It’s been widely reported that the October 2018 tranche of opportunity zone regulations created a major disruption for operating businesses who wanted to use the opportunity zone tax incentive to raise equity, and in turn finance an expansion or relocation. Thankfully, the April 2019 proposed regulations largely eradicated that disruption. They provide several safe harbors that allow operating businesses, whose customers aren’t based in an opportunity zone, to take advantage of the Opportunity Zone Program. They also include very favorable rules that allow leased real property to be treated as qualified opportunity zone business property even if the tenant does not substantially improve the property.
However, with the proposed regulations, the Treasury gave with one hand while taking away with the other, creating another major disruption for the opportunity zone ecosystem. This time, the disruption impacts all potential investors, qualified opportunity funds (QOF), and qualified opportunity zone businesses (QOZB) that are involved in a transaction where gains from the sale of business property (including real estate) will be invested into a QOF. It all ties back to a little-understood section in the Internal Revenue Code (IRC) – Section 1231. In particular, the new proposed regulations significantly impact the timing of the investment of Section 1231 gains into QOFs. They likely impact QOF investments that have already been made, as well as those that are planned in the near future.
All participants in opportunity zone investment transactions should become familiar with Section 1231 and the potential disruptive impact of Treasury’s guidance on the opportunity zone industry. To mitigate the negative impact of Treasury’s April 2019 proposed regulations, investors and QOFs should take the steps noted below.
What is Section 1231?
Generally speaking, Section 1231 is a very taxpayer-friendly code section. It provides taxpayers with the best of both worlds when it comes to the character of gain/loss from the sale of assets used in a trade or business for more than one year (i.e., Section 1231 assets). In particular, gain recognized on the sale of Section 1231 assets is generally treated as capital gain, which is taxed at favorable capital gain tax rates. However, loss recognized on the sale of Section 1231 assets is generally treated as an ordinary loss and is immediately deductible against ordinary income, which is taxed at higher rates. Buildings, land, machinery, and equipment can all qualify as Section 1231 assets. Due to nuances of the tax law, certain passive real estate investments such as land held for investment and property subject to a true triple-net lease (where no services are provided by the landlord) aren’t eligible for favorable Section 1231 tax treatment.
The last — and most important — fact about Section 1231 is that gains and losses from the same tax year must be netted to determine the character of the net gain/loss. Taxpayers with a net Section 1231 gain are only eligible for favorable capital gain treatment to the extent that such net gain exceeds net Section 1231 losses over the past five tax years. For example, if a taxpayer has a Section 1231 gain of $1 million and a Section 1231 loss of $300,000 in the same tax year, such taxpayer’s net Section 1231 gain of $700,000 will be eligible for favorable capital gain treatment. In addition, if that same taxpayer had a $200,000 net Section 1231 loss three years ago, then only $500,000 of the current-year net Section 1231 gain will be eligible for favorable capital gain treatment and the residual $200,000 of the current year gain will be taxed at higher ordinary income tax rates.
How will Treasury’s Section 1231 guidance disrupt opportunity zones?
So how could this taxpayer-favorable provision possibly disrupt the opportunity zone industry? The answer lies in the Treasury’s determination as to when the 180-day investment period begins for such gains as outlined in the April 2019 proposed regulations. The October 2018 proposed regulations clarified that only capital gains can be deferred via investment into a QOF. The new regulations acknowledge that, as a result of the netting process discussed above, a taxpayer cannot know if a Section 1231 gain will be taxed as a capital gain until their tax year is over. Consequently, the new regulations take the position that for all Section 1231 gains, a taxpayer’s 180-day investment period doesn’t begin until the last day of their tax year.
This means that all calendar-year taxpayers with net Section 1231 gains have the same 180-day investment period — beginning on December 31 of the year the gain is recognized. Prior to the issuance of the new proposed regulations, many taxpayers assumed that the reinvestment period for Section 1231 gains was the same as the reinvestment period for gains from capital asset sales, which begins on the date of the sale. The October 2018 regulations also clarified that owners of a pass-through entity can chose between two different 180-day periods for their share of the pass-through entity’s capital gain — beginning on the date of the sale or the last day of the pass-through entity’s tax year.
This new guidance could have significant impacts, mostly negative but some positive. Following are some of the highlights:
- Blackout period during second half of each year: Taxpayers cannot invest Section 1231 gains in QOFs during the second half of any tax year, other than on December 31. Consequently, QOFs closing transactions in the second half of any tax year will need to seek investments from taxpayers whose capital gains aren’t associated with the sale of business property.
- Overload of December 31 QOF investments: There could be an overload of opportunity zone investments funded on December 31, particularly around significant dates:
- Dec. 31, 2019 – The last day to take advantage of full 15 percent gain exclusion
- Dec. 31, 2021 – The last day to take advantage of 10 percent gain exclusion
Thankfully, the new regulations allow QOFs to disregard capital contributions received within six months from the 90 percent asset test, otherwise QOFs receiving significant investments on December 31 would’ve been required to fund them into qualified opportunity zone property on the same day. It’s also worth noting that December 31 falls on a weekend in 2022 and 2023, creating potential issues if investors need to initiate a wire transfer to fund their investment, or if investors or QOFs need to take out or repay a bridge loan.
- Delay in investment window: Taxpayers’ ability to invest Section 1231 gains into a QOF will be delayed by almost a year for sales occurring early in the tax year. While this will provide investors with more time to find good investments, it also may preclude investors who find a good investment sooner from making it. This delay will also make it more challenging for QOFs and QOZBs to raise capital.
