[Federal Register Volume 84, Number 84 (Wednesday, May 1, 2019)]
[Proposed Rules]
[Pages 18652-18693]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 2019-08075]



[[Page 18651]]

Vol. 84

Wednesday,

No. 84

May 1, 2018

Part II





Department of the Treasury





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Internal Revenue Service





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26 CFR Part 1





Investing in Qualified Opportunity Funds; Proposed Rule

  Federal Register / Vol. 84 , No. 84 / Wednesday, May 1, 2018 / 
Proposed Rules  

[[Page 18652]]


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DEPARTMENT OF TREASURY

Internal Revenue Service

26 CFR Part 1

[REG-120186-18]
RIN 1545-BP04


Investing in Qualified Opportunity Funds

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking; partial withdrawal of a notice 
of proposed rulemaking.

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SUMMARY: This document contains proposed regulations that provide 
guidance under new section 1400Z-2 of the Internal Revenue Code (Code) 
relating to gains that may be deferred as a result of a taxpayer's 
investment in a qualified opportunity fund (QOF), as well as special 
rules for an investment in a QOF held by a taxpayer for at least 10 
years. This document also contains proposed regulations that update 
portions of previously proposed regulations under section 1400Z-2 to 
address various issues, including: the definition of ``substantially 
all'' in each of the various places it appears in section 1400Z-2; the 
transactions that may trigger the inclusion of gain that a taxpayer has 
elected to defer under section 1400Z-2; the timing and amount of the 
deferred gain that is included; the treatment of leased property used 
by a qualified opportunity zone business; the use of qualified 
opportunity zone business property in the qualified opportunity zone; 
the sourcing of gross income to the qualified opportunity zone 
business; and the ``reasonable period'' for a QOF to reinvest proceeds 
from the sale of qualifying assets without paying a penalty. These 
proposed regulations will affect QOFs and taxpayers that invest in 
QOFs.

DATES: Written (including electronic) comments must be received by July 
1, 2019. Outlines of topics to be discussed at the public hearing 
scheduled for July 9, 2019, at 10 a.m. must be received by July 1, 
2019. The public hearing will be held at the New Carrollton Federal 
Building at 5000 Ellin Road in Lanham, Maryland 20706.

ADDRESSES: Submit electronic submissions via the Federal eRulemaking 
Portal at www.regulations.gov (indicate IRS and REG-120186-18) by 
following the online instructions for submitting comments. Once 
submitted to the Federal eRulemaking Portal, comments cannot be edited 
or withdrawn. The Department of the Treasury (Treasury Department) and 
the IRS will publish for public availability any comment received to 
its public docket, whether submitted electronically or in hard copy. 
Send hard copy submissions to: CC:PA:LPD:PR (REG-120186-18), room 5203, 
Internal Revenue Service, PO Box 7604, Ben Franklin Station, 
Washington, DC 20044. Submissions may be hand-delivered Monday through 
Friday between the hours of 8 a.m. and 4 p.m. to CC:PA:LPD:PR (REG-
120186-18), Courier's Desk, Internal Revenue Service, 1111 Constitution 
Avenue NW, Washington, DC 20224.

FOR FURTHER INFORMATION CONTACT: Concerning the proposed regulations, 
Erika C. Reigle of the Office of Associate Chief Counsel (Income Tax 
and Accounting), (202) 317-7006, and Kyle C. Griffin of the Office of 
Associate Chief Counsel (Income Tax and Accounting), (202) 317-4718; 
concerning the submission of comments, the hearing, or to be placed on 
the building access list to attend the hearing, Regina L. Johnson, 
(202) 317-6901 (not toll-free numbers).

SUPPLEMENTARY INFORMATION: 

