Opportunity Zones and A Possible 2026 Tax Surprise

The 2016 Tax Cut and Jobs Act introduced a new provision to the Code - the qualified opportunity zone – sometimes called an “OZ.” I suspect that there was some humor while drafting the legislation, as here is the Code section:

         26 U.S. Code § 1400Z-1 – Designation

(a)      Qualified opportunity zone defined

For the purposes of this subchapter, the term “qualified opportunity zone” means a population census tract that is a low-income community that is designated as a qualified opportunity zone.

Yep: 140 OZ.

There are different technical terms in this area; For example, “QOZ business property” would include tangible business property; “QOZ business” would include an active trade or business where substantially all of the tangible property is QOZ business property; and “QOZ Fund” would be an investment vehicle – can be a corporation but usually a partnership – used to pool funds for investment in OZs.

For this post we will use the generic term “OZ.”

BTW, if you are presently in an OZ, there is a tax event in 2026 that you must be aware of. We will discuss the issue below.

Let’s discuss the following topics: 

     (1)          What are OZs?

(2)          Pre-2027 OZs

(3)          Post-2026 OZs

(4)          Gains reported through Schedule K-1

(5)          Another tax form

(6)          An example

What are OZs?

Introduced with the Tax Cut and Jobs Act of 2017, OZs were and are an effort to redirect private capital into historically overlooked economic areas. These areas (“zones”) were identified by the individual states and thereafter certified by the Treasury Secretary, a process which stretched into 2019.

There are – in general – two ways to invest in an OZ: a direct investment in a trade or business that operates within an OZ or in real estate located within an OZ; or an indirect investment via a fund which does the same.

Remember that an OZ’s purpose is to generate new investment. An intuitive example is starting a new business in an OZ zone. Buying an existing business can also work, but you must be willing to spend at least as much on new assets as you are spending to buy the existing assets.  Real estate can certainly work, but just buying an existing building or raw land will not suffice. The Code wants to see substantial improvement of the existing real estate. You are either renovating or building new if you want to OZ.

OZs have been compared to Section 1031 tax-free exchanges, but they actually operate quite differently. For example, to obtain the full benefit of a Section 1031, one has to reinvest (at least) the full sales price of the real estate sold. OZs are very different: one has to reinvest only the gain portion of the proceeds, not the total proceeds.

EXAMPLE: Let’s say you sell a building for $12 million with a gain of $3.5 million.

If you want a (full) Section 1031 like-kind exchange, you will have to invest at least $12 million (and meet other requirements) in replacement real estate.

If you want a (full) OZ, you will have to invest $3.5 million in an OZ-located business, real estate, or a fund that does that for you.

You see what powers the OZ: you must have a capital gain somewhere on your return. It does not matter what type of taxpayer you are. An individual, decedent, corporation, trust or estate will qualify – as long as you have capital gain as an admission ticket.

BTW your OZ investment must be equity. It cannot be debt back to you, much to the disappointment of tax planners nationwide.

And you have 180 days after the sale date to get the investment done. You cannot invest before the sale date. A Section 1031 can do that but not an OZ.

The driving force behind OZs are two potential tax breaks: one a tax deferral and the other an outright tax exclusion. These two can vary depending upon whether one invested in 2026 or earlier or invests in 2027 and later.

Pre-2027 OZs

(1)          The tax deferral

a.     Taxes on the underlying sale are not payable until December 31, 2026 (or when you sell the OZ, if earlier).

b.    There is a bonus for holding on to the OZ.

                                       i.     Only 90% of the gain will be taxable if you hold for at least 5 years.

                                     ii.     That changes to 85% if you hold for at least 7 years.

1.    COMMENT: I doubt that we will see many 7-years as the rules were not finalized until 2019.

c.     If you have a pre-2027, you will owe tax on December 31, 2026, unless you sold the property previously.

                                       i.     If you haven’t sold, you may want to start freeing-up cash for tax.

 (2)          The tax exclusion

a.     This one is tricky: all gain AFTER the original sale AND before December 31, 2047 is tax-free IF you hold the replacement property for at least 10 years.

                                       i.     Yep, the 2047 throws me too. I presume the 2047 has something to do with how the CBO scored the tax bill.

