Possible tax planning benefits, yet limited investment potential.
- Qualified Opportunity Zones (QOZs) were created under the 2017 Tax Cuts and Jobs Act as a way to incentivize long-term investments in underserved communities.
- While Qualified Opportunity Funds may present attractive investment opportunities in the future, the return targets of high-quality investment managers in the space are not, in the view of Wilmington Trust, sufficiently compelling at this time to warrant investing.
- For those who wish to invest, proper planning and guidance may help to achieve income and wealth transfer tax benefits, although several open questions remain about both the planning and investment merits of QOZs.
As part of the 2017 Tax Cuts and Jobs Act, Congress enacted legislation designed to encourage investment and economic growth in designated underserved communities. A QOZ is an economically-distressed community where new investments, under certain conditions, may be eligible for preferential tax treatment. Opportunity Zones are designated by the state and certified by the Internal Revenue Service. Thus far, there are over 8,700 designated Opportunity Zones in the U.S. The QOZ provisions are found under Sections 1400Z-1 and 1400Z-2 of the Internal Revenue Code.
Those who wish to invest in a QOZ may do so through a Qualified Opportunity Fund (QOF). A QOF is a corporation or partnership for federal tax purposes, which is created for the purpose of investing in property located in a QOZ.
Individuals who invest in a QOF are afforded three main tax benefits:
- Temporary deferral of capital gains tax upon disposition of the property to an unrelated person until the earlier of when the investment is sold or exchanged, or December 31, 2026. The capital gain must be reinvested in a Qualified Opportunity Fund within 180 days of the property disposition.
- Elimination from 10% to 15% of the gain that is reinvested in a Qualified Opportunity Fund given that certain holding period requirements in a QOF are met.
- Total exclusion of gains associated with appreciation of value of Qualified Opportunity Fund if held for 10 years or more.
Overview of how it works
If an individual sells an appreciated asset, there typically would be an income tax liability on the capital gain. If the individual wanted to instead defer that gain, she may reinvest that gain (or a portion of it) into a Qualified Opportunity Fund within 180 days of the asset sale. If the gains are realized through a pass-through entity such as a partnership, there is an option where the 180-day countdown for reinvestment begins at the end of the partnership’s taxable year. This rule applies also to S corporations, trusts, and estates. The individual’s initial basis in the Qualified Opportunity Fund will be zero.
If the individual holds the Qualified Opportunity Fund interest for five years, her basis in the Qualified Opportunity Fund will increase by 10%. Therefore, when the taxpayer sells her Qualified Opportunity Fund interest, she will be able to eliminate 10% of the original deferred gain (by virtue of the fact that her basis increased by 10%).
Alternatively, if the individual holds the Qualified Opportunity Fund interest for two more years (seven years in total from original investment date), her basis will increase to 15%. Therefore, when the individual sells her Qualified Opportunity Fund interest, she will be able to eliminate 15% of the original deferred gain (by virtue of the fact that her basis increased by 15%).
If the individual then holds the Qualified Opportunity Fund interest for another three years (10 years in total from original investment date), she may sell the investment in the Qualified Opportunity Fund interest and any gain on the appreciation of the QOF itself would be excluded from income taxation altogether. The ultimate sale of the QOF has to occur before year 2048.
Regardless of the above holding periods, if the individual has not disposed of her Qualified Opportunity Fund interest, on December 31, 2026, there would be a tax recognition event in which the tax on the original deferred gain is payable minus any adjusted basis. This would occur even if the Qualified Opportunity Fund interest is not sold. After a taxpayer disposes of a QOF, it is possible to defer the gain by reinvesting in another Qualified Opportunity Fund within 180 days.
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