Does Section 1231 Mean 12/31? New Proposed Treasury Regulations Impact Investors with Section 1231 Gains

For as much excitement as there has been for Qualified Opportunity Zones (QOZs) among investors, there has also been a degree of uncertainty as to how they will actually work. Passed as part of the Tax Cuts and Jobs Act of 2017, QOZs are land tracts designated by state governors, the U.S. Treasury Department and the Internal Revenue Service to be economically depressed or underserved. To incentivize private investment in these communities, the QOZ legislation created sizeable tax breaks for investors who make certain types of long-term investments that have the potential to promote economic growth in these zones.

Since being enacted, investors have been seeking more clarity on the specifics of QOZs. On April 17, 2019, the Treasury Department released its second round of proposed regulations for QOZs (the first set was published in October 2018) For the most part, the second round of regulations are taxpayer and investor friendly. Of specific interest to many investors are the rules related to Section 1231 gains.

What is Section 1231?

Section 1231 of the U.S. Internal Revenue Code generally deals with depreciable business property held for more than a year. Depreciable real estate is a common type of Section 1231 asset. However, any business asset that has been held for longer than a year and is subject to depreciation is a Section 1231 asset, including buildings, furniture and fixtures, machinery, unharvested crops, timber and other natural resources.

How do the new regulations impact Section 1231?

The regulations state that taxpayers with Section 1231 gains can only contribute their net Section 1231 gains at the end of the taxable year. Therefore, most taxpayers with Section 1231 gain transactions arising from transactions taking place during 2019 are required to wait until Dec. 31, 2019. That date also represents the start of the 180-day period within which to make a qualifying contribution into a QOZ fund. The reason that the 180-day period starts on the last day of a taxpayer’s taxable year is so the taxpayer can determine his or her net gain by combining all Section 1231 gains, losses and carryforwards throughout the year.  However, this provision effectively limits the ability for taxpayers with a single Section 1231 gain event to invest that gain right away.

Is there a solution for investors who don’t want to wait until Dec. 31?

Yes. Investors can contribute their estimated Section 1231 gain at any point during the year and receive a non-qualifying QOZ fund interest. On Dec. 31, 2019, or within 180 days after year-end, those investors would be able to convert their interest from a non-qualifying QOZ Fund interest into a qualifying QOZ Fund interest through a distribution and re-contribution procedure.

The benefits to investors who contribute assets to a QOZ fund prior to Dec. 31, 2019, include:

  • Preferred Return: The preferred return, or preferential return to investors before the fund incentive, typically starts when investors contribute into a fund.  By investing earlier, the investors will receive a larger allocation of preferred return.
  • Reduced Interest Charge: Funds typically have an interest charge for investors entering later in the investment period. By investing earlier, the interest charge paid by investors can be significantly reduced.
  • Capacity Risk: Investors that invest later in the investment period run the risk of a fund reaching its funding capacity.  Investing earlier mitigates that capacity risk.

In summary, investors with a single Section 1231 net gain transaction generated in 2019 don’t have to wait until 12/31 to participate in a QOZ fund. Rather, they can participate using the structure outlined above at any time during 2019.  Investors with multiple Section 1231 transactions in 2019 (either through a flow-through investment or directly) or with Section 1231 losses from the previous five years, should factor those transactions in when determining the amount of their contribution.