New Opportunity Zone Regulations Present Estate And Gift Tax Implications
Picture of cranes, pipes, scaffoldings and other building devices in downtown Montreal, the main business hub of Quebec, and one of the biggest of Canada, surrounded by condos and skyscrapers.
Chances are you have heard about Opportunity Zones (OZones) by now. They were created by the Tax Cuts and Jobs Act to spur investment in designated distressed communities by granting investors certain preferential tax treatment.
The discussion has increased since the IRS proposed a second set of OZone regulations (the New Proposed Regulations) recently. These regulations are designed to alleviate some of the uncertainty that has hindered many OZone projects to date.
What you may not know is that the New Proposed Regulations clarify the treatment of gifts of interests in a qualified opportunity fund (QOF interests) to grantor trusts. This proposed clarification has estate and gift tax implications that Todd Angkatavanich (National Tax Principal, EY) and I will explore, not only for straight gifts of QOF interests to grantor trusts but also gifts of common interests in preferred partnerships and gifts of QOF interests to Grantor Retained Annuity Trusts (GRATs).
Benefits of QOFs
Generally, investments in QOFs come with three main tax benefits: (1) investors can defer tax on capital gains timely invested into a QOF until no later than December 31, 2026; (2) investors that held the QOF investment for five or seven years upon the expiration of the deferral period can receive a 10% or 15% reduction on their deferred capital gains tax bill; and (3) investors that sell the QOF investment after holding the investment for at least 10 years can receive the added benefit of paying no tax on any post-acquisition realized appreciation in the QOF investment. (For additional discussion on Opportunity Zones, see EY Tax Alerts 2018-2119 and 2019-0823.)
Gift Tax Consequences
The New Proposed Regulations address the issue of whether a gift of some or all of a taxpayer’s QOF interest would qualify as an “inclusion event.” If so, the deferred capital gains would be included in the taxpayer’s gross income. The New Proposed Regulations would treat the gift as either reducing or terminating the owners qualifying investment. Put another way, giving away your QOF interest outright would generally subject the interest to immediate taxation under the New Proposed Regulations.
Not all gifts, however, are treated equally. Under the New Proposed Regulations, a gift to a taxpayer’s grantor trust is treated differently. The New Proposed Regulations would not treat a grantor’s gift of a QOF interest to his or her grantor trust as an “inclusion event” accelerating the deferred capital gains tax. Why is that?
Back in the 1980s, the IRS ruled (Revenue Ruling 85-13) that a transaction between the grantor and the grantor trust is a tax nothing; after all, the same taxpayer was responsible for the taxes. Treasury uses the same logic to treat a gift of a QOF interest to a grantor trust as a tax nothing. Since the tax owner of the grantor trust continues to be the same tax owner of the income tax liability deferred by the OZone investment, a gift of some or all of the interest would not reduce or eliminate the transferor’s deferred income tax liability.
This treatment prompts another question: what happens when either the grantor dies or no longer has grantor trust powers? Will the apparent reliance on Revenue Ruling 85-13 continue to stand true? The New Proposed Regulations address those questions. Termination of grantor trust status due to the taxpayer’s death would not be treated as an “inclusion event” that would subject the deferred income to tax. On the other hand, termination of grantor trust status for other reasons would subject the deferred capital gains to the tax. The rational for this disparate outcome is important but beyond the scope of this Forbes piece.
Estate Tax Consequences
What happens if the QOF interest is transferred not because of a gift but because of death? Would that transfer also be treated as an “inclusion event” subjecting the deferred capital gains to immediate tax?
The New Proposed Regulations do not consider the death of a taxpayer owning a QOF interest to be an “inclusion event.” Neither the transfer of the qualifying investment to the taxpayer’s estate nor the distribution by the estate to the heirs would be an “inclusion event.” In each case, the New Proposed Regulations would require the estate or the beneficiary, as the case may be, to include the deferred gain in gross income upon a subsequent inclusion event, such as the recipient’s disposal of the qualifying investment.
