Final Regulations on Qualified Opportunity Funds: Trust and Estate Issues

By:
Kevin Matz, JD, Esq., CPA, LLM
Published Date:
Feb 1, 2020

On Dec. 19, 2019, the U.S. Department of Treasury and the IRS (collectively, the Treasury Department) released long-awaited final regulations on qualified opportunity funds (QOF). The final regulations come on the heels of two tranches of proposed regulations, which generated more than 300 comment letters from organizations and other interested parties. The NYSSCPA submitted a comment letter to the Treasury Department dated Jan. 9, 2019, that addressed a wide range of issues. In addition, the American College of Trust and Estate Counsel (ACTEC) submitted two separate comment letters to the Treasury Department on trust- and estate-related issues, the second of which was dated Jun. 27, 2019.

Background

The 2017 Tax Act included in section 1400Z-2 a new tax incentive provision that is intended to promote investment in economically distressed communities, referred to as “opportunity zones.” Through this program, investors can achieve the following three significant tax benefits:

  • The deferral of gain on the disposition of property to an unrelated person, generally until the earlier of the date on which the subsequent investment is sold or exchanged, or Dec. 31, 2026, so long as the gain is reinvested in a QOF within 180 days of the property’s disposition.
  • The elimination of up to 15% of the gain that has been reinvested in a QOF, provided that certain holding-period requirements are met.
  • The potential elimination of tax on gains associated with the appreciation in the value of a QOF, provided that the investment in the QOF is held for at least 10 years.

An opportunity Zone is an economically distressed community where new investments, under certain conditions, may be eligible for preferential tax treatment. Localities qualify as opportunity zones if they have been nominated for that designation by the state and that nomination has been certified by the IRS.  All Opportunity Zones were designated as of Jun. 14, 2018, and are available on the U.S. Department of Treasury website.

A QOF, in turn, is an investment vehicle that 1) is established as either a domestic partnership or a domestic corporation for the purpose of investing in eligible property located in an opportunity zone, and 2) uses investor gains from prior investments as a funding mechanism. To become a QOF, the entity self-certifies by meeting certain requirements—in particular, a general requirement that at least 90% of its assets be “qualified opportunity zone property” used within an opportunity zone—but no approval or action by the IRS is required. To self-certify, the entity completes Form 8996, then attaches it to the entity’s timely filed federal income tax return for the taxable year (taking extensions into account ). 

The final regulations generally apply to taxable years beginning after Mar. 13, 2020 (which is 60 days after the date of publication of the final regulations in the Federal Register)—which, for calendar-year taxpayers, will be to taxable years beginning on or after Jan. 1, 2021.  However, until then, taxpayers generally may choose to either 1) apply the rules set forth in the final regulations, if applied in their entirety and in a consistent manner for all such taxable years, or 2) rely on each section of the proposed QOF regulations, issued on Oct. 29, 2018, and on May 1, 2019, but only if applied in their entirety and in a consistent manner for all such taxable years. 

Income in Respect of a Decedent (IRD)

The finals regulations established that IRD concepts under IRC section 691 apply upon the death of a taxpayer who has deferred gain through a timely reinvestment of gain in a QOF.

IRC section 1400Z-2(e)(3) provides that “[i]n the case of a decedent, amounts recognized under this section shall, if not properly includible in the gross income of the decedent, be includible in gross income as provided by section 691.” This statutory provision raises questions concerning the appropriate treatment of the deferred gain where a person who has rolled over gain through a timely investment in a QOF dies prior to Dec. 31, 2026, without having previously disposed of the QOF investment.

The final regulations resolved these questions consistent with IRC section 691, which sets forth the rules that apply to a person’s receipt of IRD income—that is, income earned by a decedent who was a cash-basis taxpayer prior to his death, but that is not properly includible in income until after the decedent’s death.  IRD is not reportable on the decedent's final income tax return; rather, it is reportable by the recipient of the IRD item (e.g., by the decedent’s estate or some other person). One very significant aspect of IRD is that IRC section 1014(c) denies a step-up in basis at death to items of IRD. 

The final regulations state, as a general rule, that “a transfer of a qualifying investment by reason of the taxpayer’s death is not an inclusion event” [Treasury Regulations section 1.1400Z2(b)-1(c)(4)(i)], and provides the following examples:

  • A transfer by reason of death to the deceased owner’s estate.
  • A distribution of a qualifying investment by the deceased owner’s estate.
  • A distribution of a qualifying investment by the deceased owner’s trust that is made by reason of the deceased owner’s death.
  • The passing of a jointly owned qualifying investment to the surviving co-owner by operation of law.
  • Any other transfer of a qualifying investment at death by operation of law.

The final regulations then specify that the following transfers are not considered transfers by reason of the taxpayer’s death, and thus are inclusion events, with the amount recognized to be includible in the gross income of the transferor as provided in section 691:

  • A sale, exchange or other disposition by the deceased taxpayer’s estate or trust, other than a distribution described above.
  • Any disposition by the legatee, heir, or beneficiary who received the qualifying investment by reason of the taxpayer’s death.
  • Any disposition by the surviving joint owner or other recipient who received the qualifying investment by operation of law on the taxpayer’s death.

