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.

Can You Have Income From Life Insurance?

 

I was looking at a recent case wondering: why did this even get to court?

Let’s talk about life insurance.

The tax consequences of life insurance are mostly straightforward:

(1) Receiving life insurance proceeds (that is, someone dies) is generally not an income-taxable event.

(2) Permanent insurance accumulates reserves (that is, cash value) inside the policy. The accumulation is generally not an income-taxable event.

(3) Borrowing against the cash value of a (permanent) insurance policy is generally not an income-taxable event.

Did you notice the word “generally?” This is tax, and almost everything has an exception, if not also an exception to the exception.

Let’s talk about an exception having to do with permanent life insurance.

Let’s time travel back to 1980. Believe it or not, the prime interest rate reached 21.5% late that year. It was one of the issues that brought Ronald Reagan into the White House.

Some clever people at life insurance companies thought they found a way to leverage those rates to help them market insurance:

(1)  Peg the accumulation of cash value to that interest rate somehow.

(2)  Hyperdrive the buildup of cash value by overfunding the policy, meaning that one pays in more than needed to cover the actual life insurance risk. The excess would spill over into cash value, which of course would earn that crazy interest rate.

(3)  Remind customers that they could borrow against the cash value. Money makes money, and they could borrow that money tax-free. Sweet.

(4)  Educate customers that – if one were to die with loans against the policy – there generally would be no income tax consequence. There may be a smaller insurance check (because the insurance is diverted to pay off the loan), but the customer had the use of the cash while alive. All in all, not a bad result – except for the dying thing, of course.

You know who also reads these ads?

The IRS.

And Congress.

Neither were amused by this. The insurance whiz kids were using insurance to mimic a tax shelter.

Congress introduced “modified endowment contracts” into the tax Code. The acronym is pronounced “meck.”

The definition of a MEC can be confusing, so let’s try an example:

(1)  You are age 48 and in good health.

(2)  You buy $4,000,000 of permanent life insurance.  

(3)  You anticipate working seven more years.

(4)  You ask the insurance company what your annual premiums would be to pay off the policy over your seven-year window.

(5)  The company gives you that number.

(6)  You put more than that into the policy over the first seven years.

I used seven years intentionally, as a MEC has something called a “7 pay test.” Congress did not want insurance to morph into an investment, which one could do by stuffing extra dollars into the policy. To combat that, Congress introduced a mathematical hurdle, and the number seven is baked into that hurdle.     

If you have a MEC, then the following bad things happen:

(1) Any distributions or loans on the policy will be immediately taxable to the extent of accumulated earnings in the policy.

(2) That taxable amount will also be subject to a 10% penalty if one is younger than age 59 ½.

Congress is not saying you cannot MEC. What it is saying is that you will have to pay income tax when you take monies (distribution, loan, whatever) out of that MEC.

Let’s get back to normal, vanilla life insurance.

Let’s talk about Robert Doggart.

Doggart had two life insurance contracts with Prudential Insurance. He took out loans against the two policies, using their cash value as collateral.

Yep. Happens every day.

In 2017 he stopped paying premiums.

This might work if the earnings on the cash value can cover the premiums, at least for a while. Most of the time that does not happen, and the policy soon burns out.

Doggart’s policies burned out.

But there was a tax problem. Doggart had borrowed against the policies. The insurance company now had loans with no collateral, and those loans were uncollectible.   

You know there is a 1099 form for this.

Doggart did not report these 1099s in his 2017 income. The IRS easily caught this via computer matching.

Doggart argued that he did not have income. He had not received any cash, for example.

The Court reminded him that he received cash when he took out the loans.

Doggart then argued that income – if income there be - should have been reported in the year he took out the loans.

The Court reminded him that loans are not considered income, as one is obligated to repay. Good thing, too, as any other answer would immediately shut down the mortgage industry.  

The Court found that Doggart had income.

The outcome was never in doubt.

But why did Doggart allow the policies to lapse in 2017?

Because Doggart was in prison.

Our case this time was Doggart v Commissioner, T.C. Summary Opinion 2023-25.

Requesting A Payment Plan With Over $7 Million In The Bank

Sometimes I wonder how people get themselves into situations.

Let’s take a look at a recent Tax Court case. It does not break new ground, but it does remind us that – sometimes – you need common sense when dealing with the IRS.

The Strashny’s filed their 2017 tax return on time but did not pay the tax due.

COMMENT: In and of itself, that does not concern me. The penalty for failing to file a tax return is 10 ten times more severe than filing but not paying. If the Strashny’s were my client and had no money, I would have advised the same.

The 2017 return had tax due, including interest, of over $1.1 million.

COMMENT: Where did the money go? I am curious now.

In June, 2018 the IRS assessed the tax along with a failure-to-pay penalty.

In July, 2018 the Strashny’s sent an installment payment request. Because of the amount of money involved, they had to disclose personal financial information (Form 433-A). They wanted to stretch the payments over 72 months.

COMMENT: Standard procedure so far.

Meanwhile the IRS sent out a Notice of Intent to Levy letter (CP90), which seemed to have upset the Strashny’s.

A collection appeal goes before an IRS officer settlement officer (or “SO,” in this context). In April, 2019 she sent a letter requesting a conference in May.

COMMENT: Notice the lapsed time – July, 2018 to April, 2019. Yep, it takes that long. It also explains while the IRS sent that CP90 (Notice of Intent to Levy): they know the process is going to take a while.

The taxpayers sent and the SO received a copy of their 2018 tax return. They showed wages of over $200,000.

OK, so they had cash flow.

