New developments of qualified opportunity areas
In this article, we’ll explore some of what you need to know now about Qualified Opportunity Zones (QOZs), which arose with the not-so-distant Tax Cuts and Jobs Act of 2017.
First, the goal of QOZs is to encourage investment in designated economic zones. The tax incentive encourages the reinvestment of short and long term capital gains in these areas.
Such earnings, if reinvested within 180 days, are eligible for a deferral and even a surrender of certain earnings. There have been some extensions to the 180-day rule in the COVID-19 environment (Notice 2020-39, Notice 2021-10).
One of the strategies focuses on selecting long-term gains for deferral, when this releases long-term capital losses to offset short-term capital gains (“Three Years of Opportunity Zones and Outlook for 2021” , bloombergtax.com, 11/20/20; https://news.bloombergtax.com/daily-tax-report/three-years-of-opportunity-zones-and-outlook-for-2021). If the investor was in the program early, it would be possible to forgo up to 15 percent of the taxpayer’s capital gains.
The test for a 15 percent discount is whether the investment will be held for seven years until December 31, 2026. As we write in 2021, it is possible that even new investments may be eligible for a discount. 10 percent of earnings under the rule that asks if the investment has been held for five years as of December 31, 2026.
This key date is only a little over five years away as we write in the latter part of 2021. As a result, investments must be made by the end of 2021 in order to qualify for a payout discount. to any degree under the law as it is currently drafted.
Capital gains eligible for deferral include stock market capital gains and real estate capital gains. The idea is that the investments go into defined areas of activity. The source of capital gains can be varied.
The deferred gain, unless you follow the 15% or 10% gain discount rules, is reintegrated into taxable income as of December 31, 2026. One of the general issues here is the concentration of income over one year, 2026. , with the exception of intermediate sales which might minimize deferral and negate the gain forgiveness aspects of the rules. For investments held for 10 years, there is no prospect of taxable gain.
The new 2021 investments therefore have three main advantages:
- deferral of initial gain
- some prospect that 10% of the old reinvested gain will be forfeited if the new investment is held for five years by the end of 2026
- no gain on the investment per se assuming very long-term ownership
Keep in mind that investing after 2021 will not access the 10 percent cash back rebate incentive that requires five years of ownership by the end of 2026. Not surprisingly, there is considerable discussion about liberalization of the law as currently drafted (three proposals are noted at “Legislation would expand OZ incentive by creating subsequent designation rounds”, Opportunity Zone Resource Center, novoco.com, 8 / 10/21).
There have been concessions of time relief from the IRS regarding various detailed rules: 30-month Substantial Improvement Period, 90% Investment Standard, Working Capital Safe Harbor, and Period of 12-month reinvestment (Notice 2021-10).
The IRS has confirmed that the 2020 Census changes do not affect the previously established boundaries of the Qualified Opportunity Zones, which were based on the 2010 Census (Announcement 2021-10). The IRS has issued some retroactive corrections to the final QOZ regulation, TD 9889, most notably the Working Capital Safe Harbor Rule. The corrections come into force on August 5, 2021 and are applicable from January 13, 2020 (Documents FR 2021-16663 and 2021-16664, 86 FR 42715, 42716; https://www.federalregister.gov/documents/2021/08 / 05).
In January 2021, the IRS released the latest Form 8996, “Qualified Opportunity Fund”. The IRS has issued a correction regarding areas of opportunity qualified in the 2020 Instructions for Form 8949 Sales and Other Dispositions of Capital Assets (“Corrections to the 2020 Instructions for Form 8949,” IRS.gov).
The IRS issued a timely filing relief decision to an LLC self-certifying its qualified opportunity fund status (PLR 202116011, 4/23/21; see also PLR 202103013, 1/22/21). The United States Government Accountability Office has requested more data and reporting on the performance of areas of opportunity (“Areas of Opportunity: Improving Oversight Needed to Assess Tax Expenditure Performance,” GAO-21-30 , gao.gov, 9/11/20).
Protecting the QOF Incentive – A Perspective
Are the rules changing? In the many discussions of the Biden administration’s “green paper” on proposed legislation, we don’t hear that the QOZ provisions are being changed.
There are many provisions generally focused on raising capital gains taxes, especially for the rich and the less rich who are having a good year. There is a certain prospect that our traditional rule of increase on death will be eliminated or watered down, and even a certain prospect that death will trigger a gain. Similar exchanges of investment real estate may even become taxable.
Higher taxes on capital gains can bode well as they encourage the deferral of gains through the QOF. Yet there is the problem of “income pooling”. The postponement of QOZ turns around at the end of 2026, which creates the prospect of a significant capital gain in one year (Sec. 1.1400Z-2 (b) (1) (B)). The Biden proposal, among others, suggests an improved tax on large gains that could discourage investment in QOZs.
What is the outlook for the Biden proposals imposing a particularly large earnings tax in 2026, and what impact could such a tax have on QOZ investments?
In the author’s opinion, when the topic is the increase in the earnings tax, one should consider possible exceptions or special rules for large QOZ deferrals turning in one year. Otherwise, large gains tax proposals can discourage QOZ investments.