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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

TD 9889

RIN 1545-BP04

Investing in Qualified Opportunity Funds

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulation.

SUMMARY: This document contains final regulations governing the extent to which

taxpayers may elect the Federal income tax benefits provided by section 1400Z-2 of the

Internal Revenue Code (Code) with respect to certain equity interests in a qualified

opportunity fund (QOF). The final regulations address the comments received in

response to the two notices of proposed rulemaking issued under section 1400Z-2 and

provide additional guidance for taxpayers eligible to elect to temporarily defer the

inclusion in gross income of certain gains if corresponding amounts are invested in

certain equity interests in QOFs, as well as guidance on the ability of such taxpayers to

exclude from gross income additional gain recognized after holding those equity

interests for at least 10 years. The final regulations also address various requirements

that must be met for an entity to qualify as a QOF, including requirements that must be

met for an entity to qualify as a qualified opportunity zone business. The final

regulations affect entities that self-certify as QOFs and eligible taxpayers that make

investments, whether qualifying or non-qualifying, in such entities.

DATES: Effective Date: The final regulations contained in this document are effective

on [INSERT DATE 60 DAYS AFTER PUBLICATION IN THE FEDERAL REGISTER].

Applicability Dates: For dates of applicability, see §§1.1400Z2(a)-1,

1.1400Z2(b)-1, 1.1400Z2(c)-1, 1.1400Z2(d)-1, 1.1400Z2(d)-2, 1.1400Z2(f)-1, 1.150214Z, and 1.1504-3 set forth in this document, which provide that the final regulations set

forth in §§1.1400Z2(a)-1 through 1.1400Z2(d)-2, 1.1400Z2(f)-1, 1.1502-14Z, and

1.1504-3 are generally applicable for taxable years beginning after [INSERT DATE 60

DAYS AFTER PUBLICATION IN THE FEDERAL REGISTER]. With respect to the

portion of a taxpayer’s first taxable year ending after December 21, 2017 that began on

December 22, 2017, and for taxable years beginning after December 21, 2017, and on

or before [INSERT DATE 60 DAYS AFTER PUBLICATION IN THE FEDERAL

§§1.1400Z2(a)-1 through 1.1400Z2(d)-2, 1.1400Z2(f)-1, 1.1502-14Z, and 1.1504-3

contained in this document, if applied in a consistent manner for all such taxable years,

or (2) to rely on each section of proposed §§1.1400Z2(a)-1 through 1.1400Z2(g)-1,

except for proposed §1.1400Z2(c)-1, contained in the notices of proposed rulemaking

published on October 29, 2018, and on May 1, 2019, in the Federal Register (83 FR

54279; 84 FR 18652), but only if relied upon in a consistent manner for all such taxable

years. Taxpayers relying on each section of proposed §§1.1400Z2(a)-1 through

1.1400Z2(g)-1, except for proposed §1.1400Z2(c)-1, contained in the notices of

proposed rulemaking published on October 29, 2018, and on May 1, 2019, in the

Federal Register (83 FR 54279; 84 FR 18652), must apply §1.1400Z2(c)-1 of the final

regulations contained in this document with respect to any elections made under section

1400Z-2(c).

FOR FURTHER INFORMATION CONTACT: Concerning section 1400Z-2 and these

regulations generally, Alfred H. Bae, (202) 317-7006, or Kyle C. Griffin, (202) 317-4718,

of the Office of Associate Chief Counsel (Income Tax and Accounting); concerning

issues related to C corporations and consolidated groups, Jeremy Aron-Dine, (202)

317-6848, or Sarah Hoyt, (202) 317-5024, of the Office of Associate Chief Counsel

(Corporate); concerning issues related to gains from financial contracts, REITs, or RICs,

Andrea Hoffenson or Pamela Lew, (202) 317-7053, of the Office of Associate Chief

Counsel (Financial Institutions and Products); concerning issues related to investments

by foreign persons, Eric Florenz, (202) 317-6941, or Milton Cahn (202) 317-6937, of the

Office of Associate Chief Counsel (International); concerning issues related to

partnerships, S corporations or trusts, Marla Borkson, Sonia Kothari, or Vishal Amin, at

(202) 317-6850, and concerning issues related to estates and gifts, Leslie Finlow or

Lorraine Gardner, at (202) 317-6859, of the Office of Associate Chief Counsel

(Passthroughs and Special Industries). These numbers are not toll-free numbers.

SUPPLEMENTARY INFORMATION:

Background

This document amends the Income Tax Regulations (26 CFR part 1) by adding

final regulations under section 1400Z-2 of the Code. Section 13823 of Public Law 11597, 131 Stat. 2054 (December 22, 2017), commonly referred to as the Tax Cuts and

Jobs Act (TCJA), added sections 1400Z-1 and 1400Z-2 to the Code. Section 1400Z-1

addresses the designation of population census tracts located in the 50 states, U.S.

territories, and the District of Columbia as qualified opportunity zones (QOZs). See

Notice 2018-48, 2018-28 I.R.B. 9, and Notice 2019-42, 2019-29 I.R.B. 352, for the list of

population census tracts designated as QOZs (each, a QOZ designation notice).

Section 1400Z-2 provides two main Federal income tax benefits to eligible

taxpayers that make longer-term investments of new capital in one or more designated

QOZs through QOFs and qualified opportunity zone businesses. The first main Federal

income tax benefit provided by section 1400Z-2 is the ability of an eligible taxpayer,

upon the making of a valid election, to defer until as late as December 31, 2026, the

inclusion in gross income of certain gains that would otherwise be recognized in a

taxable year if the taxpayer invests a corresponding amount of such gain in a qualifying

investment in a QOF within a 180-day statutory period. The eligible taxpayer may

potentially exclude 10 percent of such deferred gain from gross income if the eligible

taxpayer holds the qualifying investment in the QOF for at least five years. See section

1400Z-2(b)(2)(B)(iii). An additional five percent of such gain may potentially be

excluded from gross income if the eligible taxpayer holds that qualifying investment for

at least seven years. See section 1400Z-2(b)(2)(B)(iv). The second main Federal

income tax benefit provided by section 1400Z-2 is the ability for the eligible taxpayer,

upon the making of a separate valid election, to exclude from gross income any

appreciation on the eligible taxpayer’s qualifying investment in the QOF if the eligible

taxpayer holds the qualifying investment for at least 10 years. See section 1400Z-2(c).

On October 29, 2018, the Department of the Treasury (Treasury Department)

and the IRS published a notice of proposed rulemaking (REG-115420-18) in the

Federal Register (83 FR 54279) containing a first set of proposed regulations under

section 1400Z-2 (October 2018 proposed regulations). The October 2018 proposed

regulations addressed the type of gain that is eligible for deferral by eligible taxpayers,

the timing by which eligible taxpayers must invest amounts in QOFs corresponding to

the gains to be deferred, and the manner in which eligible taxpayers could make

deferral elections of any gains. The October 2018 proposed regulations also provided

rules for the self-certification of QOFs, valuation of QOF assets, and general guidance

on the requirements for a corporation or partnership to be a qualified opportunity zone

business, including providing that the term “substantially all” as used in section 1400Z2(d)(3)(A)(i) means at least 70 percent. The Treasury Department and the IRS received

180 written and electronic comments responding to the October 2018 proposed

regulations. A public hearing on the October 2018 proposed regulations was held on

February 14, 2019.

A second notice of proposed rulemaking (REG-120186-18) was published in the

Federal Register (84 FR 18652) on May 1, 2019, containing additional proposed

regulations under section 1400Z-2 (May 2019 proposed regulations). The May 2019

proposed regulations updated portions of the October 2018 proposed regulations to

address various issues, including: the definition of the term “substantially all” in each of

the various places the term appears in section 1400Z-2; transactions resulting in the

inclusion under section 1400Z-2(a)(1)(B) and (b) of eligible gain that an eligible taxpayer

elected to defer under section 1400Z-2(a); the treatment of leased property used by a

QOF or qualified opportunity zone business; the use of qualified opportunity zone

business property in the QOZ; 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 the penalty imposed by section 1400Z-2(f)(1).

The Treasury Department and the IRS received 127 written and electronic comments

responding to the May 2019 proposed regulations. A public hearing on the May 2019

proposed regulations was held on July 9, 2019.

The October 2018 proposed regulations and the May 2019 proposed regulations

are collectively referred to in this Treasury decision as the “proposed regulations.” All

comments received on the proposed regulations are available at www.regulations.gov

or upon request.

The preamble to the May 2019 proposed regulations stated that the Treasury

Department and the IRS would schedule tribal consultation with officials of governments

of Federally recognized Indian tribes (Indian tribal governments) before finalizing the

proposed regulations to obtain additional input, within the meaning of the Treasury

Department’s Tribal Consultation Policy (80 FR 57434, September 23, 2015), in

accordance with Executive Order 13175, “Consultation and Coordination with Indian

tribal governments” (65 FR 67249, November 6, 2000), on the ability of entities

organized under the law of an Indian tribe to be QOFs or qualified opportunity zone

businesses, whether any additional guidance may be needed regarding the ability of

QOFs or qualified opportunity zone businesses to lease tribal government Federal trust

lands or leased real property located on such lands, and any other tribal implications of

the proposed regulations. This tribal consultation took place via telephone on October

21, 2019 (Consultation) (see part VI. of the Special Analyses for additional discussion).

After full consideration of all comments received on the proposed regulations,

including comments received from the Consultation, and the testimony heard at both

public hearings, this Treasury decision adopts the proposed regulations with

modifications in response to such comments and testimony, as described in the

Summary of Comments and Explanation of Revisions following this Background.

Summary of Comments and Explanation of Revisions

I. Overview

The final regulations set forth in §§1.1400Z2(a)-1 through 1.1400Z2(f)-1, 1.150214Z, and 1.1504-3 (section 1400Z-2 regulations) retain the basic approach and

structure of the proposed regulations, with certain revisions. The Treasury Department

and the IRS have refined and clarified certain aspects of the proposed regulations in

these final regulations to make the rules easier to follow and understand. Specifically,

proposed §1.1400Z2(d)-1 has been split into two separate sections: §1.1400Z2(d)-1

and §1.1400Z2(d)-2. Further, the Treasury Department and the IRS have combined

duplicative rules regarding QOFs and qualified opportunity zone businesses, and have

added defined terms to allow the reader to more intuitively grasp the meaning of the

numerous provisions cross-referenced in the final regulations.

This Summary of Comments and Explanation of Revisions discusses those

revisions as well as comments received in response to each of §§1.1400Z2(a)-1

through 1.1400Z2(g)-1 of the proposed regulations (proposed §§1.1400Z2(a)-1 through

1.1400Z2(g)-1). The rules proposed in the October 2018 proposed regulations and the

May 2019 proposed regulations are explained in greater detail in the Explanation of

Provisions sections of the preambles to each set of proposed regulations.

II. Comments on and Changes to Proposed §1.1400Z2(a)-1

Proposed §1.1400Z2(a)-1 prescribed rules regarding the election to defer gains

under section 1400Z-2(a)(1), including rules regarding which taxpayers are eligible to

make the election, which gains are eligible for deferral, and the method by which eligible

taxpayers may make deferral elections. This part II describes the revisions made to

proposed §1.1400Z2(a)-1 based on the comments received on those proposed rules,

including revisions to the definition of eligible gain and revisions to the rules applying the

statutory 180-period and other requirements with regard to the making of a qualifying

investment in a QOF.

A. Definitions and Related Operating Rules

1. Eligible gain

Proposed §1.1400Z2(a)-1(b)(2) generally provided that an amount of gain would

be eligible for deferral under section 1400Z-2(a) if the gain (i) is treated as a capital gain

for Federal income tax purposes that would be recognized for Federal income tax

purposes before January 1, 2027, if section 1400Z-2(a)(1) did not apply to defer

recognition of the gain; and (ii) did not arise from a sale or exchange with a related

person within the meaning of section 1400Z-2(e)(2) (eligible gain). This part II.A.1.

describes the comments received on various aspects of the proposed definition of

eligible gain and explains the revisions, based on those comments, adopted by

§1.1400Z2(a)-1(b)(11) of the final regulations.

a. Gains from Section 1231 Property

Proposed §1.1400Z2(a)-1(b)(2)(iii) of the May 2019 proposed regulations

provided that the only gain arising from property used in the taxpayer’s trade or

business (section 1231 property) eligible for deferral under section 1400Z-2(a)(1) was

“capital gain net income” for a taxable year, which was defined as the amount by which

the capital gains arising from all of a taxpayer’s section 1231 property exceeded all of

the taxpayer’s losses from section 1231 property for a taxable year. The Treasury

Department and the IRS have reconsidered this approach based on the numerous

comments received on this aspect of the May 2019 proposed regulations.

i. Section 1231 generally

Section 1231 governs the character of a taxpayer’s gains or losses with respect

to section 1231 property not otherwise characterized by section 1245 or 1250. Section

1231(b) defines “section 1231 property” generally as depreciable or real property that is

used in the taxpayer’s trade or business and held for more than one year, subject to

enumerated exceptions (for example, property held by the taxpayer primarily for sale to

customers in the ordinary course of the taxpayer’s trade or business).

Under section 1231(a)(1), if a taxpayer’s aggregate gains from each sale and

exchange (each gain, a section 1231 gain) during the taxable year exceed the

taxpayer’s aggregate losses from each sale and exchange (each loss, a section 1231

loss), the taxpayer’s section 1231 gains and section 1231 losses are treated as longterm capital gains and long-term capital losses, respectively. However, if the aggregate

section 1231 gains do not exceed the aggregate section 1231 losses (that is, the

aggregate amount of section 1231 gains equals or is less than the aggregate amount of

section 1231 losses), those gains and losses are not treated as gains and losses from

sales or exchanges of capital assets (that is, they are treated as ordinary income and

ordinary losses). See sections 64, 1221, 1222, and 1231(a)(2) of the Code.

Several provisions of the Code may apply to limit the long-term capital treatment

otherwise potentially provided under section 1231(a)(1). For example, prior to the

aggregation of section 1231 gains and losses under section 1231(a), the recapture rules

of sections 1245 and 1250 must be applied on an asset-by-asset basis. Section 1245,

which applies to sales, exchanges, or dispositions of depreciable tangible and intangible

property, characterizes any gain recognized as ordinary income (as defined in section

64) to the extent depreciation or amortization has been allowed or allowable with

respect to that property. Section 1250 provides a similar “pre-aggregation” recapture

rule with regard to sales, exchanges, or dispositions of depreciable real property that is

not section 1245 property, and it characterizes as ordinary income (as defined in section

64) any gain recognized in excess of straight line depreciation.

Section 1231(c), on the other hand, sets forth a “post-aggregation” recapture

provision, requiring the net section 1231 gain for any taxable year to be treated as

ordinary income to the extent that such gain does not exceed the non-recaptured net

section 1231 losses. Non-recaptured net section 1231 losses are net section 1231

losses for the five most recent preceding taxable years of the taxpayer that have not yet

been recaptured. However, section 1231(c)(5), provides that the principles of section

1231(a)(4) apply for purposes of section 1231(c). Under section 1231(a)(4), to

determine whether gains exceed losses for the section 1231(a) character determination,

section 1231 gains are included only if and to the extent that they are taken into account

in computing gross income, and section 1231 losses are included only if and to the

extent that they are taken into account in computing taxable income.

Essentially, the operation of the “pre-aggregation” recapture rules under sections

1245 and 1250, as well as the “post-aggregation” recapture rule under section 1231(c),

requires a gain recognized with respect to section 1231 property potentially to be

treated as ordinary income, even if that gain otherwise would have been characterized

differently under section 1231(a) in the absence of such recapture rules.

