If someone asked you to handpick one provision from the recently enacted Tax Cuts and Jobs Act that perfectly embodies the many shortcomings of this most recent round of tax reform, you could do far worse than settling on Section 1400Z-2, the “Opportunity Zone” incentive.
For starters, like the rest of the Act, Section 1400Z-2 was, by all appearances, drafted by a sleep-deprived eleven-year old. It causes confusion in the first sentence. It’s riddled with cross-references to incorrect paragraphs and critical but poorly-defined terms of art that often differ from one another by one word. As a result, while this provision — like the Act as a whole — promises a bounty of tax cuts, only the brightest among us will be able to unlock its secrets.
I, unfortunately, am not particularly bright. But that’s never stopped me from taking on seemingly incomprehensible Code sections before. I once wrote 5,000 words on Section 263A — what can be worse than that?
And here’s the thing: Section 1400Z-2 is worth trying to dissect. After all, this is a provision that offers both gain deferral and gain exclusion in exchange for investing in a low-income community, or in Section 1400Z-2 parlance, an “Opportunity Zone.”
So let’s do it. And as we always do when stuff gets messy, let’s break it down using the Q&A format:
Q: I’ve gotta’ be honest: “Opportunity Zones” sound like one of those countless “Zone” sections of the Code I’ve never given a second look — DC Zones, GO Zones, Enterprise Zones, you get the idea…What makes this one different?
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A: Trust, me; I get it. It doesn’t sound like much. But it is….it really, really is. Think of it this way — where else in the tax law can you sell property for a gain, get to touch the cash for up to 180 days, and if you elect to reinvest the cash within that time window, enjoy the following tax benefits:
- Deferral of the gain recognized on the original sale of up to 8 years,
- Exclusion of up to 15% of the original gain, and
- An exclusion of ALL of the gain eventually recognized upon the disposition of the qualified investment???
That’s a whole lot of benefit, no?
Q: I concede that sounds nice, particularly the exclusion part. But what makes gain deferral so special? I mean, you can defer gain by using a Section 1031 like-kind exchange, right?
A: Oh, it’s different. Think of it this way: if you want to defer gain using a like-kind exchange, after 2017, you’re limited to exchanging real estate. So if you cash in a bunch of Amazon stock, Section 1031 isn’t going to help you out. And of course, you must exchange for property of “like kind,” which creates even more constraints. And finally, there’s the big one: if you don’t want to recognize any gain on a like-kind exchange, you can’t take ANY cash off the table. For example, if you exchange a building with a basis of $1 million and a FMV of $2 million for a building with a FMV of $1.5 million and $500,000 of cash, you recognize gain of $500,000.
Compare this with the incentives offered by qualified opportunity zones. As discussed more fully below, gain from the sale of any type of property –not just real estate — that produces capital gain can be deferred if the gain is reinvested in an opportunity zone. And there is no “like kind” requirement; for example, you can reinvest gain from the sale of that Amazon stock into an investment in an apartment building and still get the benefit of deferral. But here’s the best part — you can actually take cash off the table from the original sale and STILL defer all of the gain. Building on our previous example, if you sell a building with a basis of $1 million for $2 million, reinvest $1 million into a qualified opportunity zone and pocket the remaining million, you get to defer the $1 million of gain on the original sale, because you have reinvested an amount equal to the gain. So you get to blow $1 million of the $2 million sales price on a speed boat, and still defer $1 million of gain — that’s not a bad deal.
And that’s just the start: as we mentioned above and will discuss further below, if you meet certain holding requirements, you may be able to permanently exclude from income up to 15% of that $1 million in gain from the sale of the building, as well as ALL of the gain from a subsequent disposition of your investment in the qualified opportunity zone.
Q: OK, you’ve piqued my interest. This does sound worth learning a little more about. So how do we start with this whole thing?
A: We start by accepting this: there are a LOT of moving parts to Section 1400Z-2. A lot of critical terms that sound very similar. And a lot of quantitative standards that must be met. We’re going to have to sort through all of this stuff, but let’s start by laying out a rudimentary flowchart showing how this all works:
Step 1. Taxpayer recognizes capital gain on the sale of assets.
