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The Tax Cuts and Jobs Act (TCJA) was passed in late 2017 making changes to several income tax provisions like brackets, standard deductions, personal exemptions, and corporate tax rates. A relatively unknown provision included, which garnered bipartisan support (a rare thing, indeed), is Qualified Opportunity Funds (QOF).
Qualified Opportunity Zones, as defined in the law, are “low-income communities” with poverty rates over 20% and specifically designated by each state. These areas are generally in need of revitalization and outside investment that never comes. To incentivize this investment, the new law permits tax breaks to those individuals making qualified investments in these funds.
I have already seen the advertisements for various QOFs popping up with misleading information about what tax benefits are available under the new law. It is important to understand exactly what you stand to gain to make informed decisions BEFORE you invest.
1. You have a $120,000 worth of concentrated stock with a basis of $20,000 and $100,000 of capital appreciation.
a. You sell the stock, reinvest the $100,000 of gain into a QOF, and make an election to defer the gain. Your basis in the QOF is $0 since it is made up entirely of untaxed gains. The remaining $20,000 can be used for whatever other purpose you desire (not invested in the QOF).
· If you sold the investment before the 5-year period is over for $107,000, the entire gain is taxable (both the $100,000 deferred plus $7,000 of additional gains).
b. You hold the QOF and hit the 5-year holding period. Your basis was $0 initially but is increased by 10% of the $100,000 deferred gain initially to $10,000.
· If you sold the investment after the 5-year holding period but before the 7-year holding period for $112,000, the taxable gain is $90,000 of the deferred gain ($100,000 - $10,000) and $12,000 of additional appreciation. Therefore, the total gain is $102,000.
c. You hold the QOF and hit the 7-year holding period. Your basis was $10,000 but is now increased by 5% of the $100,000 deferred gain initially to $15,000. That is $10,000 + $5,000 = $15,000.
· If you sold the investment after the 7-year holding period but before December 31, 2026 for $118,000, the taxable gain is $85,000 of the deferred gain ($100,000 - $15,000) and $18,000 of additional appreciation. Therefore, the total gain is $103,000.
d. You hold the QOF to December 31, 2026. You must now realize the initial deferred gain, less basis, as taxable and increase your basis accordingly. So, the taxable gain for tax year 2026 will be $85,000 (that is $100,000 - $15,000) and your basis will increase to $100,000. Note, you recognize this gain whether you sell the QOF or not!
· If you sold the investment after December 31, 2026 but before the 10-year holding period for $127,000, the taxable gain is $27,000.
e. You hold the QOF and hit the 10-year holding period. Your basis was $100,000 but it is now stepped up to the full value of the QOF, eliminating any additional taxable gains.
· If you sell the investment after the 10-year holding period for $140,000 and make the election on your tax return, the $40,000 in appreciation is tax free.The following graphic depicts the above example assuming the investor holds the QOF for the requisite 10 years.
The following graphic depicts the above example assuming the investor holds the QOF for the requisite 10 years.
Examples get much more convoluted with investment of basis and dealing with rental property sales. I have stuck to the basics above but am happy to discuss the finer points upon request.
The big question for investors is not “what are the tax benefits?” but “what are the investment merits?” Are investments in low-income communities a good investment? Will the area receive so much capital as to cause gentrification? That doesn’t seem to be the government’s aim, but what do they expect with the billions of cash piling up inside QOFs?
Other questions regarding the merit of investing in a QOF include: Who manages the QOF? What are the fees? What is the income and growth potential? Has this been done before and if so what are the results?
The last consideration is whether your average investor can put capital into QOF. So far, the funds that I’ve see are all in the hedge fund space, requiring investors to be “accredited” to qualify. This puts an investment in such funds out of consideration for most.
Why the government determines the most complicated ways of doing these things remains to be determined, but this is what we must deal with. Based on the tax implications alone, I don’t view these investments as a home run by any means. Assuming a 5-year holding period, taxpayers would save 15% (assuming long-term capital gains rates) on 10% (due to the basis step up) or 1.5%. 1.5% for the 5-year holding period works out to 0.3% per year. At 7 years, tax savings equates to 15% on 15% or 2.25% (0.321% per year). We do not believe the tax benefits alone justify using QOFs. As with most tax-favored investments, they must be evaluated on their investment merits. If you would not invest in them otherwise, do not invest in them because they provide a marginal tax benefit.
The new rules are all outlined in the Internal Revenue Code sections 1400Z-1 and 1400Z-2 and Proposed Treasury Regulations 115420-18, if you care for more information.
Bryan Strike, MS, MTx, CFP®, CFA, CPA, PFS, CIPM is a Senior Financial Advisor at Kays Financial Advisory Corporation. He can be reached at (770) 951-9001 or at email@example.com.
This report and Mr. Strikes’ comments are provided as a general market overview and should not be considered investment or tax advice or predictive of any future market performance.
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