On January 13, 2020 the U.S. Department of Treasury published Final Regulations for the OpportunityZone (OZ) program – a full two years after the powerful and flexible OZ program was implemented as part of the 2017 Tax Cuts and Jobs Act. The Final Regulations were widely applauded following much controversy and public input over the first two rounds of Proposed Regulations that had been released on October 29, 2018 and April 17, 2019.
The several hundred pages of preamble and the text of the Final Regulations certainly have varying levels of complexity, but clearly one of the more challenging areas for OZ investors is determining exactly when the 180-day reinvestment period begins and ends. Taxpayers who get this wrong will completely miss out on the best tax program in decades. A situation you won’t want to be in the middle of.
The general OZ reinvestment rule is that taxpayers must invest all or a portion of their recognized capital gains within 180-days of the tax reporting period for such gain(s). One source of the complexity is that the OZ rules have their own criteria for when a capital gain is “recognized” for OZ purposes. In cases where the taxpayer held a capital asset directly, the date of sale will generally start the 180 day period. However net Section 1231 gains and capital gains flowing through on a K-1 will generally not be recognized until
the year-end (generally on December 31) of the flow-through entity under the Proposed Regulations. The Final Regulations push this recognition period further to the K-1 reporting period – generally March 15th or March 31st (for trusts) following the entity’s tax year-end.
For calendar year 2019 K-1 and net 1231 gains, these unique income recognition timing rules result in a reinvestment Qualified Opportunity Fund (QOF) deadline of June 27, 2020 under the Proposed Regulations. However, taxpayers can elect an early application of the Final Regulations and thereby extend the reinvestment period until September 10, 2020. The net result of these rules can give taxpayers over 20 months to roll their capital gains into a QOF. To illustrate – If a partner was allocated a January
2019 capital gain that is reported on a 2019 K-1, under the Proposed Regulations the reinvestment deadline is June 27, 2020 (18 months) or for taxpayers electing early application of the Final Regulations September 10, 2020 (20+ months).
As a result of the COVID-19 National Disaster designation in March, on April 9, 2020 the IRS issued Notice 2020-23 which allows an automatic extension for QOF reinvestment until July 15th for gains that had a reinvestment deadline between April 1, 2020 and July 14, 2020. Various OZ trade groups are continuing to push for a longer extension period due to the COVID business disruption.
Following are some of the key rules and planning opportunities:
1. The Final Regulations are generally the most liberal so taxpayers should evaluate applying them early for the longest reinvestment period, as well as other benefits.
2. The 180-day period generally starts on the date of sale of an asset held directly by an individual, grantor trust or C Corporation which creates a capital gain. The taxpayer has 179 days after the date of a sale to contribute all (or a portion) of their capital gains into a QOF. The deadline is NOT six calendar months from the date of sale.
3. A flow-through entity can make an election to defer capital gains at the entity level rather than allowing the equity holders to elect to invest at their level.
4. IRC Section 1231 NET gains are deemed to be realized at year-end rather than the date of sale in order to allow all gain and loss activity to be netted. Only net gains are eligible for QOF rollover under the Proposed Regulations. The Final Regulations now allow gross 1231 gains to be reinvested. Therefore, early adoption of the Final Regulations can allow GROSS 1231 gains to be reinvested in a QOF – even if there was no net gain for the year.
5. Taxpayers with net 1231 losses in the prior five years can gain additional benefit from QOF rollovers since net 1231 gains will be taxed at ordinary tax rates as a result of IRC Section 1231 (c).
6. K-1 gains will generally have until June 27, 2020 to reinvest their gains under the Proposed Regulations. Under the Final Regulations, the reinvestment period is extended until September 10, 2020. Therefore, consideration of early application of the Final Regulations may be advisable if additional time is needed.
7. The Final Regulations clarified that capital gains resulting from pre-2018 installment sales that involve post-2018 payouts are considered qualified gains for the OZ program. Under the Final Regulations, taxpayers start their 180-day countdown on the date which they receive their installment payment, unless the payment is reported on a K-1. These rules allow taxpayers to start a new 180-day period each time an installment payment is received, or on the date of the pass-through entity’s year-end, or on the original due date of the pass-through entity’s tax return.
8. 180-days for capital gain dividend distributions from a REIT/RIC start at the taxpayers year-end or the Final Regulations added taxpayers can elect to start the 180-day period on the date their dividends are actually received, if they prefer to reinvest early.
9. Treasury nor the IRS has provided any possible relief for missing the 180-day reinvestment deadline.
10. The COVID-19 virus outbreak provides significant uncertainty for investors with a long-term investment horizon. The OZ program offers investors tremendous flexibility and a longer time to deploy the QOF cash once the funds are dropped down into a Qualified Opportunity Zone Business (QOZB) subsidiary. Taxpayers with deferred capital gains can use the OZ program to “park” their qualified gains in a QOF temporarily while they evaluate long-term strategies. This “parking” strategy provides investors with some level of access to the QOF and QOZB cash during the maximum 62-
month Working Capital Safe Harbor period.
11. Due to the National Disaster designation resulting from the COVID-19 crisis, the regulations allow up to a 24-month extension to make substantial improvements to real estate or other assets and deploy other QOF and QOZB cash.
These liberal reinvestment rules and the overall flexibility of the OZ program offers investors a tremendous amount of time to make important long-term investment decisions during this period of economic uncertainty. We can expect additional refinements to the OZ program which may make the program even more attractive.
Have a question on Opportunity Zones? Contact Blake Christian, HCVT at: email@example.com or (562) 305-8050
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