Background

    This document contains proposed regulations under section 1400Z-2 
of the Code that amend the Income Tax Regulations (26 CFR part 1). 
Section 13823 of the Tax Cuts and Jobs Act, Public Law 115-97, 131 
Stat. 2054, 2184 (2017) (TCJA), amended the Code to add sections 1400Z-
1 and 1400Z-2. Sections 1400Z-1 and 1400Z-2 seek to encourage economic 
growth and investment in designated distressed communities (qualified 
opportunity zones) by providing Federal income tax benefits to 
taxpayers who invest new capital in businesses located within qualified 
opportunity zones through a QOF.
    Section 1400Z-1 provides the procedural rules for designating 
qualified opportunity zones and related definitions. Section 1400Z-2 
provides two main tax incentives to encourage investment in qualified 
opportunity zones. First, it allows for the deferral of inclusion in 
gross income of certain gain to the extent that a taxpayer elects to 
invest a corresponding amount in a QOF. Second, it allows for the 
taxpayer to elect to exclude from gross income the post-acquisition 
gain on investments in the QOF held for at least 10 years. 
Additionally, with respect to the deferral of inclusion in gross income 
of certain gain invested in a QOF, section 1400Z-2 permanently excludes 
a portion of such deferred gain if the corresponding investment in the 
QOF is held for five or seven years.
    On October 29, 2018, the Department of the Treasury (Treasury 
Department) and the IRS published in the Federal Register (83 FR 54279) 
a notice of proposed rulemaking (REG-115420-18) providing guidance 
under section 1400Z-2 of the Code for investing in qualified 
opportunity funds (83 FR 54279 (October 29, 2018)). A public hearing on 
83 FR 54279 (October 29, 2018) was held on February 14, 2019. The 
Treasury Department and the IRS continue to consider the comments 
received on 83 FR 54279 (October 29, 2018), including those provided at 
the public hearing.
    As is more fully explained in the Explanation of Provisions, the 
proposed regulations contained in this notice of proposed rulemaking 
describe and clarify requirements relating to investing in QOFs not 
addressed in 83 FR 54279 (October 29, 2018). Specifically, and as was 
indicated in 83 FR 54279 (October 29, 2018), these proposed regulations 
address the meaning of ``substantially all'' in each of the various 
places where it appears in section 1400Z-2; the reasonable period for a 
QOF to reinvest proceeds from the sale of qualifying assets without 
paying a penalty pursuant to section 1400Z-2(e)(4)(B); the transactions 
that may trigger the inclusion of gain that has been deferred under a 
section 1400Z-2(a) election; and other technical issues with regard to 
investing in a QOF. Because portions of 83 FR 54279 (October 29, 2018) 
contained certain placeholder text, included less detailed guidance in 
certain areas that merely cross-referenced statutory rules, or lacked 
sufficient detail to address these issues, this notice of proposed 
rulemaking withdraws paragraphs (c)(4)(i), (c)(5) and (6), 
(d)(2)(i)(A), (d)(2)(ii) and (iii), (d)(5)(i), and (d)(5)(ii)(B) of 
proposed Sec.  1.1400Z2(d)-1 of 83 FR 54279 (October 29, 2018), and 
proposes in their place new paragraphs (c)(4)(i), (c)(5) and (6), 
(d)(2)(i)(A), (d)(2)(ii) and (iii), (d)(5)(i), and (d)(5)(ii)(B) of 
proposed Sec.  1.1400Z2(d)-1.
    The Treasury Department and the IRS welcome suggestions as to other 
issues that should be addressed to further clarify the rules under 
section 1400Z-2, as well as comments on all aspects of these proposed 
regulations.
    Within a few months of the publication of these proposed 
regulations, the Treasury Department and the IRS expect to address the 
administrative rules under section 1400Z-2(f) applicable to a QOF that 
fails to maintain the required 90 percent

[[Page 18653]]

investment standard of section 1400Z-2(d)(1), as well as information-
reporting requirements for an eligible taxpayer under section 1400Z-2, 
in separate regulations, forms, or publications.
    In addition, the Treasury Department and the IRS anticipate 
revising the Form 8996 (OMB Control number 1545-0123) for tax years 
2019 and following. As provided for under the rules set forth in 83 FR 
54279 (October 29, 2018), a QOF must file a Form 8996 with its Federal 
income tax return for initial self-certification and for annual 
reporting of compliance with the 90-Percent Asset Test in section 
1400Z-2(d)(1). Subject to tax administration limitations, the Paperwork 
Reduction Act of 1995 (44 U.S.C. 3507(d)), and other requirements under 
law, it is expected that proposed revisions to the Form 8996 could 
require additional information such as (1) the employer identification 
number (EIN) of the qualified opportunity zone businesses owned by a 
QOF and (2) the amount invested by QOFs and qualified opportunity zone 
businesses located in particular Census tracts designated as qualified 
opportunity zones. In that regard, consistent with Executive Order 
13853 of December 12, 2018, Establishing the White House Opportunity 
and Revitalization Council (E.O. 13853), published in the Federal 
Register (83 FR 65071) on December 18, 2018, and concurrent with the 
publication of these proposed regulations, the Treasury Department and 
the IRS are publishing a request for information (RFI) under this 
subject in the Notices section of this edition of the Federal Register, 
with a docket for comments on www.regulations.gov separate from that 
for this notice of proposed rulemaking, requesting detailed comments 
with respect to methodologies for assessing relevant aspects of 
investments held by QOFs throughout the United States and at the State, 
Territorial, and Tribal levels, including the composition of QOF 
investments by asset class, the identification of designated qualified 
opportunity zone Census tracts that have received QOF investments, and 
the impacts and outcomes of the investments in those areas on economic 
indicators, including job creation, poverty reduction, and new business 
starts. E.O. 13853 charges the White House Opportunity and 
Revitalization Council, of which the Treasury Department is a member, 
to determine ``what data, metrics, and methodologies can be used to 
measure the effectiveness of public and private investments in urban 
and economically distressed communities, including qualified 
opportunity zones.'' See the requests for comments in the RFI regarding 
these or other topics regarding methodologies for assessing the impacts 
of sections 1400Z-1 and 1400Z-2 on qualified opportunity zones 
throughout the Nation.

