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The IRS has added a new frequently asked question (FAQ) to its Opportunity Zones Frequently Asked Questions. The new FAQ addresses investments made into Qualified Opportunity Funds (QOFs) following the realization of an IRC Section 1231 gain in a tax year that ended before the publication on May 1, 2019, of proposed regulations that included revised rules on investments of net IRC Section 1231 gain.

Background

QOFs are specially created investment vehicles that must have at least 90% of fund assets invested in Opportunity Zones, which were created by Tax Cuts and Jobs Act (TCJA) to spur investment in distressed communities. Taxpayers who invest eligible capital gain into QOFs within a 180-day investment period receive certain preferential tax treatment, including deferring tax on the invested capital gains until no later than December 31, 2026. In general, the 180-day investment period begins on the day that the taxpayer realizes the capital gain.

The IRS issued proposed regulations on investing in QOFs in October 2018. The October 2018 Proposed Regulations clarified that only capital gains are eligible for deferral under IRC Section 1400Z-2(a)(1) (see Tax Alert 2018-2119). Commenters noted, however, that IRC Section 1231 gain represents a unique fact pattern; when a partnership has IRC Section 1231 gain, the question of whether the gain is capital or ordinary is not determined until it is allocated to the ultimate taxpayer and then it is only capital gain to the extent that the gain exceeds IRC Section 1231 losses.

The IRS published additional proposed regulations on investing in QOFs on May 1, 2019 (see Tax Alert 2019-0823). For IRC Section 1231 gain, the May 2019 Proposed Regulations stated that they would treat only "capital gain net income from [IRC Section] 1231 property" as eligible gain for purposes of IRC Section 1400Z-2. Additionally, the May 2019 Proposed Regulations specified that the 180-day period for investing eligible IRC Section 1231 gain into a QOF would begin on the last day of the tax year.

New FAQ

The new FAQ addresses the situation in which a taxpayer realized IRC Section 1231 gain in 2018 and then invested the gain into a QOF within 180 days after that gain was realized but before the last day of the taxpayer's 2018 tax year. The FAQ asks whether the taxpayer may make a valid deferral election based on the QOF investment (which was made in an amount less that the taxpayer's 2018 net IRC Section 1231 gain), even though the May 2019 Proposed Regulations state that the 180-day period for the taxpayer's net IRC Section 1231 gain began on December 31, 2018 (i.e., the last day of the tax year).

In the answer to the FAQ, the IRS states that, yes, under these facts, when the taxpayer's tax year ended before May 1, 2019 (the date that the May 2019 Proposed Regulations were published), the taxpayer may make a valid deferral election for its QOF investment. The IRS adds that making that election will not impair the taxpayer's ability to rely consistently on all other aspects of the May 2019 Proposed Regulations.

Implications

The May 2019 Proposed Regulations clearly state that only net IRC Section 1231 gain is eligible for a qualified Opportunity Zone investment and that the 180-day investment period begins on the last day of the investor's tax year. Before the IRS published the May 2019 Proposed Regulations, however, there was no guidance on IRC Section 1231 gain. Some investors with gain from the sale or exchange of IRC Section 1231 property may have in good faith made QOF investments within 180 days of the sale or exchange date, but before the last day of the tax year. The updated FAQ provides leniency for those investors by allowing for a valid deferral election, even though the gain was invested outside the 180-day investment window.

For example, per the updated FAQ, a taxpayer that sold an IRC Section 1231 asset on February 1, 2018, and invested gain from that sale on March 1, 2018, can make a valid deferral election for the invested gain, even though the window for investment likely did not begin until December 31, 2018. The IRS specifically addresses in the FAQ a question about an investment of gain before the 180-day investment window that was ultimately less than the taxpayer's 2018 net IRC Section 1231 gain.

Investors should not assume that the updated FAQ opens the door for deferral elections of IRC Section 1231 gain in an amount greater than the net IRC Section 1231 gain amount. Additionally, the IRS specified that the leniency provided should not impair a taxpayer's ability to consistently "rely on all other aspects" of the May 2019 Proposed Regulations.

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