Qualified opportunity funds provide investors long-term tax benefits

Investors consider long-term investments in qualified opportunity funds because of their potential tax benefits: gain deferral and exclusion.

By: Alison Flores  /  June 14, 2019
Qualified Opportunity Funds | H&R Block Tax Institute

Qualified opportunity funds are a new type of investment established by the Tax Cuts and Jobs Act (TCJA) of 2017. Qualified opportunity funds received bipartisan support from members of Congress because they have the potential to increase private-sector investment in lower-income communities across the United States.

Qualified opportunity funds must hold assets in designated opportunity zones. States and territories nominated up to 25 percent of their low-income census tracts based on data from 2011-2015. The IRS approved opportunity zones in 2018. Opportunity zones exist in all 50 states, the District of Columbia, and the U.S. territories. Approved opportunity zones include metropolitan and rural areas. 26 states have at least one qualified opportunity zone in a tribal area.

The U.S. Treasury announced it intends to collect and track information about how effective the opportunity zone program is at meeting their potential for creating growth in lower-income communities.

Qualified opportunity funds offer investors two types of tax benefits: tax deferral and income exclusion.

Investors can defer tax on capital gains they reinvest in a qualified opportunity fund

Investors can postpone paying income tax on their long-term or short-term capital gains if they invest those gains in a qualified opportunity fund (QOF). The sale of stock, bonds, real estate, and other capital assets generates capital gain.

Capital gains must be invested within 180 days of the gain-triggering event to qualify for deferral. The gain-triggering event is usually the sale of the capital asset.

The deferred capital gain is not subject to tax until the earlier of:

  • The date the qualified opportunity fund investment is sold, or
  • December 31, 2026.

Example 1: Vidya sold her investment in stock on July 15, 2019. Her basis was $40,000. She sold the stock for $50,000. Vidya’s capital gain is $10,000.

Vidya invested $10,000 in a QOF on October 15, 2019 (within 180 days of the sale). She holds the QOF through the end of 2019. Vidya qualifies to defer the $10,000 in capital gain, so it is not included in her 2019 taxable income. Her gain will not be subject to tax until she either sells the QOF investment or December 31, 2026.

Example 2: The facts are the same as in Example 1, except that Vidya waits until January 20, 2020 to invest her gain. Vidya cannot exclude the gain from her 2019 taxable income. She did not invest within 180 days of the gain-triggering event.

Investors who qualify for gain deferral include individuals, C corporations, partnerships, trusts, estates, and real estate investment trusts (REITS).

Investors elect to defer their gain by reporting it as they normally would on Form 8949, Sales and Dispositions of Capital Assets. Then, the deferral is reported on a separate row. See the Form 8949 Instructions under “How To Report an Election To Defer Tax on Eligible Gain Invested in a QO Fund” for further details.

Investors can exclude capital gains on qualified opportunity zone funds

The exclusion of gain on qualified opportunity zone fund investments is based on how long the QOF investment is held. If an investor holds the qualified opportunity fund investment longer than five years, they may exclude 10 percent of the original deferred gain. If the investment is held longer than seven years, they may exclude 15 percent of the original deferred gain.

Example 3:  Mandala invested $100,000 of capital gain in a QOF on November 25, 2019. She holds the investment and sells it in December 2024. Mandala can exclude 10 percent of the original $100,000 investment because she met the five-year holding period. That means she would only pay tax on $90,000 of the capital gain from 2019.

Example 4: The facts are the same as example 3, except that Mandala sells the QOF in December 2026. She can exclude 15 percent of the original $100,000 investment because she meets the seven-year holding period. That means she would only pay tax on $85,000 of the capital gain from 2019. Because she sold the investment in 2026, any other gains generated by the investment would be subject to capital gains tax in 2026.

Investors must make their investments by the end of 2019 to qualify for the 15 percent exclusion. That’s because gain can only be deferred until December 31, 2026. On December 31, 2026, the deferred capital gain will be subject to tax. The deferred capital gain is subject to tax even if the investor continues to hold the investment.

Example 5: The facts are the same as in example 3, except that Mandala sold the QOF investment in January 2027.

  • Mandala can take advantage of the 15 percent exclusion and will pay tax on $85,000 of the deferred capital gain from 2019 with her 2026 taxes. This amount is subject to tax in 2026, even though she did not sell it in 2026. It is considered a deemed sale and the non-excluded gain is recognized.
  • Mandala will be treated as having a $100,000 basis in the QOF investment when she sells it in 2027; the $85,000 she paid tax on plus the $15,000 she excluded from tax. Any gain she realizes on the sale will be 2027 gain on her 2027 taxes, taxed at the capital gains rate then in effect.

