Qualified Opportunity Zone Investments

There are three main tax benefits associated with Qualified Opportunity Zone investments – gain deferral, gain reduction, and gain exclusion.

Deferral

Taxpayers realizing capital gains can defer recognition of those gains by reinvesting in a QOZ fund within 180 days of the sale or exchange that generated the capital gain. By doing so, the initial gain will generally not be recognized until the earlier of (1) the disposition of the QOZ fund investment or (2) December 31, 2026 (mandatory recognition date).

Reduction

If a taxpayer defers gain through a QOZ fund investment, their initial basis is reduced by the gain deferred. However, if the taxpayer holds the QOZ fund investment for five years, they will receive an automatic 10% basis increase. If held for two additional years, they will receive an additional 5% basis increase (percentages are of the initial deferred gain). Assuming the holding periods are met, when the QOZ fund investment is sold (or mandatorily recognized on December 31, 2026), only 85% of the initial deferred gain will be recognized. This results in a 15% permanent gain reduction.  To maximize gain reduction, qualifying investments will need to be made by December 31, 2019 (seven years prior to the 2026 mandatory gain recognition date).

Given the complexities that accompany these new provisions, there are many aspects that warrant thoughtful consideration.  The QOZ program only applies when investors have capital gain proceeds to reinvest; ordinary gains are not eligible for reinvestment.  QOZ funds can also have cash investors who are not deferring gains; but there are no additional tax benefits for cash investors beyond what a typical investment entails.  Both investors and fund operators need to be clear on all aspects of the program to ensure compliance throughout the lengthy process.

While the QOZ tax benefits are powerful and attractive, careful attention must continue to be paid to entity formation, deal structure, future tax rates, pricing, discount rates, risk, and long-term economic outlook.