On April 17, 2019, Treasury issued its second installment of proposed regulations relating to Qualified Opportunity Zones (“QOZs”). The regulations are 169 pages in length, and (as suspected) are fairly complex. Nevertheless, Treasury addresses a significant number of important QOZ issues.
We will dive into the proposed regulations in some detail in subsequent blog posts. In this post, however, we provide a high-level overview of some of the more significant provisions in the proposed regulations.
There has been a lot of “buzz” in the media about Qualified Opportunity Zones (“QOZs”). Some of the media accounts have been accurate and helpful to taxpayers. Other accounts, however, have been less than fully accurate, and in some cases have served to misinform or mislead taxpayers. Let’s face it, the new law is quite complex. Guidance to date from Treasury is insufficient to answer many of the real life questions facing taxpayers considering embarking upon a QOZ investment.
In this installment of our series on QOZs, we will try to address some of the questions that are plaguing taxpayers relative to investing in or forming Qualified Opportunity Funds (“QOFs”). Please keep in mind before you attempt to read this blog post that we readily admit that we do not have all of the answers. We do, however, recognize the many questions being posed by taxpayers.
As with any investment, due diligence is required. Investing in an Opportunity Zone Fund (“OZF”) is not any different.
Historically, we have seen taxpayers go to great lengths to attain tax deferral. In some instances, the efforts have resulted in significant losses. With proper due diligence, many of these losses could have been prevented.
A TALE OF IRC § 1031 EXCHANGES GONE WRONG
Tax deferral efforts under IRC § 1031 have often resulted in significant losses for unwary taxpayers. The best examples of these losses resulted from the mass Qualified Intermediary failures we saw over the last two decades.
On February 21, 2014, then House Ways and Means Committee Chairman Dave Camp (R-Michigan) issued a discussion draft of the “Tax Reform Act of 2014.” The proposed legislation spanned almost 1,000 pages and contained some interesting provisions, including repealing IRC § 1031, thereby prohibiting tax deferral from like-kind exchanges. Not only would taxpayers have been impacted by this proposal, but it would have turned the real estate industry upside down. Qualified intermediaries would have been put out of business. Likewise, title and escrow companies, as well as real estate advisors specializing in exchanges, would have been adversely affected by the proposal.
House Ways and Means Committee Chairman David Camp issued a discussion draft of the Tax Reform Act of 2014 earlier this year. The proposed legislation spans almost 1,000 pages.* One of its provisions repeals IRC § 1031 and taxpayers’ ability to participate in tax-deferred exchanges. The Obama Administration responded to Chairman Camp’s proposal. It wants to retain IRC § 1031, but limit its application to $1,000,000 of tax deferral per taxpayer in any tax year. Based upon the precise wording of the White House’s response to Chairman Camp’s proposal, it appears the $1,000,000 limitation would only apply to real property exchanges. So, personal property exchanges would be spared from the proposed limitation. Of course, there is always the possibility that lawmakers, if they take this approach, would expand the White House’s proposed limitation to apply to personal property exchanges. Only time will tell.
Despite this talk, many practitioners believe IRC § 1031 will survive tax reform unscathed. After reviewing a recent report issued by the Treasury Office of Tax Analysis (“OTA”), I am not convinced IRC § 1031 will remain unchanged in any tax reform legislation enacted by lawmakers.
In its report, Treasury points out that tax deferral under IRC § 1031 is not considered a tax expenditure for purposes of the federal budget. The Joint Committee on Taxation (“JCT”), however, does not adopt this approach. Rather, it considers the gain deferral from IRC § 1031 exchanges as a tax expenditure. For 2014, the JCT estimates IRC § 1031 will result in a federal tax expenditure of about $8.7 billion. That number is large enough to get the attention of lawmakers.
The OTA report primarily focuses on 2007. In that year, it found:
- Total IRC § 1031 tax deferral amounted to about $82.6 billion.
- $25.8 billion was claimed by C corporations.
- $35.6 billion was claimed by partnerships.