                                     ii.     If not sold by then, one steps-up basis in the property to its December 31, 2047 fair market value.

                                   iii.     Let’s be frank: all we are after is to hold for at least 10 years. 2047 is an after-thought, if it is even a thought.

b.    Example: You sell something in 2026 for a $1 million gain. You reinvest the $1 million and sell the replacement property 11 years later for a $2 million gain (totaling $3 million in gains over the transaction cycle - congrats). You will pay tax on the $1 million in 2026 – no one escapes 2026. You however will not pay tax on the subsequent $2 million, as you would have held the replacement property for the (actually, more than) required 10 years.

 (3)          Tax planners are a tricky lot

a.     Can one rollover the gain otherwise taxable at December 31, 2026 and defer the tax one more time?

                                       i.     In the preceding example, that would be the $1 million.

b.    The IRS was clear, blunt, and concise: NO!

                                       i.     No two bites at the same apple.

                                     ii.     The cite for the tax nerds is IRS Notice 2026-40.

Post-2026 OZs  

 (1)          The big change is getting rid of that one-size-fits-all-tax-recognition-date (of December 31, 2026). The new rules say that you will owe tax on the deferred gain on the 5^th anniversary of when you invested the gain.

a.     Makes more sense to me. I suspect that the original December 31, 2026 date had more to do with Congress being unsure whether the Code section would even be renewed.

 (2)          You still have the 10% gain exclusion if you hold the OZ for at least 5 years.

 (3)          However, there is no longer a 15% exclusion.

 (4)          Congress replaced that 2047 nonsense with a 30-year anniversary of the investment date.

a.     Once again, do not get caught-up here. What we are after is to hold for at least 10 years.

 (5)          Congress provided a specialized break for rural OZs.

a.     The 10% gain exclusion is 30% instead.

b.    Rural is described (generally) as 50,000 people or less.

Gains reported through Schedule K-1

One has 180 days to invest capital gains into an OZ.

How does that rule work when the capital gain is reported via a Schedule K-1?

If you sell an asset personally, you are (likely) aware of the sale and its sale date. You can more easily work with the 180-day window.

A sale through a passthrough entity (a partnership or S corporation, for example) can be more problematic. The passthrough may do an excellent job of alerting one of the sale and gain; it is equally likely that it may not. Take a partnership that extends its return, for example. As the tax preparer for a partner, my first knowledge of that gain may occur in September when the extended K-1 arrives. That would – without some relief – eliminate an OZ roll as a viable planning option.

So the Regulations provided relief.

First, the passthrough entity itself may decide to reinvest into an OZ. If so, then the 180 days begins with the exact date of sale. This would, of course, take the passthrough owners out of it.

Second, the entity may decide not to directly invest and instead distribute the gain to its passthrough owners. Each owner can decide whether or not to invest, as one owner does not bind another. However, if one does invest, when does the 180-day window start?

The passthrough owner has three options:

(1)          The actual date of the sale (of course);

(2)          The last day of the passthrough entity’s taxable year (most likely December 31);

(3)          The unextended due date of the passthrough entity return (most likely March 15).  

I am leaning toward Option (3) as my default.

Another tax form

There has to be a capital gain to power an OZ, so expect your return to include a Schedule D (where capital gains are reported) and perhaps Form 8949 (providing supplemental detail to the Schedule D).

Reinvest the gain into an OZ and you will add this beauty to your tax return:  

It has four parts, and you will attach (and update) the form each year as the OZ goes through its life cycle - from acquisition to disposition.

An example

Let’s walk through what happens depending on whether one has a pre-2027 or post-2026 OZ.

EXAMPLE: You have a $7.5 million sale with a gain of $1.5 million.

Pre-2027 

          (1)          You sold in 2025.

(2)          You bought the OZ in 2026.

(3)          The $1.5 million gain can be deferred only until December 31, 2026. Sorry.

(4)          There is no 10% or 15% exclusion, as you hit the gain recognition date (December 31, 2026) well before any 5- or 7-year anniversary.

a.     Had you sold and bought in 2019, however, you would qualify for the 7-year 15% exclusion.