Step 2. Within 180 days, the taxpayer reinvests some or all of that gain in a qualified opportunity fund (QOF).
Step 3. The QOF,in turn, must invest more than 90% of its assets in qualified opportunity zone property (QOZP) located within a qualified opportunity zone (QOZ), either by:
- Investing in a subsidiary that operates a qualified opportunity zone business (QOZB), or
- Operating a QOZB directly by holding qualified opportunity zone business property (QOZBP).
If the QOZB is operated through a subsidiary (#1 above), the subsidiary must invest more than 70% of its assets in QOZBP.
If the QOZB is operated directly by the QOF, more than 90% of the assets of the QOF must be QOZBP.
Do all that, and there are tax savings aplenty. Piece of cake, right?
Q: You’ve got to be kidding me. May as well take it from the top…so it all starts from gain on the sale of assets. I’m guessing there are a lot of constraints around that. For starters: can any type of taxpayer defer gain using the opportunity zone incentive, or is this provision just for individuals?
Original Gain Eligible for Deferral
A: Nah, it’s not just for individuals. C corporations, S corporations, partnerships, trusts, estates, regulated investment companies (RICs) and even real estate investment trusts (REITs) can share in the fun. In addition, the owner of a partnership, S corporation, trust or estate will have the option to defer gain on sales by the business entity if the entity chooses not to defer at the business level. But more on that later.
Q: Got it. Next question: what type of gain is eligible for deferral? I assume you can’t defer gain on, like, the sale of inventory, right?
A: You’ve got it. The gain eligible for deferral is restricted to capital gain, so no, you can’t defer gain from the sale of inventory or depreciable property to the extent it produces recapture taxed at ordinary rates. Interestingly, however, the statute makes a bit of a mess of trying to establish that fact. If you read Section 1400Z-2 (you won’t) while the title of the section refers to the reinvestment of “capital gains,” the text of the statute provides that any gain from the sale of property is eligible for deferral. So how do I know the deferral is only for capital gains?
The proposed regulations provide clarity. Prop. Reg. Section 1.1400Z-2(a)(1)(b)(2) states that that the original gain recognized by the taxpayer must be “treated as capital gain” for Federal income tax purposes. There is an important distinction to be made here, however. The regulations don’t require that the asset sold be a capital asset; rather, the gain must be treated as capital gain. And these are two different things because the tax law makes virtually no sense.
To illustrate the difference, let’s say you sell an apartment building for $1 million of gain and want to reinvest the proceeds into an opportunity zone and defer the gain. That apartment building, by definition, is not a capital asset. Instead, as a a depreciable asset used in a trade or business for more than a year, the building is a “Section 1231 asset.” The character of gain or loss on the disposition of a Section 1231 asset is a chameleon: if a taxpayer’s net Section 1231 gains or losses is a gain, the gain is treated as capital gain; if the net Section 1231 gains or losses is a loss, however, the loss is ordinary. Thus, because a net Section 1231 gain is taxed as capital gain, you will be able to defer the gain on the sale of the apartment building under Section 1400Z-2, even though the building is not a capital asset.
Q: So a building is not a capital asset but produces capital gain. Makes total sense. We’re off to a tough start in terms of me having any chance at understanding what this opportunity zone incentive is all about. Maybe I should toss you an easier question. When does the sale giving rise to the gain have to happen? Is this just a 2018 thing?
A: No, it’s not; we’ve got some time. The capital gain has to arise from a sale occurring AFTER December 22, 2017 and BEFORE January 1, 2027. So any time over the next eight-plus years, if a taxpayer sells property and generates capital gain, this deferral/exclusion opportunity will be at their disposal. As we’ll discuss later, however, the tax savings start to slip away for sales occurring after 2019.
Q: Anything else I need to know about the gain-producing sale that starts this whole process?
