the IRS request comments on the
proposed safe harbor rules regarding the 50-percent gross income
requirement, including comments offering possible additional safe
harbors, such as one based on headcount of certain types of service
providers, and whether certain modifications would be warranted to
prevent potential abuses.
C. Use of Intangibles
    As provided in 83 FR 54279 (October 29, 2018) and section 1400Z-
2(d)(3), a qualified opportunity zone trade or business must satisfy
section 1397C(b)(4). Section 1397C(b)(4) requires that, with respect to
any taxable year, a substantial portion of the intangible property of a
qualified business entity must be used in the active conduct of a trade
or business in the qualified opportunity zone, but section 1397C does
not provide a definition of ``substantial portion.'' The IRS and the
Treasury Department have received comments asking for the definition of
substantial portion. Accordingly, the proposed regulations provide
that, for purposes of determining whether a substantial portion of
intangible property of a qualified opportunity zone is used in the
active conduct of a trade or business, the term substantial portion
means at least 40 percent.
D. Active Conduct of a Trade or Business
    Section 1400Z-2(d)(3)(A)(ii) also incorporates requirement (2) of
section 1397C(b), which requires at least 50 percent of the total gross
income of a qualified business entity to be derived from the active
conduct of a trade or business within a zone. The IRS has received
comments asking if the active conduct of a trade or business will be
defined for purposes of section 1400Z-2. Other commentators have
expressed concern that the leasing of real property by a qualified
opportunity zone business may not amount to the active conduct of a
trade or business if the business has limited leasing activity.
    Section 162(a) permits a deduction for ordinary and necessary
expenses paid or incurred in carrying on a trade or business. The rules
under section 162 for determining the existence of a trade or business
are well-established, and there is a large body of case law and
administrative guidance interpreting the meaning of a trade or business
for that purpose. Therefore, these proposed regulations define a trade
or business for purposes of section 1400Z-2 as a trade or business
within the meaning of section 162. However, these proposed regulations
provide that the ownership and operation (including leasing) of real
property used in a trade or business is treated as the active conduct
of a trade or business for purposes of section 1400Z-2(d)(3). No
inference should be drawn from the preceding sentence as to the meaning
of the ``active conduct of a trade or business'' for purposes of other
provisions of the Code, including section 355.
    The Treasury Department and the IRS request comments on the
proposed definition of a trade or business for purposes of section
1400Z-2(d)(3). In addition, comments are requested on whether
additional rules are needed in determining if a trade or business is
actively conducted. The Treasury Department and the IRS further request
comments on whether it would be appropriate or useful to extend the
requirements of section 1397C applicable to qualified opportunity zone
businesses to QOFs.
E. Working Capital Safe Harbor
    Responding to comments received on 83 FR 54279 (October 29, 2018)
the proposed regulations make two changes to the safe harbor for
working capital. First, the written designation for planned use of
working capital now includes the development of a trade or business in
the qualified opportunity zone as well as acquisition, construction,
and/or substantial improvement of tangible property. Second, exceeding
the 31-month period does not violate the safe harbor if the delay is
attributable to waiting for government action the application for which
is completed during the 31-month period.
IV. Special Rule for Section 1231 Gains
    In 83 FR 54279 (October 29, 2018) the proposed regulations
clarified that only capital gains are eligible for deferral under
section 1400Z-2(a)(1). Section 1231(a)(1) provides that, if the section
1231 gains for any taxable year exceed the section 1231 losses, such
gain shall be treated as long-term capital gain. Thus, the proposed
regulations provide that only this gain shall be treated as an eligible
gain for purposes of section 1400Z-2.
    In addition, the preamble in 83 FR 54279 (October 29, 2018) stated
that some capital gains are the result of Federal tax rules deeming an
amount to be a gain from the sale or exchange of a capital asset, and,
in many cases, the statutory language providing capital gain treatment
does not provide a specific date for the deemed sale. Thus, 83 FR 54279
(October 29, 2018) addressed this issue by providing that, except as
specifically provided in the proposed regulations, the first day of the
180-day period set forth in section 1400Z-2(a)(1)(A) and the
regulations thereunder is the date on which the gain would be
recognized for Federal income tax purposes, without regard to the
deferral available under section 1400Z-2. Consistent with 83 FR 54279
(October 29, 2018) and because the capital gain income from section
1231 property is determinable only as of the last day of the taxable
year, these proposed regulations provide that the 180-day period for
investing such capital gain income from section 1231 property in a QOF
begins on the last day of the taxable year.
    The Treasury Department and the IRS request comments on the
proposed treatment of section 1231 gains.
V. Relief With Respect to the 90-Percent Asset Test
A. Relief for Newly Contributed Assets
    A new QOF's ability to delay the start of its status as a QOF (and
thus the start of its 90-percent asset tests) provides the QOF the
ability to prepare to deploy new capital before that capital is
received and must be tested. Failure to satisfy the 90-percent asset
test on a testing date does not by itself cause an entity to fail to be
a QOF within the meaning of section 1400Z-2(d)(1) (this is the case
even if it is the QOF's first testing date). Some commentators on 83 FR
54279 (October 29, 2018) pointed out that this start-up rule does not
help an existing QOF that receives new capital from an equity investor
shortly before the next semi-annual test. The proposed regulations,
therefore, allow a QOF to apply the test without taking into account
any investments received in the preceding 6 months. The QOF's ability
to do this, however, is dependent on those new assets being held in
cash,
[[Page 18660]]
cash equivalents, or debt instruments with term 18 months or less.
B. QOF Reinvestment Rule
    Section 1400Z-2(e)(4)(B) authorizes regulations to ensure a QOF has
``a reasonable period of time to reinvest the return of capital from
investments in qualified opportunity zone stock and qualified
opportunity zone partnership interests, and to reinvest proceeds
received from the sale or disposition of qualified opportunity zone
property.'' For example, if a QOF, shortly before a testing date, sells
qualified opportunity zone property, that QOF should have a reasonable
amount of time in which to bring itself into compliance with the 90-
percent asset test. Many stakeholders have requested guidance not only
on the length of a ``reasonable period of time to reinvest,'' but also
on the Federal income tax treatment of any gains that the QOF reinvests
during such a period.
    The proposed regulations provide that proceeds received by the QOF
from the sale or disposition of (1) qualified opportunity zone business
property, (2) qualified opportunity zone stock, and (3) qualified
opportunity zone partnership interests are treated as qualified
opportunity zone property for purposes of the 90-percent investment
requirement described in 1400Z-1(d)(1) and (f), so long as the QOF
reinvests the proceeds received by the QOF from the distribution, sale,
or disposition of such property during the 12-month period beginning on
the date of such distribution, sale, or disposition. The one-year rule
is intended to allow QOFs adequate time in which to reinvest proceeds
from qualified opportunity zone property. Further, in order for the
reinvested proceeds to be counted as qualified opportunity zone
business property, from the date of a distribution, sale, or
disposition until the date proceeds are invested in other qualified
opportunity zone property, the proceeds must be continuously held in
cash, cash equivalents, and debt instruments with a term of 18 months
or less. Finally, a QOF may reinvest proceeds from the sale of an
investment into another type of qualifying investment. For example, a
QOF may reinvest proceeds from a sale of an investment in qualified
opportunity stock into qualified opportunity zone business property.
Analogous to the flexibility in the safe harbor for working capital,
the proposed regulations extend QOF reinvestment relief from
application of the 90-percent asset test if failure to meet the 12-
month deadline is attributable to delay in government action the
application for which is complete.
    The Treasury Department and the IRS request comments on whether an
analogous rule for QOF subsidiaries to reinvest proceeds from the
disposition of qualified opportunity zone property would be beneficial.
    Additionally, commenters have requested that the grant of authority
in section 1400Z-2(e)(4)(B) be used to exempt QOFs and investors in
QOFs from the Federal income tax consequences of dispositions of
qualified opportunity zone property by QOFs or qualified opportunity
zone businesses if the proceeds from such dispositions are reinvested
within a reasonable timeframe. The Treasury Department and the IRS
believe that the grant of this regulatory authority permits QOFs a
reasonable time to reinvest such proceeds without the QOF being harmed
(that is, without the QOF incurring the penalty set forth in section
1400Z-2(f) because the proceeds would not be qualified opportunity zone
property). However, the statutory language granting this regulatory
authority does not specifically authorize the Secretary to prescribe
rules for QOFs departing from the otherwise operative recognition
provisions of sections 1001(c) and 61(a)(3).
    Regarding the tax benefits provided to investors in QOFs under
section 1400Z-2(b) and (c), as stated earlier, sections 1400Z-1 and
1400Z-2 seek to encourage economic growth and investment in designated
distressed communities (qualified opportunity zones) by providing
Federal income tax benefits to taxpayers who invest in businesses
located within these zones through a QOF. Congress tied these tax
incentives to the longevity of an investor's stake in a QOF, not to a
QOF's stake in any specific portfolio investment. Further, Congress
expressly recognized that many QOFs would experience investment
``churn'' over the lifespan of the QOF and anticipated this by
providing the Secretary the regulatory latitude for permitting QOFs a
reasonable time to reinvest capital. Consistent with this regulatory
authority, the Treasury Department and the IRS clarify that sales or
dispositions of assets by a QOF do not impact in any way investors'
holding periods in their qualifying investments or trigger the
inclusion of any deferred gain reflected in such qualifying investments
so long as they do not sell or otherwise dispose of their qualifying
investment for purposes of section 1400Z-2(b). However, the Treasury
Department and the IRS are not able to find precedent for the grant of
authority in section 1400Z-2(e)(4)(B) to permit QOFs a reasonable time
to reinvest capital and allow the Secretary to prescribe regulations
permitting QOFs or their investors to avoid recognizing gain on the
sale or disposition of assets under sections 1001(c) and 61(a)(3), and
notes that examples of provisions in subtitle A of the Code that
provide for nonrecognition treatment or exclusion from income can be
found in sections 351(a), 354(a), 402(c), 501(a), 721(a), 1031(a),
1032(a), and 1036(a), among others, some of which are applied in the
proposed rules and described as selected examples in this preamble. In
this regard, the Treasury Department and the IRS are requesting
commenters to provide prior examples of tax regulations that exempt
realized gain from being recognized under sections 1001(c) or 61(a)(3)
by a taxpayer (either a QOF or qualified opportunity zone business, or
in the case of QOF partnerships or QOF S corporations, the investors
that own qualifying investments in such QOFs) without an operative
provision of subtitle A of the Code expressly providing for
nonrecognition treatment; as well as to provide any comments on the
possible burdens imposed if these organizations are required to reset
the holding period for reinvested realized gains, including
administrative burdens and the potential chilling effect on investment
incentives that may result from these possible burdens, and whether
specific organizational forms could be disproportionately burdened by
this proposed policy.
VI. Amount of an Investment for Purposes of Making a Deferral Election
    A taxpayer may make an investment for purposes of an election under
section 1400Z-2(a) by transferring cash or other property to a QOF,
regardless of whether the transfer is taxable to the transferor (such
as where the transferor is not in control of the transferee
corporation), provided the transfer is not re-characterized as a
transaction other than an investment in the QOF (as would be the case
where a purported contribution to a partnership is treated as a
disguised sale). These proposed regulations provide special rules for
determining the amount of an investment for purposes of this election
if a taxpayer transfers property other than cash to a QOF in a
carryover basis transaction. In that case, the amount of the investment
equals the lesser of the taxpayer's adjusted basis in the equity
received in the transaction (determined without regard to section
1400Z-2(b)(2)(B)) or the fair market value of the equity received in
the transaction (both as determined immediately after the transaction).
In the case of a
[[Page 18661]]
contribution to a partnership that is a QOF (QOF partnership), the
basis in the equity to which section 1400Z-2(b)(2)(B)(i) applies is
calculated without regard to any liability that is allocated to the
contributor under section 752(a). These rules apply separately to each
item of property contributed to a QOF, but the total amount of the
investment for purposes of the election is limited to the amount of the
gain described in section 1400Z-2(a)(1).
    The proposed regulations set forth two special rules that treat a
taxpayer as having created a mixed-funds investment (within the meaning
of proposed Sec.  1.1400Z2(b)-1(a)(2)(v)). First, a mixed-funds
investment will result if a taxpayer contributes to a QOF, in a
nonrecognition transaction, property that has a fair market value in
excess of the property's adjusted basis. Second, a mixed-funds
investment will result if the amount of the investment that might
otherwise support an election exceeds the amount of the taxpayer's
eligible gain described in section 1400Z-2(a)(1). In each instance,
that excess (that is, the excess of fair market value over adjusted
basis, or the excess of the investment amount over eligible gain, as
appropriate) is treated as an investment described in section 1400Z-
2(e)(1)(A)(ii) (that is, the portion of the contribution to which a
deferral election does not apply).
    If a taxpayer acquires a direct investment in a QOF from a direct
owner of the QOF, these proposed regulations also provide that, for
purposes of making an election under section 1400Z-2(a), the taxpayer
is treated as making an investment in an amount equal to the amount
paid for the eligible interest.
    The Treasury Department and the IRS request comments on the
proposed rules regarding the amount with respect to which a taxpayer
may make a deferral election under section 1400Z-2(a).
VII. Events That Cause Inclusion of Deferred Gain (Inclusion Events)
A. In General
    Section 1400Z-2(b)(1) provides that the amount of gain that is
deferred if a taxpayer makes an equity investment in a QOF described in
section 1400Z-2(e)(1)(A)(i) (qualifying investment) will be included in
the taxpayer's income in the taxable year that includes the earlier of
(A) the date on which the qualifying investment is sold or exchanged,
or (B) December 31, 2026. By using the terms ``sold or exchanged,''
section 1400Z-2(b)(1) does not directly address non-sale or exchange
dispositions, such as gifts, bequests, devises, charitable
contributions, and abandonments of qualifying investments. However, the
Conference Report to accompany H.R. 1, Report 115-466 (Dec. 15, 2017)
provides that, under section 1400Z-2(b)(1), the ``deferred gain is
recognized on the earlier of the date on which the [qualifying]
investment is disposed of or December 31, 2026.'' See Conference Report
at 539.
    The proposed regulations track the disposition language set forth
in the Conference Report and clarify that, subject to enumerated
exceptions, an inclusion event results from a transfer of a qualifying
investment in a transaction to the extent the transfer reduces the
taxpayer's equity interest in the qualifying investment for Federal
income tax purposes. Notwithstanding that general principle, and except
as otherwise provided in the proposed regulations, a transaction that
does not reduce a taxpayer's equity interest in the taxpayer's
qualifying investment is also an inclusion event under the proposed
regulations to the extent the taxpayer receives property from a QOF in
a transaction treated as a distribution for Federal income tax
purposes. For this purpose, property generally is defined as money,
securities, or any other property, other than stock (or rights to
acquire stock) in the corporation that is a QOF (QOF corporation) that
is making the distribution. The Treasury Department and the IRS have
determined that it is necessary to treat such transactions as inclusion
events to prevent taxpayers from ``cashing out'' a qualifying
investment in a QOF without including in gross income any amount of
their deferred gain.
    Based upon the guidance set forth in the Conference Report and the
principles underlying the ``inclusion event'' concept described in the
preceding paragraphs, the proposed regulations provide taxpayers with a
nonexclusive list of inclusion events, which include:
    (1) A taxable disposition (for example, a sale) of all or a part of
a qualifying investment (qualifying QOF partnership interest) in a QOF
partnership or of a qualifying investment (qualifying QOF stock) in a
QOF corporation;
    (2) A taxable disposition (for example, a sale) of interests in an
S corporation which itself is the direct investor in a QOF corporation
or QOF partnership if, immediately after the disposition, the aggregate
percentage of the S corporation interests owned by the S corporation
shareholders at the time of its deferral election has changed by more
than 25 percent. When the threshold is exceeded, any deferred gains
recognized would be reported under the provisions of subchapter S of
chapter 1 of subtitle A of the Code (subchapter S);
    (3) In certain cases, a transfer by a partner of an interest in a
partnership that itself directly or indirectly holds a qualifying
investment;
    (4) A transfer by gift of a qualifying investment;
    (5) The distribution to a partner of a QOF partnership of property
that has a value in excess of basis of the partner's qualifying QOF
partnership interest;
    (6) A distribution of property with respect to qualifying QOF stock
under section 301 to the extent it is treated as gain from the sale or
exchange of property under section 301(c)(3);
    (7) A distribution of property with respect to qualifying QOF stock
under section 1368 to the extent it is treated as gain from the sale or
exchange of property under section 1368(b)(2) and (c);
    (8) A redemption of qualifying QOF stock that is treated as an
exchange of property for the redeemed qualifying QOF stock under
section 302;
    (9) A disposition of qualifying QOF stock in a transaction to which
section 304 applies;
    (10) A liquidation of a QOF corporation in a transaction to which
section 331 applies; and
    (11) Certain nonrecognition transactions, including:
    a. A liquidation of a QOF corporation in a transaction to which
section 332 applies;
    b. A transfer of all or part of a taxpayer's qualifying QOF stock
in a transaction to which section 351 applies;
    c. A stock-for-stock exchange of qualifying QOF stock in a
transaction to which section 368(a)(1)(B) applies;
    d. A triangular reorganization of a QOF corporation within the
meaning of Sec.  1.358-6(b)(2);
    e. An acquisitive asset reorganization in which a QOF corporation
transfers its assets to its shareholder and terminates (or is deemed to
terminate) for Federal income tax purposes;
    f. An acquisitive asset reorganization in which a corporate
taxpayer that made the qualifying investment in the QOF corporation
(QOF shareholder) transfers its assets to the QOF corporation and
terminates (or is deemed to terminate) for Federal income tax purposes;
    g. An acquisitive asset reorganization in which a QOF corporation
transfers its assets to an acquiring corporation that is not a QOF
corporation within a prescribed period after the transaction;
    h. A recapitalization of a QOF corporation, or a contribution by a
QOF
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shareholder of a portion of its qualifying QOF stock to the QOF
corporation, if the transaction has the result of reducing the
taxpayer's equity interest in the QOF corporation;
    i. A distribution by a QOF shareholder of its qualifying QOF stock
to its shareholders in a transaction to which section 355 applies;
    j. A transfer by a QOF corporation of subsidiary stock to QOF
shareholders in a transaction to which section 355 applies if, after a
prescribed period following the transaction, either the distributing
corporation or the controlled corporation is not a QOF; and
    k. A transfer to, or an acquisitive asset reorganization of, an S
corporation which itself is the direct investor in a QOF corporation or
QOF partnership if, immediately after the transfer or reorganization,
the percentage of the S corporation interests owned by the S
corporation shareholders at the time of its deferral election has
decreased by more than 25 percent.
    Each of the previously described transactions would be an inclusion
event because each would reduce or terminate the QOF investor's direct
(or, in the case of partnerships, indirect) qualifying investment for
Federal income tax purposes or (in the case of distributions) would
constitute a ``cashing out'' of the QOF investor's qualifying
investment. As a result, the QOF investor would recognize all, or a
corresponding portion, of its deferred gain under section 1400Z-
2(a)(1)(B) and (b).
    The Treasury Department and the IRS request comments on the
proposed rules regarding the inclusion events that would result in a
QOF investor recognizing an amount of deferred gain under section
1400Z-2(a)(1)(B) and (b), including the pledging of qualifying
investments as collateral for nonrecourse loans.
B. Timing of Basis Adjustments
    Under section 1400Z-2(b)(2)(B)(i), an electing taxpayer's initial
basis in a qualifying investment is zero. Under section 1400Z-
2(b)(2)(B)(iii) and (iv), a taxpayer's basis in its qualifying
investment is increased automatically after the investment has been
held for five years by an amount equal to 10 percent of the amount of
deferred gain, and then again after the investment has been held for
seven years by an amount equal to an additional five percent of the
amount of deferred gain. The proposed regulations clarify that such
basis is basis for all purposes and, for example, losses suspended
under section 704(d) would be available to the extent of the basis
step-up.
    The proposed regulations also clarify that basis adjustments under
section 1400Z-2(b)(2)(B)(ii), which reflect the recognition of deferred
gain upon the earlier of December 31, 2026, or an inclusion event, are
made immediately after the amount of deferred capital gain is taken
into income. If a basis adjustment is made under section 1400Z-
2(b)(2)(B)(ii) as a result of a reduction in direct tax ownership of a
qualifying investment, a redemption, a distribution treated as gain
from the sale or exchange of property under section 301(c)(3) or
section 1368(b)(2) and (c), or a distribution to a partner of property
with a value in excess of the partner's basis in the qualifying QOF
partnership interest, the basis adjustment is made before determining
the tax consequences of the inclusion event with respect to the
qualifying investment (for example, before determining the recovery of
basis under section 301(c)(2) or the amount of gain the taxpayer must
take into account under section 301, section 1368, or the provisions of
subchapter K of chapter 1 of subtitle A of the Code (subchapter K), as
applicable). For a discussion of distributions as inclusion events, see
part VII.G of this Explanation of Provisions.
    The proposed regulations further clarify that, if the taxpayer
makes an election under section 1400Z-2(c), the basis adjustment under
section 1400Z-2(c) is made immediately before the taxpayer disposes of
its QOF investment. For dispositions of qualifying QOF partnership
interests, the bases of the QOF partnership's assets are also adjusted
with respect to the transferred qualifying QOF partnership interest,
with such adjustments calculated in a manner similar to the adjustments
that would have been made to the partnership's assets if the partner
had purchased the interest for cash immediately prior to the
transaction and the partnership had a valid section 754 election in
effect. This will permit basis adjustments to the QOF partnership's
assets, including its inventory and unrealized receivables, and avoid
the creation of capital losses and ordinary income on the sale. See
part VII.D.4 of this Explanation of Provisions for a special election
for direct investors in QOF partnerships and S corporations that are
QOFs (QOF S corporations) for the application of section 1400Z-2(c) to
certain sales of assets of a QOF partnership or QOF S corporation. With
respect to that special election, the Treasury Department and the IRS
intend to implement targeted anti-abuse provisions (for example,
provisions addressing straddles). The Treasury Department and IRS
request comments on whether one or more such provisions are appropriate
to carry out the purposes of section 1400Z-2.
    More generally, the Treasury Department and the IRS request
comments on the proposed rules regarding the timing of basis
adjustments under section 1400Z-2(b) and (c).
C. Amount Includible
    In general, other than with respect to partnerships, if a taxpayer
has an inclusion event with regard to its qualifying investment in a
QOF, the taxpayer includes in gross income the lesser of two amounts,
less the taxpayer's basis. The first amount is the fair market value of
the portion of the qualifying investment that is disposed of in the
inclusion event. For purposes of this section, the fair market value of
that portion is determined by multiplying the fair market value of the
taxpayer's entire qualifying investment in the QOF, valued as of the
date of the inclusion event, by the percentage of the taxpayer's
qualifying investment that is represented by the portion disposed of in
the inclusion event. The second amount is the amount that bears the
same ratio to the remaining deferred gain as the first amount bears to
the total fair market value of the qualifying investment in the QOF
immediately before the transaction.
    For inclusion events involving partnerships, the amount includible
is equal to the percentage of the qualifying QOF partnership interest
disposed of, multiplied by the lesser of: (1) The remaining deferred
gain less any basis adjustments pursuant to section 1400Z-
2(b)(2)(B)(iii) and (iv) or (2) the gain that would be recognized by
the partner if the interest were sold in a fully taxable transaction
for its then fair market value.
    For inclusion events involving a QOF shareholder that is an S
corporation, if the S corporation undergoes an aggregate change in
ownership of more than 25 percent, there is an inclusion event with
respect to all of the S corporation's remaining deferred gain (see part
VII.D.3 of this Explanation of Provisions).
    A special ``dollar-for-dollar'' rule applies in certain
circumstances if a QOF owner receives property from a QOF that gives
rise to an inclusion event. These circumstances include actual
distributions with respect to qualifying QOF stock that do not reduce a
taxpayer's direct interest in qualifying QOF stock, stock redemptions
to which section 302(d) applies, and the receipt
[[Page 18663]]
of boot in certain corporate reorganizations, as well as actual or
deemed distributions with respect to qualifying QOF partnership
interests. This dollar-for-dollar rule would be simpler to administer
than a rule that would require taxpayers to undertake valuations of QOF
investments each time a QOF owner received a distribution with respect
to the qualifying investment or received boot in a corporate
reorganization. If this dollar-for-dollar rule applies, the taxpayer
includes in gross income an amount of the taxpayer's remaining deferred
gain equal to the lesser of (1) the remaining deferred gain, or (2) the
amount that gave rise to the inclusion event. The Treasury Department
and the IRS request comments on the dollar-for-dollar rule and the
circumstances in which this rule would apply under these proposed
regulations.
D. Partnership and S Corporation Provisions
1. Partnership Provisions in General
    With respect to property contributed to a QOF partnership in
exchange for a qualifying investment, the partner's basis in the
qualifying interest is zero under section 1400Z-2(b)(2)(B)(i),
increased by the partner's share of liabilities under section 752(a).
However, the carryover basis rules of section 723 apply in determining
the basis to the partnership of property contributed. The Treasury
Department and the IRS are aware that, where inside-outside basis
disparities exist in a partnership, taxpayers could manipulate the
rules of subchapter K to create non-economic gains and losses.
Accordingly, the Treasury Department and the IRS request comments on
rules that would limit abusive transactions that could be undertaken as
a result of these disparities.
    The proposed regulations provide that the transfer by a partner of
all or a portion of its interest in a QOF partnership or in a
partnership that directly or indirectly holds a qualifying investment
generally will be an inclusion event. However, a transfer in a
transaction governed by section 721 (partnership contributions) or
section 708(b)(2)(A) (partnership mergers) is generally not an
inclusion event, provided there is no reduction in the amount of the
remaining deferred gain that would be recognized under section 1400Z-2
by the transferring partners on a later inclusion event. Similar rules
apply in the case of tiered partnerships. However, the resulting
partnership or new partnership becomes subject to section 1400Z-2 to
the same extent as the original taxpayer that made the qualifying
investment in the QOF.
    Partnership distributions in the ordinary course of partnership
operations may, in certain instances, also be considered inclusion
events. Under the proposed regulations, the actual or deemed
distribution of cash or other property with a fair market value in
excess of the partner's basis in its qualifying QOF partnership
interest is also an inclusion event.
2. Partnership Mixed-Funds Investments
    Rules specific to section 1400Z-2 are needed for mixed-funds
investments where a partner contributes to a QOF property with a value
in excess of its basis, or cash in excess of the partner's eligible
section 1400Z-2 gain, or where a partner receives a partnership
interest in exchange for services (for example, a carried interest).
Section 1400Z-2(e)(1) provides that only the portion of the investment
in a QOF to which an election under section 1400Z-2(a) is in effect is
treated as a qualifying investment. Under this rule, the share of gain
attributable to the excess investment and/or the service component of
the interest in the QOF partnership is not eligible for the various
benefits afforded qualifying investments under section 1400Z-2 and is
not subject to the inclusion rules of section 1400Z-2. This is the case
with respect to a carried interest, despite the fact that all of the
partnership's investments might be qualifying investments.
    The Treasury Department and the IRS considered various approaches
to accounting for a partner holding a mixed-funds investment in a QOF
partnership and request comments on the approach adopted by the
proposed regulations. For example, a partner could be considered to own
two separate investments and separately track the basis and value of
the investments, similar to a shareholder tracking two separate blocks
of stock. However, that approach is inconsistent with the subchapter K
principle that a partner has a unitary basis and capital account in its
partnership interest. Thus, the proposed regulations adopt the approach
that a partner holding a mixed-funds investment will be treated as
holding a single partnership interest with a single basis and capital
account for all purposes of subchapter K, but not for purposes of
section 1400Z-2. Under the proposed regulations, solely for purposes of
section 1400Z-2, the mixed-funds partner will be treated as holding two
interests, and all partnership items, such as income and debt
allocations and property distributions, would affect qualifying and
non-qualifying investments proportionately, based on the relative
allocation percentages of each interest. Allocation percentages would
generally be based on relative capital contributions for qualifying
investments and other investments. However, section 704(c) principles
apply to partnership allocations attributable to property with value-
basis disparities to prevent inappropriate shifts of built-in gains or
losses between qualifying investments and non-qualifying investments.
