The Tax Cuts and Jobs Act (TCJA) signed into law in December 2017 created two deferral opportunities for taxpayers with capital gains, by allowing them to invest in a Qualified Opportunity Zone (QOZ).
The planning opportunity arises when a taxpayer has a capital gain from the sale of any type of asset. This differs from the 1031 exchange which can only be done with real estate.
The QOZ encompasses two different deferral opportunities. The first opportunity is to defer gain from the sale of capital gain property when it is reinvested in a Qualified Opportunity Fund (QOF) investment.
A taxpayer must invest a portion or all of their gain within 180 days into a QOF. This will defer the gain from the capital asset until the earlier of December 31, 2026, or when the taxpayer sells or exchanges their QOF interest.
In addition, once the taxpayer holds the QOF interest for at least five years, then 10% of the deferred gain is permanently excluded. When the taxpayer holds the QOF interest for at least seven years, an additional 5% of the deferred gain is excluded.
Please note that then the entire amount of the deferred gain becomes taxable if the QOF is held or disposed of within five years.
The second deferral opportunity is available when the gain can be permanently excluded from the sale or exchange of the investment in the QOF. This occurs when a ten year holding period is maintained, and where any gain realized after 2026 is excluded permanently.
The TCJA created new definitions and requirements for the deferral or exclusion opportunity. First of all, a Qualified Opportunity Zone needs to be established by the governors of the various states and territories (Including Washington DC). Typically, these QOZ’s are low income communities or neighborhoods. These designated Qualifies Opportunity Zones will remain in effect for ten years.
The next definition is a Qualified Opportunity Fund (QOF). A QOF is an investment vehicle which can be a partnership or C corporation that is formed for the purpose of investing in QOZ’s.
There are very strict rules and requirements that have to be followed in order to qualify as a QOF. For instance, a QOF must hold at least 90% of its assets in QOZ property and cannot invest in another QOF.
A taxpayer can either form their own QOF or invest in a QOF that is maintained and managed by a third party.
Please note that the temporary deferral election cannot be made for any sale or exchange after December 31, 2026.
The rules on this new planning opportunity are very complex. In addition, the IRS is currently in the process of providing additional guidance. Pease contact us if you would like to discuss this planning opportunity in further detail.