A number of special federal tax benefits are available for investing capital gains in a qualified opportunity fund. These include: (1) the temporary deferral of tax on the capital gains, (2) the partial exclusion of the capital gains from gross income if invested in the qualified opportunity fund for certain lengths of time, and (3) the permanent exclusion of post-acquisition capital gains from sale of an interest in a qualified opportunity fund held for at least 10 years.
What is a qualified opportunity fund?
A qualified opportunity fund is an investment vehicle organized as a corporation or a partnership for the purpose of investing (after December 31, 2017) in qualified opportunity zone property (other than another qualified opportunity fund) that holds at least 90% of its assets in qualified opportunity zone property.
Qualified opportunity zone property can include investment by the fund in qualified opportunity zone stock and qualified opportunity zone partnership interests, as well as direct investment by the fund in qualified opportunity zone business property. A qualified opportunity zone is a low-income community population census tract that is designated as a qualified opportunity zone.
Qualified opportunity zone business property is tangible property used in the trade or business of a qualified opportunity fund. The property must be acquired by purchase after 2017 from an unrelated person. The original use of the property in the qualified opportunity zone must be by the qualified opportunity fund, or the property must be substantially improved by the qualified opportunity fund. Property is substantially improved only if capital expenditures on the property in the 30 months after acquisition exceed the property's adjusted basis on the date of acquisition. And the property must be in a qualified opportunity zone during substantially all of the qualified opportunity fund's holding period for the interest.
Special tax benefits for investors
When you sell property, gain is generally recognized for tax purposes to the extent the sales price exceeds your tax basis in the property. However, if you roll over the gain by investing in a qualified opportunity fund, special tax treatment may be available.
The gain for which special tax treatment is sought must be from a sale of property to an unrelated person. Generally, the maximum amount of gain that can be deferred is equal to the amount invested in a qualified opportunity fund by the taxpayer during the 180-day period starting with the date of sale of the asset to which the deferral pertains. An election should be made as to the amount of gain to be deferred. No election can be made with respect to any sale or exchange after December 31, 2026.
If only a portion of the investment in the qualified opportunity fund consists of gains for which the election is made, the investment should be treated as two separate investments. The special tax benefits described here are available only with respect to the portion for which the election is made.
The basis of the deferred-gain investment in a qualified opportunity fund is zero immediately after acquisition. If the deferred-gain investment in the qualified opportunity fund is held by the taxpayer for at least five years, the basis in the deferred-gain investment is increased by 10% of the original deferred gain. If the investment is held for at least seven years, the basis in the deferred-gain investment is increased by an additional 5% of the original deferred gain.
The deferred gain (after appropriate basis adjustments) is generally recognized on the earlier of the date the interest in the qualified opportunity fund is disposed of or December 31, 2026. Thus, if the investment is held to at least December 31, 2026, the basis in the investment is also increased by the deferred gain that is recognized. Technically, the amount of deferred gain recognized here is equal to (a) the lesser of the deferred gain or the fair market value of the investment, minus (b) the taxpayer's basis in the investment. Therefore, the deferred gain will generally be excluded from taxation to the extent (if any) that the fair market value of the investment is reduced below the amount of the deferred gain, and also to the extent of the basis adjustments at five and seven years.
In the case of a sale of an interest in a qualified opportunity fund held for more than 10 years (and for which the election to defer gain was previously made), the taxpayer can elect that the basis of the interest shall be the fair market value on the date of sale, and thus exclude any post-acquisition capital gains from taxation. The election should not be made, however, if the fair market value is less than the basis without the election. In that case, making the election could prevent the taxpayer from claiming a loss for tax purposes.
Example
Taxpayer sold stock to an unrelated person for a gain of $1,000 on January 1, 2019, then invested $1,000 in a qualified opportunity fund within 180 days of the stock sale, and elected to defer the tax on the gain. Assume taxpayer holds the investment for 10 years and then sells it at fair market value for $1,500.
Taxpayer's initial basis in the deferred-gain investment is zero. After five years, the basis increases to $100 ($1,000 original deferred gain x 10%). After seven years, the basis increases to $150 [$100 + ($1,000 original deferred gain x 5%)]. On December 31, 2026, assume the taxpayer has to recognize the remaining $850 of deferred gain ($1,000 original deferred gain – $150 basis). The basis increases to $1,000 ($150 + $850 gain recognized). The basis increases of $100 and $50 effectively excluded $150 of the original deferred gain from taxation.
If the taxpayer makes the election to increase the basis to fair market value when the taxpayer sells the investment after 10 years, the basis is increased to $1,500 and no tax is due on the sale ($1,500 sales price – $1,500 basis). The $500 post-acquisition capital gain ($1,500 sales price – $1,000 basis after deferred gain recognized) is effectively excluded from taxation.
In this example, tax on $850 of gain was deferred for about seven years, and $650 of gain ($150 original deferred gain + $500 post-acquisition gain) was excluded from tax. Without the elections, $1,000 of gain would have been recognized on the sale of stock in 2019, and $500 of gain ($1,500 sales price – $1,000 basis) would be recognized when the taxpayer sells the investment after 10 years.
This hypothetical example is for illustrative purposes only. Actual results will vary. Please reach out if you have questions.