Explanation of Provisions

I. Qualified Opportunity Zone Business Property

A. Definition of Substantially All for Purposes of Sections 1400Z-
2(d)(2) and (d)(3)

    The proposed rule published at 83 FR 54279 (October 29, 2018) 
clarified that, for purposes of section 1400Z-2(d)(3)(A)(i), for 
determining whether an entity is a qualified opportunity zone business, 
the threshold to determine whether a trade or business satisfies the 
substantially all test is 70 percent. See 83 FR 54279, 54294 (October 
29, 2018). If at least 70 percent of the tangible property owned or 
leased by a trade or business is qualified opportunity zone business 
property (as defined in section 1400Z-2(d)(3)(A)(i)), proposed Sec.  
1.1400Z2(d)-1(d)(3)(i) in 83 FR 54279 (October 29, 2018) provides that 
the trade or business is treated as satisfying the substantially all 
requirement in section 1400Z-2(d)(3)(A)(i).
    The phrase substantially all is also used throughout section 1400Z-
2(d)(2). The phrase appears in section 1400Z-2(d)(2)(D)(i)(III), which 
establishes the conditions for property to be treated as qualified 
opportunity zone business property (``during substantially all of the 
qualified opportunity fund's holding period for such property, 
substantially all of the use of such property was in a qualified 
opportunity zone''). The phrase also appears in sections 1400Z-
2(d)(2)(B)(i)(III) and 1400Z-2(d)(2)(C)(iii), which require that during 
substantially all of the QOF's holding period for qualified opportunity 
zone stock or qualified opportunity zone partnership interests, such 
corporation or partnership qualified as a qualified opportunity zone 
business.
    The proposed rule published at 83 FR 54279 (October 29, 2018) 
reserved the proposed meaning of the phrase substantially all as used 
in section 1400Z-2(d)(2). The statute neither defines the meaning of 
substantially all for the QOF's holding period for qualified 
opportunity zone stock, qualified opportunity zone partnership 
interests, and qualified opportunity zone business property, nor 
defines it for purposes of testing the use of qualified opportunity 
zone business property in a qualified opportunity zone. The Treasury 
Department and the IRS have received numerous questions and comments on 
the threshold limits of substantially all for purposes of section 
1400Z-2(d)(2). Many commenters suggested that a lower threshold for the 
use requirement of section 1400Z-2(d)(2)(D)(i)(III) would allow a 
variety of businesses to benefit from qualifying investments in QOFs. 
Other commentators suggested that too low a threshold would negatively 
impact the low-income communities that section 1400Z-2 is intended to 
benefit, because the tax-incentivized investment would not be focused 
sufficiently on these communities.
    Consistent with 83 FR 54279 (October 29, 2018) these proposed 
regulations provide that, in testing the use of qualified opportunity 
zone business property in a qualified opportunity zone, as required in 
section 1400Z-2(d)(2)(D)(i)(III), the term substantially all in the 
context of ``use'' is 70 percent. With respect to owned or leased 
tangible property, these proposed regulations provide identical 
requirements for determining whether a QOF or qualified opportunity 
zone business has used substantially all of such tangible property 
within the qualified opportunity zone within the meaning of section 
1400Z-2(d)(2)(D)(i)(III). Whether such tangible property is owned or 
leased, these proposed regulations propose that the substantially all 
requirement regarding ``use'' is satisfied if at least 70 percent of 
the use of such tangible property is in a qualified opportunity zone.
    As discussed in the preamble to 83 FR 54279 (October 29, 2018) a 
compounded use of substantially all must be interpreted in a manner 
consistent with the intent of Congress. Consequently, the Treasury 
Department and the IRS have determined that a higher threshold is 
necessary in the holding period context to preserve the integrity of 
the statute and for the purpose of focusing investment in designated 
qualified opportunity zones. Thus, the proposed regulations provide 
that the term substantially all as used in the holding period context 
in sections 1400Z-2(d)(2)(B)(i)(III), 1400Z-2(d)(2)(C)(iii), and 1400Z-
2(d)(2)(D)(i)(III) is defined as 90 percent. Using a percentage 
threshold that is higher than 70-percent in the holding period context 
is warranted as taxpayers are more easily able to control and determine 
the period for which they hold property. In addition, given the lower 
70-percent thresholds for testing both the use of tangible property in 
the qualified opportunity zone and the amount of owned and leased 
tangible property of a qualified opportunity zone business

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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