The passage of the Tax Cuts and Jobs Act in 2017 created the Qualified Opportunity Zone program. The program was designed to encourage investment in economically disadvantaged communities. When the legislation passed, each state and territorial governor had the opportunity to nominate specific census tracts as QOZ-eligible. The Treasury Department completed the final evaluation and determination; currently, over 8700 areas are eligible. The selection process considered median income and the pervasiveness of poverty.
The means of encouraging investment in these designated areas is a deferral of capital gains taxes when the gain is reinvested in a QOZ Fund and the potential to exempt capital gains earned within a QOZ Fund from taxation if the rules are followed. However, before we look at each of these opportunities, it's essential to be clear that while individual taxpayers invest in these QOZ Funds, the Fund must be organized as a partnership or corporation. So, individuals do invest in Qualified Opportunity Zones, but they do so through a QOF.
A qualified opportunity fund (QOF) must hold at least 90 percent of its assets in a QOZ and earn at least 50 percent of its income from activities conducted within the QOZ. Any property acquired by the QOF must be sufficiently improved within 30 months to experience a doubling of basis in that time. A QOF must follow other regulations, one of which prohibits the funds from investing in “sin” businesses, such as bars, casinos, and racetracks.
Suppose a taxpayer sells an asset (property, stock, or business) and earns a profit, called a capital gain. Ordinarily, that taxpayer would owe capital gains taxes on the appreciation. However, if the taxpayer reinvests the gain amount into a QOF within 180 days of the triggering event, they can defer the payment of capital gains until the end of 2026 (payment in 2027). If the taxpayer terminates the investment sooner, the tax would be due at the time of sale.
If the taxpayer invests in a QOF and keeps the money invested for at least ten years, they will not owe capital gains taxes on any appreciation the investment enjoys. For example, suppose you sell an asset with a capital gain of $100,000. Then, within 180 days of the sale, you reinvest that $100,000 into a QOZ Fund project. As a result, you can defer the tax payment due on the sale until the end of 2026. Moreover, if the $100,000 investment earns another $50,000 in appreciation, that amount will not be subject to capital gains tax if you leave the money in place for at least ten years.
Keep in mind that while you can invest money that did not derive from a capital gain, that amount won’t enjoy the same exemption from capital gains while invested in the QOF.