All that personal financial information they had sent earlier showed cryptocurrency holdings of over $7 million. Heck, they were even drawing over $19,000 per month on the account.

More cash flow.

COMMENT: Folks, there are technical issues in this case, such as checking or not checking a certain box when requesting a collection hearing. I am a tax nerd, so I get it. However, all that is side noise. Just about anyone is going to look at you skeptically if you cite cash issues when you have $7 million in the bank.

The SO said no to the payment plan.

The Strashny’s petitioned the Tax Court.

COMMENT: Notice that this case does not deal with tax law. It deals, rather, with tax procedure. Procedure established by the IRS to deal with the day-to-day of tax administration. There is a very difficult standard that a taxpayer has to meet in cases like this: the taxpayer has to show that the IRS abused its authority.

The Strashny’s apparently thought that the IRS had to approve their request for a payment plan.

The Court made short work of the matter. It reasoned that the IRS has (with limited exceptions) the right to accept or reject a payment plan. To bring some predictability to the process, the IRS has published criteria for its decision process. For example, economic hardship, ill health, old age and so on are all fair considerations when reviewing a payment plan.

What is not fair consideration is a taxpayer’s refusal to liquidate an asset.

Mind you, we are not talking a house (you have to live somewhere) or a car (you have to get to work). There are criteria for those. We are talking about an investment portfolio worth over $7 million.

The Court agreed with the IRS SO.

So do I.

Was there middle ground? Yes, I think so. Perhaps the Strashny’s could have gotten 12 or 24 months, citing the market swings of cryptocurrency and their concern with initiating a downward price run. Perhaps there was margin on the account, so they had to be mindful of paying off debt as they liquidated positions. Maybe the portfolio was pledged on some other debt – such as business debt – and its rash liquidation would have triggered negative consequences. That approach would have, however, required common sense – and perhaps a drop of empathy for the person on the other side of the table – traits not immediately apparent here.

They got greedy. They got nothing.

Our case this time was Strashny v Commissioner.

Is Income From Investing Tax-Exempt Income Also Tax-Exempt?

Our story starts in 2005. Taxpayer (Lundy) received a Form 1099-R reporting approximately $42,000 of “retirement” income. The Lundys left it off their tax return. The IRS noticed and demanded payment. Off to Tax Court they went. Before there could be any hearing, the IRS settled, agreeing there was no tax due.

This action is referred to as a “stipulated” decision, and they tend to be about as terse as Bill Belichick at a press conference. We won’t read much there.

That said, I am thinking personal injury. We know that damages for personal injuries (think car accident) are tax-free. My hunch is that Lundy got injured, received a $42,000 settlement and a Form 1099-R to boot. Somebody messed up by issuing the 1099 in the first place. The IRS made a second mistake by not adequately investigating the facts before taking the matter to court.

Fast forward 6 years.

The Lundys file their tax return for 2011. Mr. Lundy has a W-2 from driving a school bus, and Mrs. Lundy has approximately $20,000 from a small business. There is some income tax, throw in some self-employment tax, and the Lundys owed about $3,500.

They send in the return. They do not send in any money, nor was there any withholding on Mr. Lundy’s W-2.

The IRS – of course – wants to know why. And they want their money.

The Lundy’s have no intention of sending money. 

The Lundys file a request for a due process hearing.

Their argument?

The funds that you are attempting to collect from are indeed part of my total and permanently [sic] disability benefits which were subject of the UNITED STATES TAX COURT CASE # 2759-07S***. We filed a timely appeal to the U.S. TAX COURT and laid out all of our affirmative defenses to the Commissioner of the Internal Revenue Service claims at that time. The most important claim that we made at that time is that whatever we funded, financed, and paid for with my total and permanently [sic] disability funds which were determined by this order to be non-reportable, tax free, and tax exempt from the clutches of the IRS was also off limits from the IRS.”

Well then.

Let’s think about their argument for a moment. The Lundys were arguing that any income earned from a tax-free source would – in turn – also be tax-free. Does this make sense? Let me give you a few situations:

·        You sell your primary residence, excluding $500,000 of gain. You invest the $500,000 in the next hot IPO. It takes off, and next thing you know you are rubbing shoulders with Gates, Buffett and Zuckerberg.

·        You take the interest from your municipal bond fund to fund the next great mobile app. You are subsequently acquired by Apple and you buy Ecuador.

·        You work overseas for a number of years, always claiming the foreign earned income exclusion. You invest your tax savings in raw land. Two decades later you sell the land to someone developing an outdoor mall. You buy a county in Wyoming so you have somewhere to hunt.

Of course it doesn’t make sense. It is clear that we have to separate the cart from the groceries. The cart stays at the store while the groceries go home with you. They are two different things, and the fate of the cart is not the fate of the groceries. Income from a tax-free pile of money does not mean that the earnings are magically tax-free. If only it were so. Could you imagine the ads from Fidelity or Vanguard if it were that simple?

The Lundys lost, of course.

Of surprise to me, as a practitioner, was the IRS restraint on penalties. The IRS popped them for late payment penalties, of course, but not for the super-duper penalties, such as for substantial accuracy. Why?

Who knows, but I did notice the Tax Court case was “pro se,” meaning that the Lundys represented themselves. There is a way to have a tax practitioner involved in a “pro se,” but I do not think that is what happened here. I suspect they actually represented themselves, without an accountant or attorney.

Not that an accountant or attorney could have represented them in any event. A practitioner is prohibited from taking frivolous positions. The Lundy positon was as close to frivolous as I have heard in a while.

And the IRS gave them a break.

Not that the Lundys would see it that way, though.