A Deep Dive into Opportunity Zones:New Tax Incentives Stimulating Community Investment(including Proposed Regulations)

Co-Hosted by Impact Capital Forum &

Orrick, Herrington & Sutcliffe LLP

Time Topic8:30 – 8:45 am

8:45 – 9:00 am

Breakfast & Networking

Welcome Remarks – Carolyn Allwin, Managing Director, Elysian Advisers

9:00 – 10:00 amPanel 1: Legislative Updates from Tax and OZ Thought Leaders

10:00-10:15 am Coffee & Networking

10:15 – 11:15 am Panel 2: Practical Implementation – How Investors and Fund Managers are Putting OZ Capital to Work

11:15 – 11:45 am Networking and Interaction with speakers

Agenda

2

Legislative Updates for Tax and OZ Thought Leaders

Panel 1

3

• Quinn Moss – Partner, Orrick, Herrington & Sutcliffe, LLP (Moderator)

• Richard Chirls – Partner, Orrick, Herrington & Sutcliffe, LLP

• John Cochrane – Senior Associate, U.S. Impact Investing Alliance, Ford Foundation

• Lauren Lovelace – Principal, Ernst & Young LLP

Congress created new tax incentives in the December 2017 Tax Cuts and Jobs Act to spur targeted economic growth by driving long-term capital to distressed communities in the U.S. States and Territories:

In broad terms:

Investors must act fast to receive tax benefits (unusual combination of both deferral and reduction of tax on gain, but need to act by 2019 to gain full benefit)

by investing proceeds received from capital gains(an estimated $6 trillion in unrealized capital gains available)

into Qualified Opportunity Funds that make investments in Qualifying Opportunity Zones Businesses in Opportunity Zones(distressed census tracts that meet eligibility requirements)

Understanding Opportunity Zones

4

Promising Uses: Variety of enterprises, including real estate development, housing, infrastructure and energy projects, tech and service businesses, etc., to help spur economic growth and modernize:

Potential Investments by Qualified Opportunity Funds (QOF)

5

Rural areas with sluggish economies

Deteriorating neighborhoods adjoining older industrial

areas

Blighted industrial/commercial areas

with adjoining residential areas

Declining commercial corridors

QOF Investments to spur economic

growth

WHAT ARE QUALIFIED OPPORTUNITY ZONES (“QOZs”):

Low-income areas nominated by governor of a U.S. state or territory based on New Market Tax Credit (NMTC) definition of “low-income” and designated by the U.S. Secretary of the Treasury, comprised of

Census tract’s poverty rate is Contiguous census tracts where medianat least 20% of median family income income does not exceed 125% of the for the tract and does not exceed median family income (limited to80% of the area median 5% of total)

“Opportunity Zone” Basics

6

LOW INCOME COMMUNITY

(LIC)

TRACTS

ELIGIBLE NON-LIC

CONTIGUOUS TRACTS

HOW MANY QOZs WERE PERMITTED TO BE DESIGNATED PER STATE/TERRITORY?

Up to 25% of the total number of low-income census tracts(or up to 25, if total number of qualified low-income communities is less than 100)

IRS List of QOZs as of June 14, 2018 reflects final QOZ designations, with census tracts in 50 states and 5 territories receiving QOZ designation

Approximately 12% of U.S. land mass included in QOZs

Every major city has at least one QOZ

All of Puerto Rico is a QOZ

Over 8,700 QOZ available overall

“Opportunity Zone” Basics (cont.)

7

See also interactive map at cdfifund.gov/pages/opportunity-zones.aspx

Opportunity Zones: Sample Maps

8

A Qualified Opportunity Fund (“QOF”)* is an investment vehicle that:

Is funded by QOF investor(s) with proceeds from a sale that generated capital gain (for each investor, funded within 180 days of the investor’s event generating the gain)

Is set up as a partnership or corporation (for tax),

Invests in eligible property located in an Opportunity Zone in cash

An eligible taxpayer SELF-CERTIFIES as a QOF (by attaching IRS form (TBD) to federal income tax return for taxable year).

*sometimes referred to as “Opportunity Zone Funds” or “OZ Funds”

What are Opportunity Funds?

9

CASH

QOF Investors QOF BusinessesQOFInvest gains

w/in 180 days Invest

CASH

• Qualified Opportunity Funds (“QOFs”):

– Required to hold at least 90% of their assets in equity or property of Qualified Opportunity Zone Business (businesses/and or business property), purchased after December 31, 2017

What is a Qualified Opportunity Zone Business (“QOZB”)?