Additionally, special rules apply in calculating the allocation
percentages in the case of a partner who receives a profits interest
for services, with the percent attributable to the profits interest
being treated as a non-qualifying investment to the extent of the
highest percentage interest in residual profits attributable to the
interest.
    In the event of an additional contribution of qualifying or non-
qualifying amounts, a revaluation of the relative partnership
investments is required immediately before the contribution in order to
adequately account for the two components.
    Consistent with the unitary basis rules of subchapter K, a
distribution of money would not give rise to section 731 gain unless
the distribution exceeded the partner's total outside basis. For
example, if a partner contributed $200 to a QOF partnership, half of
which related to deferred section 1400Z-2 gain, and $20 of partnership
debt was allocated to the partner, the partner's outside basis would be
$120 (zero for the qualifying investment contribution, plus $100 for
the non-qualifying investment contribution, plus $20 under section
752(a)), and only a distribution of money in excess of that amount
would trigger gain under subchapter K. However, for purposes of
calculating the section 1400Z-2 gain, the qualifying investment portion
of the interest would have a basis of $10, with the remaining $110
attributable to the non-qualifying investment. A distribution of $40
would be divided between the two investments and would not result in
gain under section 731; however, the distribution would constitute an
inclusion event under section 1400Z-2, and the partner would be
required to recognize gain in the amount of $10 (the excess of the $20
distribution attributable to the qualifying investment over the $10
basis in the interest).
    The Treasury Department and the IRS are concerned with the
potential complexity associated with this approach and request comments
on alternative ways to account for
[[Page 18664]]
distributions in the case of a mixed-funds investment in a QOF
partnership. The Treasury Department and the IRS also request comments
on whether an ordering rule treating the distribution as attributable
to the qualifying or non-qualifying investment portion first is
appropriate, and how any alternative approach would simplify the
calculations.
3. Application to S Corporations
    Under section 1371(a), and for purposes of these proposed
regulations, the rules of subchapter C of chapter 1 of subtitle A of
the Code (subchapter C) applicable to C corporations and their
shareholders apply to S corporations and their shareholders, except to
the extent inconsistent with the provisions of subchapter S. In such
instances, S corporations and their shareholders are subject to the
specific rules of subchapter S. For example, similar to rules
applicable to QOF partnerships, a distribution of property to which
section 1368 applies by a QOF S corporation is an inclusion event to
the extent that the distributed property has a fair market value in
excess of the shareholder's basis, including any basis adjustments
under section 1400Z-2(b)(2)(B)(iii) and (iv). In addition, the rules
set forth in these proposed regulations regarding liquidations and
reorganizations of QOF C corporations and QOF C corporation
shareholders apply equally to QOF S corporations and QOF S corporation
shareholders.
    However, flow-through principles under subchapter S apply to S
corporations when the application of subchapter C would be inconsistent
with subchapter S. For example, if an inclusion event were to occur
with respect to deferred gain of an S corporation that is an investor
in a QOF, the shareholders of such S corporation would include such
gain pro rata in their respective taxable incomes. Consequently, those
S corporation shareholders would increase their bases in their S
corporation stock at the end of the taxable year during which the
inclusion event occurred. Pursuant to the S corporation distribution
rules set forth in section 1368, the S corporation shareholders would
receive future distributions from the S corporation tax-free to the
extent of the deferred tax amount included in income and included in
stock basis.
    In addition, these proposed regulations set forth specific rules
for S corporations to provide certainty to taxpayers regarding the
application of particular provisions under section 1400Z-2. Regarding
section 1400Z-2(b)(1)(A), these proposed regulations clarify that a
conversion of an S corporation that holds a qualifying investment in a
QOF to a C corporation (or a C corporation to an S corporation) is not
an inclusion event because the interests held by each shareholder of
the C corporation or S corporation, as appropriate, would remain
unchanged with respect to the corporation's qualifying investment in a
QOF. With regard to mixed-funds investments in a QOF S corporation
described in section 1400Z-2(e)(1), if different blocks of stock are
created for otherwise qualifying investments to track basis in these
qualifying investments, the proposed regulations make clear that the
separate blocks will not be treated as different classes of stock for
purposes of S corporation eligibility under section 1361(b)(1).
    The proposed regulations also provide that, if an S corporation is
an investor in a QOF, the S corporation must adjust the basis of its
qualifying investment in the manner set forth for C corporations in
proposed Sec.  1.1400Z2(b)-1(g), except as otherwise provided in these
rules. This rule does not affect adjustments to the basis of any other
asset of the S corporation. The S corporation shareholder's pro-rata
share of any recognized deferred capital gain at the S corporation
level will be separately stated under section 1366 and will adjust the
shareholders' stock basis under section 1367. In addition, the proposed
regulations make clear that any adjustment made to the basis of an S
corporation's qualifying investment under section 1400Z-2(b)(2)(B)(iii)
or (iv) or section 1400Z-2(c) will not (1) be separately stated under
section 1366, and (2) until the date on which an inclusion event with
respect to the S corporation's qualifying investment occurs, adjust the
shareholders' stock basis under section 1367. If a basis adjustment
under section 1400Z-2(b)(2)(B)(ii) is made as a result of an inclusion
event, then the basis adjustment will be made before determining the
other tax consequences of the inclusion event.
    Finally, under these proposed regulations, special rules would
apply in the case of certain ownership shifts in S corporations that
are QOF owners. Under these rules, solely for purposes of section
1400Z-2, the S corporation's qualifying investment in the QOF would be
treated as disposed of if there is a greater-than-25 percent change in
ownership of the S corporation (aggregate change in ownership). If an
aggregate change in ownership has occurred, the S corporation would
have an inclusion event with respect to all of the S corporation's
remaining deferred gain, and neither section 1400Z-2(b)(2)(B)(iii) or
(iv), nor section 1400Z-2(c), would apply to the S corporation's
qualifying investment after that date. This proposed rule attempts to
balance the status of the S corporation as the owner of the qualifying
investment with the desire to preserve the incidence of the capital
gain inclusion and income exclusion benefits under section 1400Z-2. The
Treasury Department and the IRS request comments on the proposed rules
regarding ownership changes in S corporations that are QOF owners.
4. Special Election for Direct Investors in QOF Partnerships and QOF S
Corporations
    For purposes of section 1400Z-2(c), which applies to investments
held for at least 10-years, a taxpayer that is the holder of a direct
qualifying QOF partnership interest or qualifying QOF stock of a QOF S
corporation may make an election to exclude from gross income some or
all of the capital gain from the disposition of qualified opportunity
zone property reported on Schedule K-1 of such entity, provided the
disposition occurs after the taxpayer's 10-year holding period. To the
extent that such Schedule K-1 separately states capital gains arising
from the sale or exchange of any particular capital asset, the taxpayer
may make an election under section 1400Z-2(c) with respect to such
separately stated item. To be valid, the taxpayer must make such
election for the taxable year in which the capital gain from the sale
or exchange of QOF property recognized by the QOF partnership or QOF S
corporation would be included in the taxpayer's gross income, in
accordance with applicable forms and instructions. If a taxpayer makes
this election with respect to some or all of the capital gain reported
on such Schedule K-1, the amount of such capital gain that the taxpayer
elects to exclude from gross income is excluded from income for
purposes of the Internal Revenue Code and the regulations thereunder.
For basis purposes, such excluded amount is treated as an item of
income described in sections 705(a)(1) or 1366 thereby increasing the
partners or shareholders' bases by their shares of such amount. These
proposed regulations provide no similar election to holders of
qualifying QOF stock of a QOF C corporation that is not a QOF REIT.
    The Treasury Department and the IRS request comments on the
eligibility for, and the operational mechanics of, the proposed rules
regarding this special election.
[[Page 18665]]
5. Ability of QOF REITs To Pay Tax-Free Capital Gain Dividends to 10-
Plus-Year Investors
    The proposed rules authorize QOF real estate investment trusts (QOF
REITs) to designate special capital gain dividends, not to exceed the
QOF REIT's long-term gains on sales of Qualified Opportunity Zone
property. If some QOF REIT shares are qualified investments in the
hands of some shareholders, those special capital gain dividends are
tax free to shareholders who could have elected a basis increase in
case of a sale of the QOF REIT shares. The Treasury Department and the
IRS request comments on the eligibility for, and the operational
mechanics of, the proposed rules regarding this special treatment.
E. Transfers of Property by Gift or by Reason of Death
    For purposes of sections 1400Z-2(b) and (c), any disposition of the
owner's qualifying investment is an inclusion event for purposes of
section 1400Z-2(b)(1) and proposed Sec.  1.1400Z2(b)-1(a), except as
provided in these proposed regulations. Generally, transfers of
property by gift, in part or in whole, either will reduce or terminate
the owner's qualifying investment. Accordingly, except as provided in
these proposed regulations, transfers by gift will be inclusion events
for purposes of section 1400Z-2(b)(1) and proposed Sec.  1.1400Z2(b)-
1(c).
    For example, a transfer of a qualifying investment by gift from the
donor, in this case the owner, to the donee either will reduce or will
terminate the owner's qualifying investment, depending upon whether the
owner transfers part or all of the owner's qualifying investment. A
charitable contribution, as defined in section 170(c), of a qualifying
interest is also an inclusion event because, again, the owner's
qualifying investment is terminated upon the transfer. However, a
transfer of a qualifying investment by gift by the taxpayer to a trust
that is treated as a grantor trust of which the taxpayer is the deemed
owner is not an inclusion event. The rationale for this exception is
that, for Federal income tax purposes, the owner of the grantor trust
is treated as the owner of the property in the trust until such time
that the owner releases certain powers that cause the trust to be
treated as a grantor trust. Accordingly, the owner's qualifying
investment is not reduced or eliminated for Federal income tax purposes
upon the transfer to such a grantor trust. However, any change in the
grantor trust status of the trust (except by reason of the grantor's
death) is an inclusion event because the owner of the trust property
for Federal income tax purposes is changing.
    Most transfers by reason of death will terminate the owner's
qualifying investment. For example, the qualifying investment may be
distributed to a beneficiary of the owner's estate or may pass by
operation of law to a named beneficiary. In each case, the owner's
qualifying investment is terminated. Nevertheless, in part because of
the statutory direction that amounts recognized that were not properly
includible in the gross income of the deceased owner are to be
includible in gross income as provided in section 691, the Treasury
Department and the IRS have concluded that the distribution of the
qualifying investment to the beneficiary by the estate or by operation
of law is not an inclusion event for purposes of section 1400Z-2(b).
Thus, the proposed regulations would provide that neither a transfer of
the qualifying investment to the deceased owner's estate nor the
distribution by the estate to the decedent's legatee or heir is an
inclusion event for purposes of section 1400Z-2(b). Similarly, neither
the termination of grantor trust status by reason of the grantor's
death nor the distribution by that trust to a trust beneficiary by
reason of the grantor's death is an inclusion event for purposes of
section 1400Z-2(b). In each case, the recipient of the qualifying
investment has the obligation, as under section 691, to include the
deferred gain in gross income in the event of any subsequent inclusion
event, including for example, any further disposition by that
recipient.
F. Exceptions for Disregarded Transfers and Certain Types of
Nonrecognition Transactions
1. In General
    Proposed Sec.  1.1400Z2(b)-1(c) describes certain transfers that
are not inclusion events with regard to a taxpayer's qualifying
investment for purposes of section 1400Z-2(b)(1). For example, a
taxpayer's transfer of its qualifying investment to an entity that is
disregarded as separate from the taxpayer for Federal income tax
purposes is not an inclusion event because the transfer is disregarded
for Federal income tax purposes. The same rationale applies here as in
the case of a taxpayer's transfer of its qualifying investment to a
grantor trust of which the taxpayer is the deemed owner. However, a
change in the entity's status as disregarded would be an inclusion
event.
    Additionally, a transfer of a QOF's assets in an acquisitive asset
reorganization described in section 381(a)(2) (qualifying section 381
transaction) generally is not an inclusion event if the acquiring
corporation is a QOF within a prescribed period of time after the
transaction. Following such a qualifying section 381 transaction, the
taxpayer retains a direct qualifying investment in a QOF with an
exchanged basis. However, the proposed regulations provide that a
qualifying section 381 transaction generally is an inclusion event,
even if the acquiring corporation qualifies as a QOF within the
prescribed post-transaction period, to the extent the taxpayer receives
boot in the reorganization (other than boot that is treated as a
dividend under section 356(a)(2)) because, in those situations, the
taxpayer reduces its direct qualifying investment in the QOF (see part
VII.F.2 of this Explanation of Provisions).
    A transfer of a QOF shareholder's assets in a qualifying section
381 transaction also is not an inclusion event, except to the extent
the QOF shareholder transfers less than all of its qualifying
investment in the transaction, because the successor to the QOF
shareholder will retain a direct qualifying investment in the QOF.
Similar reasoning extends to a transfer of a QOF shareholder's assets
in a liquidation to which section 332 applies, to the extent that no
gain or loss is recognized by the QOF shareholder on the distribution
of the QOF interest to the 80-percent distributee, pursuant to section
337(a). This rule does not apply if the QOF shareholder is an S
corporation and if the qualifying section 381 transaction causes the S
corporation to have an aggregate ownership change of more than 25
percent (as discussed in part VII.D.2 of this Explanation of
Provisions).
    Moreover, the distribution by a QOF of a subsidiary in a
transaction to which section 355 (or so much of section 356 as relates
to section 355) applies is not an inclusion event if both the
distributing corporation and the controlled corporation qualify as QOFs
immediately after the distribution (qualifying section 355
transaction), except to the extent the taxpayer receives boot. The
Treasury Department and the IRS have determined that continued deferral
under section 1400Z-2(a)(1)(A) is appropriate in the case of a
qualifying section 355 transaction because the QOF shareholder
continues its original direct qualifying investment, albeit reflected
in investments in two QOF corporations.
[[Page 18666]]
    Finally, a recapitalization (within the meaning of section
368(a)(1)(E)) of a QOF is not an inclusion event, as long as the QOF
shareholder does not receive boot in the transaction and the
transaction does not reduce the QOF shareholder's proportionate
interest in the QOF corporation. Similar rules apply to a transaction
described in section 1036.
2. Boot in a Reorganization
    An inclusion event generally will occur if a QOF shareholder
receives boot in a qualifying section 381 transaction in which a QOF's
assets are acquired by another QOF corporation. Under proposed Sec.
1.1400Z2(b)-1(c), if the taxpayer realizes a gain on the transaction,
the amount that gives rise to the inclusion event is the amount of gain
under section 356 that is not treated as a dividend (see section
356(a)(2)). A similar rule applies to boot received by a QOF
shareholder in a qualifying section 355 transaction to which section
356(a) applies. If the taxpayer in a qualifying section 381 transaction
realizes a loss on the transaction, the amount that gives rise to the
inclusion event is an amount equal to the fair market value of the boot
received.
    However, if both the target QOF and the acquiring corporation are
wholly and directly owned by a single shareholder (or by members of the
same consolidated group), and if the shareholder receives (or the group
members receive) boot with respect to a qualifying investment, proposed
Sec.  1.1400Z2(b)-1(c)(8) (applicable to distributions by QOF
corporations) applies to the boot as if it were distributed in a
separate transaction to which section 301 applies.
    Similarly, the corporate distribution rules of proposed Sec.
1.1400Z2(b)-1(c)(8) would apply to a QOF shareholder's receipt of boot
in a qualifying section 355 transaction to which section 356(b)
applies. By its terms, section 356(b) states that the corporate
distribution rules of section 301 apply if a distributing corporation
distributes both stock of its controlled corporation and boot. As a
result, under these proposed regulations, there would be an inclusion
event to the extent section 301(c)(3) would apply to the distribution.
The Treasury Department and the IRS request comments on the proposed
treatment of the receipt of boot as an inclusion event.
    If the qualifying section 381 transaction is an intercompany
transaction, the rules in Sec.  1.1502-13(f)(3) regarding boot in a
reorganization apply to treat the boot as received in a separate
distribution. These rules do not apply in cases in which either party
to the distribution becomes a member or nonmember as part of the same
plan or arrangement. However, as noted in part VIII of this Explanation
of Provisions, a qualifying section 355 transaction cannot be an
intercompany transaction.
G. Distributions and Contributions
    Under the proposed regulations, and subject to certain exceptions,
distributions made with respect to qualifying QOF stock (including
redemptions of qualifying QOF stock that are treated as distributions
to which section 301 applies) and certain distributions with respect to
direct or indirect investments in a QOF partnership are treated as
inclusion events. In the case of a QOF corporation, an actual
distribution with respect to a qualifying investment results in
inclusion only to the extent it is treated as gain from a sale or
exchange under section 301(c)(3). A distribution to which section
301(c)(3) applies results in inclusion because that portion of the
distribution is treated as gain from the sale or exchange of property.
Actual distributions treated as dividends under section 301(c)(1) are
not inclusion events because such distributions neither reduce a QOF
shareholder's direct equity investment in the QOF nor constitute a
``cashing out'' of the QOF shareholder's equity investment in the QOF.
In turn, actual distributions to which section 301(c)(2) applies are
not inclusion events because the reduction of basis under that
statutory provision is not treated as gain from the sale or exchange of
property.
    For these purposes, a distribution of property also includes a
distribution of stock by a QOF that is treated as a distribution of
property to which section 301 applies under section 305(b). The
Treasury Department and the IRS have determined that this type of
distribution should be an inclusion event, even though it does not
reduce the recipient's interest in the QOF, because it results in an
increase in the basis of QOF stock. The Treasury Department and the IRS
request comments on the proposed treatment of distributions to which
section 305(b) applies.
    In the case of a redemption that is treated as a distribution to
which section 301 applies, the Treasury Department and the IRS have
determined that the full amount of the redemption generally should be
an inclusion event, regardless of whether a portion of the redemption
proceeds are characterized as a dividend under section 301(c)(1) or as
the recovery of basis under section 301(c)(2). Otherwise, such a
redemption could reduce a shareholder's direct equity investment
without triggering an inclusion event (if the full amount of the
redemption proceeds is characterized as either a dividend or as the
recovery of basis). However, there are circumstances in which the
shareholder's interest in the QOF is not reduced by a redemption (for
example, if the shareholder wholly owns the distributing corporation).
Thus, if a QOF redeems stock wholly and directly held by its sole QOF
shareholder (or by members of the same consolidated group), the
proposed regulations do not treat the redemption as an inclusion event
to the extent the proceeds are characterized as a dividend under
section 301(c)(1) or as a recovery of basis under section 301(c)(2).
The Treasury Department and the IRS request comments on the proposed
treatment of redemptions that are treated as distributions to which
section 301 applies.
    In the case of a QOF partnership, interests in which are directly
or indirectly held by one or more partnerships, a distribution by one
of the partnerships (including the QOF partnership) of property with a
value in excess of the basis of the distributee's partnership interest
is also an inclusion event. In the absence of this rule, a direct or
indirect partner in a QOF partnership could dilute the value of its
qualifying investment and thereby reduce the amount of deferred gain
that would be recognized in a subsequent transaction.
    The transfer by a QOF owner of its qualifying QOF stock or
qualifying QOF partnership interest in a section 351 exchange generally
would be an inclusion event under the proposed regulations, because the
contribution would reduce the QOF owner's direct interest in the QOF.
However, the contribution by a QOF shareholder of a portion (but not
all) of its qualifying QOF stock to the QOF itself in a section 351
exchange would not be so treated, as long as the contribution does not
reduce the taxpayer's equity interest in the qualifying investment (for
example, if the QOF shareholders made pro rata contributions of
qualifying QOF stock).
    The Treasury Department and the IRS request comments on the
proposed rules governing inclusion events, including whether additional
rules are needed to prevent abuse.
[[Page 18667]]
VIII. Consolidated Return Provisions
A. QOF Stock is Not Stock for Purposes of Affiliation
    The framework of section 1400Z-2 and the consolidated return
regulations are incompatible in many respects. If a QOF corporation
could be a subsidiary member of a consolidated group, extensive rules
altering the application of many consolidated return provisions would
be necessary to carry out simultaneously the policy objectives of
section 1400Z-2 and the consolidated return regulations. For example,
special rules would be required to take into account the interaction of
section 1400Z-2 with Sec. Sec.  1.1502-13 (relating to intercompany
transactions), 1.1502-32 (relating to the consolidated return
investment adjustment regime), and 1.1502-19 (relating to excess loss
accounts).
    Section 1400Z-2 is inconsistent with the intercompany transaction
regulations under Sec.  1.1502-13. The stated purpose of the
regulations under Sec.  1.1502-13 is to ensure that the existence of an
intercompany transaction (a transaction between two members of a
consolidated group) does not result in the creation, prevention,
acceleration, or deferral of consolidated taxable income or tax
liability. In other words, the existence of the intercompany
transaction must not affect the consolidated taxable income or tax
liability of the group as a whole. Therefore, Sec.  1.1502-13 generally
determines the tax treatment of items resulting from intercompany
transactions by treating members of the consolidated group as divisions
of a single corporation (single-entity treatment).
    The deferral of gain permitted under section 1400Z-2 would conflict
with the purposes of Sec.  1.1502-13 if the QOF shareholder and QOF
corporation were members of the same consolidated group. Under section
1400Z-2, a qualifying investment in a QOF results in the deferral of
the recognition of gain that would otherwise be recognized. However,
allowing a transfer by a member investor to a member QOF to result in
the deferral of gain recognition directly contradicts the express
purpose of the intercompany transaction regulations. Therefore,
consolidation of a QOF corporation with a corporation that otherwise
would be a QOF shareholder not only would violate a basic tenet of
single-entity treatment, but also would necessitate the creation of an
elaborate system of additional consolidated return rules to establish
the proper tax treatment of intercompany transactions involving a group
member that is a QOF (QOF member). For the same reasons, special rules
would be necessary to address the consequences under section 1400Z-2 of
distributions from QOF members to other group members. In addition,
special rules would be required to determine if and how Sec.  1.1502-13
would apply for purposes of testing whether a member of the group
(tested member) met the requirements of section 1400Z-2(d) to continue
to be treated as a QOF following an intercompany transaction. For
example, such rules would need to address whether satisfaction of the
requirements should be tested by taking into account not only property
held by the tested member, but also property held by other members that
have been counterparties in an intercompany transaction.
    Section 1400Z-2 is also inconsistent with the consolidated return
investment adjustment regime. Section 1.1502-32 requires unique
adjustments to the basis of member stock to reflect income, gain,
deduction, and loss items of group members. These rules apply only to
members of consolidated groups, and they cause stock basis in
subsidiary members of consolidated groups to be drastically different
from the stock basis that would exist outside of a group. These
investment adjustment rules would affect the timing and amount of
inclusion of the deferred capital gain under section 1400Z-2, because
the governing rules under section 1400Z-2 depend on the observance of
very particular stock basis adjustments. Therefore, significant
modifications to the application of the investment adjustment rules
under Sec.  1.1502-32 would be required to implement section 1400Z-2 if
the QOF shareholder and QOF corporation were members of the same group.
Further, the rules of Sec.  1.1502-32 are integral to the application
of the consolidated return system, and it would be virtually impossible
to accurately anticipate all of the instances in which the special
basis rules should be applied to the QOF member, as well as to any
includible corporations owned by the QOF member (such corporations also
would be included in the group).
    As a final example, special rules would also be needed to harmonize
the excess loss account (ELA) concept established by the rules in Sec.
1.1502-19 with the operation of section 1400Z-2. The consolidated
return regulations provide for downward stock basis adjustments that
take into account distributions by lower-tier members to higher-tier
members and the absorption of member losses by other members of the
group. As a result of these adjustments, a member of a group may have
negative basis (that is, an ELA) in its stock in another member. The
existence of negative stock basis is not contemplated under section
1400Z-2, and it is unique to the consolidated return regulations.
Harmonizing rules would be required to ensure the special QOF basis
election under section 1400Z-2(c) would not eliminate an ELA in the
stock of the QOF member and provide a benefit beyond what was intended
by section 1400Z-2. In other words, the basis adjustment under section
1400Z-2(c) should exclude from income no more than the appreciation in
the QOF investment.
    In summary, section 1400Z-2 and the consolidated return system are
based on incompatible principles and rules. To enable the two systems
to interact in a manner that effectuates the purposes of each,
complicated additional regulations would be required. However, it is
not possible to anticipate all possible points of conflict. Therefore,
rather than trying to forcibly harmonize the two frameworks, these
proposed regulations treat QOF stock as not stock for purposes of
section 1504, which sets forth the requirements for corporate
affiliation. Consequently, a QOF C corporation can be the common parent
of a consolidated group, but it cannot be a subsidiary member of a
consolidated group. In other words, a QOF C corporation owned by
members of a consolidated group is not a member of that consolidated
group. These proposed regulations treat QOF stock as not stock for the
broad purpose of section 1504 affiliation.
    The Treasury Department and the IRS request comments on whether
this rule should be limited to treat QOF stock as not stock only for
the purposes of consolidation, as well as whether the burden of
potentially applying two different sets of consolidated return rules
would be outweighed by benefits of permitting QOF C corporations to be
subsidiary members of consolidated groups.
B. Separate Entity Treatment for Members of a Consolidated Group
Qualifying for Deferral Under Section 1400Z-2
    The proposed regulations clarify that section 1400Z-2 applies
separately to each member of a consolidated group. Accordingly, to
qualify for gain deferral, the same member of the consolidated group
must: (i) Sell a capital asset to an unrelated person, the gain of
which the member elects to be deferred under section 1400Z-2; and (ii)
invest an amount of such deferred gain from the original sale into a
QOF.
[[Page 18668]]
C. Basis Increases in Qualifying Investment ``Tier Up'' the
Consolidated Group
    Sections 1400Z-2(b)(2)(B)(iii) and (iv) and 1400Z-2(c) provide
special basis adjustments applicable to qualifying investments held for
five years, seven years, and at least 10 years. If the QOF owner is a
member of a consolidated group, proposed Sec.  1.1400Z2(g)-1(c) would
treat these basis adjustments to the qualifying investment as meeting
the requirements of Sec.  1.1502-32(b)(3)(ii)(D), and thus as tax-
exempt income to the QOF owner. Consequently, upper-tier members that
own stock in the QOF owner would increase their basis in the stock of
the QOF owner by the amount of the resulting tax-exempt income. The
basis increase under section 1400Z-2(c) would be treated as tax-exempt
income only if the qualifying investment were sold or exchanged and the
QOF owner elected to apply the special rule in section 1400Z-2(c).
Treating these special basis adjustments under section 1400Z-2 as tax-
exempt income to the QOF owner is necessary to ensure that the amounts
at issue remain tax-free at all levels within the consolidated group.
For example, this treatment would prevent an unintended income
inclusion upon a member's sale of the QOF owner's stock.
D. The Attribute Reduction Rule in Sec.  1.1502-36(d)
    These proposed regulations clarify how a member's basis in a
qualifying investment is taken into account for purposes of applying
the attribute reduction rule in Sec.  1.1502-36(d). When a member (M)
transfers a loss share of subsidiary (S) stock, the rules in Sec.
1.1502-36 apply. If the transferred S share is a loss share after the
application of Sec.  1.1502-36(b) and (c), the attribute reduction rule
in Sec.  1.1502-36(d) applies to prevent duplication of a single
economic loss. In simple terms, Sec.  1.1502-36(d) compares M's basis
in the loss S share to the amount of S's tax attributes that are
allocable to the loss share. If loss duplication exists on the transfer
of the S share (as determined under the mechanics of Sec.  1.1502-
36(d)), S must reduce its tax attributes by its attribute reduction
amount (ARA). In certain cases, M instead may elect to reduce its basis
in the loss S share. To ensure that the purposes of both section 1400Z-
2 and Sec.  1.1502-36(d) are effectuated, the proposed regulations
provide special rules regarding the application of Sec.  1.1502-36(d)
when S owns a qualifying investment.
    In applying the anti-loss duplication rule discussed in the
preceding paragraph, S includes its basis in a qualifying investment in
determining whether there is loss duplication and, if so, the amount of
the duplicated loss. However, if loss duplication exists, S cannot cure
the loss duplication by reducing its basis in the qualifying investment
under Sec.  1.1502-36(d). Because of the special QOF basis election
available under section 1400Z-2(c), reducing S's basis in the
qualifying investment would not achieve the anti-loss duplication
purpose of Sec.  1.1502-36(d) if the special QOF basis election were
made at a later date. This is because any basis reduced under Sec.
