Briefing: QOZ Update: IRS Provides Relief for Early Investments of Net Section 1231 Gain
There are many complex and confusing aspects to the qualified opportunity zone (QOZ) program, and the treatment of Section 1231 gain is no exception.
Internal Revenue Code Section 1231 applies to depreciable property and real property used in a trade or business that is held for more than one year. On the last day of a taxpayer’s tax year, the taxpayer’s gains and losses from sales of Section 1231 property are netted to determine if the taxpayer has net Section 1231 gain or net Section 1231 loss. Net Section 1231 gain is treated as long-term capital gain (subject to a recapture rule) and net Section 1231 loss is treated as an ordinary loss.
Because a taxpayer will not know if it has net Section 1231 gain until the end of a tax year, the April 2019 Proposed Regulations treat net Section 1231 gain as recognized on the last day of the tax year and start the first day of the taxpayer’s 180-day period to roll over the gain on the last day of the taxpayer’s tax year. This creates a less favorable result for net Section 1231 gain than for other capital gain because, unlike other capital gains, only the net amount, not the gross amount, may be rolled over into a qualified opportunity fund (QOF).
Under the April 2019 Proposed Regulations, a taxpayer cannot roll over net Section 1231 gain by investing an amount equal to that gain in a QOF before the last day of the taxpayer’s tax year. Prior to the April 2019 Proposed Regulations, most practitioners and taxpayers thought that the 180-day rollover period started on the date of the sale giving rise to the gain, even for Section 1231 gain. As a result, some taxpayers invested Section 1231 gain into a QOF before the end of their tax years, which technically would make the investment ineligible for QOZ benefits.
The IRS fixed this timing problem by posting a new FAQ on its qualified opportunity zone webpage. The FAQ guidance allows a taxpayer whose tax year ended before May 1, 2019, to elect to defer net Section 1231 gain by investing in a QOF within 180 days of the sale that produced that Section 1231 gain to qualify as an eligible investment, even if that investment was made before the last day of the taxpayer’s tax year. However, this new FAQ does not provide relief for a taxpayer that invested more than the amount of its net Section 1231 gain, either timely or within 180 days of a sale, but before the end of its tax year.
Among the QOZ benefits available to taxpayers is elimination of 15 percent of the taxpayer’s rollover gain if the investor does not have an inclusion event before December 31, 2026, and the investor holds its QOF interest for at least seven years. The last day to make an investment in a QOF that is eligible for this seven-year benefit is December 31, 2019. As a result, the rule that prohibits a qualifying rollover of net Section 1231 gain until the last day of a taxpayer’s tax year means that the first day net Section 1231 gain from a 2019 sale may be invested in a QOF is December 31, 2019, for calendar year pass-through entities and for almost all individual taxpayers. This means that Tuesday, December 31, 2019, could be a very busy day for many taxpayers.