QOZ update: IRS issues final regulations

Published March 12, 2020

  • Articles

The IRS has recently released final regulations on the new tax incentives for investments in Qualified Opportunity Zones (QOZs). The incentives, created by the Tax Cuts and Jobs Act, permit taxpayers to defer, reduce and even permanently exclude capital gains on their investments. The final regulations include several provisions that are favorable for real estate investors. This article will dive into a few key points from the new legislation.

Incentives in a nutshell

Investors can form private Qualified Opportunity Funds (QOFs) for development and redevelopment projects in QOZs. The funds must keep at least 90% of their assets in QOZ property, including investments in qualified businesses and new or substantially improved commercial buildings, equipment and multifamily complexes.

Investors can defer their short- or long-term capital gains on a sale or disposition of their investments as long as they reinvest the gains in a QOF within 180 days. The tax will be deferred until the fund investment is 1) sold or exchanged, or 2) December 31, 2026, whichever is earlier.

After five years, a QOF investor receives a step-up in tax basis for the investment equal to 10% of the original gain, meaning the investor will pay tax on only 90% of that gain. If an investment is held in the QOF for at least 10 years, post-acquisition gains are fully tax-exempt.

Section 1231 Final Regulations

Section 1231 refers to the tax treatment of gains and losses on the sale or exchange of real or depreciable property in a trade or business held over one year. Under the final regulations, gross Section 1231 gains are now allowed to be reinvested into a QOF, even if they have other Section 1231 losses during the year. Though the Section 1231 gains now have capital gain treatment, taxpayers must recapture any net Section 1231 losses from the previous five years as ordinary income.

180-Day Investment Period

To qualify for tax benefits, eligible gain must be invested in a QOF during a 180-day investment period, generally beginning on the date the gain is realized. The final regulations confirm that gains from installment sales can be considered eligible gains, even if the sale occurred before December 22, 2017. Now, taxpayers will have a choice to make. They can either start the 180-day investment period on the date an installment sale payment is received, or they can elect to start the 180-day investment period on the last day of the taxable year in which the installment gain is recognized.

10-Year Gain Exclusion

The previously proposed regulations allowed qualifying investors in QOF partnerships or S corporations to sell their interest after 10 years without federal income tax on its gain. The final regulations extend the 10-year gain exclusion to all losses and gains from the sale of property owned through a QOF partnership or S corporation and allocated to a qualifying investor. It’s important to note that only investments of deferred gains are eligible for the QOZ tax benefits, after-tax cash is not eligible to be invested in pursuit of the 10-year exclusion.

If you have questions or would like additional information regarding the impact of these or other provisions of the Qualified Opportunity Zone regulations, please contact Andy Ackermann or any member of your MCM Real Estate Service Team.