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June 2019
This new tax incentive gives investors the ability to defer tax on gains from the sale of an asset if the gain is reinvested in assets located in a certified economically challenged geographic area.
At the end of 2017, Congress passed tax legislation with provisions intended to spur investment in specific economically challenged geographic areas by creating what have become known as Qualified Opportunity Funds (QOFs).1 This new tax incentive gives investors the ability to defer tax on gains from the sale of an asset if the gain is reinvested in assets located in a certified economically challenged geographic area. If the new investment is held long enough, investors may exclude portions of the gain as well.2
How does a qualied opportunity fund work?
A QOF is a fund that holds at least 90% of its holdings in Qualified Opportunity Zone Property that was acquired after December 31, 2017. Qualified Opportunity Zones are challenged areas designated for incentivized economic development. They are identified by the states and certified by the IRS.
Individuals may defer short- or long-term capital gains from the sale of existing assets if they reinvest their gain in a QOF within 180 days of the sale.4 Investment in Qualified Opportunity Zone Property may take the form of either a direct investment by the QOF in tangible property, such as equipment, buildings or land located in a Qualified Opportunity Zone, or it may be an indirect investment by the QOF through ownership of corporate stock or partnership shares in an operating business substantially located in the Qualified Opportunity Zone.3
The QOF investment is held by the investor like any other investment. However, capital gain from the disposition of the original asset prior to reinvestment in the QOF is deferred until either the sale of the QOF investment or December 31, 2026, whichever is earlier. If the investment is held until December 31, 2026, the gain recognized is either the deferred gain or the fair market value of the QOF investment at that time, whichever is less. This means that even if the QOF investment is still owned by the investor on December 31, 2026, the investor will need to pay the deferred tax, either by using other funds or by selling a portion of the QOF funds to raise the necessary funds.
If the QOF investment is held for at least five years or seven years, then the basis of the asset can be increased by 10% or 15% of the initial value of the deferred gain invested in the QOF, respectively, resulting in a reduction in the tax paid on the original asset. If the QOF investment is held for greater than 10 years, then all gain from the QOF investment can be excluded and the basis of the investment can be stepped up to its then fair market value. The only tax paid on the investment if held for more than 10 years would be 85% of the deferred gain paid on December 31, 2026. This is illustrated in Exhibit 1.
Case study: patience is a virtue
Alexander, who lives in Florida, sold his company on October 1, 2018 for $20 million. His basis in the company was $0, and as a result, he will owe $4 million in capital gains tax. If he invests a quarter of the proceeds ($5 million) in a QOF within 180 days of the sale, he will be able to defer a quarter of the capital gains tax ($1 million). At this point, his basis in the QOF investment would be $0.
10% of initial capital gains eliminated after five years
However, after five years, his basis would be increased to $500,000, which would effectively wipe out 10% of his deferred capital gains tax, or $100,000.
15% of initial capital gains eliminated after seven years
After seven years, his basis is increased to 15% of the deferred gain invested, or $750,000, eliminating another $50,000 in capital gains tax.
What if Alexander's investment in the QOF has performed extraordinarily well and doubled in value to $10 million? Were he to sell it after seven years, he would realize $9.25 million in gains ($10 million, less the basis of $750,000), on which he would owe $1.85 million in taxes. In the end, he would net $8.15 million.
Remaining initial capital gains must be paid after December 31, 2026
Otherwise, were he to hold onto the QOF investment through December 31, 2026, he would have to realize all deferred capital gains, per the Internal Revenue Code. In this case, he would realize a $4.25 million gain (the initial $5 million investment, less the adjusted $750,000 basis) and owe $850,000 in capital gains tax. He would continue to hold the investment, but now with an adjusted basis of $5 million.
No capital gains owed if sold after 10 years
If he held onto the QOF investment for more than 10 years, his basis would be adjusted again to match the fair market value of the QOF when he sells it. Alexander would pay no capital gains tax on gains earned from the investment. The only taxes he would have paid on the investment would have been the deferred tax paid on December 31, 2026.
An unprecedented opportunity
The QOF deferral and gain exclusion represents an unprecedented opportunity for investors. Unlike other tax incentives for deferring capital gain, investments in QOFs provide the possibility of also eliminating a significant portion of the deferred gain on the original asset while potentially eliminating all capital gain on the QOF. Additionally, the substantial tax advantages of QOFs can uniquely be accessed by reinvesting only the gain portion of the original asset and not the entire proceeds from the sale. Neither of these benefits are true of like-kind exchanges. Thus, for the investor incurring gains who is interested in or willing to consider the types of assets held in QOFs, these compelling tax advantages make QOFs well worth consideration in the planning process, both before a sale and during the 180-day window of opportunity afterward. However, prior to any investment in a QOF, an investor should consult his or her tax advisors to determine the applicability and requirements of a QOF investment.
Footnotes
1. IRC Sections 1400Z-1 & 1400Z-2.
2. It is important to note that this is a federal tax benefit and whether states follow or do not follow this benefit varies by state.
3. Note that unlike like-kind exchanges under Section 1031 of the Internal Revenue Code, only the capital gain portion of the asset sale, not the entire proceeds, must be invested in QOFs to obtain deferral of the gain.
4. In order for a business to be located in the Qualified Opportunity Zone, substantially all of its owned or leased tangible property must have been used in the Qualified Opportunity Zone and acquired in a non-related party transaction after December 31, 2017. Certain businesses, such as golf courses, casinos, racetracks, liquor stores, suntan facilities or massage parlors are excluded businesses.
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