Section 64 defines the term “ordinary income” for purposes of subtitle A of the

Code (subtitle A), which includes sections 1231, 1245, 1250, and 1400Z-2, to include

“any gain from the sale or exchange of property which is neither a capital asset nor

property described in section 1231(b),” and provides further that “[a]ny gain from the

sale or exchange of property which is treated or considered, under other provisions of

this subtitle, as ‘ordinary income’ shall be treated as gain from the sale or exchange of

property which is neither a capital asset nor property described in section 1231(b).” See

for example, sections 1231(c), 1245, and 1250; see also §§1.1245-1(a)(1), 1.12451(b)(2), 1.1250-1(a)(1), 1.1250-1(b)(1), and 1.1250-1(c)(1).

ii. Comments on treatment of section 1231 property

Commenters suggested that the gross amount of section 1231 gain realized from

sales or exchanges of section 1231 property should be eligible gain, provided that such

gain is determined to be capital gain at the end of the taxable year by taking into

account all section 1231 gains and section 1231 losses. Some commenters also

recommended that the 180-day period for investment begin on the date of the sale or

exchange that gives rise to a section 1231 gain instead of at the end of the taxable year.

Many of the commenters recognized that, because section 1231(a)(1) requires a netting

process to determine whether section 1231 gains and losses are capital in character,

investors might not be certain if any of the section 1231 gain invested from sales or

exchanges before the end of the taxable year is capital in character. Therefore, several

commenters suggested that gross section 1231 gains be eligible for investment on the

date of the sale or exchange, contingent on such gains being capital in character as

determined by the netting process at the end of the taxable year. Under this approach,

if the section 1231 gains invested in a QOF during a taxable year are determined not to

be capital in character because section 1231 gains for the year do not exceed section

1231 losses, the section 1231 gains invested that year would constitute an investment

that does not qualify for deferral under section 1400Z-2(a)(1) (a non-qualifying

investment).

In the alternative, many commenters recommended an election to permit a

taxpayer to begin the 180-day period for section 1231 gains on the last day of the

taxable year. This election would accommodate the needs of taxpayers who are unable

to determine whether section 1231 gains will be capital in character until all transactions

involving section 1231 property have been completed for a taxable year. As a model for

this elective approach, commenters referred to proposed §1.1400Z2(a)-1(c)(2)(iii)(B),

which permits a partner to elect to align its 180-day period with that of the partnership,

that is, the date of the sale or exchange giving rise to such gain.

Commenters observed that because gain that is deferred under section 1400Z-2

would not be taken into account in computing gross income until recognized, pursuant

to section 1231(a)(4), any deferred gains would be excluded from the section 1231(a)

character determination. As a result, taxpayers could ensure that section 1231 gains do

not exceed section 1231 losses for a taxable year under section 1231(a) by investing

the excess of gains realized from the sale or exchange of section 1231 property over

the losses from those sales, thus, rendering all section 1231 losses, that otherwise

would be capital in character, ordinary in character. However, commenters noted that

section 1231(a)(4) gives rise to a circularity issue if applied in this manner. If the only

section 1231 gains that are eligible for deferral under section 1400Z-2 are capital

character section 1231 gains, then, if a taxpayer invests an amount of section 1231

gains in a QOF such that the character determination under section 1231(a) produces

ordinary character gains and losses for a taxable year, then all section 1231 gains in

that taxable year would not be eligible gains. Therefore, in light of the application of

section 1231(a)(4), a taxpayer could only defer an amount of section 1231 gains such

that even after subtracting deferred gains, the remaining non-deferred section 1231

gains for the taxable year would still exceed section 1231 losses. In many cases, this

excess amount would be substantially less than the gross amount of section 1231 gains

realized from the sale or exchange section 1231 property for the taxable year. To

resolve both the issue of shifting the character of otherwise capital character section

1231 losses to ordinary character section 1231 losses and the circularity issue

described previously, a commenter suggested treating section 1231 gains deferred

under section 1400Z-2 as if they were “taken into account in computing gross income”

for purposes of section 1231(a)(4). Under such a rule, even if the full amount of section

1231 gains that are capital in character were deferred under section 1400Z-2, section

1231 gains would still exceed section 1231 losses and both section 1231 gains and

losses would retain their capital character after the application of section 1231(a).

Several commenters also requested additional rules with respect to the

application of the rules of section 1231(c) (described earlier) to deferred section 1231

gain. Commenters suggested a rule providing that deferred section 1231 gain to the

extent of non-recaptured net section 1231 losses be treated as ordinary income when

those gains are recognized rather than in the year of gain deferral. In some instances,

this approach may require a taxpayer to account for its non-recaptured net section 1231

losses for a period longer than the five most recent taxable years section 1231(c)

requires. A commenter suggested that the extension of the recapture period be

accomplished by means of an election by the taxpayer at the time any section 1231

gain is deferred under section 1400Z-2. In electing to defer section 1231 gain, a

taxpayer also would elect to extend the section 1231(c) recapture period to the longer of

the statutory five-year period or the taxable year that includes December 31, 2026.

Alternatively, some commenters asked that section 1231(c) not apply at all to deferred

section 1231 gains.

One commenter also noted that the term “capital gain net income” already is

defined in section 1222(9), and that its separate definition and use in the section 1400Z2 regulations might lead to confusion.

In response to these comments, the final regulations provide that eligible gains

that may be deferred pursuant to section 1400Z-2(a)(1)(A) and the section 1400Z-2

regulations include gains from the sale or exchange of property described in section

1231(b) not required to be characterized as ordinary income by sections 1245 or 1250

(qualified section 1231 gains), regardless of whether section 1231(a) (without regard to

section 1231(a)(4)) would determine those gains to be capital or ordinary in character.

As noted earlier, section 64 provides that gains from the sale or exchange of section

1231 property generally are not considered ordinary income for purposes of subtitle A,

although recaptured income under sections 1245 or 1250 would be ordinary income

under section 64.

However, the final regulations do not set forth a special rule to address the

application of section 1231(a)(4) for purposes of applying section 1400Z-2 and the

section 1400Z-2 regulations. Thus, section 1231(a)(4) applies to eligible section 1231

gains deferred pursuant to section 1400Z-2(a)(1)(A) as it would under similar deferral

provisions, such as sections 453 and 1031. That is, unless a section 1231 gain (as

defined in section 1231(a)(3)(A)) is taken into account in computing gross income in a

taxable year, section 1231(a)(4) does not include that gain in calculating whether

section 1231 gains exceed section 1231 losses under section 1231(a)(1) for the taxable

year.

Additionally, these final regulations do not alter the statutory application of the

section 1231(c) recapture of net ordinary loss. Therefore, if a deferral election with

respect to an eligible section 1231 gain is made in year 1, any non-recaptured net

section 1231 losses from the five most recent taxable years that precede year 1 apply to

recapture as ordinary income in year 1 any net section 1231 gain that has not been

deferred in year 1. In other words, the section 1231(c) amount that would have applied

to the eligible section 1231 gain absent a deferral election and corresponding

investment in a QOF is not an attribute associated with the deferred eligible section

1231 gain that is taken into account in applying section 1231 in the ultimate year in

which the deferred gain is included in income under section 1400Z-2(b) and the section

1400Z-2 regulations. Instead, when deferred eligible section 1231 gain is subsequently

included in income on December 31, 2026, or on an earlier date as a result of an

inclusion event, section 1231(c) will recapture net section 1231 gain in the year of

inclusion by taking into account non-recaptured section 1231 losses only from the five

most recent taxable years preceding the taxable year of inclusion.

Unlike the net approach of the proposed regulations, the final regulations adopt a

gross approach to eligible section 1231 gains without regard to any section 1231 losses.

In addition, under the final regulations, the character of eligible section 1231 gains,

other than as gains arising from the sale or exchange of section 1231 property, is not

determined until the taxable year such gains are taken into account in computing gross

income pursuant to section 1231(a)(4). Accordingly, the term “capital gain net income”

used in the proposed regulations is no longer applicable when referring to the amount of

any gain from the sale or exchange of section 1231 property that is eligible for deferral

under section 1400Z-2(a)(1)(A) and the section 1400Z-2 regulations.

The Treasury Department and the IRS have determined that a gross approach

that does not apply section 1231(a) and (c) (gross approach) to determine eligible gain

from the sale or exchange of section 1231 property is consistent with the long-standing

rules of section 64, and is appropriate due to the complexity of applying section 1231 to

deferred gains generally. Moreover, limiting eligible gain from the sale or exchange of

section 1231 property to an amount less than the net section 1231 gains for a taxable

year would impose a significant administrative burden on persons that are required to

report the recognition of such gains during the taxable year under Federal income tax

accounting principles (eligible taxpayers). Similarly, a gross approach to determine

eligible section 1231 gains eliminates complexity and uncertainty in determining eligible

gain for partnerships and S corporations that are eligible taxpayers.

As discussed in part II.A.3.a. of this Summary of Comments and Explanation of

Revisions, because eligible gains include the gross amount of eligible section 1231

gains unreduced by section 1231 losses regardless of character, it is not necessary for

an investor to wait until the end of the taxable year to determine whether any eligible

section 1231 gains are eligible gains. As a consequence, the final regulations provide

that the 180-day period for investing an amount with respect to an eligible section 1231

gain for which a deferral election is to be made begins on the date of the sale or

exchange that gives rise to the eligible section 1231 gain.

b. Character of Eligible Gain

Section 1400Z-2(a)(1)(A) provides that if a taxpayer has “gain from the sale to, or

exchange with, an unrelated person of any property held by the taxpayer,” the taxpayer

may elect to exclude from gross income for the taxable year the aggregate amount of

such gain invested by the taxpayer in a QOF during the 180-day period beginning on

the date of such sale or exchange. The Treasury Department and the IRS considered

whether “gain” eligible for deferral under section 1400Z-2 should include both gain from

the disposition of a capital asset as well as gain treated as ordinary income under

subtitle A.

As noted in part II.A.1.a, section 64 of the Code provides that:

For purposes of [subtitle A], the term “ordinary income” includes any gain

from the sale or exchange of property which is neither a capital asset nor

property described in section 1231(b). Any gain from the sale or

exchange of property which is treated or considered, under other

provisions of [subtitle A], as “ordinary income” shall be treated as gain

from the sale or exchange of property which is neither a capital asset nor

property described in section 1231(b).

Thus, for purposes of subtitle A, including section 1400Z-2, section 64 defines gains

treated as ordinary income as categorically different from gains from the sale or

exchange of capital assets or section 1231 property.

In this regard, proposed §1.1400Z2(a)-1(b)(2)(i) as contained in the October

2018 proposed regulations provided that an amount of gain is an “eligible gain,” and

thus is eligible for deferral under section 1400Z-2(a), if the gain is treated as a capital

gain for Federal income tax purposes. In addition, the May 2019 proposed regulations

provided that the only gain arising from section 1231 property eligible for deferral under

section 1400Z-2(a)(1) was “capital gain net income” for a taxable year, which was

defined as the amount by which the capital gains arising from all of a taxpayer’s section

1231 property exceeded all of the taxpayer’s losses from section 1231 property for a

taxable year.

Based on the statutory text of section 1400Z-2(a)(1)(A), several commenters

requested that the final regulations permit taxpayers to treat both capital gains and

ordinary gains (that is, gains treated as ordinary income) as eligible gains. For

example, commenters requested that gain from property used in a trade or business

required to be characterized as ordinary income, such as recapture income under

sections 1231(c) or 1245(a), should be permitted to be invested in a QOF.

After consideration of the language, structure and purpose of section 1400Z-2 as

a whole, the Treasury Department and the IRS have determined that it would be

inconsistent with section 64 and the statutory framework of section 1400Z-2 to extend

the meaning of the term “gain” in section 1400Z-2(a)(1) to gain required to be treated as

ordinary income under subtitle A, including section 1245 gain. The interpretation of the

Treasury Department and the IRS of the text and structure of the statute is confirmed by

the legislative history, which explicitly identifies “capital gains” as the gains that are

eligible for deferral. See H.R. Rep. No. 115-466, at 537-540 (Dec. 15, 2017)

(Conference Report).

Accordingly, the Treasury Department and the IRS have retained in the final

regulations the general rule set forth in the proposed regulations that limits eligible gains

to gains treated as capital gains for Federal income tax purposes. For purposes of

section 1400Z-2(a)(1), eligible gains generally include gains from the disposition of

capital assets as defined in section 1221(a), gains from the disposition of property

described in section 1231(b), and income treated as capital gain under any provision of

the Code, such as capital gain dividends distributed by certain corporations. For this

purpose, both long-term capital gain and short-term capital gain may be determined to

be eligible gain under the section 1400Z-2 regulations. However, consistent with

section 64, any gain required to be treated as ordinary income under subtitle A, such as

section 1245 recapture income, is not eligible gain.

In that regard, one commenter suggested that, unlike other investors in QOFs,

existing residents of a QOZ should be provided a special accommodation not available

to other eligible taxpayers -- such residents should be permitted to invest any gain,

regardless of character, in QOFs and elect to defer the corresponding amounts in

accordance with section 1400Z-2. The Treasury Department and the IRS have

determined that neither the statutory language nor legislative history of section 1400Z-2

supports different treatment for residents of QOZs regarding the deferral of eligible

gains. Section 1400Z-2 references the term “taxpayer,” which section 7701(a)(14)

defines as “any person subject to any internal revenue tax.” In turn, section 7701(a)(1)

defines the term “person” to include “an individual, a trust, estate, partnership,

association, company or corporation.”

The Treasury Department and the IRS have determined that construction of the

term “taxpayer” in accordance with section 7701(a)(14) would be consistent with the

language and purpose of section 1400Z-2 as a whole, and therefore would give effect to

the intent of Congress. Moreover, disparate treatment of eligible taxpayers residing in

QOZs and those who do not is not warranted given that the statute equally incents

investment in QOZs by any taxpayer, including those that have historically invested in

businesses operated within QOZs and those that have not. Accordingly, the section

1400Z-2 regulations do not adopt the comment recommending special treatment for

residents of QOZs to invest ordinary income, including gain required to be treated as

ordinary income under subtitle A, in QOFs.

c. Gain from Sales of Capital Assets, Unreduced by Any Losses

One commenter also requested clarification that the deferral election under

section 1400Z-2(a)(1) applies to the gross amount of gain treated as capital gain

unreduced by losses. The proposed regulations generally provided that in the case of

gain from the sale of a capital asset as defined under section 1221, the full amount of

capital gain from that sale or exchange, unreduced by any losses, is eligible gain that

generally may be invested during the 180-day period beginning on the date of the sale

or exchange of the property giving rise to the gain.

The section 1400Z-2 regulations retain the general rule of the proposed

regulations providing that the full amount of gain that would be recognized from the sale

or exchange of a capital asset as defined under section 1221, unreduced by any losses,

is eligible gain and therefore eligible taxpayers do not have to net a gain from a section

1221 capital asset against the sum of the taxpayer’s losses from section 1221 capital

assets. Thus, if a capital gain is realized by an eligible taxpayer during a taxable year,

section 1400Z-2 and the section 1400Z-2 regulations generally do not require that any

losses reduce the amount of the gain that may be an eligible gain.

However, gain that otherwise may qualify as a capital gain may be required to be

recharacterized or redetermined by other provisions of the Code. For example, sections

1245 and 1250 may require gain that potentially could be characterized as capital in

nature to instead be treated as ordinary income “notwithstanding any other provision of

this subtitle,” referring to subtitle A, which includes section 1400Z-2. Consistent with

section 64, if a provision of the Code requires the character of a potential capital gain to

be recharacterized, redetermined, or treated as ordinary income for purposes of

subtitle A, such gain cannot be, and is not, treated as other than ordinary income under

the Code, and therefore is not eligible gain for purposes of section 1400Z-2 and the

section 1400Z-2 regulations. See §§1.1245-1(a)(1), 1.1245-1(b)(2), 1.1250-1(a)(1),

1.1250-1(b)(1), and 1.1250-1(c)(1).

d. Gains from Sales to, or Exchanges of Property with, a QOF or Qualified Opportunity

Zone Business

The October 2018 proposed regulations provided that eligible gain does not

include gain from the sale to, or the exchange of property with, a person that is related

to the taxpayer within the meaning of section 1400Z-2(e)(2). Section 1400Z-2(d)(2)(D)

and the May 2019 proposed regulations provided that qualified opportunity zone

business property that a QOF owns must be acquired by the QOF by purchase from an

unrelated party. As a result, property that is purchased by a QOF from a related party,

as well as property that is contributed to a QOF in a transfer to which section 351 or

section 721(a) applies, is not qualified opportunity zone business property.

