Ushered into the tax code under the 2017 Tax Cuts and Jobs Act, Qualified Opportunity Zone Funds (“QOF”) provide investors with an incredibly compelling combination of tax benefits for those with realized capital gains. This unique combination of benefits may help to generate tax, financial planning and investment alpha in a singular solution. While the tax tail should never wag the dog, it is critical for a financial professional to understand how the combination of QOF benefits, when applied appropriately, can be a significant differentiator for high-net-worth (“HNW”) clients as a holistic solution.

Three Questions To Consider
Assuming one likes the underlying investment and believes it is a suitable part of a diversified portfolio, one should consider the following:

1. When facing a capital gains tax liability, is it valuable to defer recognition of all or part of that gain until December 31, 2026, and therefore provide time to put strategies in place to proactively plan for and minimize it?

2. When thinking about how to reinvest that realized capital gain, is it attractive to allocate all or part of that capital to a structure that may have the opportunity to grow free of future taxation?

3. When thinking about future income planning needs, is it helpful to take part of the realized capital gain and invest it in a structure where several years from, now it could potentially generate tax-free income?

Deferral Of Capital Gain Recognition And Associated Planning Strategies And Benefits
One of the benefits of investing realized capital gains in a QOF is the ability to defer recognition of that invested gain through December 31, 2026. This provides several unique benefits:

• This is analogous to an interest-free loan. Instead of the capital gain liability that would ordinarily be owed in the current period going to the U.S. Treasury, it is being invested in a vehicle where it could potentially grow tax-free. More capital working for an investor over a longer period of time with the opportunity to grow free of taxation may create financial planning alpha.

• Deferral of recognition of the capital gain until December 31, 2026, provides an investor and the financial professionals that serve that investor time to plan for the future event. Strategies like tax loss harvesting can be implemented over the deferral period to help minimize the liability on the capital gain when it is recognized, creating tax planning alpha for that investor.

• Because a QOF investment is not an all-or-none proposition, it allows an investor and their financial professionals to spread tax liability over multiple tax periods as well as engage in liquidity planning. An investor may take part of their realized capital gain, invest that portion in a QOF and defer recognition of that gain until December 31, 2026. The rest of the gain they can recognize in the current period and utilize the after-tax liquidity to fund other investment or lifestyle needs.

Tax-Free Growth And Tax-Advantaged Income
There are very few investors that do not have an interest in potentially growing more of their capital free of taxation as well as potentially drawing tax-advantaged income from the investment.

• Opportunity for Tax-Free Growth
By far, the biggest economic benefit for a QOF investor is that as long as the investor holds their interest in the fund for 10 years, upon their basis is stepped-up to fair market value. This means that if the investor holds their interest in a QOF for at least 10 years, the growth of the investment upon exit is free of taxation (assumes the investor exits the investment on or before December 31, 2047).

While 10 years may seem like a long time, a reasonable financial plan for a HNW investor would assume there is sufficient liquidity elsewhere to feel comfortable allocating a part of a portfolio to illiquid investment strategies. To add exposure to a structure that allows the underlying investment that provides the opportunity to grow tax-free generates additional investment alpha and if capital gains rates should increase, increases the value of the strategy.

• Tax-Advantaged Income
Because of the requirements of the QOF Regulations, most real estate focused Qualified Opportunity Zone Funds are executing development or redevelopment strategies. As such, once the property is developed or the improvements are completed, most QOFs expect to be able to generate regular operating cash flow distributions.

One significant benefit for real estate investors is the ability to minimize taxable income with depreciation expense. As a function of this dynamic, real estate investors generally enjoy the benefit of tax advantaged income. In a typical, taxable real estate strategy, income sheltered by depreciation may be taxed upon exit when it is typically recognized as a 1250 gain.

It gets better for QOF investors. Because a QOF investor’s cost basis is stepped-up to fair market value upon exit (assuming they hold their interest for at least 10 years), there is no recapture of the depreciated basis and therefore, the income that was sheltered is actually tax-free. As a result, a QOF investment provides the opportunity to potentially generate income planning alpha.

There are few investors that do not like the idea of keeping more of what they earn.

Retroactive Tax Planning Opportunities
To defer a capital gain, a taxpayer has 180 days from the date of the sale that gave rise to the capital gain to invest the realized capital gain or part of it, into a QOF. The asset that gave rise to the gain can be anything including a business, securities, real estate or even collectables as long as it is considered a capital gain under the U.S. Tax Code. This encompasses both short and long-term capital gains as well as unrecaptured 1250 gains from real estate depreciation.

For investors that have realized capital gains through pass-throughs, there is even more latitude for investors to retroactively leverage QOF benefits.

A taxpayer who receives a reported capital gain from a flow-through entity, such as a partnership, an S-corporation, or an estate or non-grantor trust, has the option to start the 180-day investment period on any of the following dates:

• the last day of the entity’s taxable year, which is usually December 31;

• the same date that the gain was realized; or

•  the due date for the entity’s tax return, without extensions, for the taxable year in which the entity realized the eligible gain. 

This means that any gain realized in a flow-through entity in 2022 can be invested in a QOF as far out as September 10, 2023.

For financial professionals seeking to prospect business owners who have had exits or that work with investors that have capital gains from investments flowing through to their K-1’s or who are working with tax and estate planning professionals and M&A advisors to drive new business opportunities, the conversation about the extended look-back period for flow-through entity capital gains is a conversation worthy of your time.

Separating Basis From Gain
Investors often have illiquid financial assets that are not managed by their financial professional. In many cases, the challenge with selling those assets and reallocating that capital is the punitive nature of the capital gains such a transaction creates. Qualified Opportunity Zone Funds provide a tool for financial professionals to help investors separate cost basis from the capital gain as only the capital gain is required to be invested in a QOF in order to enjoy the potential tax benefits the Qualified Opportunity Zone legislation provides. This solution allows the basis to be reallocated and managed by the financial professional while the investor has a tax-advantageous strategy to deal with the capital gains.

What Else Financial Professionals Should Know
Netting losses to determine eligible gains. You do not need to net losses to determine your eligible gain to invest in a QOF. This allows an investor to carry forward losses to use in future periods when they don’t have the benefit of a QOF strategy. If losses are not used prior to 2026, they can be utilized to minimize the capital gain liability on the capital gain invested in the QOF when it is recognized.

Does the source of the investment in the Opportunity Zone Fund have to be the gain? No, the capital is fungible, and you can use different capital to fund a QOF investment as long as the amount corresponds with a realized capital gain.

Can I combine multiple capital gains to make my Opportunity Zone Fund investment? Yes. You can cobble together as many capital gains as you would like to determine what is eligible for QOF investment so long as your investment in the QOF is made within an eligible 180-day window. For example, a financial professional onboarding a new client can re-allocate that portfolio triggering capital gains across various positions. The totality of those gains, if made within 180 days of gain realization, are eligible for QOF investment.

Conclusion
If used effectively, the unique combination of benefits provided to QOF investors has broad application. From tax and financial planning to generating investment alpha, QOFs can provide financial professionals with a differentiated value proposition when seeking to attract HNW prospects and serve their best existing clients. Financial professionals should be well versed in how the strategy can be utilized as it will help them to attain the clients’ and referral sources they seek to attract.

Nick Rosenthal is managing director of wealth solutions at Griffin Capital Company.