Investing in Qualified Opportunity Funds

Published date01 May 2019
Record Number2019-08075
SectionProposed rules
CourtInternal Revenue Service,Treasury Department
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 IIDepartment of the Treasury-----------------------------------------------------------------------Internal Revenue Service-----------------------------------------------------------------------26 CFR Part 1Investing 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.
                -----------------------------------------------------------------------
                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
                [[Page 18662]]
                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
                

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