Don Warrant, CPA
Director | Tax Practice
A discussion of Qualified Opportunity Fund (QOF) benefits, eligibility requirements, and action steps
The Tax Cuts and Jobs Act of 2017 (TCJA) created a new tax incentive program for taxpayers to defer capital gains tax by investing in certain economically distressed areas known as “Opportunity Zones.”
Tax Director Don Warrant Speaks Out on Opportunity Zone Opportunities. Listen here.
Qualified Opportunity Zones (QOZ) are areas nominated by the governors of U.S. states and territories based on Census data that identify low-income communities. A map of the communities can be found on the U.S. Treasury’s CDFI Fund web page.
At this point, the maximum number of eligible zones has been nominated by each state and the current law does not allow for additional or revised designations, even if future census data might suggest that the boundaries have shifted. In other words, the universe of Opportunity Zones has been determined and is expected to remain stable unless the law changes.
Opportunity Zone Investment Program Tax Incentives
The Opportunity Zones program tax incentives include deferral of capital gains tax from the sale or exchange of assets with unrelated persons and capital gains tax exclusion. To access the tax incentives, taxpayers (including corporations, partnerships, individuals, estates and trusts), have a 180 day period in which to reinvest capital gain proceeds in a Qualified Opportunity Fund (QOF). The beginning of the 180 day period varies based on the type of taxpayer and the classification of the gain as capital or section 1231.
The Opportunity Zone tax incentives are as follows:
- The capital gain that would have been recognized in the year of the sale is deferred until the QOF investment is sold or exchanged, or until Dec. 31, 2026, whichever is earlier;
- 10 percent of the deferred capital gain is permanently excluded from federal taxable income after holding the QOF investment for 5 years;
- An additional 5 percent of the deferred capital gain is permanently excluded from federal taxable income after holding the QOF investment for 7 years; and
- Any appreciation in the QOF investment is permanently excluded from federal taxable income after holding the QOF investment for 10 years.
How to Make a QOF Investment
To make a QOF investment, taxpayers must first generate a gain from the sale or exchange of assets that will be treated as a capital gain for federal income tax purposes. The federal income tax treatment of a net section 1231 gain is not determined until the last day of the tax year. Capital gains must be invested in a QOF within the required 180 day period.
The tax incentives apply to the portion of capital gains that are timely invested in a QOF. Any investment of non-capital gains are treated as a separate investment by the QOF since they don’t qualify for the tax incentives.
A QOF is an entity organized as a corporation or partnership for the purpose of investing in QOZ property (other than another QOF). The QOF does not need to be located in an Opportunity Zone. However, at least 90 percent of the QOF’s assets must be QOZ property for substantially all of the QOF’s holding period of such assets. QOZ property includes QOZ stock, QOZ partnership interest, and QOZ business property.
The QOZ stock or partnership interest must be acquired by the QOF after Dec. 31, 2017 for cash provided the entity is a QOZ business, or is being organized as a QOZ business. Alternatively, the QOF may acquire QOZ business property.
Taxpayers who are considering a real estate development project located in a QOZ or considering the operation of a business located in a QOZ can establish their own QOF. Alternatively, taxpayers seeking the tax incentives provided by the Opportunity Zones program can invest capital gain proceeds in a QOF that is professionally managed by others. In that case, taxpayers should perform the appropriate amount of due diligence before making the investment to assure the investment will operate as required in accordance with the program rules.
When to Make an Opportunity Zone Investment
The tax incentives provided by the Opportunity Zones program are based in part, on satisfying a 5 year, 7 year, and 10 year holding period. Under the rules, any QOF investments made after Dec. 31, 2019 are not eligible for the additional 5 percent capital gain exclusion since the investment will not be held for 7 years by Dec. 31, 2026.
Likewise, any QOF investments made after Dec. 31, 2021 are not eligible for the 10 percent capital gain exclusion since the investment will not be held for 5 years by Dec. 31, 2026.
Otherwise, taxpayers can obtain capital gains tax deferral by making a QOF investment at any time before Dec. 31, 2026. On Dec. 31, 2026, the lesser of the fair market value of the QOF investment or the deferred capital gain, reduced by the tax basis in the QOF investment, is recognized. Taxpayers will need to plan accordingly for this tax payment.
Taxpayers can continue to hold their QOF investment after Dec. 31, 2026 (and through Dec. 31, 2047). Under the rules, gain on the sale of the QOF investment after 10 years is excluded from federal taxable income and potentially state taxable income.
Freed Maxick Provides Opportunity Zone Consulting
If you own appreciated assets that would result in a capital gain upon sale or exchange with an unrelated person, then you may be a candidate for a QOF investment. The Opportunity Zones program experts at Freed Maxick can assist in comparing a fully taxed investment to a QOF investment.
In addition, a proposed Opportunity Zone business or real estate development project should consider the other Federal, State and Local tax credit and incentive programs that are available. Consultation with professional tax advisors knowledgeable in these programs could significantly increase the return on investment.
Freed Maxick provides advisory, tax planning and reporting services for both investors and fund sponsors considering involvement in the Opportunity Zone program, Click on the image to schedule a complementary Tax Situation Review, or contact Don Warrant, CPA at 716-332-2647 for consultation regarding the Opportunity Zones program.