After issuing two earlier sets of proposed regulations for qualified opportunity zones (QOZs), the IRS has released 544 pages of final regulations. Taxpayers interested in deferring, reducing and even permanently excluding capital gains on their investments in QOZs will be particularly interested in certain changes the final regs make to the proposed regs. While you might not currently have gains to reinvest due to the COVID-19-related market volatility, the long-term benefits of QOZs are still worth considering. And, if you’ve already invested in a qualified opportunity fund (QOF), it’s important that you understand the impact of the final regs.
Gains Eligible for Reinvestment
Investors generally can defer short- or long-term capital gains on a sale or disposition of their investments if they reinvest the gains in a QOF. A QOF is, generally, an investment vehicle that is organized as a corporation or a partnership for the purpose of investing in QOZ property (other than another QOF) and holds at least 90% of its assets in QOZ property.
You must reinvest into the QOF within 180 days. The tax will be deferred until the fund investment is 1) sold or exchanged, or 2) December 31, 2026, whichever is earlier.
Note that, in response to the COVID-19 pandemic, the IRS adjusted filing and reporting deadlines, including a taxpayer’s election to invest in a QOF. Taxpayers have until July 15 to make the election for the 180-day-period ending April 1 through July 14. (It’s possible that, by the time you’re reading this, deadlines could have been postponed further; check with your tax advisor for the latest information.)
After five years, a QOF investor receives a step-up in tax basis for the investment equal to 10% of the original gain, so only 90% of that gain is taxable. After seven years, the step-up increases to 15%, reducing the taxable portion of the original gain even more. For investments held in the QOF for at least 10 years, post-acquisition gains are fully tax-exempt.
Under the proposed regs, only capital gains (for example, gains from the sale of stock or a business) qualified for deferral. The final rules clarify that only eligible gain taxable in the United States can be invested in a QOF. They also allow a taxpayer to invest the entire amount of gains from the sale of Section 1231 business property (that is, the gross amount), rather than just the amount that exceeded the investor’s losses (the net amount).
As a result, investors needn’t wait until the end of the tax year to determine eligible gains, so the 180-day period begins on the sale date of the business property. The proposed regs required the investment period to begin on the last day of the investor’s tax year. The final rules also make changes related to when the period begins for partners, S corporation shareholders and owners of other pass-through entities — as well as shareholders in regulated investment companies (RICs) and real estate investment trusts (REITs) — that receive a share of gains.
Excludable Gains After 10 Years
The final regs amend the proposed regs regarding which gains an investor could elect to exclude after holding the QOF investment for 10 years. The proposed regs only permitted the exclusion of gains from the sale of qualifying investments or property sold by a QOF operating as a partnership or S corporation; investors couldn’t exclude gains on property sold by a subsidiary entity.
The final regs, though, allow investors to exclude from income the capital gains on the sale of property by a QOZ business that’s held by a QOF if the investor has held the qualifying QOF investment for 10 years. However, the amount of gain from such asset sales that’s excluded each year will reduce the amount of the investor’s interest in the QOF that remains a qualifying investment.
In addition, the final regs make clear that the exclusion after 10 years is available for other gains that are treated as gains from the sale or exchange of noninventory property for federal income tax purposes. That includes, for example, distributions by a corporation to shareholders or a partnership to a partner. The final rules also allow shareholders invested in QOF RICs and REITs for at least 10 years to simply exclude certain capital gain dividends, rather than apply a 0% tax rate as required under the proposed regs.
And That’s Not All
The final QOZ regs cover much more, including transition rules regarding the applicability of the proposed versus the final regs. These are especially important for taxpayers who have already invested in QOFs. We can help you navigate the complexities.
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