- $21.2 billion was claimed by individuals.
- Over one half of the tax deferral claimed by C corporations related to vehicle exchanges (e.g., car rental companies or businesses with large fleets of trucks and/or automobiles).
- Banks are a significant user of IRC § 1031 exchanges (primarily exchanges of automobile fleets).
- Real estate exchanges accounted for almost 90% of the exchanges conducted by partnerships.
- Nearly $10.6 billion of the gain deferred by individuals related to residential rental properties.
- Over 90% of all individual exchanges involved real estate.
- Tax deferral from real estate dramatically decreased from 2007 to 2010 due to the recession, but interestingly, during this same period, tax deferral by corporations increased by about $3.5 billion due to an increase in vehicle exchanges.
The OTA report makes one thing crystal clear--IRC § 1031 exchanges result in a significant amount of gain deferral. Accordingly, eliminating or limiting exchanges could be a significant source of tax revenue. Treasury is obviously closely analyzing IRC § 1031 for this very reason.
Tax practitioners that believe IRC § 1031 will remain unchanged, if and when we see tax reform, may be unrealistic. Given these huge numbers and the JCT’s view of exchanges (i.e., they result in a tax expenditure), it is not farfetched to conclude there is a high probability tax reform will result in the repeal of IRC § 1031 as Chairman Camp proposes or a significant limitation on the amount of tax deferral as the Obama Administration proposes. STAY TUNED!
*For a more detailed discussion of the proposed legislation, see: http://www.larrystaxlaw.com/2014/02/are-we-going-to-see-tax-reform-2014
Larry J. Brant is a Shareholder in Garvey Schubert Barer, a law firm based out of the Pacific Northwest, with offices in Seattle, Washington; Portland, Oregon; New York, New York; Washington, D.C.; and Beijing, China. Mr. Brant practices in the Portland office. His practice focuses on tax, tax controversy and transactions. Mr. Brant is a past Chair of the Oregon State Bar Taxation Section. He was the long term Chair of the Oregon Tax Institute, and is currently a member of the Board of Directors of the Portland Tax Forum. Mr. Brant has served as an adjunct professor, teaching corporate taxation, at Northwestern School of Law, Lewis and Clark College. He is an Expert Contributor to Thomson Reuters Checkpoint Catalyst. Mr. Brant is a Fellow in the American College of Tax Counsel. He publishes articles on numerous income tax issues, including Taxation of S Corporations, Reasonable Compensation, Circular 230, Worker Classification, IRC § 1031 Exchanges, Choice of Entity, Entity Tax Classification, and State and Local Taxation. Mr. Brant is a frequent lecturer at local, regional and national tax and business conferences for CPAs and attorneys. He was the 2015 Recipient of the Oregon State Bar Tax Section Award of Merit.
Upcoming Speaking Engagements
- "The Road Between Subchapter C and Subchapter S – It May Be a Well-Traveled Two-Way Thoroughfare, but It Isn’t Free of Potholes and Obstacles," New York University Tax Conferences in July – Advanced Conference on Subchapter SNew York NY, 7.25.19
- "Tax Law Update for Family Law Practitioners," Oregon State Bar - Family Law Section 2019 Annual ConferenceSunriver, OR, 10.10.19-10.12.19
- "The Road Between Subchapter C and Subchapter S – It May Be a Well-Traveled Two-Way Thoroughfare, but It Isn’t Free of Potholes and Obstacles," New York University 78th Institute on Federal TaxationNew York, NY, 10.20.19-10.25.19
- "Subchapter S After the Tax Cuts and Jobs Act – the Good, the Bad and the Ugly," Oregon Society of Certified Public Accountants (OSCPA) 2019 Northwest Federal Tax ConferencePortland, OR, 10.28.19
- "The Road Between Subchapter C and Subchapter S – It May Be a Well-Traveled Two-Way Thoroughfare, but It Isn’t Free of Potholes and Obstacles," New York University 78th Institute on Federal TaxationSan Francisco, CA, 11.10.19–11.15.19