The Tax Cuts and Jobs Act (TCJA) of 2017 introduced incentives for taxpayers to defer capital gains by investing in low-income areas. Certain taxpayers can benefit if they make a long-term investment in Qualified Opportunity Zone (QOZ) through Qualified Opportunity Fund (QOF).

Investment Opportunities

QOZs were created under TCJA to encourage investment in low-income communities. Thousands of QOZs are designated in all 50 states, the District of Columbia and five U.S. territories. Partnerships or corporations are typically formed to run and manage QOFs. Ninety percent of QOFs must be invested in QOZs.

Taxes on capital gains and qualified 1231 gains (gains from the disposition of depreciable assets held by the business for longer than one year) may be temporarily deferred. The gains have to be recognized before Jan. 1, 2027, for federal income tax purposes and cannot be from a transaction with a related person.

One of the benefits of investing in a QOF is that there is a basis (amount of the investment) step-up by 10% of the deferred gain for investments held for five years, and an additional 5% (15% in total) for investments held for seven years if met by Dec. 31, 2026. For the majority of taxpayers, this benefit has timed out, however, there is an exception for pass-through entities to still reinvest 2021 gains through Sept. 11, 2022.

Even though the basis step-up is no longer available for most taxpayers, there is still a significant benefit remaining. If the investment is held for 10 years, the appreciation on the asset will be tax free at sale; this is including any depreciation recapture that otherwise would have been recognized at that time.

Filing Requirements

An entity must file Form 8996 (Qualified Opportunity Fund) annually with its eligible partnership or corporate federal income tax return. Taxpayers must also (self) certify that the corporation or partnership is organized to invest in QOZ property. This is done by:

• Filing a federal income tax return as a partnership, corporation or LLC that is treated as a partnership or corporation;
• Organizing for the purpose of investing in QOZ property under the laws in one of the 50 states, the District of Columbia, a U.S. possession or a federally recognized Indigenous tribal government; and
• Holding 90% of its assets in QOZ property.

90% Investment Standard

A QOF must invest 90% of its assets in QOZ property. This is determined by the average of the percentage of QOZ property held in the QOF as measured on:

• The last day of the first six-month period of the tax year of the QOF; and
• The last day of the tax year of the QOF.

Taxpayers must report the amount of gain or loss in the tax year it was sold or exchanged on Form 8949, Sales and Other Dispositions of Capital Assets.

Allowable Deferment

As noted above, the IRS allows the deferral of all or part of a gain that is invested into a QOF that would otherwise be includible in income. The gain is deferred until the investment is sold or exchanged or Dec. 31, 2026, whichever is earlier.

IRS guidance permits tangible property acquired after Dec. 31, 2017, under a market rate lease to qualify as QOZ business property. “Substantially all” (at least 70% of the property) must be used in a QOZ.

The guidance notes there are situations where deferred gains may become taxable if an investor transfers their interest in QOF. For example, if the transfer is done by gift the deferred gain may become taxable. However, inheritance by a surviving spouse is not a taxable transfer, nor is a transfer, upon death, of an ownership interest in a QOF to an estate or a revocable trust that becomes irrevocable upon death.

Taxpayers need to consider if the tax rate on capital gains is expected to increase or decrease within the investment period. As always, it is good to check with financial and tax advisors before making an investment.