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Death in O-Zone Regime Doesn’t Always Equal Basis Step-Up

Posted on Dec. 30, 2019

The tax treatment of a qualified opportunity fund interest when the owner dies isn’t exactly intuitive under recently released final rules, according to practitioners.

It makes sense that heirs wouldn’t receive traditional basis step-up on the inherited interest for capital gain amounts deferred under the Opportunity Zone regime, but it makes less sense that the appreciated amount of that interest wouldn’t get a step-up, Libin Zhang of Fried, Frank, Harris, Shriver & Jacobson LLP told Tax Notes.

“That’s not what I would have expected,” Steven R. Schneider of Baker McKenzie said. “It’s not intuitive.”

The IRS and Treasury said in the final rules (T.D. 9889) released December 19 that Congress intended that the basis for a fund interest with rolled-over capital gains would generally be zero, but that’s at odds with the decision to allow those same investors to get basis for debt allocations from a partnership fund, Zhang pointed out.

The Opportunity Zone program was added in the Tax Cuts and Jobs Act and allows taxpayers to roll over capital gains into a QOF and defer paying tax. After five and seven years, the taxpayer gets up to a 10 or 15 percent basis increase on the deferred gains, and the fund’s appreciation is not subject to income tax after 10 years.

When partners invest in a partnership, they get basis in their partnership interest for the adjusted basis of contributed property and money, including deemed contributions due to partnership-level debt. That basis allows them to take losses or receive tax-free distributions.  But under the Opportunity Zone regime, investors generally must have a basis of zero in their QOF interests.

Basis Step-Up for Heirs?

When an individual dies, his or her heir usually can get a basis step-up on inherited assets under section 1014. But under the Opportunity Zone rules, if the owner of a fund interest dies and the interest in the fund has appreciated, there’s no basis step-up for either the deferred capital gain amounts or the appreciation.

For example, say someone invested $100 of capital gain in a qualified fund for a 50 percent interest in 2019. That partner would start with a basis of zero in that partnership interest under section 1400Z-2(b)(2)(B)(i). After five years, the basis would increase to $10; two years later, the basis would increase to $15. In 2026, $85 of gain could be recognized and the outside basis of the partnership interest would be $100.  

But what if that investor dies in 2021 when the interest is worth $150?

“It has always been clear that the $100 of deferred gain does not get a basis step-up under section 1014, because that $100 is income in respect of a decedent (IRD) under sections 1400Z-2(e)(3) and 691, which is not allowed any basis step-up under 1014(c),” Zhang said. “That makes sense, because death should not cause that deferred gain to permanently escape tax, just like how installment note gains are IRD too.”

However, the final regulations say the heirs also wouldn’t get a basis step-up to $50 for the appreciation because the basis in the fund interest must generally always be zero, Zhang said. That’s an odd result, he said, because if that partnership borrowed $300, the 50 percent investor would receive $150 of outside basis for that debt, which would have allowed for $150 of tax losses or debt-financed distributions that reduce the basis back down to zero, subject to modified disguised sale rules.

“Why the statute’s zero basis rule can be overridden in one case but not in the other is not fully explained,” Zhang said.  “There are lots of other basis adjustment rules in the tax code, and now it is unclear whether any of them apply to QOF interests.”

Schneider said the seller presumably intended to hold the interest in the qualified fund for at least 10 years to get the basis step-up on accrued amounts in the fund, so maybe the government was concerned that if an investor died, the heirs would just pull the money out right away.

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