Commenters have requested confirmation that eligible gain includes gain arising

from the sale to, or the exchange of property with, a QOF if the amount of the gain is

later invested in that QOF. Commenters similarly have requested confirmation that gain

from the sale to, or the exchange of property with, a qualified opportunity zone business

is eligible for investment into the QOF that owns the qualified opportunity zone

business. Relatedly, commenters have requested that the final regulations provide that

a sale to, or an exchange of property with, a QOF or qualified opportunity zone

business, followed by an investment of the amount of the sales proceeds into the QOF,

would not be characterized as a purchase from a related party for purposes of section

1400Z-2(d)(2)(D).

One commenter expressed concern that, if a taxpayer sold property to an

unrelated QOF and then invested the amount of the sales proceeds in the same QOF,

that sequence of transactions could be characterized under circular cash flow principles

as if the taxpayer contributed the property directly to the QOF (and each transfer of the

amount of the sales proceeds would be disregarded for Federal income tax purposes).

If this construct applied, the acquired property would not qualify as qualified opportunity

zone business property.

The Treasury Department and the IRS agree that generally applicable Federal

income tax principles would require this result if, under the facts and circumstances, the

consideration paid by the QOF or by a qualified opportunity zone business returns to its

initial source as part of the overall plan. See Rev. Rul. 83-142, 1983-2 C.B. 68; Rev.

Rul. 78-397, 1978-2 C.B. 150. Under the step transaction doctrine and circular cash

flow principles, the circular movement of the consideration in such a transaction would

be disregarded for Federal income tax purposes, including for purposes of section

1400Z-2 and the section 1400Z-2 regulations. Thus, the transaction would be treated

for Federal income tax purposes as a transfer of property to the purchasing QOF for an

interest therein or, if applicable, as a transfer of property to a QOF for an interest therein

followed by a transfer of such property by the QOF to the purchasing qualified

opportunity zone business.

Accordingly, an eligible taxpayer’s gain from a sale to or an exchange of property

with an unrelated QOF (acquiring QOF), as part of a plan that includes the investment

of the consideration received by the eligible taxpayer back into the acquiring QOF, is not

eligible gain to the eligible taxpayer because the transaction would not be characterized

as a sale or exchange to an unrelated person for Federal income tax purposes.

Similarly, an eligible taxpayer’s gain from a sale to or an exchange of property with an

unrelated qualified opportunity zone business (acquiring qualified opportunity zone

business) is not eligible gain to the eligible taxpayer if the sale occurs as part of a plan

that includes (i) the investment of the consideration received by the eligible taxpayer

back into the QOF that owns the acquiring qualified opportunity zone business, followed

by (ii) the contribution by the QOF of that consideration to the qualified opportunity zone

business. Furthermore, because the transaction is not treated as a “purchase” of

tangible property by the qualified opportunity zone business from an unrelated party, the

newly acquired property will not qualify as qualified opportunity zone business property

under section 1400Z-2(d)(2)(D).

The Treasury Department and the IRS also note that, if an eligible taxpayer sells

property to, or exchanges property with, an unrelated qualified opportunity zone

business as part of a plan that includes the investment of the consideration by the

taxpayer back into the QOF that owns the acquiring qualified opportunity zone business,

the transaction potentially may be recast or recharacterized as a non-qualifying

investment even if the QOF retains the consideration (rather than transferring the

consideration to the qualified opportunity zone business). See §1.1400Z2(f)-1(c)(1).

See also part II.D (discussing the transfer of property for a qualifying investment) and

part VI.A (discussing the applicability of the step transaction doctrine) of this Summary

of Comments and Explanation of Revisions.

e. Gain Not Subject to Federal Income Tax

The Treasury Department and the IRS received comments regarding the scope

of the term “eligible gain” with respect to gains realized by persons that generally are

not subject to Federal income tax with respect to those gains, such as persons that are

not United States persons under section 7701(a)(30) (foreign persons) or that are

entities generally exempt from tax under the Code. Some commenters suggested that

an eligible gain should include all realized capital gains, including gains that are not

subject to Federal income tax. However, other commenters stated that permitting

deferral elections with respect to gains that are not subject to Federal income tax would

be inappropriate because section 1400Z-2 is premised on the assumption that a person

could make qualified investments in a QOF only with respect to amounts of capital gains

for which taxation is deferred.

The Treasury Department and the IRS have determined that eligible taxpayers

generally should be able to make an election under section 1400Z-2(a)(1) and the

section 1400Z-2 regulations only for capital gains that would be subject to tax under

subtitle A before January 1, 2027 (subject to Federal income tax) but for the making of a

valid deferral election under section 1400Z-2(a)(1) and the section 1400Z-2 regulations.

Section 1400Z-2 defers the time when eligible gains are included in income, and there

would not be any taxable income to defer for a gain that is not subject to Federal

income tax. This approach ensures that both United States persons and foreign

persons may be eligible for the Federal income tax benefits of section 1400Z-2 under

the same conditions. Moreover, particularly with respect to foreign persons, the lack of

any requirement that a gain be subject to Federal income tax would make it difficult for

the IRS to verify the extent to which the amount being invested in a QOF was, in fact,

with respect to a capital gain.

Accordingly, the final regulations clarify that deferral of a gain under section

1400Z-2(a)(1) and the section 1400Z-2 regulations generally is available only for capital

gain that would be subject to Federal income tax but for the making of a valid deferral

election under section 1400Z-2(a)(1) and the section 1400Z-2 regulations. Thus, for

example, a deferral election may generally be made by nonresident alien individuals

and foreign corporations with respect to an item of capital gain that is effectively

connected with a U.S. trade or business. Further, individual bona fide residents of U.S.

territories who are United States persons may generally make a deferral election with

respect to an item of capital gain that is derived from sources outside their territory of

residence. Similarly, an organization that is subject to the unrelated business income

tax imposed by section 511 may generally make a deferral election with respect to an

item of capital gain to the extent the item would be included in computing the

organization’s unrelated business taxable income (such as under the unrelated debtfinanced income rules).

In contrast, an eligible taxpayer who is not a United States person within the

meaning of section 7701(a)(30), or who is treated as a resident of another country for

purposes of an applicable income tax treaty (foreign eligible taxpayer), should not be

able to elect to defer an item of capital gain if, in the taxable year in which such gain is

includible, the item is treated as exempt from Federal income tax under a provision of

an applicable income tax treaty (for example, capital gain that is effectively connected

with a U.S. trade or business but is not attributable to a permanent establishment of the

taxpayer within the United States). To prevent foreign eligible taxpayers from taking

inconsistent positions with respect to treaty benefits in the taxable year of deferral and

the taxable year of inclusion, the final regulations provide that a foreign eligible taxpayer

cannot make a deferral election under section 1400Z-2(a) and the section 1400Z-2

regulations with respect to an eligible gain unless the foreign eligible taxpayer

irrevocably waives, in accordance with forms and instructions, any treaty benefits that

would exempt that gain from Federal income tax at the time of inclusion pursuant to an

applicable U.S. income tax convention.

In the event that forms and instructions have not yet been published

incorporating the treaty waiver requirement for a foreign eligible taxpayer for the taxable

year that the deferral election applies to, the final regulations require the attachment of a

written statement to waive such treaty benefits. Eligible taxpayers other than foreign

eligible taxpayers will only be required to make this treaty waiver if and to the extent

required in forms and publications.

The Treasury Department and the IRS have determined that it would be unduly

burdensome to require a partnership to determine the extent to which a capital gain

would be, but for a deferral election by the partnership under section 1400Z-2(a) and

the section 1400Z-2 regulations, subject to Federal income tax by its direct or indirect

partners because partnerships do not generally have sufficient information about the tax

treatment and positions of their partners to perform this analysis. Thus, in the case of

partnerships, the final regulations provide an exception to the general requirement that

gain be subject to Federal income tax in order to constitute eligible gain.

The Treasury Department and the IRS are aware that foreign persons who are

not subject to Federal income tax may plan to enter into transactions including, but not

limited to, the use of partnerships formed or availed of to circumvent the rule generally

requiring eligible gains to be subject to Federal income tax. Therefore, under an antiabuse rule added in §1.1400Z2(f)-1(c)(2), a partnership formed or availed of with a

significant purpose of avoiding of avoiding the requirement in §1.1400Z2(a)1(b)(11)(i)(B) that eligible gains be subject to Federal income tax will be disregarded, in

whole or in part to prevent the creation of a qualifying investment by the partnership with

respect to any partner that would not otherwise satisfy the requirement of that

paragraph. The anti-abuse rule may apply even if some of the partners in the

partnership are subject to Federal income tax. See §1.1400Z2(f)-1(c)(3), Examples 1

and 2.

Finally, in response to comments expressing uncertainty as to whether persons

who do not or cannot make a valid deferral election for eligible gains nevertheless may

invest in QOFs, the Treasury Department and the IRS note that nothing in section

1400Z-2 or the section 1400Z-2 regulations prevents persons who do not have eligible

gains from investing in QOFs. Thus, Indian tribal governments, and tax-exempt

organizations that invest amounts other than items of capital gain that would be

included in computing their unrelated business taxable income, may invest in a QOF to

the extent otherwise permitted by law or regulation. However, those investments will

not qualify for the Federal income tax benefits under section 1400Z-2 or the section

1400Z-2 regulations. That is, those investments are not qualifying investments

described in section 1400Z-2(e)(1)(A)(i).

f. Measuring Gain from Sales or Exchanges of Virtual Currency

Section 1400Z-2 and the proposed regulations clearly provide that eligible gain is

gain that has been realized pursuant to a sale or exchange. One commenter identified

a potential obstacle in calculating the eligible gain from sales or exchanges of certain

types of digital assets, including virtual currency. The commenter expressed concern

that the vast majority of digital assets could not directly be exchanged for traditional

types of money. The commenter explained that these digital assets first must be

converted into other digital assets in taxable transactions before ultimately being sold

for the type of currency that would be invested in a QOF. The commenter expressed

concern that gain or loss from these intermediate transactions in which a digital asset is

exchanged for another digital asset may not necessarily be tracked in detail. Thus, the

commenter requested a separate rule for these digital assets under which eligible gain

would be calculated by reference to the basis of the original digital asset and to the

actual proceeds received in the ultimate transaction that converts an intermediate digital

asset to money or property that would be invested in a QOF.

Notice 2014-21, 2014-16 I.R.B. 938 provides that convertible virtual currency is

property for Federal income tax purposes, and that general Federal income tax

principles applicable to property transactions apply to transactions involving convertible

virtual currency. Section 1400Z-2(a) applies to gain that, absent a deferral election,

would be included in the taxpayer’s gross income. To determine the amount of such

gain, the taxpayer must know the basis of the property, regardless of the type of such

property. If the amount invested in a QOF exceeds the amount of eligible gain, then the

taxpayer will have a non-qualifying investment for the amount of gain invested in excess

of eligible gain invested in the QOF and a qualifying investment for the amount of

eligible gain invested in the QOF (mixed-funds investment). Taxpayers selling digital

assets are not prevented from investing eligible gain generated from the sale into a

QOF simply because one digital asset must be converted into another type of asset

before the taxpayer can convert its assets into U.S. dollars. Therefore, the Treasury

Department and the IRS decline to adopt the commenter’s request for a special rule for

digital assets.

g. Gain from a Section 1256 Contract or a Position Part of an Offsetting-Positions

Transaction

The preamble to the October 2018 proposed regulations explained that the

Treasury Department and the IRS considered allowing deferral under section 1400Z2(a)(1) for a net amount of capital gain related to a straddle (as defined in section

1092(c)(1)) after the disposition of all positions in the straddle, but concluded that such

a rule would pose significant administrative burdens. Proposed §1.1400Z2(a)1(b)(2)(iv) provided that, if a capital gain is from a position that is or has been part of an

offsetting-positions transaction, the gain is not eligible for deferral under section 1400Z2(a)(1). For this purpose, an offsetting-positions transaction generally is a transaction in

which a taxpayer has substantially diminished the taxpayer’s risk of loss from holding

one position with respect to personal property by holding one or more other positions

with respect to personal property (whether or not of the same kind) and includes

positions with respect to personal property that is not actively traded.

Proposed §1.1400Z2(a)-1(b)(2)(iii)(A) provided that the only gain arising from

section 1256 contracts that is eligible for deferral under section 1400Z-2(a)(1) is capital

gain net income from all of a taxpayer’s section 1256 contracts for a taxable year.

Additionally, proposed §1.1400Z2(a)-1(b)(2)(iii)(B) provided that, if at any time during

the taxable year, any of the taxpayer’s section 1256 contracts were part of an offsettingpositions transaction and any other position in that transaction was not a section 1256

contract, then no gain from any section 1256 contract is an eligible gain with respect to

that taxpayer in that taxable year.

Two commenters expressed concern about the application of the offsettingpositions transaction rule in the October 2018 proposed regulations to positions that are

not part of a straddle under section 1092. One commenter stated that the IRS did not

adequately describe its policy concerns when extending the offsetting-positions

transaction rule beyond the scope of section 1092. The second commenter argued that

a taxpayer is permitted to recognize losses while deferring gains by continuing to hold

an asset that is not actively traded, and that allowing deferral under section 1400Z2(a)(1) would be no different than having the taxpayer continue to hold its gain position.

The Treasury Department and the IRS appreciate the concerns expressed regarding

the extension of the proposed offsetting-positions transaction rule to transactions that

are not straddles under section 1092 and the final regulations do not include the

provisions that applied to transactions that are not straddles under section 1092.

Two commenters expressed concern that the proposed offsetting-positions

transaction rule excluded gains from a position that, at any time, had been part of an

offsetting-positions transaction, including offsetting-positions transactions that occurred

many years ago. The commenters recommended either deleting the phrase “or has

been” or limiting application of that phrase to permit deferral of capital gain from an

offsetting-positions transaction if there is no offsetting position on or after the enactment

of the TCJA. The Treasury Department and the IRS have concluded that the rule

should not exclude gains that have, at any time, been part of an offsetting position but

should instead exclude gains based on whether an offsetting position was in existence

during a limited time period. Limiting the application of the straddle rules to situations in

which there was an offsetting position on or after the date of the enactment of the TCJA

would, in future years, require taxpayers and the IRS to look back over an extended

period of time. This requirement could result in significant administrative burdens

without serving a significant tax policy purpose. As a result, the Treasury Department

and the IRS have revised the limitation on the use of gains from a straddle to net gain

from a position that was either part of a straddle during the taxable year or part of a

straddle in a prior taxable year if a loss from that straddle is carried over under section

1092(a)(1)(B) to the taxable year.

One commenter suggested that, in the context of a straddle, the deferral under

section 1400Z-2(a)(1) of gain from the disposition of a position in a straddle would not

permit the current recognition of an otherwise suspended loss from an offsetting

position in the straddle. The commenter also recognized, however, that it might be

overly generous for a taxpayer investing in a QOF to eliminate 15 percent of the

taxpayer’s deferred gain (assuming that the taxpayer holds that QOF interest for seven

years by December 31, 2026), if the taxpayer was also permitted ultimately to recognize

all of its suspended loss from the offsetting straddle position. The commenter

suggested a rule eliminating any suspended loss in the same proportion as any

elimination of gain in one or more offsetting positions.

The Treasury Department and the IRS have determined that there would be

significant administrative burdens for taxpayers and the IRS in tracking specific gains

deferred under section 1400Z-2(a)(1) for the purpose of determining whether and when

some or all of a deferred straddle loss might ultimately become deductible. In addition,

the Treasury Department and the IRS have determined that the tracking of deferred

losses for multiple taxable years after the positions in the straddle have been disposed

of and a potential proportional elimination of a suspended loss, years after the

suspension, would create additional complexity and administrative burdens for both

taxpayers and the IRS. The final regulations therefore provide a general rule that net

gain from positions that are or, as described previously, in certain circumstances have

recently been part of a straddle, are not eligible for deferral under section 1400Z-2(a)(1).

