Opportunity zones provide one of the greatest tax deferral vehicles in the tax reform law commonly known as the Tax Cuts and Jobs Act (TCJA). However, the rollout of investment opportunities in qualifying funds has been hampered by confusion and uncertainty.
The IRS recently published final regulations to alleviate some of this uncertainty, and also published a set of FAQs to clarify the changes from the proposed regulations to the final regulations. Much of the final rules pertains to the Opportunity Zone (QOZ) Funds themselves, and what they must do to remain eligible for investments from potential investors. However, favorable changes in the final rules also pertain to investments in QOZ Funds. Three of these changes are significant, and are discussed below.
Investing Section 1231 Gains into QOZ Funds
Business owners will be most interested in the ability to invest Section 1231 gains into QOZ Funds. General income tax rules provide that Section 1231 gains must be netted against Section 1231 losses, where net Section 1231 gains are taxed at the favorable capital gains rates, while net Section 1231 losses are taxed at the higher ordinary rates (i.e., the best of both worlds). But the result from such netting cannot be ascertained for income tax purposes until the end of the year, requiring taxpayers to wait under the proposed QOZ regulations to invest a net Section 1231 gain. The netting rule under the proposed QOZ regulations also limits the potential pool of investable gains, since the gross gain amount decreases through the netting process.
In a taxpayer-friendly result under the final regulations, the IRS not only clarifies that Section 1231 gains are eligible for QOZ Fund investment, but it also does away with the proposed requirement to determine the net amount of Section 1231 capital gains. The rule under the final regulations produces a double benefit, if followed to its logical conclusion.
Example of Investing Section 1231 Gains
For example, consider a taxpayer who sells two pieces of Section 1231 property (defined as property used in a trade or business), where one produces a $100,000 gain and the other produces a $75,000 loss. Under general income tax rules (and the proposed QOZ regulations), these transactions would be netted to result in a Section 1231 capital gain of $25,000. The proposed QOZ regulations provide that only the $25,000 net gain can be invested, and further require the taxpayer to wait until the end of the year to invest the gain in a QOZ Fund. But under the final regulations, the gross $100,000 gain can be deferred through an investment in a Qualified QOZ Fund, and the gain can be invested immediately after the transaction that creates it. This leaves the $75,000 Section 1231 loss, which retains its nature as an ordinary loss that offsets other income of the taxpayer. The gain deferral and the ordinary loss deduction provide for a double benefit under the final regulations.
Enhanced Flexibility for Exiting the QOZ Fund Investment
Another major change designed to benefit investors in QOZ Funds involves the type of transaction eligible for gain exclusion at the end of the 10-year investment period. As a reminder, QOZ Fund investments provide two income tax benefits to the investor: the ability to defer recognition on current gains that are re-invested into the QOZ Fund, and the ability to exclude all gains that accrete after the QOZ Fund investment is made. The gain exclusion benefit is contingent on the investor holding the QOZ Fund investment for a minimum of 10 years.
The 10-year rule in the proposed regulations provides that a taxpayer is able to exclude the post-investment gain only on the sale of equity in a QOZ Fund itself, or on gains allocated by the QOZ Fund from the sale of its own eligible property. This led many to predict that it would be difficult to actually receive the benefit of the 10-year rule, because the eligible transaction types under the proposed regulations may not be commercially viable.
For instance, the proposed regulations require the QOZ Fund to have direct ownership of eligible property for the post-investment gain exclusion benefit to apply on gains allocated from the QOZ Fund. If the QOZ Fund created a subsidiary entity — a common business practice — and the subsidiary conducted a qualified business and later sold the property, the post-investment gain exclusion provisions would not be available to the investor under the proposed regulations.
The final regulations address this concern and add flexibility to the types of transactions eligible for the post-investment gain exclusion. Under the final regulations, post-investment gains allocated from a subsidiary entity through a QOZ Fund and out to the QOZ Fund investor are also eligible to be excluded. Thus, each of the following types of post-investment gains are eligible to be excluded under the final regulations:
1. Gains on the investor’s sale of equity in the QOZ Fund itself;
2. Allocated gains on the sale of eligible property held directly by the QOZ Fund;
3. Allocated gains on the sale of equity in a subsidiary (a partnership, LLC, or corporation) held by the QOZ Fund; and
4. Allocated gains from a subsidiary to the QOZ Fund on the subsidiary’s sale of eligible property, which in turn are allocated from the QOZ Fund to the investor.
More Time to Invest Gains Allocated from Pass-Through Entities
The third significant change in the final regulations eases the timing rules somewhat for investments into a QOZ Fund. In its simplest terms, a taxpayer has 180 days from the date a qualifying gain is recognized to invest in a QOZ Fund, but not all situations are simple. For example, a partner in a partnership may not know that a qualifying gain has been recognized during the year by the partnership, until much later when the Schedule K-1 is delivered. The proposed regulations attempt to provide flexibility for this situation by allowing QOZ Fund investments to be made 180 days from the end of the partnership year. Unfortunately, this did not adequately address situations where the partnership (or an S corporation) sought an extension to file, as in these scenarios the Schedule K-1 may not be delivered to the partner (or shareholder) prior to the end of the 180-day period.
The final regulations rectify this dilemma, where the 180-day period starts on the due date for the partnership (or S corporation) return, without extensions. This allows the taxpayer time to make a qualifying investment even if the entity return is not filed until the extended due date. A similar rule also now applies to gains from investments in a Regulated Investment Company (RIC) and Real Estate Investment Trust (REIT), where the 180-day period starts with the date the taxpayer receives a capital gain distribution from the RIC or REIT. Note that taxpayers can still elect to begin the 180-day period on the date the pass-through entity, RIC, or REIT recognized the gain, if the taxpayer desires to make a QOZ Fund investment earlier.
Additionally, the final regulations add timing flexibility for gains realized under installment sales. For such gains, the investor has a choice. The investor can make a QOZ Fund investment (and apply the 180-day rule) with respect to the entire amount of the gain in the year of the installment sale transaction. Alternatively, the investor can choose to start the 180-day period with respect to the date each payment is received and when qualifying gains are included under the installment method, even if the sale occurred prior to Jan. 1, 2018.
Takeaways for CFOs
Many other changes were included in the final regulations that generally make it more administrable for a QOZ Fund to receive eligible investments. The changes that directly impact investors will help to implement Congressional intent with respect to the benefits under the QOZ program. For more information on the potential tax benefits of a QOZ investment, or information on the rules for managing a QOZ Fund, please contact us.