The 2017 Tax Cuts and Jobs Act (TCJA) created a tax investment incentive program targeting economically distressed areas. Each state and all eligible US territories nominated these areas as Qualified Opportunity Zones, and the Treasury Department selected the final list of over 8,700 census tracts. The QOZ program offers tax benefits for taxpayers who reinvest capital gains into business opportunities in the designated areas.
From the beginning, investors have been somewhat confused about the provisions and expiration dates for the QOZ benefits. However, QOZ designations are active until December 31, 2047, but some potential benefits have already expired, and important deadlines are pending.
The opportunity to reduce the tax on originally reinvested gains has passed.
The TCJA included a highly visible provision that allowed investors to defer the payment of capital gains and obtain a step-up in basis by reinvesting recent profits into QOZ Funds. This component had two parts and several deadlines. Taxpayers who made early investments had the chance to earn significant tax benefits. First, the gain had to be invested by the end of 2019 to reach the initial milestones in 2024 and 2026. Those provisions allowed a step-up in value for reinvested gains of ten percent if held for five years and an additional five percent (fifteen total) for gains contained in the QOZ fund for seven years.
Because that seven-year period comes at the end of 2026, the opportunity ends. Also, on December 31, 2026, taxpayers will owe taxes on the deferred gains they reinvested, minus any step-up. For example, suppose you had a capital gain in 2019 of $100,000. If you invested that amount into a QOZ project, you received a deferment of the capital gains tax. In addition, in 2024, your tax due will be effectively reduced by $10,000, resulting from a step-up in the value of the original asset. However, at the end of 2026, you will receive an additional five percent step up, so now your effective gain is $85,000, but the tax is now due on that $85,000.
Investors may not want to sell just yet.
Another crucial component of the QOZ legislation is that if the investor maintains the investment in the QOZ fund for ten years, the basis of the asset is stepped-up to the current fair market value, which eliminates the capital gains tax. However, the first batch of investments will reach the ten-year mark in 2029, meaning that investors will have to pay the deferred taxes on their investments without selling the reinvested asset.
Returning to the previous example, if you invested a gain of $100,000 in 2019, you will owe capital gains taxes on $85,000 in 2026. However, suppose that the $100,000 enjoys an appreciation of thirty percent ($30,000). To avoid owing capital gains taxes on that $30,000, you must leave the money invested until 2029.
New investments still benefit from the QOZ.
For investors with current capital gains, it may still make sense to consider QOZ projects. First, you can still defer the payment of the taxes on the growth until December 2026. Second, you can enjoy the benefit of eliminating the taxes on any gain within the QOZ as long as you hold the investment for ten years. However, keep in mind that QOZ investments are complex and considered risky.
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.
All investments have an inherent level of risk. The value of your investment will fluctuate with the value of the underlying investments. You could receive back less than you initially invested and there is no guarantee that you will receive any income.
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.
Hypothetical examples shown are for illustrative purposes only.
