While qualified opportunity funds (QOFs) offer a number of tax benefits, investors understandably have reason to be concerned about the tax implications of distributions from these funds. In this article, we’ll take a closer look at whether distributions from a QOF are taxable and how specifically they are taxed.
Taxation of Qualified Opportunity Funds
While investors may enjoy certain tax benefits from the income or gains on qualified opportunity funds (QOFs), these funds are still taxed. QOFs do not hold any special tax exemption. How exactly income and gains are taxed depends on several factors.
One benefit of investing in a QOF is the deferment of taxes on capital gains. Taxes are deferred until December 31, 2026, or until the investor sells their investment, whichever comes first.
This means that if an investor invests capital gains into a QOF and receives a distribution before December 31, 2026, they will not owe taxes on the distributed amount as long as the distribution is not greater than the amount of the original investment.
However, if the investor receives a distribution after December 31, 2026, he will be required to pay taxes on the distributed amount, regardless of whether the investment was sold. The taxes owed will depend on the type of income generated by the QOF and the investor’s individual tax situation.
Type of Distribution
Two types of distributions from a QOF are operating income and capital gains. Operating income is created from rental income and interest, among other sources. Capital gains are created when an asset is sold for more than it was purchased.
Operating income is taxed at the investor’s regular income tax rate. Capital gains are taxed at the regular capital gains rates, which are split into short (held for a year or less) and long-term (held for more than a year) gains. Only long-term capital gains offer a lower tax rate benefit.
Step-Up in Basis Tax Benefits
Finally, there is the step-up in basis. This occurs when a QOF holds an asset for 10 years or longer. A step-up in basis means the value of the investment is adjusted to its fair market value at the time of sale. It can mean significant tax savings, as any capital gains realized on the investment will be taxed at the stepped-up basis rather than the original investment amount.
To summarize, distributions from a QOF are generally taxable, but the tax treatment depends on the timing and nature of the distributions, as well as the investor’s individual tax situation. Additionally, the taxes owed will depend on the type of income generated by the QOF and the length of time the investor held the investment.
QOFs can be complex investment vehicles, and investors should carefully consider the potential tax implications before investing. Consulting with a tax professional or financial advisor can help ensure that investors fully understand the tax consequences of their investment and can make informed decisions.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor.
Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation.
Investors in QOFs will need to hold their investments for certain time periods to receive the full QOZ Program tax benefits. A failure to do so may result in the potential tax benefits to the investor being reduced or eliminated.
If a fund fails to meet any of the qualification requirements to be considered a QOF, the anticipated QOZ Program tax benefits may be reduced or eliminated. Furthermore, a fund may fail to qualify as a QOF for non-tax reasons beyond its control, such as financing issues, zoning issues, disputes with co-investors, etc.
Distributions to investors in a QOF may result in a taxable gain to such investors.
The tax treatment of distributions to holders of interests in a QOF are uncertain, including whether distributions impact the aforementioned QOZ Program tax benefits.
A QOF must make investments in Qualified Opportunity Zones, which carries the inherent risk associated with investing in economically depressed areas.