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Qualified Opportunity Funds

Last year’s Tax Cuts and Jobs Act (TCJA) made sweeping changes to many areas of tax law for both individuals and businesses. We’ve spent a lot of time explaining these changes and how they will impact you. However, there was an important piece of the legislation we haven’t discussed yet that created a new type of investment called Qualified Opportunity Funds (QOF) that offer intriguing tax benefits. The IRS recently released further guidance on QOF’s and that has spurred additional awareness and publicity. This is still a new area of tax law and there are open questions on certain aspects of the legislation, but here is what we know now.

Qualified Opportunity Funds are created for the purpose of investing in Qualified Opportunity Zones, which were authorized under the TCJA. Each state was allowed to designate a certain number of low income communities as Qualified Opportunity Zones, which can be found on this map or in this spreadsheet. The goal behind the legislation was to encourage investment into communities that need it most, by attaching a number of attractive tax incentives to these investments.

The primary benefit from investing in a QOF is that you are able to defer the taxation of a capital gain by rolling that gain into the QOF. You have 180 days after the sale or exchange that produced the gain to make the investment. That gain is deferred until the earlier of the date when the QOF is sold or December 31, 2026. That means even if you invest in a QOF and hold it past December 31, 2026, you would owe the tax on your original deferred gain in that year. However, there are additional tax benefits to holding the new QOF investment that long.

These additional benefits include step ups in basis of your original gain once you have held the QOF for 5 and 7 years. At the 5 year mark you are able to increase your basis in the original gain by 10% and after 7 years you can step up the basis by an additional 5%. This means you not only are able to defer your original taxable capital gain until 2026, if you hold the QOF until that date you also would reduce the taxable gain by 15%.

The final major tax benefit to rolling a capital gain into a QOF is the ability to completely eliminate any gain on the actual QOF investment itself if you hold the investment for 10 years. If held for that long, you are able to elect to make the basis equal to the proceeds from the sale/exchange.

These are all substantial tax benefits and anyone who has recognized large capital gains recently or anticipates recognizing a large gain in the near future should look at possibly using some of that gain to invest in a QOF. If you have a large allocation to a single stock holding with low basis and want to diversify your portfolio but are reluctant to trigger the capital gain, this might be a good way to do so.

As with all investment opportunities, significant due diligence should be performed on any potential QOF before investing and no investment decision should be made solely for tax planning purposes. This is a very new investment arena and there will surely be unscrupulous characters promoting QOF’s that aren’t sound investments. All of the tax benefits become negligible if the QOF turns out to be a poor investment that loses value over time.

There will certainly be some great opportunities arising from this legislation to help improve low-income communities while also saving a significant amount of taxes and possibly earning a nice return on your investment. Just be sure to take the time to fully understand any potential investments and how the new tax law will impact you. We are here to discuss any opportunities with you.

For a more detailed explanation of the QOF rules, I suggest checking out this great article from Jeff Levine.

-Chris Benson, CPA, PFS

The views expressed represent the opinions of L.K. Benson & Company and are subject to change. These views are not intended as a forecast, a guarantee of future results, investment recommendation, or an offer to buy or sell any securities. The information provided is of a general nature and should not be construed as investment advice or to provide any investment, tax, financial or legal advice or service to any person. Please see Additional Disclosures more information.