Another commenter suggested that, absent a clearly articulated policy concern

with permitting deferral of net gain from a straddle, the Treasury Department and the

IRS should consider eliminating or minimizing the scope of capital gains subject to the

prohibition in the proposed regulations. The Treasury Department and the IRS have

concluded that, in certain circumstances, deferral of net gain from a straddle does not

present significant policy concerns or unreasonable administrative burdens for

taxpayers and the IRS. Under the final regulations, if during the taxable year: (i) a

position was covered by an identification under section 1092 or 1256(d), (ii) no gain or

loss with respect to any position that was part of the identified straddle remains

unrecognized at the end of the taxable year (other than gain that would be recognized

but for deferral under section 1400Z-2(a)(1)), (iii) none of the positions in the identified

straddle were part of any other straddle during the taxable year, and (iv) none of the

positions in the identified straddle were part of a straddle in a previous taxable year from

which a loss was carried over to the taxable year under section 1092(a)(1)(B), then the

net gain during the taxable year from positions that were part of the identified straddle is

not prevented from being an eligible gain. Net gain from an identified straddle during

the taxable year is equal to the excess of the capital gains recognized for Federal

income tax purposes in the taxable year, determined without regard to section 1400Z2(a)(1), over the sum of the capital losses and net ordinary losses from all positions that

were part of the straddle, including capital gains and losses from section 1256 contracts

and other positions marked to market on the last business day of the taxable year or

upon transfer or termination and annual account net gain from positions in a mixed

straddle account.

The final regulations clarify that, if a taxpayer identifies a straddle under section

1092(a)(2), the taxpayer must adjust basis in accordance with section 1092(a)(2)(A)(ii)

and (iii) when determining the net gain during the taxable year from positions that were

part of the straddle. The net gain realized during the taxable year that is deferred under

section 1400Z-2(a)(1) is not treated as unrecognized gain for purposes of determining

whether a loss from a position in the straddle is deferred under section 1092(a)(3)(A)(ii).

A commenter suggested that the provision in the October 2018 proposed

regulations disqualifying all gains from section 1256 contracts if at any time during the

taxable year, any of the taxpayer’s section 1256 contracts were part of an offsettingpositions transaction and any other position in that transaction was not a section 1256

contract be revised to limit the disqualification to the specific type of offsetting-positions

transaction identified by the Treasury Department and the IRS. In response to this

comment, under the final regulations net gain during the taxable year from section 1256

contracts that were not part of a straddle is not prevented from being eligible gain.

The final regulations also provide that additional exceptions to the general rule

may be provided in guidance published in the Internal Revenue Bulletin. The Treasury

Department and the IRS request comments on whether there are other situations that

might warrant an exception from the general rule that net gain from a position that was

either part of a straddle during the taxable year or part of a straddle in a prior year if a

loss from that straddle is carried over under section 1092(a)(1)(B) to the taxable year is

not eligible gain.

2. Eligible interests

Proposed §1.1400Z2(a)-1(b)(3) provided that an eligible interest in a QOF must

be an equity interest issued by a QOF, and that eligible interests do not include debt

instruments as defined in section 1275(a)(1) and §1.1275-1(d). One commenter

requested clarification with respect to debt instruments issued by a QOF or a potential

investor. The commenter set forth a fact pattern in which an eligible taxpayer lends

money to a QOF prior to the sale of property that generates eligible gain. After the sale

of the property, the taxpayer essentially transfers its creditor position in the loan to the

QOF. The commenter requested confirmation that such an arrangement would result in

a qualifying investment in a QOF. Determination of the tax treatment of the

arrangement described previously would require a debt-equity analysis based on a

careful examination of all relevant facts and circumstances and Federal income tax

principles apart from those found in section 1400Z-2 and these regulations.

Accordingly, such an analysis would exceed the scope of these regulations.

The commenter also described a second fact pattern in which an eligible

taxpayer issues a promissory note to the QOF in exchange for an interest in the QOF.

The commenter requested clarification as to whether such an exchange would give rise

to an amount invested in the QOF. A taxpayer can make an investment in a QOF by

contributing cash or property. The contribution of a promissory note, however, is

inconsistent with the policy of the section 1400Z-2 statute to incentivize investments in

QOZs, and is beyond the scope of these regulations. The Treasury Department and the

IRS have determined that a taxpayer should not receive the benefits under section

1400Z-2 merely by promising to pay, and thereby invest in a QOZ, in the future. As

such, the Treasury Department and the IRS decline to adopt this comment.

3. 180-day investment requirement

a. Section 1231 Gains

As discussed in part II.A.1.a. of this Summary of Comments and Explanation of

Revisions, proposed §1.1400Z2(a)-1(b)(2)(iii) of the May 2019 proposed regulations

provided that the 180-day period for investment with respect to capital gain net income

from section 1231 property for a taxable year began on the last day of the taxable year

without regard to the date of any particular disposition of section 1231 property.

The Treasury Department and the IRS have received numerous comments

regarding the “capital gain net income” approach of the May 2019 proposed regulations.

In response to the May 2019 proposed regulations, taxpayers and practitioners

consistently have emphasized that the year-long character testing period under section

1231 often can frustrate a taxpayer’s ability to defer gains resulting from sales or

exchanges of section 1231 property. Unlike typical transactions that result in ordinary

or capital gain upon their completion, taxpayers generally lack the ability to determine

whether section 1231 gain from a sale or exchange of section 1231 property will be

capital in character until the completion of all sales or exchanges of section 1231

property during a taxable year. See generally section 1231(a), (c) (describing taxableyear-based determination). However, to defer recognition under section 1400Z-2(a),

taxpayers must invest eligible gain within a 180-day period that begins on the date on

which the taxpayer otherwise would have recognized that gain (180-day investment

requirement). See section 1400Z-2(a)(1)(A) (setting forth the 180-day investment

requirement). Accordingly, commenters have recommended a wide spectrum of

approaches to integrate the rules of section 1231 with section 1400Z-2, including

approaches that would (i) modify the timing of the section 1231 calculation (including

recapture), the start of the 180-day period, or both; or (ii) allow for immediate investment

of gross section 1231 gains to be treated as eligible gains if those gains are determined

to be capital at the end of the taxable year.

As described in part II.A.1.a. of this Summary of Comments and Explanation of

Revisions, the Treasury Department and the IRS have determined that a “gross

approach” solely with regard to eligible section 1231 gains (without regard to any

section 1231 losses) would eliminate unnecessary barriers to potential QOF investors.

Specifically, the final regulations provide that eligible gains include gains from the sale

or exchange of property described in section 1231(b) not required to be characterized

as ordinary income by sections 1245 or 1250 (eligible section 1231 gains), regardless of

whether section 1231(a) (without regard to section 1231(a)(4)) would determine those

gains to be capital or ordinary in character. This approach will eliminate significant

complexity, as well as uncertainty in determining eligible gain for partnerships and

S corporations that are eligible taxpayers. Importantly, although the determination

under section 1231(a) of the character of an eligible section 1231 gain would ordinarily

occur at the end of a taxable year, that section 1231(a) determination is not necessary

to determine whether that gain is eligible for deferral under section 1400Z-2 and the

section 1400Z-2 regulations. Because status as an eligible gain relies on facts that are

known at the time of a sale or exchange, the 180-day period for an eligible taxpayer to

invest an amount with respect to an eligible section 1231 gain begins on the date of the

sale or exchange giving rise to the gain rather than at the end of the taxable year.

Therefore, an investor can invest an amount with respect to an eligible section 1231

gain from a sale or exchange of section 1231 property and have certainty as to the

amount of the qualifying investment on the date the investment is made. Finally,

allowing the 180-day period to begin on the date of the sale, exchange, or other

disposition that gives rise to the eligible section 1231 gain accelerates both capital

infusion into a QOZ and allows an investor to invest eligible proceeds from dispositions

of section 1231 property as soon as any such funds are available to invest.

b. RIC and REIT Capital Gain Dividends

Several commenters noted that the application of the 180-day investment

requirement to real estate investment trust (REIT) capital gain dividends may preclude

some shareholders from making qualifying investments in QOFs because REIT capital

gain dividends are based on the net capital gain of the REIT during the relevant taxable

year of the REIT. In other words, REITs determine that a dividend, or part thereof, is

eligible for capital gain dividend status after the REIT’s taxable year has ended, when

the REIT can compute net capital gain for the year. Thus, a shareholder may receive a

dividend during the year but may not receive the designation that the dividend is a

capital gain dividend until after the REIT’s taxable year has ended. To facilitate

investment in QOZs, commenters requested that the 180-day investment requirement

apply beginning on the last day of the REIT’s taxable year, rather than the date on

which the shareholder receives a dividend, thereby providing a 180-day period after the

shareholder has notice of the dividend’s capital gain designation. In the alternative,

some commenters proposed beginning the 180-day period for investment of REIT

capital gain dividends on the date that is 30 days after the close of the REIT’s taxable

year. Commenters also noted that the same concerns apply to regulated investment

company (RIC) capital gain dividends and maintained that the 180-day period should be

the same for both RIC and REIT capital gain dividends.

The Treasury Department and the IRS seek to facilitate the ability of RIC and

REIT shareholders to make qualifying investments in QOFs that result from capital gain

dividends received during a taxable year. However, because shareholders may not

have the same taxable year as the RIC or REIT in which they are invested, these final

regulations provide that the 180-day period for RIC or REIT capital gain dividends

generally begins at the close of the shareholder’s taxable year in which the capital gain

dividend would otherwise be recognized by the shareholder. To ensure that RIC and

REIT shareholders do not have to wait until the close of their taxable year to invest

capital gain dividends received during the taxable year, these final regulations provide

that shareholders may elect to begin the 180-day period on the day each capital gain

dividend is paid. The 180-day period for undistributed capital gain dividends, however,

begins on either the last day of the shareholder’s taxable year in which the dividend

would otherwise be recognized or the last day of the RIC or REIT’s taxable year, at the

shareholder’s election. Regardless of the 180-day period applicable to its capital gain

dividends, the aggregate amount of a shareholder’s eligible gain with respect to capital

gain dividends received from a RIC or a REIT in a taxable year cannot exceed the

aggregate amount of capital gain dividends that the shareholder receives as reported or

designated by that RIC or that REIT for the shareholder’s taxable year. Any excess

investments will be treated under the final regulations as non-qualifying investments.

c. Installment Sales

Commenters requested clarification regarding the application of the 180-day

investment requirement to gains recognized in an installment sale pursuant to the

installment method under section 453. See section 453(c) (defining the term

“installment method”). Section 453(a) provides generally that income from an

installment sale must be taken into account for purposes of the Code under the

installment method. In general, the installment method allows taxpayers to report gain

from a sale of property in the taxable year or years during which payments are received

rather than in the year of the sale. Commenters expressed concern that, for taxpayers

who are considering investing the gain from an installment sale in a QOF, it is not clear

whether (i) there is a single 180-day period for all income from the installment sale that

begins on the date and year of the sale (for example, March 15, 2020), or (ii) there are

multiple 180-day periods, each beginning in the year during which a payment is

received and income is recognized under the installment method.

To provide flexibility to these types of potential investors in QOZs, the Treasury

Department and the IRS have included in these final regulations a rule that

accommodates both of the potential options described by the commenters previously.

Specifically, the final regulations allow an eligible taxpayer to elect to choose the 180day period to begin on either (i) the date a payment under the installment sale is

received for that taxable year, or (ii) the last day of the taxable year the eligible gain

under the installment method would be recognized but for deferral under section 1400Z2. As a result, if the taxpayer defers gain from multiple payments under an installment

sale, there might be multiple 180-day periods, or a single 180-day period at the end of

the taxpayer’s taxable year, depending upon taxpayer’s election.

One commenter also requested confirmation that only capital gain realized with

respect to an installment sale that occurred after the effective date of section 1400Z-2

(that is, December 22, 2017) should be eligible gain. The Treasury Department and the

IRS have determined that it would be inconsistent with the general rule for eligible gains

in the final regulations, as well as installment sale case law, to exclude from the

definition of eligible gains any capital gains recognized by an eligible taxpayer under the

installment method, regardless of whether the installment sale occurred before the

effective date of section 1400Z-2. Accordingly, the Treasury Department and the IRS

decline to adopt this comment.

d. Special 180-day Period for Partners, S Corporation Shareholders, and Trust

Beneficiaries

The May 2019 proposed regulations provided that, for purposes of the 180-Day

Investment Requirement, the period during which a partner must invest an amount

equal to the partner’s eligible gains in the partner’s distributive share generally begins

on the last day of the partnership taxable year in which the partner’s allocable share of

the partnership’s eligible gain is taken into account under section 706(a). However, if a

partnership does not elect to defer all of its eligible gain, the partner may elect to treat

the partner’s own 180-day period regarding the partner’s distributive share of that gain

as being the same as the partnership’s 180-day period.

Several commenters requested an additional special rule for application of the

180-day investment requirement with regard to partners in a partnership, shareholders

in an S corporation, and beneficiaries of a trust. These commenters highlighted that

owners of flow-through entities experience information delays regarding the Federal

income tax consequences of transactions taken by such entities due to the ordinary

course timing of Schedule K-1 issuances. As a result of this delay in receiving

information necessary to determine the existence of eligible gain, commenters

contended that partners in a partnership, shareholders in an S corporation, and

beneficiaries of a trust should have an additional option to commence the 180-day

period upon the due date of the entity’s tax return.

The Treasury Department and the IRS agree with the commenters’ suggestions.

As a result, the final regulations provide partners of a partnership, shareholders of an

S corporation, and beneficiaries of decedents’ estates and non-grantor trusts with the

option to treat the 180-Day period as commencing upon the due date of the entity’s tax

return, not including any extensions. However, the Treasury Department and the IRS

have determined that similar rules for a grantor trust are not necessary because the

grantor is treated as the owner of the grantor trust’s property for Federal income tax

purposes. Therefore, the final regulations set forth different rules applicable to the

grantor.

4. Additional deferral of previously invested gains

Section 1400Z-2(a)(2)(A) provides that no deferral election under section 1400Z2(a)(1) may be made with respect to a sale or exchange if an election previously made

with respect to the sale or exchange is in effect. In proposed §1.1400Z2(a)1(b)(4)(ii)(D), Example 4 (Proposed Example 4), a taxpayer disposed of its entire

qualifying investment in a QOF in 2025 in a transaction that constituted an event

described in proposed §1.1400Z(b)-1(c) (inclusion event) and recognized gain as a

result. In the example, the taxpayer wanted to defer the amount of gain from the

inclusion transaction by making another qualifying investment. The example concluded

that the gain recognized due to the inclusion event may be invested in either the original

QOF or a different QOF within 180 days of the inclusion event in order to make a new

deferral election under section 1400Z-2. The preamble to the May 2019 proposed

regulations explained that, upon disposition of that QOF interest, deferring an inclusion

otherwise mandated by section 1400Z-2(a)(1)(B) is permitted only if the taxpayer has

disposed of the entire initial investment because section 1400Z-2(a)(2)(A) expressly

prohibits the making of a deferral election under section 1400Z-2(a)(1) with respect to a

sale or exchange if an election previously made with respect to the same sale or

exchange remains in effect.

A commenter requested that gain from an inclusion event in which a taxpayer

disposes of less than its entire investment in a QOF be eligible for the deferral election

under section 1400Z-2(a)(1). The commenter asserted that gain arising from an

inclusion event, whether representing all or part of the initially deferred gain, represents

new gain that should be eligible for deferral under section 1400Z-2(a).

