The Wizard of OZ (that’s “Opportunity Zones”): Interim gains & reinvestment - by Dan Flanigan

Interim Gains & Reinvestment: A Few Problems¹

OZ proponents claimed a victory when Treasury, in the recent “second round” of proposed regulations, accommodated, in a limited way, the ability of an OZ Fund² to sell an asset and reinvest the proceeds before the expiration of the 10-year hold period without triggering the recognition of gain on the original investment and allowing the prior hold period to “tack” rather than begin anew. 

However, there may be some misunderstanding regarding the limited value of this concession. It’s time, on this issue and many other OZ issues, to wade “into the weeds.” The following are what some may consider to be negative consequences of an interim gain:

• If the asset is sold prior to the expiration of the 10-year hold period, the amount of the gain is taxable. The investor will be required to pay the tax on the next due date to the extent the investor is unable to invest the amount of the gain in an OZ Fund (including a reinvestment in the existing Fund). 
• Even if the investor is able to do this, that investment is no different than a brand new OZ investment with capital gain proceeds, resulting in (1) a new 10-year hold period for the “new” investment but (2) the deferred gain will still become taxable on December 31, 2026 along with the original investment.  
• Moreover, the early harvesting of gain on the investment will reduce the amount of gain that would otherwise be tax-free at the end of the 10-year period.  

An example: Assume a $1 million initial investment and an interim gain four years out (tax year ending December 31, 2023) of $400,000:

• Investor’s deferral period on the initial $1 million investment continues to extend to December 31, 2026.
• If the investor does not or cannot find another OZ investment within which to invest an amount equal to the $400,000 interim gain, the tax on the uncovered portion of the gain is triggered immediately, not on December 31, 2026, and becomes payable on the next tax due date. Note that the investor may or may not actually receive a distribution of the investor’s share of the gain proceeds depending on the authority granted in the Fund governing documents to the managers or a majority of the investor interests in the Fund concerning reinvestment or distribution of interim gain funds. Thus, the investor may need to access funds from other sources in order to make the protective investment and avoid immediate triggering of tax liability.
• Even if the investor finds another OZ investment, the investor must begin a new 10-year hold to reap the 10-year benefit attributable to the $400,000 gain and still must pay the tax on the interim gain on December 31, 2026. Thus the investor must consider where the funds will come from to pay this additional tax liability, which could not have been planned for at the outset as in the case of the initial $1 million investment. 
• Assume that the remainder of the portfolio is liquidated after 10 years (though not the additional investment caused by the interim sale) for an additional gain to the investor of $600,000, for a total gain of $1 million. If all assets had remained in place for the full 10 years, i.e. there was no interim sale and gain, the investor’s basis step-up would avoid taxable gain on the entire $1 million proceeds. However, due to the interim gain and resulting payment of tax, the investor will avoid taxable gain on only $600,000 of the proceeds. Perhaps the investor will make up for this loss from the after-tax profit from the new investment of the interim gain but will need to wait a few years to find out.

It is possible, though doubtful, that the cavalry may come to the rescue, at least in part. In its second round commentary, the Treasury acknowledged that it had received comments requesting exemption of Funds and their investors from the immediate recognition of gain from dispositions by Funds or businesses if the proceeds are reinvested in other qualified property. Treasury expressed doubt that it has the authority to do so but requested “commenters to provide prior examples of tax regulations that exempt realized gain from being recognized . . .” But it sure sounds like they doubt that persuasive examples will be forthcoming. 

Thanks to Jeff Goldman and Pat O’Bryan of the POLSINELLI Tax Department for their help identifying and analyzing the issues discussed in this article.  

1 Note, however, that the distribution would reduce the investor’s basis again to zero, which would affect the investor’s ability to deduct losses including depreciation deductions until the investor’s basis increased (either as of December 31, 2026, as a result of Fund income being allocated to the investor, or by sale of the property following the 10-year holding period).

2  The relief provided extended only to a Fund, not to an OZ business itself. The government commentary on this issue said, “The Treasury Department and the IRS request comments on whether an analogous rule for QOF subsidiaries to reinvest proceeds from the disposition of qualified opportunity zone property would be beneficial.” Simple comment: It would seem obvious that it is better to be able to sell assets than only the equity interests in an entity. 

Dan Flanigan is managing partner of the New York office of POLSINELLI. 
Flanigan and POLSINELLI have provided the above material for informational purposes only. The material provided is general and not intended to be legal advice. Nothing in the material should be relied upon or used without consulting a lawyer to consider your specific circumstances, possible changes to applicable laws, rules and regulations and other legal issues. Receipt of this material does not establish an attorney-client relationship.