(5)          However, the 10-year exclusion is still possible. You would keep the OZ, pay the tax in 2026 and hold it for (at least) 10 years. If you do, any further gain (that is, beyond the $1.5 million you already paid tax on) would be tax-free.  

Post-2026 

          (1)          You sell in 2027.

(2)          You buy the OZ in 2027.

(3)          Tax on the $1.5 million is deferred for 5 years. You will not pay tax until sometime in 2032.

(4)          You will get a 10% exclusion at the 5-year anniversary, meaning that only $1,350,000 of the gain will be taxable. (The 10% becomes 30% if you reinvest in a rural OZ).

(5)          Same as the pre-2027, the 10-year exclusion is possible.  

Closing thoughts  

There are some nice tax features to an OZ, but remember that we are talking about investments. Not all investments make sense to all investors. An OZ might appeal to a business owner recognizing a large capital gain upon the sale of his/her business. An OZ would not appeal to a well-maintained older CPA who sold his practice via a 5-year compensation-as-purchase arrangement.  

This is a longer-term investment. The Code is straightforward about this with its 5-year, 7-year and 10-year thresholds.   

Be sure to consider state taxes. We have discussed the federal tax considerations, but your individual state may or may not follow the federal rules.  

Do not overlook the routine tax reporting of an OZ. If you start an OZ business as a single-member LLC, for example, you will be filing a Schedule C with your annual personal return. If the LLC is instead owned by a partnership in which are a partner, then you will report the K-1 every year on Schedule E. Yes, the December 31, 2026/5-year/7-year/10-year stuff is also out there, but that is in addition to the routine annual reporting.  

And remember: if you already own an OZ, hopefully your tax advisor has been in contact about (a) whether the December 31, 2026 deadline matters to you and (b) if it does, how much it matters. If this is you, you likely have deferred taxes due for 2026.

Ohtani’s New Baseball Contract

I was reading about Shohei Ohtani’s new contract with the Las Angeles Dodgers. If the name rings a bell, that is because he both bats and pitches. He is today’s Babe Ruth. He played with the Los Angeles Angels in 2023, led the American League with 44 home runs and pitched over 130 innings with a 3.14 ERA.

I am more an NFL than an MLB fan these days, but it is hard to ignore this guy’s athletic chops. It is also hard to ignore his new contract.

•  Contract totals at $700 million
•  He will draw “only” $2 million for the first 10 years.
•  He will draw the deferral (that is, $68 million annually) beginning in 2034 and through 2043.

At $700 million, Ohtani’s is the largest MLB contract ever, but what caught my eye was deferring 98% of the contract for over a decade. Do not be concerned about his cash flow, however. $2 million a year is sweet (that is way over CPA bank), and I understand that his endorsements alone may exceed $50 million annually. Cash flow is not a problem.

Why would Ohtani do this?

For one, remember that athletes at his level are hyper-competitive. There is something about saying that you received the largest contract in MLB history.

Why would the Dodgers do this?

A big reason is the time value of money. $100 ten years from now is worth less than $100 today. Why? Because you can invest that $100 today. With minimal Google effort, I see a 10-year CD rate of 3.8%. Invest that $100 at 3.8% and you will have a smidgeon more than $145 in ten years. Invest in something with a higher yield and it will be worth even more.

Flip that around.

What is $100 ten years from now worth today?

Let’s make it easy and assume the same 3.8%. What would you have to invest today to have $100 in ten years, assuming a 3.8% return?

Around $70.

Let’s revisit the contract considering the above discussion.

Assuming 10 years, 3.8% and yada yada, Ohtani’s contract is worth about 70 cents on today’s dollar. So, $700 million times 70% = $490 million today.

My understanding is the experts considered Ohtani’s market value to be approximately $45 million annually, so our back-of-the-envelope math is in the ballpark.

Looks like the Dodgers did a good job.

And deferring all that money frees cash for the Dodgers to spend during the years Ohtani is on the team and playing. He may be today’s Ruth, but he cannot win games by himself.

There is one more thing …

This is a tax blog, so my mind immediately went to the tax angle – federal or state – of structuring Ohtani’s contract this way.

