The IRS is back at modifying frequently asked questions (FAQ) on its website for TCJA related changes, this time related to the Qualified Opportunity Zone investments under IRC §1400Z-2.  But unlike the significant additions made to the §199A FAQ just before the filing deadline for 2018 returns, this time the IRS added a single question and answer to its Opportunity Zones Frequently Asked Questions page.[1]

The second set of proposed regulations for Qualified Opportunity Zone funds published in the Federal Register on May 1[2] provides the following rule on the reinvestment of §1231 gains, specifically providing a rule for when the 180-day period begins that took some taxpayers by surprise:

(iii) Gains from section 1231 property. The only gain arising from section 1231 property that is eligible for deferral under section 1400Z-2(a)(1) is capital gain net income for a taxable year. This net amount is determined by taking into account the capital gains and losses for a taxable year on all of the taxpayer's section 1231 property. The 180-day period described in paragraph (b)(4) of this section with respect to any capital gain net income from section 1231 property for a taxable year begins on the last day of the taxable year.[3]

Why the IRS did this is because the actual determination of whether a §1231 gain will be treated as a capital gain takes place at the end of year, taking into account all other §1231 transactions that took place during the year.[4]

Example

Harry sells a rental property for a $125,000 §1231 gain on January 10, 2018.  On December 28, 2018 he sells a second rental property, incurring a $200,000 §1231 loss.

To determine the nature of these gains and losses, Harry must combine all §1231 gains and losses.  When Harry does that, he finds he has incurred a net §1231 loss of $75,000 for the year.  Per IRC §1231(a)(2), none of Harry’s §1231 gains or losses for the year are treated as capital gains or losses.

This created issues for taxpayers who invested in qualified opportunity zone funds based on §1231 gains incurred in 2018, since they were not aware the 180-day period did not begin until December 31, 2018 for calendar year taxpayers.

In fact, such taxpayers who incurred a §1231 gain prior to July 1, 2018 likely believed they had to reinvest the gain in a qualified opportunity fund prior to December 31—if they had waited until December 31 or later to make the investment, they assumed they would have been investing after the end of the 180-day period.

In the FAQ updated on June 28, 2019 the IRS provided the following limited relief via a new question and answer added at the end of the document:

Q: Before the last day of my 2018 tax year but during the 180-day period beginning with the realization of a section 1231 gain, I invested the amount of that section 1231 gain into a QOF.  The amount that I invested was less than my 2018 net section 1231 gain.  Can I make a valid deferral election based on that investment, even though proposed regulations say that the 180-day period for my net section 1231 gain began on December 31, 2018?

A:  Yes.  Under these facts, because your tax year ended before May 1, 2019, your QOF investment can support a valid deferral election.  Making that election will not impair your ability consistently to rely on all other aspects of proposed regulations published on May 1, 2019.[5]

That is, for tax years ending before the publication of the proposed regulations, the taxpayer may start the 180-day period on the date the §1231 transaction giving rise to the gain took place.  Note that this will not necessarily save the investment for all taxpayers who may have rushed out to reinvest gains incurred early in 2018.

Example

Assume Harry had rushed out to reinvest the $125,000 gain he had incurred in early 2018, believing the 180-day period would end in July 2018.  Since at the end of the year it was determined that Harry had a net §1231 loss, the amount he put into the qualified opportunity fund (QOF) will not qualify for the special benefits provided for reinvested gains.

That not only means that Harry’s $125,000 gain will offset the $200,000 loss, but also that he will not be eligible to treat the basis of the QOF as equal to the selling price if he holds the interest for more than ten years.  Rather, the disposition will be taxed under the standard rules for sales of the interest in the type of entity that Harry invested in.

Advisers should remember that the IRS asked specifically for comments on the §1231 gain treatment, so the final regulations may revise the proposed treatment of §1231 gains.[6] 

[1] https://www.irs.gov/newsroom/opportunity-zones-frequently-asked-questions, revision date June 28, 2019, retrieved July 2, 2019

[2] REG-120186-18; 84 F.R. 18652-18693; 2019-21 IRB 1193

[3] Prop. Reg. §1.1400Z2(a)-1(b)(2)(iii)

[4] IRC §1231(a)

[5] https://www.irs.gov/newsroom/opportunity-zones-frequently-asked-questions, revision date June 28, 2019, retrieved July 2, 2019

[6] REG-120186-18, Preamble Explanation of Provisions, Section IV