The Treasury Department and the IRS agree with the commenter. The final

regulations adopt the position that gain arising from an inclusion event is eligible for

deferral under section 1400Z-2(a) even though the taxpayer retains a portion of its

qualifying investment after the inclusion event. Although such gain relates in part to

gain from a sale or exchange for which there was a prior election in effect, it is no longer

subject to that prior election within the meaning of section 1400Z-2(a)(2)(A) as soon as

the inclusion event triggers an income inclusion. Therefore, if an inclusion event relates

only to a portion of a taxpayer’s qualifying investment in the QOF, (i) the deferred gain

that otherwise would be required to be included in income (inclusion gain amount) may

be invested in a different QOF, and (ii) the taxpayer may make a deferral election under

section 1400Z-2(a) with respect to the inclusion gain amount, so long as taxpayer

satisfies all requirements for a deferral election on the inclusion gain amount. To satisfy

the requirements under section 1400Z-2(a) and §1.1400Z2(a)-1(b)(11)(iv), the eligible

taxpayer must treat the inclusion gain amount to be deferred as if it were originally

realized as a result of the inclusion event. In addition, the eligible taxpayer must meet

all other requirements to defer gain under section 1400Z-2. See section 1400Z-2(a)(1)

and §1.1400Z2(a)-1(b)(11)(i)(C) (gain that arises from a sale or exchange of property

with a related person is not eligible gain); section 1400Z-2(a)(2)(B) (election may not be

made for gain arising after December 31, 2026). Consistent with Proposed Example 4,

included in these regulations as §1.1400Z2(a)-1(b)(7)(iv)(D), the 180-day period for the

inclusion gain amount begins on the date of the inclusion event, and the holding period

for the second QOF investment begins on the date that an amount corresponding to the

inclusion gain amount is invested in the second QOF. See §1.1400Z2(a)-1(b)(7)(iv),

Example 4.

A commenter also requested clarification as to whether additional gain deferral

under section 1400Z-2(a)(1)(A), as in Proposed Example 4, is permitted for gain

included due to the operation of section 1400Z-2(b)(1)(B), which requires the full

amount of gain that was deferred under section 1400Z-2(a)(1)(A), reduced by the

amount of gain previously included under proposed §1.1400Z2(b)-1(b) (remaining

deferred gain) to be included in income in the taxable year of the eligible taxpayer that

includes December 31, 2026. The commenter explained that the ability to reinvest

gains required to be included in income under section 1400Z-2(b) would facilitate

liquidity and capital mobility for investors. Moreover, in the event that additional gain

deferral is permitted after a taxable year that includes December 31, 2026, the

commenter requested clarification regarding the effect of such an additional gain

deferral election on items including the proper amount includible as well as the amount

of deferred gain that may be reinvested for the benefits of the election under section

1400Z-2(c).

Proposed Example 4 only illustrated that a taxpayer may invest gain that

otherwise would be included pursuant to section 1400Z-2(b)(1)(A) upon the complete

disposition of a QOF interest prior to December 31, 2026 (that is, an inclusion event),

where the amount of that gain is reinvested in any QOF during the 180-day period

beginning on the date of the inclusion event. No inferences should be drawn regarding

gains from dispositions after December 31, 2026, because deferral of any gain from

such dispositions is expressly prohibited by section 1400Z-2(a)(2)(B). Section 1400Z2(b)(1) provides that all gain to which section 1400Z-2(a)(1)(A) deferral applies must be

included in income in the taxable year that includes the earlier of the date on which a

QOF investment is sold or exchanged or December 31, 2026. Further, section 1400Z2(a)(2)(B) provides that no deferral election may be made under section 1400Z-2(a)(1)

with respect to any sale or exchange after December 31, 2026. Accordingly, the

statutory language of section 1400Z-2 clearly states, and therefore the section 1400Z-2

regulations provide, that (i) the ability to defer eligible gains pursuant to section 1400Z-

2(a)(1)(A) is not permitted with respect to a gain arising after December 31, 2026, and

(ii) no additional deferral of any gain is permitted if such gain is required to be included

in gross income under section 1400Z-2(b)(1)(B).

5. Qualifying investment

Section 1400Z-2 provides Federal income tax benefits to an eligible taxpayer that

makes an equity investment in a QOF described in section 1400Z-2(e)(1)(A)(i) (that is, a

qualifying investment) if the qualifying investment is held for the various statutorily

prescribed holding periods. For example, in the case of an eligible taxpayer that

maintains a qualifying investment for seven years, the eligible taxpayer’s basis in the

qualifying investment will be increased by a total amount equal to 15 percent of the

amount of the taxpayer’s deferred gain. See section 1400Z-2(b)(2)(B)(iii) and (iv)

(providing for basis increases of 10 and five percent, respectively). With respect to a

qualifying investment that is sold or exchanged after being held by the eligible taxpayer

for at least 10 years, if the eligible taxpayer makes an election under section 1400Z2(c), the basis of the qualifying investment will be increased to an amount equal to the

fair market value of that investment on the date on which it is sold or exchanged. See

section 1400Z-2(c).

In the May 2019 proposed regulations, the Treasury Department and the IRS

specified transactions that would cause the inclusion in gross income of an eligible

taxpayer’s gain that had been deferred under section 1400Z-2(a)(1)(B) and (b). Defined

as an “inclusion event,” each of these transactions “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 ‘cashing

out’ of the QOF investor’s qualifying investment. … It is necessary to treat such

[distributive] 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.” See May 2019 proposed regulations, Explanation of Provisions, part

VII.A.

As indicated in the first sentence of part VII.E. (Transfers of Property by Gift or by

Reason of Death) and elsewhere in the Explanation of Provisions in the May 2019

proposed regulations, the termination of a direct interest in a qualifying investment that

resulted in an inclusion event terminated the status of an investment in a QOF as a

qualifying investment “[f]or purposes of sections 1400Z-2(b) and (c).” This is because

the statutory text of each of section 1400Z-2(a), (b), (c), and (e)(1) focuses on one

holding period of “the taxpayer” tested at various points during a period of at least 10

years.

The May 2019 proposed regulations excepted certain enumerated dispositions of

qualifying investments from treatment as inclusion events to provide for business

flexibility for QOFs or qualified opportunity zone businesses. However, those

exceptions were premised upon the requirement that the same eligible taxpayer

generally be treated as continuing to hold the same interest in the QOF, and thereby

continue to bear the Federal income tax liability associated with holding the interest,

such as by reason of section 381 or section 704(c). This degree of identity of taxpayer

is fundamentally different (and more demanding) than a mere “step in the shoes”

concept based on whether the transferee of the interest can tack the holding period and

basis of the transferor. Accordingly, the May 2019 proposed regulations treated, among

other transactions, gifts and section 351 exchanges as inclusion events because, in

each instance, (i) the initial eligible taxpayer had severed the direct investment interest

in the QOF and (ii) the transferee taxpayer was not treated for Federal income tax

purposes either as the same taxpayer as the initial eligible taxpayer or as a successor

taxpayer. This is true even though in each such case, the acquiring taxpayer’s basis

and holding period for purposes of determining gain or loss may be identical to that of

the taxpayer that made the initial investment in the QOF. See id., parts VII.E (regarding

gifts) and VII.G (regarding section 351 exchanges).

Commenters have requested clarification of the treatment of investments in

QOFs under section 1400Z-2(c) that have been disposed of by gift, in section 351

exchanges, and in other transactions treated as inclusion events. For the foregoing

reasons, the final regulations clarify that transactions described as inclusion events

result in a reduction or termination of a qualifying investment’s status as a qualifying

investment to the extent of the reduction or termination, except as otherwise provided in

§1.1400Z2(b)-1(c) or other provisions of the section 1400Z-2 regulations. See part IV.C

of this Summary of Comments and Explanation of Revisions. Moreover, the reduction

or termination of that status applies for purposes of section 1400Z-2(c) as well as

section 1400Z-2(a)(1)(B) and (b). An inclusion event is a transaction that reduces or

terminates 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, constitutes a

“cashing out” of the eligible taxpayer’s qualifying investment in the QOF. For that

reason and to that extent, the taxpayer holding the reduced investment in the QOF after

the inclusion event no longer possesses a qualifying investment. Thus, the benefits

provided under section 1400Z-2(c) generally are available only to a taxpayer that not

only makes an equity investment in a QOF described in section 1400Z-2(e)(1)(A)(i) (that

is, a qualifying investment), but also then continuously maintains that qualifying

investment throughout statutorily prescribed holding periods.

However, consistent with that rationale, the May 2019 proposed regulations did

not treat as an inclusion event a gift by the taxpayer to a grantor trust of which the

taxpayer is the deemed owner because, for Federal income tax purposes, the owner of

the grantor trust is treated as the owner of the trust’s property and thus of the qualifying

investment in its QOF. See id., part VII.E. See also id., part VII.F.1 (providing a similar

exception regarding section 381 transactions based on a statutory successor taxpayer

concept). Accordingly, eligibility for benefits under section 1400Z-2 in these limited

instances would be maintained.

The Treasury Department and the IRS have received several comments

requesting clarification that qualifying investments include interests received in a

transfer by reason of death that is not an inclusion event. In the case of a decedent,

section 1400Z-2(e)(3) provides a special rule requiring amounts recognized under

section 1400Z-2, if not properly includible in the gross income of the decedent, to be

includible in gross income as provided by section 691. In that specific case, the

beneficiary that receives the qualifying investment has the obligation 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. See id., part VII.E. In other

words, unlike an inclusion event contemplated by the general rules of section 1400Z2(b), the obligation to include the original taxpayer investor’s deferred gain in income

travels with that taxpayer’s qualifying investment to the beneficiary. Accordingly, the

May 2019 proposed regulations excepted transfers of a qualifying investment to the

deceased owner's estate, as well as distributions by the estate, from the definition of

“inclusion event.” See id., part VII.E.

As indicated in part VII.E. of the Explanation of Provisions of the May 2019

proposed regulations, the Treasury Department and the IRS have determined that

interests received in a transfer by reason of death continue to be a qualifying investment

in the hands of the beneficiary for purposes of section 1400Z-2(c). As described earlier,

sections 691 and 1400Z-2(e)(2) require such a transfer to not give rise to an inclusion

event because the beneficiary is treated as a successor to the original eligible taxpayer

that made the qualifying investment (that is, the beneficiary “steps into the shoes” of the

original taxpayer investor with regard to both the benefits of the qualifying investment

and the obligation to ultimately include the original taxpayer’s deferred gain into the

beneficiary’s income). As a result, the Treasury Department and the IRS have

determined that a qualifying investment received by a beneficiary in a transfer by reason

of death should continue to be a qualifying investment in the hands of the beneficiary for

purposes of section 1400Z-2(b) and (c).

The Treasury Department and the IRS have also received a comment suggesting

that the final regulations should permit QOFs to make loans to qualified opportunity

zone businesses and treat as qualifying investments the debt instruments arising from

such loans. Confirmation of the tax treatment of such debt instruments as qualifying

investments (that is, equity investments in a QOF) would require a debt-equity analysis

based on a careful examination of all relevant facts and circumstances and Federal

income tax principles apart from those found in section 1400Z-2 and the section 1400Z2 regulations. Such an analysis would exceed the scope of these regulations. As a

result, the final regulations do not adopt the commenter’s suggestion.

B. Making an Investment for Purposes of an Election Under Section 1400Z-2(a)

1. Acquisition of an eligible interest from a person other than a QOF

Proposed §1.1400Z2(a)-1(b)(9)(iii) permitted a taxpayer to make a deferral

election under section 1400Z-2(a)(1)(A) for an eligible interest acquired from a person

other than a QOF. Commenters asked whether the transferor of that eligible interest

needed to have made an election under section 1400Z-2(a) prior to the taxpayer’s

acquisition. Commenters also asked whether the acquirer must have realized eligible

gain within the 180-day period prior to the acquisition of the eligible interest in order for

acquisition of that interest to support a deferral election under section 1400Z-2(a)(1)(A)

with respect to the eligible gain. Additionally, commenters requested confirmation

regarding whether shares or partnership interests in a pre-existing entity that becomes a

QOF pursuant to proposed §1.1400Z2(d)-1(a)(3) become eligible interests when the

pre-existing corporation or partnership becomes a QOF.

The final regulations do not require the transferor to have made a prior election

under section 1400Z-2(a) for the acquirer of an eligible interest to make such an

election. Further, for interests in entities that existed before the enactment of section

1400Z-2, if such entities become QOFs pursuant to §1.1400Z2(d)-1(a)(3), then the

interests in those entities, even though not qualifying investments in the hands of a

transferor, are eligible interests that may (i) be acquired by an investor and (ii) result in a

qualifying investment of the acquirer if the acquirer has eligible gain and the acquisition

was during the 180-day period with respect to that gain.

2. Eligibility of built-in gain for deferral

One commenter requested confirmation that the built-in gain of a REIT, a RIC, or

an S corporation potentially subject to corporate-level tax under section 1374 or

§1.337(d)-7 is eligible for deferral under section 1400Z-2. To the extent the built-in gain

is an eligible gain, an election under section 1400Z-2 may be made for such gain of a

REIT, a RIC, or an S corporation. If such election is made, the amount of such gain will

not be included in the calculation of the entity’s net recognized built-in gain (as defined

in section 1374(d)(2)) in the year of deferral. Similarly, if a deferral election is made with

respect to an eligible gain that, absent the deferral election, would constitute a

recognized built-in gain (RBIG) within the meaning of section 382(h)(2)(A) or section

1374(d)(3), the amount of such eligible gain deferred as a result of a qualifying

investment in a QOF is not taken into account as RBIG in the year of deferral.

3. Grantor trusts

A commenter pointed out that the rule in proposed §1.1400Z2(a)-1(c)(3) does not

achieve the proper result for grantor trusts that do not make the deferral election but

distribute the deferred gain to a trust beneficiary other than the deemed owner of the

trust. The commenter pointed out that the proposed rule should not apply to grantor

trusts because the deemed owner of the trust is liable for the Federal income tax on the

gain regardless of whether that gain is distributed currently to a trust beneficiary other

than the deemed owner. The commenter also requested clarification that either the

grantor trust recognizing the gain or the deemed owner of that trust is eligible to both

make the deferral election and make a qualifying investment, regardless of whether the

grantor trust distributes the gain to the deemed owner or to any other person. The

Treasury Department and the IRS agree with the commenter and have made the

requested adjustments in the final regulations.

C. Identification of Disposed Interests in a QOF

Under the May 2019 proposed regulations, if a taxpayer held interests in a QOF

with identical rights (for example, equivalent shares of stock in a QOF corporation) that

were acquired on different days, and if the taxpayer disposed of less than all of those

interests on a single day, the taxpayer was required to use the first-in-first-out (FIFO)

method to identify which interests were disposed of for certain specified purposes, such

as determining the character and other attributes of the deferred gain that is included as

a result of the disposition. In circumstances in which the FIFO method did not provide a

complete answer, taxpayers were required to use a pro-rata method. In requesting

comments as to whether methods other than the FIFO method and the pro-rata method

should be used, the Treasury Department and the IRS stipulated that any such methods

must both provide certainty as to which fungible interest a taxpayer disposes of and

allow taxpayers to comply easily with the requirements of section 1400Z-2(a)(1)(B) and

(b) that certain dispositions of an interest in a QOF cause deferred gain be included in a

taxpayer’s income.

In response, commenters requested that taxpayers be permitted to specifically

identify the QOF interests that are sold or otherwise disposed of, and they

recommended that the final regulations adopt rules similar to those in §1.1012-1(c).

Under such rules, a taxpayer would be required to use the FIFO method only if the

taxpayer fails to adequately identify which shares were disposed of.

The Treasury Department and the IRS agree that specific identification should be

permitted for dispositions of interests in QOF corporations. Thus, the final regulations

permit taxpayers to employ the rules and principles of §1.1012-1(c) to specifically

identify the QOF stock that is sold or otherwise disposed. If a taxpayer fails to

adequately identify which QOF shares are disposed of, then the FIFO identification

method applies. If, after application of the FIFO method, a taxpayer is treated as having

disposed of less than all of its investment interests that the taxpayer acquired on one

day and the investments vary in its characteristics, then the pro-rata method will apply

to the remainder.

