More Time to Reinvest Capital Gains for Deferral or Exclusion
In December 2017, Congress enacted the Tax Cuts and Jobs Act (the “Act”). The Act added Qualified Opportunity Zones (26 USC § 1400Z-1, et. seq.). Congress enacted QOZs to foster investment in an economically distressed area to spur further investment in those areas and job creation. There are 427 QOZs in Florida including property in Brevard County, Orange County and Orange County’s surrounding areas. On June 4, 2020, the Internal Revenue Service issued Notice 2020-39 providing relief for “qualified opportunity funds” (QOFs) and their investors in response to the coronavirus (COVID-19) pandemic.
Notice 2020-39 provides that if a taxpayer’s 180th day to invest in a QOF would have fallen on or after April 1, 2020, and before December 31, 2020, the taxpayer now has until December 31, 2020, to invest that gain into a QOF. This extends the original extension for some taxpayers which was already postponed through Notice 2020-23.
Investing in a QOZ is done through a Qualified Opportunity Zone Fund (QOF), which must invest over 90 percent of its assets in QOZ properties and businesses. The incentive for investors is the tax benefits. The tax benefits include which will be explained more thoroughly below:
- Temporary deferral of gains for tax purposes that are invested in a QOF;
- An increase in tax basis (i.e., cost) that reduces the amount of the future recognized capital gains that were deferred by investing in a QOF; and
- Exclusion from gross income related to any appreciation in a QOF investment.
An investor can defer income tax on gains by reinvesting the amount of the gain into a QOF within 180-days of the sale or exchange. Taxes are deferred until the earlier of:
- The date the QOF investment is disposed of or another taxable event occurs; or
- December 31, 2026.
If the investment in the QOF is held for five years, the investor can increase their tax basis (i.e., cost of the investment) equal to 10% of the deferred gain invested in the fund. If the investor holds the investment for another two years, not to extend beyond December 31, 2026, the investor receives an additional increase in basis equal to 5% of the deferred gain that was invested into the QOF. Any increase in basis has the effect of reducing the future taxable gain incentivizing investors to keep funds in the QOF.
In order to obtain exclusion of the gain from gross income (taxation) related to appreciation realized while holding the investment in the QOF, the investor must hold the investment for ten or more years. At that point, the investor can elect to increase its basis in the QOF to the fair market value of the investment on the date sold or exchanged. The policy here is to incentivize investors to hold onto their investments in the QOF beyond the 5- or 7-year period.
Take the following example:
An investor realizes a $50,000.00 taxable gain from the sale or exchange of a capital asset and reinvests that money into a QOF within 180-days. As such, the tax is deferred until the earlier of December 31, 2026, or the date the investor disposes of the interest in the QOF.
Upon investing in the QOF, the investor’s tax basis is $0 (zero). The purpose of $0 initial basis in the QOF is so that the original gain that was deferred by investing in the QOF does not escape taxation except as otherwise permitted. If the investor holds the investment in the QOF for five years, the investor receives a $5,000.00 increase in basis which is essentially an amount that will be excluded from taxation when the investor realizes the deferred gain. As mentioned, if the investor holds the investment for another two years, the investor receives an additional basis increase of $2,500.00 resulting in total basis of $7,500.00 in the QOF versus the initial tax basis of $0.
If the investment in the QOF is held for ten years, the investor has the option to avoid income tax on any appreciation in the $50,000.00 in the QOF as well as the $7,500.00 basis increase discussed immediately above. So, if the investment appreciates to $75,000.00, the entire $25,000.00 appreciation would be excluded from gross income plus the $7,500.00 so that only $42,500.00 of the original gain is taxed.
Widerman Malek Takeaway
If you recognized an “eligible gain” you may now have more time to obtain the tax benefits associated with investing in QOF. Eligible gains include capital gains from, for example, the sale of a business or other investment and qualified “1231 gains.”[i] Further, the gain would have to be recognized for federal income tax purposes before January 1, 2027, and arises from a transaction with an unrelated person. For example, you cannot sell property to your children and then reinvest that gain in a QOF.