• Substantially all of its tangible property (owned/leased) is “Qualified Opportunity Zone Business Property”

• 50% of total gross income is derived from active conduct of its business in QOZ

• Substantial portion of intangible property is used in active conduct of business in QOZ

• Less than 5% of average of its aggregated unadjusted basis is attributable to non-qualified financial property (other than cash for “reasonable working capital”)

• No portion used for “vice businesses,” e.g., golf courses, country clubs, massage parlors, hot

tub facilities, suntan facilities, racetrack or gambling facilities or liquor stores

10

Other “Opportunity Fund” Basics –

In what can the QOF invest?

• What is QUALIFIED OPPORTUNITY ZONE BUSINESS PROPERTY?

• Tangible property used in a trade or business of QOF if

» Such tangible property is purchased after 12/31/17,

» Original use of such tangible property commences with the QOFor QOF substantially improves(*) tangible property,

» During substantially all of QOF’s holding period of tangible property, substantially all of its use is in QOZ

• Per Proposed Regs: Substantially improves: during 30-month period from date of acquisition, additions to basis for tangible property (**) held by QOF must exceed QOF’s adjusted basis in such tangible property at beginning of the 30-month period

** Per Rev Rul 2018-29: if substantial improvements made to buildings, improvement not also required for related land

More Opportunity Zone Basics:Qualified Opportunity Zone Business Property

11

• To encourage long-term EQUITY investment in distressed areas,

QOF investors are offered

several potential tax benefits

- Deferral of tax on gain

- Step-up in basis of QOF interest

- Exclusion from tax on sale of QOF interest held at least 10 years

if they timely invest gains from the sale of appreciated property in a QOF -

These tax benefits are available whether or not the investor lives, works or has business in the Opportunity Zone

Opportunity Funds: Why would investors invest?

12

An investor who sells or transfers property (securities, tangible assets, real property, etc.…art? crypto?) and recognizes gain on the sale/ transfer, and

» invests the amount of the gain in a QOFduring 180- day periodfollowing date gain is recognized for such sale or transfer,

» Is eligible for a tax deferral, which ends upon the earlier ofthe date the QOF investment is sold and December 31, 2026(NOTE: Potential cash flow issue once tax comes due!)

HOW: Election is made by QOF investor on Form 8949 when filing (or amending) the investor’s tax return for the taxable year in which the investor’s sale or transfer takes place (filing instructions TBD)

Opportunity Funds: Tax Benefit #1: Deferral of Tax on Gain

13

• Taxable amount recognized:

Lesser of

amount of gain deferred and

FMV of the QOF investment

MINUS

Taxpayer’s basis in the QOF

Opportunity Funds: Taxable Amount Recognized at End of Deferral Period or Upon Sale

14

If QOF investor holds its interest in the QOF for a period of 5 years or more, QOF can exclude a percentage of the deferred capital gain from tax by increasing the investor’s tax basis in its QOF interest, as follows:

Opportunity Funds: Tax Benefit #2: Capital Gains Tax Exemption related to QOF Interest

15

Holding Period % of deferred Capital Gain excluded from tax (by addition to tax basis of QOF interest)

At least 5 years (but less than 7)

10%

At least 7 years(but less than 10)

15% (i.e., an additional 5%)

Timeline illustrating Tax Benefits #1 and #2

16

v

Developer sells commercial building and realizes capital

gain of $10MM

January 2018

Traditional Investment

Opportunity Zone

Investment

May2018

April 2019

April 2027

Developer purchases residential buildings

and improves them for total cost of $9MM

Developer pays tax on capital gain from sale

of commercial building (20% rate*)

$10MM x 20% = $2MM

TAX SAVINGS with Opportunity Zone Investment: $300K (+ time value of money)

*20% capital gain tax rate applied for the purpose of mathematical simplification.**Property held for seven years eligible for 15% gain reduction

No event – tax paid in April 2019

Developer sells commercial building and

realizes capital gain of $10MM

The $10MM gain is invested into an

Opportunity Fund

Opportunity Fund purchases residential

buildings and improves them for total cost of $9MM

No event – tax deferred

Developer pays tax on capital gain from

commercial building sale (20% rate*, with

15%** gain reduction)$8.5MM x 20% = $1.7MM

If QOF investor holds its interest in the QOF

for 10 years or more

the QOF investor is entitled to:

• Forgiveness of all gains on appreciation of its QOF interest (that related to deferral of gains)*, by increasing basis in that QOFinterest up to an amount equal to FMV on the date of sale.

