Opportunity Zone’s provide a very tax efficient vehicle for those investors looking to reinvest their current unrealized gains in economically distressed communities and thus escape tax through temporary and/or permanent deferral.
Temporary Deferral of Capital Gains
Investors can invest capital gains from other investments into Qualified Opportunity Funds (QO Funds) without immediately triggering recognition of those gains. This deferral of capital gains works similarly to a 1031 exchange in real property, except the investor can elect to invest solely the capital gains from other investments and the gains can come from any investment, including stocks and bonds, not just from real property.
An investor can the defer capital gains on the amount of gains invested in the QO Fund until such time that the investment is sold or exchanged, or December 31, 2026, whichever is sooner. The investor would have a tax recognition event on December 31, 2026, even if the investor still holds the investment.
A QO Fund is a self-certified partnership or corporation that holds at least 90% of its assets in eligible QOZ property. Setting up a QO Fund does not require IRS certification and only requires a simple form be attached to the entity’s federal income tax return.
Free Basis Step-Up
If an investor holds the QO Fund investment for at least 5 years, then the investor receives a 10% basis step-up on the amount of the deferred capital gain invested. If the investor holds the investment for at least 7 years, then the investor receives an additional 5% basis step-up on the amount of the deferred capital gain (for a maximum total of 15%).
Gains on QOZ Investment can be Tax-Free
The final piece of good news is that any gains on the investment in the QO Fund are tax-free if the investment is held for at least 10 years. After 10 years, investors can elect to make their basis in the investment equal to the fair market value of the investment on the date of sale.
On July 1, 2018, Investor A sold stocks totaling $2 million with tax basis of $1 million for capital gains of $1 million.
Within 180 days of the stock stale, Investor A decides to invest the $1 million in capital gains into a QO Fund. Investor A has no immediate taxable gain from the sale of stock and now has $1 million investment in the QO Fund.
After holding the investment for 10 years, Investor A’s investment is worth $2 million. On July 2, 2028, Investor A sells the investment for $2 million and makes the fair market value basis adjustment election.
Here are the tax consequences:
- As of December 31, 2026, the investment was held at least 5 years, so Investor A received a 10% basis adjustment on the amount of the invested capital gains.
- As of December 31, 2026, the investment was held at least 7 years, so Investor A received an additional 5% basis adjustment on the amount of the invested capital gains.
- Investor A recognized $850,000 in capital gains on December 31, 2026 ($1,000,000 in capital gains invested in Qualified Opportunity Fund minus 15% basis adjustment of $150,000).
- On July 2, 2028, Investor A does not recognize any additional gain on the QO Fund investment even though the value of his investment has increased by $1 million. ($2 million sale minus $2 million in tax basis).
Understanding tax reform and how the changes will affect your business and you as an individual can be challenging with opportunities left on the table. Be sure you consult with a tax advisor who has deep expertise in the multifaceted law and all its nuances.