1.1502-36(d) would be restored on the sale of the qualifying
investment. Therefore, S must reduce its other attributes. If S's
attribute reduction amount exceeds S's attributes available for
reduction, then the parent of the group is deemed to elect under Sec.
1.1502-36(d)(6) to reduce M's basis in S to the extent of S's basis in
the qualifying investment. The reduction of M's basis in S is limited
to the remaining ARA.
IX. Holding Periods and Other Tacking Rules
    Under section 1400Z-2(b)(2)(B) and (c), increases in basis in a
qualifying investment held by an investor in a QOF are, in part,
dependent upon the QOF investor's holding period for that qualifying
investment. The proposed regulations generally provide that, for
purposes of section 1400Z-2(b)(2)(B) and (c), a QOF investor's holding
period for its qualifying investment does not include the period during
which the QOF investor held property that was transferred to the QOF in
exchange for the qualifying investment. For example, if an investor
transfers a building that it has owned for 10 years to a QOF
corporation in exchange for qualifying QOF stock, the investor's
holding period for the qualifying QOF stock for purposes of section
1400Z-2 begins on the date of the transfer, not the date the investor
acquired the building.
    Similarly, if an investor disposes of its entire qualifying
investment in QOF 1 and reinvests in QOF 2 within 180 days, the
investor's holding period for its qualifying investment in QOF 2 begins
on the date of its qualifying investment in QOF 2, not on the date of
its qualifying investment in QOF 1.
    However, a QOF shareholder's holding period for qualifying QOF
stock received in a qualifying section 381 transaction in which the
acquiring corporation is a QOF immediately thereafter, or received in a
recapitalization of a QOF, includes the holding period of the QOF
shareholder's qualifying QOF stock exchanged therefor. Similar rules
apply to QOF stock received in a qualifying section 355 transaction.
The Treasury Department and the IRS have determined that, in these
situations, a QOF shareholder should be permitted to tack its holding
period for its initial qualifying investment because the investor's
direct equity investment in a QOF continues. In the case of a
qualifying section 381 transaction in which the acquiring corporation
is a QOF immediately thereafter, the investor's continuing direct
equity investment in a QOF is further reflected in the investor's
exchanged basis in the stock of the acquiring corporation. Tacked
holding period rules apply in the same manner with respect to a QOF
partner's interest in a QOF partnership, for example, in the case of a
partnership merger where the QOF partner's resulting investment in the
QOF partnership continues. Finally, the recipient of a qualifying
investment by gift that is not an inclusion event, or by reason of the
death of the owner, may tack the donor's or decedent's holding period,
respectively.
    Similar rules apply for purposes of determining whether the
``original use'' requirement in section 1400Z-2(d)(2)(D) commences with
the acquiring corporation (after a qualifying section 381 transaction
in which the acquiring corporation is a QOF immediately thereafter) or
the controlled corporation (after a qualifying section 355
transaction). In each case, the acquiring corporation or the controlled
corporation satisfies the original use requirement if the target
corporation or the distributing corporation, respectively, did so
before the transaction. Thus, the acquiring corporation and the
controlled corporation may continue to treat the historic qualified
opportunity zone business property received from the target corporation
and the distributing corporation, respectively, as qualified
opportunity zone business property.
X. General Anti-Abuse Rule
    Proposed Sec.  1.1400Z2(f)-1(c) provides a general anti-abuse rule
pursuant to section 1400Z-2(e)(4)(C), which provides that ``the
Secretary shall prescribe such regulations as may be necessary or
appropriate to carry out the purposes of this section, including * * *
rules to prevent abuse.'' The Treasury Department and the IRS expect
that most taxpayers will apply the rules in section 1400Z-2 and
Sec. Sec.  1.1400Z2(a)-1 through 1.1400Z2(g)-1 in a manner consistent
with the purposes of section 1400Z-2. However, to prevent abuse,
[[Page 18669]]
proposed Sec.  1.1400Z2(f)-1(c) provides that if a significant purpose
of a transaction is to achieve a tax result that is inconsistent with
the purposes of section 1400Z-2, the Commissioner can recast a
transaction (or series of transactions) for Federal tax purposes as
appropriate to achieve tax results that are consistent with the
purposes of section 1400Z-2. Whether a tax result is inconsistent with
the purposes of section 1400Z-2 must be determined based on all the
facts and circumstances. For example, this general anti-abuse rule
could apply to a treat a purchase of agricultural land that otherwise
would be qualified opportunity zone business property as a purchase of
non-qualified opportunity zone business property if a significant
purpose for that purchase were to achieve a tax result inconsistent
with the purposes of section 1400Z-2 (see part I.B of this Explanation
of Provisions).
    The Treasury Department and the IRS request comments on this
proposed anti-abuse rule, including whether additional details
regarding what tax results are inconsistent with the purposes of
section 1400Z-2 is required or whether examples of particular types of
abusive transactions would be helpful.
XI. Entities Organized Under a Statute of a Federally Recognized Indian
Tribe and Issues Particular to Tribally Leased Property
    Commenters have asked whether Indian tribal governments, like state
and territorial governments, can charter a partnership or corporation
that is eligible to be a QOF. Proposed Sec.  1.1400Z2(d)-1(e)(1)
provides that, if an entity is not organized in one of the 50 states,
the District of Columbia, or the U.S. possessions, it is ineligible to
be a QOF. Similarly, proposed Sec.  1.1400Z2(d)-1(e)(2) provides that,
if an entity is not organized in one of the 50 states, the District of
Columbia, or the U.S. possessions, an equity interest in the entity is
neither qualified opportunity zone stock nor a qualified opportunity
zone partnership interest. The Treasury Department and the IRS have
determined that, for purposes of both proposed Sec.  1.1400Z2(d)-
1(e)(1) and (2), an entity ``organized in'' one of the 50 states
includes an entity organized under the law of a Federally recognized
Indian tribe if the entity's domicile is located in one of the 50
states. Such entity satisfies the requirement in section 1400Z-
2(d)(2)(B)(i) and (C) that qualified opportunity zone stock is stock in
a domestic corporation and a qualified opportunity zone partnership
interest is an interest in a domestic partnership. See section
7701(a)(4). The Treasury Department and the IRS, while acknowledging
the sovereignty of federally recognized Indian tribes, note that an
entity that is eligible to be a QOF will be subject to Federal income
tax under the Code, regardless of the laws under which it is
established or organized.
    Commenters also noted that Indian tribal governments occupy Federal
trust lands, and that these lands are often leased for economic
development purposes. According to these commenters, the right to use
Indian tribal government reservation land managed by the Secretary of
the Interior can raise unique issues with respect to lease valuations.
As discussed in part II of this Explanation of Provisions, these
proposed regulations address the treatment of leased tangible property
in general.
    In order to obtain tribal input in accordance with Executive Order
13175, ``Consultation and Coordination with Indian Tribal
Governments,'' and consistent with Treasury's Tribal Consultation
Policy (80 FR 57434, September 23, 2015), the Treasury Department and
the IRS will schedule Tribal Consultation with Tribal Officials before
finalizing these regulations to obtain additional input, within the
meaning of the Tribal Consultation Policy, on QOF entities organized
under the law of a Federally recognized Indian tribe and whether any
additional guidance may be needed regarding QOFs leasing tribal
government Federal trust lands or regarding leased real property
located on such lands, as well as other Tribal implications of the
proposed regulations. Such Tribal Consultation will also seek input on
questions regarding the tax status of certain tribally chartered
corporations other than QOFs.
Proposed Effective/Applicability Dates
    Section 7805(b)(1)(A) and (B) of the Code generally provides that
no temporary, proposed, or final regulation relating to the internal
revenue laws may apply to any taxable period ending before the earliest
of (A) The date on which such regulation is filed with the Federal
Register; or (B) in the case of a final regulation, the date on which a
proposed or temporary regulation to which the final regulation relates
was filed with the Federal Register. However, section 7805(b)(2)
provides that regulations filed or issued within 18 months of the date
of the enactment of the statutory provision to which they relate are
not prohibited from applying to taxable periods prior to those
described in section 7805(b)(1). Furthermore, section 7805(b)(3)
provides that the Secretary may provide that any regulation may take
effect or apply retroactively to prevent abuse.
    Consistent with authority provided by section 7805(b)(1)(A), the
rules of proposed Sec. Sec.  1.1400Z2(a)-1, 1.1400Z2(b)-1, 1.1400Z2(c)-
1, 1.1400Z2(d)-1, 1.1400Z2(e)-1, 1.1400Z2(f)-1, and 1.1400Z2(g)-1
generally apply to taxable years ending after May 1, 2019. However,
taxpayers may generally rely on the rules of proposed Sec. Sec.
1.1400Z2(a)-1, 1.1400Z2(b)-1, 1.1400Z2(d)-1, 1.1400Z2(e)-1,
1.1400Z2(f)-1, and 1.1400Z2(g)-1 set forth in this notice of proposed
rulemaking for periods prior to the finalization of those sections if
they apply these proposed rules consistently and in their entirety.
This pre-finalization reliance does not apply to the rules of proposed
Sec.  1.1400Z2(c)-1 set forth in this notice of proposed rulemaking as
these rules do not apply until January 1, 2028.
Special Analyses
I. Regulatory Planning and Review
    Executive Orders 13771, 13563, and 12866 direct agencies to assess
the costs and benefits of available regulatory alternatives and, if
regulation is necessary, to select regulatory approaches that maximize
net benefits (including potential economic, environmental, public
health and safety effects, distributive impacts, and equity). Executive
Order 13563 emphasizes the importance of quantifying both costs and
benefits, reducing costs, harmonizing rules, and promoting flexibility.
    These proposed regulations have been designated by the Office of
Management and Budget's Office of Information and Regulatory Affairs
(OIRA) as economically significant under Executive Order 12866 pursuant
to the Memorandum of Agreement (April 11, 2018) between the Treasury
Department and the Office of Management and Budget regarding the review
of tax regulations. Accordingly, the proposed regulations have been
reviewed by the Office of Management and Budget. In addition, the
Treasury Department and the IRS expect the proposed regulations, when
final, to be an Executive Order 13771 deregulatory action and request
comment on this designation.
A. Background and Overview
    Congress enacted section 1400Z-2, in conjunction with section
1400Z-1, as a temporary provision to encourage private sector
investment in certain
[[Page 18670]]
lower-income communities designated as qualified opportunity zones (see
Senate Committee on Finance, Explanation of the Bill, at 313 (November
22, 2017)). Taxpayers may elect to defer the recognition of capital
gain to the extent of amounts invested in a QOF, provided that such
amounts are invested during the 180-day period beginning on the date
such capital gain would have been recognized by the taxpayer. Inclusion
of the deferred capital gain in income occurs on the date the
investment in the QOF is sold or exchanged or on December 31, 2026,
whichever comes first. For investments in a QOF held longer than five
years, taxpayers may exclude 10 percent of the deferred gain from
inclusion in income, and for investments held longer than seven years,
taxpayers may exclude a total of 15 percent of the deferred gain from
inclusion in income. In addition, for investments held longer than 10
years, the post-acquisition gain on the qualifying investment in the
QOF also may be excluded from income through a step-up in basis in the
qualifying investment. In turn, a QOF must hold at least 90 percent of
its assets in qualified opportunity zone property, as measured by the
average percentage of assets held on the last day of the first 6-month
period of the taxable year of the fund and on the last day of the
taxable year. The statute requires a QOF that fails this 90-percent
test to pay a penalty for each month it fails to satisfy this
requirement.
    The proposed regulations clarify several terms used in the statute,
such as what constitutes ``substantially all'' in each of the different
places that phrase is used in section 1400Z-2, the use of qualified
opportunity zone business property (including leased property) in a
qualified opportunity zone, the sourcing of income to a qualified
opportunity zone business, the ``reasonable period'' for a QOF to
reinvest proceeds from the sale of qualifying assets without paying a
penalty, and what transactions comprise an inclusion event that would
lead to the inclusion of deferred gain in gross income. In part, the
proposed regulations amend portions of previously proposed regulations
related to section 1400Z-2.
B. Need for the Proposed Regulations
    The Treasury Department and the IRS are aware of concerns raised by
commenters that investors have been reticent to make substantial
investments in QOFs without first having additional clarity on which
investments in a QOF would qualify to receive the preferential tax
treatment specified by the TCJA. This uncertainty could reduce the
amount of investment flowing into lower-income communities designated
as qualified opportunity zones. The lack of additional clarity could
also lead to different taxpayers interpreting, and therefore applying,
the same statute differently, which could distort the allocation of
investment across the qualified opportunity zones.
C. Economic Analysis
1. Baseline
    The Treasury Department and the IRS have assessed the benefits and
costs of the proposed regulations relative to a no-action baseline
reflecting anticipated Federal income tax-related behavior in the
absence of these proposed regulations.
2. Economic Effects of the Proposed Regulation
a. Summary of Economic Effects
    The proposed regulations provide certainty and clarity to taxpayers
regarding utilization of the tax preference for capital gains provided
in section 1400Z-2 by defining terms, calculations, and acceptable
forms of documentation. The Treasury Department and the IRS project
that this added clarity generally will encourage taxpayers to invest in
QOFs and will increase the amount of investment located in qualified
opportunity zones. The Treasury Department and the IRS have not made
quantitative estimates of these effects.
    The benefits and costs of major, specific provisions of these
proposed regulations relative to the no-action baseline and
alternatives to these proposed rules considered by the Treasury
Department and the IRS are discussed in further detail below.
b. Qualified Opportunity Zone Business Property and Definition of
Substantially All
    The proposed regulations establish the threshold for satisfying the
substantially all requirements for four out of the five uses of the
term in section 1400Z-2. The other substantially all test in section
1400Z-2(d)(3)(A)(i) already had been set at 70 percent by prior
proposed regulations (83 FR 54279, October 29, 2018). The proposed
regulations provide that the term substantially all means at least 90
percent with regard to the three holding period requirements in section
1400Z-2(d)(2). The other substantially all term in section 1400Z-
2(d)(2)(D)(i)(III) in the context of ``use'' is set to 70 percent, the
same as the threshold established under the prior proposed rulemaking.
The clarity provided in the proposed regulations reduces uncertainty
for prospective investors regarding which investments would satisfy the
requirements of section 1400Z-2. This clarity likely would lead to a
greater level of investment in QOFs.
    In choosing what values to assign to the substantially all terms,
the Treasury Department and the IRS considered the costs and benefits
of setting the threshold higher or lower. Setting the threshold higher
would limit the type of businesses and investments that would be able
to meet the proposed requirements and possibly distort the industry
concentration within some opportunity zones. Setting the threshold
lower would allow investors in certain QOFs to receive capital gains
tax relief while placing a relatively small portion of its investment
within a qualified opportunity zone. A lower threshold would increase
the likelihood that a taxpayer may receive the benefit of the
preferential treatment on capital gains without placing in service more
tangible property within a qualified opportunity zone than would have
occurred in the absence of section 1400Z-2. This latter concern is
magnified by the way the different requirements in section 1400Z-2
interact.
    For example, these regulations imply that a QOF could satisfy the
substantially all standards with as little as 40 percent of the
tangible property effectively owned by the fund being used within a
qualified opportunity zone. This could occur if 90 percent of QOF
assets are invested in a qualified opportunity zone business, in which
70 percent of the tangible assets of that business are qualified
opportunity zone business property; and if, in addition, the qualified
opportunity zone business property is only 70 percent in use within a
qualified opportunity zone, and for 90 percent of the holding period
for such property. Multiplying these shares together (0.9 x 0.7 x 0.7 x
0.9 = 0.4) generates the result that a QOF could satisfy the
requirements of section 1400Z-2 under the proposed regulations with
just 40 percent of its assets effectively in use within a qualified
opportunity zone.
    The Treasury Department and the IRS recognize that the operations
of certain types of businesses may extend beyond the Census tract
boundaries that define qualified opportunity zones. The substantially
all thresholds provided in the proposed regulations are set at levels
so as to limit the ability of investors in QOFs to receive preferential
capital gains treatment, unless a consequential amount of tangible
property used in the underlying business is located within a
[[Page 18671]]
qualified opportunity zone, while also allowing flexibility to business
operations so as not to significantly distort the types of businesses
that can qualify for opportunity zone funds.
c. Valuation of Leased Property
    The proposed regulations provide two methods for determining the
asset values for purposes of the 90-percent asset test in section
1400Z-2(d)(1) for QOFs or the value of tangible property for the
substantially all test in section 1400Z-2(d)(3)(A)(i) for qualified
opportunity zone businesses. Under the first method, a taxpayer may
value owned or leased property as reported on its applicable financial
statement for the reporting period. Alternatively, the taxpayer may set
the value of owned property equal to the unadjusted cost basis of the
property under section 1012. The value of leased property under the
alternative method equals the present value of total lease payments at
the beginning of the lease. The value of the property under the
alternative method for the 90-percent asset test and substantially all
test does not change over time as long as the taxpayer continues to own
or lease the property.
    The two methods should provide similar values for leased property
at the time that the lease begins, as beginning in 2019, generally
accepted accounting principles (GAAP) require public companies to
calculate the present value of lease payments in order to recognize the
value of leased assets on the balance sheet. However, there are
differences. On financial statements, the value of the leased property
declines over the term of the lease. Under the alternative method, the
value of the leased asset is calculated once at the beginning of the
lease term and remains constant while the term of the lease is still in
effect. This difference in valuation of property over time between
using financial statements and the alternative method also exist in the
case of owned property. In addition, the two approaches would generally
apply different discount rates, thus leading to some difference in the
calculated present value under the two methods.
    The Treasury Department and the IRS provide the alternative method
to allow for taxpayers that either do not have applicable financial
statements or do not have them available in time for the asset test. In
addition, the alternative method is simpler, thus reducing compliance
costs, and would provide greater certainty in projecting future
compliance with the 90-percent asset and substantially all tests. Thus,
some taxpayers with applicable financial statements may elect to use
the alternative method. The drawback to the alternative method is that
it does not account for depreciation, and, over time, the values used
for the sake of the 90-percent asset test and the substantially all
test may diverge from the actual value of the property.
    The Treasury Department and the IRS have determined that the value
of leased property should be included in both the numerator and the
denominator of the 90-percent asset test and the substantially all
test, as this would be less distortive to business decisions compared
to other available options. Leasing is a common business practice, and
treating leased property differently than owned property could lead to
economic distortions. If the value of leased property were not included
in the tests at all, then it would be relatively easy for taxpayers to
choose where to locate owned and leased property so as to technically
meet the standards of the test, while maintaining substantial business
operations outside of a qualified opportunity zone.
    The Treasury Department and the IRS considered a third option for
how leased property should be included in the 90-percent asset and
substantially all tests. Under this option, leased property of the
taxpayer would be included only in the denominator of the fraction. The
reason for this is that leased property generally would not satisfy the
purchase and original use requirements of section 1400Z-2(d)(2)(D)(i)
and thus would not be deemed as qualified opportunity zone business
property. However, not allowing leased property located within a
qualified opportunity zone to be treated as qualified opportunity zone
business property could distort business decisions of taxpayers and
also could make it difficult for some businesses to satisfy the
substantially all test in section 1400Z-2(d)(3)(A)(i), despite bringing
new economic activity to a qualified opportunity zone.
    For example, a start-up business that rented office space within a
qualified opportunity zone and owned tangible property in the form of
computers and other office equipment likely would fail the
substantially all test if leased property only were included in the
denominator of the substantially all fraction, despite all of its
operations being located within a qualified opportunity zone. This may
lead businesses to take on extra debt in order to purchase property
located within a qualified opportunity zone, thus increasing the risk
of financial distress, including bankruptcy.
    One potential disadvantage of including leased property in both the
numerator and denominator of the substantially all test is that it may
weaken the incentive to construct new real property or renovate
existing real property within a qualified opportunity zone, as
taxpayers would be able to lease existing real property in a zone
without improving it and become a qualified opportunity zone business.
However, allowing the leasing of existing real property within a zone
may encourage fuller utilization and improvement of such property and
limit the abandonment or destruction of existing productive property
within a qualified opportunity zone when new tax-favored real property
becomes available.
    Hence, including leased property in both the numerator and the
denominator of the 90-percent asset test and substantially all test
encourages economic activity within qualified opportunity zones while
reducing the potential distortions between owned and leased property
that may occur under other options.
d. Qualified Opportunity Zone Business
    Section 1400Z-2(d)(3)(A)(ii) incorporates the requirement of
section 1397C(b)(2) that a qualified business entity must derive at
least 50 percent of its total gross income during a taxable year from
the active conduct of a qualified business in a zone. The proposed
regulations provide multiple safe harbors for determining whether this
standard has been satisfied.
    Two of these safe harbors provide different methods for measuring
the labor input of the entity. The labor input can be measured in terms
of hours or compensation paid. The proposed regulations provide that if
at least 50 percent of the labor input of the entity is located within
a zone (as measured by one of the two provided approaches), then the
section 1397C(b)(2) requirement is satisfied.
    In addition, a third safe harbor provides that the 50 percent gross
income requirement is met if the tangible property of the trade or
business located in a qualified opportunity zone and the management or
operational functions performed in the qualified opportunity zone are
each necessary for the generation of at least 50 percent of the gross
income of the trade or business.
    The determination of the location of income for businesses that
operate in multiple jurisdictions can be complex, and the rules
promulgated by taxing authorities to determine the location of income
are often burdensome and may distort economic activity. The provision
of alternative safe harbors in these proposed regulations should reduce
the
[[Page 18672]]
compliance and administrative burdens associated with determining
whether this statutory requirement has been met. In the absence of such
safe harbors, some taxpayers may interpret the 50 percent of gross
income standard to require that a majority of the sales of the entity
must be located within a zone. The Treasury Department and the IRS have
determined that a standard based strictly on sales would discriminate
against some types of businesses (for example, manufacturing) in which
the location of sales is often different from the location of the
production, and thus would preclude such businesses from benefitting
from the incentives provided in section 1400Z-2. Furthermore, the
potential distortions introduced by the provided safe harbors would
increase incentives to locate labor inputs within a qualified
opportunity zone. To the extent that such distortions exist, they
further the statutory goal of encouraging economic activity within
qualified opportunity zones. Given the flexibility provided to
taxpayers in choosing a safe harbor, other distortions, such as to
business organizational structuring, are likely to be minimal.
e. QOF Reinvestment Rule
    The proposed regulations provide that a QOF has 12 months from the
time of the sale or disposition of qualified opportunity zone property
or the return of capital from investments in qualified opportunity zone
stock or qualified opportunity zone partnership interests to reinvest
the proceeds in other qualified opportunity zone property before the
proceeds would not be considered qualified opportunity zone property
with regards to the 90-percent asset test. This proposed rule provides
clarity and gives substantial flexibility to taxpayers in satisfying
the 90-percent asset test, which should encourage greater investment
within QOFs compared to the baseline.
f. Other Topics
    The proposed regulations clarify several other areas where there is
uncertainty in how to apply the statute in practice. For example, the
proposed regulations clarify what events cause the inclusion of
deferred gain, that a QOF may not be a subsidiary member of a
consolidated group, and how to determine the length of holding periods
in a qualifying investment. These proposed regulations provide greater
certainty to taxpayers regarding how to structure investments so as to
comply with the statutory requirements of the opportunity zone
incentive. This should reduce administration and compliance costs and
encourage greater investment in QOFs.
D. Paperwork Reduction Act
    The proposed regulation establishes a new collection of information
in Sec.  1.1400Z2(b)-1(h). In proposed Sec.  1.1400Z2(b)-1(h)(1), the
collection of information requires (i) a partnership that makes a
deferral election to notify all of its partners of the deferral
election, and (ii) a partner that makes a deferral election to notify
the partnership in writing of its deferral election, including the
amount of the eligible gain deferred. Similar requirements are set
forth in proposed Sec.  1.1400Z2(b)-1(h)(4) regarding S corporations
and S corporation shareholders. The collection of information in
proposed Sec.  1.1400Z2(b)-1(h)(2) requires direct and indirect owners
of a QOF partnership to provide the QOF partnership with a written
statement containing information requested by the QOF partnership that
is necessary to determine the direct and indirect owners' shares of
deferred gain. Lastly, the collection of information in proposed Sec.
1.1400Z2(b)-1(h)(3) requires a QOF partner to notify the QOF
partnership of an election under section 1400Z-2(c) to adjust the basis
of the qualifying QOF partnership interest that is disposed of in a
taxable transaction. Similar requirements again are set forth in
proposed Sec.  1.1400Z2(b)-1(h)(4) regarding QOF S corporations and QOF
S corporation shareholders. The collection of information contained in
this proposed regulation will not be conducted using a new or existing
IRS form.
    The likely respondents are partnerships and partners, and S
corporations and S corporation shareholders.
    Estimated total annual reporting burden: 8,500 hours.
    Estimated average annual burden per respondent: 1 hour.
    Estimated number of respondents: 8,500.
    Estimated frequency of responses: 8,500.
    The collections of information contained in this notice of proposed
rulemaking will be submitted to the Office of Management and Budget in
accordance with the Paperwork Reduction Act of 1995 (44 U.S.C.
3507(d)). Comments on the collection of information should be sent to
the Office of Management and Budget, Attn: Desk Officer for the
Department of the Treasury, Office of Information and Regulatory
Affairs, Washington, DC 20503, with copies to the Internal Revenue
Service, Attn: IRS Reports Clearance Officer, SE:W:CAR:MP:T:T:SP,
Washington, DC 20224. Comments on the collection of information should
be received by July 1, 2019. Comments are specifically requested
concerning:
    Whether the proposed collection of information is necessary for the
proper performance of the functions of the IRS, including whether the
information will have practical utility;
    The accuracy of the estimated burden associated with the proposed
collection of information;
    How the quality, utility, and clarity of the information to be
collected may be enhanced;
    How the burden of complying with the proposed collection of
information may be minimized, including through the application of
automated collection techniques or other forms of information
technology; and
    Estimates of capital or start-up costs and costs of operation,
maintenance, and purchase of services to provide information.
    An agency may not conduct or sponsor, and a person is not required
to respond to, a collection of information unless it displays a valid
control number assigned by the Office of Management and Budget.
II. Regulatory Flexibility Act
    Under the Regulatory Flexibility Act (RFA) (5 U.S.C. chapter 6), it
is hereby certified that these proposed regulations, if adopted, would
not have a significant economic impact on a substantial number of small
entities that are directly affected by the proposed regulations.
    As discussed elsewhere in this preamble, the proposed regulations
would provide certainty and clarity to taxpayers regarding utilization
of the tax preference for capital gains provided in section 1400Z-2 by
defining terms, calculations, and acceptable forms of documentation.
The Treasury Department and the IRS anticipate that this added clarity
generally will encourage taxpayers to invest in QOFs and will increase
the amount of investment located in qualified opportunity zones.
Investment in QOFs is entirely voluntary, and the certainty that would
be provided in the proposed regulations is anticipated to minimize any
compliance or administrative costs, such as the estimated average
annual burden (1 hour) under the Paperwork Reduction Act. For example,
the proposed regulations provide multiple safe harbors for purpose of
determining whether the 50-percent gross income test has been met as
required by section
[[Page 18673]]
1400Z-2(d)(3)(A)(ii) for a qualified opportunity zone business.
    Taxpayers affected by these proposed regulations include QOFs,
investors in QOFs, and qualified opportunity zone businesses in which a
QOF holds an ownership interest. The proposed regulations will not
directly affect the taxable incomes and liabilities of qualified
opportunity zone businesses; they will affect only the taxable incomes
and tax liabilities of QOFs (and owners of QOFs) that invest in such
businesses. Although there is a lack of available data regarding the
extent to which small entities invest in QOFs, will certify as QOFs, or
receive equity investments from QOFs, the Treasury Department and the
IRS project that most of the investment flowing into QOFs will come
from large corporations and wealthy individuals, though some of these
funds would likely flow through an intermediary investment partnership.
