In December 2017, Congress passed the Tax Cuts and Jobs Act which included provisions to encourage long-term investments to build and rebuild low-income communities across the country. These investment vehicles, called Qualified Opportunity Funds (QOFs), will make tax-advantaged investments in communities, dubbed Qualified Opportunity Zones (QOZs). The investments are designed to spark economic development by providing tax breaks to investors who invest gains from prior vestments into property located in a QOZ.
A population census tract within a state is eligible to be designated as a QOZ if it meets the definition of a “low-income community” under Sec. 45D9(e) of the Code. Each state governor is authorized to designate 25% of the eligible census tracts as QOZs. Here is the current list of approved QOZs.
Opportunity Funds pool investments in a QOZ. An Opportunity Fund under Code Section 1400Z-2(d) is generally privately-managed and organized as a corporation, partnership or limited liability company for the sole purpose of investing in qualified property within a QOZ. The investor has 180 days from the date of disposition of his, her or its property to reinvest the gain into the QOF.
The first QOZs were designated in April 2018, and Minnesota is home to multiple counties with QOZs.
Qualified Opportunity Funds provide three tax benefits to investors:
1. Temporary tax deferral for capital gains. Investors can avoid the typical tax on capital gains by placing their prior gains in the fund until the investment in the Opportunity Fund is sold or exchanged, or until December 31, 2026, whichever comes first.
2. Step-up basis for capital gains reinvested in an Opportunity Fund. An investor who holds his interest in an Opportunity Fund for at least five years can increase his basis by 10% of the deferred gain, and an additional 5% if the investment is held for seven years.
3. Permanent exclusion from taxable income of capital gains. If the investor continues to hold an interest in the fund for at least 10 years, he will not be taxed on the appreciation.
Here’s an example:
Dave has $1 million in unrealized capital gain on the sale of stock. He sells the stock on August 1, 2018 and on September 1, 2018 (within 180 days) he reinvests the $1 million gain into an Opportunity Fund, Patrick’s Projects, LLC, which invests in dilapidated communities in northeast St. Louis County. He holds his interest in Patrick’s Projects for 10 years. It is now October 1, 2028 and Dave has disposed of the investment. Here’s how he benefitted:
- He was able to defer the capital gains tax on the $1 million until December 31, 2026.
- He increased the basis of the investment by 15% of the deferred gain, so only $850,000 is subject to taxation.
- He will not owe tax on the appreciation after the investment is made in the Opportunity Fund.
The final details about Qualified Opportunity Funds are still not completely known as we are waiting for the Internal Revenue Service to issue guidance as to how the program will work. Despite the lack of guidance, investors are already working to establish QOFs.