Impact Investing

Qualified Opportunity Fund Investments & the Tax Breaks

How an investment in distressed communities can lower your capital gains exposure.

Introduction

More and more people are looking to put their personal capital to work in support of society and their communities. And Congress gave them a new way to do just that when it passed the comprehensive tax reform law in late 2017. Among the many changes in the law was a section that encouraged taxpayers to invest in economically distressed communities across the United States and, in return, potentially receive very favorable capital gains tax breaks.

People at a desk discussing financial planning

In October 2018, the U.S. Department of the Treasury issued proposed regulations to clarify the tax laws surrounding Opportunity Zones and Opportunity Funds, hoping to reduce uncertainty and encourage investors to get involved. A second set of regulations proposed in April 2019 provided additional clarity, easing many of the remaining concerns and driving increased interest among investors. As a result, we are likely to see the formation of additional Opportunity Funds moving forward.

Rules Vary State-to-State

Some states have yet to bring their tax rules into conformance with the federal Opportunity Zone rules. For example, New York has done so, while California has not.

How It Works

Investors who realize a short-term or long-term capital gain from the sale of such investments as securities, collectibles, real estate or businesses can reinvest those gains in what is called a Qualified Opportunity Fund (QOF). These funds are corporations or partnerships (which may include some LLCs) that invest in businesses or assets in any of the nearly 9,000 low-income communities within the United States or its possessions certified by the U.S. Treasury as Qualified Opportunity Zones (QOZ).

Breaking Down the Benefits

Investing in a QOF may allow you to defer recognition of a capital gain on your income tax return, so long as you reinvest that gain into a QOF within 180 days of realizing it. (There are some exceptions to this deadline.) You then defer recognition of the capital gain until December 31, 2026, or until you sell or dispose of the investment, whichever comes first.

In addition to the deferral, taxpayers can reduce the taxable capital gain by 10% or 15% if they hold their QOF investment for five or seven years, respectively, and the deferral period hasn’t ended. That means to qualify for the 10% reduction, the capital gain would need to be reinvested into a QOF by December 31, 2022, and for the full 15% reduction, it would need to be reinvested by the end of 2024.

Perhaps the greatest tax benefit is reserved for taxpayers willing to make a truly long-term commitment to the investment in a QOF. Any gain realized after the investment in the fund can be considered eliminated for tax purposes if the investor holds the investment for 10 years and then sells it by 2047.

In identifying partners to manage Opportunity Zone investments, it’s important to pay close attention to past discipline in capital allocation.

Looking Out for Yourself

It should be noted that to realize the full benefits of this program, investors must commit to holding illiquid assets for at least 10 years. In addition, some QOFs (1) might hold only a single asset — or multiple assets that may not be well-diversified in terms of industry and geography:

  • Investing in a QOF
  • Capital gain on your income tax return
  • Deferral of capital gain
  • Generating a majority of gross income from your community

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