By Billy Litz
With the end of the year approaching, there are many tax planning opportunities that we are discussing with our clients. One of the newest tools available are Qualified Opportunity Zone Funds (QOZF). QOZFs were created by the Tax Cuts and Jobs Act in December 2017. The idea behind this program was to tap into the trillions of dollars of unrealized capital gains by incentivizing taxpayers to develop certain areas throughout the United States. If you are not familiar with QOZFs, please check out my previous article which outlines the various tax incentives and mechanics of the program. This article will focus on recent changes that will impact real estate investors looking to defer gains by investing in QOZFs.
With the issuance of Proposed Regulations in April 2019, there are now complications that need to be considered for investors with Sec. 1231 gains, which arise mostly from the sale of real estate held for more than one year and used in a trade or business. Sec. 1231 gains are a hybrid of sorts, since net gains are taxed at capital gains rates and net losses are treated as ordinary losses. It is important to understand that you must first net all of your Sec. 1231 gains and losses to determine the tax treatment, and not solely look at the gain from an individual investment that you might be investing into a QOZF. Due to the interplay with Sec. 1231 losses, the Proposed Regulations state that taxpayers that wish to invest Sec. 1231 gains into QOZFs must first determine their net Sec. 1231 gain.
- Example 1: In 2019, you recognize a $1,000 Sec. 1231 gain from the sale of land/building in Partnership A and a $500 Sec. 1231 loss from the sale of land/building in Partnership B. Your net Sec. 1231 gain would be $500. This would be taxed at capital gains rates, and therefore $500 would be able to be invested into a QOZF for deferral.
- Example 2: In 2019, you recognize a $500 Sec. 1231 gain from the sale of land/building in Partnership A and a $1,000 Sec. 1231 loss from the sale of land/building in Partnership B. Your net Sec. 1231 loss would be $500. This loss would be an ordinary loss and would be able to offset ordinary income. You would not have any net gain to invest into a QOZF for 2019.
In most cases, taxpayers must make their investment into the QOZF within 180 days after the gain is realized. Since a taxpayer would not be able to determine their net Sec. 1231 gain until the end of the tax year, the 180-day window for investing Sec. 1231 gains into QOZFs begins on the last day of the taxable year. This differs from the 180-day investment window during the 2018 tax year, for which the investment window began on the day the gain was realized for an individual taxpayer while taxpayers who received gains from pass-through entities were given the option to start their window on the day the gain was realized or the last day of the taxable year.
The timing of the investment window for Sec. 1231 gains is particularly important for those investors looking to receive the additional 5% step-up (15% total) for holding an investment in a QOZF for 7 years, because in order to meet the 7 year holding period the investment cannot be made after December 31, 2019.
With some planning and a knowledgeable team, investors can avoid costly mistakes when making their investments in QOZFs. While there is speculation that Treasury could change the investment window for Sec. 1231 gains, I would imagine that there will be a lot of money being invested in QOZFs on December 31, 2019.
If you have any gains and are interested in investing into QOZFs, you should work with your advisor to make sure that you have a plan in place before year-end. The real estate team at Snyder Cohn is available for any questions you may have, and are always happy to help.