True Alert: Benefits of Qualified Opportunity Funds (“QOF”)
On December 22, 2017, President Trump signed into law the Tax Cuts and Jobs Act (“TCJA”) which created Internal Revenue Code Sections 1400Z-1 and -2. These sections set forth the procedure for states to designate Qualified Opportunity Zones, and provide tax benefits to taxpayers who invest in those Zones. On October 19, 2018, the IRS published proposed regulations for the TCJA, in order to clarify the Zone requirements covered in the Act and to provide additional rules for the tax benefits for investments in Qualified Opportunity Zones. The IRS is currently soliciting comments on these proposed regulations through December 18, 2018. They noted in the current release that additional proposed regulations on the Opportunity Zone program will be published in the near future.
What is the benefit?
Taxpayers who invest in Qualified Opportunity Funds (“QOF”) may elect to defer recognition of one or more eligible gains. In addition, the amount of deferred gain may be reduced by 10 percent or 15 percent if the qualifying investment is held for more than 5 or 7 years, respectively. This gain may be deferred until the earlier of (1) the date the qualifying investment is disposed of or (2) December 31, 2026.
Furthermore, taxpayers who hold their qualifying investments for more than ten years will be able to exclude from gross income the post-acquisition gains on the investment.
What is an eligible gain?
Typically, gains are eligible for deferral if:
- They are treated as capital gains for federal income tax purposes,
- They would be recognized before January 1, 2027 for federal income tax purposes, and
- They do not arise from a sale or exchange to a related person who would otherwise recognize the gain.
Eligible taxpayers are any persons that may recognize gains for federal income tax, which include individuals, C corporations, S corporations, regulated investment companies (RICs) and real estate investment trusts (REITs), partnerships, trusts and estates. There are specific rules set forth in the proposed regulations related to qualifying gains earned through partnerships that do not choose to invest in QOFs.
What is a qualifying investment?
Taxpayers who incur eligible gains may defer these gains if they are invested in a QOF within the 180-day period beginning on the date of the sale or exchange which gives rise to the gain.
A QOF is a certified investment fund organized as a domestic corporation or partnership for the purpose of investing in Qualified Opportunity Zone Property. A QOF must hold at least 90 percent of its assets in an eligible interest, or qualified opportunity zone property. Specifically, Qualified Opportunity Zone Property is either (a) an equity interest in an operating subsidiary entity (a corporation or a partnership) that operates a qualified opportunity zone business or (b) qualified Opportunity Zone business property.
An eligible corporation or partnership may self-certify as a QOF. To self-certify, the corporation or partnership must determine the first taxable year and may specify the first month that the entity would like to be declared a QOF. Consequently, if the entity does not specify the first month, the proposed regulations provide rules establishing the entity’s first month as a QOF. A pre-existing entity may qualify as a QOF if the entity satisfies all of the requirements, however investments in the QOF that occur prior to the certification would not qualify for the gain deferral benefit discussed above.
What are the Qualified Opportunity Zones?
A Qualified Opportunity Zone is a “population census tract” that is in a low-income community and designated by the state or federal government as a Qualified Opportunity Zone. A list of the Qualified Opportunity Zones may be found in IRB Notice 2018-48.
How does this affect me?
If your company has plans to dispose of capital gain property and reinvest those earnings, additional tax benefits may be available if those gains are invested in QOF investments. This incentive provides for gain deferral and potential reduction of basis in your original capital gain. In addition, gain that accrues on the qualifying investment in a QOF that is held for more than ten years may be excluded from income after the ten year period.
Example of Benefit
- Taxpayer, a C corporation, sells a capital asset on 11/1/2021 for a capital gain of $10,000,000.
- Taxpayer then invests the $10,000,000 capital gain in a QOF on December 15, 2021.
- Taxpayer elects to defer this gain for federal income tax purposes until the later of when he sells the investment or December 31, 2026.
- Taxpayer sells the investment in the QOF on December 15, 2034, for $17,000,000.
The Taxpayer would receive the following benefits:
- On December 31, 2026, Taxpayer should recognize $9,000,000 in capital gain for federal income tax purposes. Because Taxpayer held the investment for more than 5 years by December 31, 2026, 10% of the original capital gain is excluded from Taxpayer’s income upon recognition of the gain. Estimated federal income tax savings: $210,000 ($1M x 21%).
- DROP DEAD DATE – 12 /31/2026 – Deferred Gain Must be Recognized by this Date (or measured for stepped by basis)
- On December 15, 2034, Taxpayer may exclude the entire post-acquisition gain of $7,000,000 from taxable income because the investment in the QOF was held for more than ten years. Estimated federal income tax savings: $1,470,000 ($7M x 21%).
Ten Year Investment Benefit
Taxpayers who purchased QOF property prior to December 31, 2026 with deferred gains and hold such investments for more than ten years should be able to exclude any gain from the QOF property for federal income tax purposes.
During the period of investment, the QOF must hold at least 90 percent of its assets in a Qualified Opportunity Zone in order to maintain this benefit for investors. The expiration of a Qualified Opportunity Zone’s designation prior to a taxpayer’s disposal of their QOF investment should not impact the exclusion of gain from the taxpayer’s federal taxable income, as long as such sale occurs prior to January 1, 2048.
How can True Partners help?
True Partners Consulting’s Federal Income Tax and Credits and Incentives teams offer a combination of highly experienced advisors and an approach that puts our clients at a competitive advantage. We are prepared to work closely with clients to assist with the entire process related to investment and expansion into new jurisdictions.