Tax reform added attractive tax deferral and exclusion incentives for investing in a qualified opportunity zone fund (QOF), including:
- Capital gain reinvested in a QOF during a 180-day period is deferred until the earlier of:
- The day the QOF is sold or exchanged
- December 31, 2026
- Up to 15% of the deferred gain is permanently excluded from income if the QOF is held for more than seven years. In other words, you may only have to pay tax on 85% of the deferred gain when that gain is eventually recognized.
- Any post-investment appreciation in the QOF is permanently excluded from tax if the investment is held at least 10 years.
The incentives are available only when gains are reinvested during a 180-day period. You may intuitively expect the 180-day period to begin on the day you receive sales proceeds. But in some cases, the investment may need to be delayed, particularly when gains are from the sale of business assets. This article provides an overview for determining the 180-day rules.
General timing rule
In general, the 180-day period begins on the day capital gain is recognized. 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 pass-through 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. In this case, the 180-day period generally begins on the last day of the owner’s tax year (rather than the day on which the pass-through entity recognized the gain). The owner can elect to use the same 180-day period as the pass-through entity.
Example 1: Abigail owns an interest in AB LP. AB LP is a calendar year partnership that generates a capital gain on February 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. Abigail 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, December 31, 2019. Alternatively, Abigail can use the elective rule to use the partnership’s 180-day period. In that case, Abigail 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 February 1, 2019. If AB LP extends its tax return, the window for its partners to reinvest the gain may close before K-1s are issued.
If AB LP requests an extension to file its tax return and anticipates having a gain or loss during the year, the general partner should communicate the anticipated gain or loss to the partners so they have the information they need to decide whether and how much to invest in a QOF.
Special timing rules for Section 1231 gains
Section 1231 in general
Gain from the sale of real estate and depreciable property used in a trade or business is generally Section 1231 gain rather than capital gain. (To determine when rental real estate is a trade or business rather than an investment, see our article, IRS Safe Harbor on Section 199A Impacts 2018 Filing for Rental Real Estate). Section 1231 offers the best of both worlds — a net Section 1231 gain is taxed at capital gain rates and a net loss offsets ordinary income. If a net Section 1231 loss is used to offset ordinary income in one year, net Section 1231 gains recognized at any time in the next five years are taxed at ordinary rates to the extent of the previously recognized net Section 1231 loss. The five year rule prevents taxpayers from timing their Section 1231 gains and losses to use the loss to offset ordinary income and apply capital gains rates to the entire Section 1231 gain.
Special timing rule for deferring net Section 1231 gains
A Section 1231 gain that would otherwise be subject to tax at capital gain rates is eligible for the Opportunity Zone incentive, whereas a Section 1231 gain that would otherwise offset a Section 1231 loss or be taxed at ordinary rates is not. A taxpayer will not know until the end of the year whether the taxpayer has a net Section 1231 gain or loss, so the proposed regulations break from the general rule and provide that the 180-day replacement period begins on the last day of the tax year. This is surprising to many taxpayers, financial advisors, and tax preparers, particularly because the last-day-of-the-year rule applies regardless of whether the taxpayer anticipates recognizing any Section 1231 losses during the year.
Example 2: Ryan owns several rental properties that he treats as a Section 162 trade or business (e.g., he claims the 20% Section 199A deduction against his rental income). Ryan sold one of the rental properties on March 1, 2019, and recognizes a Section 1231 gain of $100,000. Ryan’s golfing buddy told him about Opportunity Zones and Ryan invested $100,000 in a QOF on June 15, 2019, within 180 days from the date of sale. Ryan is not able to defer the gain — even if he ends up having a net Section 1231 gain for the year — because the gain was invested before the start of the 180-day period. Ryan needed to wait until the last day of the year for the 180-day period to start because the gain being deferred is a Section 1231 gain.
The IRS issued FAQ guidance recently that provides relief to taxpayers who reinvested net Section 1231 gains in a QOF within 180 days from the day the gain was recognized but before the last day of the tax year. The guidance is only applicable for tax years ending before May 1, 2019 (i.e., calendar year clients cannot rely on that guidance for gain recognized in 2019).
How we can help
Opportunity Zones provide incentives that can enhance after-tax investment returns for the well advised but traps for the unwary. Our business tax planning professionals and wealth advisors are immersed in the real estate field, the investment market, tax reform, and the industries our clients operate businesses in.
We can help you make clear decisions and realize the full benefits of the Opportunity Zone program. Whatever road leads you to Opportunity Zones, CLA is right there with you.