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George F. Bearup, J.D. Senior Legal Trust Advisor

7-Jul-20

Opportunity Zone Funds and Estate Planning

Take-Away: The IRS’s Final Regulations on Opportunity Zone Funds answered a few questions that estate planners had when a client dies owning such an investment. Unfortunately, not all the answers the IRS provided were what planners wanted to hear. In addition, a surprising number of transactions with respect to an opportunity zone fund investment will cause the deferred gain, embedded in an opportunity zone investment, to accelerate and be recognized.

Background: The 2017 Tax Act created opportunity zone funds (OZFs) as a tax incentive to invest in economically depressed areas throughout the country. There are three basic benefits derived from an OZF investment:

  • Deferral of Capital Gain Recognition: A current capital gain transaction can have that gain deferred by investing the gain in an OZF. The gain will later be recognized on either (i) the sale or exchange of that OZF or (ii) on December 31, 2026. To obtain the deferral of the recognition of the gain, the gain must be reinvested in an OZF within 180 days of the property’s disposition that causes the gain to be incurred.
  • Partial Elimination of 15% of Deferred Gain: 15% of the deferred capital gain can be eliminated if it was reinvested in the OZF and the OZF investment is held for a specified period of time: if held for 5 years, 10% of the deferred gain is eliminated (by adding it as additional basis to the OZF investment); and an additional 5% of the deferred gain is eliminated if the OZF is held for at least 7 years by its owner.
  • No Gain Recognition of OZF Investment: The potential exists to eliminate the tax on all gains associated with the appreciation in the value of a OZF investment, if that investment is held for at least 10 years.

Opportunity zones were formally designated by Treasury on June 14, 2018.

I will skip all the technical requirements to qualify as an OZF. Suffice it to say that they are mind-numbing, much like what follows. However, it is important to note that in IRS Notice 2020-39 some of the qualifying rules for an OZF were relaxed due to COVID-19, along with some limited relief with regard to the 180-day investment ‘rollover’ period for OZF investors.

Inclusion Event: While an OZF investment is intended to defer the recognition of capital gain to later date, meaning either the holding periods until a sale or exchange occurs, or until December 31, 2026, that deferral will end on an inclusion event which is a transaction that reduces or terminates the OZF investor’s direct, or in the case of partnerships, indirect, qualifying OZF investment for federal income tax reporting purposes. [Regulation Preamble, page 48.] Thus, there surfaced many questions in the context of estate planning with regard to when an inclusion event might arise and the delayed gain tax comes due. In addition,  questions surfaced with regard to a step-up in basis on the death of the OZF investment owner with regard to the imbedded deferred gain.

Final OZF Regulations: In December, 2019, the IRS published Final Regulations that address the tax consequences of an individual who invests in an OZF. Those Final Regulations addressed several comments and concerns raised by estate planners, but not all of the IRS’ answers addressed the concerns that were raised. Some of those questions or concerns raised by estate planners, and the IRS’s response follow.

Transfers to Grantor Trusts:  If an OZF investor transferred his or her OZF investment to a grantor trust, would that transfer result in a sale or exchange that would cause the deferred gain to be accelerated and recognized?

  • Answer: The Final Regulations provide that non-gift transactions with grantor trusts will not constitute an inclusion event accelerating the recognition of the deferred gain. The Regulations expand the scope of exceptions to inclusion event treatment to include other non-recognition transactions between a grantor and that grantor’s trust, such as: (i) the grantor’s sales to the grantor trust; (ii) in-kind note payments from the grantor trust to the grantor; (iii) the grantor’s exercise of a power to substitute assets with the grantor trust; and (iv) distributions of OZF interests to the grantor from a GRAT.
  • This position pretty much reflects Revenue Ruling 85-13 which generally describes the grantor’s transactions with a grantor trust as non-recognition events.
  • The Regulations also confirm that a new holding period will not be imposed if the grantor has a transaction with his or her grantor trust regarding the OZF investment.
  • However, if the trust ceases to be a grantor trust, such as by the grantor releasing a power that causes the trust to be taxed as a grantor trust, then the release of the retained power will be an inclusion event that triggers the deferred tax liability.

Partnership and S corporation Tax Reporting: In order to defer the gain, the investor must ‘rollover’ that gain into an OZF investment within 180 days of the transaction that gives rise to the gain. What happens if S corporations and partnerships do not timely issue Schedule K-1’s, or beneficiaries of trusts or estate may not receive their Schedule K-1 indicating their share of capital gain until more than 180 days after the end of the taxable year?

  • Answer: The Final Regulations provide that partners, S-shareholders, and beneficiaries of trusts or estates have the option to start the 180-day investment period on the due date of the issuing entity’s tax return, not including any extensions.
  • This addresses the concern that an investor might miss the OZF 180-day investment period due to the owner, or beneficiary, receiving a late Schedule K-1 from the issuing entity, i.e. the partnership, S corporation, or trust or estate.

Gift of OZF investment: What is the tax result if the OZF investor decides to gift the OZF investment to another individual?

  • Answer: The Final Regulations confirm that the donor’s gift of an interest in an OZF investment will be an inclusion event for the deferred gain, unless the gift is made to a grantor trust.
  • The owner’s transfer of a qualifying OZF investment, either outright or in trust, is therefore an inclusion event, regardless of whether the transfer is a completed gift for federal gift tax purposes, and regardless of the taxable or tax exempt status of the donee.
  • In addition, the position of the IRS is that transactions between spouses with regard to OZF investments, which normally are non-recognition events under IRC 1041, will nonetheless be treated as inclusion events thus accelerating the tax liability with an intra-spousal transfer of an OZF investment.

