A Qualified Opportunity Zone Trap for the Unwary

When depreciable and real property (usually buildings and equipment) used in a trade or business and held for more than one year is sold, the result is typically Section 1231 gain. Absent recapture rules, this gain is treated as capital gain, but it must first be netted against any losses from other sales of 1231 property during the tax year.

Recent tax reform guidance from the IRS has altered the timing for investors who want to defer 1231 gains by investing in a Qualified Opportunity Zone (QOZ) business or a Qualified Opportunity Fund (QOF). Generally, an investor has 180 days from the date of the sale that gives rise to capital gains to invest those gains directly in a QOF (this rule is modified where the gain is realized in a pass-through entity). However, in  the most recent set of proposed regulations, the IRS stated that for 1231 gain, the 180-day period does not start until the last day of the tax year (i.e., after the investor has fully netted 1231 gain against any 1231 loss incurred during the year). This could create several problems for QOZ investors:

1. It is unclear how the IRS will treat QOZ investments made with 1231 gains prior to the issuance of this second tranche of proposed regulations. Presumably, the deferral will remain intact as investors were operating on the guidance available at the time the investment was made.

2. This provision may limit investors from receiving the full QOZ tax benefits by delaying their holding period. Because 1231 gain investors will have to wait until Dec. 31, 2019 (the last day of their tax year), to invest, they may be ineligible for the additional 5% basis step-up available to investors who kept their capital in place for seven years (as this investment must be made on or before Dec. 31, 2019). Essentially, in order to take advantage of this additional basis step-up, investors must invest their 1231 gains on Dec. 31, 2019, not a day sooner or later.

3. The deferred start of the 180-day investment period effectively creates a “dead zone” during which qualifying investments may not be made, forcing investors to wait until the end of the year to make QOZ investments.

It is important to note that this guidance is issued under proposed regulations, as a result, the rules are subject to change when final regulations are published. However, taxpayers may rely on the proposed regulations until then. If you have any questions or would like to learn more, please contact your KSM advisor.