Ever since the Qualified Opportunity Zones (OZ’s) were born out of the Tax Cuts and Jobs Act in December 2017, questions have arisen regarding how Opportunity Zone funds function and the tax benefits and rules for investors. The IRS has dutifully responded to these inquiries, offering two tranches of proposed regulations and clarification, the most recent in April 2019.

In that ruling, the IRS provided additional guidance on the treatment of gains and losses as specifically applied to the sale of what’s known as Section 1231 property. The Internal Revenue Code defines Section 1231 property as real or depreciable property used in a trade or business and held for more than one year.  Examples include buildings, machinery, land, timber, and other natural resources, unharvested crops, cattle, livestock, and leaseholds that are at least one year old.

But here’s the catch. Current law states that gains from the sale of a property must be invested in an Opportunity Zone Fund within 180 days of when the capital gains were realized (i.e. the date the property sold) in order to receive the preferred tax-deferred benefits afforded by the OZ investment. Section 1231 properties, however, are handled differently because they are not subject to capital gains.

Because gains on “real or depreciable property used in a trade or business” are treated as Section 1231 gains rather than capital gains, different rules apply. A Section 1231 gain is eligible for the Opportunity Zone benefit but a Section 1231 gain that would normally be used to offset a Section 1231 loss is NOT eligible. Because taxpayers typically won’t know whether a property has a gain or loss until the last day of the tax year, the 180-day replacement rule can’t be applied. For example, a property sold April 1st would need to be replaced by the end of September, and the taxpayer would not yet know which Section 1231 gains would be eligible for the OZ incentive. So, for Section 1231 gains, the IRS has determined that the 180-day period doesn’t begin until the last tax-day of the year: December 31st.

This has proven to be challenging for advisors, taxpayers and accountants alike, especially considering that that the December 31st rule applies whether the taxpayer expects to recognize any Section 1231 losses or not. In addition, with the 180-day replacement clock not starting until December 31st, a taxpayer who sells a Section 1231 property earlier in the year, would likely miss out on opportunities for suitable OZ replacement properties that come available throughout the course of the year.

Opportunity Zone Funds offer taxpayers beneficial tax-deferred treatment as well as unique investment opportunities, and we see increasing investment interest among individuals and businesses. But, as mentioned here, the rules can be confusing and they are often changing, so we encourage you to work only with a qualified professional when considering an Opportunity Zone investment.

If you would like more information on this subject, feel free to contact our team.