With the issuance of the final Tax Regulations on qualified opportunity zones (QOZ), taxpayers who have Section 1231 gains that would like to reinvest in a qualified opportunity fund (QOF) received very favorable guidance.
What is a Section 1231 Gain?
Section 1231 property is property used in a trade or business which has been held at least 1 year. Section 1231 property can include real property, equipment, furniture and other fixed assets used in a trade or business. If a taxpayer has a net Section 1231 gain for the year (1231 gains exceed losses), the gain is taxed at long-term capital gains rates (25 percent if relating to unrecaptured depreciation from real estate). Note that gains relating to depreciation recapture is taxed as ordinary income and not subject to the favorable Section 1231 tax treatment. If a taxpayer has a net Section 1231 loss for the year, it receives ordinary loss treatment. If a taxpayer incurs a Section 1231 loss and receives an ordinary loss deduction, the taxpayer may have to recapture these losses if they have 1231 gains in the subsequent 5 tax years.
Guidance under Proposed Regulations
The proposed regulations allowed for the taxpayer’s net Section 1231 gain for the year taxed as a capital gain to be reinvested in a QOF and take advantage of the QOZ benefits. Additionally, since a net Section 1231 gain cannot be measured until the last day of the tax year, the 180-day reinvestment period would not begin until the last day of the tax year. This rule would require the taxpayer to wait on making their QOF investment until the end of the tax year even if they found a suitable deal prior to then.
Guidance under Final Regulations
The final regulations provided very welcomed guidance for taxpayers. The regulations now allow for a gross Section 1231 gain to be reinvested into a QOF. This is the case even for gains that would have been subject to tax as ordinary income due to the recapture for prior Section 1231 loss deductions. Since the Section 1231 gains are now on a gross basis, the reinvestment period begins the day of the sale resulting in the gain. Please note that there are special rules for gains from partnerships and S corporations which is beyond the scope of this blog post. Taxpayers should be aware that 1231 loss recapture rules will be based on the tax year in which the gain is ultimately recognized which could convert a Section 1231 gain that would have been taxed as a long-term capital gain into ordinary income.