The new Opportunity Zones program created in the Tax Cuts and Jobs Act (TCJA) encourages investment in low-income communities throughout the United States by providing favorable tax treatment for investors in Qualified Opportunity Funds (QOF). Benefits are available if existing capital gains are reinvested into a QOF. Possible benefits include:
- Deferral of capital gain
- Reduction of amount of gain realized through a basis adjustment
- Exclusion of gain on disposition of interest in a QOF
What is a Qualified Opportunity Fund (QOF)?
A QOF is an investment vehicle setup as a corporation or partnership. The QOF uses invested capital to make equity investments in qualified property located in Opportunity Zones. QOFs must hold at least 90% of their assets in Opportunity Zone Property which includes partnership interests, newly issued stock, or business property.
A QOF self certifies that it is eligible to be a QOF by attaching a form to its federal tax return. We are currently waiting for guidance from the IRS including what this form will look like.
What is an Opportunity Zone?
Opportunity Zones are economically-distressed communities designated by state governors and US Treasury in order to encourage growth. Designations will be effective for 10 years. For the listing of all zones, please visit: https://www.cdfifund.gov/Pages/Opportunity-Zones.aspx
Who will benefit from investing in a Qualified Opportunity Fund?
If you have realized or unrealized capital gains, you may benefit by investing the gain in a QOF. All capital gains realized by an investor within 180 days of investing in an Opportunity Fund are eligible for tax benefits.
What are the benefits of investing in a Qualified Opportunity Fund?
The program incentivizes long term investments by providing increasing benefits the longer you are invested in the fund. In order to take advantage of the full benefit, you would need to stay invested in the Opportunity Fund for more than 10 years.
Below is a summary of benefits depending on length of investment.
John Smith sells stock in Amazon for a gain of $1 million on August 1, 2018. John invests this $1 million into a QOF on November 1, 2018 (within 180 days of the day John sold his stock). Since John invested the gain into a QOF, John recognizes no gain on the Amazon stock on his 2018 tax return.
Scenario 1: Let’s assume John sells his interest in the QOF on November 1, 2024 for $2 million after holding it for 6 years. On John’s 2024 tax return, he would recognize a gain from the sale of Amazon stock in the amount of $900,000 (10% reduction of original gain). He would also recognize a gain of $1 million on sale of the QOF.
Scenario 2: Now let’s assume John didn’t sell his interest in the QOF until November 1, 2027 after holding it for 9 years. We will assume the same sale price. Since John held his interest for 9 years he would receive a 15% reduction in tax on the Amazon gain. However, he would have to recognize this gain on December 31, 2026 instead of November 1, 2027. As such, John would recognize a gain from the sale of Amazon stock in the amount of $850,000 on his 2026 tax return. On his 2027 tax return, he would recognize a gain of $1 million on sale of the QOF.
Scenario 3: Finally, let’s assume John held his interest in the QOF until December 31, 2028 after holding it for over 10 years. Similar to the prior scenario, John would recognize a gain of $850,000 on his 2026 tax return. There would be no capital gains tax due on the QOF sale on his 2028 tax return.
Some open questions and planning thoughts:
- How the states will follow this law is not certain, however these exclusions would generally be available at the state level given how they are constructed in the Internal Revenue Code and how most states follow various federal gain exclusions, absent legislation to disallow the tax benefits of QOF investments.
- Most private equity funds return principal to investors over the life of the fund, not just at the end of the fund’s life. How would partial returns of capital impact these deferral provisions?
- Real estate would seem like an ideal fit here, given that the assets are less mobile and generally longer term investments. Investments can be made across multiple zones, thus allowing for geographic diversity for both real estate and operating company focused funds.
This is an exciting new opportunity in the investment space which could be a great tool for those with unrealized capital gains. If you would like to learn more, please Contact Us as our team would be happy to have a conversation with you if you are a fund manager interested in setting up an Opportunity Fund or if you are an investor looking to reinvest your capital gains to get preferential treatment.