Financial Planning Using Qualified Opportunity Zones

Deferral of Gain Through Timely Reinvestment

To qualify for these tax benefits, an investor’s reinvestment in the QOF must occur during the 180-day period beginning on the date of the sale. Under IRC section 1400Z-2(a)(2), a taxpayer may elect to defer the tax on some or all of that gain. If, during the 180-day period, the taxpayer invests in one or more QOFs an amount that was less that the taxpayer’s entire gain, the taxpayer may still elect to defer paying tax on the portion of the gain invested in the QOF. If, in contrast, an amount in excess of the taxpayer’s gain is transferred to the fund (an “investment with mixed funds”), the taxpayer is treated, for tax purposes, as having made two separate investments—one that only includes amounts as to which the investor’s deferral election is made, and a separate investment consisting of other amounts.

Importantly, the law requires only that the gain be reinvested in the QOF, not the total sales proceeds. The proposed regulations have clarified that, in general, only capital gains are eligible to be invested in a QOF.

In addition, and in contrast to IRC section 1031 like-kind exchanges (another mechanism of gain deferral through rein-vestment), in the QOF context the cash from the sale does not need to be specifically tracked or escrowed. Instead, the requirement is merely that an amount of cash equal to the gain on the sale be rein-vested in a QOF within 180 days of the property’s disposition (subject to potential relief in the case of certain pass-through entities).

The taxpayer’s basis in the QOF is initially zero, but will be increased by 10% of the deferred gain if the investment in the QOF is held for five years, and increased by an additional 5% if the investment in the QOF is held for seven years. Thus, if a gain on the sale of property is timely rein-vested in a QOF, the taxpayer may be able to decrease the taxable portion of the originally deferred gain by as much as 15% (via a corresponding step-up in basis). The taxpayer makes an election to defer the gain, in whole or in part, when filing the return on which the tax would otherwise be due if it were not deferred.

The tax incentives of this program go well beyond tax deferral (even putting aside the potential basis adjustments discussed above), as subsequent gain on the appreciation in the value of the QOF is capable of being fully excluded from income. In order to qualify, an investor must hold its reinvestment in the QOF for at least 10 years.

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