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.

Whose Job Is It Anyway?

One of our accountants asked me recently:

R:      Do you think [so and so] qualifies as a real estate professional?

CTG: I do not know [so and so]. Tell me a little.

R:      Husband pulls a W-2.

CTG: How much and how many hours?

R:      Blah blah dollars.

CTG: Works in real estate?

R:      Nah.

CTG: Hours?

R:      Maybe 2,000.

CTG: Is the wife in real estate?

R:      No.

I have told you (almost) everything you need to answer the question.

Let’s look at the Warren case.

James Warren organized Warren Assisted Living, LLC in 2015.

He purchased a group home in 2016.

He started repairing the home almost immediately.

In 2017 he worked at Lockheed Martin for 1,913 hours as an engineer.

On his 2017 tax return he claimed a $41 thousand-plus loss from the group home. He claimed he was a real estate professional.

Warren did not keep time logs.

What sets this up are the passive activity rules under Section 469. As initially passed, that Section considered rental activities (with minimal exceptions) to be “per se” passive.

The passive activity rules would then stifle your ability to claim losses. You – for the most part – had to wait until you had income from the activity. You could then use the losses against the income. 

Well, that caught real estate landlords and others around the country by surprise. When you do one thing, it is difficult to have a Congressional staffer decide that your thing is not a regular thing like the next thing across the street.

Congress made a change.

(c)(7)  Special rules for taxpayers in real property business.

 

(A)  In general. If this paragraph applies to any taxpayer for a taxable year-

 

(i)  paragraph (2) shall not apply to any rental real estate activity of such taxpayer for such taxable year, and

(ii)  this section shall be applied as if each interest of the taxpayer in rental real estate were a separate activity.

 

Notwithstanding clause (ii) , a taxpayer may elect to treat all interests in rental real estate as one activity. Nothing in the preceding provisions of this subparagraph shall be construed as affecting the determination of whether the taxpayer materially participates with respect to any interest in a limited partnership as a limited partner.

 

(B)   Taxpayers to whom paragraph applies. This paragraph shall apply to a taxpayer for a taxable year if-

 

(i)  more than one-half of the personal services performed in trades or businesses by the taxpayer during such taxable year are performed in real property trades or businesses in which the taxpayer materially participates, and

(ii)  such taxpayer performs more than 750 hours of services during the taxable year in real property trades or businesses in which the taxpayer materially participates.

 

In the case of a joint return, the requirements of the preceding sentence are satisfied if and only if either spouse separately satisfies such requirements. For purposes of the preceding sentence, activities in which a spouse materially participates shall be determined under subsection (h) .

The above is called the real estate professional exception. It is a mercy release from the per se rule that would otherwise inaccurately (and unfairly) consider people who work in real estate all day to not be working at all.

It has two main parts:

(1) You have to spend at least 750 hours working in real estate, and

(2)  You have to spend more than 50% of your “working at something” total hours actually “working in real estate.”

If you are a real estate professional, you avoid the “per se” label. You have not yet escaped the passive activity rules – you still have to show that you worked - but at least you have the opportunity to present your case.

The Court looked at Warren’s 1,913 hours at Lockheed. That means he would need 3,827 total hours for real estate to be more than ½ of his total work hours. (1,913 times 2 plus 1).

First of all, 3,827 total hours means he was working at least 74 hours a week, every week, without fail, for the entire year.

Maybe. Doubt it.

Warren is going to need really good records to prove it.

Here is the Court:

Mr Warren did not keep contemporaneous logs of his time renovating the group home.”

Not good, but not necessarily fatal. I represented a client who kept Outlook and other records. She created her log after the fact but from records which themselves were contemporaneous. Mind you, we had to go to Appeals, but she won.

In preparation for trial, Mr Warren created – and presented – two time logs.”

Good grief.

The first log maintained that he worked 1,421 hours at the group home; it was created one week before trial.”

End it. That is less than his 1,913 hours at Lockheed.

The second log maintained that Mr. Warren worked 1,628 at the group home; it was created the night before trial.”

Why bother?

This was a slam dunk for the Court. They did not have to dwell on contemporaneous or competing logs or believability or whether the Bengals will turn their season around. Whether 1,421 or 1,628, he could not get to more-than-50%.

Warren lost.

