The law known at the Tax Cuts and Jobs Act, P.L. 115-97, added new provisions to encourage investment in economically depressed areas referred to here as opportunity zones — qualified opportunity funds (QOFs). These incentives include:
- Capital gain reinvested in a QOF during a 180-day period is deferred until the earlier of:
- The date on which the opportunity zone investment is sold or exchanged; or
- Dec. 31, 2026 (Secs. 1400Z-2(a)(1)(A) and (B)).
- Up to 15% of the deferred gain is permanently excluded from income if the opportunity zone investment is held for more than seven years (Secs. 1400Z-2(b)(2)(B)(iii) and (iv)). In other words, the investor will pay tax on only 85% of the deferred gain when that gain is eventually recognized.
- Any post-investment appreciation in the QOF is permanently excluded from income if the investment is held at least 10 years (Secs. 1400Z-2(a)(1)(C) and 1400Z-2(c)).
The tax deferral and exclusion incentives are available only if gain is reinvested during a 180-day period. Gain invested before the 180-day period begins is not eligible for deferral.
Taxpayers may intuitively expect the 180-day period to begin on the day they receive the sale proceeds. In some cases, the 180-day period does not begin until the end of the tax year, requiring taxpayers to delay investing in an opportunity zone to benefit from the deferral. This article provides an overview of the rules for determining the 180-day period to qualify for the full benefits of a qualified opportunity zone investment.
General timing rule
In general, the 180-day period begins on the day capital gain is recognized (Prop. Regs. Sec. 1.1400Z2(a)-1(b)(4)). The party recognizing the gain usually must make the replacement (e.g., if a partnership sells an asset, the partnership can defer the gain at the entity level by investing in a QOF).
If a passthrough entity such as a partnership does not elect to defer gain by reinvesting in a QOF, each owner has the option to directly reinvest his or her share of gain (Prop. Regs. Sec. 1.1400Z2(a)-1(c)(2)(ii)(B)). The 180-day period in this case generally begins on the last day of the passthrough entity's tax year (rather than the day on which the passthrough entity recognized the gain) (Prop. Regs. Sec. 1.1400Z2(a)-1(c)(2)(iii)(A)). The owner can elect to use the same 180-day period as the passthrough entity (Prop. Regs. Sec. 1.1400Z2(a)-1(c)(2)(iii)(B)).
Example 1: A owns an interest in AB LP. AB LP is a calendar year partnership that generates a long-term capital gain from selling stock held for investment on Feb. 1, 2019. AB LP distributes the sales proceeds to the partners rather than investing in a QOF. Because AB LP did not reinvest the gain in a QOF, it will pass the capital gain through to its partners on Schedule K-1, Partner's Share of Income, Deductions, Credits, etc.
A can elect to defer her share of AB LP's gain by investing the gain in a QOF during the 180-day period beginning on the last day of AB LP's tax year, Dec. 31, 2019. Alternatively, A can use the elective rule to use the partnership's 180-day period. In that case, A can elect to defer her share of AB LP's gain by investing the gain in an opportunity zone fund during the 180-day period beginning on Feb. 1, 2019. If AB LP had not distributed the proceeds, A could use cash from other sources to invest in the QOF and defer the gain.
If a passthrough entity extends the time for filing its return, the 180-day reinvestment period may end before the owners receive their K-1s. A best practice would be for the passthrough entity to advise its owners of any estimated gains or losses well in advance of the close of the 180-day period to provide the owners time to decide whether and how much to invest in a QOF.
Special timing rules for Sec. 1231 gains
Gain from the sale of real estate and depreciable property used in a trade or business and held for more than one year is generally Sec. 1231 gain rather than capital gain (Secs. 1231(b)(1) and 1221(a)(2)). Sec. 1231 offers the best of both worlds: A net Sec. 1231 gain is taxed at capital gain rates, and a net Sec. 1231 loss offsets ordinary income (Sec. 1231(a)).
If a net Sec. 1231 loss is used to offset ordinary income in one year, net Sec. 1231 gains recognized at any time in the next five years are taxed at ordinary rates to the extent of the previously recognized net Sec. 1231 loss (Sec. 1231(c)). The five-year rule prevents taxpayers from timing their Sec. 1231 gains and losses to use the entire Sec. 1231 loss to offset ordinary income and apply capital gains rates to the entire Sec. 1231 gain.
Example 2: In 2019, E recognizes a $100 Sec. 1231 gain from selling land used in his sole proprietorship business and a $60 Sec. 1231 loss from selling business equipment. E would generally pay tax at capital gains rates on $40 of his net Sec. 1231 gain.
Example 3: In 2019, E recognizes a $40 Sec. 1231 gain from selling land used in his business and a $100 Sec. 1231 loss from selling business equipment. E can generally use the $60 net loss to offset ordinary income from other sources.