It is expected that some QOFs and qualified opportunity zone businesses
would be classified as small entities; however, the number of small
entities significantly affected is not likely to be substantial.
    Accordingly, it is hereby certified that this rule would not have a
significant economic impact on a substantial number of small entities.
The Treasury Department and the IRS specifically invite comments from
any party, particularly affected small entities, on the accuracy of
this certification.
    Pursuant to section 7805(f), this notice of proposed rulemaking has
been submitted to the Chief Counsel for Advocacy of the Small Business
Administration for comment on its impact on small business.
III. Unfunded Mandates Reform Act
    Section 202 of the Unfunded Mandates Reform Act of 1995 (UMRA)
requires that agencies assess anticipated costs and benefits and take
certain other actions before issuing a final rule that includes any
Federal mandate that may result in expenditures in any one year by a
state, local, or tribal government, in the aggregate, or by the private
sector, of $100 million in 1995 dollars, updated annually for
inflation. In 2018, that threshold is approximately $150 million. This
rule does not include any Federal mandate that may result in
expenditures by state, local, or tribal governments, or by the private
sector in excess of that threshold.
IV. Executive Order 13132: Federalism
    Executive Order 13132 (entitled ``Federalism'') prohibits an agency
from publishing any rule that has federalism implications if the rule
either imposes substantial, direct compliance costs on state and local
governments, and is not required by statute, or preempts state law,
unless the agency meets the consultation and funding requirements of
section 6 of the Executive Order. This proposed rule does not have
federalism implications and does not impose substantial direct
compliance costs on state and local governments or preempt state law
within the meaning of the Executive Order.
Statement of Availability of IRS Documents
    IRS Revenue Procedures, Revenue Rulings, and Notices cited in this
preamble are published in the Internal Revenue Bulletin (or Cumulative
Bulletin) and are available from the Superintendent of Documents, U.S.
Government Publishing Office, Washington, DC 20402, or by visiting the
IRS website at http://www.irs.gov.
Comments
    Before these proposed regulations are adopted as final regulations,
consideration will be given to any electronic and written comments that
are submitted timely to the IRS as prescribed in this preamble under
the ADDRESSES heading. The Treasury Department and the IRS request
comments on all aspects of the proposed rules. All comments will be
available at http://www.regulations.gov or upon request.
Drafting Information
    The principal authors of these proposed regulations are Erika C.
Reigle and Kyle Griffin, Office of the Associate Chief Counsel (Income
Tax & Accounting); Jeremy Aron-Dine and Sarah Hoyt, Office of the
Associate Chief Counsel (Corporate); and Marla Borkson and Sonia
Kothari, Office of the Associate Chief Counsel (Passthroughs and
Special Industries). Other personnel from the Treasury Department and
the IRS participated in their development.
List of Subjects in 26 CFR Part 1
    Income Taxes, Reporting and recordkeeping requirements.
Partial Withdrawal of a Notice of Proposed Rulemaking
    Accordingly, under the authority of 26 U.S.C. 1400Z-2(e)(4) and
7805, Sec.  1.1400Z2(d)-1(c)(4)(i), (c)(5), (6), and (7), (d)(2)(i)(A),
(d)(2)(ii) and (iii), (d)(5)(i), and (d)(5)(ii)(B) of the notice of
proposed rulemaking (REG-115420-18) published in the Federal Register
on October 29, 2018 (83 FR 54279) are withdrawn.
Proposed Amendments to the Regulations
    Accordingly, 26 CFR part 1 is proposed to be amended as follows:
PART 1--INCOME TAX
0
Paragraph 1. The authority citation for part 1 is amended by adding
entries in numerical order for Sec. Sec.  1.1400Z2(a)-1, 1.1400Z2(b)-1,
1.1400Z2(c)-1, 1.1400Z2(d)-1, 1.1400Z2(f)-1, 1.1400Z2(g)-1(a), (c),
(d), (e), (f), and (g)(1), 1.1400Z2(g)-1(b) and (g)(2), and
1.1400Z2(g)-1(b) and (g)(2) to read in part as follows:
    Authority:  26 U.S.C. 7805***
    Section 1.1400Z2(a)-1 also issued under 26 U.S.C. 1400Z-2(e)(4).
    Section 1.1400Z2(b)-1 also issued under 26 U.S.C. 1400Z-2(e)(4).
    Section 1.1400Z2(c)-1 also issued under 26 U.S.C. 1400Z-2(e)(4)
and 857(g)(2).
    Section 1.1400Z2(d)-1 also issued under 26 U.S.C. 1400Z-2(e)(4).
    Section 1.1400Z2(f)-1 also issued under 26 U.S.C. 1400Z-2(e)(4).
    Section 1.1400Z2(g)-1(a), (c), (d), (e), (f), and (g)(1) also
issued under 26 U.S.C. 1400Z-2(e)(4) and 1502.
    Section 1.1400Z2(g)-1(b) and (g)(2) also issued under 26 U.S.C.
1400Z-2(e)(4) and 1504(a)(5).
0
Par. 2. Section 1.1400Z2(a)-1, as proposed to be added by 83 FR 54279,
October 29, 2018 is amended by:
0
1. Redesignating (b)(2)(iii) and (iv) as paragraphs (b)(2)(v) and (vi),
respectively.
0
2. Adding new paragraphs (b)(2)(iii) and (iv) and paragraphs (b)(9) and
(10).
    The revisions and additions read as follows:
Sec.  1.1400Z2(a)-1   Deferring tax on capital gains by investing in
opportunity zones.
* * * * *
    (b) * * *
    (2) * * *
    (iii) Gains from section 1231 property. The only gain arising from
section 1231 property that is eligible for deferral under section
1400Z-2(a)(1) is capital gain net income for a taxable year. This net
amount is determined by taking into account the capital gains and
losses for a taxable year on all of the taxpayer's section 1231
property. The 180-day period described in paragraph (b)(4) of this
section with respect to any capital gain net income from section 1231
property for a taxable year begins on the last day of the taxable year.
    (iv) No deferral for gain realized upon the acquisition of an
eligible interest. Gain is not eligible for deferral under section
1400Z-2(a)(1) if such gain is realized upon the sale or other transfer
of property to a QOF in exchange for an eligible interest (see
paragraph
[[Page 18674]]
(b)(10)(i)(C) of this section) or the transfer of property to an
eligible taxpayer in exchange for an eligible interest (see paragraph
(b)(10)(iii) of this section).
* * * * *
    (9) Making an investment for purposes of an election under section
1400Z-2(a)--(i) Transfer of cash or other property to a QOF. A taxpayer
makes an investment for purposes of an election under section 1400Z-
2(a)(1)(A) (section 1400Z-2(a)(1)(A) investment) by transferring cash
or other property to a QOF in exchange for eligible interests in the
QOF, regardless of whether the transfer is one in which the transferor
would recognize gain or loss on the property transferred.
    (ii) Furnishing services. Services rendered to a QOF are not
considered the making of a section 1400Z-2(a)(1)(A) investment. Thus,
if a taxpayer receives an eligible interest in a QOF for services
rendered to the QOF or to a person in which the QOF holds any direct or
indirect equity interest, then the interest in the QOF that the
taxpayer receives is not a section 1400Z-2(a)(1)(A) investment but is
an investment to which section 1400Z-2(e)(1)(A)(ii) applies.
    (iii) Acquisition of eligible interest from person other than QOF.
A taxpayer may make a section 1400Z-2(a)(1)(A) investment by acquiring
an eligible interest in a QOF from a person other than the QOF.
    (10) Amount invested for purposes of section 1400Z-2(a)(1)(A). In
the case of any investments described in this paragraph (b)(10), the
amount of a taxpayer's section 1400Z-2(a)(1)(A) investment cannot
exceed the amount of gain to be deferred under the election. If the
amount of the taxpayer's investment as determined under this paragraph
(b)(10) exceeds the amount of gain to be deferred under the section
1400Z-2(a) election, the amount of the excess is treated as an
investment to which section 1400Z-2(e)(1)(A)(ii) applies. See paragraph
(b)(10)(ii) of this section for special rules applicable to transfers
to QOF partnerships.
    (i) Transfers to a QOF--(A) Cash. If a taxpayer makes a section
1400Z-2(a)(1)(A) investment by transferring cash to a QOF, the amount
of the taxpayer's section 1400Z-2(a)(1)(A) investment is that amount of
cash.
    (B) Property other than cash--Nonrecognition transactions. This
paragraph (b)(10)(i)(B) applies if a taxpayer makes a section 1400Z-
2(a)(1)(A) investment by transferring property other than cash to a QOF
and if, but for the application of section 1400Z-2(b)(2)(B), the
taxpayer's basis in the resulting investment in the QOF would be
determined, in whole or in part, by reference to the taxpayer's basis
in the transferred property.
    (1) Amount of section 1400Z-2(a)(1)(A) investment. If paragraph
(b)(10)(i)(B) of this section applies, the amount of the taxpayer's
section 1400Z-2(a)(1)(A) investment is the lesser of the taxpayer's
adjusted basis in the eligible interest received in the transaction,
without regard to section 1400Z-2(b)(2)(B), or the fair market value of
the eligible interest received in the transaction, both as determined
immediately after the contribution. Paragraph (b)(10)(i)(B) of this
section applies separately to each item of property contributed to a
QOF.
    (2) Fair market value of the eligible interest received exceeds its
adjusted basis. If paragraph (b)(10)(i)(B) of this section applies, and
if the fair market value of the eligible interest received is in excess
of the taxpayer's adjusted basis in the eligible interest received,
without regard to section 1400Z-2(b)(2)(B), then the taxpayer's
investment is an investment with mixed funds to which section 1400Z-
2(e)(1) applies. Paragraph (b)(10)(i)(B)(1) of this section determines
the amount of the taxpayer's investment to which section 1400Z-
2(e)(1)(A)(i) applies. Section 1400Z-2(e)(1)(A)(ii) applies to the
excess of the fair market value of the investment to which section
1400Z-2(e)(1)(A)(i) applies over the taxpayer's adjusted basis therein,
determined without regard to section 1400Z-2(b)(2)(B).
    (3) Transfer of built-in loss property and section 362(e)(2). If
paragraph (b)(10)(i)(B) of this section and section 362(e)(2) both
apply to a transaction, the taxpayer is deemed to have made an election
under section 362(e)(2)(C).
    (C) Property other than cash--Taxable transactions. This paragraph
(b)(10)(i)(C) applies if a taxpayer makes a section 1400Z-2(a)(1)(A)
investment by transferring property other than cash to a QOF and if,
without regard to section 1400Z-2(b)(2)(B), the taxpayer's basis in the
eligible interest received would not be determined, in whole or in
part, by reference to the taxpayer's basis in the transferred property.
If this paragraph (b)(10)(i)(C) applies, the amount of the taxpayer's
section 1400Z-2(a)(1)(A) investment is the fair market value of the
transferred property, as determined immediately before the transfer.
This paragraph (b)(10)(i)(C) applies separately to each item of
property transferred to a QOF.
    (D) Basis in an investment with mixed funds. If a taxpayer's
investment in a QOF is an investment with mixed funds to which section
1400Z-2(e)(1) applies, the taxpayer's basis in the investment to which
section 1400Z-2(e)(1)(A)(ii) applies is equal to the taxpayer's basis
in all of the QOF interests received, determined without regard to
section 1400Z-2(b)(2)(B), and reduced by the basis of the taxpayer's
investment to which section 1400Z-2(e)(1)(A)(i) applies, determined
without regard to section 1400Z-2(b)(2)(B).
    (ii) Special rules for transfers to QOF partnerships. In the case
of an investment in a QOF partnership, the following rules apply:
    (A) Amounts not treated as an investment--(1) Non-contributions in
general. To the extent the transfer of property to a QOF partnership is
characterized other than as a contribution (for example, as a sale for
purposes of section 707), the transfer is not a section 1400Z-
2(a)(1)(A) investment.
    (2) Reductions in investments otherwise treated as contributions.
To the extent any transfer of cash or other property to a partnership
is not disregarded under paragraph (b)(10)(ii)(A)(1) of this section
(for example, it is not treated as a disguised sale of the property
transferred to the partnership under section 707), the transfer to the
partnership will not be treated as a section 1400Z-2(a)(1)(A)
investment to the extent the partnership makes a distribution to the
partner and the transfer to the partnership and the distribution would
be recharacterized as a disguised sale under section 707 if:
    (i) Any cash contributed were non-cash property; and
    (ii) In the case of a distribution by the partnership to which
Sec.  1.707-5(b) (relating to debt-financed distributions) applies, the
partner's share of liabilities is zero.
    (B) Amount invested in a QOF partnership--(1) Calculation of amount
of qualifying and non-qualifying investments. To the extent paragraph
(b)(10)(ii)(A) of this section does not apply, the amount of the
taxpayer's qualifying investment in a QOF partnership is the lesser of
the taxpayer's net basis in the property contributed to the QOF
partnership, or the net value of the property contributed by the
taxpayer to the QOF partnership. The amount of the taxpayer's non-
qualifying investment in the partnership is the excess, if any, of the
net value of the contribution over the amount treated as a qualifying
investment.
    (2) Net basis. For purposes of paragraph (b)(10)(ii)(B) of this
section, net basis is the excess, if any, of--
[[Page 18675]]
    (i) The adjusted basis of the property contributed to the
partnership; over
    (ii) The amount of any debt to which the property is subject or
that is assumed by the partnership in the transaction.
    (3) Net value. For purposes of paragraph (b)(10)(ii)(B) of this
section, net value is the excess of--
    (i) The gross fair market value of the property contributed; over
    (ii) The amount of the debt described in paragraph
(b)(10)(ii)(B)(2)(ii) of this section.
    (4) Basis of qualifying and non-qualifying investments. The basis
of a qualifying investment is the net basis of the property
contributed, determined without regard to section 1400Z-2(b)(2)(B) or
any share of debt under section 752(a). The basis of a non-qualifying
investment (before any section 752 debt allocation) is the remaining
net basis. The bases of qualifying and non-qualifying investments are
increased by any debt allocated to such investments under the rules of
Sec.  1.1400Z2(b)-1(c)(6)(iv)(B).
    (5) Rules applicable to mixed-funds investments. If one portion of
an investment in a QOF partnership is a qualifying investment and
another portion is a non-qualifying investment, see Sec.  1.1400Z2(b)-
1(c)(6)(iv) for the rules that apply.
    (iii) Acquisitions from another person. If a taxpayer makes a
section 1400Z-2(a)(1)(A) investment by acquiring an eligible interest
in a QOF from a person other than the QOF, then the amount of the
taxpayer's section 1400Z-2(a)(1)(A) investment is the amount of the
cash, or the fair market value of the other property, as determined
immediately before the exchange, that the taxpayer exchanged for the
eligible interest in the QOF.
    (iv) Examples. The following examples illustrate the rules of
paragraph (b)(10) of this section. For purposes of the following
examples, B is an individual and Q is a QOF corporation.
     (A) Example 1: Transfer of built-in gain property with basis
less than gain to be deferred. B realizes $100 of eligible gain
within the meaning of paragraph (b)(2) of this section. B transfers
unencumbered property with a fair market value of $100 and an
adjusted basis of $60 to Q in a transaction that is described in
section 351(a). Paragraph (b)(10)(i)(B) of this section applies
because B transferred property other than cash to Q and, but for the
application of section 1400Z-2(b)(2)(B), B's basis in the eligible
interests in Q would be determined, in whole or in part, by
reference to B's basis in the transferred property. The fair market
value of the eligible interest B received is $100, and, without
regard to section 1400Z-2(b)(2)(B), B's basis in the eligible
interest received would be $60. Thus, pursuant to paragraph
(b)(10)(i)(B)(2) of this section, B's investment is an investment
with mixed funds to which section 1400Z-2(e)(1) applies. Pursuant to
paragraphs (b)(10)(i)(B)(1) and (2) of this section, B's section
1400Z-2(a)(1)(A) investment is $60 (the lesser of the taxpayer's
adjusted basis in the eligible interest, without regard to section
1400Z-2(b)(2)(B), of $60 and the $100 fair market value of the
eligible interest received). Pursuant to section 1400Z-
2(b)(2)(B)(i), B's basis in the section 1400Z-2(a)(1)(A) investment
is $0. Additionally, B's other investment is $40 (the excess of the
fair market value of the eligible interest received ($100) over the
taxpayer's adjusted basis in the eligible interest, without regard
to section 1400Z-2(b)(2)(B) ($60)). B's basis in the other
investment is $0 (B's $60 basis in its investment determined without
regard to section 1400Z-2(b)(2)(B), reduced by the $60 of adjusted
basis allocated to the investment to which section 1400Z-
2(e)(1)(A)(i) applies, determined without regard to section 1400Z-
2(b)(2)(B)). See paragraph (b)(10)(i)(D) of this section. Pursuant
to section 362, Q's basis in the transferred property is $60.
     (B) Example 2: Transfer of built-in gain property with basis in
excess of eligible gain to be deferred. The facts are the same as
Example 1 in paragraph (b)(10)(iv)(A) of this section, except that B
realizes $50 of eligible gain within the meaning of paragraph (b)(2)
of this section. Pursuant to paragraph (b)(10) of this section, B's
section 1400Z-2(a)(1)(A) investment cannot exceed the amount of
eligible gain to be deferred (that is, the $50 of eligible gain)
under the section 1400Z-2(a) election. Therefore, pursuant to
paragraph (b)(10)(i)(B)(1) of this section, B's section 1400Z-
2(a)(1)(A) investment is $50 (the lesser of the taxpayer's adjusted
basis in the eligible interest received, without regard to section
1400Z-2(b)(2)(B), of $60 and the $100 fair market value of the
eligible interest, limited by the amount of eligible gain to be
deferred under the section 1400Z-2(a) election). B's section 1400Z-
2(a)(1)(A) investment has an adjusted basis of $0, as provided in
section 1400Z-2(b)(2)(B)(i). Additionally, B's other investment is
$50 (the excess of the fair market value of the eligible interest
received ($100) over the amount ($50) of B's section 1400Z-
2(a)(1)(A) investment). B's basis in the other investment is $10
(B's $60 basis in its investment determined without regard to
section 1400Z-2(b)(2)(B)), reduced by the $50 of adjusted basis
allocated to B's section 1400Z-2(a)(1)(A) investment, determined
without regard to section 1400Z-2(b)(2)(B)).
     (C) Example 3: Transfers to QOF partnerships--(1) Facts. A and
B each realized $100 of eligible gain and each transfers $100 of
cash to a QOF partnership. At a later date, the partnership borrows
$120 from an unrelated lender and distributes the cash of $120
equally to A and B.
    (2) Analysis. If the contributions had been of property other
than cash, the contributions and distributions would have been
tested under the disguised sale rules of Sec.  1.707-5(b) by, among
other things, determining the timing of the distribution and amount
of the debt allocated to each partner. Under paragraph
(b)(10)(ii)(A)(2) of this section, the cash of $200 ($100 from A and
$100 from B) is treated as property that could be sold in a
disguised sale transaction and each partner's share of the debt is
zero for purposes of determining the amount of the investment. To
the extent there would have been a disguised sale applying the rule
of paragraph (b)(10)(ii)(A)(2) of this section, the amount of the
investment would be reduced by the amount of the contribution so
recharacterized.
    (3) Property contributed has built-in gain. The facts are the
same as in this Example 3 in paragraph (b)(10)(iv)(C)(1) of this
section, except that the property contributed by A had a value of
$100 and basis of $20 and the partnership did not borrow money or
make a distribution. Under paragraph (b)(10)(ii)(B)(1) of this
section, the amount of A's qualifying investment is $20 (the lesser
of the net value or the net basis of the property that A
contributed), and the excess of the $100 contribution over the $20
qualifying investment constitutes a non-qualifying investment. Under
paragraph (b)(10)(ii)(B)(2) of this section, A's basis in the
qualifying investment (determined without regard to section 1400Z-
2(b)(2)(B) or section 752(a)) is $20. After the application of
section 1400Z-2(b)(2)(B) but before the application of section
752(a), A's basis in the qualifying investment is zero. A's basis in
the non-qualifying investment is zero without regard to the
application of section 752(a).
    (4) Property contributed has built-in gain and is subject to
debt. The facts are the same as in this Example 3 in paragraph
(b)(10)(iv)(C)(3) of this section, except that the property
contributed by A has a gross value of $130 and is subject to debt of
$30. Under paragraph (b)(10)(ii)(B)(1) of this section, the amount
of A's qualifying investment is zero, the lesser of the property's
$100 net value ($130 minus $30) or zero net basis ($20 minus $30,
but limited to zero). The entire contribution constitutes a non-
qualifying investment.
    (5) Property contributed has built-in loss and is subject to
debt. The facts are the same as in this Example 3 in paragraph
(b)(10)(iv)(C)(4) of this section, except that the property
contributed by A has a basis of $150. Under paragraph
(b)(10)(ii)(B)(1) of this section, the amount of A's qualifying
investment is $100, the lesser of the property's $100 net value
($130 minus $30) or $120 net basis ($150 minus $30). The non-
qualifying investment is $0, the excess of the qualifying investment
($100) over the net value ($100). A's basis in the qualifying
investment (determined without regard to section 1400Z-2(b)(2)(B)
and section 752(a)) is $120, the net basis. After the application of
section 1400Z-2(b)(2)(B), A's basis in the qualifying investment is
zero, plus its share of partnership debt under section 752(a).
* * * * *
0
Par. 3. Section 1.1400Z2(b)-1 is added to read as follows:
[[Page 18676]]
Sec.  1.1400Z2(b)-1   Inclusion of gains that have been deferred under
section 1400Z-2(a).
    (a) Scope and definitions--(1) Scope. This section provides rules
under section 1400Z-2(b) of the Internal Revenue Code regarding the
inclusion in income of gain deferred under section 1400Z-2(a)(1)(A).
This section applies to a QOF owner only until all of such owner's gain
deferred pursuant to section 1400Z-2(a)(1)(A) has been included in
income, subject to the limitations described in paragraph (e)(5) of
this section. Paragraph (a)(2) of this section provides additional
definitions used in this section and Sec. Sec.  1.1400Z2(c)-1 through
1.1400Z2(g)-1. Paragraph (b) of this section provides general rules
under section 1400Z-2(b)(1) regarding the timing of the inclusion in
income of the deferred gain. Paragraph (c) of this section provides
rules regarding the determination of the extent to which an event
triggers the inclusion in income of all, or a portion, of the deferred
gain. Paragraph (d) of this section provides rules regarding holding
periods for qualifying investments. Paragraph (e) of this section
provides rules regarding the amount of deferred gain included in gross
income under section 1400Z-2(a)(1)(B) and (b), including special rules
for QOF partnerships and QOF S corporations. Paragraph (f) of this
section provides examples illustrating the rules of paragraphs (c),
(d), and (e) of this section. Paragraph (g) of this section provides
rules regarding basis adjustments under section 1400Z-2(b)(2)(B).
Paragraph (h) of this section provides special reporting rules
applicable to partners, partnerships, and direct or indirect owners of
QOF partnerships. Paragraph (i) of this section provides dates of
applicability.
    (2) Definitions. The following definitions apply for purposes of
this section and Sec. Sec.  1.1400Z2(c)-1 and 1.1400Z2(g)-1:
    (i) Boot. The term boot means money or other property that section
354 or 355 does not permit to be received without the recognition of
gain.
    (ii) Consolidated group. The term consolidated group has the
meaning provided in Sec.  1.1502-1(h).
    (iii) Deferral election. The term deferral election means an
election under section 1400Z-2(a) made before January 1, 2027, with
respect to an eligible interest.
    (iv) Inclusion event. The term inclusion event means an event
described in paragraph (c) of this section.
    (v) Mixed-funds investment. The term mixed-funds investment means
an investment a portion of which is a qualifying investment and a
portion of which is a non-qualifying investment.
    (vi) Non-qualifying investment. The term non-qualifying investment
means an investment in a QOF described in section 1400Z-2(e)(1)(A)(ii).
    (vii) Property--(A) In general. The term property means money,
securities, or any other property.
    (B) Inclusion events regarding QOF corporation distributions. For
purposes of paragraph (c) of this section, in the context in which a
QOF corporation makes a distribution, the term property does not
include stock (or rights to acquire stock) in the QOF corporation that
makes the distribution.
    (viii) QOF. The term QOF means a qualified opportunity fund, as
defined in section 1400Z-2(d)(1) and associated regulations.
    (ix) QOF C corporation. The term QOF C corporation means a QOF
corporation other than a QOF S corporation.
    (x) QOF corporation. The term QOF corporation means a QOF that is
classified as a corporation for Federal income tax purposes.
    (xi) QOF owner. The term QOF owner means a QOF shareholder or a QOF
partner.
    (xii) QOF partner. The term QOF partner means a person that
directly owns a qualifying investment in a QOF partnership or a person
that owns such a qualifying investment through equity interests solely
in one or more partnerships.
    (xiii) QOF partnership. The term QOF partnership means a QOF that
is classified as a partnership for Federal income tax purposes.
    (xiv) QOF S corporation. The term QOF S corporation means a QOF
corporation that has elected under section 1362 to be an S corporation.
    (xv) QOF shareholder. The term QOF shareholder means a person that
directly owns a qualifying investment in a QOF corporation.
    (xvi) Qualifying investment. The term qualifying investment means
an eligible interest (as defined in Sec.  1.1400Z2(a)-1(b)(3)), or
portion thereof, in a QOF to the extent that a deferral election
applies with respect to such eligible interest or portion thereof.
    (xvii) Qualifying QOF partnership interest. The term qualifying QOF
partnership interest means a direct or indirect interest in a QOF
partnership that is a qualifying investment.
    (xviii) Qualifying QOF stock. The term qualifying QOF stock means
stock in a QOF corporation that is a qualifying investment.
    (xix) Qualifying section 355 transaction. The term qualifying
section 355 transaction means a distribution described in paragraph
(c)(11)(i)(B) of this section.
    (xx) Qualifying section 381 transaction. The term qualifying
section 381 transaction means a transaction described in section
381(a)(2), except the following transactions:
    (A) An acquisition of assets of a QOF by a QOF shareholder that
holds a qualifying investment in the QOF;
    (B) An acquisition of assets of a QOF by a tax-exempt entity as
defined in Sec.  1.337(d)-4(c)(2);
    (C) An acquisition of assets of a QOF by an entity operating on a
cooperative basis within the meaning of section 1381;
    (D) An acquisition by a QOF of assets of a QOF shareholder that
holds a qualifying investment in the QOF;
    (E) A reorganization of a QOF in a transaction that qualifies under
section 368(a)(1)(G);
    (F) A transaction, immediately after which one QOF owns an
investment in another QOF; and
    (G) A triangular reorganization of a QOF within the meaning of
Sec.  1.358-6(b)(2)(i), (ii), or (iii).
    (xxi) Remaining deferred gain. The term remaining deferred gain
means the full amount of gain that was deferred under section 1400Z-
2(a)(1)(A), reduced by the amount of gain previously included under
paragraph (b) of this section.
    (b) General inclusion rule. The gain to which a deferral election
applies is included in gross income, to the extent provided in
paragraph (e) of this section, in the taxable year that includes the
earlier of:
    (1) The date of an inclusion event; or
    (2) December 31, 2026.
    (c) Inclusion events--(1) General rule. Except as otherwise
provided in this paragraph (c), the following events are inclusion
events (which result in the inclusion of gain under paragraph (b) of
this section) if, and to the extent that--
    (i) Reduction of interest in QOF. A taxpayer's transfer of a
qualifying investment reduces the taxpayer's equity interest in the
qualifying investment;
    (ii) Distribution of property regardless of whether the taxpayer's
direct interest in the QOF is reduced. A taxpayer receives property in
a transaction that is treated as a distribution for Federal income tax
purposes, whether or not the receipt reduces the taxpayer's ownership
of the QOF; or
    (iii) Claim of worthlessness. A taxpayer claims a loss for
worthless stock under section 165(g) or otherwise claims a
worthlessness deduction with respect to its qualifying investment.
[[Page 18677]]
    (2) Termination or liquidation of QOF or QOF owner--(i) Termination
or liquidation of QOF. Except as otherwise provided in this paragraph
(c), a taxpayer has an inclusion event with respect to all of its
qualifying investment if the QOF ceases to exist for Federal income tax
purposes.