A: Yup. The statute provides that you CANNOT defer gain on the sale of property to a related person. For these purposes, you are “related” to a person if you and that person are described in Sections 267(b) or Section 707(b). The rules get a little tighter for a shareholder and a corporation, however. Ordinarily, a shareholder would only be related to a corporation if it owned 50% or more of the corporation. For these purposes, however, the threshold is lowered to 20%.
Q: Alright…so to summarize, if I sell property to an unrelated person giving rise to capital gain sometime between December 22, 2017 and December 31, 2026, I’m off to a good start. My gain can potentially be deferred/excluded under Section 1400Z-2, right?
A: You’ve got it. Why don’t we do this: let’s work with a basic set of facts. Assume you sell stock you’ve held for a few years with a basis of $1 million for $3 million on October 16, 2018, generating $2 million of capital gain that would ordinarily be reported on your 2018 Form 1040. You would really prefer not to recognize that gain on your 2018 tax return, however, and so you’re willing to consider all options, short of changing your name, fleeing the country, and starting a new life in the Sudan.
Q: Fair enough. So if I want to defer the $2 million of long-term capital gain in that scenario, what’s next?
180 Day Window to Reinvest Gain Proceeds
A: Listen up, because this part is critical: the date of the sale — October 16, 2018, in this case — starts the clock. From that day, you have 180 days to reinvest as much of the $2 million of gain that you would like to defer into a “qualified opportunity fund” (QOF). A couple of important things about that 180 day period:
- It would appear it is a firm 180 days, regardless of whether the 180th day lands on a weekend or holiday, and
- As you’re probably aware, 180 days is a long time. That’s like, five Ariana Grande engagements. So if you have a sale near the end of the year — say, December 10th, 2018 — the 180 day window will not close until AFTER the original due date of the tax return (April 15, 2019). And when April rolls around, you might not have made the decision whether you definitively want to reinvest your sales proceeds into a QOF, and thus, it follows, whether you can ignore the gain on your 2018 tax return. The lesson, of course, is that if you sell at the end of a year, you’ll want to extend your return for that year to buy yourself the full 180 days to decide on your next step.
- If you make the investment within 180 days, you have to actually elect to defer the gain. In other words, the deferral is not automatic, you have to proactively elect on your tax return to defer the gain via your investment in the QOF. This will apparently be done on Form 8949.
Q: Back up. In our example, I sold stock with a basis of $1 million for $3 million, realizing $2 million of gain. From the date of sale, I have 180 days to reinvest the cash if I want to defer the $2 million of gain. That much is clear. But do I have to reinvest $3 million to defer the gain (the full amount of the sales proceeds) or $2 million (the amount of the gain)?
A: Great question. This is the beauty of Section 1400Z-2. Like I pointed out in the intro, unlike like-kind exchanges under Section 1031, you don’t have to reinvest the full $3 million; rather, if you want to defer $2 million of gain, you simply have to reinvest $2 million into a QOF. As a result, you get to take $1 million of cash off the table and put it into your pockets. As I pointed out above, try that with a like-kind exchange, and you’ve got $1 million of taxable gain.
Q: But riddle me this — what if I only reinvest $1 million of the $2 million gain?
A: This ain’t rocket science. In that case, you only defer $1 million of gain. The other $1 million of gain must be recognized on your 2018 tax return. In other words, whatever you reinvest within 180 days — up to the amount of total gain recognized — is equivalent to the amount of gain you defer. Whatever you don’t reinvest, you recognize in the year of sale.
Q: Wait…why did you write “up to the amount of total gain recognized” in italics. Am I not allowed to reinvest MORE than my gain amount into a QOF? It would seem odd that Congress would limit the amount of your investment, no?
A: Of course you are allowed to reinvest more than your gain amount. It’s just that any amount you invest above and beyond your original gain amount is treated as a separate investment, and is not eligible for any of the deferral/exclusion benefits of Section 1400Z-2. So in our example, if you were to invest the entire $3 million you received from the sale of the stock within 180 days, you would be treated as having made two separate investments. The first, equal to $2 million, would allow you to defer the $2 million of gain and would be available for the additional benefits of Section 1400Z-2 that we’ll get into shortly. The second investment, equal to $1 million, would stand on its own as just an ol’ normal investment, with no potential future tax benefits attached to it. Got it?