*if QOF investor invested additional amounts that were not a deferral

of gains, that investment would be treated separately with no increase in basis

* Tax Benefit #3 requires Special Election (to permit taxpayer to forgo this treatment if QOF interest has declined in value)

* Under Proposed Regs, benefit allowed until 12/31/47(beyond OZ designation expiration date of 12/31/28)

Opportunity Funds: Tax Benefit #3: Exclusion of Gain on Sale by Investor of QOF Interest

17

•

Timeline illustrating Tax Benefit #1, 2 and 3

18

Developer sells commercial building and realizes capital

gain of $10MM

January 2018

Traditional Investment

Opportunity Zone

Investment

May2018

April 2019

April 2027

Developer purchases residential buildings

and improves them for total cost of $9MM

Developer pays tax on capital gain from sale

of commercial building (20% rate*)

$10MM x 20% = $2MM

Total Post-Tax Profits with Opportunity Zone Investment: $6.3MMTotal Post-Tax Profits with Traditional Investment: $4.4MM

*20% capital gain tax rate applied for the purpose of mathematical simplification.**Property held for seven years eligible for 15% gain reduction

No event – tax paid in April 2019

Developer sells commercial building and

realizes capital gain of $10MM

The $10MM gain is invested into an

Opportunity Fund

Opportunity Fund purchases residential

buildings and improves them for total cost of $9MM

No event – tax deferred

Developer pays tax on capital gain from

commercial building sale (20% rate*, with 15%**

gain reduction)$8.5MM x 20% = $1.7MM

February 2028

April 2029

Developer sells residential buildings and realizes capital

gain of $8MM

Developer sells interest

in Opportunity Fund, which

owns the residential buildings,

and realizes capital gain

of $8MM

No event – tax exempt

Developer pays tax on capital gain from sale of

residential buildings $8MM x 20% = $1.6MM

QOF must pay

UNLESS Fund can show failure is due to “reasonable cause”

Opportunity Funds – What Happens if QOFFails to Comply with 90% test?

PENALTY =

Shortfall

multiplied by

Underpayment rate(Federal short-term rate plus 3%)

19

IF QOF FAILS TO MEET THE 90% REQUIREMENT TO INVEST IN QUALIFIED OPPORTUNITY ZONE BUSINESS,

1) What gains will be eligible? Just capital gains, or other types as well?

2) Which taxpayers are eligible to elect gains?

3) How will LPs in a partnership elect to make the election and what type off interest should they hold to qualify for benefit

» Can the LP elect to defer gains realized by a partnership? » Will the partnership will be responsible for making the election? » When does the 180 day period to reinvest start if LP elects to take an election on a gain realized by the

partnership?

4) 90% Test:

» Will there be a “preparatory period” for new funds (any grace period for a QOF to begin investing in Qualifying Property?)

» How will reasonable working capital be defined (at QOF level and entities in which QOF invests?)» How will assets be valued (FMV, cost basis, other method?)» What constitutes original use for land?» What constitutes substantially all (also, any relief provided for operating businesses with respect to

substantially all property being acquired after December 31, 2017?).’» What do other statutory terms mean in this context: “active conduct”, “use of intangible property”,

remaining a QOZB for “substantially all” of the QOF’s holding period, etc.

5) Will leverage within a partnership be treated?

6) What is reasonable period for reinvestment of proceeds from sale of assets inside an Opportunity Zone (to address interim gains).

7) Will multi-asset funds unwind after disposition of assets (will partners be permitted to be redeemed (without triggering a tax event upon the sale of assets).

Uncertainty in Tax Interpretation – Proposed Regs Offer Some Clarity (see Appendix A for more details)

20

A. Reporting requirements

B. Can QOF operate as a fund of funds

C. Can QOF reserve for the 7th year liquidity event

D. Rules re: marketing of QOF

E. Effect of transfer of QOF interest? to affiliate? From another fund?

F. Limitations on non-pro rata distributions from QOF

G. Start up QOF timing of investment in QOZBP.

H. Gross income test

I. QOF operations outside QOZ

J. Penalty tax mechanism

K. Any limits on pairing of QOZ/ QOF tax benefits with those other tax credit programs

Tax Benefits Uncertainty – Other questions (a sampling)

21

• Can QOZ/QOF tax benefits be paired with other tax credits/benefits?

Yes?

– No Statutory Prohibition

– Rev Proc. 2018-16: “Investments in a qualified opportunity fund may also be eligible for other tax benefits”

– Other tax benefits to consider/contrast/supplement:

• low-income housing credit

• NMTC

• ITC

• IRC §1031 Like-kind exchanges, etc.

Opportunity Zones and QOFs – Pair with other tax benefits?

22

• QOFs sponsored by Enterprise Community Partners for affordable housing

• $100M QOF sponsored by Access Ventures, Local Initiatives Support Corp (LISC) and Village Capital to invest in mixed use (small business, commercial rental and affordable housing) across 3-5 cities

• QOFs sponsored by LISC in multi-family housing, health clinics, charter schools and workforce housing

• $100M QOF sponsored by TPP Capital Management to revitalize blighted neighborhood in Philadelphia

• $100M QOF sponsored by Beekman Advisors to incubate small businesses in Virginia and North Carolina

• QOFs (Obsidian Opportunity Funds) to extend solar power within 86 opportunity zones In Oregon

• QOZ Marketplace to be launched on-line by Realized, provider of tax-optimized real estate investments

Early Movers in QOFs

23

Considerations:

• What are the roles of state and local governments to encourage impact-aligned strategies in QOZs?

• What is likelihood that state/local tax regimes will be aligned with the Federals QOZ program?

• What areas are most likely to benefit as QOZs? What areas most likely to lose (through displacement, rapid gentrification, etc.)

• Can steps possible to ensure workforce development is part of the overall plan?

• How can exits be made from investments (e.g., in affordable housing) to preserve the impact benefits achieved?

• Are there investment opportunities in QOZs that are likely to encourage impact-aligned decisions by philanthropic partners (e.g., grants, concessionary loans, PRIs)?

• Will the program invite investment by diverse investors and fund managers?

• Is there a tension between Investor-directed impact metrics and accountability vs. IRS tracking and incentives?

• Tracking investment with reliable & baseline data is clearly important – have impact investors begun to develop ways to track

– Money flowing into QOFs

– Where QOFs are investing

– Which investors are claiming tax breaks through QOFs

• Are there other tax and regulatory puzzles to be solved?

Opportunity Zones Through an Impact Lens

24

• NO TIME TO WASTE: Given deferral deadline of 2026, urgency to locate QOF investors, establish QOF terms, and put QOF money to work in QOZB

• ROLE OF PUBLIC SECTOR: Local leaders and economic organizations to work with state counterparts to align private investment behind strategic plans

• ROLE FOR PRIVATE SECTOR: Urgency for private sector

– To raise awareness about program with local entrepreneurs, universities, start-up incubators and accelerators, to expand beyond real estate development

– To develop template documents geared to keep QOF in compliance the tax laws while also being on mutually acceptable QOF terms, with appropriate sharing of risk relating to program, and

– To provide metrics, data and monitoring to assist in proper implementation of program

Next Steps – Key Takeaways

25

Panel 2

26

Practical Implementation - How Investors and Fund Managers are Putting OZ Capital to Work

• Carolyn Allwin – Managing Director, Elysian Advisers (Moderator)

• Eric Clement – Senior Vice President, Strategic Investments Group at NYC

EDC

• Julia Shin – Vice President & Managing Director, Impact Investing at Enterprise

Community Partners

• Sherry Wang – Managing Director, Goldman Sachs, Urban Investment Group

• Evan Weiss – Director, PEL Analytics

: Opportunity Zones New Investment Tools Catalyzing Growth Eric Clement Senior Vice President, Strategic Investments Group, NYCEDC

Table of Contents

I. Background on NYCEDC & SIG

II. What is an Opportunity Zone?

III. The Zones in New York City

IV. Next Steps: NYCEDC Engagement

2

Background on NYCEDC & SIG

3

Our VISION: New York City is the global model for inclusive innovation and economic growth, fueled by the diversity of our people and our businesses

Our MISSION: Create shared prosperity across all five boroughs of New York City by strengthening neighborhoods and growing good jobs

4

Two Pillars of NYC’s Economic Development

1 Dynamic, Resilient Neighborhoods 2 Advancing 21st

Century Jobs

Ensuring businesses have

the neighborhood with the

resources space, resources,

and talent to provide

opportunity for New Yorkers

of diverse backgrounds

5

Equipping all New Yorkers

& every neighborhood

with the resources and

infrastructure necessary

to participate in the

economy

NYCEDC Organizational Background Capital Construction & Asset Management Departments: Capital, Asset Management Major Initiatives: Brooklyn Army Terminal, Cruise Terminals,

Public Markets

Real Estate Development Departments: Planning, Development & Transportation

Real Estate Transaction Services Major Initiatives: 168th Street Garage, Downtown Far Rockaway,

Downtown Staten Island

Industry and Innovation Departments: Center for Urban Innovation, Strategic Investment Group

Economic Research and Analysis Major Initiatives: Applied Sciences, Fashion,

Tax Credits & Bond Financing 6

Two Pillars of NYC’s Economic Development

1 Dynamic, Resilient Neighborhoods 2 Advancing 21st

Century Jobs

Ensuring businesses have the neighborhood with the resources space, resources, and talent to provide opportunity for New Yorkers of diverse backgrounds

5

Equipping all New Yorkers & every neighborhood with the resources and infrastructure necessary to participate in the economy

NYCEDC Organizational Background Capital Construction & Asset Management Departments: Capital, Asset Management Major Initiatives: Brooklyn Army Terminal, Cruise Terminals,

Public Markets

Real Estate Development Departments: Planning, Development & Transportation

Real Estate Transaction Services Major Initiatives: 168th Street Garage, Downtown Far Rockaway,

Downtown Staten Island

Industry and Innovation Departments: Center for Urban Innovation, Strategic Investment Group

Economic Research and Analysis Major Initiatives: Applied Sciences, Fashion,

Tax Credits & Bond Financing 6

Strategic Investments Group

7

TOOL DESCRIPTION

DISCRETIONARY TAX INCENTIVES

BOND FINANCING

NEW MARKETS TAX CREDITS

Offer credits against federal taxes to spur projects in low income areas

Issues tax-exempt bonds to facilitate access to low-cost private capital and

non-profits and other exempt facilities such as wharfs, airports and solid waste

Reduce taxes to incentivizecreation or renovation of

industrial/commercial space

Strategic Investments Group Financial Analysis: Modeling cash flows, reviewing debt to equity ratios and projecting profits Example: Vetting an early stage energy company for EDC equity investment

Program & Deal Structuring: Programs: Advise on program structure and function of EDC contribution Transactions: Determine equity vs. debt and payout amount for specific deals Example: Establish flexibility of co-investments with venture partners to support early stage lifescience companies

Deal Terms: Review proposed legal covenants and negotiate agreements between EDC and external parties Example: Negotiating partnerships structures with CyberNYC operators

Risk Mitigation: Analyzing costs of capital, payout agreements and default scenarios Example: Reducing EDC exposure by sharing risk w/ external financial partners

8

What is an Opportunity Zone?

9

What is an Opportunity Zone?

A census tract designated by each state or territory and certified by Treasury as eligible to receive private investments via Qualified Opportunity Funds

Meets definition of a “low-income community” (LIC), or...

Contiguous to a LIC and with a median family income that doesn’t exceed 125% of the LIC’s

10-year designation as Opportunity Zone

More than 8,700 Opportunity Zones have been designated in the 50 US states, the District of Columbia, and five territories

1 0

What is a Qualified Opportunity Fund?

An investment vehicle set up as a partnership or corporation for the purpose of investing in eligible property that is located in an Opportunity Zone

Qualified Opportunity Funds are capitalized by realized capital gains and must deploy 90% of capital into Opportunity Zones

Eligible investments include real estate and operating companies, although real estate investments are subject to improvement tests (100% basis)

Qualified Opportunity Funds must self-certify they meet all rules; forms expected 1Q 2019; IRS revenue guidance pending

11

How do the Tax Benefits work?

Tax Deferral

A temporary tax deferral for all newly realized capital gains reinvested into an Opportunity Fund, lasting until the investment is sold or December 31, 2026, whichever is sooner

Step-up in Basis

A step-up in basis for capital gains reinvested in an Opportunity Fund. The basis is increased by 10% if the investment is held for at least 5 years and by an additional 5% if held for at least 7 years

Permanent Exclusion

A permanent exclusion from taxable income on capital gains from the Opportunity Fund investment if held for at least 10 years

1 2

The Zones in New York City

1 3

Eligible Contiguous Neighborhoods

Opportunity Zones in New York City NYC Total: 306 (LIC**292/Non-LIC 14)

Manhattan: 36 (36/0) Bronx: 75 (75/0) Brooklyn: 125 (116/9) Queens: 62 (58/4) Staten Island: 8 (7/1) To qualify, a census tract must be:

-A LIC (poverty rate >20%, median family income <80% of AMI)

-Contiguous to a LIC (median family income <125% of the LIC)

In NYC, <5% of the total census tracts selected were LIC-Contiguous

-NYC Total: 306 (292 LIC/14 LIC-Contiguous)

14

The Process: Our Targeting Strategy

1 5

Tier tracts based on need

• Household income

• Poverty rate

• Labor force participation

• Unemployment rate

Select based on growth potential • Anchor higher education

institutions • Industrial Business Zones

(industrial business development & NYC freight system plans)

• City investing big capital for economic development (key infrastructure)

Opportunity Zones in the 5 Boroughs

514 census tracts were selected statewide in New York for designation as Opportunity Zones

Representing 25% of the more than 2,000 tracts deemed eligible by the Federal government

306 census tracks (60%) were selected within the five boroughs of New York City

1 6

Opportunity Zones in the 5 Boroughs

Brooklyn The Bronx Queens Manhattan Staten Island

# of Opportunity Zones

Key Areas Included

125

Sunset Park and the Brooklyn Navy Yard

75

Hunts Point and the

South Bronx

62

Long Island City as well

as areas in Jamaica, Southeast

Queens, and Far Rockaway

36

Inwood, as well as

the 125th St. corridor

in Harlem

8

Bay Street Corridor

and North Shore area

1 7

Opportunity Zones: Final Selection

Tracts submitted by State (306)*

Other Eligible Tracts (1,142)

*State data as of 04/20/18

18

Next Steps: NYCEDC Engagement

1 9

Opportunity Zone: Challenges & Opportunities

Identify Barriers

Identify and address local implementation barriers, including those created by regulation or tax policy

Promote Collaboration

Promote regional and multi-sector collaboration to mitigate gentrification and displacement risks and maximize community development and job creation

Facilitate Investment to Support Priority Projects

Facilitate investment through Qualified Opportunity Funds that leverage other economic development programs and support local infrastructure and public works projects

2 0

Qualified Opportunity Fund: Challenges & Opportunities

Leverage Capital

Leverage different forms of capital (commercial and philanthropic) and gains (tax-advantaged and other) to optimize product features and returns

Partner with Local Institutions

Partner with local institutions to execute high-potential investments in an efficient fashion

Establish Impact Metrics

Establish impact metrics to quantify results

21

Next Steps: NYCEDC Engagement Plans

Incentivize private markets to engage with NYCEDC by offering:

- Financial resources;

- A project pipeline; and

- Services and expertise

Opportunity Zones

Private NYCEDC Markets

2 2

Next Steps: NYCEDC Opportunity Zone Program

Financial

Competitive debt products (loan at 3% interest rate vs. 8%)

City capital (grants)

Other Services

Consulting / advisory services in NYCEDC areas of expertise such as zoning or permitting

Connections with experienced city agencies and contractors

Projects

Offer investors an attractive pipeline of projects in NYC

Recommend projects with significant cash flow potential based on NYCEDC analysis

2 3

Appendix A – Proposed Regulations Analysis

52

1

Appendix A

Opportunity Zone Proposed Treasury Regulations

Orrick, Herrington & Sutcliffe, LLP

On October 19, 2018, the U.S. Treasury Department and the Internal Revenue Service (“IRS”) released greatly anticipated guidance regarding the implementation of the tax benefits offered by the Opportunity Zone provisions of the 2017 tax reforms, in the form of Proposed Treasury Regulations (“Proposed Regulations”) and an Internal Revenue Service Revenue Ruling (“IRS Ruling,” together the “Guidance”). Although many questions and concerns remain unaddressed, the new Guidance is largely very helpful and favorable toward encouraging Opportunity Zone (“OZ”) investment. A supplemental set of regulations are expected to be released by the end of 2018.

Can Taxpayers Rely on the Proposed Regulations?

Although public hearings will be held in January 2019, and comments are requested prior to the Proposed Regulations being issued in final form, taxpayers can rely on the provisions of the Guidance for all transactions and investments undertaken before the Final Regulations are released.

Key elements of the new guidance are summarized below.

Who Can Invest in an Opportunity Zone Fund?

Virtually any type of U.S. taxpayer, including, for example, individuals, C corporations, RICs, REITs and trusts, U.S. or foreign domiciled, can make an investment in a Qualified Opportunity Fund (a “QOF”) and take advantage of the associated tax benefits. A specific rule allows a partnership to make a QOF investment and elect the OZ tax benefits or, if the partnership does not elect the tax benefits, any individual partner can invest capital gains earned from the partnership into a QOF and elect the OZ tax benefits. A similar approach will apply to other types of pass-through entities, such as S corporations.

When Must the QOF Investment be Made?

Generally, a taxpayer must transfer cash equal to part or all of the capital gain within 180 days of the gain recognition transaction, e.g., a sale or exchange of a capital asset. In the case of an electing partner in a partnership, the investment in the QOF must occur within 180 days of the end of the tax year of the partnership that realized the capital gain.

What Income Qualifies for the Tax Benefits of a QOF Investment?

Capital gains realized from virtually all types of assets (except certain straddle transactions and “Section 1256 transactions”) are eligible for the OZ tax benefits. A capital gain realized from a transaction with a related party to the taxpayer will not be eligible for the OZ tax benefits. Only capital gains qualify, not ordinary income. Short term or long term capital gains will

2

qualify. Whatever is the nature or character of the capital gain at the time of realization, e.g., short or long term gain, will carry through and apply when the deferred gain is subsequently taxed.

Must the Taxpayer Invest All of a Capital Gain in a QOF?

A taxpayer may choose to invest all or a portion of capital gains from one or more transactions into one or more QOFs. The investment(s) may occur at one time or in separate steps (all within the required 180 day limit). The capital gain, or portion thereof, properly invested in QOF(s) will be eligible for the OZ tax benefits, and any remaining capital gain will be subject to normal rules for current taxation. A taxpayer may also invest additional funds that are not derived from capital gains in the QOF, but such additional investment will not be eligible for the OZ tax benefits. The taxpayer will file IRS Form 8949 with its normal tax return to report the QOF investment and elect the OZ tax benefits. If a qualified QOF investment is made in a tax year after the tax year in which the capital gain was realized (of course, within the 180 day limit), e.g., gain realized in December 2018 with QOF investment made in June 2019, the taxpayer may have to report the capital gain on its tax return (for 2018) and subsequently file an amended tax return (for 2018) to take advantage of the OZ tax benefits, including gain deferral.

What is the Form of Investment in the QOF?

The taxpayer's capital gain amount must be invested as cash in a QOF that is a corporation or partnership and will receive an equity interest in the QOF (including preferred stock or a partnership interest that provides for special allocations). An investment in debt issued by the QOF or an obligation or security issued by the QOF that is not treated as equity for federal tax purposes will not qualify for the OZ tax benefits. The equity interest received for the QOF investment may be used by the taxpayer to serve as collateral for a loan without interfering with the qualification of the QOF investment, as long as the taxpayer remains the owner of the QOF interest for federal tax purposes.

A helpful technical provision of the Proposed Regulations clarifies that an allocation of liabilities of a QOF that is a partnership under Section 752(a) of the Internal Revenue Code to the partner investor is not treated as an investment in the QOF and, therefore, does not result in the partner having a separate, non-qualifying, non-equity investment in the QOF.

How is a QOF Created?

A QOF must be formed as an entity that is treated as a corporation or partnership for federal tax purposes, including an LLC or LLP. The QOF may be formed in any state or a U.S. territory (if formed in a territory, it must be the same territory where the particular OZ trade or business is created). A QOF may receive funding of capital and issue its equity at one time or spread over a period of time as taxpayers transfer funds. The QOF will “self-certify” (i.e., it is not necessary to obtain approval from the IRS) that it is eligible for OZ treatment and meets the OZ requirements by filing IRS Form 8996.

How Does the QOF Invest in an OZ?

There are several requirements and limitations on how and when the QOF will deploy its capital in an OZ. The QOF may own and operate an OZ business directly or through an equity

3

investment in a separately created OZ partnership or OZ corporation. Unless and until subsequent regulations provide additional flexibility for OZ businesses directly held by QOFs, early on, QOFs will most likely be set up to own an interest through a separately created partnership or corporation (also referred to as a “second-tier” OZ corporation or OZ partnership), rather than directly operating the OZ business. Some QOFs will be set up to own or operate a single OZ project and others will seek to diversify its investments through multiple OZ projects and, in some cases, may add OZ projects as additional capital funding is received.

The QOF must hold 90% of its assets as qualified OZ properties of an OZ business or an equity interest in a second tier OZ partnership or OZ corporation. Thus, only a limited portion of the QOF assets may be held as cash or financial assets or assets that are not qualified OZ assets. The 90% requirement must be tested and met by the QOF every six months (i.e., twice per tax year, except for the first tax year if the tax year is shorter than six months).

Potential investors have been very concerned about how the 90% test can be met where a new start-up business or construction project will be undertaken because it may take significantly longer than six months to complete the required investment of 90% of its assets in order to meet the test. The Proposed Regulations provide substantial relief and guidance to address this concern permitting assets to be deployed, in certain cases, to acquire or construct qualifying OZ properties within a period as long as 31 months. It is important to recognize that the 31-month grace period for deployment of capital by the QOF is only available for an OZ partnership or an OZ corporation; and is not applicable for a QOF investing into a directly operated OZ business. It is hoped that guidance will be included in future regulations to permit flexible initial spending or investing by the QOF.

In order to be eligible for this extended spending period, it will be necessary to develop a written plan for acquiring or constructing such assets and a time schedule for expenditure. Furthermore, it will be necessary to prove substantial compliance with the planned time schedule for expenditure. It is not clear what detail is required to be set forth in the written plan or when the plan and schedule must be in place. Further, it is not certain what will constitute actual substantial compliance with the written schedule and whether the IRS will use tax audits to determine whether there is the required compliance with the schedule or how unexpected delays in implementing the schedule will be addressed. During the period of up to 31 months that the funds will be expended, such funds must be held as cash, cash equivalents or instruments with a maturity of no longer than 18 months.

Are There Requirements for Investment by the OZ Partnership or OZ Corporation?

