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OZONE ALCHEMY: Turning Net 1231 Gains Into Gross 1231 Gains (And Losses)



IRC Section 1231 (Gains And Losses)

Key Takeaways

  • Treasury and IRS initially struggled regarding how to deal with IRC Section 1231 gains and losses in the context of the OZ program; however, the final OZ Regulations ended up being extremely taxpayer-friendly.
  • Understanding how and why Treasury arrived at its decision unlocks a remarkable, yet brief, planning opportunity for taxpayers and their advisors.
  • With the right planning, taxpayers can isolate gross 1231 gains for OZ reinvestment eligibility but still claim gross 1231 losses in the same year at ordinary income rates – resulting in permanent tax savings.
  • Taxpayers who already reported net 1231 gains in tax years 2019 and 2020 can still likely make tax-advantaged QOF investments for those years—but the window is closing fast – especially for 2019 1231 gains.
  • This ability to defer 1231 gain and recognize 1231 losses can further benefit certain taxpayers who would have otherwise been forced to pay ordinary rates on net 1231 gains in a given year as a result of the five-year “look-back” period under 1231(c).

The following discussion is arguably the most powerful planning opportunity for OZ investors with the right fact pattern.  This planning opportunity recently became available as a result of very taxpayer-friendly rules for IRC 1231 gains and losses contained in the final OZ regulations, as well as the issuance of IRS Notice 2021-10 – a secondary COVID-19 extension for OZ investors.

It took the Treasury Department and Internal Revenue Service (collectively “Treasury”) almost two years to issue “Final Regulations” under Code Section 1400Z-2 (“OZ Act”) covering special rules for capital gains invested into Opportunity Zones (OZ). During this long and often meandering trek toward clarity, the tax authorities initially required taxpayers to net Section 1231 gains and losses (which arise on the sale or exchange of certain trade or business assets held for more than 12 months) occurring from all sources during a given year.  Furthermore, all net activity was deemed to have occurred on the last day of the tax year.  This was good news for taxpayers wanting the maximum time to reinvest the gains, but bad news for those taxpayers wanting to reinvest the gains as quickly as possible after a 1231 gain was realized.  That is because these initial Proposed Regulation rules did not start the 180-day clock ticking until December 31st of the year of the gain.

Fortunately for taxpayers, Treasury ended up treating 1231 gains and losses similar to “regular” capital gains. This means that taxpayers are not required to net 1231 losses with 1231 gains and the sale date and 180-day reinvestment period generally begins on the sale date.  1231 gains flowing from LLC/ Partnerships, S Corps or non-grantor trusts begin their 180-day reinvestment period on the later of December 31st of the year of sale, or March 15th of the following year (the initial K-1 issue deadline).

This extremely favorable treatment of 1231 activity is arguably one of the most beneficial planning opportunities for OZ investors. CPAs and taxpayers are wise to jump on this remarkable (yet short-term for 2019 gains) planning opportunity and engage in what might be termed “OZone Alchemy” – the art of turning net 1231 gains and losses (aka lead) into investable gross gains and immediately deductible ordinary losses (aka gold).

A rare no-lose ruling for taxpayers

Remember, Section 1231 gains and losses have benefitted from unique and very taxpayer-friendly treatment under the Internal Revenue Code for decades. Taxpayers with a net 1231 gain in a given tax year are generally allowed to treat those gains as long-term capital gains (thus making them potentially eligible for more favorable capital gain rates – maximum 23.8% [20% +3.8% Net Investment Income Tax) for federal]. At the same time, they can treat net 1231 losses as “ordinary” losses [generating a maximum 40.8% (37%+3.8%) benefit]. Thus, these losses are eligible to offset ordinary income instead of being trapped within the bucket of capital losses—losses that can only be used to offset capital gains.  So, we have a rare situation in which the rule is “heads I win/ tails you lose” in favor of the taxpayer rather than the government. In other words, a potential 17% permanent tax rate arbitrage – a gold-plated result.

Brief window remains open for those with business property gains in 2019 and 2020

Thanks to the COVID relief rules contained in IRS Notices 2020-39 and 2021-10, the OZ re-investment deadline for those years is in many cases extended until at least March 31, 2021. Therefore, taxpayers may STILL have the opportunity to amend their 2019 tax return, as well as disaggregate a net 1231 gain into a gross 1231 gain and gross 1231 loss, and then make a timely investment of gross 1231 gain within the applicable 180-day period (which, under COVID relief, can stretch as long as 821 days!).

