At the time of this writing, U.S. investors are sitting on a total of more than $2.3 trillion in unrealized capital gains. Could these untapped resources help stimulate the economy by being invested in businesses and real estate within our nation’s most economically challenged areas? That’s the thinking behind the 2017 Tax Cuts and Jobs Act’s (TCJA) Qualified Opportunity Funds (QOF) legislation. While offering financially struggling rural and urban areas, identified as Qualified Opportunity Zones (QOZ), a leg up, QOFs offer investors some tantalizing tax benefits. The question is: do the risks and long-term illiquidity outweigh the attractive tax advantages? Before deciding, speak with your financial advisor to objectively weigh the pros and cons.
How the program works. When an investor elects to rollover his capital gains into a Qualified Opportunity Fund and that money remains invested for at least five years, they receive a 10% step-up basis which means that 10% of the original invested gain will be tax free when the QOF is liquidated. If the monies remain in the QOF for seven to ten years, another 5% of the starting investment is no longer subject to tax. By far the biggest advantage is if the investment is held for more than 10 years, then the basis of the investment will be adjusted to be equal to the fair market value of the investment on the date on which it is sold. In other words, there is ZERO capital gains due on any profits from the sale of an opportunity fund investment after a 10-year holding period.
The rules. Investors have 180 days to reinvest capital gains from the sale of a stock, real estate or other investment into a QOF. The entire gain need not be rolled over, but only the rolled over portion will receive the tax advantages. Capital gains tax can be deferred for as long as the monies are held in a QOF or until December 31, 2026 whichever occurs first. Under proposed regulations, the ability to make the election for investments held for at least 10 years would not be impaired solely because the designation of one or more QOZs ceases to be in effect.
Compare to Section 1031. Savvy investors are familiar with 1031 exchanges. While QOZs may appear similar, at first glance, there are substantial differences. Section 1031 exchanges require both principal and gain to be reinvested. With a QOF, only the gain, or any portion thereof, may be reinvested. QOFs do not require an intermediary to manage the exchange. Section 1031 can only be used for real property where QOFs apply to capital gains from any type of capital asset. With a 1031 exchange, the investor owes capital gains tax on the final sale of the asset. As stated above, zero capital gains tax is due on any appreciation of the QOF when sold after having been held for at least 10 years.
It’s important to note. For investors sitting on highly appreciated assets with the potential for significant capital gain on sale, a QOF may be something to consider. It may be also be suitable for passive investors looking for a professionally managed fund or for individuals looking to diversify their portfolios.
A QOF must be certified by the U.S. Treasury Department and must hold at least 90 percent of its assets in QOZ businesses, real estate and/or business assets. To see a comprehensive list of government approved QOZs, visit: https://opportunitydb.com/location/.
A word of caution. QOFs are not for everyone and do come with some inherent risks. Remember, you are entering unchartered waters. These are not tried-and-true investments. There is no performance track record to guide you and no barometer of success or failure upon which to judge the prospective investment. Moreover, a QOF could shut down in less than five years due to insufficient funding and you could instantly lose your tax deferred status. As a rule, when choosing to invest in QOFs, spend the time to do your research. Make sure you understand the possible pitfalls before investing. Be sure to seek expert advice to determine if investing in a QOF makes sense for you, is in line with your risk tolerance and on track with your overall investment strategy.
DSJ is happy to offer advice on the tax effects of this new alternative investment or any other investment. Please call us at 516-541-6549.
NOTE: DSJ has provided the above for informational purposes only and is not offering an opinion on investment strategies or making any recommendation for investing in any QOF.