Guerra TWP frequently provides guidance to clients in connection with income tax benefits which may be achieved through Qualified Opportunity Zone (“QOZ”) planning under the Tax Cuts and Jobs Act of 2017. Three tax benefits, (1) income tax deferral, (2) capital gain exclusions, and (3) income tax free appreciation, can be achieved by investing in a Qualified Opportunity Fund (“QOF”).
A QOF is a corporation or partnership organized to seek funds from investors and invest in any of the opportunity zones designated by the IRS. These zones are located across the United States in both rural and urban areas and include low-income communities. The public policy behind the program is to encourage investment in low-income communities. QOF investments include real property and businesses operating within an opportunity zone. Additionally, for common investors looking to defer taxable gain recognition and eliminate taxation on future appreciation (discussed in further detail below), many financial institutions have created funds qualifying for the tax benefits available to QOFs so that an investor may conveniently invest in the fund without the need to directly monitor the operation of the QOF.
Individuals, partnerships (or their partners), C corporations, S corporations (or their shareholders), trusts, estates and beneficiaries may achieve tax benefits by investing in a QOF. When these taxpayers sell real property, marketable securities, mutual funds, or if the business is sold, the gains can be invested in a QOF. A taxpayer generally has 180 days from a sale triggering a capital gain to invest in a QOF.
To qualify for the tax benefits, an amount up to the capital gain realized during the tax year can be invested in a QOF. Such reinvested gains may be from the sale of any asset that generates a capital gain. The gains invested can be either short-term or long-term.
For real estate investors, a QOF can offer significant advantages over a tax deferred exchange governed by Section 1031. Unlike a Section 1031 exchange, only the gain needs to be reinvested (not the entirety of the sales proceeds). For example, if a taxpayer sells a parcel of property for $10 million which the taxpayer purchased for $6 million generating a $4 million capital gain, only $4 million needs to be reinvested in a QOF to defer the entire gain. In a Section 1031 exchange, the entire $10 million would need to be reinvested in a replacement property to defer the entire gain. Investing in a QOF allows the taxpayer to diversify the taxpayer’s asset holdings in non-real estate assets.
In addition to deferral of taxes on the capital gain, permanent gain exclusion for post-investment appreciation can be achieved if the investment in the QOF is held for over ten years.
Taxpayers investing in QOFs receive the following income tax benefits:
1. The original taxable gain being invested in the QOF is deferred until the earlier of December 31, 2026 or until the funds are withdrawn from the QOF (the “Deferred Tax Recognition Date”);
2. If the QOF investment is held for over 5 years as of the Deferred Tax Recognition Date, 10% of the original gain is excluded from taxation;
3. If the QOF investment is held for over 7 years as of the Deferred Tax Recognition Date, an additional 5% is excluded from taxation; and
4. If the QOF investment is held for over 10 years before being sold, any post-investment appreciation is excluded from tax.
To illustrate, assume an investor sells marketable securities on January 1, 2021 and realizes a $1 million capital gain. The entire gain is reinvested in a QOF on February 1, 2021 to defer paying taxes on the gain. The investor’s gain is taxable on Dec 31, 2026, and the gain is reported on his or her 2026 income tax return, but because the QOF was held over 5 years, only $900,000 is taxable (10% of the original gain is excluded). Additionally, if the investor waits until after February 1, 2031 to sell his or her QOF investment, the entire post acquisition gain will be realized in a tax free manner. To illustrate, assume investor sells his or her QOF investment in 2032 for $3 million. The $2 million gain will be free of tax.
Guerra TWP advises taxpayers looking to defer realized capital gains and eliminate future gains through investment in QOFs. We also assist in the establishment of business entity structures designed to qualify as QOFs to achieve these significant tax benefits.