On Dec. 19, 2019, the U.S. Department of Treasury and the Internal Revenue Service (collectively, the Treasury Department) released long-awaited final regulations on qualified opportunity funds (QOFs): The final regs come on the heels of two tranches of proposed regulations, which generated more than 300 comment letters from organizations and other interested parties. The American College of Trust and Estate Counsel (ACTEC) submitted two separate comment letters to the Treasury Department on trust and estate related issues, the second of which was dated June 27, 2019.
The 2017 Tax Cuts and Jobs Act (TCJA) included a new tax incentive provision that is intended to promote investment in economically-distressed communities, referred to as “opportunity zones.” Through this program, investors can achieve the following three significant tax benefits:
- The deferral of gain on the disposition of property to an unrelated person generally until the earlier of the date on which the subsequent investment is sold or exchanged or Dec. 31, 2026, so long as the gain is reinvested in a QOF within 180 days of the property’s disposition;
- The elimination of up to 15% of the gain that’s been reinvested in a QOF provided that certain holding period requirements are met; and
- The potential elimination of tax on gains associated with the appreciation in the value of a QOF, provided that the investment in the QOF is held for at least 10 years.
An opportunity zone is an economically-distressed community where new investments, under certain conditions, may be eligible for preferential tax treatment. Localities qualify as opportunity zones if they’ve been nominated for that designation by the state, and the IRS has certified that nomination. All opportunity zones were designated, as of June 14, 2018, and are available on the U.S. Department of Treasury website.
A QOF, in turn, is an investment vehicle that’s established as either a domestic partnership or a domestic corporation for the purpose of investing in eligible property that’s located in an opportunity zone and uses investor gains from prior investments as a funding mechanism.
To become a QOF, the entity self-certifies itself. The entity must meet certain requirements, in particular a general requirement that at least 90% of its assets be “qualified opportunity zone property” used within an opportunity zone, but no approval or action by the IRS is required. To self-certify, the entity completes Form 8996 and then attaches that form to the entity’s timely-filed federal income tax return for the taxable year (taking into account extensions).
So how did the final regs come out on trust and estate related issues?
Income in Respect of a Decedent
Income in respect of a decedent (IRD) concepts under Internal Revenue Code Section 691 apply on the death of a taxpayer who’s deferred gain through a timely reinvestment of gain in a QOF. TCJA Section 1400Z-2(e)(3) provides that “[i]n the case of a decedent, amounts recognized under this section shall, if not properly includible in the gross income of the decedent, be includible in gross income as provided by section 691.” This statutory provision raises questions concerning the appropriate treatment of the deferred gain when a person who’s rolled over gain through a timely investment in a QOF dies prior to Dec. 31, 2026 without having previously disposed of the QOF investment.
The final regs resolved these questions consistent with IRC Section 691, which sets forth the rules that apply to a person’s receipt of IRD. IRD refers to income earned by a decedent who was a cash basis taxpayer prior to his death, but that’s not properly includible in income until after the decedent’s death. IRD isn’t reportable on the decedent’s final income tax return. Rather, it’s reportable by the recipient of the IRD item (for example, by the decedent’s estate or some other person). One very significant aspect of IRD is that IRC Section 1014(c) denies a step-up in basis at death to items of IRD.
The final regs state, as a general rule, that “a transfer of a qualifying investment by reason of the taxpayer’s death is not an inclusion event” and provides the following examples:
(A) A transfer by reason of death to the deceased owner’s estate;
(B) A distribution of a qualifying investment by the deceased owner’s estate;
(C) A distribution of a qualifying investment by the deceased owner’s trust that’s made by reason of the deceased owner’s death;
(D) The passing of a jointly owned qualifying investment to the surviving co-owner by operation of law; and
(E) Any other transfer of a qualifying investment at death by operation of law.
The final regs then specify that the following transfers are not considered transfers by reason of the taxpayer’s death and thus are inclusion events, with the amount recognized to be includible in the gross income of the transferor as provided in Section 691.
(A) A sale, exchange or other disposition by the deceased taxpayer’s estate or trust, other than a distribution described in items (A) – (E) above.
(B) Any disposition by the legatee, heir or beneficiary who received the qualifying investment by reason of the taxpayer’s death; and
(C) Any disposition by the surviving joint owner or other recipient who received the qualifying investment by operation of law on the taxpayer’s death.