    (ii) Liquidation of QOF owner--(A) Portion of distribution treated
as sale. A distribution of a qualifying investment in a complete
liquidation of a QOF owner is an inclusion event to the extent that
section 336(a) treats the distribution as if the qualifying investment
were sold to the distributee at its fair market value, without regard
to section 336(d).
    (B) Distribution to 80-percent distributee. A distribution of a
qualifying investment in a complete liquidation of a QOF owner is not
an inclusion event to the extent section 337(a) applies to the
distribution.
    (3) Transfer of an investment in a QOF by gift. A taxpayer's
transfer of a qualifying investment by gift, whether outright or in
trust, is an inclusion event, regardless of whether that transfer is a
completed gift for Federal gift tax purposes, and regardless of the
taxable or tax-exempt status of the donee of the gift.
    (4) Transfer of an investment in a QOF by reason of the taxpayer's
death--(i) In general. Except as provided in paragraph (c)(4)(ii) of
this section, a transfer of a qualifying investment by reason of the
taxpayer's death is not an inclusion event. Transfers by reason of
death include, for example:
    (A) A transfer by reason of death to the deceased owner's estate;
    (B) A distribution of a qualifying investment by the deceased
owner's estate;
    (C) A distribution of a qualifying investment by the deceased
owner's trust that is made by reason of the deceased owner's death;
    (D) The passing of a jointly owned qualifying investment to the
surviving co-owner by operation of law; and
    (E) Any other transfer of a qualifying investment at death by
operation of law.
    (ii) Exceptions. The following transfers are not included as a
transfer by reason of the taxpayer's death, and thus are inclusion
events, and the amount recognized is includible in the gross income of
the transferor as provided in section 691:
    (A) A sale, exchange, or other disposition by the deceased
taxpayer's estate or trust, other than a distribution described in
paragraph (c)(4)(i) of this section;
    (B) Any disposition by the legatee, heir, or beneficiary who
received the qualifying investment by reason of the taxpayer's death;
and
    (C) Any disposition by the surviving joint owner or other recipient
who received the qualifying investment by operation of law on the
taxpayer's death.
    (5) Grantor trusts--(i) Contributions to grantor trusts. If the
owner of a qualifying investment contributes it to a trust and, under
the grantor trust rules, the owner of the investment is the deemed
owner of the trust, the contribution is not an inclusion event.
    (ii) Changes in grantor trust status. In general, a change in the
status of a grantor trust, whether the termination of grantor trust
status or the creation of grantor trust status, is an inclusion event.
Notwithstanding the previous sentence, the termination of grantor trust
status as the result of the death of the owner of a qualifying
investment is not an inclusion event, but the provisions of paragraph
(c)(4) of this section apply to distributions or dispositions by the
trust.
    (6) Special rules for partners and partnerships--(i) Scope. Except
as otherwise provided in this paragraph (c)(6), in the case of a
partnership that is a QOF or, directly or indirectly solely through one
or more partnerships, owns an interest in a QOF, the inclusion rules of
this paragraph (c) apply to transactions involving any direct or
indirect partner of the QOF to the extent of such partner's share of
any eligible gain of the QOF.
    (ii) Transactions that are not inclusion events--(A) In general.
Notwithstanding paragraphs (c)(1) and (2) and (c)(6)(iii) of this
section, and except as otherwise provided in paragraph (c)(6) of this
section, no transaction described in paragraph (c)(6)(ii) of this
section is an inclusion event.
    (B) Section 721 contributions. Subject to paragraph (c)(6)(v) of
this section, a contribution by a QOF owner, including any contribution
by a partner of a partnership that, solely through one or more upper-
tier partnerships, owns an interest in a QOF (contributing partner), of
its direct or indirect partnership interest in a qualifying investment
to a partnership (transferee partnership) in a transaction governed all
or in part by section 721(a) is not an inclusion event, provided the
interest transfer does not cause a partnership termination of a QOF
partnership, or the direct or indirect owner of a QOF, under section
708(b)(1). See paragraph (c)(6)(ii)(C) of this section for transactions
governed by section 708(b)(2)(A). Notwithstanding the rules in this
paragraph (c)(6)(ii)(B), the inclusion rules in paragraph (c) of this
section apply to any part of the transaction to which section 721(a)
does not apply. The transferee partnership becomes subject to section
1400Z-2 and all section 1400Z-2 regulations in this chapter with
respect to the eligible gain associated with the contributed qualifying
investment. The transferee partnership must allocate and report the
gain that is associated with the contributed qualifying investment to
the contributing partner to the same extent that the gain would have
been allocated and reported to the contributing partner in the absence
of the contribution.
    (C) Section 708(b)(2)(A) mergers or consolidations. Subject to
paragraph (c)(6)(v) of this section, a merger or consolidation of a
partnership holding a qualifying investment, or of a partnership that
holds an interest in such partnership solely through one or more
partnerships, with another partnership in a transaction to which
section 708(b)(2)(A) applies is not an inclusion event. The resulting
partnership or new partnership, as determined under Sec.  1.708-
1(c)(1), becomes subject to section 1400Z-2, and all section 1400Z-2
regulations in this chapter, to the same extent that the original
partnership was so subject prior to the transaction, and must allocate
and report any eligible gain to the same extent and to the same
partners that the original partnership allocated and reported such
items prior to the transaction. Notwithstanding the rules in this
paragraph (c)(6)(ii)(C), the general inclusion rules of paragraph (c)
of this section apply to the portion of the transaction that is
otherwise treated as a sale or exchange under paragraph (c) of this
section.
    (iii) Partnership distributions. Notwithstanding paragraph
(c)(6)(i) of this section, and subject to paragraph (c)(6)(v) of this
section, and except as provided in paragraph (c)(6)(ii)(C) of this
section, an actual or deemed distribution of property (including cash)
by a QOF partnership to a partner with respect to its qualifying
investment is an inclusion event only to the extent that the
distributed property has a fair market value in excess of the partner's
basis in its qualifying investment. Similar rules apply to
distributions involving tiered partnerships. See paragraph (c)(6)(iv)
of this section for special rules relating to mixed-funds investments.
    (iv) Special rules for mixed-funds investments--(A) General rule.
The rules of paragraph (c)(6)(iv) of this section apply solely for
purposes of section 1400Z-2. A partner that holds a mixed-funds
investment in a QOF partnership (a mixed-funds partner)
[[Page 18678]]
shall be treated as holding two separate interests in the QOF
partnership, one a qualifying investment and the other a non-qualifying
investment (the separate interests). The basis of each separate
interest is determined under the rules described in paragraphs
(c)(6)(iv)(B) and (g) of this section as if each interest were held by
different taxpayers.
    (B) Allocations and distributions. All section 704(b) allocations
of income, gain, loss, and deduction, all section 752 allocations of
debt, and all distributions made to a mixed-funds partner shall be
treated as made to the separate interests based on the allocation
percentages of such interests as defined in paragraph (c)(6)(iv)(D) of
this section. For purposes of this paragraph (c)(6)(iv)(B), in
allocating income, gain, loss, or deduction between these separate
interests, section 704(c) principles shall apply to account for any
value-basis disparities attributable to the qualifying investment or
non-qualifying investment. Any distribution (whether actual or deemed)
to the holder of a qualifying investment is subject to the rules of
paragraphs (c)(6)(iii) and (v) of this section, without regard to the
presence or absence of gain under other provisions of subchapter K of
chapter 1 of subtitle A of the Code.
    (C) Subsequent contributions. In the event of an increase in a
partner's qualifying or non-qualifying investment (for example, as in
the case of an additional contribution for a qualifying investment or
for an interest that is a non-qualifying investment or a change in
allocations for services rendered), the partner's interest in the
separate interests shall be valued immediately prior to such event and
the allocation percentages shall be adjusted to reflect the relative
values of these separate interests and the additional contribution, if
any.
    (D) Allocation percentages. The allocation percentages of the
separate interests shall be determined based on the relative capital
contributions attributable to the qualifying investment and the non-
qualifying investment. In the event a partner receives a profits
interest in the partnership for services rendered to or for the benefit
of the partnership, the allocation percentages with respect to such
partner shall be calculated based on:
    (1) With respect to the profits interest received, the highest
share of residual profits the mixed-funds partner would receive with
respect to that interest; and
    (2) With respect to the remaining interest, the percentage
interests for the capital interests described in the immediately
preceding sentence.
    (v) Remaining deferred gain reduction rule. An inclusion event
occurs when and to the extent that a transaction has the effect of
reducing--
    (A) The amount of remaining deferred gain of one or more direct or
indirect partners; or
    (B) The amount of gain that would be recognized by such partner or
partners under paragraph (e)(4)(ii) of this section to the extent that
such amount would reduce such gain to an amount that is less than the
remaining deferred gain.
    (7) Special rule for S corporations--(i) In general. Except as
provided in paragraphs (c)(7)(ii), (iii), and (iv) of this section,
none of the following is an inclusion event:
    (A) An election, revocation, or termination of a corporation's
status as an S corporation under section 1362;
    (B) A conversion of a qualified subchapter S trust (as defined in
section 1361(d)(3)) to an electing small business trust (as defined in
section 1361(e)(1));
    (C) A conversion of an electing small business trust to a qualified
subchapter S trust;
    (D) A valid modification of a trust agreement of an S-corporation
shareholder whether by an amendment, a decanting, a judicial
reformation, or a material modification;
    (E) A 25 percent or less aggregate change in ownership pursuant to
paragraph (c)(7)(iii) of this section in the equity investment in an S
corporation that directly holds a qualifying investment; and
    (F) A disposition of assets by a QOF S corporation.
    (ii) Distributions by QOF S corporation--(A) General rule. An
actual or constructive distribution of property by a QOF S corporation
to a shareholder with respect to its qualifying investment is an
inclusion event to the extent that the distribution is treated as gain
from the sale or exchange of property under section 1368(b)(2) and (c).
    (B) Spill-over rule. For purposes of applying paragraph (c)(7)(ii)
of this section to the adjusted basis of a qualifying investment, or
non-qualifying investment, as appropriate, in a QOF S corporation, the
second sentence of Sec.  1.1367-1(c)(3) applies--
    (1) With regard to multiple qualifying investments, solely to the
respective bases of such qualifying investments, and does not take into
account the basis of any non-qualifying investment; and
    (2) With regard to multiple non-qualifying investments, solely to
the respective bases of such non-qualifying investments, and does not
take into account the basis of any qualifying investment.
    (iii) Aggregate change in ownership of an S corporation that is a
QOF owner--(A) General rule. Solely for purposes of section 1400Z-2, an
inclusion event occurs when there is an aggregate change in ownership,
within the meaning of paragraph (c)(7)(iii)(B) of this section, of an S
corporation that directly holds a qualifying investment in a QOF. The S
corporation is treated as having disposed of its entire qualifying
investment in the QOF, and neither section 1400Z-2(b)(2)(B)(iii) or
(iv) nor section 1400Z-2(c) applies to the S corporation's qualifying
investment after that date. The disposition under this paragraph
(c)(7)(iii)(A) is treated as occurring on the date the requirements of
paragraph (c)(7)(iii)(B) of this section are satisfied.
    (B) Aggregate ownership change threshold. For purposes of paragraph
(c)(7)(iii)(A) of this section, there is an aggregate change in
ownership of an S corporation if, immediately after any change in
ownership of the S corporation, the percentage of the stock of the S
corporation owned directly by the shareholders who owned the S
corporation at the time of its deferral election has decreased by more
than 25 percent. The ownership percentage of each shareholder referred
to in this paragraph (c)(7)(iii)(B) is measured separately from the
ownership percentage of all other shareholders. Any decrease in
ownership is determined with regard to the percentage held by the
relevant shareholder at the time of the election under section 1400Z-
2(a), and all decreases are then aggregated. Decreases in ownership may
result from, for example, the sale of shares, the redemption of shares,
the issuance of new shares, or the occurrence of section 381(a)
transactions. The aggregate change in ownership is measured separately
for each qualifying investment of the S corporation.
    (iv) Conversion from S corporation to partnership or disregarded
entity--(A) General rule. Notwithstanding paragraph (c)(7)(i) of this
section, and except as provided in paragraph (c)(7)(iv)(B) of this
section, a conversion of an S corporation to a partnership or an entity
disregarded as separate from its owner under Sec.  301.7701-3(b)(1)(ii)
of this chapter is an inclusion event.
    (B) Exception for qualifying section 381 transaction. A conversion
described in paragraph (c)(7)(iv)(A) of this section is not an
inclusion event if the conversion comprises a step in a series of
related transactions that together qualify as a qualifying section 381
transaction.
[[Page 18679]]
    (v) Treatment of separate blocks of stock in mixed-funds
investments. With regard to a mixed-funds investment in a QOF S
corporation, if different blocks of stock are created for otherwise
qualifying investments to track basis in such qualifying investments,
the separate blocks are not treated as different classes of stock for
purposes of S corporation eligibility under section 1361(b)(1).
    (vi) Applicability. Paragraph (c)(7) of this section applies
regardless of whether the S corporation is a QOF or a QOF shareholder.
    (8) Distributions by a QOF C corporation. A distribution of
property by a QOF C corporation with respect to a qualifying investment
is not an inclusion event except to the extent section 301(c)(3)
applies to the distribution. For purposes of this paragraph (c)(8), a
distribution of property also includes a distribution of stock by a QOF
C corporation that is treated as a distribution of property to which
section 301 applies pursuant to section 305(b).
    (9) Dividend-equivalent redemptions--(i) General rule. Except as
provided in paragraph (c)(9)(ii) or (iii) of this section, a
transaction described in section 302(d) is an inclusion event with
respect to the full amount of the distribution.
    (ii) Redemption of stock of wholly owned QOF. If all stock in a QOF
is held directly by a single shareholder, or directly by members of the
same consolidated group, and if shares are redeemed in a transaction to
which section 302(d) applies, see paragraph (c)(8) of this section
(applicable to distributions by QOF corporations).
    (iii) S corporations. S corporation section 302(d) transactions are
an inclusion event to the extent the distribution exceeds basis in the
QOF as adjusted under paragraph (c)(7)(ii) of this section.
    (10) Qualifying section 381 transactions--(i) Assets of a QOF are
acquired--(A) In general. Except to the extent provided in paragraph
(c)(10)(i)(C) of this section, if the assets of a QOF corporation are
acquired in a qualifying section 381 transaction, and if the acquiring
corporation is a QOF immediately after the acquisition, then the
transaction is not an inclusion event.
    (B) Determination of acquiring corporation's status as a QOF. For
purposes of paragraph (c)(10)(i)(A) of this section, the acquiring
corporation is treated as a QOF immediately after the qualifying
section 381 transaction if the acquiring corporation satisfies the
certification requirements in Sec.  1.1400Z2(d)-1 immediately after the
transaction and holds at least 90 percent of its assets in qualified
opportunity zone property on the first testing date after the
transaction (see section 1400Z-2(d)(1) and Sec.  1.1400Z2(d)-1).
    (C) Receipt of boot by QOF shareholder in qualifying section 381
transaction--(1) General rule. Except as provided in paragraph
(c)(10)(i)(C)(2) of this section, if assets of a QOF corporation are
acquired in a qualifying section 381 transaction and a taxpayer that is
a QOF shareholder receives boot with respect to its qualifying
investment, the taxpayer has an inclusion event. If the taxpayer
realizes a gain on the transaction, the amount that gives rise to the
inclusion event is the amount of gain under section 356 that is not
treated as a dividend under section 356(a)(2). If the taxpayer realizes
a loss on the transaction, the amount that gives rise to the inclusion
event is an amount equal to the fair market value of the boot received.
    (2) Receipt of boot from wholly owned QOF. If all stock in both a
QOF and the corporation that acquires the QOF's assets in a qualifying
section 381 transaction are held directly by a single shareholder, or
directly by members of the same consolidated group, and if the
shareholder receives (or group members receive) boot with respect to
the qualifying investment in the qualifying section 381 transaction,
paragraph (c)(8) of this section (applicable to distributions by QOF
corporations) applies to the boot as if it were distributed from the
QOF to the shareholder(s) in a separate transaction to which section
301 applied.
    (ii) Assets of a QOF shareholder are acquired--(A) In general.
Except to the extent provided in paragraph (c)(10)(ii)(B) of this
section, a qualifying section 381 transaction in which the assets of a
QOF shareholder are acquired is not an inclusion event with respect to
the qualifying investment. However, if the qualifying section 381
transaction causes a QOF shareholder that is an S corporation to have
an aggregate change in ownership within the meaning of paragraph
(c)(7)(iii)(B) of this section, see paragraph (c)(7)(iii)(A) of this
section.
    (B) Qualifying section 381 transaction in which QOF shareholder's
qualifying investment is not completely acquired. If the assets of a
QOF shareholder are acquired in a qualifying section 381 transaction in
which the acquiring corporation does not acquire all of the QOF
shareholder's qualifying investment, there is an inclusion event to the
extent that the QOF shareholder's qualifying investment is not
transferred to the acquiring corporation.
    (11) Section 355 transactions--(i) Distribution by a QOF--(A) In
general. Except as provided in paragraph (c)(11)(i)(B) of this section,
if a QOF corporation distributes stock or securities of a controlled
corporation to a taxpayer in a transaction to which section 355, or so
much of section 356 as relates to section 355, applies, the taxpayer
has an inclusion event with respect to its qualifying investment. The
amount that gives rise to such inclusion event is equal to the fair
market value of the shares of the controlled corporation and the boot
received by the taxpayer in the distribution with respect to its
qualifying investment.
    (B) Controlled corporation becomes a QOF--(1) In general. Except as
provided in paragraph (c)(11)(i)(B)(3) of this section, if a QOF
corporation distributes stock or securities of a controlled corporation
in a transaction to which section 355, or so much of section 356 as
relates to section 355, applies, and if both the distributing
corporation and the controlled corporation are QOFs immediately after
the final distribution (qualifying section 355 transaction), then the
distribution is not an inclusion event with respect to the taxpayer's
qualifying investment in the distributing QOF corporation or the
controlled QOF corporation. This paragraph (c)(11)(i)(B) does not apply
unless the distributing corporation distributes all of the stock and
securities in the controlled corporation held by it immediately before
the distribution within a 30-day period. For purposes of this paragraph
(c)(11)(i)(B), the term final distribution means the last distribution
that satisfies the preceding sentence.
    (2) Determination of distributing corporation's and controlled
corporation's status as QOFs. For purposes of paragraph
(c)(11)(i)(B)(1) of this section, each of the distributing corporation
and the controlled corporation is treated as a QOF immediately after
the final distribution if the corporation satisfies the certification
requirements in Sec.  1.1400Z2(d)-1 immediately after the final
distribution and holds at least 90 percent of its assets in qualified
opportunity zone property on the first testing date after the final
distribution (see section 1400Z-2(d)(1) and Sec.  1.1400Z2(d)-1)).
    (3) Receipt of boot. If a taxpayer receives boot in a qualifying
section 355 transaction with respect to its qualifying investment, and
if section 356(a) applies to the transaction, the taxpayer has an
inclusion event, and the amount that gives rise to the inclusion event
is the
[[Page 18680]]
amount of gain under section 356 that is not treated as a dividend
under section 356(a)(2). If a taxpayer receives boot in a qualifying
section 355 transaction with respect to its qualifying investment, and
if section 356(b) applies to the transaction, see paragraph (c)(8) of
this section (applicable to distributions by QOF corporations).
    (4) Treatment of controlled corporation stock as qualified
opportunity zone stock. If stock or securities of a controlled
corporation are distributed in a qualifying section 355 transaction,
and if the distributing corporation retains a portion of the controlled
corporation stock after the initial distribution, the retained stock
will not cease to qualify as qualified opportunity zone stock in the
hands of the distributing corporation solely as a result of the
qualifying section 355 transaction. This paragraph (c)(11)(i)(B)(4)
does not apply unless the distributing corporation distributes all of
the stock and securities in the controlled corporation held by it
immediately before the distribution within a 30-day period.
    (ii) Distribution by a QOF shareholder. If a QOF shareholder
distributes stock or securities of a controlled QOF corporation in a
transaction to which section 355 applies, then for purposes of section
1400Z-2(b)(1) and paragraph (b) of this section, the taxpayer has an
inclusion event to the extent the distribution reduces the taxpayer's
direct tax ownership of its qualifying QOF stock. For distributions by
a QOF shareholder that is an S corporation, see also paragraph
(c)(7)(iii) of this section.
    (12) Recapitalizations and section 1036 transactions--(i) No
reduction in proportionate interest in qualifying QOF stock--(A) In
general. Except as otherwise provided in paragraph (c)(8) of this
section (relating to distributions subject to section 305(b)) or
paragraph (c)(12)(i)(B) of this section, if a QOF corporation engages
in a transaction that qualifies as a reorganization described in
section 368(a)(1)(E), or if a QOF shareholder engages in a transaction
that is described in section 1036, and if the transaction does not have
the result of decreasing the taxpayer's proportionate interest in the
QOF corporation, the transaction is not an inclusion event.
    (B) Receipt of property or boot by QOF shareholder. If the taxpayer
receives property or boot in a transaction described in paragraph
(c)(12)(i)(A) of this section and section 368(a)(1)(E), then the
property or boot is treated as property or boot to which section 301 or
section 356 applies, as determined under general tax principles. If the
taxpayer receives property that is not permitted to be received without
the recognition of gain in a transaction described in paragraph
(c)(12)(i)(A) of this section and section 1036, then, for purposes of
this section, the property is treated in a similar manner as boot in a
transaction described in section 368(a)(1)(E). For the treatment of
property to which section 301 applies, see paragraph (c)(8) of this
section. For the treatment of boot to which section 356 applies
(including in situations in which the QOF is wholly and directly owned
by a single shareholder or by members of the same consolidated group),
see paragraph (c)(10) of this section.
    (ii) Reduction in proportionate interest in the QOF corporation. If
a QOF engages in a transaction that qualifies as a reorganization
described in section 368(a)(1)(E), or if a QOF shareholder engages in a
transaction that is described in section 1036, and if the transaction
has the result of decreasing the taxpayer's proportionate qualifying
interest in the QOF corporation, then the taxpayer has an inclusion
event in an amount equal to the amount of the reduction in the fair
market value of the taxpayer's qualifying QOF stock.
    (13) Section 304 transactions. A transfer of a qualifying
investment in a transaction described in section 304(a) is an inclusion
event with respect to the full amount of the consideration.
    (14) Deduction for worthlessness. If a taxpayer claims a loss for
worthless stock under section 165(g) or otherwise claims a
worthlessness deduction with respect to all or a portion of its
qualifying investment, then for purposes of section 1400Z-2 and all
section 1400Z-2 regulations in this chapter, the taxpayer is treated as
having disposed of that portion of its qualifying investment on the
date it became worthless. Thus, the taxpayer has an inclusion event
with respect to that portion of its qualifying investment, and neither
section 1400Z-2(b)(2)(B)(iii) or (iv) nor section 1400Z-2(c) applies to
that portion of the taxpayer's qualifying investment after the date it
became worthless.
    (15) Other inclusion and non-inclusion events. Notwithstanding any
other provision of this paragraph (c), the Commissioner may determine
by published guidance that a type of transaction is or is not an
inclusion event.
    (d) Holding periods--(1) Holding period for QOF investment--(i)
General rule. Solely for purposes of sections 1400Z-2(b)(2)(B) and
1400Z-2(c), and except as otherwise provided in this paragraph (d)(1),
the length of time a qualifying investment has been held is determined
without regard to the period for which the taxpayer had held property
exchanged for such investment.
    (ii) Holding period for QOF investment received in a qualifying
section 381 transaction, a reorganization described in section
368(a)(1)(E), or a section 1036 exchange. For purposes of section
1400Z-2(b)(2)(B) and 1400Z-2(c), the holding period for QOF stock
received by a taxpayer in a qualifying section 381 transaction in which
the target corporation was a QOF immediately before the acquisition and
the acquiring corporation is a QOF immediately after the acquisition,
in a reorganization described in section 368(a)(1)(E), or in a section
1036 exchange, is determined by applying the principles of section
1223(1).
    (iii) Holding period for controlled corporation stock. For purposes
of section 1400Z-2(b)(2)(B) and 1400Z-2(c), the holding period of a
qualifying investment in a controlled corporation received by a
taxpayer on its qualifying investment in the distributing corporation
in a qualifying section 355 transaction is determined by applying the
principles of section 1223(1).
    (iv) Tacking with donor or deceased owner. For purposes of section
1400Z-2(b)(2)(B) and 1400Z-2(c), the holding period of a qualifying
investment held by a taxpayer who received that qualifying investment
as a gift that was not an inclusion event, or by reason of the prior
owner's death, includes the time during which that qualifying
investment was held by the donor or the deceased owner, respectively.
    (2) Determination of original use of QOF assets--(i) Assets
acquired in a section 381 transaction. For purposes of section 1400Z-
2(d), including for purposes of determining whether the original use of
qualified opportunity zone business property commences with the
acquiring corporation, any qualified opportunity zone property
transferred by the transferor QOF to the acquiring corporation in
connection with a qualifying section 381 transaction does not lose its
status as qualified opportunity zone property solely as a result of its
transfer to the acquiring corporation.
    (ii) Assets contributed to a controlled corporation. For purposes
of section 1400Z-2(d), including for purposes of determining whether
the original use of qualified opportunity zone business property
commences with the controlled corporation, any qualified opportunity
zone property contributed
[[Page 18681]]
by the distributing corporation to the controlled corporation in
connection with a qualifying section 355 transaction does not lose its
status as qualified opportunity zone property solely as a result of its
contribution to the controlled corporation.
    (3) Application to partnerships. The principles of paragraphs
(d)(1) and (2) of this section apply to qualifying QOF partnership
interests with regard to non-inclusion transactions described in
paragraph (c)(6)(ii) of this section.
    (e) Amount includible. Except as provided in Sec.  1.1400Z2(a)-
1(b)(4), the amount of gain included in gross income under section
1400Z-2(a)(1)(B) on a date described in paragraph (b) of this section
is determined under this paragraph (e).
    (1) In general. Except as provided in paragraphs (e)(2) and (4) of
this section, and subject to paragraph (e)(5) of this section, in the
case of an inclusion event, the amount of gain included in gross income
is equal to the excess of the amount described in paragraph (e)(1)(i)
of this section over the amount described in paragraph (e)(1)(ii) of
this section.
    (i) The amount described in this paragraph (e)(1)(i) is equal to
the lesser of:
    (A) An amount which bears the same proportion to the remaining
deferred gain, as:
    (1) The fair market value of the portion of the qualifying
investment that is disposed of in the inclusion event, as determined as
of the date of the inclusion event, bears to;
    (2) The fair market value of the total qualifying investment
immediately before the inclusion event; or
    (B) The amount described in paragraph (e)(1)(i)(A)(1) of this
section.
    (ii) The amount described in this paragraph (e)(1)(ii) is the
taxpayer's basis in the portion of the qualifying investment that is
disposed of in the inclusion event.
    (iii) For purposes of paragraph (e)(1)(i)(A)(1) of this section,
the fair market value of that portion is determined by multiplying the
fair market value of the taxpayer's entire qualifying investment in the
QOF, valued as of the date of the inclusion event, by the percentage of
the taxpayer's qualifying investment that is represented by the portion
disposed of in the inclusion event.
    (2) Property received from a QOF in certain transactions. In the
case of an inclusion event described in paragraph (c)(6)(iii) or (v) or
(c)(8), (9), (10), (11), or (12) of this section, the amount of gain
included in gross income is equal to the lesser of:
    (i) The remaining deferred gain; or
    (ii) The amount that gave rise to the inclusion event. See
paragraph (c) of this section for rules regarding the amount that gave
rise to the inclusion event, and see paragraph (g) of this section for
applicable ordering rules.
    (3) Gain recognized on December 31, 2026. The amount of gain
included in gross income on December 31, 2026 is equal to the excess
of--
    (i) The lesser of--
    (A) The remaining deferred gain; and
    (B) The fair market value of the qualifying investment held on
December 31, 2026; over
    (ii) The taxpayer's basis in the qualifying investment as of
December 31, 2026, taking into account only section 1400Z-2(b)(2)(B).