Take a look at this bad boy from California Publication 1005 Pension and Annuity Guidelines:

          Nonresidents of California Receiving a California Pension

In General

California does not impose tax on retirement income received by a nonresident after December 31, 1995. For this purpose, retirement income means any income from any of the following:

• A private deferred compensation plan program or arrangement described in IRC Section 3121(v)(2)(C) only if the income is either of the following:

1.    Part of a series of substantially equal periodic payments (not less frequently than annually) made over the life or life expectancy of the participant or those of the participant and the designated beneficiary or a period of not less than 10 years.

Hmmm. “Substantially equal periodic payments” … and “a period of not less than 10 years.”

Correlation is not causation, as we know. Still. Highly. Coincidental. Just. Saying.

Ohtani is 29 years old. 98% of his contract will commence payment when he is 40 years old. I doubt he will still be playing baseball then. I doubt, in fact, he will still be in California then. He might return to Japan, for example, upon retirement.

That is what nonresident means.

Let me check something. California’s top individual tax rate for 2024 is 14.4%.

COMMENT: Seriously??

Quick math: $680 million times 98% times 14.4% equals $95.96 million.

Yep, I’d be long gone from California.

 

Are Minimum Required Distribution Rules Changing Again?

I wonder what is going on at the IRS when it comes to IRA minimum required distributions.

You may recall that prior law allowed for something called a “stretch” IRA.  The idea was simple, but planners and advisors pushed on it so long and so hard that Congress changed the law.

An IRA (set aside Roth IRAs for this discussion) must start distributing at some point in time. The tax Code tells you the minimum you must distribute. If you want more, well, that is up to you and the tax Code has nothing further to say.  The minimum distribution uses actuarial life expectancies in its calculation. Here is an example:

                   Age of IRA Owner            Life Expectancy

                            72                                    27.4

                            73                                    26.5

                            74                                    25.5

                            75                                    24.6                                        

Let’s say that you are 75 years old, and you have a million dollars in your IRA. Your minimum required distribution (MRD) would be:

                  $1,000,000 divided by 24.6 = $40,650

There are all kinds of ancillary rules, but let’s stay with the big picture. You have to take out at least $40,650 from your IRA.

President Trump signed the SECURE Act in late 2019 and upset the apple cart. The new law changed the minimum distribution rules for everyone, except for special types of beneficiaries (such as a surviving spouse or a disabled person).

How did the rules change?

Everybody other than the specials has to empty the IRA in or by the 10^th year following the death.

OK.

Practitioners and advisors presumed that the 10-year rule meant that one could skip MRDs for years 1 through 9 and then drain the account in year 10. It might not be the most tax-efficient thing to do, but one could.

The IRS has a publication (Publication 590-B) that addresses IRA distributions. In March, 2021 it included an example of the new 10-year rule. The example had the beneficiary pulling MRDs in years 1 through 9 (just like before) and emptying the account in year 10.

Whoa! exclaimed the planners and advisors. It appeared that the IRS went a different direction than they expected. There was confusion, tension and likely some anger.

The IRS realized the firestorm it had created and revised Publication 590-B in May with a new example. Here is what it said:

For example, if the owner dies in 2020, the beneficiary would have to fully distribute the plan by December 31, 2030. The beneficiary is allowed, but not required, to take distributions prior to that date.”

The IRS, planners and advisors were back in accord.

Now I am skimming the new Proposed Regulations. Looks like the IRS is changing the rules again.

The Regs require one to separate the beneficiaries as before into two classes: those exempt from the 10-year rule (the surviving spouse, disabled individuals and so forth) and those subject to the 10-year rule.

Add a new step: for the subject-to group and divide them further by whether the deceased had started taking MRDs prior to death. If the decedent had, then there is one answer. If the decedent had not, then there is a different answer.

Let’s use an example to walk through this.

Clark (age 74) and Lois (age 69) are killed in an accident. Their only child (Jon) inherits their IRA accounts.

Jon is not a disabled individual or any of the other exceptions, so he will be subject to the 10-year rule.

One parent (Clark) was old enough to have started MRDs.

The other parent (Lois) was not old enough to have started MRDs.

Jon is going to see the effect of the proposed new rules.

Since Lois had not started MRDs, Jon can wait until the 10^th year before withdrawing any money. There is no need for MRDS because Lois herself had not started MRDs.

OK.