As a rule of thumb, if you have a full-time W-2, it will be almost impossible to qualify as a real estate professional. The exception is when your full-time W-2 is in real estate, maybe with an employer such as CBRE or Cushman & Wakefield.  At 1,900-plus Lockheed hours, I have no idea what Warren was thinking, although I see that it was a per se case. That means he represented himself, and it shows.

I suppose one could have a W-2 and work crazy hours and meet the more-than-50% requirement, but your records should be much tighter. And skip the night before thing.

BTW another way to meet this test is by being married.

Look at (B)(ii) again:

In the case of a joint return, the requirements of the preceding sentence are satisfied if and only if either spouse separately satisfies such requirements. For purposes of the preceding sentence, activities in which a spouse materially participates shall be determined under subsection (h) .

If your spouse can meet the test (both parts), then you will qualify by riding on the shoulders of your spouse.

Our case this time was Warren v Commissioner, T.C. Summary Opinion 2024-20.

A Real Estate Course – And Dave

 

The case made me think of Dave, a friend from long ago – one of those relationships that sometimes surrenders to time, moving and distance.

Dave was going to become a real investor.

That was not his day job, of course. By day he was a sales rep for a medical technology company. And he was good at sales. He almost persuaded me to join his incipient real estate empire.

He had come across one of those real estate gurus – I cannot remember which one – who lectured about making money with other people’s money.

There was even a  3-ring binder or two which Dave gave me to read.

I was looking over a recent case decided by the Tax Court.

The case involved an engineer (Eason) and a nurse (Leisner).

At the start of 2016 they owned two residential properties. One was held for rent; the other was sold during 2016.

COMMENT: Seems to me they were already in the real estate business. It was not a primary gig, but it was a gig.

Eason lost his job during 2016.

A real estate course came to his attention, and he signed up – for the tidy amount of $41,934.

COMMENT: Say what?

In July 2016 the two formed Ashley & Makai Homes (Homes), an S corporation. Homes was formed to provide advice and guidance to real estate owners and investors.  They had business cards and stationary made and started attending some of those $40 grand-plus courses. Not too many, though, as the outfit that sponsored the courses went out of business.

COMMENT: This is my shocked face.

By 2018 Eason and Leisner abandoned whatever hopes they had for Homes. They never made a dime of income.

You know that $40 grand-plus showed up on the S corporation tax return.

The IRS disallowed the deduction.

And tacked on penalties for the affront.

This is the way, said the IRS.

And so we have a pro se case in the Tax Court.

Respondent advances various reasons why petitioners are not entitled to any deductions …”

The respondent will almost always be the IRS in these cases, as the it is the taxpayer who petitions the Court.

And we have discussed “pro se” many times. It generally means that a taxpayer is representing himself/herself, but that is not fully accurate. A taxpayer can be advised by a professional, but if that professional has not taken and passed the exam to practice before the Tax Court the matter is still considered pro se.

Back to the Court:

          … we need to focus on only one [reason].”

That reason is whether a business had started.

Neither Homes nor petitioners reported any income from a business activity related to the disputed deductions, presumably because none was earned.”

This is not necessarily fatal, though.

The absence of income, in and of itself, does not compel a finding that a business has not yet started if other activities show that it has.”

This seems a reasonably low bar to me: take steps to market the business, whatever those words mean in context. If the context is to acquire clients, then perhaps a website or targeted advertising in the local real estate association newsletter.

Here, however, the absence of income coupled with the absence of any activity that shows that services were offered or provided to clients or customers […] supports respondent’s position that the business had not yet started by the close of the year.”

Yeah, no. The Court noted that a business deduction requires a business. Since a business had not started, no business deduction was available.

The Court disagreed with any penalties, though. There was enough there that a reasonable person could have decided either way.

I agree with the Court, but I also think that just a slight change could have changed the outcome in the taxpayers’ favor.

How?

Here’s one:  remember that Eason and Leisner owned a rental property together?

What if they had broadened Homes’ principal activity to include real estate rental and transferred the property to the S corporation? Homes would have been in business at that point. The tax issue then would have been expansion of the business, not the start of one.

Our case this time was Eason and Leisner v Commissioner, T.C. Summary Opinion 2024-17.

Renting Real Estate And Self-Employment Tax

 

I was looking at a tax return recently. There was an issue there that I did not immediately recognize.

Let’s go over it.

