Since coming into effect in January 2018, Subchapter Z of the U.S. Tax Code, also known as the Opportunity Zone provisions, has allowed investors to pour billions of dollars into a wide range of businesses. , from real estate development companies to tech startups. Investments in Qualified Opportunity Funds (QOF) offer a number of distinct tax advantages, not the least of which is the reduction in capital gains tax. But the rules governing these investments are novel, confusing and, in some cases, severely restrictive.
In the following series of articles, we discuss the basics of investing in a QOF, provide a detailed analysis of the law surrounding the area of opportunity provisions, and provide case studies that take a closer look at the specific structuring. to industry areas of opportunity.
In January 2018, Subchapter Z of the U.S. Tax Code (also known as the Zone of Opportunity Provisions) came into effect. At that time, taxpayers and advisers alike were intrigued by its significant benefits. However, as this was brand new legislation, there was just as much uncertainty about the law and, perhaps more importantly, whether the investments would turn out to generate income.
Over the next three years, the U.S. Internal Revenue Service (IRS) issued important regulations that broadly clarified the law. Additionally, several billion dollars have been invested in qualified opportunity funds and the funds have allowed investors to invest in a wide range of industries, from real estate development to tech startups. Taken together, this legislative clarity and track record of success have demonstrated that investing in a qualified opportunity fund can be a prudent option that offers legal certainty and amazing tax benefits. This is especially extraordinary in a world where the US federal rate of capital gains is likely to increase significantly. However, like with most great rewards, the perk comes with significant challenges: The rules governing these investments are quirky, confusing, and can be very restrictive.
From a US federal tax perspective, investing in a Qualified Opportunity Fund (QOF) offers three important advantages:
First, the opportunity zone provisions allow investors who have recently generated capital gain (g., from the sale of a business, stocks, commodities, collectibles, real estate) to reinvest, within 180 days of the sale or exchange of such an asset, the gain in a qualified opportunity fund, thus allowing the investor to postpone the US federal capital gain decision until December 31, 2026 at the latest.
Second, if the investment is made by the investor in the qualified opportunity fund before December 31, 2021, the capital gains tax will be reduced by 10% when the gain is recognized on December 31, 2026.
Third, and perhaps most importantly, when an investor holds their stake in the QOF for 10 years or more and after that 10-year holding period has been passed, the investor may be able to exclude from permanently from US federal tax any gain realized on the QOF Investment (including any recapture of depreciation).
the 10 years of waiting tax exclusion benefit is remarkable for a number of reasons. Primarily, there is no limit on the amount of the gain that is excluded from tax. For example, if an investor contributes $ 1 million to a tech startup that is sold 10 years or later for $ 1 billion, the entire $ 999 million in gain would be excluded from U.S. federal income tax. .
In addition, the recapture of depreciation is also excluded from US federal income tax. The benefit of a tax-free depreciation recovery offers taxpayers the opportunity to generate income offset by depreciation during the 10 years of holding the investment. Typically, this depreciation reduces the tax base by an equivalent amount and, on a future sale, tax is applied. to resume depreciation at the rate of ordinary income or capital gains. Under the provisions of the Zone of Opportunity, however, the recapture of depreciation and any appreciation of the asset is not subject to tax. For example, if an investor invests $ 100 in an asset that depreciates evenly over a 10-year period, that investor could offset $ 10 of otherwise taxable income with $ 10 of capital cost allowance for 10 years. At the end of the 10 year period, the investor would have a tax base of $ 0 in the asset. Thus, if the investor sold the asset for $ 200, he would recognize a gain of $ 200, which would be subject to tax at the ordinary income rate or at the long-term capital gains rate, as the case may be. That same investment in a qualifying opportunity fund could be sold tax free from a U.S. federal income tax perspective, which would exclude the depreciation recapture tax and l ‘appreciation of the value of the asset.
An investment in a QOF also offers investors the option of refinancing the investment and receiving a distribution of the refinancing without being subject to immediate US federal tax. For example, in year 1 an investor invests $ 100 in a qualifying opportunity fund and these amounts are invested appropriately by the fund. In the third year, a bank grants the qualified opportunity fund a loan of $ 50, which is immediately distributed by the fund to the investor. The investor can use these funds for any purpose. Properly structured, the distribution of the product should generally not trigger a US federal tax liability for the investor.
How it works, in numbers
As an example, suppose an investor invests a $ 1,000,000 capital gain in a QOF in 2021 (QOF investment). The deferred gain will be taxed no earlier than (1) the date the taxpayer sells the QOF investment, or (2) December 31, 2026. The taxable amount will be $ 1,000,000, reduced by the base of the investor in QOF investment. If on the date the QOF investment is sold, the QOF investment is worth less than $ 1,000,000, then the QOF investment is taxed at its fair market value on the date it is sold, less the base of the investor in the QOF investment.
The investor’s base in the QOF investment is initially zero, but if the investor holds the QOF investment for at least five years (for example, until 2026), the investor base in the QOF investment becomes $ 100,000 (10% of $ 1,000,000). After the $ 1,000,000 is taxed, the taxpayer’s new base in the QOF investment becomes $ 1,000,000. Therefore, if the investor holds the QOF investment for nine years (for example, until 2030), the amount taxed will be any capital appreciation greater than the base $ 1,000,000, less any capital cost allowance taken to reduce the base. If the investor holds the QOF investment for at least 10 years (for example, until 2031), the investor’s base in the QOF investment is increased to the fair market value of the QOF investment on the date it is sold, so that none of the capital gain or the recapture of depreciation is subject to U.S. federal income tax (that is to say, the gain is not subject to U.S. federal income tax, but may be subject to applicable state and local taxes).
The benefits to the investor in this example are (1) the tax deferral of the $ 1,000,000 initial capital gain invested in the QOF until the date closest to the date on which the QOF investment is sold, or December 31, 2026; (2) decrease in the initial capital gain of $ 1,000,000 ultimately taxed to $ 900,000 (90%); and, more importantly, (3) tax avoidance on any appreciation and depreciation recovered that the $ 1,000,000 of initial capital gain invested in the QOF generates, if the investment in the QOF is held for 10 years.