However, Clark had started MRDs. This means that Jon must take MRDs beginning the year following Clark’s death (the same rule as before the SECURE Act). The calculation is also the same as the old stretch IRA: Jon can use his life expectancy to slow down the required distributions – well, until year 10, of course.

Jon gets two layers of rules for Clark’s IRA:

·      He has to take MRDs every year, and

·      He has to empty the account on or by the 10^th year following death

There is a part of me that gets it: there is some underlying rhyme or reason to the proposed rules.

However, arbitrarily changing rules that affect literally millions of people is not effective tax administration.

Perhaps there is something technical in the statute or Code that mandates this result. As a tax practitioner in mid-March, this is not my time to investigate the issue.  

The IRS is accepting comments on the proposed Regulations until May 25.

I suspect they will hear some.

Section 1202 Stock And A House Tax Proposal

I am not a fan of fickleness and caprice in the tax law.

I am seeing a tax proposal in the House Ways and Means Committee that represents one.

It has been several years since we spoke about qualified small business stock (QSBS). Tax practice is acronym rich, and one of the reasons is to shortcut who qualifies – and does not qualify – for a certain tax provision. Section 1202 defines QSBS as stock:

·      issued by a C corporation,

·      with less than $50 million in assets at time of stock issuance,

·      engaged in an active trade or business,

·      acquired at original issuance by an eligible shareholder in exchange for either cash or services provided, and

·      held for at least five years.

The purpose of this provision is to encourage – supposedly – business start-ups.

How?

A portion of the gain is not taxed when one sells the stock.

This provision has been out there for approximately 30 years, and the portion not taxed has changed over time. Early on, one excluded 50% (up to a point); it then became 75% and is now 100% (again, up to a point).

What is that point?

The amount of gain that can be excluded is the greater of:

·      $10 million, or

·      10 times the taxpayer’s basis in the stock disposed

Sweet.

Does that mean I sell my tax practice for megabucks, all the while excluding $10 million of gain?

Well, no. Accounting practices do not qualify for Section 1202. Not to feel singled- out, law and medical practices do not qualify either.

I have seen very few Section 1202 transactions over the years. I believe there are two primary reasons for this:

                 

(a)  I came into the profession near the time of the 1986 Tax Reform Act, which single-handedly tilted choice-of-entity for entrepreneurial companies from C to S corporations. Without going into details, the issue with a C corporation is getting money out without paying double tax. It is not an issue if one is talking about paying salary or rent, as one side deducts and the other side reports income. It is however an issue when the business is sold. The S corporation allows one to mitigate (or altogether avoid) the double tax in this situation. Overnight the S corporation became the entity of choice for entrepreneurial and closely-held companies. There has been some change in recent years as LLCs have gained popularity, but the C corporation continues to be out-of-favor for non-Wall Street companies. 

 

(b)  The sale of entrepreneurial and closely-held companies is rarely done as a stock purchase, a requirement for Section 1202 stock. These companies sell their assets, not their stock. Stock acquisitions are more a Wall Street phenomenon.

So, who benefits from Section 1202?

A company that would be acquired via a stock purchase. Someone like … a tech start-up, for example. How sweet it would have been to be an early investor in Uber or Ring, for example. And remember: the $10 million cap is per investor. Take hundreds of qualifying investors and you can multiply that $10 million by hundreds.

You can see the loss to the Treasury.

Is it worth it?

There has been criticism that perhaps the real-world beneficiaries of Section 1202 are not what was intended many years ago when this provision entered the tax Code.

I get it.

So what is the House Ways and Means Committee proposing concerning Section 1202?

They propose to cut the exclusion to 50% from 100% for taxpayers with adjusted gross income (AGI) over $400 grand and for sales after September 13, 2021.

Set aside the $400 grand AGI. That sale might be the only time in life that someone ever got close to or exceeded $400 grand of income.

The issue is sales after September 13, 2021.

It takes at least five years to even qualify for Section 1202. This means that the tax planning for a 2021 sale was done on or before 2016, and now the House wants to retroactively nullify tax law that people relied upon years ago.