For example, if a taxpayer generated a 1231 gain for 2019 via a partnership, S corporation and/or non-grantor trust, then their 180-day investment period for 2019 has still not expired under the COVID Relief rules. Thus, if a taxpayer reported a net 1231 gain on December 31, 2019 (e.g. a K-1 reported gain), he or she may still be able to “disaggregate” that transaction into the gross amount of section 1231 gain (good) and gross amount of section 1231 loss (perhaps even better). Further, they can then reinvest the gross amount of 1231 gain into a QOF in before March 31, 2021 and thereby “create” a 1231 ordinary loss than can dramatically reduce taxes (and, at this point, provide a generous refund) for calendar 2019.

The same concept likewise applies to gains and losses netted from a sale of assets at the end of 2019.  This extended OZ reinvestment opening also exists for taxpayers who held “direct” investments in capital gain assets – say from a rental property held individually that was sold on, or after, October 5, 2019.  The 180-day reinvestment period would not have expired until April 1, 2020 – which keeps the COVID-19 relief extension open until March 31, 2021.

Real world example

Assume Taxpayer J sold a business in November 2019 and recognized $1 million of 1231 gains and $800,000 of 1231 losses–for a net 1231 gain of $200,000. Assume Taxpayer J initially reported the $200,000 of net 1231 gain as long-term capital gain on their 2019 federal income tax return–and paid the applicable tax. However, Taxpayer J can now amend their 2019 return and re-characterize the transaction as $1 million of gross 1231 gain that could be invested in a QOF at any time up to March 31, 2021. By investing this $1 million of gross 1231 gain, and by reporting a corresponding loss of $800,000 on an amended Form 8949, Taxpayer J will now be able to report $800,000 of 1231 loss as an ordinary loss and deduct that amount against other ordinary income reported in 2019.

That’s a major tax benefit in every respect. The taxpayer can make an OZ investment $800,000 larger than they could have under the original rules they obtain a huge tax deferral and potentially permanently save up 17% ($136,000) on the $800,000 1231 loss they have now recognized. Instead of paying tax on $200,000 in capital gain – if they did not make the OZ investment, Taxpayer J will report $800,000 of ordinary loss, and thus claim significant federal and state tax refunds for tax year 2019 amounting to as much as $424,000. (See Footnote 1).

Conclusion

The highly beneficial final regulations for 1231 activity provides CPAs and their clients to perform some highly impactful tax planning and create permanent tax savings in the year of sale, plus allow the taxpayer to still get into the OZ Program much later than was originally allowed.  A gold-plated result.

About the authors

Blake Christian is a CPA in the Park City Office of Holthouse Carlin & Van Trigt LLP (HCVT), a top 30 CPA firm. Jay Darby is a tax attorney and founder of Boston-based Joseph Darby Law PC. Both focus on Opportunity Zone Funds and complex tax issues.

Have a question? Contact blake.christian@hcvt.com or (562) 305-8050 

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[1] If Taxpayer J is a resident in a state with a 5% tax rate, the tax cost of $200,000 of LTCG is estimated to be 28.8% (20% federal LTCG tax rate, plus 3.8% NIIT, plus 5% state tax) for a tax cost in 2019 of $57,600.  By contrast, an $800,000 ordinary loss (assuming Taxpayer J can absorb that level of loss if full on the 2019 return, which we will in fact assume for the sake of argument and fun), the tax rate avoided is estimated to be 45.8% (37% federal, plus 3.8% social security tax or NIIT Tax, plus 5% state tax) for a tax savings/refund estimated to be worth $366,400.  Eliminating the capital gain and benefitting fully from the ordinary loss is $424,000 ($57,600 + $366,400).

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Blake is a nationally recognized expert and frequent author and speaker on State and Federal Location-based Incentive Credits (LBIC’s), including State Enterprise Zone Credits, Federal Empowerment, Renewal Community, Indian Tribal Lands and Gulf Opportunity Zone Credits. He has also assisted in the development of specialized software, which is used by over 200 tax departments throughout the U.S. to identify LBIC’s. Blake’s clients include multi-national, publicly traded corporations, as well as closely held owner-managed businesses. His industry concentration includes manufacturing and distribution, service companies, restaurant, shipping and transportation, energy and healthcare. In addition to corporate, partnership and individual tax compliance and planning, Blake is experienced in the design and implementation of executive compensation plans.

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