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Considering an investment in a Qualified Opportunity Fund?

A Qualified Opportunity Fund (QOF) is an economically distressed community where new investments, under certain conditions, may be eligible for preferential tax treatment.  These can be found via an internet search for state Qualified Opportunity Zones (QOZ). QOZ were added to the tax code by the Tax Cuts and Jobs Act on December 22, 2017. The Federal government created income tax incentives to enhance the taxpayer incentives to invest in QOZ which is meant to spur the economy and renovate these areas. So, let’s discuss the basics of a QOF. A QOF is a Corporation or a partnership which holds Qualified Opportunity property. The QOF would complete IRS Form 8996 to self-certify the QOF status. It is most beneficial to read the tax laws to understand the requirements.

The income tax benefits of these QOF are getting a lot of attention from wealthy investors. Why? Because the law allows a taxpayer to defer gain on capital gains and provides the ability to exclude the gain ultimately, based on the rules and regulations. The gain would have to be invested into a QOF within 180 days from the date of the sale. Based on the current rules, the gain would be shown gross on the taxpayer’s tax return and then the amount invested in the QOF would be shown as a loss. This method allows the IRS to review the transaction and see the investment into the QOF. Thus, the net of the transaction invested in the QOF would be taxable.

The tax benefits are:

  • Investors can defer tax on any prior capital gains invested in a QOF until the earlier of the date on which the investment in the QOF is sold or exchanged, or December 31, 2026.
  • If the investment is held for longer than 5 years, there is a 10% exclusion of the deferred gain.
  • If the investment is held for more than 7 years, the 10% exclusion becomes 15% of the deferred gain.
  • If the investment is held for at least 10 years, the investor is eligible for an increase in basis of the QOF investment equal to its fair market value on the date of the QOF investment is sold or exchanged. This is the tax benefit that everyone is talking about. This part of the law allows for 100% gain exclusion. However, if someone invests in 2019, how will they get to a 10-year hold? The tax law is set to expire on December 31, 2026, and 10 years from 2019 is 2029. This means most taxpayers are not planning on being able to fully benefit from the 100% exclusion unless the tax law is revised.

 

 

Here is an example to review the application of the law:

  1. A taxpayer sells 1,000 shares of ABC stock. The shares were purchased in 2009 for $300,000. The sale of the stock is for $700,000 which results in a capital gain of $500,000.
  2. The Federal income tax on the gain would be $119,000 (23.8% which includes 20% federal capital gains tax and 3.8% NIIT).
  3. If the taxpayer instead rolls the gain of $500,000 into a QOF within 180 days of the sale then the gain of $500,0000 is deferred until the earlier of the date of the QOF investment is sold or exchanged, or December 31, 2026.
  4. If the taxpayer holds the QOF investment for at least 5 years, then the basis of the original investment is increased by 10% of the deferred gain. The calculation is $500,000 multiplied by 10% = $50,000 is added to the basis.
  5. A sale after 5 years will reduce the original deferred gain of $500,000 to $450,000.
  6. If the taxpayer holds the QOF investment for another 2 years (total of 7 years), then the basis in the original investment is increased by an additional 5%. So, a sale after 7 years will reduce the original deferred capital gain of $500,000 to $425,000.
  7. If the investor holds the QOF investment for a total of 10 years, all appreciation on the investment in the Fund will be excluded from income tax entirely. Let’s assume the value of the original $300,000 investment has now appreciated to $1,000,000 at the 10-year mark. The gain of $700,000 will be exempt from any capital gains tax. Note that the taxpayer will have to pay the deferred capital gains tax as of December 31, 2026, even if their investment in the Fund continues. The amount included in taxable income should be added to the taxpayer’s basis in the fund.

Most taxpayers are focused on the 10-year full exemption of the tax. However, based on the expiration date, it doesn’t seem practical, since the taxpayer will not get a full tax exclusion unless the tax law is changed. Also, if a taxpayer is trying to implement any estate tax planning and they own a QOF investment, a deferred gain could be triggered if not done correctly. Also, most holdings of QOF’s in an estate will not be able to receive a step up. Please be careful with this and speak with your estate planner or tax advisor, as the law gets complicated here.

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