Matthew D. Mitchell

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Tax Update Seminar
November 13, 2019
Matthew D. Mitchell
Qualified Opportunity Zones in Practice

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Outline
- Review of the Opportunity Zone Program
- Investing into the Program
- Operating the Fund
- Conclusion

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Review Opportunity
Zone of Program
Part I

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- Tax incentive program to spur investment in
certain low-income designated areas
- Each state nominated census tracts to be
designated as “opportunity zones”
- Investment in real estate and businesses
existing and operating within the
“opportunity zones” may qualify for tax
benefits of the program
Program
and Zones

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Designated
Census
Tracts in
Arkansas

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Investor
Basics
Provides taxpayers three main benefits:
- Deferral of capital gain
- Partial forgiveness of that capital gain
- Forgiveness of additional future gains
To qualify, Taxpayer invests the gain in a
qualified opportunity zone fund (QOF) within
180 days of the date of the sale or exchange
by the Taxpayer

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Tax
Benefits
- Deferral of capital gain
- The gain invested into the QOF deferred until the earlier of: (1) sale
of the investment in the QOF (or an “inclusion event”) and (2)
December 31, 2026
- Partial forgiveness of that capital gain
- After holding the QOF interest for 5 years, Taxpayer receives basis
increase in its QOF interest of 10% of Taxpayer’s gain
- After holding the QOF interest for 7 years, Taxpayer receives
additional basis increase in its QOF interest of 5% of Taxpayer’s
gain
- Forgiveness of additional future gains
- If Taxpayer holds the QOF interest for at least 10 years, the
Taxpayer may make an election to increase the basis of Taxpayer’s
QOF interest to equal the FMV of such QOF interest when the
Taxpayer sells or exchanges the QOF interest

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Sample Investment (Part 1)
Jan 2, 2018:
Taxpayer sells property
generating $1MM of capital
gain
2018 2018 2019
May 29, 2018:
Taxpayer contributes entire
$1MM capital gain into
QOZF and makes timely
election.
Taxpayer deemed to have
$0 basis in its QOZF
investment

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Sample Investment (Part 2)
May 29, 2023:
Taxpayer’s basis in QOZF
increases from $0 to
$100k
2022 2023 2025 2026 2028
May 29, 2025:
Taxpayer’s basis in QOZF
increases from $100k - $150k
December 31, 2026
$850k of $1MM of deferred capital
gains are taxed
May 29, 2028
Taxpayer sells its
investment for
$2MM.
No additional tax

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Summary of Benefit
- Started with $1MM of investment
- Paid tax on $850k of income, ~$170k in 2026 (federal,
assumed 20% rate)
- Receives $2MM in 2028, no additional federal tax in 2028

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Investing into the Program
Part II

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Investor Details
Who is the Taxpayer to make the election?
- Any taxpayer, special rules for pass-through entities
What type of gain?
- “Eligible gain” is a gain “treated as a capital gain”
- ordinary income/1245 (no)
- Capital gain income from section 1231 property is determinable only as
of the last day of the taxable year, 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.

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Additional Investor Detail
What type of sale?
- Only gain arising from the sale to “unrelated” persons
- Proposed Regs adopt 20% test (Prop. Reg. 1.1400Z-2(a)-1(b)(2))
When does the 180-day period run?
- 180 days from the gain event, usually…
- 180 days runs from last day of partnership’s taxable year, unless elected
otherwise by Partner (Prop. Reg. 1.1400Z-2(a)-1(c)(iii)
- 1231 gains? From last day of the tax year

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Example of
Timing
- Five partners in partnership P, and P’s taxable year is the
calendar year.
- On January 17, 2019, P realizes a capital gain of $1000x
that it decides not to elect to defer. Two of the partners,
however, want to defer their allocable portions of that
gain.
- One of these two partners invests $200x in a QOF
during February 2020. Under the general rule in
paragraph (c)(2)(iii)(A) of this section, this investment is
within the 180-day period for that partner (which begins
on December 31, 2019).
- Another partner decides to make the election provided in
paragraph (c)(2)(iii)(B) of this section and invests $200x
in a QOF during February 2019. Under that elective
rule, this investment is within the 180-day period for that
partner (which begins on January 17, 2019).

