When you choose to invest in a Qualified Opportunity Zone (QOZ), there are several potential motivations. First, you may be seeking to defer the payment of taxes on capital gains earned on another investment. If that is one of the reasons, keep in mind that you must invest the eligible profit into a Qualified Opportunity Fund (QOF) within 180 days of the date that the gain would be recognized for federal income tax purposes.
That fund (the QOF) is an investment vehicle, either a corporation or a partnership, that invests at least 90% of its assets in eligible property or businesses in a Qualified Opportunity Zone—a federally designated area that is economically challenged and thus targeted for additional investment through special incentives. The incentives were established through the Tax Cuts and Jobs Act in 2017 and allow investors to potentially defer and reduce taxes on capital gains earned by reinvesting the profits into these funds.
Let’s illustrate with an example:
Suppose that Taxpayer A has a capital gain of $100,000 and would prefer to defer and potentially reduce the taxes owed on the gain. If Taxpayer A invests the $100,000 into a QOF within 180 days of the event that resulted in the increase (and files IRS Form 8996), then that sum is not subject to the tax as long as it remains in the eligible QOF. If the amount stays invested for five years, the tax on the original $100,000 will be reduced by 10%. If the investment is held for seven years, the reduction is 15%. If the investor maintains the investment for ten years, they also reap the benefit of a step-up to the fair market value of the invested $100,000, regardless of current value.
However, the deferred capital gain on the $100,000 invested is recognized if the investment experiences an inclusive event (being sold or otherwise disposed of) or on December 31, 2026, whichever is sooner. Thus, investments must have been made by 2019 to obtain the complete 15% benefit reduction in tax owed.
What Happens in 2026?
Although the recognition of the capital gain occurs at the end of 2026, the maximum potential benefit to the investor still arrives after ten years of holding, so the date should not cause a uniform abandonment of the funds. Nonetheless, investors need to plan ahead for the eventual decision to exit and where to direct the funds when they decide to or need to move on.
The ability of the investor to exclude earnings made in the investment in the Opportunity fund is dependent on the successful execution of the fund in complying with the rules of the Act. Since the Tax Cuts and Jobs Act created Opportunity Zones in 2017, the IRS and Treasury have slowly dispensed supporting guidance for investors and fund managers. Therefore, investors should be diligent about checking the performance of the QOF they are considering investing in and consult their own tax advisor for assistance.
