Last week, the IRS released proposed regulations regarding investing in Qualified Opportunity Funds (“QOFs”).  Click here for a summary of the QOF regime that was enacted as part of the 2017 Tax Cuts and Jobs Act. The proposed regulations generally address three topics:

  1. The requirements for deferring gain recognition by investing in a QOF;
  2. Rules for corporations or partnerships to self-certify as QOFs; and
  3. The requirements for a corporation or partnership to qualify as a QOF.

Highlights of the proposed regulations include the following:

  • The proposed regulations provide that only capital gains are eligible for deferral. Where a sale results in both capital gain and ordinary income (such as depreciation recapture), a taxpayer can defer only the capital gain.
  • A partnership itself can elect deferral of eligible gain. To the extent the partnership does not elect, a partner in the partnership can elect deferral with respect to the partner’s distributive share of eligible gain.  The partner can make such an election within 180 days of the last day of the tax year in which the gain occurs.
  • The deferral election will be reported on a Form 8949. The self-certification to qualify as a QOF will be reported on a Form 8996.
  • The proposed regulations clarify that the exclusion of gain after holding a QOF investment for 10 years qualifies even after a Qualified Opportunity Zone (“QOZ”) designation expires. This was a concern raised by many commentators based on the statute.
  • Pre-existing entities may qualify as QOFs, subject to certain requirements.
  • A QOF may hold cash and other nonqualified financial property for up to 31 months (a “working capital safe harbor”) if the QOF has a written plan that identifies the property as held for acquisition, construction or substantial improvement of tangible property in the QOZ, a written schedule exists evidencing the use of the property, and the QOF substantially complies with the schedule.
  • The proposed regulations provide further guidance about how to qualify as a “QOZ Business.” In brief:  A QOF must hold 90% of its assets in “QOZ Property.”  QOZ Property is either (1) “QOZ Stock” (stock of a corporation that is a QOZ Business), (2) “QOZ Partnership Interest” (partnership interest in a partnership that is a QOZ Business), or (3) “QOZ Business Property.”  If the QOF invests in a QOZ Business (eg, stock or partnership interests) to meet this requirement, the proposed regulations provide that 70% of the tangible property of the subsidiary corporation or partnership must be held for use in QOZ Business Property.  The leniency of this rule makes it likely that QOF will use subsidiary entities to make investments.
  • The proposed regulations also clarify how a business will qualify as a QOZ business.

The IRS is soliciting comments on the proposed regulations and planning to issue additional regulations.  Investors should try to stay flexible as the rules in this new area may change.  Nonetheless, as the rules become clearer, investors can better evaluate the planning opportunities that investing in QOZs offer.

 

On October 19, 2018, the IRS released Revenue Ruling 2018-29, an eagerly awaited ruling addressing real estate investment in Qualified Opportunity Zones (“QOZs”). In brief, the Revenue Ruling holds that, for purposes of measuring whether a real estate investment is “substantially improved” so that it will qualify as “QOZ business property” and therefore will qualify for favorable tax deferral rules, the taxpayer uses his or her adjusted basis in the building as the measure and ignores his or her basis in the land.

The 2017 Tax Cuts and Jobs Act created an Opportunity Zone Program to encourage investments in economically distressed areas. Taxpayers who invest realized gains in Qualified Opportunity Funds (“QOFs”) (1) get to defer recognition of the gain (until the earlier of the date of sale of the QOF investment or December 31, 2026), (2) get a step-up in basis up to 15% (if the QOF interest is held for five to seven years), and (3) may exclude all of the gain due to the new QOF investment if they hold the investment for 10 years.

A QOF must hold at least 90% of its assets in “QOZ property.” For real estate investors, the investment generally must be QOZ business property, which is tangible property (including real estate) used in a trade or business that is purchased after December 31, 2017, and either the original use of the property began with the QOF, or the QOF “substantially improves the property.” Property is treated as substantially improved if, within 30 months of acquisition, the additions to the tax basis of the property exceed the original basis at the beginning of the 30 month period. In other words, if the investor makes improvements to the property that doubles its basis, then the property will qualify as “substantially improved.”

The statute is complicated and there have been a number of questions about the details of how to implement the QOZ rules. The IRS has issued proposed regulations and will issue more. Nonetheless, the Revenue Ruling is taxpayer-friendly and helpful because it makes clear that one ignores basis in land and uses only basis in the building in order to determine whether the QOZ property is substantially improved and thus qualifies for tax benefits.

Beginning January 1, 2018, the IRS will begin implementing Section 7345 of the Internal Revenue Code to certify tax debt to the State Department.  This will allow the State Department to revoke or withhold the issuance of passports to delinquent U.S. taxpayers.

To warrant IRS certification to the State Department, the IRS debt has to be deemed “seriously delinquent tax debt.”  This is defined as: (a) an amount exceeding $50,000, as adjusted annually for inflation and including penalties and interest; (b) a levy or notice of federal tax lien has been issued by the IRS; and (c) all administrative remedies, such as the right to request a collection due process hearing, have lapsed or been exhausted.  This only relates to Title 26 of the United States Code and does not include other tax-related penalties, such as FBAR penalties.

The IRS will be required to notify the taxpayer in writing at the time it issues a tax debt certification to the State Department. Before denying a passport, the State Department will hold a passport application for 90 days to allow the taxpayer to resolve the tax debt or enter into a payment alternative with the IRS.

It is also possible to seek relief in U.S. Tax Court or District Court.  The court can order the IRS to reverse the certification if it was erroneously issued, or was required to be reversed but the IRS failed to do so.

The certification will not apply or will be reversed in the following scenarios:

  • The debt is paid in full. (The IRS will not reverse the certification if the taxpayer pays down the debt to an amount below $50,000.)
  • The taxpayer enters into an installment agreement with the IRS to pay off the debt.
  • The IRS accepts an offer in compromise to satisfy the debt, or the Justice Department enters into a settlement agreement with the taxpayer to satisfy the debt.
  • Collection is suspended based on a request of innocent spouse relief, or for collection due process based on a notice of levy, but only if the request is with respect to the debt underlying the certification.
  • The debt becomes unenforceable based on statute of limitations.

The law affects expatriates living abroad and individuals traveling regularly overseas for work.  If the taxpayer finds himself or herself traveling or living outside of the country with a revoked passport, the Secretary of State has the discretion to limit the existing passport, or issue a limited one, for return travel to the United States.

It is not clear if this statute will ultimately pass constitutional challenges.  In the meantime, starting January 1, 2018, you may be at risk of having your U.S. passport revoked if you travel outside of the U.S. without first addressing delinquent tax debts exceeding $50,000 through any administrative remedies and/or collection alternatives available to you.

Experts have started to calculate the inflation adjustments to key estate and gift exemption amounts for 2018.  Note that these are not the official figures to be released by the IRS, but should be used as a guide.  The IRS will officially release the numbers later this year.

For an estate of any decedent dying during calendar year 2017, the applicable exclusion was increased from $5.45 million to $5.49 million.  This change increased not only the applicable exclusion amount available at death, but also a taxpayer’s lifetime gift applicable exclusion amount and generation skipping transfer exclusion amount.  This means a husband and wife with proper planning could transfer $10.98 million estate, gift and GST tax free to their children and grandchildren in 2017.  The projected 2018 adjustment to the applicable exclusion will increase from $5.49 million to $5.6 million which means that a husband and wife with proper planning could potentially transfer $11.2 million estate, gift and GST tax free to their children and grandchildren in 2018.

For 2017, the estate, gift and GST tax rate remains the same at 40% and the gift tax annual exclusion remains at $14,000.  For gifts made in 2018, the projected gift tax annual exclusion will be adjusted to $15,000 (up from $14,000 for gifts made in 2017).

