Advisor Insights

Must-Knows About Qualified Opportunity Funds

Helen Modly, CFP, CPWA

The Tax Cuts and Jobs Act, enacted on Dec. 22, 2017, established new tax codes that provide significant tax deferral opportunities for recently realized capital gains when they are invested in a Qualified Opportunity Fund (QOF or O Fund) for at least five years. There are still many unanswered questions about how exactly this will work in practice, and investors are waiting on soon-to-be-released Treasury Department regulations for guidance. But there is substantial interest on the part of large private client banks, hedge funds and ultrahigh-net-worth individuals.

Here are some must-knows so far.

What is an Opportunity Zone?
State governors were asked to identify economically distressed communities that also showed a real potential for revitalization. Many of these zones truly are suffering in terms of low household income, joblessness rates, age of housing stock, and eligibility for low income housing tax credits, to name a few. More than two thirds of the zones also contain a Brownfield site, which are eligible for EPA grants to fund the cleanup of environmental problems. About three fourths of O-Zones are in urban areas, with the remainder located in rural communities.

The Treasury Department reviewed the list and certified over 8,700 O-Zones. A real concern was that areas already undergoing gentrification would be over-represented, but the Urban Institute found less than 4% of zones had high enough levels of economic growth from 2000 to 2016 to be considered a community in upward transition. The nonprofit group Enterprise Community Partners has created a tool identifying eligible O-Zones.

What is a Qualified Opportunity Fund?
A QOF is an investment vehicle created for investing in eligible property located within an O-Zone and provides a tax benefit to investors who invest realized capital gains from other investments into the fund. The fund can buy the stock of any business, whether newly formed or expanding, not classified as a "sin" business, such as tanning salons, liquor stores, adult entertainment, casinos, racetracks, etc. It can buy a partnership interest that holds businesses within the zone and it can own tangible property directly.

If a QOF buys real estate, it must substantially improve that property for it to be considered an eligible investment. For example, buying an existing home and converting it to a multifamily rental would qualify, but substantial improvement requires an investment over 30 months that exceeds the adjusted basis. This is a much higher standard than in other programs.

The businesses must generate at least 50% of their gross income from activity conducted in the zone. The QOF can only invest in the equity of businesses, and 90% of the fund's assets must be invested within an O-Zone, although investments can be made in multiple zones. A qualified fund is described as a corporation or partnership, and it is unclear whether the limited liability corporation may be used.

Any taxpayer can create a QOF by self-certifying on a form (which has yet to be created by the Treasury Department) and attaching it to the tax return. The investor does not need to live or work in the O-Zone to receive the tax benefits of investing in the fund. More details about existing regulations, as well as information about questions yet to be resolved, can be found at the Economic Innovation Group's website. The bipartisan public policy organization, headed by Sean Parker, the first president of Facebook and founder of Napster, was the driving force behind the O-Zone program, which was incorporated into the Tax Cuts and Jobs Act under the leadership of Sen. Tim Scott of South Carolina, who proposed it as an amendment.

What's in It for the Investor?
There are three tax benefits available depending on how long an investor holds the QOF interest.

Tax Deferral
An investor who has or is about to realize capital gains from any other investment (stocks, real estate, sale of a business, etc.) can elect to invest the amount of that gain into a QOF and the capital gain will be deferred until the earlier of two dates: when the interest in the QOF is sold or Dec. 31, 2026. The gains must have been realized within 180 days of the QOF purchase to be eligible for tax deferral.

Tax Reduction
Because the capital gains are invested in the fund before tax, the investor has zero basis in the fund. If the QOF interest is held for at least five years, 10% of the amount of the capital gain will be added to the investor's basis in the fund, thus reducing by 10% the amount of gain that eventually will be taxed.

If the investor holds the QOF shares for another two years, another 5% of the amount of the deferred gain will be added to the basis amount for a total 15% reduction in gain after seven years.

Tax Forgiveness
If the investor holds his or her interest in the fund for 10 years, the fair market value on the sale of the QOF shares is deemed the tax cost basis, thus not generating a taxable gain.

Based on what we know so far, here's a hypothetical of how taxation should work.

Let's assume $100,000 of capital gain is invested into a QOF on July 1, 2018, and held for 12 years (if possible; we don't know for sure if the funds must liquidate or can continue). After the fifth year, the cost basis should become $10,000, thus $90,000 of gain is deferred. After the seventh year, the cost basis should become $15,000, thus $85,000 of gain is deferred. On Dec. 31, 2026, the deferred gain should become taxable regardless of whether the QOF interest has been sold. This represents a phantom income for the investor.

On July 1, 2028, any gain from the activity of the fund should become nontaxable. So, it seems, the investor will have to determine if enough potential gain exists from the QOF activity to warrant paying tax on $85,000 of capital gain in 2026 when no proceeds are available for the tax payment.

There are many other legal and accounting issues the Treasury Department is expected to address this summer. The Economic Innovation Group estimates investors are holding $6 trillion in unrealized capital gains, which represents an enormous potential investment. There are many big players lined up to create QOFs as soon as the regulations and the certifying form are available. We can only hope this program really will raise the economic vitality of thousands of struggling communities in addition to providing a tax-break for capital gains.

Helen Modly, CFP, CPWA, is a wealth advisor with Buckingham Strategic Wealth, a fee-only registered investment advisor. The opinions in this article are the author’s own and may not reflect the opinions of Buckingham Strategic Wealth or Morningstar.com. The author may be reached at nova@bamadvisor.com.