    (4) Special amount includible rule for partnerships and S
corporations. For purposes of paragraphs (e)(1) and (3) of this
section, in the case of an inclusion event involving a qualifying
investment in a QOF partnership or S corporation, or in the case of a
qualifying investment in a QOF partnership or S corporation held on
December 31, 2026, the amount of gain included in gross income is equal
to the lesser of:
    (i) The product of:
    (A) The percentage of the qualifying investment that gave rise to
the inclusion event; and
    (B) The remaining deferred gain, less any basis adjustments
pursuant to section 1400Z-2(b)(2)(B)(iii) and (iv); or
    (ii) The gain that would be recognized on a fully taxable
disposition of the qualifying investment that gave rise to the
inclusion event.
    (5) Limitation on amount of gain included after statutory five- and
seven-year basis increases. The total amount of gain included in gross
income under this paragraph (e) is limited to the amount deferred under
section 1400Z-2(a)(1), reduced by any increase in the basis of the
qualifying investment made pursuant to section 1400Z-2(b)(2)(B)(iii) or
(iv). See paragraph (g)(2) of this section for limitations on the
amount of basis adjustments under section 1400Z-2(b)(2)(B)(iii) and
(iv).
    (f) Examples. The following examples illustrate the rules of
paragraphs (c), (d) and (e) of this section. For purposes of the
following examples: A, B, C, W, X, Y, and Z are C corporations that do
not file a consolidated Federal income tax return; Q is a QOF
corporation or a QOF partnership, as specified in each example; and
each divisive corporate transaction satisfies the requirements of
section 355.
     (1) Example 1: Determination of basis, holding period, and
qualifying investment--(i) Facts. A wholly and directly owns Q, a
QOF corporation. On May 31, 2019, A sells a capital asset to an
unrelated party and realizes $500 of capital gain. On October 31,
2019, A transfers unencumbered asset N to Q in exchange for a
qualifying investment. Asset N, which A has held for 10 years, has a
basis of $500 and a fair market value of $500. A elects to defer the
inclusion of $500 in gross income under section 1400Z-2(a) and Sec.
1.1400Z2(a)-1.
    (ii) Analysis. Under Sec.  1.1400Z2(a)-1(b)(10)(i)(B)(1), A made
a qualifying investment of $500. Under section 1400Z-2(b)(2)(B)(i),
A's basis in its qualifying investment in Q is $0. For purposes of
sections 1400Z-2(b)(2)(B) and 1400Z-2(c), A's holding period in its
new investment in Q begins on October 31, 2019. See paragraph
(d)(1)(i) of this section. Other than for purposes of applying
section 1400Z-2, A has a 10-year holding period in its new Q
investment as of October 31, 2019.
    (iii) Transfer of built-in gain property. The facts are the same
as in this Example 1 in paragraph (f)(1)(i) of this section, but A's
basis in transferred asset N is $200. Under Sec.  1.1400Z2(a)-
1(b)(10)(i)(B)(1), A made a qualifying investment of $200 and a non-
qualifying investment of $300.
     (2) Example 2: Transfer of qualifying investment--(i) Facts. On
May 31, 2019, A sells a capital asset to an unrelated party and
realizes $500 of capital gain. On October 31, 2019, A transfers $500
to newly formed Q, a QOF corporation, in exchange for a qualifying
investment. On February 29, 2020, A transfers 25 percent of its
qualifying investment in Q to newly formed Y in exchange for 100
percent of Y's stock in a transfer to which section 351 applies (the
Transfer), at a time when the fair market value of A's qualifying
investment in Q is $800.
    (ii) Analysis. Under Sec.  1.1400Z2(a)-1(b)(10)(i)(A), A made a
qualifying investment of $500 on October 31, 2019. In the Transfer,
A exchanged 25 percent of its qualifying investment for Federal
income tax purposes, which reduced A's direct qualifying investment.
Under paragraph (c)(1)(i) of this section, the Transfer is an
inclusion event to the extent of the reduction in A's direct
qualifying investment. Under paragraph (e)(1) of this section, A
therefore includes in income an amount equal to the excess of the
amount described in paragraph (e)(1)(i) of this section over A's
basis in the portion of the qualifying investment that was disposed
of, which in this case is $0. The amount described in paragraph
(e)(1)(i) is the lesser of:
    (A) $125 ($500 x ($200/$800)); or
    (B) $200. As a result, A must include $125 of its deferred
capital gain in income in 2020. After the Transfer, the Q stock is
not qualifying Q stock in Y's hands.
    (iii) Disregarded transfer. The facts are the same as in this
Example 2 in paragraph (f)(2)(i) of this section, except that Y
elects to be treated as an entity that is disregarded as an entity
separate from its owner for Federal income tax purposes effective
prior to the Contribution. Since the Transfer would be disregarded
for Federal income tax purposes, A's transfer of its qualifying
investment in Q
[[Page 18682]]
would not be treated as a reduction in direct tax ownership for
Federal income tax purposes, and the Transfer would not be an
inclusion event with respect to A's qualifying investment in Q for
purposes of section 1400Z-2(b)(1) and paragraph (b) of this section.
Thus, A would not be required to include in income any portion of
its deferred capital gain.
    (iv) Election to be treated as a corporation. The facts are the
same as in this Example 2 in paragraph (f)(2)(iii) of this section,
except that Y (a disregarded entity) subsequently elects to be
treated as a corporation for Federal income tax purposes. A's deemed
transfer of its qualifying investment in Q to Y under Sec.
301.7701-3(g)(1)(iv) of this chapter is an inclusion event for
purposes of section 1400Z-2(b)(1) and paragraph (b) of this section.
     (3) Example 3: Part sale of qualifying QOF partnership interest
in Year 6 when value of the QOF interest has increased--(i) Facts.
In October 2018, A and B each realize $200 of eligible gain, and C
realizes $600 of eligible gain. On January 1, 2019, A, B, and C form
Q, a QOF partnership. A contributes $200 of cash, B contributes $200
of cash, and C contributes $600 of cash to Q in exchange for
qualifying QOF partnership interests in Q. A, B, and C hold 20
percent, 20 percent, and 60 percent interests in Q, respectively. On
January 30, 2019, Q obtains a nonrecourse loan from a bank for
$1,000. Under section 752, the loan is allocated $200 to A, $200 to
B, and $600 to C. On February 1, 2019, Q purchases qualified
opportunity zone business property for $2,000. On July 31, 2024, A
sells 50 percent of its qualifying QOF partnership interest in Q to
B for $400 cash. Prior to the sale, there were no inclusion events,
distributions, partner changes, income or loss allocations, or
changes in the amount or allocation of debt outstanding. At the time
of the sale, the fair market value of Q's qualified opportunity zone
business property is $5,000.
    (ii) Analysis. Because A held its qualifying QOF partnership
interest for at least five years, A's basis in its partnership
interest at the time of the sale is $220 (the original zero basis
with respect to the contribution, plus the $200 debt allocation,
plus the 10% increase for interests held for five years). The sale
of 50 percent of A's qualifying QOF partnership interest to B
requires A to recognize $90 of eligible gain, the lesser of 50
percent of the remaining $180 deferred gain ($90) or the gain that
would be recognized on a taxable sale of 50 percent of the interest
($390). A also recognizes $300 of gain relating to the appreciation
of its interest in Q.
     (4) Example 4: Sale of qualifying QOF partnership interest when
value of the QOF interest has decreased--(i) Facts. The facts are
the same as in Example 3 in paragraph (f)(3) of this section, except
that A sells 50 percent of its qualifying QOF partnership interest
in Q to B for cash of $50, and at the time of the sale, the fair
market value of Q's qualified opportunity zone business property is
$1,500.
    (ii) Analysis. Because A held its qualifying QOF partnership
interest for at least five years, A's basis at the time of the sale
is $220. Under section 1400Z-2(b)(2)(A), the sale of 50 percent of
A's qualifying QOF partnership interest to B requires A to recognize
$40 of eligible gain, the lesser of $90 (50 percent of A's remaining
deferred gain of $180) or $40 (the gain that would be recognized by
A on a sale of 50 percent of its QOF interest). A's remaining basis
in its qualifying QOF partnership interest is $110.
     (5) Example 5: Amount includible on December 31, 2026--(i)
Facts. The facts are the same as in Example 3 in paragraph (f)(3) of
this section, except that no sale of QOF interests takes place in
2024. Prior to December 31, 2026, there were no inclusion events,
distributions, partner changes, income or loss allocations, or
changes in the amount or allocation of debt outstanding.
    (ii) Analysis. For purposes of calculating the amount includible
on December 31, 2026, each of A's basis and B's basis is increased
by $30 to $230, and C's basis is increased by $90 to $690 because
they held their qualifying QOF partnership interests for at least
seven years. Each of A and B is required to recognize $170 of
eligible gain, and C is required to recognize $510 of eligible gain.
    (iii) Sale of qualifying QOF partnership interests. The facts
are the same as in this Example 5 in paragraph (f)(5)(i) of this
section, except that, on March 2, 2030, C sells its entire
qualifying QOF partnership interest in Q to an unrelated buyer for
cash of $4,200. Assuming an election under section 1400Z-2(c) is
made, the basis of C's Q interest is increased to its fair market
value immediately before the sale by C. C is treated as purchasing
the interest immediately before the sale and the bases of the
partnership's assets are increased in the manner they would be if
the partnership had an election under section 754 in effect.
     (6) Example 6: Mixed-funds investment--(i) Facts. On January 1,
2019, A and B form Q, a QOF partnership. A contributes $200 to Q,
$100 of which is a qualifying investment, and B contributes $200 to
Q in exchange for a qualifying investment. All the cash is used to
purchase qualified opportunity zone property. Q has no liabilities.
On March 30, 2023, when the values and bases of the qualifying
investments remain unchanged, Q distributes $50 to A.
    (ii) Analysis. Under paragraph (c)(6)(iv) of this section, A is
a mixed-funds partner holding two separate interests, a qualifying
investment and a non-qualifying investment. One half of the $50
distribution is treated under that provision as being made with
respect to A's qualifying investment. For the $25 distribution made
with respect to the qualifying investment, A is required to
recognize $25 of eligible gain.
    (iii) Basis adjustments. Under paragraph (g)(1)(ii)(B) of this
section, prior to determining the tax consequences of the
distribution, A increases its basis in its qualifying QOF
partnership interest by $25 under section 1400Z-2(b)(2)(B)(ii). The
distribution of $25 results in no gain under section 731. After the
distribution, A's basis in its qualifying QOF partnership interest
is $0 ($25-$25).
     (7) Example 7: Qualifying section 381 transaction of a QOF
corporation--(i) Facts. X wholly and directly owns Q, a QOF
corporation. On May 31, 2019, X sells a capital asset to an
unrelated party and realizes $500 of capital gain. On October 31,
2019, X contributes $500 to Q in exchange for a qualifying
investment. In 2020, Q merges with and into unrelated Y (with Y
surviving) in a transaction that qualifies as a reorganization under
section 368(a)(1)(A) (the Merger). X does not receive any boot in
the Merger with respect to its qualifying investment in Q.
Immediately after the Merger, Y satisfies the requirements for QOF
status under section 1400Z-2(d)(1) (see paragraph (c)(10)(i)(B) of
this section).
    (ii) Analysis. The Merger is not an inclusion event for purposes
of section 1400Z-2(b)(1) and paragraph (b) of this section. See
paragraph (c)(10)(i)(A) of this section. Accordingly, X is not
required to include in income in 2020 its $500 of deferred capital
gain as a result of the Merger. For purposes of section 1400Z-
2(b)(2)(B) and 1400Z-2(c), X's holding period for its investment in
Y is treated as beginning on October 31, 2019. For purposes of
section 1400Z-2(d), Y's holding period in its assets includes Q's
holding period in its assets, and Q's qualified opportunity zone
business property continues to qualify as such. See paragraph
(d)(2)(i) of this section.
    (iii) Merger of QOF shareholder. The facts are the same as in
this Example 7 in paragraph (f)(7)(i) of this section, except that,
in 2020, X (rather than Q) merges with and into Y in a section 381
transaction in which Y acquires all of X's qualifying interest in Q,
and Y does not qualify as a QOF immediately after the merger. The
merger transaction is not an inclusion event for purposes of section
1400Z-2(b)(1) and paragraph (b) of this section. See paragraph
(c)(10)(ii) of this section.
    (iv) Receipt of boot. The facts are the same as in this Example
7 in paragraph (f)(7)(i) of this section, except that the value of
X's qualifying investment immediately before the Merger is $1,000, X
receives $100 of cash in addition to Y stock in the Merger in
exchange for its qualifying investment, and neither Q nor Y has any
earnings and profits. X realizes $1,000 of gain in the Merger. Under
paragraphs (c)(10)(i)(C)(1) and (e)(2) of this section, X is
required to include $100 of its deferred capital gain in income in
2020.
    (v) Realization of loss. The facts are the same as in this
Example 7 in paragraph (f)(7)(iv) of this section, except that the
Merger occurs in 2025, the value of X's qualifying investment
immediately before the Merger is $25, and X receives $10 of boot in
the Merger. X realizes $25 of loss in the Merger. Under paragraphs
(c)(10)(i)(C)(1) and (e)(2) of this section, X is required to
include $10 of its deferred capital gain in income in 2020.
     (8) Example 8: Section 355 distribution by a QOF--(i) Facts. A
wholly and directly owns Q, a QOF corporation, which wholly and
directly owns Y, a corporation that is a qualified opportunity zone
business. On May 31, 2019, A sells a capital asset to an unrelated
party and realizes $500 of capital gain. On October 31, 2019, A
contributes $500 to Q in exchange for a qualifying investment. On
June 26, 2025, Q distributes all of the stock of Y to A in a
transaction in
[[Page 18683]]
which no gain or loss is recognized under section 355 (the
Distribution). Immediately after the Distribution, each of Q and Y
satisfies the requirements for QOF status (see paragraph
(c)(11)(i)(B)(2) of this section).
    (ii) Analysis. Because each of Q (the distributing corporation)
and Y (the controlled corporation) is a QOF immediately after the
Distribution, the Distribution is a qualifying section 355
transaction. Thus, the Distribution is not an inclusion event for
purposes of section 1400Z-2(b)(1) and paragraph (b) of this
section.. See paragraph (c)(11)(i)(B) of this section. Accordingly,
A is not required to include in income in 2025 any of its $500 of
deferred capital gain as a result of the Distribution. For purposes
of section 1400Z-2(b)(2)(B) and 1400Z-2(c), A's holding period for
its qualifying investment in Y is treated as beginning on October
31, 2019. See paragraph (d)(2)(i) of this section.
    (iii) Section 355 distribution by a QOF shareholder. The facts
are the same as in this Example 8 in paragraph (f)(8)(i) of this
section, except that A distributes 80 percent of the stock of Q (all
of which is a qualifying investment in the hands of A) to A's
shareholders in a transaction in which no gain or loss is recognized
under section 355. The distribution is an inclusion event for
purposes of section 1400Z-2(b)(1) and paragraph (b) of this section,
and A is required to include in income $400 (80 percent of its $500
of deferred capital gain) as a result of the distribution. See
paragraphs (c)(1) and (c)(11)(ii) of this section.
    (iv) Distribution of boot. The facts are the same as in this
Example 8 in paragraph (f)(8)(i) of this section, except that A
receives boot in the Distribution. Under paragraphs (c)(8) and
(c)(11)(i)(B)(3) of this section, the receipt of boot in the
Distribution is an inclusion event for purposes of section 1400Z-
2(b)(1) and paragraph (b) of this section to the extent of gain
recognized pursuant to section 301(c)(3).
    (v) Section 355 split-off. The facts are the same as in this
Example 8 in paragraph (f)(8)(i) of this section, except that Q
stock is directly owned by both A and B (each of which has made a
qualifying investment in Q), and Q distributes all of the Y stock to
B in exchange for B's Q stock in a transaction in which no gain or
loss is recognized under section 355. The distribution is a
qualifying section 355 transaction and is not an inclusion event for
purposes of section 1400Z-2(b)(1) and paragraph (b) of this section.
Neither A nor B is required to include its deferred capital gain in
income in 2025 as a result of the distribution.
    (vi) Section 355 split-up. The facts are the same as in this
Example 8 in paragraph (f)(8)(v) of this section, except that Q
wholly and directly owns both Y and Z; Q distributes all of the Y
stock to A in exchange for A's Q stock and distributes all of the Z
stock to B in exchange for B's Q stock in a transaction in which no
gain or loss is recognized under section 355; Q then liquidates; and
immediately after the Distribution, each of Y and Z satisfies the
requirements for QOF status. The distribution is a qualifying
section 355 transaction and is not an inclusion event for purposes
of section 1400Z-2(b)(1) and paragraph (b) of this section. Neither
A nor B is required to include its deferred capital gain in income
in 2025 as a result of the transaction.
    (vii) Section 355 split-off with boot. The facts are the same as
in this Example 8 in paragraph (f)(8)(v) of this section, except
that B also receives boot. Under paragraph (c)(11)(i)(B)(3) of this
section, B has an inclusion event, and the amount that gives rise to
the inclusion event is the amount of gain under section 356 that is
not treated as a dividend under section 356(a)(2).
     (9) Example 9: Recapitalization--(i) Facts. On May 31, 2019,
each of A and B sells a capital asset to an unrelated party and
realizes $500 of capital gain. On October 31, 2019, A contributes
$500 to newly formed Q in exchange for 50 shares of Q non-voting
stock (A's qualifying investment) and B contributes $500 to Q in
exchange for 50 shares of Q voting stock (B's qualifying
investment). A and B are the sole shareholders of Q. In 2020, when
A's qualifying investment is worth $600, A exchanges all of its Q
non-voting stock for $120 and 40 shares of Q voting stock in a
transaction that qualifies as a reorganization under section
368(a)(1)(E).
    (ii) Analysis. Because A's proportionate interest in Q has
decreased in this transaction, the recapitalization is an inclusion
event under paragraph (c)(12)(ii) of this section. Thus, A is
treated as having reduced its direct tax ownership of its investment
in Q to the extent of the reduction in the fair market value of its
qualifying QOF stock. The $120 that A received in the reorganization
represents the difference in fair market value between its
qualifying investment before and after the reorganization. Under
paragraphs (c)(12)(i)(B) and (e)(2) of this section, A is required
to include $120 of its deferred capital gain in income in 2020.
Because B's proportionate interest in Q has not decreased, and
because B did not receive any property in the recapitalization, B
does not have an inclusion event with respect to its qualifying
investment in Q. See paragraph (c)(12)(i) of this section.
Therefore, B is not required to include any of its deferred gain in
income as a result of this transaction.
     (10) Example 10: Debt financed distribution--(i) Facts. On
January 1, 2019, A and B form Q, a QOF partnership, each
contributing $200 that is deferred under the section 1400Z-2(a)
election to Q in exchange for a qualifying investment. On November
18, 2022, Q obtains a nonrecourse loan from a bank for $300. Under
section 752, the loan is allocated $150 to A and $150 to B. On
November 30, 2022, when the values and bases of the investments
remain unchanged, Q distributes $50 to A.
    (ii) Analysis. A is not required to recognize gain under Sec.
1.1400Z2(b)-1(c) because A's basis in its qualifying investment is
$150 (the original zero basis with respect to the contribution, plus
the $150 debt allocation). The distribution reduces A's basis to
$100.
     (11) Example 11: Debt financed distribution in excess of
basis--(i) Facts. The facts are the same as in Example 10 in
paragraph (f)(10) of this section, except that the loan is entirely
allocated to B under section 752. On November 30, 2024, when the
values of the investments remain unchanged, Q distributes $50 to A.
    (ii) Analysis. Under Sec.  1.1400Z2(b)-1(c)(6)(iii), A is
required to recognize $30 of eligible gain under section Sec.
1.1400Z2(b)-1(c) because the $50 distributed to A exceeds A's $20
basis in its qualifying investment (the original zero basis with
respect to its contribution, plus $20 with regard to section 1400Z-
2(b)(2)(B)(iii)).
     (12) Example 12: Aggregate ownership change threshold--(i)
Facts. On May 31, 2019, B, an S corporation, sells a capital asset
to an unrelated party for cash and realizes $500 of capital gain. On
July 15, 2019, B makes a deferral election and transfers the $500 to
Q, a QOF partnership in exchange for a qualifying investment. On
that date, B has outstanding 100 shares, of which each of
individuals D, E, F, and G owns 25 shares. On September 30, 2019, D
sells 10 shares of its B stock. On September 30, 2020, E sells 16
shares of its B stock.
    (ii) Analysis. Under paragraph (c)(7)(iii)(A) of this section,
the sales of stock by D and E caused an aggregate change in
ownership of B because, the percentage of the stock of B owned
directly by D, E, F, and G at the time of B's deferral election
decreased by more than 25 percent. Solely for purposes of section
1400Z-2, B's qualifying investment in Q would be treated as disposed
of. Consequently, B would have an inclusion event with respect to
all of B's remaining deferred gain of $500, and neither section
1400Z-2(b)(2)(B)(iii) or (iv), nor section 1400Z-2(c), would apply
to B's qualifying investment after that date.
    (g) Basis adjustments--(1) Timing of section 1400Z-2(b)(2)(B)(ii)
adjustments--(i) In general. Except as provided in paragraph (g)(1)(ii)
of this section, basis adjustments under section 1400Z-2(b)(2)(B)(ii)
are made immediately after the amount of gain determined under section
1400Z-2(b)(2)(A) is included in income under section 1400Z-2(b)(1). If
the basis adjustment under section 1400Z-2(b)(2)(B)(ii) is being made
as a result of an inclusion event, then the basis adjustment is made
before determining the other tax consequences of the inclusion event.
    (ii) Specific application to section 301(c)(3) gain, S corporation
shareholder gain, or partner gain--(A) General rule. This paragraph
(g)(1)(ii) applies if a QOF makes a distribution to its owner, and if,
without regard to any basis adjustment under section 1400Z-
2(b)(2)(B)(ii), at least a portion of the distribution would be
characterized as gain under section 301(c)(3) or paragraphs (c)(6)(iii)
and (c)(7)(ii) of this section with respect to its qualifying
investment.
    (B) Ordering rule. If paragraph (g)(1)(ii) of this section applies,
the taxpayer is treated as having an inclusion event to the extent
provided
[[Page 18684]]
in paragraph (c)(6)(iii) or (c)(7), (8), (9), (10), (11), or (12) of
this section, as applicable. Then, the taxpayer increases its basis
under section 1400Z-2(b)(2)(B)(ii), before determining the tax
consequences of the distribution.
    (C) Example. The following example illustrates the rules of this
paragraph (g)(1)(ii).
     (1) Example 1--(i) Facts. On May 31, 2019, A sells a capital
asset to an unrelated party and realizes $500 of capital gain. On
October 31, 2019, A contributes $500 to Q, a newly formed QOF
corporation, in exchange for all of the outstanding Q common stock
and elects to defer the recognition of $500 of capital gain under
section 1400Z-2(a) and Sec.  1.1400Z2(a)-1. In 2020, when Q has $40
of earnings and profits, Q distributes $100 to A (the Distribution).
    (ii) Recognition of gain. Under paragraph (g)(1)(ii)(A) of this
section, the Distribution is first evaluated without regard to any
basis adjustment under section 1400Z-2(b)(2)(B)(ii). Of the $100
distribution, $40 is treated as a dividend and $60 is treated as
gain from the sale or exchange of property under section 301(c)(3),
because A's basis in its Q stock is $0 under section 1400Z-
2(b)(2)(B)(i). Under paragraphs (c)(8) and (e)(2) of this section,
$60 of A's gain that was deferred under section 1400Z-2(a) and Sec.
1.1400Z2(a)-1 is recognized in 2020.
    (iii) Basis adjustments. Under paragraph (g)(1)(ii)(B) of this
section, prior to determining the further tax consequences of the
Distribution, A increases its basis in its Q stock by $60 in
accordance with section 1400Z-2(b)(2)(B)(ii). As a result, the
Distribution is characterized as a dividend of $40 under section
301(c)(1) and a return of basis of $60 under section 301(c)(2).
Therefore, after the section 301 distribution, A's basis in Q is $0
($60-$60).
    (2) [Reserved]
    (2) Amount of basis adjustment. The increases in basis under
section 1400Z-2(b)(2)(B)(iii) and (iv) only apply to that portion of
the qualifying investment that has not been subject to previous gain
inclusion under section 1400Z-2(b)(2)(A).
    (3) Special partnership rules--(i) General rule. The initial basis
under section 1400Z-2(b)(2)(B)(i) of a qualifying investment in a QOF
partnership is zero, as adjusted to take into account the contributing
partner's share of partnership debt under section 752.
    (ii) Tiered arrangements. Any basis adjustment described in section
1400Z-2(b)(2)(B)(iii) and (iv) and section 1400Z-2(c) (the basis
adjustment rules) shall be treated as an item of income described in
section 705(a)(1) and shall be reported in accordance with the
applicable forms and instructions. Any amount to which the basis
adjustment rules or to which section 1400Z-2(b)(1) applies shall be
allocated to the owners of the QOF, and to the owners of any
partnership that directly or indirectly (solely through one or more
partnerships) owns such QOF interest, and shall track to such owners'
interests, based on their shares of the remaining deferred gain to
which such amounts relate.
    (4) Basis adjustments in S corporation stock--(i) S corporation
investor in QOF--(A) S corporation. If an S corporation is an investor
in a QOF, the S corporation must adjust the basis of its qualifying
investment as set forth in this paragraph (g). The rule in this
paragraph (g)(4)(i)(A) does not affect adjustments to the basis of any
other asset of the S corporation.
    (B) S corporation shareholder--(1) In general. The S corporation
shareholder's pro-rata share of any recognized capital gain that has
been deferred at the S corporation level will be separately stated
under section 1366 and will adjust the shareholders' stock basis under
section 1367.
    (2) Basis adjustments to qualifying investments. Any adjustment
made to the basis of an S corporation's qualifying investment under
section 1400Z-2(b)(2)(B)(iii) or (iv), or section 1400Z-2(c), will not:
    (i) Be separately stated under section 1366; or
    (ii) Until the date on which an inclusion event with respect to the
S corporation's qualifying investment occurs, adjust the shareholders'
stock basis under section 1367.
    (3) Basis adjustments resulting from inclusion events. If the basis
adjustment under section 1400Z-2(b)(2)(B)(ii) is being made as a result
of an inclusion event, then the basis adjustment is made before
determining the other tax consequences of the inclusion event.
    (ii) QOF S corporation--(A) Transferred basis of assets received.
If a QOF S corporation receives an asset in exchange for a qualifying
investment, the basis of the asset shall be the same as it would be in
the hands of the transferor, increased by the amount of the gain
recognized by the transferor on such transfer.
    (B) Basis adjustments resulting from inclusion events. If the basis
adjustment under section 1400Z-2(b)(2)(B)(ii) for the shareholder of
the QOF S corporation is being made as a result of an inclusion event,
then the basis adjustment is made before determining the other tax
consequences of the inclusion event.
    (h) Notifications by partners and partnerships, and shareholders
and S corporations--(1) Notification of deferral election. A
partnership that makes a deferral election must notify all of its
partners of the deferral election and state each partner's distributive
share of the eligible gain in accordance with applicable forms and
instructions. A partner that makes a deferral election must notify the
partnership in writing of its deferral election, including the amount
of the eligible gain deferred.
    (2) Notification of deferred gain recognition by indirect QOF
owner. If an indirect owner of a QOF partnership or QOF S corporation
sells a portion of its partnership interest or S corporation shares in
a transaction to which Sec.  1.1400Z2(b)-1(c)(6)(iv) applies, or which
is subject to Sec.  1.1400Z2(b)-1(c)(7)(iii), such indirect owner must
provide to the QOF owner notification and information sufficient to
enable the QOF owner, in a timely manner, to recognize an appropriate
amount of deferred gain.
    (3) Notification of section 1400Z-2(c) election by QOF partner or
QOF partnership. A QOF partner must notify the QOF partnership of an
election under section 1400Z-2(c) to adjust the basis of the qualifying
QOF partnership interest that is disposed of in a taxable transaction.