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Additional Investor Detail
Investing non-gain cash (“mixed funds”)
- Statute clear that only gain gets the three benefits above
- If principal and gain invested treated as two investments
Arkansas is conforming – with a key exception: For Arkansas,
only tracts in Arkansas count as “qualified census” tracts

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April regulations provided additional clarity around the 10-year
step-up
- A QOF Fund can sell certain qualifying property to a Buyer after ten
years and the investor in the QOF can step-up basis
- Planning opportunities here, more to come
Final Investor Detail
10 Year Rule

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Operating the Fund
Part III

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QOF Basics
Type and Formation
- Tax Corporation or Partnership (can be an LLC)
- Pre-existing entity OK
- No disregarded entities
- Self-certifies (Form 8996)
Asset Test
- 90% of Fund’s assets are “Qualified Opportunity Zone Property”
- Fund’s assets are tested semi-annually

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Qualified
Opportunity Zone
Stock (indirect)
Qualified
Opportunity Zone
Partnership
Interest (indirect)
Qualified
Opportunity Zone
Business Property
(direct)
Qualified
Opportunity
Zone Property
Qualified
Opportunity Zone
Stock
Qualified
Opportunity Zone
Stock
Qualified
Opportunity Zone
Business Property

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Direct and Indirect Investment
Indirect Approach Direct Approach
Fund
GP
Fund
LP
Fund
LP
Project Partnership
Project
Project
GP
Opportunity
Zone Fund
Fund
GP
Fund
LP
Fund
LP
Project
Opportunity
Zone Fund

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- Tangible property used in a trade or business;
- Acquired by purchase from an unrelated party (20% standard)
- After December 31, 2017;
- During substantially all of holding period, substantially all the use is in a
Qualified Opportunity Zone; AND
- Original Use or Substantially Improved
Qualified Opportunity Zone
Business Property

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QOZ Stock and Partnership Interests
Qualified Opportunity Zone Stock and Qualified Opportunity
Zone Partnership Interests similar three requirements
3
2
1
QOZF acquired interest after 12/31/17 for cash
Established to be a “Qualified Opportunity Zone
Business”
Remains “Qualified Opportunity Zone Business” for
substantially all of QOZF’s ownership

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Qualified Opportunity Zone
Business
A trade or business in which
“substantially all” of the tangible
property owned or leased by the
taxpayer is qualified opportunity
zone business property
Less than 5 percent of the
average of the aggregate
unadjusted bases of
property is nonqualified
financial property
At least 50% of income
derived from active conduct
within the QOZ
A substantial portion of the
intangible property used in
the active conduct of the
business
Not a “sin” business

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Benefits of Indirect Approach
Indirect Approach Direct Approach
Fund
GP
Fund
LP
Fund
LP
Project Partnership
Project
Project
GP
Opportunity
Zone Fund
Fund
GP
Fund
LP
Fund
LP
Project
Opportunity
Zone Fund

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Benefits of Indirect Approach
- “substantially all” of the property of the qualified opportunity
zone business was required to be “qualified opportunity zone
business property”
- Proposed Regs adopted 70% threshold for definition of “substantially
all”
- Proposed Regs adopt a “start-up” safe harbor that permits
qualified opportunity zone business to hold working capital

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QOZB Working Capital Safe Harbor
- Under the “start-up” safe harbor, a qualified opportunity zone
business may adopt a written business plan that outlines
sources and uses of the business for the first 31 months of the
business
- The cash held by the qualified opportunity zone business is
treated as reasonable working capital and counts as “qualified
opportunity zone business property” during the “start-up”
period

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QOF and QOZB Operations
- Newly Acquired Capital
- Original Use or Substantially Improved
- Leased Property
- Debt and distributions
- Reinvestment
- Revisiting 10-year step-up

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Newly Contributed Capital
- Structural problem for QOFs required to test immediately after
receiving capital
- IRS provides relief:
- In its asset testing, a QOF may ignore capital contributed to the QOF if
that capital is held in in cash, cash equivalents, or debt instruments with
term 18 months or less

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- Taxpayer A incurs $1MM capital gain
9/1/19
- Taxpayer A invests $1MM in QOF Z on
1/15/20
- QOF Z holds the cash invested in cash
until 7/30/20, when it invests in a QOZB
Newly
Contributed
Capital
Example The $1MM is not included in QOF Z’s asset testing for
12/31/19 (prior to investing) or 6/30/20 (within 6 months
of the test). The cash would have been included in the
6/30/20 test.

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Basic Rule:
- Original use in the Qualified Opportunity Zone commences with the
taxpayer; OR
- Taxpayer substantially improves the property (i.e., during any 30-month
period after acquisition, additions to basis exceed an amount equal to the
adjusted basis of such property at the beginning of such period)
Original Use or Substantially
Improved

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Classifications
Catalogue of Asset Types (Real Estate)
- Classification 1: Unimproved land
- Classification 2: Land with operational building
- Classification 3: Land with vacant building

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- Unimproved land does not need to be substantially improved
- …but improved by “more than an insubstantial amount”
- Remember, still must be used in a trade or business
- IRS warns of broad anti-abuse rule here, specifically mentions
farming
Classification One
(Unimproved Land)

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- Substantial improvement is measured only by a comparison of
the allocation to the building basis and additions to the building
- Only substantial improvement of the building is necessary –
land does not need to be separately improved
- Both land and building count as good assets once improved
Classification Two
(Land With Operational Building)