Q: I think so. But what about this: what if early in the 180 day period I reinvest part of my gain amount, and then before the 180-day period ends, I reinvest more. Is that OK?
A: Yes, that’s fine, as long as both investments are made within the 180-day window.
Q: I’ve got a good one for you. Above, you said that if a partnership sells property for a gain and chooses not to reinvest the funds in a QOF, the partners can reinvest those gain amounts in their individual capacity and get the deferral/exclusion benefits. But explain this smart guy…what if the partnership sells the asset on, say, June 3rd, 2018? The partners wouldn’t even know the partnership sold the asset until they get their K-1 in March of 2019. The 180-day window will have already passed!!
A: I’m not sure I like your tone, but here goes. First, let’s talk about what happens if a partnership (or S corporation, trust or estate) DOES choose to defer the gain by reinvesting those amounts at the entity level within 180 days of the date of sale. In that case, the partnership doesn’t recognize the gain in the year of sale, and the gain is not passed out to the partners.
If, as in your hypothetical, however, the partnership chooses NOT to defer, then the partnership passes out the capital gain to all the partners under the normal allocation rules. Each partner then gets to decide at the partner level if he or she wants to defer his or her share of gain by reinvesting in a QOF. And here’s the trick: for each partner, the 180-day period begins on the last day of the partnership’s tax year. So in your situation where the asset was sold by the partnership on June 3rd, that date is ignored for the partners. Instead, the asset is treated as having been sold on December 31, 2018, so that the partners will each have until the end of June of 2019 to decide whether to take advantage of Section 1400Z-2. Not bad, eh?
Q: Bear with me…but what if the partners knew about the partnership sale of assets on June 3rd, and didn’t want to miss a great investment opportunity in a QOF, so they reinvested the cash right away, like in July or August. Wouldn’t they get screwed because the 180-day clock hadn’t even started yet — i.e., it doesn’t start until December 31, 2018?
A: You’re getting good at this. That’s exactly what would happen under the general rules. But of course, the IRS doesn’t want people waiting around for an arbitrary clock to start before reinvesting much needed funds into a desperate community, and so the proposed regulations allow a partner who is aware of a partnership sale to elect to treat the 180-day period as starting on the date of the actual sale. So if a partner knows the partnership sold its asset on June 3rd, 2018, the partner could elect to treat his or her 180-day period as starting on that date, so that they wouldn’t have to wait until December 31, 2018 to make their investment in a QOF.
Q: Don’t take this the wrong way; I appreciate what you’re trying to do. But so far, we’ve spent 2,500 words discussing eligible gain that can be reinvested, eligible taxpayers who can reinvest, and a 180-day window for making that investment, and yet I still have no idea what I’d actually be reinvesting in. Shouldn’t we take that on sooner or later?
A: Why yes, yes we should. That would be the aforementioned qualified opportunity fund, or QOF for short.
Q: So make with the knowledge. What is a QOF?
Qualified Opportunity Funds
A: A QOF may sound daunting, but it’s really pretty simple. It is any partnership or C corporation (no S corporations) that is “organized for the purpose of investing in qualified opportunity zone property.”
Q: Does it need to be a newly-formed entity? Or can you just use an old partnership or S corporation you have lying around?
A: Oh, it can be a pre-existing entity. But here’s the key: whether you’re using an old entity or setting up a new one, you have to be very careful: if you make an investment into an entity before it qualifies as a QOF, the investment won’t be eligible for deferral/exclusion benefits of Section 1400Z-2.
Q: But I still don’t understand how I know if a corporation or a partnership is “organized for the purpose of investing in qualified opportunity zone property?” Who makes that determination?
