Qualified Opportunity Funds: A Tax Perk You Don’t Want to Miss
By Judd Nordquist, CPA, Tyler Petzel, CPA, and Jake Ouradnik, CPA
What follows is an update to an article we originally posted in September 2018 on this topic. At the moment, there are still several unknowns regarding Qualified Opportunity Zone Funds, and we expect to receive additional guidance from the Internal Revenue Service. In other words, the information we’ve listed below is subject to change.
Many of the tax perks brought about by the Tax Cuts and Jobs Act (TCJA) are now common knowledge. But despite the new law having been in effect for nearly a year, one in particular has flown largely under the radar: Qualified Opportunity Zone Funds. These funds, when used correctly, have the potential to offer eligible investors powerful tax benefits.
Intrigued? Here are a few things you should know:
What is a Qualified Opportunity Zone Fund?
A Qualified Opportunity Zone Fund, or QOZF, is an investment vehicle structured as a partnership, LLC (excluding single-member LLCs), or corporation to invest in eligible property within the bounds of a Qualified Opportunity Zone (QOZ).
A QOZ is a state-designated geographical area where new investments, under certain conditions, may be eligible for preferential tax treatment. When the TCJA was signed into law, it gave every U.S. state and territory the authority to designate certain areas as QOZs. Simply put, QOZs are an economic development tool—that is, they are designed to spur development and create jobs within economically distressed communities.
The eligible property referenced above could be in the form of QOZ stock, QOZ partnership interest, or QOZ business property. Examples include real estate and active trade or businesses within a QOZ. This map shows the locations of QOZs across the U.S (Zoom to view specific areas).
What are the tax benefits of investing into a QOZF?
There are three primary tax benefits associated with investing into a QOZF:
First, it gives you the opportunity to temporarily defer up to 100 percent of a current capital gain or other type of qualified taxable gain from the year of sale. As we approach the one-year marker of the TCJA, we are still left in the dark about many of the details around this new law. However, the proposed regulations issued in October provided general direction on the types of capital gains eligible for deferral. Per these latest regulations, qualified gains include capital gains. The new regulations also state that gains taxed on Schedule D are eligible, whereas Section 1245 gains ultimately taxed as ordinary income are excluded.
Second, if you hold the QOZF for five years or longer, you could realize a permanent 10 percent reduction in taxable gain. If you hold it for seven years or longer, you could exclude an additional 5 percent.
Third, and perhaps most powerfully, if you hold the investment for 10 years or longer, you wouldn’t incur any taxable gain from its sale from the original purchase price of the investment.
How do you invest in a QOZF?
To be able to invest in a QOZF, you must have a qualified gain (as noted above) from a previous sale to an unrelated party. Furthermore, a taxpayer has 180 days from the date of the previous sale to make an investment into a QOZF. The investment must be made through a cash contribution and may consist of both tax-deferred (the previous gain) and non-tax deferred funds (additional amounts you wish to invest). Any cash contribution made of non-tax deferred funds will not receive the tax benefits noted above.
The proposed regulations also issued additional guidance regarding qualified gains incurred within a partnership or S corporation (i.e., pass-through entities). When a taxpayer is allocated a gain from an asset sold within a pass-through entity, their 180-day investment window defaults to starting on the date of the pass-through entity’s tax year-end. For example, if a taxpayer is allocated gain from a partnership, and the partnership’s tax year-end is December 31, the taxpayer’s 180-day window will begin on December 31 of that tax year. Alternatively, taxpayers can elect to have their 180-day window begin on the actual date the gain was recognized by the partnership.
What should you watch out for?
With every opportunity there seem to be exclusions that apply. Here are a few exclusions relating to QOZFs:
- If you defer the gain by making an investment in a QOZ, the respective gain will be taxed on or before 2026. If you continue to hold your investment, the gain will be taxed on your 2026 tax return. To ensure you have the funds necessary to pay the tax in the year it comes due, you’ll need to carefully consider your cash flow.
- This is currently federal law; no state has addressed its position on it. It is possible (and likely) states will not follow the same set of rules. Therefore, state-level tax could apply to these gains.
- Certain industries do not qualify for eligible investments. These include golf courses, country clubs, massage parlors, hot tub facilities, sun tanning facilities, racetracks, and liquor stores.
- The gains produced retain their tax attributes. So, if you sell an asset that produces a short-term gain, the ultimate taxation when you sell the QOZ property will retain its short-term attribute.
Explore your options sooner rather than later.
Per the TCJA, taxpayers have until 2020 to reap the full tax benefits of investing into a QOZF—which means it’s prudent to explore your options as soon as possible. If you’d like to learn more about investing in a QOZF, give us a call. We can help you better understand your options, so you can make the most of a short-lived opportunity.