Interaction with Existing Gift and Estate Planning Techniques
Gifts of QOF Interests
As previously noted, the New Proposed Regulations would permit taxpayers to make straight gifts of QOF interests to their grantor trusts. The grantor would continue to own the interests in the trust for income tax purposes and would be responsible for paying income taxes on the interests. This structure also allows the grantor’s estate to be reduced by the amount of tax liability paid on behalf of the trust.
When payment comes due in 2026, the New Proposed Regulations would permit income taxes on the deferred gain to be paid from the taxpayer’s otherwise estate-taxable assets while the grantor trust held the QOF interests. The New Proposed Regulations would also permit the grantor trust, as donee of the gift, to take a tacked holding period from the donor. This would allow the trust to enjoy the benefit of income tax-free appreciation in the QOF interest, as the holding period dates back to the taxpayer’s original QOF interest.
Thus, a gift of a QOF interest to a grantor trust has the potential to mitigate the income tax cost, since future appreciation after 10 years is excluded from income tax. This differs from a traditional gift to a grantor trust, which requires taxpayers to weigh the transfer-tax benefits of gifting assets before appreciation against the income tax cost of having a low-basis asset in the trust.
Gifts of Preferred Partnership Interests
The first set of proposed regulations issued in October of 2018 indicated that a QOF could be structured to have preferred and common equity interests. Transfers of common interests are very effective ways to balance the interests of cash flow for the senior generation and growth for the younger generation. This is done by having the senior generation retain preferred interests, which provide a steady predictable stream of cashflow and transferring the common interests to the younger generation, which shifts future appreciation to them for their benefit. Often, this planning is coupled with a trust that is generation-skipping transfer tax-exempt (and also a grantor trust) to improve multigenerational tax efficiency. The New Proposed Regulations would allow for planning with a QOF that is structured as a partnership with common and preferred interests.
Along with the advantage of grantor trust status, giving a common interest in a QOF to a grantor trust could allow for the long-term shifting of growth into the grantor trust. If the investment performs at the expected rate, and the 10-year holding period is satisfied (which would very likely be the case with common interests), significant growth would be shifted into a GST-exempt grantor trust. Additionally, future growth (after 10 years) would not be subject to income taxation.
As with any gift of a common interest in a family-controlled vehicle, the preferred interest will need to be structured to satisfy the technical requirements of Section 2701, to prevent triggering a large deemed gift, and Sections 2036 and 2038, to address any estate tax inclusion.
Gifts of QOF Interests to a GRAT
The New Proposed Regulations would also permit gifts of QOF interests to traditional GRATs. GRATs are statutorily blessed vehicles that allow the taxpayer/grantor to make a gift to a trust while retaining an annuity interest that roughly equals the fair market value of the transferred asset, resulting in a nearly tax-free gift. To the extent the transferred asset grows beyond what is needed to pay the required annuity stream back to the grantor, however, all that future appreciation passes to the grantor’s remainder beneficiaries (typically, children or their trusts) gift tax-free. Thus, GRATs provide a statutorily mandated way to essentially make a gift tax-free transfer of future appreciation.
Because GRATs are nearly always created to be grantor trusts for income tax purposes, the ability to give QOF interests to grantor trusts under the New Proposed Regulations should provide a basis to do GRAT planning with these investments. Thus, such a combination could transfer future appreciation gift tax-free, while also allowing further appreciation on the transferred interest to be income tax-free after 10 years.
The New Proposed Regulations would treat the change of status from grantor to non-grantor trust (except when that status change occurs due to the grantor’s death) as an inclusion event that would subject the deferred gain to tax. As such, the remainder beneficiary of a GRAT funded with a QOF interest should be structured as a grantor trust, rather than having the remainder interest pass outright to the intended beneficiaries or into non-grantor trusts.
The New Proposed Regulations do not address whether valuation discounts of the QOF interests will be allowed. The first set of proposed regulations would calculate deferred gain recognized in 2026 based on the lower of the originally deferred gain or the fair market value of the QOF interests as of that date. To the extent that capital gain sales proceeds are rolled over into an investment in a QOF, the interests should reflect valuation discounts.
The New Proposed Regulations also do not address whether a sale to a grantor trust by the grantor will be treated in a similar fashion as a gift to a grantor trust. The Treasury Department has requested additional comments on the New Proposed Regulations and the issue of sales to grantor trusts are expected to be addressed.