Of particular relevance, section 1400Z-2(b)(2) contains a special rule that caps the amount of the gain so as not to exceed the fair market value of the investment as of the date that the gain is included in income. 

In addition, the final regulations contain a special rule for determining the amount includible for partnerships and S corporations. Specifically, Treasury Regulations section 1.1400Z2(b)-1(e)(4) provides that, in the case of an inclusion event involving a qualifying investment in a QOF partnership or S corporation, or in the case of a qualifying investment in a QOF partnership or S corporation held on Dec. 31, 2026, the amount of gain included in gross income is equal to the lesser of 1) the product of the percentage of the qualifying investment that gave rise to the inclusion event and the remaining deferred gain, less any basis adjustments pursuant to section 1400Z-2(b)(2)(B)(iii) and (iv), or 2) the gain that would be recognized on a fully taxable disposition at fair market value of the qualifying investment that gave rise to the inclusion event.

It is incumbent upon estate planners to consider strategies to provide liquidity on the so-called “judgment day” of Dec. 31, 2026, in cases where the taxpayer dies prior to that date. This may include life insurance—perhaps held through an irrevocable life insurance trust of which the person who inherits the QOF interest under the insured’s estate plan is a primary beneficiary. Along these lines, in their comment letters, both the NYSSCPA and ACTEC suggested a possible extension of the “judgment day” when death has occurred prior to Dec. 31, 2026.  The Treasury Department, however, declined to adopt the suggestion on the grounds that the QOF statute does not allow for the deferral of gain beyond Dec. 31, 2026.

A Donor’s Gift of an Interest in a QOF

The final regulations generally treat gifts as constituting an inclusion event, regardless of whether that transfer is a completed gift for federal gift tax purposes, and regardless of the taxable or tax-exempt status of the donee of the gift. An exception applies, however, in the case of gifts to grantor trusts, since they generally would not involve a change in the taxpayer for federal income tax purposes. According to the Treasury Department, its position that gifts generally constitute inclusion events is supported by the legislative history (although the Treasury Department’s position would appear to be contrary to the unambiguous language of the QOF statute, which both the NYSSCPA and ACTEC pointed out in their comment letters). Similarly, transactions involving QOF interests between spouses are treated as inclusion events unless a grantor trust is involved.

Transactions with Grantor Trusts

As suggested by both the NYSSCPA and ACTEC, the Treasury Department has now clarified in the final regulations that a broad array of transactions between a grantor and that grantor’s grantor trust that involve QOFs will not constitute an inclusion event. The proposed regulations had limited this exception solely to gifts to grantor trusts. The final regulations expand the scope to include other transactions between a grantor and that grantor’s grantor trust, and as such will also embrace sales to grantor trusts, the grantor’s exercise of the power to substitute assets with a grantor trust, and distributions of QOF interests to the grantor from a grantor retained annuity trust (GRAT).  In addition, the Treasury Department has clarified that it does not matter whether the gain that is sought to be deferred, or the funds that are subsequently invested in the QOF, belong to the taxpayer or to such taxpayer’s grantor trust. 

Commencement of the 180-Day Period

Also at the NYSSCPA’s and ACTEC’s suggestion, the final regulations provide partners of a partnership, shareholders of an S corporation, and beneficiaries of decedents’ estates and non-grantor trusts with the option to treat the 180-day period as commencing upon the due date of the entity’s tax return, not including any extensions. Both the NYSSCPA and ACTEC expressed concern in their comment letters about the potential for an “information gap” to exist between the partnership, S corporation, executor, and trustee, on the one hand, and the partner, S corporation shareholder, and beneficiary on the other hand. The Schedule K-1 is the mechanism for a partnership, S corporation, estate, or trust to report tax attributes— including capital gains—not only to the IRS, but also to the partner, S corporation shareholder, or beneficiary, as the case may be. If the tax return for the passthrough entity is placed on extension, there will be a substantial possibility that the Schedule K-1 will not be issued until more than 180 days after the end of the tax year, at which point the opportunity to roll over gain to a QOF will have been lost. The Treasury Department was sensitive to this concern and responded by allowing taxpayers this option to treat the 180-day period as commencing upon the due date of the entity’s tax return, not including any extensions.

No Step-Up in Basis under IRC Section 1014

Finally, the final regulations clarify that a step-up in basis under IRC section 1014 is not available to adjust the basis on an inherited qualifying investment in a QOF to its fair market value as of the deceased owner’s death. ACTEC had suggested that a step-up in basis should be available upon death to the limited extent that the value of the QOZ investment at death exceeds the deferred gain amount. The Treasury Department, however, declined that request.


Kevin Matz, JD, Esq., CPA, LLM, is a partner at the law firm of Stroock & Stroock & Lavan LLP in New York City. His practice is devoted principally to domestic and international estate and tax planning, family offices, and qualified opportunity zone (QOZ) funds and he is a Fellow of the American College of Trust and Estate Counsel (ACTEC) and a co-chair of the Tax Committee of the Trusts and Estates Law Section of the New York State Bar Association. Mr. Matz is also currently the Secretary/Treasurer of the NYSSCPA and a past president of the Foundation for Accounting Education’s Board of Trustees. He also writes and lectures frequently on estate and tax planning topics.  He can be reached at kmatz@stroock.com or 212-806-6076.

 
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