One of today’s hottest tax topics is the relatively new concept of “qualified opportunity zones,” created by the Tax Cuts and Jobs Act (TCJA) at the end of 2017. Many are feverishly broadcasting the potential tax benefits of investing in “qualified opportunity funds,” and, indeed, these new provisions are intriguing. Yet, there are several important points that are being overlooked.
The Basics Of QOZs And QOFs
At the risk of oversimplification, we will start with a brief summary of qualified opportunity zones (QOZs) and qualified opportunity funds (QOFs). In short, the concept of a QOZ was introduced as a means to stimulate private investment in economically disadvantaged areas around the country.
The stimulus comes in the form of potentially powerful tax incentives. Generally, an investor who has a taxable gain on an investment can elect to defer all or part of the gain for federal income tax purposes by reinvesting it in a QOF—essentially a partnership or corporation properly set up to make investments within a QOZ—within 180 days of the event triggering the gain. The tax deferral period can last until the earlier of December 31, 2026 or the date on which the QOF investment is sold or exchanged.
The incentive can get even more powerful if the QOF investment is held for at least five years. If it is, then the deferred gain is eligible for a 10 percent reduction through a basis increase. If it’s held for at least seven years, then the deferred gain is eligible for a 15 percent reduction. If the QOF investment is held for at least 10 years, then, in addition to the 15 percent reduction of the deferred gain, the investor also is eligible for a step-up in basis equal to the fair market value of the QOF investment on the date that it is sold. Essentially, this allows the investor to escape taxation on any future appreciation in the QOF investment.
Have you read something like this before? Probably, but here are some things you may not know:
Be Mindful About ‘Letting The Tax Tail Wag The Dog.’
Most importantly, while the benefits of tax deferral and reduction can be quite substantial, keep in mind the potential costs of achieving those benefits. Investing in a relatively illiquid partnership or corporation with the intent of holding the investment for as many as 10 years in order to maximize the available tax benefits requires a strong conviction regarding the merits of the investment itself.
Investing in underserved areas of the country can be seen as a form of impact investing while also offering great economic upside, but it can also carry disproportionate downside risk. It is important to understand and assess this risk alongside the corresponding rewards of tax deferral and reduction. Consider the fact that the government believed that a tax-incentive was necessary to spur these investments because natural market forces were otherwise insufficient to do so. Consider also the fact that QOFs already are becoming a “popular trade,” which is not always the best kind of trade from a long-term perspective, especially if inexperienced promoters seeking to maximize management fees based on short-term demand become involved.
This is not to say that QOFs do not make sense, but they need to be considered in the appropriate—and complete—economic context. Of course, as one considers this deferral opportunity, the fundamentals of sound financial planning should also be applied. Global asset allocation must be revisited, including with respect to real estate and other infrastructure investments; and liquidity needs must be assessed.