Qualified Opportunity Zones, a tax incentive created by the Tax Cuts and Jobs Act, offer certain deferrals of capital gains tax if the capital gains are invested in economically distressed areas. The basic rules for this incentive are codified in Internal Revenue Code Sections 1400Z-1 and 1400Z-2 but more guidance was necessary.
On October 29, 2018 and May 1, 2019, the U.S. Treasury Department and the IRS issued proposed regulations as an initial attempt to provide detailed guidance as to how Qualified Opportunity Zone investments could be made to obtain those tax benefits. On December 19, 2019, after considering public comment on those proposed regulations, the U.S. Treasury Department and the IRS issued final regulations implementing the Qualified Opportunity Zones tax incentive.
Over the next few weeks, we will explain the most important changes these final regulations provide and issue an updated version of our white paper. This is the first installment and focuses on the additional flexibility regarding when capital gains must be invested and the new guidance as to the type of capital gains that may be invested in Qualified Opportunity Zone Funds (QOFs).
Changes to the Investment Window
Generally, capital gains must be reinvested into a QOF within a period of 180 days which begins on the date the capital gain would be recognized for federal tax purposes. The final regulations allow that 180-day window to begin at additional times, providing investors more flexibility for investing capital gains into QOFs.
In the proposed regulations partnerships, S corporations, estates and trusts needed to make a QOF investment within 180 days of the date on which the entity recognized capital gain for federal tax purposes. Moreover, the 180-day window for the partners, shareholders and beneficiaries of these entities could begin on the date the capital gain is recognized by the pass-through entity or the last day of the taxable year for its owner.
The final regulations now provide an additional date on which the 180-day window can begin for partners, shareholders and beneficiaries—the due date of the entity’s tax return, not including any extensions.
This change addresses taxpayer concerns about potentially missing investment opportunities due to an owner of a business entity receiving a late Schedule K-1 (or other form) from the entity. Notably, a similar rule does not apply to a grantor trust because the grantor is treated as the owner of the grantor trust’s property for federal income tax rules. Therefore, the grantor does not need to wait for a Schedule K-1 to be prepared.
The proposed regulations only permitted the amount of an investor’s gains from the sale of business property (section 1231 property) that was in excess of the investor’s losses from such sales to be invested in QOFs, which required the 180-day investment period to begin on the last day of the investor’s tax year. This created a significant impediment to investment of these capital gains.
The final regulations allow a taxpayer to invest the entire amount of gains from such sales without regard to losses and permit the 180-day investment period to begin on the date of the sale of the asset giving rise to the gain. Notably, the section 1245 and 1250 rules still apply to recharacterize 1231 gains as ordinary income; only those 1231 gains not recharacterized are eligible capital gains.
RIC and REIT Gains
The amount of capital gain dividends from a regulated investment company (RIC) and real estate investment trust (REIT) are determined after the end of the relevant tax year. Under the proposed regulations, the 180-day period for RIC and REIT shareholders begins on the date the shareholder receives a dividend, which could be more than 180 days before the end of the year. As a result, shareholders could be prevented from investing their capital gain dividends in a QOF during the 180-day window depending on when the capital gain dividend is received.
To address this issue, the final regulations change the date on which the 180-day investment period begins to the last day of the shareholder’s tax year. In addition, the final regulations permit the shareholder to elect to begin the 180-day investment period on the date the shareholder receives a capital gain dividend from the RIC or REIT.
Installment Sale Gains
The final regulations also provide additional flexibility with respect to the rules applicable to gains from installment sales. Generally, gains from an installment sale are required to be taken into account for federal tax purposes in the taxable year or years during which payments are received rather than the year of sale. It was not clear whether gains from an installment sale are able to be invested when received, even if the initial installment payment was made before 2018 or the year of sale. Therefore, there could be a single 180-day period for all income from the installment sale that begins on the date and year of the sale, or multiple 180-day periods, each beginning in the year during which a payment is received and income is recognized under the installment method.
The final regulations adopt the rule that the gain is to be invested when received and, to provide investors additional flexibility, accommodate beginning the 180-day period on either (i) the date a payment under the installment sale is received for that taxable year, or (ii) the last day of the table year the eligible gain under the installment method would be recognized. As a result, if a taxpayer defers gain from multiple payments under an installment sale, there may either be multiple 180-day periods or a single 180-day period at the end of the taxpayer’s taxable year.
Gains Subject to Deferral
Additional guidance is also provided for the types of capital gains that may be invested in QOFs.
New flexibility is provided with respect to gains that were previously invested in a QOF. The preamble to the May 2019 proposed regulations explained that, upon disposition of a QOF interest, deferring the amount otherwise resulting from an “inclusion event” is permitted only if the investor has disposed of the entire initial QOF investment. This is due to the explicit prohibition in section 1400Z-2 on making a deferral election with respect to a sale or exchange if an election is already in effect with respect to the same capital gain
The final regulations acknowledge that a deferral election is no longer in effect for any capital gain arising from an inclusion event. As a result, such capital gain is considered new capital gain for which a new deferral election may be made if invested in another QOF. In other words, an investor no longer needs to dispose of their entire initial investment in a QOF to reinvest and defer capital gain arising from an inclusion event.
Only Gains Subject to Federal Income Tax
It was not clear from the proposed regulations whether the term eligible gains included capital gains realized by persons that are generally not subject to federal income tax with respect to those gains. That includes entities generally exempt from federal income tax and persons who are neither U.S. citizens nor U.S. residents (nonresident aliens, who are generally not subject to U.S. federal income tax).
The final regulations clarify that deferral of a gain under the Qualified Opportunity Zone tax incentive program is available only for capital gains that would be subject to federal income tax. So eligible capital gains for a tax-exempt organization are only those gains that are subject to the unrelated business income tax. Similarly, eligible capital gains for nonresident aliens are only those gains that are effectively connected with a U.S. trade or business.