The law known at the Tax Cuts and Jobs Act, P.L. 115-97, added Secs. 1400Z-1 and -2 to encourage investment in economically depressed areas. They are referred to as opportunity zones — and provide for investments in qualified opportunity funds (QOFs) including:
- 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 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, which makes it important to determine that date.
Investment in QOFs can be a significant benefit for individual taxpayers with capital gains that they wish to defer. Determining the appropriate timing for a qualified investment is challenging. The author's goal is to provide a comprehensive discussion of the applicable deadlines for individuals for investing in a QOF and obtaining tax deferral.
For 2020, taxpayers can choose to follow the proposed or the final regulations under Sec. 1400Z-2 (Regs. Sec. 1.1400Z2(a)-1(g)(2)). The rules for Sec. 1231 gains were significantly revised by the final regulations. It is important to understand the differences, since many individuals can still make qualifying investments in 2021 that will reduce 2020 tax.
Note that the ordinary gain portion of the gain under Secs. 1245 and 1250 cannot be deferred by making a QOF investment (Regs. Sec. 1.1400Z2(a)-1(b)(11)(iii)(A)). In addition, the taxpayer must be consistent in choosing to follow the proposed or final regulations for all deferrals for the 2020 tax year (Regs. Sec. 1.1400Z2(a)-(1)(g)(2)(i)). Investments in a QOF before the applicable start date will not qualify for deferral. Therefore, it is important to document the start date and the chosen accounting method.
Gains from property a taxpayer holds directly
Capital gains from sales of stock, bonds, and other security investments have a 180-day reinvestment window starting date as of the date the gain would have been recognized for federal income tax purposes, usually the date of sale (Regs. Sec. 1.1400Z2(a)-1(b)(7)(i)). This rule is the same under the proposed and final regulations. See below for a discussion of the extension of the 180-day window under Notice 2021-10 that applies to 2020 capital gains.
Under the final regulations, capital gain dividends of a regulated investment company or real estate investment trust have a reinvestment start date as of the last day of the individual's tax years. The date paid can also be used, if elected (Regs. Sec. 1.1400Z2(a)-1(b)(7)(ii)B)). Under the proposed regulations, the 180-day window begins on the date of payment (Prop. Regs. Sec. 1.1400Z2(a)-1(b)(7)(iv)(B), Example 2).
However, Sec. 1231 gains treated as capital gains have different 180-day start dates for reinvestment under the proposed and final regulations.
Proposed regulations on Sec. 1231 gains
Net Sec. 1231 gains are eligible for deferral under the proposed regs. Sec. 1231 losses reduce the amount eligible for deferral.
The proposed regulations on Sec. 1231 gains clearly stated that:
The only gain arising from section 1231 property that is eligible for deferral under section 1400Z-2(a)(1) is capital gain net income for a taxable year. This net amount is determined by taking into account the capital gains and losses for a taxable year on all of the taxpayer's section 1231 property. The 180-day period described in paragraph (b)(4) of this section with respect to any capital gain net income from section 1231 property for a taxable year begins on the last day of the taxable year. [Prop. Reg. 1.1400Z2(a)-1(b)(2)(iii)]
This means that if the proposed regulations are followed for 2020, QOF investments made in calendar 2020 will not be eligible to offset 2020 Sec. 1231 gains recognized as capital gains. Conversely, under the proposed regulations, QOF investments made in the first 180 days of 2021 will be eligible to offset Sec. 1231 gains recognized as capital gains for the 2020 tax year, without regard to the date of sale.
This is great news for individuals who are still looking for some tax deferral for 2020.
Final regulations on Sec. 1231 gains
Under the final regulations, gross Sec. 1231 gains (not reduced by Sec. 1231 losses) are eligible for deferral (Regs. Sec. 1.1400Z2(a)-1(b)(11)(iii)).
And, instead of beginning the 180-day window after the last day of the tax year, the final regulations provide that the date that the gain would be recognized for tax purposes becomes the start date. In most cases this would be the date of sale. Notice 2021-10 extends the reinvestment deadline.
Notice 2021-10 says that if the 180-day deadline would have fallen on or after April 1, 2020, and before March 31, 2021, the reinvestment deadline is moved to March 31, 2021.
For tax years beginning after March 13, 2020 (that would be 2021 for calendar-year taxpayers), the final regulations and the 180-day window apply as described above, without regard to Notice 2021-10.
The final regulations clarified that taxpayers with installment sales can elect to start the 180-day period on the date payment is received, or on the last day of the tax year that the installment sale gain would be recognized but for deferral under Sec. 1400Z-2. Electing to treat each installment sale payment date as the start date results in multiple 180-day periods eligible for deferral (Regs. Sec. 1.1400Z2(a)-1(b)(11)(viii)(B)).
Gains from 2020 payments received on installment sales that occurred before Dec. 22, 2017, are also eligible for reinvestment (Regs. Sec. 1.1400Z2(a)-1(b)(viii)(A)). Note that the start date election appears to be an annual election based on the gain recognized under the installment method in each year.
Capital gains from passthrough entities
There are three possible start dates for the beginning of the 180-day period for capital gains passed through to partners, shareholders of S corporations, and beneficiaries of decedent's estates and nongrantor trusts. In general, the start date is the last day of the entity's tax year (Regs. Sec. 1.1400Z2(a)-1(c)(8)(iii)(A)).
However, when the partner, shareholder, or beneficiary knows or is notified by the entity of the date of the gain and the entity's decision not to elect deferral under Sec. 1400Z-2, the earlier date of the gain can be used as the start date.
Under the final regulations, the third option is to start the clock on the due date of the entity's return, without extension (rules for partnerships, Regs. Sec. 1.1400Z2(a)-1(c)(8)(iii)(B)); rules for other eligible entities, Regs. Sec. 1.1400Z2(a)-1(c)(9)).
Again, this is great news for investors who are still looking for 2020 tax deferral.
When the taxpayer is reinvesting gains from different sources, it is important to track each investment date and the start of the 180-day window, particularly with respect to the differences under the proposed and final regulations. While this may make the 2020 tax year filings more challenging, tax practitioners have the opportunity to provide valuable advice to clients about the QOF tax deferral options when preparing their 2020 tax returns.
A full discussion of the QOF tax deferral rules is beyond the scope of this article. For information regarding the tax deferral rules, see Werlhof, "A Cautionary Tale of Opportunity Zone Deferrals," Tax Insider (Aug. 15, 2019).
— Janet C. Hagy, CPA, is a shareholder of Hagy & Associates PC in Austin, Texas, and is also a former member of the AICPA Tax Practice and Procedures Committee. To comment on this article or suggest an idea for another article, contact Sally Schreiber, senior editor, at Sally.Schreiber@aicpa-cima.com.