Notification of the section 1400Z-2(c) election, and the adjustments to
the basis of the qualifying QOF partnership interest(s) disposed of or
to the QOF partnership asset(s) disposed of, is to be made in
accordance with applicable forms and instructions.
    (4) S corporations. Similar rules to those in paragraphs (h)(1) and
(3) of this section apply to S corporations as appropriate.
    (i) Applicability dates. This section applies for taxable years
that begin on or after the date of publication in the Federal Register
of a Treasury decision adopting these proposed rules as final
regulations. However, a taxpayer may rely on the proposed rules in this
section with respect to taxable years that begin before that date, but
only if the taxpayer applies the rules in their entirety and in a
consistent manner.
0
Par. 4. Section 1.1400Z2(c)-1, as proposed to be added by 83 FR 54279
October 29, 2018, is amended by:
0
1. Revising paragraph (a).
0
2. Redesignating paragraphs (b), (c), and (d) as paragraphs (c), (d),
and (f) respectively.
0
3. Adding new paragraph (b).
0
4. Revising newly redesignated paragraph (d) introductory text.
0
5. In newly redesignated paragraph (d)(1)(ii), removing the language
``paragraph (b) of this section'' and adding in its place ``paragraph
(c) of this section'' and removing the language ``paragraph (a) of this
section'' and
[[Page 18685]]
adding in its place ``paragraphs (a) and (b) of this section''.
0
6. Adding paragraph (d)(2).
0
7. Adding paragraph (e).
0
8. Revising newly redesignated paragraph (f).
    The revisions and additions read as follows:
Sec.  1.1400Z2(c)-1   Investments held for at least 10 years.
    (a) Scope and definitions--(1) Scope. This section provides rules
under section 1400Z-2(c) of the Internal Revenue Code regarding the
election to adjust the basis in a qualifying investment in a QOF or
certain eligible property held by the QOF. See Sec.  1.1400Z2(b)-1(d)
for purposes of determining the holding period of a qualifying
investment for purposes of this section.
    (2) Definitions. The definitions provided in Sec.  1.1400Z2(b)-
1(a)(2) apply for purposes of this section.
    (b) Investment to which an election can be made--(1) In general--
(i) Election by taxpayer. If the taxpayer sells or exchanges a
qualifying investment that it has held for at least 10 years, then the
taxpayer can make an election described in section 1400Z-2(c) on the
sale or exchange of the qualifying investment.
    (ii) Limitation on the 10-year rule. As required by section 1400Z-
2(e)(1)(B) (treatment of investments with mixed funds), section 1400Z-
2(c) applies only to the portion of an investment in a QOF with respect
to which a proper election to defer gain under section 1400Z-2(a)(1) is
in effect. For rules governing the application of section 1400Z-2(c) to
the portion of an investment in a QOF for which a loss has been claimed
under section 165(g), see Sec.  1.1400Z2(b)-1(c)(14). See also Sec.
1.1400Z2(b)-1(c)(7)(iii) for rules governing the application of section
1400Z-2(c) to the portion of an investment in a QOF held by an S
corporation QOF owner that has an aggregate change in ownership within
the meaning of Sec.  1.1400Z2(b)-1(c)(7)(iii)(B).
    (2) Special election rules for QOF Partnerships and QOF S
Corporations--(i) Dispositions of qualifying QOF partnership interests.
If a QOF partner's basis in a qualifying QOF partnership interest is
adjusted under section 1400Z-2(c), then the basis of the partnership
interest is adjusted to an amount equal to the fair market value of the
interest, including debt, and immediately prior to the sale or
exchange, the basis of the QOF partnership assets are also adjusted,
such adjustment is calculated in a manner similar to a section 743(b)
adjustment had the transferor partner purchased its interest in the QOF
partnership for cash equal to fair market value immediately prior to
the sale or exchange assuming that a valid section 754 election had
been in place. This paragraph (b)(2)(i) applies without regard to the
amount of deferred gain that was included under section 1400Z-2(b)(1),
or the timing of that inclusion.
    (ii) Dispositions of QOF property by QOF partnerships or QOF S
corporations--(A) Taxpayer election--(1) In general. For purposes of
section 1400Z-2(c), if a taxpayer has held a qualifying investment (as
determined under Sec.  1.1400Z2(b)-1(c)(6)(iv)) in a QOF partnership or
QOF S corporation for at least 10 years, and the QOF partnership or QOF
S corporation disposes of qualified opportunity zone property after
such 10 year holding period, the taxpayer may make an election to
exclude from gross income some or all of the capital gain arising from
such disposition reported on Schedule K-1 of the QOF partnership or QOF
S corporation and attributable to the qualifying investment. To the
extent that the Schedule K-1 of a QOF partnership or QOF S corporation
separately states capital gains arising from the sale or exchange of
any particular qualified opportunity zone property, the taxpayer may
make an election with respect to such separately stated item.
    (2) Section 1231 gains. An election described in paragraph
(b)(2)(ii)(A)(1) of this section may be made only with respect to
capital gain net income from section 1231 property for a taxable year
to the extent of net gains determined under section 1231(a) reported on
Schedule K-1 of a QOF partnership or QOF S corporation.
    (B) Validity of election. To be valid, the taxpayer must make an
election described in paragraph (b)(2)(ii)(A)(1) of this section for
the taxable year in which the capital gain from the sale or exchange of
QOF property recognized by the QOF partnership or QOF S corporation
would be included in the taxpayer's gross income (without regard to the
election set forth in this paragraph (b)(2)(ii)), in accordance with
applicable forms and instructions.
    (C) Consequences of election. If a taxpayer makes a valid election
under this paragraph (b)(2)(ii) with respect to some or all of the
capital gain reported on Schedule K-1 of a QOF partnership or QOF S
corporation, the amount of such capital gain that the taxpayer elects
to exclude from gross income is excluded from the taxpayer's income for
purposes of the Internal Revenue Code. Such excluded amount is treated
as an item of income under sections 705(a)(1) or 1366.
* * * * *
    (d) * * * The following examples illustrate the principles of
paragraphs (a) through (c) of this section.
* * * * *
     (2) Example 2--(i) Facts. In 2019, A and B each contribute $100
to a QOF partnership for qualifying QOF partnership interests.
    (ii) Sale of qualifying QOF partnership interest. In 2030 when
the QOF assets have a value of $260 and a bases of $200, A sells its
partnership interest, recognizing $30 of gain, $15 of which is
attributable to assets described in section 751(c) and (d), and for
which sale A makes an election under section 1400Z-2(c) and
paragraph (b)(2)(i) of this section. Because A's election under
paragraph (b)(2)(i) of this section is in effect, with regard to the
sale, the bases of the assets are treated as adjusted to fair market
value immediately before A's sale and there is no gain recognized by
A.
    (iii) Sale of QOF property. The facts are the same as in this
Example 2 in paragraph (d)(2)(i) of this section, except that the
partnership sells qualified opportunity zone property with a value
of $120 and a basis of $100, recognizing $20 of gain, allocable $10
to each partner and A makes an election under section 1400Z-2(c) and
paragraph (b)(2)(ii) of this section for the year in which A's
allocable share of the partnership's recognized gain would be
included in A's gross income. Because A's election under paragraph
(b)(2)(ii) of this section is in effect, A will exclude the $10
allocable share of the partnership's $20 of recognized gain.
    (e) Capital gain dividends paid by a QOF REIT that some
shareholders may be able to elect to receive tax free under section
1400Z-2(c)--(1) Eligibility. For purposes of paragraph (b) of this
section, if a shareholder of a QOF REIT receives a capital gain
dividend identified with a date, as defined in paragraph (e)(2) of this
section, then, to the extent that the shareholder's shares in the QOF
REIT paying the capital gain dividend are a qualifying investment in
the QOF REIT--
    (i) The shareholder may treat the capital gain dividend, or part
thereof, as gain from the sale or exchange of a qualifying investment
on the date that the QOF REIT identified with the dividend; and
    (ii) If, on the date identified, the shareholder had held that
qualifying investment in the QOF REIT for at least 10 years, then the
shareholder may apply a zero percent tax rate to that capital gain
dividend, or part thereof.
    (2) Definition of capital gain dividend identified with a date. A
capital gain dividend identified with a date means an amount of a
capital gain dividend, as defined in section 857(b)(3)(B), or part
thereof, and a date that the QOF REIT designates in a notice provided
to the
[[Page 18686]]
shareholder not later than one week after the QOF REIT designates the
capital gain dividend pursuant to section 857(b)(3)(B). The notice must
be mailed to the shareholder unless the shareholder has provided the
QOF REIT with an email address to be used for this purpose. In the
manner and at the time determined by the Commissioner, the QOF REIT
must provide the Commissioner all data that the Commissioner specifies
with respect to the amounts of capital gain dividends and the dates
designated by the QOF REIT for each shareholder.
    (3) General limitations on the amounts of capital gain with which a
date may be identified--(i) No identification in the absence of any
capital gains with respect to qualified opportunity zone property. If,
during its taxable year, the QOF REIT did not realize long-term capital
gain on any sale or exchange of qualified opportunity zone property,
then no date may be identified with any capital gain dividends, or
parts thereof, with respect to that year.
    (ii) Proportionality. Under section 857(g)(2), designations of
capital gain dividends identified with a date must be proportional for
all dividends paid with respect to the taxable year. Greater than de
minimis violation of proportionality invalidates all of the purported
identifications for a taxable year.
    (iii) Undistributed capital gains. If section 857(b)(3)(C)(i)
requires a shareholder of a QOF REIT to include a designated amount in
the shareholder's long-term capital gain for a taxable year, then
inclusion of this amount in this manner is treated as receipt of a
capital gain for purposes of this paragraph (e) and may be identified
with a date.
    (iv) Gross gains. The amount determined under paragraph (e)(4) of
this section is determined without regard to any losses that may have
been realized on other sales or exchanges of qualified opportunity zone
property. The losses do, however, limit the total amount of capital
gain dividends that may be designated under section 857(b)(3).
    (4) Determination of the amount of capital gain with which a date
may be identified. A QOF REIT may choose to identify the date for an
amount of capital gain in one of the following manners:
    (i) Simplified determination. If, during its taxable year, the QOF
REIT realizes long-term capital gain on one or more sales or exchanges
of qualified opportunity zone property, then the QOF REIT may identify
the first day of that taxable year as the date identified with each
designated amount with respect to the capital gain dividends for that
taxable year. A designated identification is invalid in its entirety if
the amount of gains that the QOF REIT identifies with that date exceeds
the aggregate long-term capital gains realized on those sales or
exchanges for that taxable year.
    (ii) Sale date determination--(A) In general. If, during its
taxable year, the QOF REIT realizes long-term capital gain on one or
more sales or exchanges of qualified opportunity zone property, then
the QOF REIT may identify capital gain dividends, or a part thereof,
with the latest date on which there was such a realization. The amount
of capital gain dividends so identified must not exceed the aggregate
long-term capital gains realized on that date from sales or exchanges
of qualified opportunity zone property. A designated identification is
invalid in its entirety if the amount of gains that the QOF REIT
identifies with that date violates the preceding sentence.
    (B) Iterative application. The process described in paragraph
(e)(4)(ii) of this section is applied iteratively to increasingly
earlier transaction dates (from latest to earliest) until all capital
gain dividends are identified with dates or there are no earlier dates
in the taxable year on which the QOF REIT realized long-term capital
gains with respect to a sale or exchange of qualified opportunity zone
property, whichever comes first.
    (f) Applicability date. This section applies to taxable years of a
taxpayer, QOF Partnership, QOF S corporation, or QOF REIT, as
appropriate, that end on or after the date of publication in the
Federal Register of a Treasury decision adopting these proposed rules
as final regulations.
0
Par. 5. Section 1.1400Z2(d)-1, as proposed to be added by 83 FR 54279,
October 29, 2018, is amended by:
0
1. Revising paragraphs (b) and (c)(4) through (7).
0
2. Revising the heading of paragraph (c)(8).
0
3. In paragraph (c)(8)(i), removing ``paragraph (c)(4)(ii) of this
section'' and adding in its place ``this paragraph (c)(8)(i)''.
0
4. Adding paragraphs (c)(8)(ii)(B) and (c)(9).
0
5. Revising paragraph (d)(2)(i)(A) through (C) and adding paragraphs
(d)(2)(i)(D) and (E).
0
6. Redesignating paragraph (d)(2)(iii) as (d)(2)(iv) and revising newly
redesignated paragraph (d)(2)(iv).
0
7. Redesignating paragraphs (d)(2)(ii) as (d)(2)(iii) and revising
newly redesignated paragraph (d)(2)(iii).
0
8. Adding new paragraph (d)(2)(ii).
0
9. Revising paragraphs (d)(3)(ii)(A) through (C) and (d)(4)(ii) and the
heading of paragraph (d)(5).
0
10. Adding a sentence at the end of paragraph (d)(5)(i) and adding
paragraphs (d)(5)(i)(A) through (E).
0
11. Adding a sentence at the end of paragraph (d)(5)(ii)(A).
0
12. Revising paragraphs (d)(5)(ii)(B), (d)(5)(iv) introductory text,
and (d)(5)(iv)(A) and (C) and adding paragraphs (d)(5)(iv)(D) and (E).
0
13. Redesignating paragraph (d)(5)(viii) as (d)(5)(ix) and adding a new
paragraph (d)(5)(viii).
0
14. Adding a sentence at the end of paragraph (f).
    The revisions and additions read as follows:
Sec.  1.1400Z2(d)-1   Qualified Opportunity Funds.
* * * * *
    (b) Valuation of assets for purposes of the 90-percent asset test--
(1) In general. For purposes of the 90-percent asset test in section
1400Z-2(d)(1), on an annual basis, a QOF may value its assets using the
applicable financial statement valuation method set forth in paragraph
(b)(2) of this section, if the QOF has an applicable financial
statement within the meaning of Sec.  1.475(a)-4(h), or the alternative
valuation method set forth in paragraph (b)(3) of this section. During
each taxable year, a QOF must apply consistently the valuation method
that it selects under this paragraph (b)(1) to all assets valued with
respect to the taxable year.
    (2) Applicable financial statement valuation method--(i) In
general. Under the applicable financial statement valuation method set
forth in this paragraph (b)(2), the value of each asset that is owned
or leased by the QOF is the value of that asset as reported on the
QOF's applicable financial statement for the relevant reporting period.
    (ii) Requirement for selection of method. A QOF may select the
applicable financial statement valuation method set forth in this
paragraph (b)(2) to value an asset leased by the QOF only if the
applicable financial statement of the QOF is prepared according to U.S.
generally accepted accounting principles (GAAP) and requires an
assignment of value to the lease of the asset.
    (3) Alternative valuation method--(i) In general. Under the
alternative valuation method set forth in this paragraph (b)(3), the
value of the assets owned by a QOF is calculated under paragraph
(b)(3)(ii) of this section, and the value of the assets leased by a QOF
is calculated under paragraph (b)(3)(iii) of this section.
[[Page 18687]]
    (ii) Assets that are owned by a QOF. The value of each asset that
is owned by a QOF is the QOF's unadjusted cost basis of the asset under
section 1012.
    (iii) Assets that are leased by a QOF--(A) In general. The value of
each asset that is leased by a QOF is equal to the present value of the
leased asset as defined in paragraph (b)(3)(iii)(C) of this section.
    (B) Discount rate. For purposes of calculating present value under
paragraph (b)(3)(iii) of this section, the discount rate is the
applicable Federal rate under section 1274(d)(1), determined by
substituting the term ``lease'' for ``debt instrument.''
    (C) Present value. For purposes of paragraph (b)(3)(iii) of this
section, present value of a leased asset--
    (1) Is equal to the sum of the present values of each payment under
the lease for the asset;
    (2) Is calculated at the time the QOF enters into the lease for the
asset; and
    (3) Once calculated, is used as the value for the asset by the QOF
for all testing dates for purposes of the 90-percent asset test.
    (D) Term of a lease. For purposes of paragraph (b)(3)(iii) of this
section, the term of a lease includes periods during which the lessee
may extend the lease at a pre-defined rent.
    (4) Option to disregard recently contributed property. A QOF may
choose to determine compliance with the 90-percent asset test by
excluding from both the numerator and denominator of the test any
property that satisfies all the criteria in paragraphs (b)(4)(i)
through (iii) of this section. A QOF need not be consistent from one
semi-annual test to another in whether it avails itself of this option.
    (i) As the case may be, the amount of the property was received by
the QOF partnership as a contribution or by the QOF corporation solely
in exchange for stock of the corporation;
    (ii) This contribution or exchange occurred not more than 6 months
before the test from which it is being excluded; and
    (iii) Between the date of that contribution or exchange and the
date of the asset test, the amount was held continuously in cash, cash
equivalents, or debt instruments with a term of 18 months or less.
    (c) * * *
    (4) Qualified opportunity zone business property of a QOF--(i) In
general. Tangible property used in a trade or business of a QOF is
qualified opportunity zone business property for purposes of paragraph
(c)(1)(iii) of this section if the requirements of paragraphs
(c)(4)(i)(A) through (E) of this section, as applicable, are satisfied.
    (A) In the case of property that the QOF owns, the property was
acquired by the QOF after December 31, 2017, by purchase as defined by
section 179(d)(2) from a person that is not a related person within the
meaning of section 1400Z-2(e)(2).
    (B) In the case of property that the QOF leases--
    (1) Qualifying acquisition of possession. The property was acquired
by the QOF under a lease entered into after December 31, 2017;
    (2) Arms-length terms. The terms of the lease were market rate
(that is, the terms of the lease reflect common, arms-length market
practice in the locale that includes the qualified opportunity zone as
determined under section 482 and all section 482 regulations in this
chapter) at the time that the lease was entered into; and
    (3) Additional requirements for leases from a related person. If
the lessee and the lessor are related parties, paragraph
(c)(4)(i)(B)(4) and (5) of this section must be satisfied.
    (4) Prepayments of not more than one year. The lessee at no time
makes any prepayment in connection with the lease relating to a period
of use of the property that exceeds 12 months.
    (5) Purchase of other QOZBP. If the original use of leased tangible
personal property in a qualified opportunity zone (within the meaning
of in paragraph (c)(4)(i)(B)(6) of this section) does not commence with
the lessee, the property is not qualified opportunity zone business
property unless, during the relevant testing period (as defined in
paragraph (c)(4)(i)(B)(7) of this section), the lessee becomes the
owner of tangible property that is qualified opportunity zone business
property having a value not less than the value of that leased tangible
personal property. There must be substantial overlap of the zone(s) in
which the owner of the property so acquired uses it and the zone(s) in
which that person uses the leased property.
    (6) Original use of leased tangible property. For purposes of
paragraph (c)(4)(i)(B)(5) of this section, the original use of leased
tangible property in a qualified opportunity zone commences on the date
any person first places the property in service in the qualified
opportunity zone for purposes of depreciation (or first uses it in a
manner that would allow depreciation or amortization if that person
were the property's owner). For purposes of this paragraph
(c)(4)(i)(B)(6), if property has been unused or vacant for an
uninterrupted period of at least 5 years, original use in the zone
commences on the date after that period when any person first uses or
places the property in service in the qualified opportunity zone within
the meaning of the preceding sentence. Used tangible property satisfies
the original use requirement if the property has not been previously so
used or placed in service in the qualified opportunity zone.
    (7) Relevant testing period. For purposes of paragraph
(c)(4)(i)(B)(5) of this section, the relevant testing period is the
period that begins on the date that the lessee receives possession
under the lease of the leased tangible personal property and ends on
the earlier of--the date 30-months after the date the lessee receives
possession of the property under the lease; or the last day of the term
of the lease (within the meaning of paragraph (b)(3)(iii)(D) of this
section.
    (8) Valuation of owned or leased property. For purposes of
paragraph (c)(4)(i)(B)(5) of this section, the value of owned or leased
property is required to be determined in accordance with the valuation
methodologies provided in paragraph (b) of this section, and such value
in the case of leased tangible personal property is to be determined on
the date the lessee receives possession of the property under the
lease.
    (C) In the case of tangible property owned by the QOF, the original
use of the owned tangible property in the qualified opportunity zone,
within the meaning of paragraph (c)(7) of this section, commences with
the QOF, or the QOF substantially improves the owned tangible property
within the meaning of paragraph (c)(8) of this section (which defines
substantial improvement in this context).
    (D) In the case of tangible property that is owned or leased by the
QOF, during substantially all of the QOF's holding period for the
tangible property, substantially all of the use of the tangible
property was in a qualified opportunity zone.
    (E) In the case of real property (other than unimproved land) that
is leased by a QOF, if, at the time the lease is entered into, there
was a plan, intent, or expectation for the real property to be
purchased by the QOF for an amount of consideration other than the fair
market value of the real property determined at the time of the
purchase without regard to any prior lease payments, the leased real
property is not qualified opportunity zone business property at any
time.
    (ii) Trade or business of a QOF. The term trade or business means a
trade or business within the meaning of section 162.
[[Page 18688]]
    (iii) Safe harbor for inventory in transit. In determining whether
tangible property is used in a qualified opportunity zone for purposes
of section 1400Z-2(d)(2)(D)(i)(III), and of paragraphs (c)(4)(i)(D),
(c)(6), (d)(2)(i)(D), and (d)(2)(iv) of this section, inventory
(including raw materials) of a trade or business does not fail to be
used in a qualified opportunity zone solely because the inventory is in
transit--
    (A) From a vendor to a facility of the trade or business that is in
a qualified opportunity zone; or
    (B) From a facility of the trade or business that is in a qualified
opportunity zone to customers of the trade or business that are not
located in a qualified opportunity zone.
    (5) Substantially all of a QOF's holding period for property
described in paragraphs (c)(2) and (3) and (c)(4)(i)(D) of this
section. For purposes of determining whether the holding period
requirements in paragraphs (c)(2) and (3) and (c)(4)(i)(D) of this
section are satisfied, the term substantially all means at least 90
percent.
    (6) Substantially all of the usage of tangible property by a QOF in
a qualified opportunity zone. A trade or business of an entity is
treated as satisfying the substantially all requirement of paragraph
(c)(4)(i)(D) of this section if at least 70 percent of the use of the
tangible property is in a qualified opportunity zone.
    (7) Original use of tangible property acquired by purchase--(i) In
general. For purposes of paragraph (c)(4)(i)(C) of this section, the
original use of tangible property in a qualified opportunity zone
commences on the date any person first places the property in service
in the qualified opportunity zone for purposes of depreciation or
amortization (or first uses it in a manner that would allow
depreciation or amortization if that person were the property's owner).
For purposes of this paragraph (c)(7), if property has been unused or
vacant for an uninterrupted period of at least 5 years, original use in
the qualified opportunity zone commences on the date after that period
when any person first so uses or places the property in service in the
qualified opportunity zone. Used tangible property satisfies the
original use requirement if the property has not been previously so
used or placed in service in the qualified opportunity zone. If the
tangible property had been so used or placed in service in the
qualified opportunity zone before it is acquired by purchase, it must
be substantially improved in order to satisfy the requirements of
section 1400Z-2(d)(2)(D)(i)(II).
    (ii) Lessee improvements to leased property. Improvements made by a
lessee to leased property satisfy the original use requirement in
section 1400Z-2(d)(2)(D)(i)(II) as purchased property for the amount of
the unadjusted cost basis under section 1012 of such improvements.
    (8) Substantial improvement of tangible property acquired by
purchase-- * * *
    (ii) * * *
    (B) Unimproved land. Unimproved land that is within a qualified
opportunity zone and acquired by purchase in accordance with section
1400Z-2(d)(2)(D)(i)(I) is not required to be substantially improved
within the meaning of section 1400Z-2(d)(2)(D)(i)(II) and
(d)(2)(D)(ii).
    (9) Substantially all of tangible property owned or leased by a
QOF--(i) Tangible property owned by a QOF. Whether a QOF has satisfied
the ``substantially all'' threshold set forth in paragraph (c)(6) of
this section is to be determined by a fraction--
    (A) The numerator of which is the total value of all qualified
opportunity zone business property owned or leased by the QOF that
meets the requirements in paragraph (c)(4)(i) of this section; and
    (B) The denominator of which is the total value of all tangible
property owned or leased by the QOF, whether located inside or outside
of a qualified opportunity zone.
    (d) * * *
    (2) * * *
    (i) * * *
    (A) In the case of tangible property that the entity owns, the
tangible property was acquired by the entity after December 31, 2017,
by purchase as defined by section 179(d)(2) from a person who is not a
related person within the meaning of section 1400Z-2(e)(2).
    (B) In the case of tangible property that the entity leases--
    (1) Qualifying acquisition of possession. The property was acquired
by the entity under a lease entered into after December 31, 2017;
    (2) Arms-length terms. The terms of the lease are market rate (that
is, the terms of the lease reflect common, arms-length market practice
in the locale that includes the qualified opportunity zone as
determined under section 482 and all section 482 regulations in this
chapter) at the time that the lease was entered into; and
    (3) Additional requirements for leases from a related person. If
the lessee and the lessor are related parties, paragraphs
(d)(2)(i)(B)(4) and (5) of this section must be satisfied.
    (4) Prepayments of not more than one year. The lessee at no time
makes any prepayment in connection with the lease relating to a period
of use of the property that exceeds 12 months.
    (5) Purchase of other QOZBP. If the original use of leased tangible
personal property in a qualified opportunity zone (within the meaning
of in paragraph (d)(2)(i)(B)(6) of this section) does not commence with
the lessee, the property is not qualified opportunity zone business
property unless, during the relevant testing period (as defined in
paragraph (d)(2)(i)(B)(7) of this section), the lessee becomes the
owner of tangible property that is qualified opportunity zone business
property having a value not less than the value of that leased tangible
personal property. There must be substantial overlap of the zone(s) in
which the owner of the property so acquired uses it and the zone(s) in
which that person uses the leased property.
    (6) Original use of leased tangible property. For purposes of
paragraph (d)(2)(i)(B)(5) of this section, the original use of leased
tangible property in a qualified opportunity zone commences on the date
any person first places the property in service in the qualified
opportunity zone for purposes of depreciation (or first uses it in a
manner that would allow depreciation or amortization if that person
were the property's owner). For purposes of this paragraph
(d)(2)(i)(B)(6), if property has been unused or vacant for an
uninterrupted period of at least 5 years, original use in the qualified
opportunity zone commences on the date after that period when any
person first uses or places the property in service in the qualified
opportunity zone within the meaning of the preceding sentence. Used
tangible property satisfies the original use requirement if the
property has not been previously so used or placed in service in the
qualified opportunity zone.
    (7) Relevant testing period. For purposes of paragraph
(d)(2)(i)(B)(5) of this section, the relevant testing period is the
period that begins on the date that the lessee receives possession
under the lease of the leased tangible personal property and ends on
the earlier of--the date 30-months after the date the lessee receives
possession of the property under the lease; or the last day of the term
of the lease (within the meaning of paragraph (b)(3)(iii)(D) of this
section).
    (8) Valuation of owned or leased property. For purposes of
paragraph (d)(2)(i)(B)(5) of this section, the value of owned or leased
property is required to be determined in accordance with the valuation
methodologies provided in
[[Page 18689]]
paragraph (b) of this section, and such value in the case of leased
tangible personal property is to be determined on the date the lessee
receives possession of the property under the lease.
    (C) In the case of tangible property owned by the entity, the
original use of the owned tangible property in the qualified
opportunity zone, within the meaning of paragraph (c)(7) of this
section, commences with the entity, or the entity substantially
improves the owned tangible property within the meaning of paragraph
(d)(4) of this section (which defines substantial improvement in this
context).
    (D) In the case of tangible property that is owned or leased by the
entity, during substantially all of the entity's holding period for the
tangible property, substantially all of the use of the tangible
property was in a qualified opportunity zone.
    (E) In the case of real property (other than unimproved land) that
is leased by the entity, if, at the time the lease is entered into,
there was a plan, intent, or expectation for the real property to be
purchased by the entity for an amount of consideration other than the
fair market value of the real property determined at the time of the
purchase without regard to any prior lease payments, the leased real
property is not qualified opportunity zone business property at any
time.
    (ii) Trade or business of an entity. The term trade or business
means a trade or business within the meaning of section 162.
