From time to time, we are asked for some general advice about two elections, one to defer gain from the sale of property that is reinvested in an investment in a Qualified Opportunity Fund (QOF) and another to permanently exclude gain from the sale or exchange of the investment in the QOF. Extensive regulations clarify many rules applicable to these investments. A QOF investment can provide substantial tax benefits for taxpayers who can satisfy the detailed and quite complex set of rules.
Designation of a Qualified Opportunity Zone (QOZ). A state’s chief executive officer (CEO) (generally, a governor or the mayor of the District of Columbia) could designate certain census tracts that are low-income communities as QOZs. The designation had to occur before June 21, 2018 and will remain in effect for ten calendar years. Census tracts in Puerto Rico that are low-income communities were considered to be certified and designated as QOZs effective on Dec. 22, 2017.
QOFs. A QOF is an investment vehicle organized as a corporation or a partnership for the purpose of investing in a QOZ. A QOF must be created or organized in one of the 50 states, the District of Columbia, or a U.S. territory, or organized under the laws of an Indian tribal government. The QOF can’t invest in another QOF and has to hold at least 90% of its assets in QOZ property (i.e., any QOZ stock, any QOZ partnership interest, and any QOZ business property). A QOZ property has to meet many requirements, including that substantially all of the entity’s business property is used in a QOZ. A penalty can apply to the QOF if it fails to meet the 90% investment standard. An exception to the penalty can apply to certain reinvestments of the proceeds from the disposition of QOZ property that are reinvested within 12 months (and that period may be extended for certain delays due to federally declared disasters).
Temporary gain deferral election. If a taxpayer invests gains from the sale or exchange of property with an unrelated person in a QOF within the 180-day period beginning on the date of the sale or exchange, the taxpayer can elect to defer the gain from the sale or exchange. The regulations provide detailed rules as to how eligible taxpayers (individuals, certain C corporations, RICs, REITs, partnerships, S corporations, trusts, and certain decedents’ estates) can make the election and how the 180-day period is computed.
Recognition of deferred gain. The taxpayer defers the gain until the earlier of the date on which the investment is sold or exchanged (i.e., an “inclusion event”), or Dec. 31, 2026. At that time, the taxpayer includes the excess of (1) the gain over the lesser of the amount of deferred gain or the fair market value of the investment as determined on that date over (2) the taxpayer’s basis in the investment. Certain events (such as certain transfers of a QOF investment by reason of death) are not inclusion events.
Basis in the investment. A taxpayer’s basis in the investment is zero unless any of the following increases apply: (a) 10% of the deferred gain if the investment is held for five years, (b) 5% of the deferred gain if the investment is held for seven years; and (c) any deferred gain recognized at the end of the deferral period.
Basis adjustment /permanent gain exclusion election. At the taxpayer’s election, a taxpayer can exclude any post-acquisition capital gains on an investment in a QOF if the investment in the QOF has been held for ten years. Under the regulations, this election is not applicable to dispositions that occur after Dec. 31, 2047. IRS is considering alternative approaches that might apply to QOF investments that are not disposed of before 2048.
When elections can’t be made. A taxpayer can’t make either election if there’s already an election in effect with respect to the same sale or exchange. Also, a taxpayer can’t make a temporary deferral election with respect to any sale or exchange after Dec. 31, 2026.
Caveat: Like any investment, QOFs are speculative. We do not recommend brokers or other investment advisors, nor do we recommend this as a tax strategy. Anyone considering investing in a QOF should consult qualified investment advisors, legal counsel and other professionals before entering into this type of investment.
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