With all the changes passed in the 2017 tax reform, it was easy to overlook qualified opportunity funds. But investing in a “qualified opportunity fund” (QOF) provides powerful tax benefits. And with new regulations recently issued by the IRS, the rules have begun to take shape. What are the biggest tax benefits? QOFs allow you to:
- defer paying tax on your capital gain until as late as the end of 2026;
- reduce your original capital gain tax liability by 15% if you hold your QOF investment at least 7 years (10% if you hold at least 5 years); and
- exclude any gain from your investment in the QOF if you hold the QOF for at least 10 years.
To qualify for the tax benefits, you must have capital gain. Within 180 days of realizing the capital gain, you must invest the proceeds in a QOF. Despite the tax advantages, QOFs are not for everyone. They are tailor-made for real estate investors with substantial capital gain. And they are well worth consideration by individuals with capital gain considering some kind of diversification.
But the QOF rules include key terms that define the scope of QOFs and dictate how they may be structured.
Defining Qualified Opportunity Fund
Fundamentally QOFs require investors to invest in either real estate, equity interests in businesses or business assets located in “Qualified Opportunity Zones” (QOZs). To stimulate investment in low-income communities, each state designates certain low-income census tracts as a QOZ. You can find QOZs in your area by using a map, such as this one that shows the whole country or this one for California.
QOFs are often better thought of as a real estate deal than an investment fund. If you’re not comfortable investing in a long-term real estate project in a low income community, QOFs may not be for you. But given the potential tax benefits, if you have or are expecting capital gain, QOFs are worth at least considering.
A QOF must invest at least 90% of its assets in QOZ property. The term “QOZ property” is another key term in the QOF rules.
Qualifying Investments for QOFs
QOZ property includes (i) real estate in a QOZ, (ii) tangible business property used in a QOZ, and (iii) an equity interest in an operating business in a QOZ. An equity interest includes both stock in a corporation and a partnership interest. It also includes a membership interest in a limited liability company. But whether it is a corporation, partnership or LLC, the company must be operating a business located in a QOZ.
While a QOF can’t invest in another QOF, a QOF can invest in equity of an operating business in a QOZ. For example, Sam invests $1 million in Opportunity Investments LLC. Opportunity Investments LLC then invests $900,000 in Qualified Business LLC. Qualified Business LLC then borrows funds from an external lender and develops a commercial building in a QOZ.
In many cases, investors can get greater flexibility by “tiering” a QOF to invest the QOF funds in another operating business. This can be better than investing directly in tangible business property. It’s worth repeating that, however it is structured, the QOF must invest 90% of its funds in QOZ property. But the entire amount invested in the QOF qualifies for the tax benefits.
To qualify as QOZ property, it must either be new or substantially improved. The new Treasury rules define how much must be invested in QOZ property to qualify as substantially improved. Although questions remain about the meaning of many terms, the new IRS rules provide important guidance on what you must do to qualify.
In conclusion, as long as they comply with the rules, QOFs can be structured in different ways. You can invest directly in real estate or tangible business property or indirectly by investing in another entity. In either case, the new IRS rules provide guidance on the percentage of assets that need to be invested in qualify property. It’s also important that you invest in a new business or building or plan to make major improvements to an existing business or building.
QOF Investments Compared to Taxable Investments
The tax benefits potentially super-charge the after-tax return from a QOF. For example, assume that Mary has $100,000 in capital gain that she invests in a QOF. She earns a 5% yield on her investment, generating about $148,000 after 8 years. In year eight, she pays $20,230 in capital gain tax (85% of the original tax of $23,800). That leaves her investment with a value of about $128,000. That amount grows to about $140,600 at the end of 10 years. The entire amount of $140,600 is tax-free.
In a taxable investment, the investor would begin with $76,200 ($100,000 less capital gain tax of $23,800). Assume the investor invests in a long-term investment and holds for a total of 10 years without triggering any taxable income. In that case, to generate an after-tax return of $140,600, the investor would need to earn a yield of about 7.75%. So an investment in a QOF yielding 5% over 10 years can match a taxable investment yielding 7.75%.
Potential Tax Benefits of QOFs
|Rate of Return||5.00%||7.75%|
|Capital Gain in Year 1||$100,000.00||$100,000.00|
|Tax Paid in Year 8||($20,230.00)||$0.00|
|Value in Year 10||$140,585.89||$160,695.92|
|Tax Paid on Gain in Year 10||$0.00||$20,110.03|
If you have taxable capital gain and are considering investing the proceeds in real estate, you owe it to yourself to consider QOFs. The detailed requirements for QOFs require planning to make sure you can fully realize the tax benefits.