Of particular relevance, TCJA Section 1400Z-2(b)(2) contains a special rule that caps the amount of the gain so as not to exceed the fair market value (FMV) of the investment as of the date that the gain is included in income. It provides:
- AMOUNT INCLUDIBLE.—
- 1400Z-2(b)(2)(A) IN GENERAL.— The amount of gain included in gross income under subsection (a)(1)(A) shall be the excess of—
- the lesser of the amount of gain excluded under paragraph (1) or the fair market value of the investment as determined as of the date described in paragraph (1), over
- the taxpayer’s basis in the investment.
In addition, the final regs contain a special rule for determining the amount includible for partnerships and S corporations (S corps). Specifically, Treasury Regulations Section 1.1400Z2(b)-1(e)(4) provides that, in the case of an inclusion event involving a qualifying investment in a QOF partnership or S corp, or in the case of a qualifying investment in a QOF partnership or S corp held on Dec. 31, 2026, the amount of gain included in gross income is equal to the lesser of --
- The product of--
(A) The percentage of the qualifying investment that gave rise to the inclusion event; and
- The remaining deferred gain, less any basis adjustments pursuant to section 1400Z-2(b)(2)(B)(iii) and (iv); or
- The gain that would be recognized on a fully taxable disposition at fair market
- of the qualifying investment that gave rise to the inclusion event.
It’s incumbent on estate planners to consider strategies to provide liquidity on the so-called “judgment day” of Dec. 31, 2026 when the taxpayer dies prior to that date. This may include life insurance – perhaps held through an irrevocable life insurance trust of which the person who inherits the QOF interest under the insured’s estate plan is a primary beneficiary. Along these lines, in its Comment Letter, ACTEC suggested a possible extension of the “judgment day” when death has occurred prior to Dec. 31, 2026. The Treasury Department, however, declined to adopt ACTEC’s suggestion on the grounds that the QOF statute doesn’t allow for the deferral of gain beyond Dec. 31, 2026.
Gift of Interest in QOF
The final regs confirm that a donor’s gift of an interest in a QOF will be an inclusion event for the deferred gain unless the gift is made to a grantor trust. The final regs generally treat gifts as constituting an inclusion event, regardless of whether that transfer is a completed gift for federal gift tax purposes and regardless of the taxable or tax-exempt status of the donee of the gift. An exception applies, however, in the case of gifts to grantor trusts – as they generally wouldn’t involve a change in the taxpayer for federal income tax purposes. According to the Treasury Department, its position that gifts generally constitute inclusion events is supported by the legislative history (although the Treasury Department’s position would appear to be contrary to the unambiguous language of the QOF statute, which ACTEC pointed out in its Comment Letter). Similarly, transactions involving QOF interests between spouses are also treated as inclusion events (unless a grantor trust is involved).
Transactions With Grantor Trusts
As suggested by ACTEC, the Treasury Department has now clarified in the final regs that a broad array of transactions between a grantor and that grantor’s grantor trust that involve QOFs won’t constitute an inclusion event. The proposed regulations had limited this exception solely to gifts to grantor trusts. The final regs expand the scope of this exception to inclusion event treatment to include other transactions as well between a grantor and that grantor’s grantor trust and, as such, will also embrace sales to grantor trusts, the grantor’s exercise of the power to substitute assets with a grantor trust and distributions of QOF interests to the grantor from a grantor retained annuity trust. (This was also requested by the New York State Society of Certified Public Accountants (NYSSCPA) in its Comment Letter.)
In addition, the Treasury Department has clarified that it doesn’t matter whether the gain that is sought to be deferred, or the funds that are subsequently invested in the QOF, belong to the taxpayer or to such taxpayer’s grantor trust.
Also, at ACTEC’s suggestion, the final regs provide partners of a partnership, shareholders of an S corp and beneficiaries of decedents’ estates and non-grantor trusts with the option to treat the 180-day period as commencing on the due date of the entity’s tax return, not including any extensions. (This was also requested by the NYSSCPA in its Comment Letter.) ACTEC expressed concern in its Comment Letter about the potential for an “information gap” to exist between the partnership, S corp, executor and trustee, on the one hand, and the partner, S-corp shareholder and beneficiary on the other hand. The Schedule K-1 is the mechanism for a partnership, S corp, estate or trust to report tax attributes – including capital gains – not only to the IRS, but also to the partner, S-corp shareholder or beneficiary, as the case may be. If the tax return for the pass-through entity is placed on extension, there will be a substantial possibility that the Schedule K-won’t be issued until more than 180 days after the end of the tax year, at which point the opportunity to roll over gain to a QOF will have been lost. The Treasury Department was sensitive to this concern and responded by allowing taxpayers this option to treat the 180-day period as commencing on the due date of the entity’s tax return, not including any extensions.