Maximizing the Tax Benefits of Qualified Opportunity Zone Fund Investments
Opportunity Zones are one of the hottest investment topics in the tax world because they offer not one, not two, but three tax saving opportunities. But is it as easy as just investing in a Qualifying Opportunity Fund? And what happens when an investment partially qualifies for tax benefits? Recent IRS guidance provides insight into these pressing questions.
The Basics for a Qualifying Investment
The first thing to know is that only qualifying investments are entitled to Opportunity Zone tax benefits. A qualifying investment is essentially an investment made using the proceeds from any type of capital gain that results from a separate transaction. Sell stock? The gain is eligible to be a qualifying investment. Sell a commercial building for a profit? Congrats, that gain can be a qualifying investment. Receive an inheritance? Sorry, the inheritance is not a type of capital gain so it cannot be a qualifying investment.
Other sources of income that are not eligible to be qualifying investments include wages and salaries, ordinary business income, and gambling or lottery winnings. As mentioned previously, qualifying investments are eligible for three tax savings opportunities, which consist of:
- A 10-15% permanent exclusion from tax on the original gains that are re-invested,
- A maximum eight-year deferral of tax on the remaining 85-90% of gains that are re-invested, and
- A permanent exclusion from tax on any gains realized on the new investment itself.
Mixed Fund Rules
The relatively simple definition of a qualifying investment does not necessarily translate into practical application. For instance, it may be difficult for many taxpayers to produce a large enough capital gain to fund the entire investment into a Qualified Opportunity Zone Fund (QOZ Fund). The IRS foresees this in their proposed regulations, which allow for a mixed-funds investment consisting of qualifying and non-qualifying portions. Under these proposed regulations, if a taxpayer sells stock for $10 million with $4 million representing a return of capital and $6 million of gain, the mixed fund rules apply if the entire $10 million is invested into a QOZ Fund.
The mixed fund rules essentially permit the investor to receive the full benefit of the tax savings opportunities with respect to the gain portion of the QOZ Fund investment, and merely deny associated tax savings opportunities to the non-gain portion of the QOZ Fund investment. Under the previous example, the $4 million portion is not eligible for any of the three tax savings opportunities, so any gains realized on this portion of the new investment will be taxable. For the $6 million portion, all of the QOZ benefits still apply pursuant to the mixed fund rules. Moreover, these benefits include:
- Deferral from tax on the original $6 million gain that is invested into the QOZ Fund until the earlier of when the QOZ Fund investment is sold or Dec. 31, 2026;
- A 10% “basis bonus” in the calculation of the original $6 million gain (reducing the original taxable gain to $5.4 million) if the QOZ Fund investment is held for at least 5 years, or a 15% “basis bonus” (reducing the original taxable gain to $5.1 million) if the QOZ Fund investment is held for at least seven years (each holding period must be satisfied prior to Dec. 31, 2026); and
- Total exclusion from tax on gains realized from the $6 million portion of the QOZ Fund investment if the QOZ Fund investment is made prior to July 1, 2027, and held for at least 10 years.
In the case of a straight-up non-qualifying investment, the rules are simple. There is no gain deferral, no 10% or 15% “basis bonus”, and no permanent gain exclusion on the QOZ Fund investment. Although an original investor faces this outcome when a non-qualifying investment is made, the same is not necessarily true for a second-generation investor.
If a second-generation investor purchases the original investor’s investment from the original investor before July 1, 2027, and uses proceeds that would be a qualifying investment to fund the purchase, then the second-generation investor is eligible for all three tax savings opportunities. Given the timing that may be involved, the full extent of these opportunities may be curtailed (it may no longer be possible to obtain some or all of the “basis bonus” if the holding period cannot be satisfied prior to Dec. 31, 2026, for instance).
As for the previously discussed investment subject to the mixed fund rules, the tax benefits are easiest to understand by extending the example to a subsequent year in which the investor finally sells the QOZ Fund investment.
Continuing the previous example, consider a sale of the entire investment after 11 years for $30 million (a $20 million gain on the QOZ Fund investment). Because this involved a mixed fund investment, the investor must treat the sale as two separate transactions. First, the investor will allocate 40% of the sales proceeds to the QOZ Fund investment that was purchased as a nonqualifying investment. This computes to 40% of $30 million, or $12 million of sales proceeds. The taxable gain must then be determined with respect to this $12 million of proceeds.
For this gain calculation on the nonqualifying portion, Prop. Reg. Section 1.1400Z2(a)-1(b)(10(i)(D) provides that the first $6 million of available basis is allocable entirely to the qualifying portion of the entire QOZ Fund investment. There is $10 million of available basis because cash was used to make the QOZ Fund investment, so a full $6 million of this basis is allocated to the qualifying investment, leaving a residual $4 million of this basis allocable to the non-qualifying portion. Also for simplicity, this assumes that there were no adjustments to this basis during the intervening 11 years. Thus, an $8 million taxable gain results on the sale of the non-qualifying investment (the excess of $12 million over the $4 million of basis).
The other portion of the QOZ Fund investment (the $6 million qualifying investment) remains eligible for total gain exclusion. Thus, the $18 million of sales proceeds allocated to this qualifying investment is not subject to tax.
While the mixed fund investment rules allow taxpayers to take advantage of the benefits under the QOZ Fund provisions, they do not fully shield an investor from a future tax liability. This result may take some of the shine off of investing in one of these funds, but with proper planning taxpayers can maximize the tax benefits from a QOZ Fund by taking advantage of the rules available for mixed fund investments. For more information on these rules and the tax benefits of investing in a QOZ Fund, please contact your local CBIZ tax professional.