The Internal Revenue Service recently released proposed regulations to provide guidance relating to gains that may be deferred as a result of a taxpayer’s investment in a qualified opportunity fund (QOF). Specifically, these proposed regulations address (1) the type of gains that may be deferred by investors, (2) the time by which corresponding amounts must be invested in QOFs, and (3) the manner in which investors may elect to defer specified gains. The proposed regulations also address items applicable to QOFs, such as the rules for self-certification, valuation of QOF assets, and guidance on qualified opportunity zone businesses.
Below is a high-level overview of the proposed regulations, and is meant to provide answers to tax-related questions that may arise in reference to investing in qualified opportunity zone funds.
Overview of the Opportunity Zone Program
The Tax Cuts and Jobs Act (TCJA) includes a new incentive which allows the deferral of capital gains if those gains are invested in a QOF. The incentive allows for a potential exclusion of up to 15% of the deferred capital gain, if the investment in the QOF is held for a minimum of 7 years. Further, if the investment in the QOF is held for a minimum of 10 years, and the investment is sold for fair market value, a taxpayer’s basis in the investment will equal the fair market value of the investment, resulting in no gain on the sale of the investment.
Gains Eligible for Deferral
The proposed regulations clarify that only capital gains that arise “from the sale to, or exchange with, an unrelated person of any property held by the taxpayer” are eligible for deferral. Any capital gain is eligible for deferral if it is treated as a capital gain for Federal income tax purposes, for example, capital gain distributions from an investment portfolio. Gain that would be treated as ordinary income, such as the recapture of certain types of depreciation, would not be eligible for deferral.
Taxpayers eligible to defer capital gains under the Code include individuals, C Corporations (including REITs), partnerships, and certain other pass-through entities, including common trust funds. Taxpayers are only allowed to defer the capital gain once, however, the capital gain may be invested into multiple QOFs, provided that the total investments do not exceed the amounts of capital gain to be deferred.
180-Day Rule for Deferring Gain by Investing in a QOF
To be able to elect to defer the gain, a taxpayer must generally invest in a QOF during the 180-day period beginning on the date of the sale or exchange giving rise to the gain. For capital gains that do not have a specific date for the deemed sale (i.e. capital gain distributions), the first day of the 180-day period would be the date on which the gain would be recognized for Federal income tax purposes (generally, December 31st for calendar year taxpayers).
The investment in the QOF must be an equity interest in the QOF, including preferred stock or a partnership interest with special allocations. The proposed regulations specifically exclude debt instruments as eligible interests.
The QOF is required to hold at least 90% of its assets in qualified opportunity zone property – i.e. qualified stock, partnership interests or qualified opportunity zone business property. The 90% asset test is determined by the assets held measured (a) on the last day of the first six month period of the QOF’s taxable year, and (b) on the last day of the QOF’s taxable year.
All qualified opportunity zones are expected to lose their designations as such on December 31, 2028. The proposed regulations permit taxpayers to make the basis step-up election for property held at least 10 years even after the opportunity zone designation expires. The ability to make this election is preserved under proposed regulations until December 31, 2047.
The Qualified Opportunity Zone program is designed to provide incentive to taxpayers to invest in QOFs. This program provides many tax planning strategies for this year through 2027. If we may assist you with this type of tax planning, or some other tax planning alternatives, please contact us at (410)-546-5600.
PKS & Company, P.A., Certified Public Accountants and Advisors to Business, is a full service accounting firm with offices in Salisbury & Ocean City, MD and Lewes, DE. PKS provides traditional accounting services as well as specialized services in the areas of retirement plan audits and administration, medical practice consulting, estate and trust services, fraud and forensic services and payroll services and offers financial planning and investments through PKS Investment Advisors, LLC.