The client is a new venue for cocktail parties, formal dinners, corporate meetings, bridal showers, wedding rehearsals and receptions, and other such occasions.

The client will configure the space as you wish, but you will have to use a preselected list of caterers should you want food. There is a bar, but you will have to provide your own bartender. You can decorate, but there are strict rules on affixing decorations to walls, fixtures, and such. Nonroutine decorations must be approved in advance. You will have to bring your own sound system should you want music, as no system exists. The client will clean the space at the end of the event, but you must first remove all personal items from the property.

Somewhat specialized and not a business I would pursue, but I gave it no further thought.

The question came up: is this ordinary business income or rental income?

Another way to phrase the question is whether the income would or would not be subject to self-employment tax.

Let’s say you have a duplex. One would be hard pressed to think of a reasonable scenario where you would be paying self-employment tax, as rental income from real estate is generally excepted from self-employment income.

Let’s change the facts. You own a Hyatt Hotel. Yes, it is real estate. Yes, there is rental income. This income, however, will be subject to self-employment tax.

What is the difference? Well, the scale of the activity is one, obviously. Another is the provision of additional services. You may bring in a repairman if there were a problem at the duplex, but you are not going into the unit to wash dishes, vacuum carpets, change bed linens or provide fresh towels. There is a limit. On the other hand, who knows what concierge services at a high-end hotel might be able to provide or arrange.

We are on a spectrum, it appears. It would help to have some clarification on which services are innocuous and which are taunting the bull.

IRS Chief Counsel Advice 202151005 addressed the spectrum in the context of residential rental property.

First a warning. A CCA provides insight into IRS thinking on a topic, but that thinking is not considered precedent, nor does it constitute substantial authority in case of litigation. That is fine for us, as we have no intention of litigating anything or having a tax doctrine named after us.

Here is scenario one from the CCA:

·       You are not a real estate dealer.

·       You rent beachfront property via online marketplaces (think Airbnb).

·       You provide kitchen items, Wi-Fi, recreational equipment, prepaid ride-share vouchers to the business district and daily maid service.

Here is scenario two:

·       You are not a real estate dealer.

·       You rent out a bedroom and bathroom in your home via online marketplaces.

·       A renter has access to common areas only to enter and exit.

·       You clean the bedroom and bathroom after each renter’s stay.

I am not overwhelmed by either scenario. Scenario one offers a little more than scenario two, but neither is a stay at the Hotel Jerome.

Here is the CCA walkthrough:

·       Tax law considers rental income collected by a non-dealer to be non-self- employment income.

·       However, the law says nothing about providing services.

·       Allowable services include:

o   Those clearly required to maintain the property in condition for occupancy, and

o   Are a sufficiently insubstantial portion of the rent.

·       Nonallowable services include:

o   Those not clearly required to maintain the property in condition for occupancy, and

o   Are so substantial as to comprise a material portion of the rent.

The CCA considered scenario two to be fine.

COMMENT: I would think so. The services are minimal unless you consider ingress and egress to be substantial services.

The CCA considered scenario one not to be fine.

Why not?

·       The services are for the convenience of the occupants.

·       The services are beyond those necessary to maintain the space for occupancy.

·       The services are sufficient to constitute a material portion of the rent.       

I get the big picture: the closer you get to hotel accommodations the more likely you are to be subject to self-employment tax. I am instead having trouble with the smaller picture – the details a tax practitioner is looking for – and which signal one’s location on the spectrum.

·       Is the IRS saying that services beyond the mere availability of a bed and bathroom are the path to the dark side?

·       IRS Regulations refer to services customarily provided.

o   How is one to test customarily: with reference to nearby full-service hotels or only with other nearby online rentals?

o   In truth, did the IRS look at any nearby services in scenario one?

·       What does material portion mean?

o   Would the provision of services at a lower rent situs (say Athens, Georgia) result in a different answer from the provision of comparable services at a higher rent situs (say Aspen, Colorado)?

o   What about a different time of year? Can one provide more services during a peak rental period (say the NCAA Tournament) and not run afoul of the material portion requirement??

One wonders how much this CCA has reinforced online rental policies such as running-the-dishwasher and take-out-the-trash-when-you-leave. There is no question that I would advise an Airbnb client not to provide daily services, whatever they may be.

I also suspect why our client set up their venue the way they did.