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In order to qualify for opportunity zone tax benefits, an investor must reinvest capital gains into a qualified opportunity zone (QOZ) eligible investment vehicle within 180 days after recognizing the gain. One hundred eighty days may seem straightforward, but it’s important for investors to know that it might not be if your gains are from the sale of Section 1231 property.
What Is Section 1231 Property?
Section 1231 applies to depreciable property used in a trade or business that has been held for at least one year. A sale or exchange of property held mainly for sale to customers wouldn’t qualify for a Section 1231 gain. In order words, if you can get your investment in the property back by selling it instead of using it in your business, it likely does not qualify. Examples of Section 1231 properties include buildings, equipment, cattle, unharvested crops and other natural resources.
Regarding gains and tax treatment, part or all of a 1231 gain may require depreciation recapture. The recapture is taxed at 25%. Any remaining gain is taxed as long-term capital gains. These properties are subject to the net investment income tax (NIIT).
How Are Section 1231 Gains Treated By The QOZ Program?
The 180-day period for investing capital gains from a Section 1231 property in a qualified opportunity zone fund (QOZF) begins on the last day of the taxable year, December 31 (i.e., after the amount of long-term capital gains from such property can be determined). That means that December 31, 2019 was the first and last day investors with capital gains on Section 1231 property could have invested in a qualified opportunity fund to receive the 15% step-up in 2026. Expect a similar event to occur next year on December 31, 2021 as well, as this will be the last day to receive the 10% step-up.
Potential Issues Reinvesting Section 1231 Gains
For those who are in the process of executing a 1031 exchange on Section 1231 property and have funds with a qualified intermediary but want to invest in a qualified opportunity fund, a potential problem may arise. Once replacement property has been identified in an exchange in the allotted 45-day window, your funds are then tied up for another 135 days before being released.
Luckily, there is a way to get around this. Whereas a 1031 exchange requires that the funds reinvested into the replacement property be traceable back to the property that was sold to receive the deferral, you can use funds from any source to invest in a QOZF, as long as it is of equal value to the capital gains that were realized. This means if your sale proceeds are tied up with the qualified intermediary, you can come out of pocket to invest on behalf of the taxable funds that are being held.
Section 1231 gains are eligible for the QOZ tax benefits but operate on a different investment timeline than other capital gains. Talk to a tax professional, and stay on top of your 180-day deadline.
Full disclosure. The information provided here is not investment, tax, or financial advice. You should consult with a licensed professional for advice concerning your specific situation.