Proposed Regulations Give Pass-Through Owners Additional Time to Defer Recognition of Gains by Investing in a Qualified Opportunity Fund
June 8, 2020
As part of the Tax Cuts and Jobs Act (“TCJA”) signed into law on December 22, 2017, new tax incentives were created under Section 1400Z-2 of the Internal Revenue Code (“IRC”) that allow you to elect to defer certain gains until as late as December 31, 2026, to the extent that those gains are reinvested in a Qualified Opportunity Fund (“QOF”) within 180 days.
On October 19, 2018, the Treasury Department issued proposed regulations explaining the operation of the rules, and providing some much needed guidance and clarity. These regulations provide flexibility to owners of pass-through entities that receive an allocable share of capital gain through their investment in the pass-through entity.
The proposed regulations clarify that individuals, C corporations (including RICs and REITs), partnerships and certain other pass-through entities (such as S corporations, estates, trusts or LLCs taxed as pass-through entities) are all eligible to make the election to defer eligible capital gains reinvested in QOFs within 180 days of realizing the gain. In the case of a pass-through entity (“PTE”), either the PTE can elect to defer all or part of the gain or, to the extent that the PTE does not elect to do so, the PTE’s owners to whom the PTE allocates such gains may elect to defer all or a portion of their allocable shares of the gain.
For a PTE, the 180-day period begins on the date that it sells or exchanges an asset and realizes a gain. The proposed regulations provide that in the case of a PTE owner that receives an allocation of gain from the PTE that the owner did not elect to defer, the gain is deemed to have been realized by the owner on the last day of the PTE’s tax year. Therefore, by default, the 180-day period begins on the last day of the PTE’s tax year with respect to the owner’s allocable share of gain reported on the Schedule K-1 received from the PTE. There is also a special rule that the owner may elect to treat their own 180-day period as being the sale date, as the PTE’s 180-day period would begin on the date of the PTE’s realization event.
For example, suppose a PTE taxed as a partnership with a tax year end of December 31, has two partners that each own 50 percent of the PTE. The PTE realized a $1 million capital gain on the sale of an asset on January 5, 2018. The PTE has until July 3, 2018, to reinvest all or a portion of the $1 million gain in a QOF, to the extent it wants to defer recognition of the capital gain. The PTE decides to reinvest $200,000 of that in a new QOF on June 30, 2018. It elects to defer recognition of $200,000 of the capital gain and recognizes the remaining $800,000 of gain on Form 8949. Each partner receives a 2018 Schedule K-1 reporting $400,000 of long-term capital gain (i.e., their respective 50 percent share of the $800,000 capital gain that was not elected to be deferred by the PTE). Each of the partners can defer all or a portion their respective $400,000 share of gain by reinvesting it in a QOF on or before June 29, 2019. Alternatively, each partner could elect to have their 180-day period begin on January 5, 2018, to the extent that partner reinvested proceeds in a QOF on or before July 3, 2018.
These rules have a significant impact on pass-through owners looking to make investments in a QOF or in establishing their own QOF as they look to make investments in qualified opportunity zone (“QOZ”) trades, businesses or QOZ property in order to defer capital gains. When you’re ready, consult your Cherry Bekaert professional, who can help you evaluate the effect of these rules.