Example 4: In 2019, E recognizes a $40 Sec. 1231 loss from selling equipment used in his sole proprietorship business. E uses the $40 loss to offset ordinary income from other sources. In 2020, E recognizes a $100 Sec. 1231 gain from selling land used in his business. Under the general rule, the entire Sec. 1231 gain recognized in 2020 would be taxed at capital gains rates; however, E used a $40 Sec. 1231 loss to offset ordinary income in the previous five years, so the first $40 of Sec. 1231 gain is taxed at ordinary rates in 2020. The balance of the Sec. 1231 gain ($100 section 1231 gain – $40 taxed at ordinary rates = $60) is taxed at capital gain rates. E recognizes the same amount of net capital gain he would have if he sold the land and equipment in the same year — he has a net $60 capital gain after offsetting the $40 ordinary loss in 2019 against the $100 ordinary gain in 2020.
A Sec. 1231 gain that would otherwise be subject to tax at capital gain rates is eligible for the opportunity zone incentive whereas a Sec. 1231 gain that would otherwise offset a Sec. 1231 loss or be taxed at ordinary rates is not (Prop Regs. Sec. 1.1400Z2(a)-1(b)(2)(iii)).
A taxpayer will not know until the end of the year whether the taxpayer has a net Sec. 1231 gain or loss, so the proposed regulations break from the general rule and provide that the 180-day replacement period for net Sec. 1231 gain begins on the last day of the tax year. This is surprising to many taxpayers, financial advisers, and tax preparers, particularly because the last-day-of-the-year rule applies regardless of whether the taxpayer anticipates recognizing any Sec. 1231 losses during the year.
Example 5: R owns several rental properties that he treats as a Sec. 162 trade or business (e.g., he claims the Sec. 199A deduction for his rental income). R sold one of the rental properties on March 1, 2019, and recognizes a Sec. 1231 gain of $100,000. After R's golfing buddy told him about opportunity zones, he invested $100,000 in an opportunity zone fund on June 15, 2019, within 180 days from the date of sale. R is not able to defer the gain — even if he ends up having a net Sec. 1231 gain for the year — because the gain was invested before the start of the 180-day period. R needed to wait until the last day of the year for the 180-day period to start because the gain being deferred is a Sec. 1231 gain.
For tax years ended before May 1, 2019—the effective date of the proposed regulations — taxpayers that reinvested net Sec. 1231 gains in a QOF within 180 days from the day the gain was recognized but before the last day of their tax year can elect to defer the gains. For more information, see the IRS explanation on its Opportunity Zone Frequently Asked Questions page (available at tinyurl.com/yxzhmvyw). Because calendar year 2019 ends on or after May 1, 2019, the rule in the proposed regulations will apply, and Sec. 1231 gains reinvested before the last day of 2019 will not qualify for deferral as shown in Example 5.
In some cases — in particular, rental real estate — it may not be clear whether a trade or business exists (and thus whether a gain should be classified as a Sec. 1231 gain from the sale of an asset used in a business or a capital gain from the sale of an asset not used in a business). A discussion of the trade or business rules is beyond the scope of this article. Advisers should be aware that if the IRS successfully challenges a taxpayer's trade or business determination, it could cause capital gain to become Sec. 1231 gain or vice versa and thus change the 180-day period. If there is considerable risk regarding the trade or business determination, it may be best to structure the sale and opportunity zone investment so that the investment occurs during the 180-day period regardless of whether the gain is characterized as a capital gain or Sec. 1231 gain.
Example 6: M owns a rental property and has historically taken the position that the rental property qualifies as a trade or business, but there is some risk the IRS would disagree. He is contemplating selling the property on June 15. M may want to delay the close a few weeks so that the 180-day period includes Jan. 1 regardless of whether the 180-day period begins on the date of sale (as in the case of the sale of a capital asset) or the last day of the tax year (as in the case of the sale of a Sec. 1231 asset). If M invests in the QOF on Jan. 1, M's investment will qualify for opportunity zone incentives regardless of whether the IRS successfully asserts that the rental does not qualify as a trade or business.
Opportunity zone investments can provide tremendous benefits but are also filled with traps for the unwary. Advisers need to carefully consider the timing rules when assisting clients with opportunity zone investments.
John Werlhof, CPA, is a principal in CliftonLarsonAllen LLP (CLA)'s National Tax Office in Roseville, Calif. The information contained herein is general in nature and is not intended, and should not be construed, as legal, accounting, investment or tax advice or opinion provided by the author or CLA to the reader. The reader also is cautioned that this material may not be applicable to, or suitable for, the reader's specific circumstances or needs, and may require consideration of nontax and other tax factors if any action is to be contemplated. The reader should contact his or her tax professional prior to taking any action based upon this information. The author and CLA assume no obligation to inform the reader of any changes in tax laws or other factors that could affect the information contained herein. To comment on this article or to suggest an idea for another article, please contact Sally Schreiber, senior editor, at Sally.Schreiber@aicpa-cima.com.