A: The fund does. In other words, the corporation or partnership is going to be able to self-certify that it is a QOF; there’s even a shiny new form (Form 8996) and everything. As part of the self-certification process, the corporation or partnership will tell the IRS the first tax year that it wants to be treated as a QOF, and even the first month. As we said above, this is critical because any investment made into the corporation or partnership before the first month it is a QOF will not be eligible for the deferral/exclusion benefits of Section 1400Z-2.
Q: So the corporation or partnership just says, “We’re a QOF” and that’s that? Seems odd. Shouldn’t a fund have to actually, you know, do something to be a QOF?
A: Oh, it has to do something alright. It has to take all that cash that has been invested by taxpayers looking to defer gain, and invest in”qualified opportunity zone property.” In fact, at least 90% of the assets of the fund must meet the definition of qualified opportunity zone property — a term that we’re going to have to dig into eventually — in order to remain as a QOF. And to prove this requirement has been satisfied, the fund will average the percentage of its assets that are qualified opportunity zone property twice a year: at the halfway point and again on the last day of the year. If the average of the qualified opportunity zone property falls below 90%, the QOF is going to pay penalty to the IRS on Form 8996.
Q: And how will this 90% be measured?
A: It depends. If the QOF has an “applicable financial statement” — think: a 10K or audit — then the fund has to measure each asset at its value as reported on that financial statement. If there is no applicable financial statement, the QOF will look to the cost of each asset.
Q: So other than self-certifying that a fund meets the 90% test, are there any other special requirements to setting up and maintaining a qualified opportunity fund?
A: Nope. That’s it. As I said, it may sound complicated, but anyone with an internet connection and a few spare minutes could set up a QOF. The real trick is making sure that the fund meets the 90% test once the fund has been formed.
Q: So that’s a QOF. It’s gotta’ be a corporation or partnership, and 90% of the assets have to meet the definition of “qualified opportunity zone property,” which at this point, is a term I do not understand. I can get behind that. But to start this thing off, we have to invest in a QOF. Can that investment take any form: like equity or a loan?
A: Nope. It has to be an equity investment. You have to put cash in the business in exchange for either stock or a partnership interest. A loan won’t cut it.
Q: Alright, so I have to invest my gain proceeds into a QOF, and a QOF has to invest in qualified opportunity zone property. I’m guessing this is the part where you tell me what qualified opportunity zone property is, right?
Qualified Opportunity Zone Property
A: You got it. But before we can do that, we should probably define an “opportunity zone,” since that’s kinda’ the point of everything we’re talking about. The idea of Section 1400Z-2 isn’t to reward a taxpayer with tax benefits in exchange for making the courageous decision to invest in Aspen real estate. Rather, Congress wanted to preserve the deferral/exlcusion benefits for those who invest in certain low income communities, i.e., opportunity zones.
Q: And how do I know where these opportunity zones are located?
A: You know that scene in Vacation when Chevy Chase is driving along, makes a wrong turn into a different part of town, and suddenly urges his family to “roll ’em up.” That part of town, my friend, is an opportunity zone.
I’m kidding, of course. Opportunity zones have nothing to do with crime rates or the like; rather, their common characteristic is that most of the inhabitants of an opportunity zone live well below the poverty level. The idea behind Section 1400Z-2, obviously, is to encourage those with the means to make a difference to do so by making NEW investments into businesses in these low-income areas. You can find a complete list of the zones here: https://www.cdfifund.gov/Pages/Opportunity-Zones.aspx.
Q: So, does everything have to be established in the opportunity zone? The QOF, the qualified opportunity zone business, etc…?
A: Yes and no. Or more accurately, no and yes. No, the QOF does not need to be formed in an opportunity zone. But yes, a qualified opportunity zone business MUST be located within a qualified opportunity zone. Or at least mostly. it’s confusing. We’ll get to it.
Q: Mostly? Oh boy, here we go. So tell me, how do we know if a QOF is operating within a “qualified operating zone?”
A: Stay with me here…first things first, a QOF will be treated as operating with an opportunity zone if at least 90% of its assets are “qualified opportunity zone property” (QOZP). A QOF can invest in QOZP in one of three ways: