Among the many changes included in the Tax Cuts and Jobs Act (TCJA) passed in the beginning of 2018, was a new tax deferred investment vehicle, the Qualified Opportunity Fund (QOF). The details behind the use of the QOF are still being sorted by the IRS, with additional guidance recently provided in the proposed regulations released on October 16, 2018. This article will give you a broad overview of the deferral and tax implications based on the proposed regulations.
QUALIFYING FOR DEFERRAL
Under the proposed regulations, the IRS made clear that the deferral of tax is available only for capital gains realized on sale or exchange after 12/31/2017. In order to qualify for deferral, the capital gain proceeds must be invested in a QOF within 180 days of the sale or exchange. Once invested in the QOF, the gain can be deferred until the earlier of the QOF sale or December 31, 2026.
To qualify as a QOF, the fund (LLC, Partnership or Corporation) must hold at least 90% of its assets in qualified opportunity zone property. This property can include stock, partnership interests, and business property (land and building) which must be located within the designated opportunity zones (a map showing these opportunity zones can be found at www.cdifund.gov/Pages/Opportunity-Zones.aspx).
While the gain is being deferred in the QOF the capital gain is reduced through increases in basis. These basis increases occur after being held within the QOF for 5, 7, or 10 years as outlined below.
- 5 Years – basis increased by 10% of the gain deferred (12/31/2021 – last day to qualify for basis adjustment)
- 7 Years – basis increased by 5% of the gain deferred (12/31/2019 – last day to qualify for basis adjustment)
- 10 Years – basis equals the fair market value on the date the investment is sold
The caveat here is the 5 and 7-year holding period must be before December 31, 2026 to benefit from the increased basis because on that date the gain is recognized and becomes the basis of the property.
As you can see, there are several moving parts to consider. To get a better understanding of how this works in practice, we will take a look at how a savvy real estate investor takes advantage of a gain he recently recognized.
John sells his interest in a multifamily residential property resulting in a long-term capital gain of $10M. If nothing is done, the current gain would be subject to a 20% tax rate ($2,000,000 of tax) and would put John in the highest tax bracket for that year. Looking to defer the gain, John invests the full $10M into an opportunity fund within the 180-day period as required. No gain is recognized in the current year and John’s basis in the fund is zero.
At the end of year 5, John’s basis in the opportunity fund is increased by 10% of his deferred gain or in the case of John $1,000,000. If John were to sell at the end of year 5, he would recognize a gain of $9,000,000 and be subject to the 20% tax on the gain ($1,800,000 of tax).
John continues to hold the investment in the opportunity fund and at the end of year 7; he receives an additional 5% basis increase ($500,000) on the original gain deferred. If John were to sell at the end of year 7, he would recognize a gain of $8,500,000 and be subject to the 20% tax on the gain ($1,700,000 of tax).
John holds the investment through Dec 31, 2026 and is forced to recognize the current deferred gain of $8,500,000 and pays tax of $1,700,000. John continues to hold the interest in the opportunity fund, but now has basis of $10M.
After holding the property for more than 10 years, John elects to step-up the basis to the current FMV of his interest in the opportunity fund at the date of sale and John has no reportable gain on the sale.
WHAT DOES THIS ALL MEAN?
The net tax benefit and required holding period may not be as attractive as other investment opportunities, however if you are already looking to invest in a business or property located within a Qualified Opportunity Zone, then creating or investing in a QOF to take advantage of these tax savings makes all the more sense. The QOF is a very new area that is still evolving as we await final regulations and forms from the IRS. Use caution before jumping into a QOF and be sure to consult your tax professional to better understand the tax implications and whether this deferral makes the most sense for your unique situation. David Higginbotham