    (iii) Substantially all of a qualified opportunity zone business's
holding period for property described in paragraph (d)(2)(i)(D) of this
section. For purposes of the holding period requirement in paragraph
(d)(2)(i)(D) of this section, the term substantially all means at least
90 percent.
    (iv) Substantially all of the use of tangible property by a
qualified opportunity zone business in a qualified opportunity zone.
The substantially all of the use requirement of paragraph (d)(2)(i)(D)
of this section is satisfied if at least 70 percent of the use of the
tangible property is in a qualified opportunity zone.
    (3) * * *
    (ii) * * * (A) In general. Whether a trade or business of the
entity satisfies the 70-percent ``substantially all'' threshold set
forth in paragraph (d)(3)(i) of this section is to be determined by a
fraction--
    (1) The numerator of which is the total value of all qualified
opportunity zone business property owned or leased by the qualified
opportunity zone business that meets the requirements in paragraph
(d)(2)(i) of this section; and
    (2) The denominator of which is the total value of all tangible
property owned or leased by the qualified opportunity zone business,
whether located inside or outside of a qualified opportunity zone.
    (B) Value of tangible property owned or leased by a qualified
opportunity zone business--(1) In general. For purposes of the fraction
set forth in paragraph (d)(3)(ii)(A) of this section, on an annual
basis, the owned or leased tangible property of a qualified opportunity
zone business may be valued using the applicable financial statement
valuation method set forth in paragraph (d)(3)(ii)(B)(2) of this
section, if the qualified opportunity zone business has an applicable
financial statement within the meaning of Sec.  1.475(a)-4(h), or the
alternative valuation method set forth in paragraph (d)(3)(ii)(B)(3) of
this section. During each taxable year, the valuation method selected
under this paragraph (d)(3)(ii)(B)(1) must be applied consistently to
all tangible property valued with respect to the taxable year.
    (2) Applicable financial statement valuation method--(i) In
general. Under the applicable financial statement valuation method set
forth in this paragraph (d)(3)(ii)(B)(2), the value of tangible
property of the qualified opportunity zone business, whether owned or
leased, is the value of that property as reported, or as otherwise
would be reported, on the qualified opportunity zone business's
applicable financial statement for the relevant reporting period.
    (ii) Requirement for selection of method. A qualified opportunity
zone business may select the applicable financial statement valuation
method set forth in this paragraph (d)(3)(ii)(B)(2) to value tangible
property leased by the qualified opportunity zone business only if the
applicable financial statement of the qualified opportunity zone
business requires, or would otherwise require, an assignment of value
to the lease of the tangible property.
    (3) Alternative valuation method--(i) In general. Under the
alternative valuation method set forth in this paragraph
(d)(3)(ii)(B)(3), the value of tangible property that is owned by the
qualified opportunity zone business is calculated under paragraph
(d)(3)(ii)(B)(3)(ii) of this section, and the value of tangible
property that is leased by the qualified opportunity zone business is
calculated under paragraph (d)(3)(ii)(B)(4) of this section.
    (ii) Tangible property owned by a qualified opportunity zone
business. The value of tangible property that is owned by the qualified
opportunity zone business is the unadjusted cost basis of the property
under section 1012 in the hands of the qualified opportunity zone
business for each testing date of a QOF during the year.
    (4) Tangible property leased by a qualified opportunity zone
business--(i) In general. For purposes of paragraph (d)(3)(ii)(B)(3) of
this section, the value of tangible property that is leased by the
qualified opportunity zone business is equal to the present value of
the leased tangible property as defined in paragraph (d)(3)(ii)(B)(5)
of this section.
    (ii) Discount rate. For purposes of calculating present value under
paragraph (d)(3)(ii)(B)(4) of this section, the discount rate is the
applicable Federal rate under section 1274(d)(1), determined by
substituting the term ``lease'' for ``debt instrument.''
    (5) Present value. For purposes of paragraph (d)(3)(ii)(B)(4),
present value of leased tangible property
    (i) Is equal to the sum of the present values of each payment under
the lease for such tangible property;
    (ii) Is calculated at the time the qualified opportunity zone
business enters into the lease for such leased tangible property; and
    (iii) Once calculated, is used as the value for such asset by the
qualified opportunity zone business for all testing dates for purposes
of the 90-percent asset test.
    (6) Term of a lease. For purposes of paragraph (d)(3)(ii)(B)(4) of
this section, the term of a lease includes periods during which the
lessee may extend the lease at a pre-defined rent.
    (C) Five-Percent Zone Taxpayer. If a taxpayer both holds an equity
interest in the entity and has self-certified as a QOF, then that
taxpayer may value the entity's assets using the same methodology under
paragraph (b) of this section that the taxpayer uses for determining
its own compliance with the 90-percent asset requirement of section
1400Z-2(d)(1) (Compliance Methodology), provided that no other equity
holder in the entity is a Five-Percent Zone Taxpayer. If two or more
taxpayers that have self-certified as QOFs hold equity interests in the
entity and at least one of them is a Five-Percent Zone Taxpayer, then
the values of the entity's assets may be calculated using the
Compliance Methodology that both is used by a Five-Percent Zone
Taxpayer and that produces the highest percentage of qualified
opportunity zone business property for the entity. A Five-Percent Zone
Taxpayer is a
[[Page 18690]]
taxpayer that has self-certified as a QOF and that holds stock in the
entity (if it is a corporation) representing at least 5 percent in
voting rights and value or holds an interest of at least 5 percent in
the profits and capital of the entity (if it is a partnership).
* * * * *
    (4) * * *
    (ii) Special rules for land and improvements on land--(A) Buildings
located in the qualified opportunity zone. If a qualified opportunity
zone business purchases a building located on land wholly within a QOZ,
under section 1400Z-2(d)(2)(D)(ii) a substantial improvement to the
purchased tangible property is measured in relation to the qualified
opportunity zone business's additions to the adjusted basis of the
building. Under section 1400Z-2(d), measuring a substantial improvement
to the building by additions to the qualified opportunity zone
business's adjusted basis of the building does not require the
qualified opportunity zone business to separately substantially improve
the land upon which the building is located.
    (B) Unimproved land. Unimproved land that is within a qualified
opportunity zone and acquired by purchase in accordance with section
1400Z-2(d)(2)(D)(i)(I) is not required to be substantially improved
within the meaning of section 1400Z-2(d)(2)(D)(i)(II) and
(d)(2)(D)(ii).
    (5) Operation of section 1397C requirements adopted by reference--
(i) * * * A trade or business meets the 50-percent gross income
requirement in the preceding sentence if the trade or business
satisfies any one of the four criteria described in paragraph
(d)(5)(i)(A), (B), (C), or (D) of this section, or any criteria
identified in published guidance issued by the IRS under Sec.
601.601(d)(2) of this chapter.
    (A) Services performed in qualified opportunity zone based on
hours. At least 50 percent of the services performed for the trade or
business are performed in the qualified opportunity zone, determined by
a fraction--
    (1) The numerator of which is the total number of hours performed
by employees and independent contractors, and employees of independent
contractors, for services performed in a qualified opportunity zone
during the taxable year; and
    (2) The denominator of which is the total number of hours performed
by employees and independent contractors, and employees of independent
contractors, for services performed during the taxable year.
    (B) Services performed in qualified opportunity zone based on
amounts paid for services. At least 50 percent of the services
performed for the trade or business are performed in the qualified
opportunity zone, determined by a fraction--
    (1) The numerator of which is the total amount paid by the entity
for services performed in a qualified opportunity zone during the
taxable year, whether by employees, independent contractors, or
employees of independent contractors; and
    (2) The denominator of which is the total amount paid by the entity
for services performed during the taxable year, whether by employees,
independent contractors, or employees of independent contractors.
    (C) Necessary tangible property and business functions. The
tangible property of the trade or business located in a qualified
opportunity zone and the management or operational functions performed
in the qualified opportunity zone are each necessary for the generation
of at least 50 percent of the gross income of the trade or business.
    (D) Facts and circumstances. Based on all the facts and
circumstances, at least 50 percent of the gross income of a qualified
opportunity zone business is derived from the active conduct of a trade
or business in the qualified opportunity zone.
    (E) Examples. The following examples illustrate the principles of
paragraphs (d)(5)(i)(C) and (D) of this section.
     (1) Example 1. A landscaping business has its headquarters in a
qualified opportunity zone, its officers and employees manage the
daily operations of the business (within and without the qualified
opportunity zone) from its headquarters, and all its equipment and
supplies are stored in the headquarters facilities. The activities
occurring and the storage of equipment and supplies in the qualified
opportunity zone are, taken together, a material factor in the
generation of the income of the business.
     (2) Example 2. A trade or business is formed or organized under
the laws of the jurisdiction within which a qualified opportunity
zone is located, and the business has a PO Box located in the
qualified opportunity zone. The mail received at that PO Box is
fundamental to the income of the trade or business, but there is no
other basis for concluding that the income of the trade or business
is derived from activities in the qualified opportunity zone. The
mere location of the PO Box is not a material factor in the
generation of gross income by the trade or business.
     (3) Example 3. In 2019, Taxpayer X realized $w million of
capital gains and within the 180-day period invested $w million in
QOF Y, a qualified opportunity fund. QOF Y immediately acquired from
partnership P a partnership interest in P, solely in exchange for $w
million of cash. P is a real estate developer that has written plans
to acquire land in a qualified opportunity zone on which it plans to
construct a commercial building for lease to other trades or
businesses. In 2023, P's commercial building is placed in service
and is fully leased up to other trades or businesses. For the 2023
taxable year, because at least 50 percent of P's gross income is
derived from P's rental of its tangible property in the qualified
opportunity zone. Thus, under P's facts and circumstances, P
satisfies the gross income test under section 1397C(b)(2).
    (ii) Use of intangible property requirement--(A) * * * For purposes
of section 1400Z-2(d)(3)(ii) and the preceding sentence, the term
substantial portion means at least 40 percent.
    (B) Active conduct of a trade or business--(1) [Reserved]
    (2) Operating real property. Solely for the purposes of section
1400Z-2(d)(3)(A), the ownership and operation (including leasing) of
real property is the active conduct of a trade or business. However,
merely entering into a triple-net-lease with respect to real property
owned by a taxpayer is not the active conduct of a trade or business by
such taxpayer.
    (3) Trade or business defined. The term trade or business means a
trade or business within the meaning of section 162.
* * * * *
    (iv) Safe harbor for reasonable amount of working capital. Solely
for purposes of applying section 1397C(e)(1) to the definition of a
qualified opportunity zone business under section 1400Z-2(d)(3),
working capital assets are treated as reasonable in amount for purposes
of sections 1397C(b)(2) and 1400Z-2(d)(3)(A)(ii), if all of the
requirements in paragraphs (d)(5)(iv)(A) through (C) of this section
are satisfied.
    (A) Designated in writing. These amounts are designated in writing
for the development of a trade or business in a qualified opportunity
zone (as defined in section 1400Z-1(a)), including when appropriate the
acquisition, construction, and/or substantial improvement of tangible
property in such a zone.
* * * * *
    (C) Property consumption consistent. The working capital assets are
actually used in a manner that is substantially consistent with
paragraphs (d)(5)(iv)(A) and (B) of this section. If consumption of the
working capital assets is delayed by waiting for governmental action
the application for which is complete, that delay does not cause a
failure of this paragraph (d)(5)(iv)(C).
[[Page 18691]]
    (D) Ability of a single business to benefit from more than a single
application of the safe harbor. A business may benefit from multiple
overlapping or sequential applications of the working capital safe
harbor, provided that each application independently satisfies all of
the requirements in paragraphs (d)(5)(iv)(A) through (C) of this
section.
    (E) Examples. The following examples illustrate the rules of
paragraph (d)(5)(iv) of this section.
     (1) Example 1: General application of working capital safe
harbor--(i) Facts. QOF F creates a business entity E to open a fast-
food restaurant and acquires almost all of the equity of E in
exchange for cash. E has a written plan and a 20-month schedule for
the use of this cash to establish the restaurant. Among the planned
uses for the cash are identification of favorable locations in the
qualified opportunity zone, leasing a building suitable for such a
restaurant, outfitting the building with appropriate equipment and
furniture (both owned and leased), necessary security deposits,
obtaining a franchise and local permits, and the hiring and training
of kitchen and wait staff. Not-yet-disbursed amounts were held in
assets described in section 1397C(e)(1), and these assets were
eventually expended in a manner consistent with the plan and
schedule.
    (ii) Analysis. E's use of the cash qualifies for the working
capital safe harbor described in paragraph (d)(5)(iv) of this
section.
     (2) Example 2: Multiple applications of working capital safe
harbor--(i) Facts. QOF G creates a business entity H to start a new
technology company and acquires equity of H in exchange for cash on
Date 1. In addition to H's rapid deployment of capital received from
other equity investors, H writes a plan with a 30-month schedule for
the use of the Date 1 cash. The plan describes use of the cash to
research and develop a new technology (Technology), including paying
salaries for engineers and other scientists to conduct the research,
purchasing, and leasing equipment to be used in research and
furnishing office and laboratory space. Approximately a year-and-a-
half after Date 1, on Date 2, G acquires additional equity in H for
cash, and H writes a second plan. This new plan has a 25-month
schedule for the development of a new application of existing
software (Application), to be marketed to government agencies. Among
the planned uses for the cash received on Date 2 are paying
development costs, including salaries for software engineers, other
employees, and third-party consultants to assist in developing and
marketing the new application to the anticipated customers. Not-yet-
disbursed amounts that were scheduled for development of the
Technology and the Application were held in assets described in
section 1397C(e)(1), and these assets were eventually expended in a
manner substantially consistent with the plans and schedules for
both the Technology and the Application.
    (ii) Analysis. H's use of both the cash received on Date 1 and
the cash received on Date 2 qualifies for the working capital safe
harbor described in paragraph (d)(5)(iv) of this section.
* * * * *
    (viii) Real property straddling a qualified opportunity zone. For
purposes of satisfying the requirements in this paragraph (d)(5), when
it is necessary to determine whether a qualified opportunity zone is
the location of services, tangible property, or business functions,
section 1397C(f) applies (substituting ``qualified opportunity zone''
for ``empowerment zone''). If the amount of real property based on
square footage located within the qualified opportunity zone is
substantial as compared to the amount of real property based on square
footage outside of the qualified opportunity zone, and the real
property outside of the qualified opportunity zone is contiguous to
part or all of the real property located inside the qualified
opportunity zone, then all of the property is deemed to be located
within a qualified opportunity zone.
* * * * *
    (f) *** Notwithstanding the preceding sentence, a QOF may not rely
on the proposed rules in paragraphs (c)(8)(ii)(B) and (d)(4)(ii)(B) of
this section (which concern the qualification of land as QOZBP) if the
land is unimproved or minimally improved and the QOF or the QOZB
purchases the land with an expectation, an intention, or a view not to
improve the land by more than an insubstantial amount within 30 months
after the date of purchase.
0
Par. 6. Section 1.1400Z2(f)-1 is added to read as follows:
Sec.  1.1400Z2(f)-1  Failure of qualified opportunity fund to maintain
investment standard.
    (a) In general. Except as provided by Sec.  1.1400Z2(d)-1(a)(2)(ii)
with respect to a taxpayer's first taxable year as a QOF, if a QOF
fails to satisfy the 90-percent asset test in section 1400Z-2(d)(1),
then the fund must pay the statutory penalty set forth in section
1400Z-2(f) for each month it fails to meet the 90-percent asset test.
    (b) Time period for a QOF to reinvest certain proceeds. If a QOF
receives proceeds from the return of capital or the sale or disposition
of some or all of its qualified opportunity zone property within the
meaning of section 1400Z-2(d)(2)(A), and if the QOF reinvests some or
all of the proceeds in qualified opportunity zone property by the last
day of the 12-month period beginning on the date of the distribution,
sale, or disposition, then the proceeds, to the extent that they are so
reinvested, are treated as qualified opportunity zone property for
purposes of the 90-percent asset test in section 1400Z-2(d)(1), but
only to the extent that prior to the reinvestment in qualified
opportunity zone property the proceeds are continuously held in cash,
cash equivalents, or debt instruments with a term of 18 months or less.
If reinvestment of the proceeds is delayed by waiting for governmental
action the application for which is complete, that delay does not cause
a failure of the 12-month requirement in this paragraph (b).
    (c) Anti-abuse rule--(1) In general. Pursuant to section 1400Z-
2(e)(4)(C), the rules of section 1400Z-2 and Sec. Sec.  1.1400Z2(a)-1
through 1.1400Z2(g)-1 must be applied in a manner consistent with the
purposes of section 1400Z-2. Accordingly, if a significant purpose of a
transaction is to achieve a tax result that is inconsistent with the
purposes of section 1400Z-2, the Commissioner can recast a transaction
(or series of transactions) for Federal tax purposes as appropriate to
achieve tax results that are consistent with the purposes of section
1400Z-2. Whether a tax result is inconsistent with the purposes of
section 1400Z-2 must be determined based on all the facts and
circumstances.
    (2) [Reserved]
    (d) Applicability date. This section applies to taxable years of a
QOF that end on or after the date of publication in the Federal
Register of a Treasury decision adopting these proposed rules as final
regulations. However, an eligible taxpayer may rely on the proposed
rules in this section (other than paragraph (c) of this section) with
respect to taxable years before the date of applicability of this
section, but only if the eligible taxpayer applies the rules in their
entirety and in a consistent manner. An eligible taxpayer may rely on
the proposed rules in paragraph (c) of this section with respect to
taxable years before the date of applicability of this section, but
only if the eligible taxpayer applies the rules of section 1400Z-2 and
Sec. Sec.  1.1400Z2(a)-1 through 1.1400Z2(g)-1, as applicable, in their
entirety and in a consistent manner.
0
Par. 7. Section 1.1400Z2(g)-1 is added to read as follows:
Sec.  1.1400Z2(g)-1   Application of opportunity zone rules to members
of a consolidated group.
    (a) Scope and definitions--(1) Scope. This section provides rules
regarding the Federal income tax treatment of QOFs owned by members of
consolidated groups.
[[Page 18692]]
    (2) Definitions. The definitions provided in Sec.  1.1400Z2(b)-
1(a)(2) apply for purposes of this section.
    (b) QOF stock not stock for purposes of affiliation--(1) In
general. Stock in a QOF corporation (whether qualifying QOF stock or
otherwise) is not treated as stock for purposes of determining whether
the issuer is a member of an affiliated group within the meaning of
section 1504. Therefore, a QOF corporation can be the common parent of
a consolidated group, but a QOF corporation cannot be a subsidiary
member of a consolidated group.
     (2) Example. The following example illustrates the rules of
this paragraph (b).
    (i) Facts. Corporation P wholly owns corporation S, which wholly
owns corporation Q. P, S, and Q are members of a U.S. consolidated
group (P group). In 2018, S sells an asset to an unrelated party and
realizes $500 of capital gain. S contributes $500 to Q and properly
elects to defer recognition of the gain under section 1400Z-2. At
such time, Q qualifies and elects to be treated as a QOF.
    (ii) Analysis. Under paragraph (b) of this section, stock of a
QOF (qualifying or otherwise) is not treated as stock for purposes
of affiliation under section 1504. Thus, once Q becomes a QOF, Q
ceases to be affiliated with the P group members under section
1504(a), and it deconsolidates from the P group.
    (c) Qualifying investments by members of a consolidated group.
Except as otherwise provided in this section or in Sec.  1.1400Z2(b)-1,
section 1400Z-2 applies separately to each member of a consolidated
group. Therefore, for example, the same member of the group must both
engage in the sale of a capital asset giving rise to gain and timely
invest an amount equal to some or all of such gain in a QOF (as
provided in section 1400Z-2(a)(1)) in order to qualify for deferral of
such gain under section 1400Z-2.
    (d) Tiering up of investment adjustments provided by section 1400Z-
2. Basis increases in a qualifying investment in a QOF under sections
1400Z-2(b)(2)(B)(iii), 1400Z-2(b)(2)(B)(iv), and 1400Z-2(c) are treated
as satisfying the requirements of Sec.  1.1502-32(b)(3)(ii)(A), and
thus qualify as tax-exempt income to the QOF owner. Therefore, if the
QOF owner is a member of a consolidated group and is owned by other
members of the same group (upper-tier members), the group members
increase their bases in the shares of the QOF owner under Sec.  1.1502-
32(b)(2)(ii). However, there is no basis increase under Sec.  1.1502-
32(b)(2)(ii) in shares of upper-tier members with regard to basis
increases under section 1400Z-2(c) and the regulations at Sec.
1.1400Z2(c)-1 unless and until the basis of the qualifying investment
is increased to its fair market value, as provided in section 1400Z-
2(c) and the regulations at Sec.  1.1400Z2(c)-1.
    (e) Application of Sec.  1.1502-36(d). This paragraph (e) clarifies
how Sec.  1.1502-36(d) applies if a member (M) transfers a loss share
of another member (S) and S is a QOF owner that owns a qualifying
investment in a QOF. To determine S's attribute reduction amount under
Sec.  1.1502-36(d)(3), S's basis in its qualifying investment is
included in S's net inside attribute amount to compute S's aggregate
inside loss under Sec.  1.1502-36(d)(3)(iii)(A). However, S's basis in
the qualifying investment is not included in S's category D attributes
available for attribute reduction under Sec.  1.1502-36(d)(4). Thus,
S's basis in the qualifying investment cannot be reduced under Sec.
1.1502-36(d). If S's attribute reduction amount exceeds S's attributes
available for reduction, then to the extent of S's basis in the
qualifying investment (limited by the remaining attribute reduction
amount), the common parent is treated as making the election under
Sec.  1.1502-36(d)(6) to reduce M's basis in the transferred loss S
shares.
    (f) Examples. The following examples illustrate the rules of this
section.
     (1) Example 1: Basis adjustment when member owns qualifying QOF
stock--(i) Facts. Corporation P is the common parent of a
consolidated group (P group), and P wholly owns Corporation S, a
member of the P group. In 2018, S sells an asset to an unrelated
party and realizes $500 of capital gain. S contributes $500 to Q (a
QOF corporation) and properly elects to defer the gain under section
1400Z-2(a) and Sec.  1.1400Z2(a)-1. S does not otherwise own stock
in Q. In 2029, when S still owns its qualifying investment in Q, P
sells all of the stock of S to an unrelated party.
    (ii) Analysis--(A) 5-year and 7-year basis increase and Sec.
1.1502-32 tier-up. In 2023, when S has held the stock of Q for five
years, under section 1400Z-2(b)(2)(B)(iii), S increases its basis in
its Q stock by $50 (10 percent of $500, the amount of gain deferred
by reason of section 1400Z-2(a)(1)(A)). The 10-percent basis
increase qualifies as tax-exempt income to S under paragraph (d) of
this section. Thus, P (an upper-tier member) increases its basis in
S's stock by $50 under Sec.  1.1502-32(b)(2)(ii). Similarly, in
2025, when S has held the stock of Q for seven years, under section
1400Z-2(b)(2)(B)(iv), S increases its basis in its Q stock by an
additional $25 (5 percent of $500). The 5 percent basis increase
also qualifies as tax-exempt income to S under paragraph (d) of this
section, and P increases its basis in S's stock by an additional $25
under Sec.  1.1502-32(b)(2)(ii).
    (B) S's recognition of deferred capital gain in 2026. S did not
dispose of its Q stock prior to December 31, 2026. Therefore, under
section 1400Z-2(b)(1)(B) and Sec.  1.1400Z2(b)-1(b)(2), S's deferred
capital gain is included in S's income on December 31, 2026. The
amount of gain included under section 1400Z-2(b)(2)(A) is $425 ($500
of deferred gain less S's $75 basis in Q). S's basis in Q is
increased by $425 to $500, and P's basis in S also is increased by
$425.
    (C) P's disposition of S. P's sale of S stock in 2029 results in
the deconsolidation of S. Q remains a non-consolidated subsidiary of
S, and S is not treated as selling or exchanging its Q stock for
purposes of section 1400Z-2(c). Therefore, no basis adjustments
under section 1400Z-2 are made as a result of P's sale of S stock.
    (iii) S sells the stock of Q after 10 years. The facts are the
same as in this Example 1 in paragraph (f)(1)(i) of this section,
except that in 2029, instead of P selling all of the stock of S, S
sells all of the stock of Q to an unrelated party for its fair
market value of $800. At the time of the sale, S has owned the Q
stock for over 10 years, and S elects under section 1400Z-2(c) to
increase its stock basis in Q from $500 (see the analysis in this
Example 1 in paragraph (f)(1)(ii)(B) of this section) to the fair
market value of Q on the date of the sale, $800. As a result of the
election, S's basis in Q is $800 and S has no gain on the sale of Q
stock. Additionally, the $300 basis increase in Q is treated as tax-
exempt income to S pursuant to paragraph (d) of this section. Thus,
P increases its basis in P's S stock by $300 under Sec.  1.1502-
32(b)(2)(ii).
     (2) Example 2: Computation and application of the attribute
reduction amount under Sec.  1.1502-36(d) when S owns a QOF--(i)
Facts. Corporation P (the common parent of a consolidated group)
wholly owns corporation M, which wholly owns corporation S, which
wholly owns Q (a QOF corporation). In 2018, S sells an asset to an
unrelated party and realizes $5,000 of capital gain. S contributes
$5,000 to Q and properly elects to defer the gain under section
1400Z-2. In 2024, M sells all of its S stock to an unrelated party
for fair market value of $100, and M's basis in the stock of S is
$300. At the time of sale, S owns the stock of Q with a basis of
$500 (S's basis in Q was increased under section 1400Z-
2(b)(2)(B)(iii) to $500 in 2023), and S has a net operating loss
carryover of $50. M's transfer of the S shares is a transfer of loss
shares under Sec.  1.1502-36. Assume that no basis redetermination
is required under Sec.  1.1502-36(b) and no basis reduction is
required under Sec.  1.1502-36(c).
    (ii) Attribute reduction under Sec.  1.1502-36(d). Under Sec.
1.1502-36(d), S's attributes are reduced by S's attribute reduction
amount. Section 1.1502-36(d)(3) provides that S's attribute
reduction amount is the lesser of the net stock loss and S's
aggregate inside loss. The net stock loss is the excess of the $300
aggregate basis of the transferred S shares over the $100 aggregate
value of those shares, or $200. S's aggregate inside loss, which
includes the basis of the stock of Q as provided by paragraph (e) of
this section, is the excess of S's net inside attribute amount over
the value of the S share. S's net inside attribute amount is $550,
computed as the sum of S's $50 loss carryover and its $500 basis in
Q. S's aggregate inside loss is therefore $450 ($550 net inside
attribute
[[Page 18693]]
amount over the $100 value of the S share). Accordingly, S's
attribute reduction amount is the lesser of the $200 net stock loss
and the $450 aggregate inside loss, or $200. Under Sec.  1.1502-
36(d)(4), S's $200 attribute reduction is first allocated and
applied to reduce S's $50 loss carryover to $0. Under Sec.  1.1502-
36(d)(4)(i)(D), S generally would be able to reduce the basis of its
category D assets (including stock in other corporations) by the
remaining attribute reduction amount ($150). However, paragraph (e)
of this section provides that S's basis in the QOF (Q) shares is not
included in S's category D attributes that are available for
reduction under Sec.  1.1502-36(d)(4), and the remaining $150 of
attribute reduction amount cannot be used to reduce the basis of Q
shares under Sec.  1.1502-36(d). Rather, under paragraph (e) of this
section, P is treated as making the election under Sec.  1.1502-
36(d)(6) to reduce M's basis in the transferred loss S shares by
$150. As a result, P's basis in its M stock will also be reduced by
$150.
    (g) Applicability date. Except as otherwise provided in this
paragraph (g), this section applies for taxable years that begin on or
after the date of publication in the Federal Register of a Treasury
decision adopting these proposed rules as final regulations. However, a
QOF may rely on the proposed rules in this section with respect to
taxable years that begin before the applicability date of this section,
but only if the QOF applies the rules in their entirety and in a
consistent manner.
Kirsten Wielobob,
Deputy Commissioner for Services and Enforcement.
[FR Doc. 2019-08075 Filed 4-30-19; 8:45 am]
 BILLING CODE 4830-01-P