If an investor holds the qualified opportunity zone fund investment at least 10 years, the investor may elect to receive an increase in basis up to its fair market value on the date the investment is sold. This means investors can exclude all growth from the original qualified opportunity fund investment from tax.

Example 6: Sahana invested $50,000 in deferred capital gain in a QOF in September 2019. She qualified for a 15 percent exclusion and paid tax on $42,500 of the original deferred gain in 2026.

If she sells the investment in August 2029 (before the 10-year holding period is met) her basis will be $50,000.

If she sells the investment in November 2029 (after the 10-year holding period is met), her basis will step up to the FMV on the date of sale. Sahana will not pay any tax on the appreciation.

Even if an investor does not invest early enough to qualify for the 15 percent or 10 percent exclusion, an investor can still benefit. To qualify:

  • The investment must occur before December 31, 2026, and
  • The investment is held at least 10 years.

Timeline for qualified opportunity fund tax benefits
tax benefit timeline for qualified opportunity funds

Facts about qualified opportunity funds

A qualified opportunity fund is a corporation, partnership, or LLC taxed as a partnership or corporation which holds at least 90 percent of its assets in qualified opportunity zones. The 90 percent investment standard is determined by the average of the percentage of qualified opportunity zone property held in the QOF as measured on:

  • The last day of the first 6-month period of the tax year of the QOF, and
  • The last day of the tax year of the QOF.

Qualified opportunity zone property includes:

  • qualified opportunity zone stock,
  • a qualified opportunity zone partnership interest, and
  • qualified opportunity zone business property.

Qualified opportunity zone business property is tangible property that a QOF acquires after 2017. The QOF must use the property in a trade or business and satisfy both tests:

  1. The use of the property in the qualified opportunity zone begins with the QOF, or the QOF substantially improves the property.
  2. During substantially all the QOF's holding period for such property, substantially all the use of such property was in a qualified opportunity zone.

Qualified opportunity funds are responsible for self-certifying that they meet the legal requirements by filing Form 8996, Qualified Opportunity Fund, with the IRS. Form 8996 must be filed every year.

Many investors will choose to invest in an operating company that invests in another company that is directly operating in an opportunity zone. However, it could also be a direct investment in a business with assets in a qualified opportunity zone.

Pros and cons of qualified opportunity fund investments

Some pros unique to qualified opportunity fund investments include:

  • Potential federal tax savings: gain deferral and exclusion
  • Potential state tax savings (some states passed or are working on legislation to create state-level tax benefits for qualified opportunity funds)

Some cons of long-term investing in general include:

  • Must have capital available to invest
  • Potential liquidity issues associated with an anticipated long-term holding period
  • Need to develop an exit strategy after 10 years
  • Capital gains rates could be higher when gain is eventually realized, or the investor’s ordinary rate bracket may be higher than expected

Some cons unique to qualified opportunity fund investments include:

  • QOFs are new investment vehicles, and funds do not have performance history; more scrutiny may be needed
  • QOFs are in economically depressed areas that may have lower employment rates and a higher rate of business closure or loss as compared to the broader economy; these factors could increase loss risk
  • Must pay tax on deferred gain in 2026, even while continuing to hold the asset
  • Risk of the qualified opportunity fund dissolving before the five, seven, or 10-year holding periods are met and the investor needing to pay tax on the deferred gain sooner than expected or being unable to exclude the appreciated gain
  • Risk of the qualified opportunity fund not complying with regulatory requirements to maintain its status before the five, seven, or 10-year holding periods are met and the investor needing to pay tax on the deferred gain sooner than expected or being unable to exclude the appreciated gain

An additional consideration is the fact investors holding qualified opportunity zone fund investments must consider how it fits within their estate and gift plan. Some transfers may be considered an income-inclusion event. That means the income may be subject to tax if a certain event occurs.

In Opportunity Zones Frequently Asked Questions, the IRS stated that if an investor gifts property to a child before the deferral period is up, the investor must include the deferred gain on their return for the year of the gift.

In proposed regulations on QOFs, the IRS stated that if qualified opportunity fund investments were transferred because of death, the beneficiary would not be required to include the deferred gain in income immediately, but instead when the beneficiary sells the qualified opportunity fund investment. The IRS also clarified transfers to some grantor trusts would not make the deferred gain subject to tax.

Discuss qualified opportunity zone fund investments with your tax and financial advisors

Investors with significant capital gains may want to look at investing in a qualified opportunity fund. While investing in a qualified opportunity fund is not appropriate for everyone, tax benefits include tax deferral and tax exclusion. Investors considering a qualified opportunity fund should discuss whether it fits into their overall investment strategy and goals with their tax and financial advisors.

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Author Name

Alison Flores

Alison Flores, JD, is a principal tax research analyst at The Tax Institute at H&R Block. Alison specializes in the Tax Cuts and Jobs Act (TCJA) and individual income tax issues.

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