Nonsense like this is damaging to normal business. I have made a career representing entrepreneurs and their closely-held businesses. I have been there – first person singular - where business decisions have been modified or scrapped because of tax disincentives. Taxing someone to death clearly qualifies as a business disincentive. So does retroactively changing the rules on a decision that takes years to play out. Mind you – I say that not as a fan of Section 1202.

To me it would make more sense to change the rules only for stock issued after a certain date – say September 13, 2021 – and not for sales after that date. One at least would be forewarned.   

Should bad-faith tax proposals like this concern you?

Well, yes. If our current kakistocracy can do this, what keeps them from retroactively revoking the current tax benefits of your Roth IRA?  How would you feel if you have been following the rules for 20 years, contributing to your Roth, paying taxes currently, all with the understanding that future withdrawals would be tax-free, and meanwhile a future Congress decides to revoke that rule - retroactively?

I can tell you how I would feel.

Wiping Out An Inherited IRA

I came across an unfortunate tax situation this week.

It has to do with IRAs and trusts.

More specifically, naming a trust as a beneficiary of an IRA.

This carried a bit more punch before the tax law change of the SECURE Act, effective for 2020. Prior to the change, best planning for an inherited IRA frequently included a much younger beneficiary. This would reset the required distribution table, with the result that the monies could stay in the IRA for decades longer than if the original owner had lived. This was referred to as the “stretch” IRA. The SECURE Act changed that result for most beneficiaries, and now IRAs have to distribute – in general – over no longer than 10 years. 

Trusts created a problem for stretch IRAs, as trusts do not have an age or life expectancy like people do. This led to something called the “look-through” or “conduit” trust, allowing one to look-through the trust to its beneficiary in arriving at an age and life expectancy to make the stretch work.

The steam has gone out of the conduit trust.

One might still want to use a trust as an IRA beneficiary, though. Why? Here is an example:

The individual beneficiary has special needs. There may be income and/or asset restrictions in order to obtain government benefits.

What is the point, you ask? Doesn’t the IRA have to distribute to the individual over no more than 10 years?

Well … not quite. The IRA has to distribute to the trust (which is the IRA beneficiary) over no more than 10 years. The trust, in turn, does not have to distribute anything to its individual beneficiary.

This is referred to as an accumulation trust. Yes, it gets expensive because the trust tax rates are unreasonably compressed. Still, the nontax objectives may well outweigh the taxes involved in accumulating.

There is something about an inherited IRA that can go wrong, however. Do you remember something called a “60-day rollover?” This is when you receive a check from your IRA and put the money back within 60 days. I am not a fan, and I can think of very few cases where I would use or recommend it.

Why?

Because of Murphy’s Law, what I do and have done for over 35 years.

You know who can do a 60-day rollover?

Only a surviving spouse can use a 60-day rollover on an inherited IRA.  

You know who cannot do a 60-day rollover on an inherited IRA?

Anyone other than a surviving spouse.

It is pretty clear-cut.  

I am looking at someone who did not get the memo.

Here are the highlights:

·      Husband died.

·      The wife rolled the IRA into her own name (this is a special rule only for surviving spouses).

·      The wife died.

·      A trust for the kids inherited the IRA.

No harm, no foul so far.

·      The kids wanted to trade stocks within the IRA.

So it begins.

·      The IRA custodian told the kids that they would have to transfer the money someplace else if they wanted to trade.

No prob. The kids should have the IRA custodian transfer the money directly to the custodian of a new IRA that will let them trade to their heart’s content.

·      The kids had the IRA custodian transfer the money to a non-IRA account owned by the trust.

And so it ends.

The kids were hosed. They tried a Hail Mary by filing a private letter request with the IRS, asking for permission to put the money back in the IRA. The IRS looked at the tax law for a split second … and said “No.”

The IRS was right.

And, as usual, I wonder what happened with calling the tax advisor before moving around not-insignificant amounts of money.  

One can point out that taxes would have been payable as the kids withdrew money, and an inherited IRA has to distribute. If mom died in 2020 or later, the IRA would have to be distributed over no more than 10 years anyway.

Still, 10 years is 10 years. If nothing else, it would have given the kids the opportunity to avoid bunching all IRA income into one taxable year.

Not to mention paying for a private letter ruling, which is not cheap.

I hope they enjoy their stock trading.

The cite for the home gamers is PLR 202125007.