Opportunity zone investing: Reinvestment requirements and the 180-day time frame
The Opportunity Zone Program offers qualifying taxpayers who have capital gains income a highly flexible way to defer and eliminate a portion of the federal gain and possibly state gain.
While there are certain complexities and open issues under the OZ Program, taxpayers who have significant gains should carefully evaluate the program and consider establishing a Qualified Opportunity Fund within the 180-day window allowed, as mentioned in my previous article.
If future regulations or the taxpayer’s specific reinvestment prospects do not fit into the OZ Program’s long-term criteria, the OZ investor can timely withdraw their funds with very little economic impact. Missing the initial reinvestment deadline, however, can be fatal from a tax perspective.
Proposed OZ regulations and Revenue Ruling 2018-29, issued last October, provide useful program clarification and remove some of the uncertainty around this intriguing program. However, there are still many open issues for investors, and this is what is keeping many taxpayers and billions of dollars of funds on the sidelines. We expect additional regulations in the coming weeks, which should open the OZ reinvestment floodgates. That will be great news for areas seeking redevelopment funding. Which of your clients are best positioned to make use of this technique?
What is a qualified opportunity fund?
To pass the first step in the OZ Program, the reinvestment of all or a portion of the deferred gain must be invested in a Qualified Opportunity Fund. Section 1400Z-2(d)(1) defines what a QOF is. A QOF means “any investment vehicle which is organized as a corporation or a partnership for the purpose of investing in qualified opportunity zone property (other than another qualified opportunity fund) that holds at least 90 percent of its assets in qualified opportunity zone property, determined by the average of the percentage of qualified opportunity zone property held in the fund as measured on:
- The last day of the first six-month period of the taxable year of the fund; and
- The last day of the taxable year of the fund.”
However, the first set of proposed regulations issued on Oct. 19, 2018, makes clear that the investment into a QOF must be an equity interest (including preferred stock and partnership interests with special allocations) into a C Corp (including Regulated Investment Companies and Real Estate Investment Trusts) or S Corp stock, a partnership or other pass-through entity. The equity can be used as collateral for a loan, but investments made in the form of convertible debt or other amounts treated as debt under the IRC Section 1275(a)(1) and Treas. Reg. 1.1275-1(d) do not qualify for QOZ gain deferral.
There is currently no statutory or regulatory relief for missing the 180-day period. Therefore, ensuring that taxpayers meet this key deadline is the most critical step under the OZ Program. CPAs and other professionals advising OZ investors must be clear about when the 180-day reinvestment period starts and ends, and what the mechanics are for reinvesting the gains and electing OZ Program deferral.
Section 1400Z-2(a)(1)(A) of the tax code states that “gross income for the taxable year shall not include so much of such gain as does not exceed the aggregate amount invested by the taxpayer in a qualified opportunity fund during the 180-day period beginning on the date of such sale or exchange.” (Emphasis added.)
The Treasury issued the first of three anticipated sets of regulatory guidance on Oct. 19, 2018, but there are many open issues causing investors to sit on the sidelines before participating in the OZ Program. Gains from as far back as 2017 were eligible for QOF reinvestment. As a result, there’s a possibility the IRS will extend the period for making QOF investments until 180 days from the issuance of additional regulations. This situation has occurred in other areas of the Internal Revenue Code, but it is far from certain. Another slim possibility is the Treasury will allow a similar concept to a “Reverse Like-Kind Exchange,” which would also allow a taxpayer to establish a QOF within 180 days before recognizing a qualified gain. Many taxpayers, especially real estate developers, may want to lock up a replacement property before they generate the actual qualifying capital gain.
The 180-day reinvestment period
IRC Section 1400Z-2 does not elaborate on the 180-day reinvestment requirement, but it is important to note that the day of the sale (or recognition if later) is counted in the 180-day period. It is equally important to note that the statute clearly refers to “180 calendar days,” not six months. Since careful date-counting is required, it is recommended that participants make their reinvestment several days prior to the 180-day deadline to avoid disqualification. For example, a gain recognized on Dec. 31, 2018, will require reinvestment no later than June 28, 2019.
The first set of proposed OZ regulations, issued Oct. 19, 2018, provided guidance on when the 180-day investment period begins and defines the “date of such sale or exchange” contained in IRC Section 1400Z-2(a)(1)(A). Under the regulations, the first day of the 180-day period begins on the day when the deferred gain is recognized for federal tax purposes (without regard to the OZ deferral election until 2026). Therefore, installment sale structuring and IRC Section 1031 Like-Kind Exchange transactions can provide additional time for investors who prefer to delay the start of the 180-day reinvestment timing. However, if you have clients taking part in the program, they will not want to defer gains too far into the future. That’s because they must generate a qualified capital gain before the termination of the investment phase of the OZ program, which ends Dec. 31, 2026.
If you have clients involved in partnerships (and other pass-through entities), remember the partnership can elect to defer gain at the partnership or entity level. In such cases the 180-day period begins on the date the gain is recognized. If the partnership does not make the OZ election, then the individual partners have the option of making the OZ reinvestment. The proposed regulations provide the partners or LLC members with additional time to make their election, since a partner/member or other pass-through equity owner is generally not deemed to recognize capital gains until the last day of the entity’s tax year. Therefore, the 180-day period does not generally begin until Dec. 31 for calendar year entities. Future regulations will likely provide guidance in situations where an entity’s tax year (or that of an equity owner) terminates before year-end, due to a technical termination or other mid-year transaction. Alternatively, taxpayers can elect to have the 180-day period begin on the actual date of the entity asset sale in order to accelerate the reinvestment window.
The 180-day period requirement can arise more than just on the original reinvestment. Taxpayers deferring gain into a QOF and disposing of their entire interest in a QOF can make subsequent OZ deferrals into another QOF within 180 days.
The federal tax procedures for deferring capital gain deferral
The regulations indicate that the IRS is updating the current IRS Form 8949 to allow for a QOZ election to be made. This form will need to be attached to the taxpayer’s appropriate timely-filed tax return (which would have reported the qualifying gain) for the year of deferral.
The original capital gain can be divided into different QOFs via multiple deferral elections. This allows taxpayers to invest their gains into more than one QOF. Based on current guidelines, separate QOFs are generally recommended for each underlying investment and/or state in which the reinvestment will be made. These strategies and possible future regulatory relief will be discussed in a subsequent column.
Taxpayers wishing to participate in the OZ Program must meet this initial reinvestment deadline or risk losing these very valuable program benefits. Therefore attention to timing is critically important.