However, the final regulations do not extend this specific identification

methodology to the disposition of interests in a QOF partnership because, under

Federal income tax law, a partnership interest represents an undivided, unitary interest

in all of the partnership assets and liabilities. Other than in the case of a mixed-funds

investment in a QOF partnership, where the section 1400Z-2 statute mandates a

division of partnership interests, the final regulations do not adopt the commenters’

recommendation because it would broaden the complexities associated with dividing

partnership interests into separate components with associated assets and liabilities.

In addition, the final regulations make it clear that if a taxpayer is required to

include in income some or all of a previously deferred gain, the gain so included has the

same attributes that the gain would have had if the recognition of gain had not been

deferred under section 1400Z-2. The final regulations generally provide that forms,

instructions, and other administrative guidance control in determining which deferred

gains are associated with particular interests in QOFs. However, the final regulations

also provide that, to the extent that such guidance does not clearly associate an

investment in a QOF with an amount of deferred gain, an ordering rule applies that

permits taxpayers to determine how to associate investments in QOFs with particular

deferred gains.

D. Property Transferred in Exchange for a Qualifying Investment is not Qualified

Opportunity Zone Business Property

The May 2019 proposed regulations clarify that taxpayers may transfer property

other than cash to a QOF in exchange for a qualifying investment. A commenter asked

whether property that is purchased in a QOZ and contributed to a QOF could be

qualified opportunity zone business property, or whether such property would be

excluded automatically because it is not purchased by the QOF. The commenter

further asked why taxpayers are permitted to contribute property to a QOF in exchange

for a qualifying investment if the property cannot be qualified opportunity zone business

property.

Taxpayers are permitted to transfer property to a QOF in exchange for a

qualifying investment because the statute does not preclude taxpayers from investing in

a QOF in this manner and because permitting such transfers is not inconsistent with the

policies underlying section 1400Z-2. As the commenter noted, property that is

contributed to a QOF cannot be qualified opportunity zone business property because

qualified opportunity zone business property must be purchased by a QOF. See

section 1400Z-2(d)(2)(D)(i)(I). The QOF may retain the contributed property among its

assets that are not qualified opportunity zone property, or it may sell the property and

use the proceeds to acquire qualified opportunity zone property in accordance with

section 1400Z-2(d) and the section 1400Z-2 regulations.

E. Amount Invested in a QOF Partnership for Purposes of Section 1400Z-2(a)(1)(A)

The May 2019 proposed regulations contained two rules that, if either were

applicable, would reduce the amount of a taxpayer’s qualifying investment.

First, proposed §1.1400Z2(a)-1(b)(11)(ii)(A)(1) provided that, to the extent the

transfer of property to a QOF partnership is characterized other than as a contribution

(for example, a transfer that is characterized as a disguised sale under section 707), the

transfer is not an investment within the meaning of section 1400Z-2(a)(1)(A) (section

1400Z-2(a)(1)(A) investment). The Treasury Department and the IRS confirm that the

reference to the disguised sale regulations under section 707 is intended to provide an

existing analytical framework and rules applicable to transfers of property to a QOF

partnership to determine whether the transfer is a contribution for purposes of making a

qualifying investment. All guidance under section 707 that otherwise would be

applicable, including any exception, applies. In particular, §1.707-4(b)(2) (relating to

operating cash flow distributions) applies to transfers to and distributions from a QOF

partnership. Therefore, to the extent a transfer of property is characterized as a sale

under the existing section 707 framework, there is no contribution and section 1400Z-2

would not apply to the transfer. These final regulations do not modify section 707 or the

regulations in this part under section 707.

Second, proposed §1.1400Z2(a)-1(b)(11)(ii)(A)(2) provided that, to the extent

proposed §1.1400Z2(a)-1(b)(11)(ii)(A)(1) did not apply, the transfer to the partnership

would 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 §1.707-5(b) (relating to debt-financed distributions) applies, the

partner’s share of liabilities is zero. The Treasury Department and the IRS received

comments asking for clarification of the application of proposed §1.1400Z2(a)1(b)(11)(ii)(A)(2) and confirmation that the regulations under section 707, including the

exceptions to the disguised sale rules, apply in determining whether a contribution, in

whole or part, is treated as part of a disguised sale. In particular, commenters asked

how debt-financed distributions should be treated and requested confirmation that

operating cash flow distributions would not be presumed to be a part of a disguised

sale.

The Treasury Department and the IRS note that, even if a contribution were not

recharacterized as a disguised sale under section 707 and the regulations in this part

under section 707, the amount of the qualifying investment is reduced under the

modified application of the section 707 disguised sale rules in §1.1400Z2(a)1(c)(6)(iii)(A)(2). This provision adopts the rule contained in the May 2019 proposed

regulations without change. However, in making the qualifying investment

determination under this rule, the other exceptions to the disguised sale rules still would

apply. For example, a distribution by the partnership would not reduce the amount of

the qualifying investment to the extent the operating cash flow distribution exception of

§1.707-4(b) applied.

Commenters also requested clarification regarding the Federal income tax

consequences of distributions by an “overfunded” QOF partnership carried out to

eliminate the amount of excess cash invested therein. Commenters explained that, in

this situation, an eligible taxpayer would contribute a cash amount in excess of the

amount that the QOF partnership desires to invest and, within the same year, the QOF

partnership distributes the excess cash back to the eligible taxpayer. The final

regulations provide an example clarifying and illustrating the application of the rules.

The later distribution by the QOF partnership would be tested under the normal

distribution rules for purposes of determining whether there is an inclusion event. For

QOF partnerships, there would be an inclusion event to the extent the distribution

exceeds the partner’s outside basis in its qualifying investment. Although the basis in

the qualifying investment is initially zero, that basis may be increased by the partner’s

share of debt and net income.

F. At-Risk Basis

One commenter requested clarification that investors get at-risk basis for their

qualifying investments. The May 2019 proposed regulations did not address whether a

taxpayer has at-risk basis in its qualifying investment. Thus, the commenter stated that

there is uncertainty under the May 2019 proposed regulations as to whether investors’

capital contributions will give rise to at-risk basis under section 465 even though

taxpayers must take zero basis in their qualifying investments.

Section 465 generally provides that a taxpayer shall be considered “at risk” for an

activity with respect to amounts including the amount of money and the adjusted basis

of other property contributed by the taxpayer to the activity. The Treasury Department

and the IRS note that a taxpayer’s amount at risk generally is determined by reference

to the amount of money and the basis of property contributed, not to the basis of the

interest received in exchange for the property. Additionally, section 465 and the

regulations in this part under section 465 provide the necessary guidance for this

determination. As a result, the Treasury Department and the IRS have determined that

the commenter’s requested clarification exceeds the scope of the section 1400Z-2

regulations.

G. Withholding Tax and FIRPTA

The Treasury Department and the IRS received comments regarding the

application of withholding tax regimes within the context of section 1400Z-2(a). For

example, a commenter requested that a foreign taxpayer engaging in a sale subject to

withholding under section 1445(a) (imposing a 15 percent withholding tax as part of the

Foreign Investment in Real Property Tax Act (FIRPTA)) be able to provide a certificate

or other form of documentation to avoid withholding on the basis of the taxpayer’s

intention to invest the resulting gain in a QOF pursuant to a deferral election under

section 1400Z-2(a)(1). Another commenter requested an exemption from withholding

when a person enters into an agreement with the IRS to pay the tax when the deferred

gain is included under section 1400Z-2(a)(1)(B) and (b), similar to when a gain

recognition agreement is “triggered” under section 367 and the regulations in this part

under section 367. The Treasury Department and the IRS continue to consider this

comment and other matters related to the mechanics of applying section 1400Z-2 in the

context of a sale subject to withholding tax.

The final regulations clarify that section 1400Z-2 is not a “nonrecognition

provision” for purposes of section 897(e) and §1.897-6T. See §1.1400Z2(a)-1(e). A

non-recognition provision is defined in section 897(e)(3) as any provision of the Code

for “not recognizing gain or loss.” Similarly, §1.897-6T(a)(2) defines a non-recognition

provision as any Code provision “which provides that gain or loss shall not be

recognized.” Pursuant to section 897(e)(1) and §1.897-6T(a)(1), nonrecognition

provisions generally do not apply upon the exchange of a U.S. real property interest in a

transaction subject to FIRPTA unless the asset received in exchange is also a U.S. real

property interest. The Treasury Department and the IRS have determined that section

1400Z-2 is not a nonrecognition provision for purposes of section 897(e) and §1.897-6T

because an election under that provision generally defers, rather than prevents

altogether, the recognition of gain. By deferring gain recognition, section 1400Z-2 is

fundamentally different from the provisions identified as nonrecognition provisions in

§1.897-6T(a)(2), such as sections 332, 351, 721, and 1031.

III. Comments on and Changes to Proposed §1.1400Z2(b)-1

Proposed §1.1400Z2(b)-1 provided rules regarding the inclusion in income of

gain deferred under section 1400Z-2(a)(1)(A), including rules regarding which events

trigger the inclusion of deferred gain, how much gain is included, and the effects of

these events on the investor’s basis and holding period in its qualifying investment.

A. General Rule Regarding Inclusion Events

Proposed §1.1400Z2(b)-1(c)(1) generally provided that, except as otherwise

provided in proposed §1.1400Z2(b)-1(c), certain events (that is, inclusion events) result

in the inclusion of gain under proposed §1.1400Z2(b)-1(b) if and to the extent that: (i) a

taxpayer’s transfer of a qualifying investment reduces the taxpayer’s equity interest in

the qualifying investment; (ii) a taxpayer receives property in a transaction treated as a

distribution for Federal income tax purposes, regardless of whether the receipt reduces

the taxpayer’s ownership of the QOF; or (iii) a taxpayer claims a worthlessness

deduction with respect to its qualifying investment. Proposed §1.1400Z2(b)-1(c)(2)

through (15) then provided specific rules for certain types of transactions that are or are

not treated as inclusion events.

The Treasury Department and the IRS received several comments and questions

regarding the general rule set forth in proposed §1.1400Z2(b)-1(c)(1). For example,

one commenter asked whether the phrase “the following events” refers to the items in

proposed §1.1400Z2(b)-1(c)(2) through (15) or whether the phrase instead refers to the

items in proposed §1.1400Z2(b)-1(c)(1)(i) through (iii). Another commenter stated that

the general rule in proposed §1.1400Z2(b)-1(c)(1)(i) could be read to suggest that there

is no inclusion event so long as a taxpayer retains an equity interest, whether direct or

indirect, in a qualifying investment after a transfer, even though the preamble to the May

2019 proposed regulations indicated that any reduction in a taxpayer’s direct interest in

a qualifying investment is an inclusion event, other than in the case of partnerships. Yet

another commenter asserted that the specific rules in proposed §1.1400Z2(b)-1(c)(2)

through (15) appear to cover all potentially relevant transactions and therefore the

purpose of the general rule seems unclear. As a result, commenters recommended that

the Treasury Department and the IRS clarify or eliminate the general rule.

As explained in the preamble to the May 2019 proposed regulations, proposed

§1.1400Z2(b)-1(c) reflected the general principle that, except as otherwise provided, an

inclusion event results from: a transfer of a qualifying investment, to the extent the

transfer reduces the taxpayer’s direct equity interest; the receipt of a distribution on or

with respect to a qualifying investment, which constitutes an impermissible ‘‘cashing

out’’ of the taxpayer’s qualifying investment; or the claim of a worthlessness deduction

(under section 165(g) or otherwise) in respect of a qualifying investment. Proposed

§1.1400Z2(b)-1(c)(1) set forth these principles as a general rule, and proposed

§1.1400Z2(b)-1(c)(2) through (15) provided elaborations of, and exceptions to, the

general rule. The Treasury Department and the IRS did not intend the general rule to

suggest that a taxpayer may avoid an inclusion event by retaining an indirect interest in

a QOF, and the specific rules clearly indicated that a transfer that reduces a taxpayer’s

direct interest is an inclusion event except as otherwise provided.

These final regulations retain the general rule in proposed §1.1400Z2(b)-1(c)(1).

However, this general rule has been clarified in response to the foregoing comments. In

addition to the changes described in this part III, the specific rules in §1.1400Z2(b)1(c)(2) through (c)(15) have been clarified as necessary.

These final regulations also clarify that if a QOF is decertified, either through the

QOF’s voluntary self-decertification or an involuntary decertification, such decertification

is an inclusion event that terminates the qualifying investment status of the taxpayer’s

interest in the QOF.

A commenter also requested clarification as to whether an inclusion event

terminates the application of section 1400Z-2 to an interest in a QOF. In some cases,

an inclusion event may be the result of a transfer of the qualifying investment that

reduces or terminates the owner’s interest in the QOF, but in other cases it may not (for

example, a distribution from a QOF C corporation subject to section 301(c)(3)). Thus,

the commenter argued that the occurrence of an inclusion event is not the appropriate

test for determining whether an interest in a QOF ceases to be a qualifying investment

eligible for the basis adjustments under section 1400Z-2(b).

As discussed in part II.A.5 of this Summary of Comments and Explanation of

Revisions, the Treasury Department and the IRS have determined that an inclusion

event generally results in a reduction or termination of a qualifying investment’s status

as a qualifying investment to the extent of the reduction or termination for purposes of

section 1400Z-2(a)(1)(B), (b), and (c). However, the Treasury Department and the IRS

agree that certain types of inclusion events (namely, certain distributions) do not

terminate a taxpayer’s qualifying investment. See part IV.C of this Summary of

Comments and Explanation of Revisions.

The Treasury Department and the IRS also recognize that the language in

proposed §1.1400Z2(b)-1(g)(2), which provided that “[t]he 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 1400Z2(b)(2)(A),” could be read to suggest that all inclusion events cause interests in a QOF

to cease to be qualifying investments. In other words, by restricting the five-year and

seven-year basis increases to qualifying investments that have “not been subject to

previous gain inclusion,” proposed §1.1400Z2(b)-1(g)(2) appeared to exclude any

qualifying investment that has been subject to any inclusion event, even if substantial

amounts of deferred gain remain.

The Treasury Department and the IRS have determined that qualifying

investments that have been subject to inclusion events should continue to be eligible for

the five-year and seven-year basis increases to the extent deferred gain has not yet

been recognized at the time of these basis increases. For example, if a taxpayer

invests $100x of eligible gain in a QOF corporation and the corporation subsequently

makes a section 301(c)(3) distribution of $20x with respect to the taxpayer’s qualifying

investment, the taxpayer still should be eligible to receive a five-year basis increase of

$8x (10 percent of its remaining deferred gain of $80x) and a seven-year basis increase

of $4x (five percent of its remaining deferred gain of $80x). Section 1.1400Z2(b)-1(g)(2)

of the final regulations has been modified accordingly.

B. Transactions Treated as Distributions for Federal Income Tax Purposes

1. Overview

Proposed §1.1400Z2(b)-1(c)(1)(ii) generally provided that, except as otherwise

provided in proposed §1.1400Z2(b)-1(c), an inclusion event occurs if and to the extent a

taxpayer receives property in a transaction that is treated as a distribution for Federal

income tax purposes, regardless of whether the receipt reduces the taxpayer’s

ownership of the QOF. Proposed §1.1400Z2(b)-1(c)(8) modified this general rule by

providing that a distribution of property by a QOF C corporation with respect to a

qualifying investment, including a distribution of stock that is treated as a distribution of

property to which section 301 applies under section 305(b), is an inclusion event only to

the extent section 301(c)(3) applies to the distribution. In the preamble to the May 2019

proposed regulations, the Treasury Department and the IRS requested comments on

the proposed treatment of distributions to which section 305(b) applies.

In turn, proposed §1.1400Z2(b)-1(c)(9) generally provided that a redemption

described in section 302(d) by a QOF C corporation is an inclusion event with respect to

the full amount of the distribution. However, if the QOF C corporation is wholly and

directly owned by a single shareholder (or by members of a single consolidated group),

the section 302(d) redemption is an inclusion event only to the extent section 301(c)(3)

applies.

2. Section 302(d) redemptions

Commenters made several recommendations with respect to the foregoing rules.