Death of OZF Investor: What are the income tax consequences that result from the death of the OZF investor, who has deferred gain by virtue of his or her OZF investment, to the deceased investor’s successors-in-interest?

  • Answer: As a general rule, that a transfer of a qualifying investment by reason of the OZF owner’s death is not an inclusion event. [Treasury Regulation 1.1400Z2(b)-1(c)(4)(i).(A) –(E).] Included in this ‘non-inclusion event’ category are: (i) a transfer of a OZF investment by reason of death to the deceased owner’s estate; (ii) a distribution of a qualifying OZF investment by the deceased owner’s estate; (iii) a distribution of a qualifying OZF investment by the deceased owner’s trust that is made by reason of the deceased owner’s death; (iv) the passing of a jointly owned qualifying OZF investment to the surviving co-owner by operation of law; and (v) any other transfer of a qualifying OZF investment at death by operation of law, e.g. TOD beneficiary designation.
  • Consequently, the death of the OZF owner will not, by itself, be treated as an inclusion event. However, if the successor owner disposes of the OZF investment, then that will constitute an inclusion event, and taxes will be owed.

Basis Step-Up: If the investor dies owning an OZF investment, do the basis step-up rules of IRC 1014 apply to the deferred amount, i.e. if the value of the OZF investment at death exceeds the deferred gain amount?

  • Answer: The Final Regulations provide that income in respect of a decedent (IRD) under IRC 691 applies on the death of a OZF owner who has deferred gain through a timely reinvestment of gain in an OZF investment.
  • This is significant since IRD is not reported on the decedent’s final income tax return. Instead, IRD is reportable by the recipient of the IRD item, e.g. the decedent’s estate or another person, like the beneficiary under a TOD beneficiary designation.
  • Equally important is that because the OZF investment is classified as IRD, it will not receive a step-up in basis on the OZF owner’s death. [IRC 1014(c).] Thus, the successor-in-interest gets stuck with the deferred tax liability.
  • The hope had been that there would be a partial step-up in basis upon the owner’s death to the extent that the value of the OZF investment at death exceeds the deferred gain amount. However, the IRS asserts that the IRD treatment applies with regard to the recipient’s basis in the qualifying investment. Restated, the basis of the qualifying OZF investment is $0.00, with specific increases for gain recognized at the time of an inclusion event and for qualifying investments held for at least 5 or 7 years. This provision, as written, applies without regard to IRC 1014 (the basis step-up at death rule.)
  • The bad news then is that IRC 1014 does not apply to adjust the basis of any inherited qualifying OZF investment to its fair market value as of the deceased owner’s death. [Treasury Regulation 1.1400Z2(b)-1(g)(6).]

Inclusion Events: The Final Regulations presumably also provide guidance on when certain transactions will constitute inclusion events that will cause the deferred gain to accelerate and be recognized and cause a tax to be immediately due. For the life of me, I have no understanding for the reasoning behind these inclusion event ‘rules.’ I would prefer to describe them as tax ‘traps.’

  • Contribution to a Partnership: No inclusion event occurs on the owner’s contribution of a OZF investment to a partnership or entity taxed as a partnership, which would otherwise not be a taxable transaction under IRC 721(a).
  • Contribution to a Corporation: An inclusion event does occur if the owner contributes his or her OZF investment to a C corporation or S corporation, even if the transfer of an asset is otherwise tax-free under IRC 351.
  • Transfer of Partnership Interest: An inclusion event occurs upon the transfer of interests in a partnership that holds OZF investment interests, unless the transfer is to a grantor
  • Transfer of a Corporate Interest: No inclusion event occurs upon the transfer of interests in corporations (C or S) that hold OZF investment interests.
  • QSST-EBST: No inclusion event occurs with a conversion from a qualified subchapter S trust (QSST) to an electing small business trust (EBST) or vice versa, if the person who is both the deemed owner of the ‘grantor portion’ of the EBST holding the OZF investment and the QSST beneficiary is the person taxable on the income from the OZF investment both before and after the conversion.

Comment: Another concern that did not resonate with the IRS had to do with the harsh tax consequences that may be faced by a beneficiary who inherits a OZF interest but who may not have the liquidity to pay the tax that is otherwise due on December 31, 2026, i.e. the ‘drop dead’ date when the gain must finally be recognized and reported. The hope had been that the Final Regulations might allow a successor-in-interest to be able to continue to defer the gain under IRC 691, even after December 31, 2026, until the successor-in-interest disposes of his or her interest in the OZF investment. By adopting such a rule, the successor-in-interest could be protected from inheriting a  potentially significant tax liability without having the liquidity to pay for it. The IRS rejected this concern for successors-in-interest by noting that the statute clearly states that December 31, 2026 is the outside, a/k/a ‘drop-dead’ date for an inclusion event. The IRS went so far in its Final Regulations to make it expressly clear that the decedent’s deferred gain is the liability of the person in receipt of that OZF interest from the decedent at the time of any inclusion event. [Treasury Regulation 1.1400Z29B)-1(c)(4)(III).]

With this potential liability in mind, some Will and Trust instruments might be modified to give the fiduciary the authority to reimburse the recipient of the OZF investment for their ‘hidden’ income tax liability if the tax day-of-reckoning of December 31, 2026 arrives and the recipient does not have the immediate liquidity to pay the ‘hidden’ tax liability.

Conclusion: Deferring taxable gains by reinvesting the gain in OZF investments sounds like a good idea. However, the Regulations make it clear than any gift of the OZF investment, short of to a grantor trust, will trigger the gain recognition and the tax liability. When all is said and done, it appears that the IRS has set several ‘traps’ to accelerate the deferred gain with its multiple and broadly interpreted inclusion events. The best advice would seem to be ‘proceed at your peril’ when it comes to OZF investments.