Earlier today the Internal Revenue Service released the first set of proposed regulations (the “Proposed Regulations”) and a revenue ruling (the “Revenue Ruling”) clarifying certain aspects of the Qualified Opportunity Zone (“QOZ”) provisions added by the tax reform legislation enacted in December 2017. The IRS indicated that it expects to issue additional guidance before the end of 2018, and the IRS has requested comments on a number of provisions in the Proposed Regulations. The Proposed Regulations state that they may apply to transactions occurring before the finalization of such regulations, provided they are applied consistently. We are preparing a more detailed bulletin to provide further comments, but want to highlight some of the key aspects of the Proposed Regulations in this Stroock Special Bulletin:
Only Capital Gains Eligible for Reinvestment
The Proposed Regulations provide that only capital gains may be “rolled over” into a QOZ investment. This would preclude ordinary income from the sale of inventory (and possibly would preclude gain recharacterized as ordinary income under certain “recapture” rules).
Partners in Pass-Through Entities May Reinvest
Share of Entity’s Gains From Asset Sales The Proposed Regulations include special provisions by which gain recognized by a partnership may (except to the extent the partnership elects to rollover the gain itself) flow through to the partners and be reinvested by such partners into qualified opportunity funds (“QOFs”). It was previously unclear whether the partner or the partnership had to make such reinvestment.
Additionally, there is the potential for such partners to have an increased period during which to reinvest gain into a QOF. The partnership’s 180-day period begins on the date of its sale, but if the gain flows through to the partners, the partners’ 180-day period begins on the last day of the partnership’s taxable year. Partners may instead elect to use the partnership’s 180-day period if they so desire (e.g. if the desired investment is already lined up).
Qualified Opportunity Funds Always Tested at End of Calendar Year
The Proposed Regulations clarify that, while the initial testing date for a QOF (for purposes of the 90% asset test, discussed below) may be as long as six months after the QOF’s start date, there is always a testing date on the last day of the calendar year. Accordingly, QOFs that are formed near the end of a calendar year may need to meet the 90% asset test sooner than expected.
The Proposed Regulations do, however, provide flexibility for QOFs to select the date on which they begin to qualify (although QOFs must qualify as such prior to receiving investments for such investments to qualify under the QOZ provisions), and for taxpayers to use pre-existing entities as QOFs.
LLCs Likely Permitted
The Proposed Regulations state that QOFs may include entities treated as partnerships for federal income tax purposes, which would presumably permit the use of limited liability companies.
Investors May Hold Investments Past Expiration of QOZ Designation
Although the statute provides that the QOZ designations expire after 10 years, the Proposed Regulations permit investors seeking to take advantage of the 10-year rule to hold their investments for an additional 20-year period — until December 31, 2047 — and still receive the benefit of the exclusion from income of all post-acquisition appreciation.
Treatment of Land
The Proposed Regulations and Revenue Ruling provide that land is treated separately from the improvements thereon for purposes of the substantial improvement test, and provide several important clarifications regarding the treatment of land.
The Revenue Ruling provides that land, given its permanence, may never be treated as originally used by a QOF in a QOZ. However, the examples in the Revenue Ruling indicate that the land may qualify as QOZ Business Property if the improvements thereon qualify, even if such land is not improved. Accordingly, for the substantial improvement test, a QOF need only substantially improve the building on a parcel of acquired land in order for the entire parcel to qualify for the 90% asset test.
Additionally, the example in the Revenue Ruling involves the conversion of a factory building into residential real property. As the building was already in existence and is being modified (rather than a new one being constructed), it must meet the substantial improvement test rather than the original use test. The example also seems to confirm that residential real property does indeed qualify as potential QOZ property.
Working Capital Safe Harbor
The Proposed Regulations provide certain safe harbors relating to working capital and asset composition of a QOF. Specifically, the “reasonable working capital” safe harbor of Section 1397C(e)(1) of the Internal Revenue Code now also extends to QOFs for a period of 31 months.
QOZ Business “Substantially All” Requirement to Mean at Least 70%
QOFs may own QOZ businesses (rather than directly owning qualified opportunity zone property), with the requirement that a QOZ business have “substantially all” of its assets be qualified opportunity zone property. The Proposed Regulations provide that, solely for this purpose, “substantially all” means at least 70%. Accordingly, a QOF that owns a QOZ business may have as little as 63% of its capital invested in qualified opportunity zone property (90% in the QOZ business, per the 90% asset test, times 70% of the business’s property). This may provide additional flexibility as to the timing of capital investments into a QOF and the use of such capital.
 Rev. Rul. 2018-29.
 See https://home.treasury.gov/news/press-releases/sm530
 Note, however, that the negative impact of this rule may be mitigated by the working capital provisions discussed infra.
 It would seem that the QOF must continue to qualify as such, solely but for the expiration of the QOZ designation, but this does not appear to be entirely clear from the regulations.
 This, although already thought by many to be the correct result, nevertheless helpfully rebuts a technical point raised by some regarding the incorporation of certain definitions from Section 1397C of the Internal Revenue Code.