By: Rachel Parsia, CPA and Nick Spoltore, Esq.
It is that dreaded time of the year. The holidays are over. No longer is it socially acceptable to wake up and eat a plate of candy and cookies for breakfast. Even worse, busy season is looming just around the corner. But fear not, there is one thing that we can still look forward to – reading all 544 pages of the Final Qualified Opportunity Zone (QOZ) Regulations! These final opportunity zone regulations were issued by the U.S. Treasury Department and the IRS on December 19, 2019, and they provide clarity on proposed regulations issued on October 29, 2018 and May 1, 2019.
The concept of the QOZ tax incentive was first introduced by the Tax Cuts and Jobs Act (TCJA), and it has captured the attention of accountants and investors ever since. The purpose of the QOZ tax incentive is to spur investment and economic growth in 8,764 designated low-income communities across the United States. When a taxpayer realizes an eligible gain, he or she has a 180-day period to reinvest the gain into a Qualified Opportunity Fund (QOF). The QOF will either invest directly into QOZs or acquire an interest in a Qualified Opportunity Zone Business (QOZB).
In return for their investment, investors can: 1) temporarily defer capital gains until December 31, 2026, 2) partially exclude these deferred capital gains to the extent holding period requirements are met, and 3) permanently exclude post-acquisition gains provided the investment in the QOF was held for at least 10 years. You may be thinking, “Easy enough! I will buy land in a QOZ and hold it for 10 years.” Not quite – the law specifically states that “substantial improvement” must occur in order to bring value to the QOZ and improve the lives of its residents.
The final regulations are generally more favorable to taxpayers than prior proposed regulations. Some of the key highlights of the final regulations are discussed below.
Flexibility in Timing
Final regulations allow taxpayers to invest gross §1231 gains, whereas proposed regulations required taxpayers to invest net §1231 gains. Generally, net §1231 gain or loss is calculated at the end of the tax year, and thus under proposed regulations, the taxpayer’s 180-day period for investment into a QOF could not begin until the end of the year. The final regulations do not require taxpayers to wait until the end of the year to begin their period of investment.
Final regulations allow taxpayers who receive capital gains from a partnership, S corporation, RIC, or REIT to elect to start the 180-day investment period on the due date of the pass-through entity’s tax return, not including extensions. This provides taxpayers with more time to get information about their allocable gains from their Schedule K-1s.
Under proposed regulations, investors had to determine substantial improvement of a QOZ property on an asset-by-asset basis. Final regulations ease this approach and allow for general aggregation of property when determining substantial improvement, so long as the property is used in the same trade or business and in the same QOZ. Final regulations also stipulate that asset aggregation of buildings is permitted with respect to the substantial improvement rule.
Post 10-year dispositions
Arguably one of the greatest tax benefits of investing in a QOF is that taxpayers can exclude from gross income any post-acquisition gains from a QOF after the 10-year holding period is met. Proposed regulations stated that a taxpayer could only exclude gains on the sale of a QOF interest or the flow-through gain from a QOF’s sale of a QOZB interest, provided the 10-year holding period was met. Final regulations permit both sales of assets or interests in QOZBs to be excluded from gain when investment in a QOF is longer than 10 years. These final regulations are embraced by investors, as they clear up much of the uncertainty around exit-planning strategies.
The changes discussed above represent only a few of the many topics addressed in the final QOZ regulations. Aside from tax considerations, each investment into a QOZ should be evaluated based on its merits and profit potential. We are not investment advisors, so our focus is on tax aspects, not the underlying viability of the investments. If you are interested in learning more about Qualified Opportunity Zones, including more technical requirements issued in the final regulations, sign up for Tax Advantages of Investing in Opportunity Zones (OZTA).
Rachel Parsia, CPA is Manager of Tax & Advisory Content for Surgent CPE. She attended Penn State University, graduating with a master’s degree and bachelor’s degree in accounting, as well as a bachelor’s degree in finance. Before joining Surgent, she worked at KPMG and TE Connectivity Ltd. and has experience in Federal Tax, International Tax, and Tax Forecasting.
Nick Spoltore is VP of Tax & Advisory Content for Surgent CPE. Mr. Spoltore is a graduate of the University of Notre Dame and of Delaware Law School. Before joining Surgent, he practiced tax and business law at the firm of Heaney, Kilcoyne in Pennsylvania and also in Delaware.