An OZ partnership or OZ corporation must hold substantially all of its assets as qualified OZ property (described further below). The Proposed Regulations define this test as 70%. Accordingly, greater flexibility is provided for a QOF that invests in a second-tier entity, as compared to a directly controlled OZ business. Thus, at least 90% of the QOF assets may be held in an OZ partnership or OZ corporation equity interest, which, in turn, must invest 70% of its assets in OZ property--a net result that at least 63% is invested in the OZ. By comparison to a QOF that directly controls an OZ business and must meet the 90% test, the 63% level allows greater flexibility to hold assets that are outside the OZ or are not qualified OZ property.

4

What are the Consequences of Failing to Meet the OZ Requirements?

The tax law imposes a penalty on a QOF that fails to meet the tax law requirements equal to the amount of the shortfall in compliance multiplied by the interest rate that would be applied to an underpayment of federal income taxes, i.e., the federal short-term rate plus 3%. It is unclear whether a QOF would be disqualified and a taxpayer would lose the benefit of the anticipated OZ tax benefits in certain circumstances due to compliance failures. The application of the penalty and other potential consequences of failed compliance are expected to be addressed in future regulations.

What are Qualified OZ Properties?

Qualified OZ properties are tangible properties used in a trade or business of a QOF that are (i) acquired by purchase after 2017 from an unrelated party, (ii) where the original use of the property commences with the acquisition by the OZ business, or is substantially improved within 30 months after the property is acquired, and (iii) during substantially all of the holding period for such property, substantially all of the use of such property was in an OZ. In addition, to qualify as property that is substantially improved, additions to the basis with respect to such property at the end of the 30-month period must exceed the adjusted cost basis of such property as of the beginning of the 30-month period, e.g., rehabilitation costs of a building are at least equal to the acquisition cost of the building.

Can the Purchase of Land and a Building be Qualified OZ Property?

The Proposed Regulations provide that land will not currently be treated as originally used by the OZ business. The underlying concept seems to be that land has always been used by some prior owner, even if it is vacant land. However, the Proposed Regulations provide a favorable rule for how land and an existing building can meet the requirements for a substantial rehabilitation and be treated as qualified OZ property. The Proposed Regulations provide that the cost basis for the acquisition will be allocated separately to the value of the land and the value of the existing building and it is only necessary to spend an amount equal to the building cost in order to satisfy the substantial rehabilitation rule. Future proposed regulations are expected to address whether the acquisition of vacant or abandoned land can qualify as qualified OZ property after a certain period has passed.

What Happens if the OZ Designation Ends?

The designation of an OZ will stay in effect from 2018 until December 31, 2028. Unless extended by future legislation, the designation of an OZ will terminate in 2028. In order to eliminate the concern of potential investors that the 10-year tax benefit will not be available after the date that the OZ designation expires, the Proposed Regulations provide that investors can continue to make the election for the OZ tax benefits after the OZ designation expires and until December 31, 2047. This will allow taxpayers to maintain their investment in the QOF without the recognition of capital gain through 2047.

5

What Happens Upon a Sale of a QOF Interest or Sale of the QOF or OZ Business Assets?

If a taxpayer that holds an interest in a QOF later sells its entire interest, the recognition of the capital gain can be further deferred by re-investing the gain in a QOF within a 180-day period and making a new gain-deferral election for the new QOF investment. If the taxpayer sells less than all of its interest in the QOF and such interests were originally acquired by original investments at different times, the determination of the gain and character of the gain will be determined by using a first-in, first-out (FIFO) method to identify which interests are sold. If the interests in the QOF were acquired at the same time, but with gains having different characteristics, a pro-rata method will be applied to identify the investments. Additional guidance is needed from future proposed regulations on several issues such as whether the sale of the QOF interest in a partnership will result in some gain being recognized even after the 10-year holding period to the extent of the allocation to a partner of the partnership’s liabilities, whether the sale of one or more underlying properties held through a QOF that invests in multiple properties will result in gain recognition and the extent to which certain distributions or allocation of income will be treated as a reduction in basis, ordinary income or gain. Future proposed regulations are expected to address the degree to which a QOF may also be able to reinvest proceeds and extend the deferral of capital gain at the QOF level.

What's Next?

The preamble to the Proposed Regulations identify topics relating to OZ's and OZ tax benefits that are expected to be covered in another set of proposed regulations to be issued as soon as the end of this year and topics for which public comments are requested. These topics for future guidance include the meaning of the term "substantially all" which appears in various places in the law, transactions that will result in capital gain reporting, the allowable reasonable period for the reinvestment of proceeds from the sale of qualifying assets, the application of the penalty and other consequences of noncompliance with tax law requirements and information reporting requirements.