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 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.
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.
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.