For example, commenters questioned the treatment of dividend-equivalent redemptions

in the May 2019 proposed regulations. One commenter acknowledged that a section

302(d) redemption reduces a taxpayer’s direct equity interest, but the commenter

recommended treating such redemptions in the same manner as section 301

distributions for purposes of section 1400Z-2 because section 302 treats such

redemptions as distributions rather than as sales or exchanges. The commenter further

recommended that section 302(d) redemptions in which each shareholder surrenders a

pro rata percentage of its shares not be treated as inclusion events. Another

commenter recognized that requiring an inclusion event only upon a complete

redemption of a shareholder’s qualifying investment would enable taxpayers to avoid

taxation by retaining even a small amount of qualifying QOF stock, but the commenter

still questioned why a partial redemption should cause acceleration. Both commenters

recommended that section 302(d) redemptions and section 301 distributions be treated

similarly for purposes of section 1400Z-2, with the exception of complete redemptions,

which would be an inclusion event to the extent of the full amount of the distribution.

As noted in the foregoing comments, a redemption transaction reduces a

taxpayer’s direct qualifying investment in a QOF, regardless of whether such transaction

is treated as a dividend for Federal income tax purposes. The Treasury Department

and the IRS have determined that the general treatment of section 302(d) redemptions

as section 301 distributions for Federal income tax purposes should not override the

general requirement that QOF shareholders must retain their direct qualifying

investment in a QOF corporation in order to retain the benefits of section 1400Z-2. See

section 1400Z-2(b)(1)(A) (“Gain to which subsection (a)(1)(B) applies shall be included

in income in the taxable year which includes … the date on which such investment is

sold or exchanged…”). As a result, the Treasury Department and the IRS have

determined that it would be inappropriate to treat such redemptions in the same manner

as section 301 distributions for purposes of section 1400Z-2.

However, in certain circumstances, a reduction in a taxpayer’s qualifying

investment by virtue of a section 302(d) redemption is meaningless. For example, if a

wholly owned QOF C corporation partially redeems its sole shareholder, the

shareholder will continue to wholly own the QOF C corporation after the redemption.

Similarly, if a QOF C corporation redeems its single outstanding class of stock from all

shareholders on a pro rata basis, each QOF shareholder will retain the same

proportionate interest in the QOF after the partial redemption.

As a result, the final regulations generally continue to treat dividend-equivalent

redemptions by QOF C corporations as inclusion events with respect to the full amount

of the distribution, with an exception for redemptions by wholly owned

QOF C corporations, which are inclusion events only to the extent section 301(c)(3)

applies. The Treasury Department and the IRS agree with the commenter that an

additional exception should be created for pro rata section 302(d) redemptions, so long

as the QOF C corporation has only one class of stock outstanding. The final regulations

have been modified to treat such redemptions in the same manner as redemptions by

wholly owned QOF C corporations. In other words, an inclusion event occurs only to

the extent section 301(c)(3) applies. Similarly, with respect to QOF S corporations, the

final regulations continue to treat dividend-equivalent redemptions as inclusion events 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). See part III.E.2.a of this Summary of Comments and Explanation of Revisions.

3. Section 305 distributions and section 306 redemptions

A commenter agreed with the treatment of section 305(b) distributions in the May

2019 proposed regulations—namely, that such distributions should be included as

distributions subject to the rule in proposed §1.1400Z2(b)-1(c)(8). However, the

commenter further recommended that the final regulations address the treatment of

stock received in a section 305(a) distribution with respect to qualifying QOF stock.

When a corporation distributes its own stock to its shareholders, section 305(a) provides

that the shareholders do not include the distribution in gross income. The basis of the

new stock received and of the stock with respect to which the distribution is made (old

stock) is determined by allocating the basis of the old stock between the old stock and

the new stock in proportion to the respective fair market values of the old stock and the

new stock on the date on which the new stock is distributed, and the holding period for

the new stock is the same as the holding period for the old stock. See §1.307-1(a)

(regarding allocation of basis) and section 1223(4) (regarding determination of holding

period). The commenter requested clarification that the new stock received in a section

305(a) distribution with respect to qualifying QOF stock is also qualifying QOF stock,

with the remaining deferred gain being allocated pro rata between the old stock and the

new stock, and with the holding period for the new stock being the same as the holding

period for the old stock. The Treasury Department and the IRS agree with the

commenter’s recommendation, and the final regulations have been modified

accordingly.

The commenter also requested clarification regarding the treatment of

redemptions of section 306 stock. Section 306 stock generally includes stock, other

than common stock, that was received tax-free in certain transactions by the

shareholder disposing of such stock, including a stock dividend under section 305(a), a

corporate reorganization described in section 368(a), or a distribution or exchange to

which section 355 (or so much of section 356 as relates to section 355) applied. See

section 306(c). Section 306(a)(2) provides that, if a shareholder disposes of its section

306 stock in a redemption, the amount realized is treated as a distribution of property to

which section 301 applies. The commenter recommended that such a redemption be

subject to the rules for section 301 distributions in proposed §1.1400Z2(b)-1(c)(8).

The Treasury Department and the IRS agree that the final regulations should

address the treatment of section 306(a)(2) redemptions. For the reasons discussed in

part III.B.2 of this Summary of Comments and Explanation of Revisions, the Treasury

Department and the IRS have determined that section 306(a)(2) redemptions should be

treated in the same manner as dividend-equivalent redemptions for purposes of section

1400Z-2. The final regulations have been modified accordingly.

4. Distributions subject to section 1059

A commenter recommended that qualifying investments in QOF C corporations

be excluded from the application of section 1059. Alternatively, the commenter

requested confirmation that (1) the recognition of gain under section 1059(a)(2) would

result in an inclusion event to the extent of that gain, and (2) the ordering rule in

proposed §1.1400Z2(b)-1(g)(1)(ii), which applied to basis increases under section

1400Z-2(b)(2)(B)(ii), also would apply to such inclusion event.

The commenter contended that, in many instances, the policy concerns

underlying section 1059, as described by the commenter, would not be applicable to

distributions made by a QOF C corporation. However, an example in the commenter’s

analysis illustrated that the concerns underlying section 1059 are present any time a

QOF corporation has earnings and profits (E&P) predating the date on which a

qualifying investment is made. The Treasury Department and the IRS have

determined that, to the extent consistent with the application of section 1400Z-2, and

unless provided otherwise by the section 1400Z-2 regulations, the rules of subchapter

C apply with respect to a QOF C corporation. The commenter’s analysis did not set

forth any statutory authority under section 1400Z-2 or subchapter C for not applying

section 1059 to distributions from a QOF C corporation. As a result, the Treasury

Department and the IRS have determined that section 1059 should apply to a

QOF C corporation, and the final regulations do not adopt the commenter’s primary

recommendation.

However, the Treasury Department and the IRS agree with the commenter’s

alternative recommendation that the recognition of gain under section 1059(a)(2)

should result in an inclusion event to the extent of that gain, and that the ordering rule

in proposed §1.1400Z2(b)-1(g)(1)(ii) should apply to such inclusion event. The final

regulations have been modified accordingly.

C. Reorganizations of QOF Corporations

1. Overview

Proposed §1.1400Z2(b)-1(c)(10) generally provided that, if the assets of a QOF

corporation are acquired in a qualifying section 381 transaction, and if the acquiring

corporation is a QOF within a prescribed period of time after the acquisition, the

transaction would not be an inclusion event. The proposed regulations included this

rule because, after the transaction, the taxpayer would have retained a direct qualifying

investment in an acquiring QOF that is a successor to the transferor QOF under section

381. The proposed regulations defined the term “qualifying section 381 transaction” to

mean an acquisitive asset reorganization described in section 381(a)(2), with certain

enumerated exceptions. See proposed §1.1400Z2(b)-1(a)(2)(xx).

However, if a QOF shareholder received boot in a qualifying section 381

transaction with respect to the shareholder’s qualifying investment, the taxpayer would

have an inclusion event because the taxpayer would have reduced its direct qualifying

investment in the QOF or cashed out part of its investment. For this purpose, the term

"boot” means money or other property that section 354 or 355 does not permit to be

received without the recognition of gain. Under the May 2019 proposed regulations, 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. If a single taxpayer or members of a single consolidated group wholly

own both the target QOF and the acquiring QOF, the boot is treated as if it were

distributed from the QOF in a separate section 301 transaction and is only taxable to the

extent section 301(c)(3) applies.

In turn, proposed §1.1400Z2(b)-1(c)(12) generally provided that, if a QOF

corporation engages in a recapitalization transaction described in section 368(a)(1)(E)

(recapitalization), or if a QOF shareholder engages in a stock-for-stock exchange

described in section 1036 (section 1036 exchange), and if the transaction does not have

the result of decreasing the shareholder’s proportionate interest in the QOF corporation,

the transaction is not an inclusion event. However, any property or boot received by the

shareholder in the transaction is treated as property or boot to which section 301 or

section 356 applies, as determined under general Federal income tax principles.

Proposed §1.1400Z2(b)-1(c)(8) or (10), respectively, then determined the extent to

which the receipt of such property or boot triggers an inclusion event. Moreover, if the

transaction decreases the shareholder's proportionate qualifying investment in the QOF

corporation, the shareholder has an inclusion event equal to the amount of the reduction

in fair market value of the shareholder’s qualifying QOF stock.

2. Proposed treatment of recapitalizations and section 1036 exchanges

Several commenters recommended that a single inclusion event rule be applied

to qualifying section 381 transactions, recapitalizations, and section 1036 exchanges.

One commenter argued that, if a taxpayer’s proportionate interest were reduced in a

recapitalization or in a section 1036 exchange, the taxpayer either would have received

actual consideration (that is, boot) in the transaction or would be deemed to have

received boot in the transaction under general Federal income tax principles. See, for

example, Rev. Rul. 74-269, 1974-1 C.B. 87. Another commenter argued that a

reduction in a shareholder’s proportionate interest by virtue of the QOF’s issuance of

new stock to a new investor should not be treated as an inclusion event, and that a

reduction in the shareholder’s interest by virtue of the shareholder’s receipt of non-stock

consideration should be covered by the boot rules for reorganizations. Thus, the

commenters argued that recapitalizations and section 1036 exchanges should be

governed by the same rules that govern qualifying section 381 transactions.

The Treasury Department and the IRS agree with many of the foregoing

comments. For example, the Treasury Department and the IRS agree that the

reduction of a shareholder’s proportionate interest in a QOF through a recapitalization

should not be treated as an inclusion event unless the shareholder receives, or is

deemed to receive, boot in the transaction. Thus, a shareholder should not have an

inclusion event by virtue of the QOF’s issuance of qualifying QOF stock to a new

investor. The Treasury Department and the IRS also agree that the rules for

recapitalizations and section 1036 exchanges should be modified to mirror more closely

the rules for qualifying section 381 transactions. The final regulations reflect these

determinations. However, the final regulations retain separately numbered rules for

reorganizations, and for recapitalizations and section 1036 exchanges.

3. Receipt of boot

Commenters also recommended simplifying the proposed rules regarding boot.

For example, one commenter recommended eliminating the special rule for the receipt

of boot from a wholly owned QOF in proposed §1.1400Z2(b)-1(c)(10)(i)(C)(2) and

subjecting qualifying section 381 transactions, recapitalizations, and section 1036

exchanges to a single rule similar to proposed §1.1400Z2(b)-1(c)(10)(i)(C)(1) (the

general rule regarding the receipt of boot by QOF shareholder in a qualifying section

381 transaction). Another commenter questioned the disparate treatment of boot in

reorganizations depending on whether gain or loss is realized.

The Treasury Department and the IRS agree with commenters that the proposed

rules regarding the receipt of boot should be simplified. Accordingly, the final

regulations adopt a single rule for the receipt of boot in a qualifying section 381

transaction. Under this rule, a taxpayer is treated as disposing of a portion of its

qualifying investment equal to the portion of total consideration received in the

transaction with respect to the taxpayer’s qualifying investment that consists of boot.

For example, if a QOF engages in a merger that is a qualifying section 381 transaction,

and if 10 percent of the consideration received by a QOF shareholder, as measured by

fair market value, consists of boot, the QOF shareholder is treated as having disposed

of 10 percent of its qualifying investment. This rule applies regardless of whether the

QOF shareholder recognizes gain or loss on the transaction, and regardless of whether

the QOF is wholly owned.

For property or boot received in recapitalizations or section 1036 exchanges, the

final regulations provide that the property or boot is treated as property or boot to which

section 301 or section 356(a) or (c) applies, as determined under general Federal

income tax principles. The receipt of property to which section 301 applies is an

inclusion event only to the extent section 301(c)(3) applies. The receipt of boot to which

section 356(a) or (c) applies is subject to the single rule for the receipt of boot in a

qualifying section 381 transaction.

If a taxpayer receives boot with respect to its qualifying investment in a qualifying

section 355 transaction, as defined in proposed §1.1400Z2(b)-1(a)(2)(xix), and if section

356(a) applies to the transaction, the receipt of boot also is subject to the single rule for

the receipt of boot in a qualifying section 381 transaction. In turn, if a taxpayer receives

boot with respect to its qualifying investment in a qualifying section 355 transaction, and

if section 356(b) applies to the transaction, the receipt of boot is an inclusion event only

to the extent section 301(c)(3) applies.

4. Treatment of the surviving or acquiring corporation as a QOF

A commenter also requested clarification that, in the event of mergers,

consolidations, share exchanges, asset acquisitions, and conversions in which the

acquiring or surviving enterprise is a QOF, such acquiring or surviving enterprise

continues to be a QOF.

Whether the surviving or acquiring corporation after a merger, consolidation,

share exchange, or asset acquisition continues to be a QOF depends on whether the

surviving or acquiring corporation satisfies the requirements of section 1400Z-2(d) and

the section 1400Z-2 regulations. Therefore, the final regulations do not adopt the

commenter’s recommended clarification. For a discussion of conversions of QOF

partnerships to QOF corporations, see part III.E.1 of this Summary of Comments and

Explanation of Revisions.

D. Reorganizations of QOF Shareholders

Proposed §1.1400Z2(b)-1(c)(10)(ii) generally provided that a transfer of a QOF

shareholder’s assets in a qualifying section 381 transaction (qualifying owner

reorganization) 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 section

381 successor to the QOF shareholder retains a direct qualifying investment in the

QOF. In other words, the section 381 successor is treated as the historic QOF

shareholder and therefore no disposition of the direct qualifying investment in the QOF

has occurred. Based on the same rationale, proposed §1.1400Z2(b)-1(c)(2)(ii)(B)

provided that the transfer of a QOF shareholder’s qualifying investment in a complete

liquidation under section 332 is not an inclusion event to the extent section 337(a)

applies (qualifying owner liquidation). Special rules applied to S corporations that are

shareholders of a QOF, and generally tracked the rules of subchapter C described

previously, to the extent consistent with the rules of subchapter S. See proposed

§1.1400Z2(b)-1(c)(7).

Proposed §1.1400Z2(b)-1(d)(1) and (2) contained special rules for qualifying

section 381 transactions in which the target corporation was a QOF immediately before

the acquisition and the acquiring corporation is a QOF immediately after the acquisition.

For purposes of section 1400Z-2(b)(2)(B) and 1400Z-2(c), the May 2019 proposed

regulations provided that the holding period for the QOF stock relinquished by a

taxpayer is “tacked” onto the holding period of the QOF stock received in the

transaction, and any qualified opportunity zone property transferred by the transferor

QOF to the acquiring QOF in connection with the transaction does not lose its status as

qualified opportunity zone property solely as a result of the transfer. However, the May

2019 proposed regulations did not provide similar rules for qualifying owner

reorganizations or liquidations. As a result, one commenter requested that a “tacked”

holding period be expressly provided for a QOF shareholder’s qualifying investment in

such transactions. Another commenter requested a rule for qualifying owner

liquidations and reorganizations similar to proposed §1.1400Z2(b)-1(c)(6)(ii)(C), which

generally provided that the resulting partnership after certain partnership mergers or

consolidations is subject to section 1400Z-2 and the section 1400Z-2 regulations to the

same extent as the original partnership before the transaction.

