If you’re selling a business interest, real estate or other highly appreciated property, it’s likely you’ll be hit with a substantial capital gains tax bill. One way to soften the blow – if you’re willing to tie up the funds long term – is to “roll over” the gain into a qualified opportunity fund (QOF). Under this new federal program, reinvesting in a QOF allows you to defer, and even reduce, the tax on your original gain and to avoid tax on future appreciation within the QOF.
What is a QOF?
A QOF is an investment fund, organized as a corporation or partnership, designed to invest in one or more Qualified Opportunity Zones (QOZs). A QOZ is a distressed area that meets certain low-income criteria, as designated by the U.S. Treasury Department. Currently, there are more than 9,000 QOZs in the United States and its territories. QOFs can be structured as multi-investor funds or as single-investor funds established by an individual or business.
To qualify for tax benefits, at least 90% of a QOF’s funds must be “QOZ property,” which includes:
QOZ business property.This is tangible property that’s used by a trade or business within a QOZ and that meets certain other requirements.
QOZ stock or partnership interests.These are equity interests in corporations or partnerships substantially all of whose assets are QOZ property.
Note: Proposed regulations, which can be relied on pending final regulations, define “substantially all” to mean at least 70%.
What are the benefits?
If you recognize capital gain by selling or exchanging property, and reinvest an amount up to the amount of gain in a QOF within 180 days, you’ll enjoy the following tax benefits:
- Deferral of tax on the reinvested gain until the earlier of Dec. 31, 2026, or the date you dispose of your QOF investment,
- Permanent reduction of the taxability of your gain by 10% if you hold the QOF investment for at least five years and an additional 5% if you hold it for at least seven years, and
- Tax-free capital gains attributable to appreciation of the QOF investment itself, if you hold it for at least 10 years.
The only way to obtain these benefits is to first sell or exchange a capital asset in a transaction that results in gain recognition. You then would reinvest some or all of that gain in a QOF. You can’t simply invest cash in a QOF.
What about the downside?
QOFs can be attractive investment opportunities, but they’re not without their drawbacks. For one thing, you’ll need to hold the investment for a significant amount of time to enjoy the full benefits. Also, you or your heirs will eventually be liable for taxes on some or all of the original gain. So, it pays to consider other options that would allow you to avoid those taxes, such as holding the original property for life or doing a tax-free exchange.
If you’re interested in investing in a QOF, it’s a good idea to start the process as soon as possible. As explained above, you can defer gain reinvested in a QOF until the end of 2026. But to enjoy a 15% gain reduction, you must hold the investment for seven years. In other words, to achieve the maximum benefit, you must invest in a QOF by the end of 2019.
This information is not intended as advice. QOFs are a new and complicated subject, so consider seeking the advice of a knowledgeable tax adviser about them.
Norm Grill, CPA, (N.Grill@GRILL1.com) is managing partner of Grill & Partners, LLC, (GRILL1.com) certified public accountants and advisers to closely held companies and high-net-worth individuals, with offices in Fairfield and Darien, 203-254-3880.