Modifications to the 10-year Gain Exclusion Option Open the Door for Multi-Asset Funds
The most notable benefit of the opportunity zones (OZ) incentive is the exclusion of tax on appreciation of a qualified opportunity fund (QOF) investment held for 10 years.
The general rule for how this is accomplished is through an election to step up the basis of a QOF interest to its fair market value immediately before its sale.
The sale of a fund interest is a non-customary way to dispose of an investor’s interest in fund assets for multi-asset funds largely because assets cannot be disposed at different times. So, despite the diversity and efficiency that comes from investing in multi-asset funds, most of the early OZ investments were structured as single-asset funds.
Proposed regulations released in April 2019 provided for an alternative exit mechanism (the gain exclusion option) that facilitated multi-asset funds by providing that if a QOF organized as a partnership or an S corporation sells property and allocates the capital gain to its owners on Schedule K-1, those owners who have held their interests for at least 10 years can exclude such capital gain from their income.
This proposed guidance helped to address some of the concerns investors had regarding the exit strategy for multi-asset funds, but these proposed rules for excluding the gain were limited compared to rules for taxpayers that realize the benefit through the sale of a QOF interest. Under the proposed rule, only capital gains from the sale of OZ property by a QOF were eligible to be excluded. Capital gains realized from the sale of non-OZ property or ordinary gains from the sale of OZ personal property were not eligible for exclusion. Also, the gain exclusion only applied to property sold by a QOF. Property sold by a qualified OZ business was not eligible for the exclusion. In contrast, taxpayers selling a QOF interest are able to exclude all gains from all property whether held directly by the QOF or indirectly through a qualified OZ business. As a result, single-asset funds remained the more attractive option pending final rules.
The final regulations that were released in December 2019 made significant modifications to the proposed gain exclusion option of accomplishing 10-year forgiveness of appreciation on a QOF investment. Under the final rule, the gain exclusion option is extended to all pass-through gains from the sale of all property by QOFs and qualified OZ businesses with the exception of gains from the sale of inventory in the ordinary course of business. These modifications are expected to give meaningful comfort to investors entering into multi-asset fund arrangements.
The final regulations set forth two requirements for the QOF and the taxpayer when the taxpayer wishes to elect the gain exclusion option. First, the taxpayer must make the election for each taxable year in which it wishes to exclude the gains. This election may be made regardless of whether the taxpayer has made an election for any prior taxable year.
The second requirement is designed to eliminate double dipping on excluded gain dollars that are reinvested by QOFs and qualified OZ businesses. Under this requirement, the QOF is treated as distributing to each electing QOF owner its share of net proceeds from the asset sales on the last day of the QOF’s tax year. For this purpose, the amount of the net proceeds from an asset sale is equal to the amount realized from the sale, less any indebtedness included in the amount realized. Immediately after the deemed distribution, the QOF owner is treated as recontributing the amount received in exchange for a non-qualifying investment. Note, the deemed distribution is reduced by actual distributions of cash with respect to any such sale that is made within 90 days of the sale.
This deemed distribution and recontribution is solely for purposes of determining interest in the QOF that constitute a qualifying investment and a non-qualifying investment, and has no other federal income tax consequences. Following this adjustment, any gains or losses from future asset sales will be prorated along the mixed-funds ratio.
The final regulations also generally provide that the merger of two or more QOF partnerships is not an inclusion event. This provision in the regulations creates the option for single-asset QOF partnerships to roll-up into a multi-asset QOF.
In conclusion, the final regulations made necessary changes to the proposed gain exclusion option to facilitate the use of multi-asset funds since properties can now be sold separately at different times at the QOF and qualified OZ business level without spoiling the gain exclusion benefit. Allowing for multi-asset funds will help investors to diversify their investments in an efficient manner, which should lead to more investments in OZs.