The Treasury Department and the IRS agree that a “tacking” rule should apply to

stock of a QOF shareholder after a qualifying owner reorganization or liquidation.

Section 1.1400Z2(b)-1(d)(1)(ii) of the final regulations has been modified accordingly.

E. Partnerships, S Corporations, and Trusts

1. Inclusion events for QOF partnerships

Proposed §1.1400Z2(b)-1(c)(6)(i) provided inclusion rules for QOF partnerships

and partnerships that directly or indirectly own interests in QOFs. These rules applied

to transactions involving any direct or indirect partner of a QOF to the extent of the

partner’s share of any eligible gain. Proposed §1.1400Z2(b)-1(c)(6)(ii)(B) provided that

a contribution by a QOF owner of its direct or indirect partnership interest in a qualifying

investment to a partnership is not an inclusion event to the extent the transaction is

governed by section 721(a), provided the transfer does not cause a termination of a

QOF partnership, or of the direct or indirect owner of a QOF, under section 708(b)(1).

The Treasury Department and the IRS received several comments on whether

certain transactions involving QOF partnerships should be considered inclusion events.

One commenter requested clarification of proposed §1.1400Z2(b)-1(c)(6)(iii), which

provided that a distribution of property by a QOF partnership to a partner is an inclusion

event if the distributed property has a fair market value in excess of the partner’s basis

in its qualifying investment, and that similar rules apply to distributions involving tiered

partnerships. The final regulations provide that, for amounts relating to a partner’s

qualifying investment, a distribution by a QOF partnership to a partner is an inclusion

event to the extent the distribution is of cash or property with a fair market value in

excess of the partner’s outside basis in the QOF partnership. However, with respect to

distributions by a partnership that owns a QOF, such distribution will only be an

inclusion event for the indirect QOF owner if the distribution is a liquidating distribution.

The commenter suggested that such a distribution should not be an inclusion

event to the extent the partner in the QOF ultimately would be allocated the gain

recognized upon the distribution. The commenter also requested an exception from

inclusion event treatment for section 731 distributions of a QOF interest by an upper-tier

partnership to the extent the distribution is to the partner that made the initial qualifying

investment in the QOF. The Treasury Department and the IRS decline to adopt these

recommendations. Under the rules in subchapter K of chapter 1 of subtitle A

(subchapter K), a distribution of property with a fair market value in excess of basis

reduces a partner’s equity interest in the partnership. Such a reduction is an inclusion

event and is economically the same as an investor cashing out its investment or

reducing its equity investment in the QOF.

One commenter also requested that a contribution of an interest in a partnership

that holds a direct interest in a QOF partnership to another partnership not be

considered an inclusion event. This transaction was addressed by proposed

§1.1400Z2(b)-1(c)(6)(ii)(B), which applied to contributions under section 721(a) by a

QOF owner, including a QOF partner. See proposed §1.1400Z2(b)-1(a)(2)(xii), which

defined a QOF partner as 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. The final regulations clarify that the rule in proposed

§1.1400Z2(b)-1(c)(6)(ii)(B) applies to any QOF owner that contributes its qualifying QOF

stock or direct or indirect partnership interest in a qualifying investment to a partnership

in a transaction governed by section 721(a).

Another commenter requested that the list of inclusion events exclude not only

section 721 contributions, but also the merger of a fund formed as a REIT into another

REIT. The commenter recommended that the final regulations clarify and expand the

scope of the permitted transactions under the rules for inclusion. The Treasury

Department and the IRS decline to adopt this suggestion but note that the exceptions to

inclusion event treatment applicable to QOF C corporations, such as the exception for

qualifying section 381 transactions, also apply to RICs and REITs.

Proposed §1.1400Z2(b)-1(c)(6)(ii)(C) provided that a merger or consolidation of a

partnership holding a qualifying investment, or of a partnership holding 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. A

commenter noted that the May 2019 proposed regulations did not explicitly provide that

a merger of a QOF partnership into another partnership in a transaction to which section

708(b)(2)(A) applies is not an inclusion event, even if the acquiring partnership is a QOF

immediately after the merger.

The Treasury Department and the IRS adopt the comment in part. The Treasury

Department and the IRS have determined that the rule in §1.1400Z2(b)-1(c)(6)(iii) of the

May 2019 proposed regulations, which provided that a QOF partnership distribution with

a fair market value in excess of the distributee partner’s basis is an inclusion event,

should be modified in the case of certain mergers or consolidations under section

708(b)(2)(A).

The final regulations provide that, in the case of an assets-over merger or

consolidation of a QOF partnership with another QOF partnership in a transaction to

which section 708(b)(2)(A) applies, the fair market value of property distributed in the

merger or consolidation is reduced by the fair market value of the partnership interest

received in the merger or consolidation for purposes of determining whether there has

been an inclusion event. Therefore, the transaction will not be an inclusion event to a

partner that receives only a partnership interest in the resulting partnership. However,

there will be an inclusion event to the extent that a partner receives other property that

exceeds that partner’s basis in the partnership.

Additionally, the final regulations provide that a merger or consolidation of a QOF

partnership with another QOF partnership in a transaction to which section 708(b)(2)(A)

applies is not an inclusion event under §1.1400Z2(b)-1(c)(2)(i), which provides that

there is an inclusion event if a QOF ceases to exist for Federal income tax purposes.

The resulting partnership becomes subject to section 1400Z-2 and the section 1400Z-2

regulations to the same extent that the terminated partnership was so subject prior to

the transaction, and must allocate and report any gain inclusion under section 1400Z2(b) to the same extent and to the same partners that the terminated partnership would

have been required to allocate and report those items prior to the transaction.

A commenter also requested clarification that any partnership distribution of

property pursuant to a division governed by §1.708-1(d) is not an inclusion event,

provided the taxpayer’s beneficial interest in a QOF has not changed and all deferred

gain still would be recognized by the same taxpayer. Several other commenters

requested that pro-rata divisions of QOF partnerships into two or more QOF

partnerships pursuant to section 708 not be treated as inclusion events, provided the

amount of a taxpayer’s equity interest in its qualifying investment remains the same.

The Treasury Department and the IRS decline to adopt a general rule excluding

divisions as inclusion events because divisions may result in deemed distributions

arising from debt shifts, as well as distributions in excess of basis, which may result in

gain recognition under the subchapter K rules. Additionally, as described in part IV.E.4

of this Summary of Comments and Explanation of Revisions, the final regulations

expand the rule of proposed §1.1400Z2(c)-1(b)(2)(ii) to provide that, with the exception

of gain from the sale of inventory in the ordinary course of business, all gain from the

sale of property by a QOF partnership or by a qualified opportunity zone business that is

a partnership is eligible for exclusion as long as the qualifying investment in the QOF

has been held for at least 10 years. This change to proposed §1.1400Z2(c)-1(b)(2)(ii)

may minimize the need for divisions of QOF partnerships as a way to dispose of certain

assets.

One commenter also asked that a distribution by a QOF partnership of its net

cash flow, measured on an annual basis by reference to taxable income, plus

depreciation deductions, not constitute an inclusion event. The Treasury Department

and the IRS decline to adopt this recommendation because allowing such distributions

in excess of the QOF partner’s basis would add significant complexity, requiring the

tracing of distributions of net cash flow proceeds versus cash from other sources.

One commenter asked why proposed §1.1400Z2(b)-1(c)(6) used the phrase

“eligible gain.” Proposed §1.1400Z2(b)-1(c)(6) stated, in relevant part, that “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 eligible gain of the QOF.”

The commenter further noted that proposed §1.1400Z2(b)-1(c)(6) used this phrase

three times, and the inclusion of that phrase seemed inappropriate.

The Treasury Department and the IRS confirm that “eligible gain” was the

intended term in proposed §1.1400Z2(b)-1(c)(6). Eligible gain is a defined term in

proposed §1.1400Z2(a)-1(b)(2), and generally refers to gain that is eligible to be

deferred under section 1400Z-2(a). The term is further defined in §1.1400Z2(a)1(b)(11) of the final regulations. In addition, proposed §1.1400Z2(b)-1(c)(6) provided

special rules relating to inclusion events for partners and partnerships, and used the

defined term “eligible gain” to reference the amount of gain deferred under section

1400Z-2(a) that is required to be included in income upon the occurrence of certain

inclusion events.

Proposed §1.1400Z2(b)-1(c)(7)(iv) provided special rules regarding inclusion

events for conversions of S corporations to partnerships or disregarded entities.

Otherwise, the May 2019 proposed regulations did not expressly address whether a

QOF’s change in classification, such as from a partnership to a corporation, is an

inclusion event. A commenter recommended that the conversion of a QOF from a

partnership to a corporation for Federal tax purposes be treated as neither an inclusion

event nor a disposition of a qualifying investment for purposes of the election in section

1400Z-2(c).

The Treasury Department and the IRS note that, if a partnership elects under

§301.7701-3(c)(1)(i) to be classified as an association, under §301.7701-3(g)(1)(i) the

partnership is deemed to contribute all of its assets and liabilities to the association in

exchange for stock and to liquidate immediately thereafter. See also Rev. Rul. 2004-59,

2004-1 C.B. 1050 (applying the same treatment to a partnership that converts to a

corporation under a state law formless conversion statute). As provided in proposed

§1.1400Z2(b)-1(c)(2)(i), a taxpayer generally has an inclusion event for all of its

qualifying investment if the QOF ceases to exist for Federal income tax purposes, and

no specific rule in proposed §1.1400Z2(b)-1(c) provides an exception for liquidations of

QOF partnerships. Thus, the conversion of a partnership to a corporation would be an

inclusion event. No change has been made to the final regulations with respect to this

comment.

2. Inclusion Events for QOF S corporations

a. General Principle of Section 1371(a)

The May 2019 proposed regulations relied upon the principle set forth in section

1371(a), which provides that the rules of subchapter C of chapter 1 of subtitle A

(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 the May 2019 proposed regulations regarding redemptions, liquidations, and

reorganizations of QOF C corporations and QOF C corporation shareholders apply

equally to QOF S corporations and QOF S corporation shareholders to the extent

consistent with the rules of subchapter S. For example, because the stock of an

S corporation cannot be held by a C corporation, no exception is provided for a

liquidation or upstream asset reorganization of an S corporation investor in a QOF.

However, the May 2019 proposed regulations also reflect that flow-through

principles under subchapter S apply to S corporations when the application of

subchapter C would be inconsistent with subchapter S. For example, under the May

2019 proposed regulations, 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 the

S corporation would include the gain pro rata in their respective taxable incomes. See

section 1366(a)(1)(A). 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. See section 1367(a)(1)(A). 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 gain

amount included in income and included in stock basis. If the S corporation has

accumulated E&P, the S corporation’s accumulated adjustments account would be

increased by the same amount as the increase in stock basis to ensure the

shareholders’ tax-free treatment of the future distributions. See section 1368(c), (e)(1).

b. Specific Inclusion Event Rules for S Corporations

The May 2019 proposed regulations also 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), the May 2019

proposed regulations clarified that a conversion of an S corporation that holds a

qualifying investment in a QOF to a C corporation (or a conversion of 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. For mixedfunds 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 May 2019 proposed regulations made clear that the

separate blocks would not be treated as different classes of stock for purposes of

S corporation eligibility under section 1361(b)(1).

The Treasury Department and the IRS received favorable comments regarding

the reliance of the May 2019 proposed regulations upon the principle set forth in section

1371(a). In addition, commenters provided favorable comments regarding the foregoing

rules, which the Treasury Department and the IRS drafted in accordance with that

principle. As a result, the final regulations adopt those rules without modification.

c. Elimination of 25-Percent Aggregate Ownership Change Rule

The May 2019 proposed regulations set forth a special rule that, solely for

purposes of section 1400Z-2, an S corporation’s qualifying investment in a QOF would

be treated as disposed of if there is a greater-than-25 percent aggregate change in

ownership of the S corporation (25-percent aggregate ownership change rule). Under

that rule, upon a greater-than-25 percent aggregate change in ownership, the

S corporation would have an inclusion event for 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. In proposing

the 25-percent aggregate ownership change rule, the Treasury Department and the IRS

attempted 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.” Section VII.D.3 of the preamble to

the May 2019 proposed regulations.

The Treasury Department and the IRS have received comments from the

taxpayer and practitioner communities critical of the 25-percent aggregate ownership

change rule. In particular, commenters have emphasized that the proposed rule

conflicts with the stated purpose of inclusion events under section 1400Z-2, which is to

“prevent taxpayers from ‘cashing out’ a qualifying investment in a QOF without including

in gross income any amount of their deferred gain.” Section VII.A of the preamble to the

May 2019 proposed regulations. In addition, commenters have noted that subchapter S

of the Code already contains provisions, such as section 1377, that achieve more

effectively the “balance” intended through the proposed 25-percent aggregate

ownership change rule.

As previously stated, for purposes of the Code, including section 1400Z-2, the

rules of subchapter C apply to an S corporation and its shareholders unless inconsistent

with subchapter S. See section 1371(a). For example, if an S corporation investor in a

QOF were to have an inclusion event regarding the S corporation’s qualifying

investment, the rules of subchapter S would apply to ensure that the shareholders of the

S corporation would include the resulting gain pro rata in their respective taxable

incomes and increase their bases in their S corporation stock at the end of the taxable

year during which the inclusion event occurred. See generally section 1366. However,

neither subchapter S nor section 1400Z-2 provides that the disposition of any stock held

by a shareholder of an S corporation should cause an inclusion event under section

1400Z-2 for a qualifying investment held by the S corporation in a QOF (that is, should

be treated as a disposition by the S corporation). Rather, the rules of subchapter S

indicate the opposite, as evidenced by the ability for S corporation shareholders to

dispose of their stock without affecting the S corporation’s tax-free treatment resulting

from a like-kind exchange of one of its assets. See generally section 1031. The

Treasury Department and the IRS have determined that, like a C corporation investor in

a QOF C corporation, an S corporation investor should not have an inclusion event for

its qualifying investment solely as the result of a disposition of shares by one of its

shareholders, regardless of the disposition’s magnitude.

Furthermore, the Treasury Department and the IRS have determined that the

proposed 25-percent aggregate ownership change rule does not achieve its stated

purpose of balancing the status of the S corporation as the owner of the qualifying

investment while directing capital gain inclusion to the proposed rule’s intended parties

(that is, the S corporation’s shareholders, upon an inclusion event). See section VII.D.3

of the May 2019 proposed regulations. Indeed, the Treasury Department and the IRS

note that the proposed rule conflicts with section 1377, the longstanding provision in

subchapter S that governs the allocation of items of income among S corporation

shareholders.

Under section 1377(a)(1), each shareholder’s pro rata share of any item for any

tax year generally equals the sum of the amounts determined for the shareholder by (1)

assigning an equal portion of the item to each day of the tax year, and then (2) dividing

that portion pro rata among the shares outstanding on that day, per share, per day. As

an exception for terminations of a shareholder’s interest, section 1377(a)(2) permits an

S corporation and the affected shareholders (that is, the remaining shareholders of the

S corporation at the time of the termination) to agree to a “closing of the books” of the

S corporation and allocate the S corporation’s items of income among those

shareholders based on their ownership before and after the termination (that is, treat the

taxable year as two taxable years, the first of which ends on the date of the termination).

As highlighted by one commenter, in the absence of a “closing of the books” election,

the inclusion of capital gain resulting from an inclusion event will be allocated pro rata

among all of the S corporation’s shareholders as of the end of the S corporation’s

taxable year, rather than to those shareholders who were shareholders at the time the

S corporation invested its deferred capital gain in its QOF. In other words, the allocation

rules of section 1377 do not operate to match S corporation items to specific

shareholders. For these reasons, the Treasury Department and the IRS agree with the

comments received and have removed the proposed 25-percent aggregate ownership

change rule from the final regulations.

d. Contributions of QOF Investments to a Partnership

With respect to the contribution

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