UPDATE: The article below is based, in part, on the position that gain not subject to Federal income tax nonetheless is “recognized” for U.S. tax purposes and thus can be “eligible gain” for opportunity zone purposes. On December 19, 2019, the IRS issued final Opportunity Zone regulations. The IRS rejected the suggestion that eligible gain include gain not subject to Federal income tax, effectively rejecting a key basis for this article.
Last October, the IRS released the much-anticipated proposed regulations for the new qualified opportunity zone (QOZ) tax regime created by the December 2017 tax reform bill. Although there are glitches and issues to work through, the proposed regulations confirmed that the new opportunity zone tax regime provides U.S. taxpayers with a user-friendly method to obtain the significant tax benefits of (1) gain deferral, (2) partial gain elimination and (3) no tax on future appreciation (click here for our earlier alert about the QOZ regime). These benefits are also available to non-U.S. persons. Moreover, for non-U.S. persons who do not need the deferral and elimination benefits (because the U.S. does not tax the gain in the first place), the availability of the no tax on future appreciation benefit could effectively repeal the Foreign Investment in Real Property Tax Act (FIRPTA) for investments in U.S. real property located in a QOZ.
Background: U.S. Taxation of Non-U.S. Persons
The United States taxes non-U.S. persons on two types of income: (1) income treated as effectively connected to a U.S. trade or business, or attributable to a permanent establishment if a treaty applies, and (2) U.S.-source income that is treated as fixed, determinable annual or periodic (“FDAP Income”). The United States taxes effectively connected income in the same manner and the same rates as a U.S. person’s income (i.e., net income tax at graduated rate). A 30 percent gross receipts tax (or lower rate pursuant to an applicable income tax treaty) applies to U.S.-source FDAP income. As a result, a non-U.S. person not engaged in a U.S. trade or business is subject to U.S. income tax only if the non-U.S. person has U.S.-source FDAP income. FDAP income does not include gain from the sale of investment property – for example, no U.S. tax applies to a non-U.S. person’s gain from the sale of stocks and securities on a U.S. stock market.
Similarly, a non-U.S. person’s gain from the sale of U.S. real property, or an entity that owns U.S. real property, is not FDAP income. Concerned about the lack of taxation of a non-U.S. person’s gains from U.S. real property investments, Congress enacted FIRPTA in 1980. FIRPTA generally treats a non-U.S. person’s gain from the sale of a United States real property interest as effectively connected income (FIRPTA also includes a withholding obligation on the buyer). Leaving aside the withholding obligation, FIRPTA equalized the U.S. tax treatment of U.S. persons and non-U.S. persons with respect to gain from the sale of U.S. real property.
The QOZ Regime Eliminates Capital Gains on Qualified Investments
The trio of QOZ tax benefits include not having to pay tax on an investment’s appreciation. That is, as part of the QOZ regime, a taxpayer invests capital gains from a sale of property into an equity interest in a qualified opportunity fund (QOF) – a partnership or corporation investment vehicle that self-certifies as a QOF. If the taxpayer satisfies a 10-year holding period for the investment in the QOF, the taxpayer will not recognize any gain from the sale of its interest in the QOF. A QOF must invest in an active trade or business in a QOZ, which generally can include rental real property. For example, a taxpayer with $10 million of capital gain in 2019 can invest that $10 million in a QOF that will build (or substantially improve) commercial real property and then manage or lease the property. If, after the 10-year holding period, the value of the taxpayer’s QOF investment increases to $25 million, the taxpayer can sell the QOF investment and pay no tax on the $15 million of gain.
The no tax on future appreciation benefit only applies to the portion of the future gain attributable to “eligible gain” rolled into a QOF for which a gain deferral election was made. Pursuant to the proposed regulation, eligible gain is gain that (1) is treated as capital gain for federal income tax purposes, (2) arises from a sale to an unrelated person and (3) would be recognized for federal income tax purposes before January 1, 2027 absent QOZ regime. It should not be difficult to ensure that a non-US person’s capital gains from sale transactions, including gains from transaction with no U.S. nexus (e.g., stock sales on non-U.S. exchanges) satisfies the first two requirements. As for the third requirement, applicable tax law provides that a non-U.S. person recognizes gain pursuant to U.S. tax law; the United States simply does not tax the gain because of the taxpayer’s status as a non-U.S. person.
Specifically, Section 1001(c) of the Internal Revenue Code of 1986, as amended (the “Code”), provides that, except as otherwise provided in the Code, all gain from the sale or exchange of property is recognized. As described above, with respect to non-U.S. persons, the Code limits U.S. taxation to effectively connected income and U.S.-source FDAP income. Nothing in those limitations, however, overrides recognition of gain. Instead, the United States does not tax the otherwise recognized gain. After all, when Congress decided to tax non-U.S. persons on gain from the sale of real property, it treated the gain, which presumably was already recognized, as effectively connected income; nothing in FIRPTA suddenly caused non-U.S. persons to start recognizing gain.
Accordingly, non-U.S. persons, just like U.S. persons, generally should be able to obtain the benefits of the QOZ regime. If the United States would otherwise tax the gains a non-U.S. person rolls into a QOF, the non-U.S. person generally should be able to obtain the deferral and reduction benefits. All we are saying here is that the no tax on appreciation benefits should be available regardless of whether the gain invested in the QOF was taxable by the United States. Ultimately, just like with U.S. persons, the QOZ regime effectively ends capital gains for QOZ investments, preserving the equal treatment of U.S. and non-U.S. investors in U.S. real property established by FIRPTA. For non-U.S. persons, this effectively means the end of FIRPTA to the extent the gain is filtered through a QOZ regime.
The above analysis doesn’t seem to be altered by new Code § 864(c)(8). As described above, the no tax on appreciation benefit operates by treating the taxpayer as having a fair market value basis in its QOF interest so there is no gain upon the sale of the QOF interest.[1]
As part of the federal tax reform bill that created the QOZ regime, Congress added Code § 864(c)(8). This provision, which legislatively overruled Grecian Magnesite Mining v. Commissioner, 149 T.C. No. 3 (2017), provides a look-through rule for determining the portion of the non-U.S. partner’s gain from the sale of a partnership interest that is treated as effectively connected income. Upon the sale of an opportunity fund that is taxed as a partnership, the sole asset of which is U.S. real property, IRC § 864(c)(8) would treat all of the non-U.S. partner’s gain as effectively connected income. Importantly, however, because of the deemed fair market value outside tax basis, the non-U.S. person should not realize any gain from the sale for IRC § 864(c)(8) to treat as effectively connected income.
In sum, the QOZ regime provides an exciting opportunity for investments that is equally available to U.S. and non-U.S. taxpayers. As with all tax benefits, guidance is needed to navigate the complex U.S. tax law labyrinth. For example, there are potential issues for the mechanics of a non-U.S. person obtaining these benefits, including making a deferral election on gain that would not have been taxed and potential FIRPTA withholding even when there is no taxable gain. Please contact us to learn more about QOZ investments
[1] Note: it does not appear that the benefit applies if a flow-through QOF sold all of its property and then liquidated. Although Congress or the IRS may provide taxpayers with such flexibility, for now it is best to structure the QOF exit as a sale of the QOF.
In sum, the QOZ regime provides an exciting opportunity for investments that is equally available to U.S. and non-U.S. taxpayers. As with all tax benefits, guidance is needed to navigate the complex U.S. tax law labyrinth. For example, there are potential issues for the mechanics of a non-U.S. person obtaining these benefits, including making a deferral election on gain that would not have been taxed and potential FIRPTA withholding even when there is no taxable gain. Please contact us to learn more about QOZ investments