Isolating Section 1231 Gains for Opportunity Zone Investing: A Taxpayer-Friendly Option

By Alan M. Blecher  |  April 27, 2021

As the real estate industry absorbed the tremendous impact of the pandemic across all sectors, the flow of insights and interest related to Opportunity Zones temporarily slowed, and the recent decoupling of New York State from the federal tax benefits of the program may have some investors wondering if Opportunity Zones are still an appealing choice for their portfolios. The fact remains that any investment must first make sense from an economic standpoint, but in the right circumstances, Opportunity Zone investments can still provide considerable benefits. The final Opportunity Zone regulations, insofar as they address Section 1231 gains, have been viewed quite favorably by the Opportunity Zone investor community. An overview of the benefits pertaining to the final regulations on isolating Section 1231 gains follows.

Understanding Section 1231 Gains

Section 1231 gains are gains from depreciable property and real property used in a trade or business and held for more than one year, other than inventory or property held for sale in ordinary course. Such gains have traditionally enjoyed “favored nation” status in the Code. A taxpayer’s net Section 1231 gains for the taxable year are treated as long term capital gains, but a net Section 1231 loss is considered an ordinary loss. (Net Section 1231 gains are treated as ordinary income, however, to the extent of net Section 1231 losses for the preceding five years).

Gain on a sale is Section 1231 gain to the extent that it is not subject to recapture as ordinary income under Section 1245 (personal property) or Section 1250 (real property). Since Section 1250 ordinary income recapture only applies to depreciation in excess of straight line, and post-1986 real property deprecation under MACRS is straight line, Section 1250 ordinary income recapture is not common at this point. (This is not to be confused with unrecaptured Section 1250 gain, which is capital gain but taxed at a special rate.)

Investing 1231 Gains into Opportunity Zones

The Opportunity Zone provisions introduced in the Tax Cuts and Jobs Act of 2017 permit eligible taxpayers to defer the recognition of capital gains invested in an Opportunity Zone and potentially take a discount on the gain when it is recognized on December 31, 2026. Most importantly, a taxpayer’s entire gain on an Opportunity Zone investment (as opposed to the capital gain which was invested in the first place) that is held for at least 10 years completely escapes federal income tax. 

Since a taxpayer must roll in a capital gain to reap the benefits of an Opportunity Zone investment, there were some initial questions as to how this requirement would dovetail with Section 1231. This has been resolved in the taxpayer’s favor in the final IRS regulations on Opportunity Zones which were released at the end of 2019. The final regulations allow taxpayers to “isolate” Section 1231 gains – that is, to invest a particular Section 1231 gain at its full amount, even if it also has Section 1231 losses during the year.

For example: assume a taxpayer has a Section 1231 gain of $800,000 and a Section 1231 loss of $800,000 in the same year. The taxpayer can invest the $800,000 gain in an Opportunity Zone, thus deferring that gain. This leaves him with an $800,000 ordinary loss under Section 1231 – a “win-win” situation for most taxpayers.

This final decision is in contrast with the guidance initially provided under the proposed regulations, which would have allowed only net Section 1231 gain to be invested in an Opportunity Zone. Under those provisions, the taxpayer would have been unable to make an Opportunity Zone investment and would have no ordinary loss to deduct currently. For this reason, careful consideration of the final regulations provides investors with an important reminder that taxpayer-friendly final decisions were made regarding the investment of these gains.

Remember that a taxpayer generally has 180 days from the sale date to invest a capital gain into an Opportunity Zone. This same rule applies to Section 1231 gains. If the gain flows through to a taxpayer on a K-1 from a partnership, the taxpayer can choose to begin the 180-day period on any one of three dates: the date of sale by the partnership; December 31^{s t} or March 15^th of the following year (the original due date for the partnership return).

For more information on this benefit of investing in Opportunity Zones, reach out to your advisor or a member of Marks Paneth’s Real Estate Group. More information on the final Opportunity Zone regulations can be found here or accessed through Marks Paneth’s Opportunity Zones Resource Center

About Alan M. Blecher