By Abe Livchitz, CPA, Senior Tax Manager & Tingting Zhang, CPA, Tax Senior
Tax deferral, gain exclusions, tax free appreciation. These seven words are very exciting as they offer potentially significant tax savings for our clients. All three of these benefits are possible by investing in a “Qualified Opportunity Fund” (QOF). The creation of these funds and their related tax benefits were authorized by the Tax Cuts and Jobs Act (TCJA) passed by Congress in December 2017. The Internal Revenue Service recently issued guidance to clarify questions unanswered by the TCJA, so QOFs should gain in popularity in the coming months. However, additional guidance is expected in the future, as many questions remain unanswered.
Taxpayers that may invest in QOFs include individuals, partnerships or the partners, C-Corps, S-Corps or the shareholders, trusts and estates or the beneficiaries. Generally, a taxpayer has 180 days from a sale which generated a capital gain to invest in a QOF.
To qualify for the benefits offered by a QOF, an eligible taxpayer can invest an amount up to the capital gains realized during the tax year. The gains can be either short or long-term and can be from the sale of any asset that generates a capital gain. Taxpayers selling stock, mutual funds, real property or even their business can invest in a QOF. For real estate investors, a QOF can offer significant advantages over a “Section 1031 tax deferred exchange”. There is the potential for permanent gain exclusion (if the QOF is held over ten years) and, unlike an exchange, only the gain needs to be reinvested, not the entire sale proceeds. For example, if a taxpayer sells a property for $5 million and generates a $1 million capital gain, only $1 million needs to be invested in a QOF to defer the entire gain.
A QOF is a corporation or partnership organized to seek funds from investors and invest in any of the 8,700 “opportunity zones” designated by the IRS. These zones are located across the US in both rural and urban areas (https://www.irs.gov/pub/irs-irbs/irb18-28.pdf) and include low income communities”. The goal of the QOF program is to encourage private sector investment in low income communities across the US. Locally, Santa Clara County has 13 designated zones. Common QOF investments would include real property and businesses operating within an Opportunity Zone.
Investors in QOFs receive several tax benefits:
- Gain is deferred until the earlier of December 31, 2026 or until funds are withdrawn from the QOF.
- If the QOF investment is held 5 years or longer, 10% of the original gain is excluded from tax.
- If the QOF investment is held over 7 years, an additional 5% is excluded from tax.
- If the QOF investment is held over 10 years, any appreciation in the investment is excluded from tax.
For example, a taxpayer sells stock on March 1, 2019 and realizes a $100,000 short term gain. The taxpayer then invests $100,000 in a QOF prior to August 28, 2019 to take advantage of the gain deferral. The taxpayer’s gain is taxable on Dec 31, 2026 and therefore reported on their 2026 tax return as a short-term capital gain, but since the QOF was held over 7 years, only $85,000 will be taxable. The taxpayer then liquidates their QOF investment in 2030 for $250,000. The $150,000 gain is tax free. To obtain all these benefits, taxpayers will need to invest in a QOF prior to the end of 2019.
Unfortunately, California has not conformed to any of these federal provisions, so a gain from an eligible sale will be taxed in the year realized and not deferred or excluded under the QOF rules discussed above.
QOFs can offer taxpayers significant tax advantages and the opportunity to help revitalize underserved communities across the US. So be sure to consider these benefits when you have taxable capital gains!