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Fact Pattern (Revenue Ruling 2018-29):
- QOZF buys property X for $800X. $480X allocated to Land and $320X
allocated to the Building.
- Within 24 months of acquisition, $400X spent on renovating the Building
- All $1200X counts as “qualified opportunity zone business property” –
only $320x needed
Classification Two
(Land with operational building)

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- Property vacant for 5 years can be “originally used” within the
zone
- Note on Personal Property
- Technically same rules, functionally apply differently
- Asset by asset approach
Classification Three
(Vacant Building)

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Leases
How does leased property count for purposes of the QOZ asset
testing?
- Two basic requirements:
- Lease entered into after 12/31/17
- Must be located in the zone

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Leases (additional rules)
No original use/substantial improvement requirement
No general related-party restriction, but, if related party lease:
- Market rate
- No prepayments of more than 12 months
- Lessee/related party must also acquire property at least equal in value to
the leased property
- Purchase options must be at FMV

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Debt and Distributions
- Debt and Section 752 rules work as usual
- for QOF Partnerships, actual or deemed distribution of cash by a QOF
partnership to a partner with respect to its qualifying investment is an
inclusion event only to the extent that the cash exceeds the partner’s
basis in its qualifying investment
- Except, be careful with distributions made within 2 years of
investment into a QOF. Disguised sale rules apply treating
cash like property
- It appears that a debt-financed distribution to a QOF investor within two
years of the investor’s qualifying contribution to the QOF will disqualify
the investor’s contribution from eligibility for QOZ benefits.

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Debt and Distributions - Example
- On 1/1/19, A and B form QOF Z, each contributing $200 of
qualifying investment
- On 11/18/22, Z obtains a nonrecourse loan from a bank for $300.
- Under section 752, the loan is allocated $150 to A and $150 to B.
- On 11/30/22, when the values and bases of the investments
remain unchanged, Q distributes $50 to A.
- A is not required to recognize gain 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.

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Reinvestment Rules
Reinvestment period permitted for QOF testing
- QOF must reinvest within 12 months of receiving proceeds
- Rule does not currently apply to QOZBs - necessary?
Reinvestment does not exclude income
- The IRS was not “able to find precedent for the grant of authority . . . to
avoid recognizing gain on the sale or disposition of assets”

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Revisiting 10-Year Step-up
- Recall statute provides that the taxpayer can sell its interest in
the Fund and step-up to FMV of the Fund interest
- The regulations permit a Fund (taxed as a partnership or s-
corp) to sell QOZ Property and the partner/shareholder to
exclude the flow-through income
- New Fund for each project?

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One Fund or Multiple Funds?
Fund
GP
Fund
LP
Fund
LP
Project Partnership
Project
Project
GP
Opportunity
Zone Fund

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One Fund or Multiple Funds?
Example: In 2019, A and B each contribute $100 to a QOF
partnership Z.
- Fact Pattern 1:
- 2030, QOF Z’s assets have a value of $260
- Basis 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)
- A makes election to step-up with regard to the sale, therefore 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.

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One Fund or Multiple Funds?
Fact Pattern 1
Sells the QOF
interest
BA
QOF Z
Project
GP
Project
Partnership

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One Fund or Multiple Funds?
Fact Pattern 2:
- The facts are the same, except
- QOF Z sells qualified opportunity zone property
- Value of $120 and a basis of $100
- Recognizing $20 of capital gain, allocable $10 to each partner
- A makes an election under section 1400Z-2(c) (and regulation
thereunder)
- A will exclude the $10 allocable share of the partnership's $20 of
recognized gain.

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One Fund or Multiple Funds?
Fact Pattern 2
QOF Z sells its
partnership
interest in the
project
BA
QOF Z
Project
GP
Project
Project
Partnership

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10 Year Mechanics: Takeaways
- The Fact Pattern 1 step-up applies to step-up all Fund
holdings to FMV
- The Fact Pattern 2 step-up applies to: (1) capital gains from (2)
QOZ Property
- Plan around the 10-year events: hot assets, marketability of
fund sale
- What about QOZB sale of its property?

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Other Notes on Guidance
- QOF Investors can sell entire QOF interests and continue to
qualify their investments
- No indirect QOF investments (feeder funds)
- April regs included a large list of “inclusion events” accelerating
the deferred gain
- April regs provide three safe harbors for 50% income
requirement
- Profits interests for services do not qualify for QOZ tax benefits

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CONCLUSION
Part IV

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FOUR RULES OF QOZ PLANNING
- Invest within 180 days
- QOFs hold equity
- QOFs don’t hold cash
- QOZBs hold assets

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www.FridayFirm.com
400 West Capitol Ave. Suite 2000 I Little Rock, AR 72201
3425 North Futrall Dr. Suite 103 I Fayetteville, AR 72703
3350 South Pinnacle Hills Pkwy. Suite 301 I Rogers, AR 72758
MATTHEW D. MITCHELL
Mergers & Acquisitions
and Real Estate
479-695-6053
mmitchell@fridayfirm.com
www.fridayfirm.com/attorney/mmitchell