- Extra time to invest 2018 Section 1231 gains: One potentially positive impact of this guidance is that it extends the deadline for investment of 2019 net Section 1231 gains, since it’s now clear that the 180-day investment period isn’t tied to the date of sale. Consequently, taxpayers with 2019 net Section 1231 gains can invest them into a QOF from December 31, 2019 through June 27, 2020.
- Delay in sale/unwind for QOF investors: The delay in the investment window for taxpayers with net Section 1231 gains could negatively affect investors contributing gains from the sale of capital assets into the same QOF. In particular, if the fund allows investors with Section 1231 gains to contribute such gains at a later time than the rest of the investors, such staggered investments could delay the timing of the sale/unwind of the investment to accommodate the Section 1231 investors’ 10-year holding period requirement (to enable such investors to exclude post-acquisition gains).
- Pass-through entity eligibility to defer Section 1231 gains: The April 2019 proposed regulations create uncertainty around whether or not a pass-through entity can elect to defer Section 1231 gains, since the determination as to whether or not a Section 1231 gain is eligible for capital gain treatment is made at the pass-through-entity-owner level, not at the pass-through-entity level. This could mean that Section 1231 gains at the pass-through-entity level must be passed through to the individual owners to be invested in a QOF, even if the pass-through entity prefers to make such an investment on behalf of its owners.
- Invalidity of prior investments: Previously funded QOF investments may not be valid, particularly:
- 2018 net Section 1231 gains that were invested before Dec. 31, 2018.
- Any investments of 2019 Section 1231 gains, which cannot be invested until Dec. 31, 2019.
- Investments of Section 1231 gains made by a pass-through entity.
- Investments of Section 1231 gains by taxpayers with Section 1231 losses in the current tax year or unrecaptured Section 1231 losses during the previous five tax years.
- Reconsider opportunity zones vs. Section 1031: Taxpayers selling Section 1231 assets should take a closer look at using a Section 1031 like-kind exchange to defer such gain. In particular, they should reassess if the limitations imposed by the April 2019 regulations as outlined above outweigh the other advantages of the Opportunity Zone Program such as the ability to defer the gain by only reinvesting the gain versus the entire proceeds.
What are potential solutions to the Section 1231 opportunity zone disruption?
To mitigate the impact of the issues discussed above, all investors and QOFs should review previous and future QOF investments involving Section 1231 gains and consider potential revisions to the structure, including:
- Identify any potentially invalid investments of Section 1231 gains and consider how/if such investments can be restructured to comply with the April 2019 proposed regulations.
It is worth noting that the IRS expanded its opportunity zones FAQs to limit the extent to which the proposed regulations invalidate prior investments. The revised FAQs state that if a taxpayer’s tax year ended before May 1, 2019 the taxpayer can make a valid deferral election even if they invested net Section 1231 gains into a QOF before the last day of their tax year. The FAQ also clarified that making such deferral election does not impair the taxpayer’s ability to rely on all other aspects of the April 2019 proposed regulations.
It is also worth noting that during a presentation at a conference, a Treasury official indicated informally that pass-through entities can invest their net Section 1231 gains.
Treasury has not yet provided any potential formal or informal relief for taxpayers that made investments into a QOF before the April 2019 regulations were released to defer 2019 Section 1231 gains or to defer 2018 and 2019 gross (vs. net) Section 1231 gains.
- To mitigate the potential negative impact of the second half of the year blackout period and the delay in the investment window, QOFs should identify creative ways to facilitate investments from taxpayers with Section 1231 gains during such periods. Such solutions could involve the use of bridge financing or convertible loans. It’s worth noting that QOFs should be careful and consider that a loan conversion could trigger cancellation of debt income to the QOF. In addition, attention to detail will be required with respect to aspects such as accrued interest.
The Department of Treasury has stated publicly that they are working to finalize both sets of opportunity zone proposed regulations before the end of 2019. If the regulations are finalized before the end of 2019, it will be important to review such final regulations and consider any changes from the proposed regulations before making a new investment into a QOF, since such regulations are expected to supersede the October 2018 and April 2019 regulations effective upon their publication. When such regulations are finalized, we hope that Treasury eliminates the disruptions related to Section 1231 gains discussed above by adopting one of the following potential solutions submitted by commentators (in order of least disruptive):
- Allow taxpayers to invest gross Section 1231 gains vs. net Section 1231 gains — similar to allowing investment of gross capital gains instead of net capital gains.
- Allow taxpayers with Section 1231 gains to follow the same timing requirements as taxpayers with gains from the sale of capital assets to the extent they have net Section 1231 gains on the date of their investment in the QOF (i.e., disregard Section 1231 losses recognized after the investment in the QOF).
- Allow taxpayers with Section 1231 gains to follow the same timing requirements as taxpayers with gains from the sale of capital assets to the extent such investors are willing to accept the risk that Section 1231 losses later in the tax year will create a mixed-fund investment, which will cause part of their post-10-year gain from the QOF investment to be taxable.
Absent a change in Treasury’s interpretation, the steps necessary to lessen the impact of Treasury’s Section 1231 guidance will depend on the facts and circumstances of the participant’s specific situation. Feel free to contact one of our opportunity zone experts to help you determine alternatives and the best strategy for your circumstances.
