The Tax Cuts and Jobs Act of 2017 created a new vehicle for investors that provides tax deferrals and reduces taxable gains on the sale of assets that are reinvested in Qualified Opportunity Funds, as defined in USC 1400Z-2. A Qualified Opportunity Fund invests in property that is within designated census tracts called Qualified Opportunity Zones. The Treasury Department certified zones in all 50 states, the District of Columbia, and certain U.S. territories. In addition to tax deferrals and reduction of the taxable gain on the original sale, taxpayers can also permanently exclude gains on the appreciation of the Qualified Opportunity Fund property if it meets certain criteria and is held for at least 10 years. This part of the Tax Code was intended to drive investment into undeveloped and impoverished areas.
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Requirements for a Qualified Opportunity Fund
To be eligible for the tax deferral and related tax benefits of a Qualified Opportunity Fund, investors must meet certain requirements as outlined by the Tax Code. A Qualified Opportunity Fund must be set up as a corporation or partnership for the purpose of investing in Qualified Opportunity Zone property and certified by the Treasury Department. Entities can self-certify their eligible entity by completing form 8996 and filing it along with their federal income tax returns.
Similar to other tax-deferral vehicles provided by the Tax Code that require reinvestment within a specific time period, the gain on the sale of the original property must be invested in the Qualified Opportunity Fund within 180 days. The gain can be derived from various sources, such as the sale of a business, stocks, bonds, or real estate.
In order to be eligible for the tax deferral and reduction of taxable gain, 90 percent of the assets must be held in a Qualified Opportunity Fund. These assets include businesses, real estate, and business assets located within a Qualified Opportunity Zone. Additionally the Qualified Opportunity Fund must substantially improve the property within a 30-month period from the initial investment. Substantial improvement is defined by the tax code as the property’s adjusted basis. This means the improvement must be equal to the Qualified Opportunity Fund’s tax-deferred investment.
Tax Advantages of a Qualified Opportunity Fund
A Qualified Opportunity Fund provides investors with three different ways to potentially reduce tax burdens: tax deferral of gains; reduction of taxable gain; and elimination of taxes on appreciated properties.
Tax deferral of gains: A taxpayer can get tax deferral on their capital gain by investing into a Qualified Opportunity Fund within 180 days from the sale of their capital asset. Any taxable gain realized from the sale can be deferred through December 31, 2026, or the sale of the Qualified Opportunity Fund property, whichever comes first.
Reduction of taxable gain: Investment into a Qualified Opportunity Fund provides tax savings in addition to the tax deferral noted above. These savings can be from 10 to 15 percent based on the holding period of the Qualified Opportunity Fund’s investment. Taxpayers who invest gains into a Qualified Opportunity Fund will receive a 10 percent increase in basis after the first five years and an additional 5 percent increase in basis after seven years. Below is an example that illustrates the tax savings of a seven-year hold.
Example: In December 2019, a taxpayer has a $5M capital gain that is invested in a Qualified Opportunity Fund. If the taxpayer holds that property through December 2026, they will receive a 15 percent increase in basis, meaning they will pay taxes on $4.25M. This allows the taxpayer to shield $750,000 from capital gains tax. Based on a 20 percent capital gains rate, that results in tax savings of $150,000.
Elimination of taxes on appreciated properties: The third tax benefit of the Qualified Opportunity Fund is the elimination of taxable gains on the appreciation of the fund’s property. In order to qualify, the fund must hold the property for 10 years.
Example: In December 2019, a taxpayer has a $5M capital gain that is invested in a Qualified Opportunity Fund. In 2030 the taxpayer sells that property for $7.5M. The appreciated value of $2.5M is not taxable. Based on a 20 percent capital gains rate, the result will be tax savings of $500,000.
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The Qualified Opportunity Funds provide investors with tax benefits and have created an incentive for investors to develop communities throughout the country.
The Tax Cuts and Jobs Act has left many financial advisors and accountants scratching their heads, wondering whether taxpayers will really obtain any tax benefits. The Qualified Opportunity Funds definitely provide investors with tax benefits and have created an incentive for investors to develop communities throughout the country. If you are considering investing in a Qualified Opportunity Fund and would like to learn more about the long-term tax benefits and how it would impact your tax situation, please reach out to our tax team.