Qualified Opportunity Fund Investments & The Tax Breaks
How an investment in distressed communities can lower your capital gains exposure — and why 2019 is an especially good year to make it.
More and more people are looking to put their personal capital to work in support of society and their communities. And Congress gave them a new way to do just that when it passed the comprehensive tax reform law in late 2017. Among the many changes in the law was a section that encouraged taxpayers to invest in economically distressed communities across the United States and, in return, potentially receive very favorable capital gains tax breaks.
In October 2018, the U.S. Department of the Treasury issued proposed regulations to clarify the tax laws surrounding Opportunity Zones and Opportunity Funds, hoping to reduce uncertainty and encourage investors to get involved. A second set of regulations proposed in April 2019 provided additional clarity, easing many of the remaining concerns and driving increased interest among investors. As a result, we are likely to see the formation of additional Opportunity Funds moving forward.
Mitchell A.
Drossman,
National Director of
Wealth Planning
Strategies, Bank of
America Private Bank
How it works
Investors who realize a short-term or long-term capital gain from the sale of such investments as securities, collectibles, real estate or businesses can reinvest those gains in what is called a Qualified Opportunity Fund (QOF). These funds are corporations or partnerships (which may include some LLCs) that invest in businesses or assets in any of the nearly 9,000 low-income communities within the United States or its possessions certified by the U.S. Treasury as Qualified Opportunity Zones (QOZ). The funds are required to invest at least 90% of their assets in QOZ businesses, either directly or in the stock or partnership interests of the qualified business. Examples include affordable and market-rate housing developments, stores, offices, recreational and healthcare facilities and other businesses, startups included. The tax law requires that the fund self-certify with the IRS that it meets relevant tax criteria, and subsequently report its alignment with relevant tax regulations on an annual basis.
Timing matters
The gains invested in the QOF must have occurred before the end of 2026 and be reinvested within 180 days of the date they were realized. The tax advantages of investing capital gains are available to individuals, corporations, partnerships — even trusts. What’s more, this is a particularly attractive year — investors can maximize their tax savings if they roll over their gains into a QOF before the end of 2019.
Getting started
There are several methods available to investors looking to access a QOF. Two stand out as the most common: You can set up your own QOF by creating a new entity or use an existing entity that complies with federal tax rules — the method often used by family offices and families whose holdings are focused in real estate. Or, you can invest in a third-party QOF that pools money in a manner similar to a private equity fund. These types of funds may require investors to have a certain net worth or to invest a designated minimum, among other restrictions.
RULES VARY STATE TO STATE
Some states have yet to bring their tax rules into conformance with the federal Opportunity Zone rules. For example, New York has done so, while California has not. Investors should be aware of the status of the states in which they live and in which they’re investing. This is especially true if they live in a state that conforms to federal tax law, but want to invest in an opportunity zone in a state that doesn’t.
Breaking down the benefits
Investing in a QOF may allow you to defer recognition of a capital gain on your income tax return, so long as you reinvest that gain into a QOF within 180 days of realizing it. (There are some exceptions to this deadline.) You then defer recognition of the capital gain until December 31, 2026, or until you sell or dispose of the investment, whichever comes first.
In addition to the deferral, taxpayers can reduce the taxable capital gain by 10% or 15% if they hold their QOF investment for five or seven years, respectively, and the deferral period hasn’t ended. That means to qualify for the 10% reduction, the capital gain would need to be reinvested into a QOF by December 31, 2022, and for the full 15% reduction, it would need to be reinvested by the end of 2024.
Perhaps the greatest tax benefit is reserved for taxpayers willing to make a truly long-term commitment to the investment in a QOF. Any gain realized after the investment in the fund can be considered eliminated for tax purposes if the investor holds the investment for 10 years and then sells it by 2047.
A unique real estate opportunity
Generally, a business in the fund must generate a majority of its gross income from the community where it is located. This has led many investors to believe that qualifying investments of significant scale are most likely to be in real estate; the regulations proposed in April provided much-needed clarity about how other kinds of businesses can qualify.
In identifying partners to manage Opportunity Zone investments, it’s important to pay close attention to past discipline in capital allocation. And because the investments must be held for at least 10 years to maximize the tax benefit, long-term management of the asset for investors is even more important than near-term market conditions.
Some things to look out for
It should be noted that to realize the full benefits of this program, investors must commit to holding illiquid assets for at least 10 years. In addition, some QOFs might hold only a single asset — or multiple assets that may not be well-diversified in terms of industry and geography. Additionally, some observers have raised the concern that investments in QOZs could potentially produce tax breaks for investors financing projects that would have happened regardless of the tax incentives, and that such investments might spur gentrification and displace low-income households.
“In identifying partners to manage Opportunity Zone investments, it’s important to pay close attention to past discipline in capital allocation.”
On a positive note, as a wealth strategy report from Bank of America Private Bank points out, partnerships and other pass-through entities may have longer than 180 days to roll over a capital gain and realize the tax advantages, so it could be beneficial to hold assets in such an entity in anticipation of greater flexibility when the time comes to roll over. It’s one of many nuances to bear in mind in exploring this new opportunity to potentially do good while doing well.
To learn more about QOFs, contact an advisor about our recent Wealth Strategy reports: “Deferring Capital Gain: Qualified Opportunity Zones” discusses rules governing the funds, and “Qualified Opportunity Funds: Timing Matters” focuses on a number of timing issues contained in the tax law and proposed regulations, some of which will be relevant for 2019 year-end planning.