The New Jersey Estate Tax repeal will be effective as of January 1, 2018.  The current $2 million exemption which increased on January 1, 2017 is set to be eliminated as of January 1, 2018.  Keep in mind that the New Jersey Inheritance Tax is still in effect. This is a tax imposed on transfers to beneficiaries who are not spouses, parents, children or grandchildren (i.e., nieces, nephews, siblings, friends, etc.) New Jersey Inheritance Tax rates start at 11% and go as high as 16%.

The New York exclusion amount was changed as of April 1, 2014.  Beginning April 1, 2014, the exclusion has increased as follows:

•           $2.0625 million for decedents dying between April 1, 2014 through March 31, 2015;

•           $3.125 million for decedents dying between April 1, 2015 through March 31, 2016;

•           $4.1875 million for decedents dying between April 1, 2016 through March 31, 2017;

•           $5.25 million for decedents dying between April 1, 2017 through December 31, 2018.  Beginning in 2019, the exclusion would be indexed for inflation, and equal to the Federal exclusion.

In 2017, the gift tax annual exclusion to a non-citizen spouse was increased from $148,000 to $149,000.  This is projected to increase to $152,000 in 2018.  While gifts between spouses are unlimited if the donee spouse is a United States citizen, there are restrictions when the donee spouse is not a United States citizen.

The US Tax Court recently held that a foreign corporation is not subject to US income tax on the sale of a partnership interest where the partnership conducts a US business.  In so holding, the Tax Court rejected a 26 year old Revenue Ruling (Rev Rul 91-32) that reached the opposite conclusion.  For foreign investors in US businesses (that do not own real estate), this is an important decision.

A foreign investor who owns an interest in a partnership that holds US real estate may be subject to US federal income tax on a sale of that partnership interest under the Foreign Investment in Real Property Tax Act (“FIRPTA”).  For real estate, the IRS has indicated that gain derived by a foreign investor from the disposition of an interest in a partnership is subject to US tax only to the extent it is attributable to US real property interests owned by the partnership.  Regs §1.897-7T(a); Notice 88-72.

In Rev Rul 91-32, the IRS set forth its view that taxation on the sale of a partner’s interest in a partnership can go beyond mere real estate investment and apply to a sale of an interest in a partnership if the partnership is engaged in any US trade or business and has effectively connected income (“ECI”).  In this ruling, the IRS applied the “aggregate” theory of partnership taxation to justify looking through the partnership to its underlying assets in determining the source and character of the partner’s gain.

In July, 2017, the Tax Court issued its decision in Grecian Magnesite, Mining, Industrial & Shipping Co, SA v Comm’r, 149 TC 3The court declined to follow the IRS’s long standing position under Rev Rul 91-32, and held that a non-US person’s gain from the sale of its interest in a partnership engaged in a US trade or business is generally not subject to US federal income tax.

Grecian Magnesite Mining was a privately owned corporation organized under the laws of Greece that sells magnesia and magnesite to customers around the world.  From 2001 through 2008, it was a member of a US LLC that was engaged in the business of extracting, producing, and distributing magnesite in the US.  In 2008, Grecian Mining’s interest in the LLC was completely redeemed, resulting in treating the transaction as a sale or exchange of the membership interest.

The IRS asserted that the capital gain was properly treated as ECI since Grecian Mining was engaged in a trade or business as a result of its investment in the LLC.  Grecian Mining’s position was that the assets of the LLC do not control the character of the gain from a disposition of an interest in the LLC.  The gain should not have been treated as US-source gain and generally cannot be taxed in the US as ECI under the proposition that foreign-source income cannot be ECI except in limited instances that arise from the presence of US real estate under FIRPTA, which only applied to a small part of their gain.

Foreign investors should carefully review their US tax exposure on a sale of a partnership interest before they simply pay tax on their realized gain.  Grecian Magnesite calls into question the validity of Rev Rul 91-32 (though an appeal or non-acquiescence is possible).  A foreign investor should be able to rely on this case to avoid paying tax.  Moreover, foreign investors that have already paid income tax based upon Rev Rul 91-32 may wish to file a refund claim based on this decision.