Tucked inside the 2017 Tax Cuts and Jobs Act was a very limited, but potentially significant, tool for deferring and reducing capital gains. The law’s objective is to promote investment in qualified opportunity zones. For more information on QOZs, see my prior article. Now, the Internal Revenue Service has issued proposed regulations regarding QOZs. This enables advisors to make more specific recommendations to their clients. They need to act quickly, though, because taxpayers must invest before Dec. 31, 2018 to receive maximum benefits from qualified opportunity fund investments. Below are some of the highlights from the proposed regulations.
Corporations and Partnerships May Defer Gain
In addition to individual investors, corporations and partnerships may defer capital gains by investing in QOFs. The regulations clarify that, generally, any U.S. taxpayer that pays capital gains tax is eligible for deferral. For example, real estate investment trusts may defer gains using QOF investments. QOFs may be particularly useful for REITs because the QOF rules are designed primarily for real estate investment.
Any entity taxed as a partnership has two opportunities to invest in a QOF and elect deferral. First, the partnership can elect deferral at the partnership level. If the partnership receives gains in a tax year and doesn’t make a QOF investment and election, then the individual partners have a second chance to do so. As long as no election was made at the partnership level, any individual partner may invest their share of partnership gains in a QOF and make a personal election.
Taxpayers Without Gains May Not Elect Deferral
Unfortunately, taxpayers can’t benefit from the preferential tax treatment of a QOF unless they have capital gains to defer. For example, a client may have some cash available to invest, but no realized capital gains in the current year. A client may want to invest in a QOF to get a stepped-up basis on the sale of the QOF property after 10 years, but this benefit isn’t available to that taxpayer. The regulations make it very clear that only capital gains are eligible for tax deferral, and only deferred gains are eligible for the stepped-up basis.
If a client has family members who are unable to invest in QOFs because they don’t have large gains, the client could give them appreciated assets to allow them to realize gains and invest in a QOF before Dec. 31, 2018. This strategy allows other family members to invest in QOFs and obtain the maximum available deferral, but it doesn’t leverage the client’s available gift tax exemption. An even better strategy may be to form a limited liability company, contribute appreciated assets to it and then have the LLC sell those assets and invest the gains in a QOF before Dec. 31, 2018. Over time, the client can gift discounted minority LLC interests to family members, and all of the LLC’s members will benefit from its deferred gains.
Preferred Stock Can Be an Eligible Interest in a QOF
A loan to a QOF doesn’t qualify for deferral of capital gains tax, but other, similar interests may qualify. The proposed regulations tell us that preferred stock and partnership interests with special allocations may be eligible QOF interests because they’re equity interests and not debt. The regulations draw this conclusion even though preferred stock and special partnership allocations can mimic the behavior of debt instruments. For clients who want the lower risk and more regular payments associated with a loan, planning options may be available.
Taxpayers May Roll Over QOF Investments
Once a taxpayer holds a QOF interest, the taxpayer may effectively roll over that interest into a new QOF and continue the original deferral of gain. This rollover process must include a sale of all of the taxpayer’s original QOF investment. To clarify, the taxpayer doesn’t have to reinvest all of the proceeds of the sale, but the taxpayer must sell the whole original QOF investment. Whether a rollover reinvests some or all of the original QOF investment, the rolled-over gains will retain their prior tax attributes. This means that when the property is finally taxed, it will have the same tax character as if it had remained in the original QOF.
Taxpayers May Divide a Gain Among Several QOFs
If a taxpayer has a large gain, the taxpayer may invest in several QOFs and make a separate election for each QOF investment. In fact, dividing a large gain among several QOFs may be a great strategy. It allows investment diversification and it makes it easier to roll over underperforming interests in the future. Before the regulations were published there was some question regarding whether or not investors could do this because the QOF statute prohibits multiple elections for the same property. The regulations clarify that when a taxpayer invests part of its capital gains and makes a QOF election, the election only applies to that investment. The QOF election doesn’t apply to the rest of the capital gains. Therefore, if the taxpayer invests more of the capital gains in another QOF and makes another election, it isn’t treated as a second election for the same property.
Maximum Deferral Period
The regulations provide that all sales of QOF property must be completed by Dec. 31, 2047 to be eligible for gain deferral. This is just over 20 years after the date that the QOZ designation terminates.
The regulations also confirm that the latest gain subject to deferral would be recognized in 2026. Gain recognized on Dec. 31, 2026 must be invested in a QOF by late June 2027, with a timely election. Any gains recognized in 2027 or after wouldn’t qualify for QOF deferral under the current legislation.
Timeline for Final Regulations
The proposed regulations were issued on Oct. 19, 2018. The period for comments ends 60 days later, on Dec. 18, 2018. A public hearing is scheduled for Jan. 10, 2019 at 10:00 a.m., and final regulations may be issued after that date.
Ruth Mattson is a partner at Vacovec, Mayotte, & Singer, LLP, in Newton, Mass.