Since coming into effect in January 2018, Subchapter Z of the US Tax Code—also known as the opportunity zone provisions—has enabled investors to pour billions of dollars into a broad array of businesses, from real estate development companies to tech startups. Investments in qualified opportunity funds (QOFs) offer a number of distinct tax benefits, not the least of which is reduced capital gains tax liability. But the rules governing these investments are quirky, perplexing and—in some cases—severely restrictive.
In the following series of articles, we discuss the basics of investing in a QOF, offer a detailed analysis of the law surrounding the opportunity zone provisions, and provide case studies that more closely examine industry-specific structuring of opportunity zones.
In January 2018, Subchapter Z of the US Tax Code (also known as the opportunity zone provisions) came into effect. At that time, taxpayers and advisors were intrigued by its significant benefits. However, because it was brand-new legislation, there was similarly significant uncertainty as to the law and—perhaps more importantly—whether the investments would prove to generate revenue.
Over the following three years, the US Internal Revenue Service (IRS) released significant regulations that have largely clarified the law. Moreover, many billions of dollars have been invested into qualified opportunity funds and the funds have allowed investors to invest in a broad array of industries, from real estate development to tech startups. Taken together, this legislative clarity and track record of success have demonstrated that investment into a qualified opportunity fund can be a prudent option that offers legal certainty and astounding tax benefits. This is especially extraordinary in a world in which the US federal capital gains rate is likely to increase significantly. However, as with most great rewards, the benefit comes with significant challenges: the rules governing these investments are quirky, perplexing and can be severely restrictive.
From a US federal tax perspective, investing in a qualified opportunity fund (QOF) provides three significant benefits:
- First, the opportunity zone provisions allow investors that recently generated a capital gain (g., from the sale of a business, stock, commodities, collectibles, real estate) to reinvest, within 180 days of the sale or exchange of such capital asset, the gain into a qualified opportunity fund, thereby allowing the investor to defer the US federal capital gain until at latest December 31, 2026.
- Second, if the investment is made by the investor into the qualified opportunity fund prior to December 31, 2021, the capital gain tax liability will be reduced by 10% when the gain is recognized on December 31, 2026.
- Third—and perhaps most significant—where an investor holds her interest in the QOF for 10 years or more and after such 10-year holding period has been surpassed, the investor may be able to permanently exclude from US federal tax any gain earned from the QOF investment (including any depreciation recapture).
The 10-year hold tax exclusion benefit is remarkable for a number of reasons. Primarily, there is no limit on the amount of gain that is excluded from tax. For example, if an investor contributes $1 million into a tech startup that is sold 10 or more years later for $1 billion, the full $999 million of gain would be excluded from US federal income tax.
Moreover, depreciation recapture is also excluded from US federal income tax. The benefit of a tax-free depreciation recapture provides taxpayers with the ability to generate revenues offset by depreciation during the 10 years the investment is held. Typically, this depreciation reduces tax basis by the equivalent amount and, at the time of a future sale, tax is applied recapturing the depreciation at ordinary income or capital gains rates. Under the Opportunity Zone provisions, however, the depreciation recapture and any appreciation in the asset is not subject to tax. For example, if an investor invests $100 into an asset that depreciates evenly over a 10-year period, that investor would be able to offset $10 of otherwise taxable income with $10 of depreciation deduction for 10 years. At the end of the 10-year period, the investor would have a tax basis of $0 in the asset. Thus, if the investor sold the asset for $200, the investor would recognize a gain of $200, which would be subject to tax at ordinary income rates or long-term capital gains rates, as the case may be. That same investment within a qualified opportunity fund could be sold tax-free from a US federal income tax perspective, which would exclude tax on both the depreciation recapture and the appreciation in the asset’s value.
An investment in a QOF also provides the investors the opportunity to refinance the investment and take a distribution of the refinancing without being subject to immediate US federal tax liability. For example, in year 1 an investor invests $100 into a qualified opportunity fund and those amounts are appropriately invested by the fund. In year 3, a bank provides the qualified opportunity fund a loan for $50, which is immediately distributed by the fund to the investor. The investor can use those funds for whatever purpose she chooses. Properly structured, the distribution of the proceeds generally should not trigger a US federal tax liability to the investor.
How It Works, By the Numbers
As an example, assume an investor invests $1,000,000 of capital gain into a QOF in 2021 (QOF investment). The deferred gain will be taxed at the earlier of (1) the date on which the taxpayer sells the QOF investment, or (2) December 31, 2026. The amount taxed will be $1,000,000, reduced by the investor’s basis in the QOF investment. If on the date that the QOF investment is sold the QOF investment is worth less than $1,000,000, then the QOF investment is taxed at its fair market value on the date on which it is sold, reduced by the investor’s basis in the QOF investment.
The investor’s basis in the QOF investment is initially zero, but if the investor holds the QOF Investment for at least five years (e.g., until 2026), the investor’s basis in the QOF Investment becomes $100,000 (10% of $1,000,000). After the $1,000,000 is taxed, the taxpayer’s new basis in the QOF investment becomes $1,000,000. Therefore, if the investor holds the QOF investment for nine years (e.g., until 2030), the amount taxed will be any appreciation in the investment greater than the $1,000,000 of basis, less any depreciation deductions taken to reduce basis. If the investor holds the QOF investment for at least 10 years (e.g., until 2031), the investor’s basis in the QOF Investment is increased to the fair market value of the QOF investment on the date on which it is sold, resulting in none of the investment appreciation or depreciation recapture being subject to US federal income tax (i.e., the gain is not subject to US federal income tax but may be subject to applicable state and local tax).
The benefits to the investor in this example are (1) tax deferral of the $1,000,000 of initial capital gain invested in the QOF until the earlier of the date that the QOF investment is sold, or December 31, 2026; (2) decrease of the $1,000,000 of initial capital gain ultimately taxed to $900,000 (90%); and, most noteworthy, (3) tax avoidance on any appreciation and depreciation recapture that the $1,000,000 of initial capital gain invested in the QOF generates, if the QOF investment is held for 10 years.
Click here for the next article in the series: How to Invest in a QOF.
View all articles in the Qualified Opportunity Funds OTS Series.