Qualified Opportunity Funds (QOFs) were created as part of the Tax Cuts and Jobs Act of 2017 in order to provide tax incentives to investors who invest capital gains in economically distressed communities. A QOF is defined as an investment vehicle organized as a corporation or a partnership for the purpose of investing in Qualified Opportunity Zone (QOZ) property. A QOF must hold at least 90% of its assets in QOZ property. A QOZ is defined as an economically-distressed community where new investments, under certain conditions, may be eligible for preferential tax treatment. These communities are nominated by the state at which they are located and are certified by the IRS. QOZ property is a qualifying ownership interest in a QOZ business or certain tangible property that is used in a business in the QOZ. In order to be considered a QOZ business, the QOZ business must earn at least fifty percent of its gross income from business activities within a QOZ each taxable year.
A taxpayer has 180 days from the date a capital gain is triggered to reinvest the gain into a QOF. There are three primary benefits to investors who reinvest capital gains into a QOF:
- Deferred tax on capital gains
An investor who reinvests capital gains into a QOF within six months of realizing the gains can defer paying federal taxes on those gains until as late as December 31, 2026.
- Reduction of capital gains tax
A second benefit of investing in a QOF is the potential reduction of the capital gains tax. When an investor invests capital gains into a QOF, his or her basis in the investment starts out at $0. Depending on how long an investor holds their investment in a QOF, the basis of the investment will increase. If the investment is held for at least five years, the basis will increase by 10% of the original investment amount. If the investment is held for at least seven years, the basis will increase by an additional 5% of the original investment amount. (In order for the additional 5% step-up in basis, the investment would have to have been made by 2019.) For example, if an investor invested $1,000,000 of capital gains into a QOF on January 1, 2019, the initial basis in the investment would be $0. After the investment is held for five years, the basis would increase to $100,000. If the investment is held for seven years, the basis will increase to $150,000.
- Elimination of capital gains tax
If the investor holds the investment in the QOF for at least ten years, the investor will not be required to pay further capital gains tax on any realized gains from the investment in the QOF. Keep in mind that this permanent exclusion is on the capital gains associated with the appreciation in value after recognition of capital gains on the initial investment on December 31, 2026. Continuing with the example from above, the investor would have paid capital gains tax on $850,000 on their 2026 return, no matter how long the investment was held. After the $850,000 gain is recognized, the new basis becomes $1,000,000. The investment is held for ten years and is sold during 2029 for $1.9M. At the time of sale, the basis in the investment would become $1.9M, resulting in no taxable gains. Therefore, the investor would have avoided paying tax on $900,000.
Although investing in a QOF offers potential attractive tax benefits, it is important to realize the risks involved with investing in a QOF. Following are some risks to consider:
- Investments in underdeveloped areas could carry significant risks. The potential cost of losing money on the investment should be weighed against any potential savings in capital gains tax.
- An investment in a QOF is a long-term investment. While holding the investment for more than one year would allow the investor to defer tax on capital gains, the basis step-up benefits only apply if the asset is held for at least 5-10 years. As an investor, if you believe you will need this cash during the investment period, you may want to look into other investing opportunities.
- The rules to maintain a QOZ investment are nuanced and complex. As an investor, it is also important to do your due diligence when deciding which QOF you want to invest in and whether you want to invest. It would be best if you considered whether your potential investment partner understands the complex rules associated with QOZ investments and whether the partner has the ability to comply with the rules to operate a viable QOF.
Please reach out to your personal Sciarabba Walker contact or email us at email@example.com if you would like to learn more about the requirements for investing in Qualified Opportunity Zones or about the potential tax benefits.
By Dylan Wright, CPA