The Qualified Opportunity Zone (QOZ) incentive program was created in late 2017 as part of the Tax Cuts and Jobs Act (TCJA). This program was built to incentivize taxpayers to invest in economically depressed regions, providing both temporary and permanent tax breaks to program participants.
Even though the QOZ incentive has been around for years, it’s worth revisiting. In these past three or four years, a couple of things have happened:
- Some of the program’s benefits have expired.
- Players in the construction industry have had the time to flesh out their roles in the program, allowing for more taxpayer participation than when the program was first implemented.
Let’s look at opportunity zones with a fresh set of eyes so that (1) we understand what QOZ investment options look like today, and (2) we see what role they can play in short and long-term tax plans.
What Is the QOZ Incentive Program?
The QOZ incentive program encourages taxpayers to make long-term investments into qualified opportunity zones.
What are QOZs?
QOZs are regions across the country that are economically distressed. In 2018, each state nominated census tracts from their jurisdiction to be classified as QOZs, and the final QOZ designations were published by the Department of the Treasury later that year.
Taxpayers who realize capital gains from selling another investment can defer (and potentially eliminate a portion of) their taxable gain if they direct those gains into a QOZ by way of an investment fund known as a Qualified Opportunity Fund (QOF). QOFs exist solely to hold assets in QOZs.
Taxpayers can receive one or more of the following possible benefits for their participation in this program:
- Taxpayers who invested in a QOF in 2018 or 2019 and hold onto that investment for at least seven years will receive a 15% step-up in basis on their original investment, effectively eliminating 15% of their original gain.
- Taxpayers who invest in a QOF in 2020 or 2021 and hold onto that investment for at least five years can receive a 10% step-up in basis on their original investment, effectively eliminating 10% of their original gain.
- Taxpayers who invest in a QOF can temporarily defer taxes on their original gain until December 31, 2026, or until they move their investment out of the QOF, whichever comes first.
- Taxpayers who invest in a QOF prior to December 31, 2026, and hold onto that investment for at least 10 years will not be taxed on appreciation within the QOF.
The 15% step-up incentive has already expired, and the 10% step-up incentive is about to expire, but QOZ investment can still play a role in your clients’ tax plans. Here are a few paths forward:
Option 1: Invest in a QOF Before December 31, 2021
Although this option will provide you with the most benefits, it may be difficult to pull off.
When you realize a capital gain (e.g., from selling stocks), they are typically given 180 days to reinvest those gains into a QOF. However, to receive the 10% step-up in basis incentive, you must invest in a QOF by December 31, 2021, even if their 180-day investment period extends into 2022.
Finding a well-run QOF in such a short time can be tricky, and rushing such an investment is not ideal. If you want to receive the 10% step-up in basis, you must hold the QOF investment for at least five years, and to exclude the growth within the fund from taxation, you must hold it for at least 10 years. Such long-term investments should be carefully considered. You want to select a QOF that will not only provide a decent return, but also one that will follow all the IRS’s requirements. If you cannot find a trustworthy QOF by the end of the year, you may be better off foregoing the 10% step-up in basis in favor of finding a better managed fund.
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Option 2: Invest in a QOF Before December 31, 2026
If investing in a QOF before the end of the year isn’t an option, you can still benefit from the QOZ incentive program. If you invest in a QOF before the end of 2026 and hold that investment for at least 10 years, you will not be taxed on appreciation within the fund. On December 31, 2026, the original gain will be taxed no matter what, but growth occurring within the QOF can escape taxation altogether if you hold the investment long enough.
Option 3: Create a Qualified Opportunity Fund
Some taxpayers are using the QOZ program to defer gains, but others are using it to attract capital to their building projects. Construction companies in particular are taking advantage of QOZ incentives by creating QOFs.
A construction company that operates a QOF will benefit from the QOZ program by being the recipient of other taxpayers’ investment dollars. Wealthy investors who want to defer or exclude capital gains are looking for places to invest their money, and construction companies have been more than happy to accept that influx of cash.
But creating a QOF is not exactly simple. Here are just a few of the requirements QOFs must meet:
QOFs must hold at least 90% of their assets in a QOZ.
Those assets can be tangible property (like business equipment, machinery, inventory, etc.) or ownership in a “QOZ business.” A QOZ business must derive at least 50% of its income from operating a trade or business within a QOZ.
QOFs must initiate investment into the QOZ, not simply hold it.
Because the IRS is seeking to incentivize new investment into economically depressed regions, they only extend QOZ benefits to new investment. This means that a QOF’s property must either be placed into service in the QOZ for the first time by the QOF or be substantially improved by the QOF soon after acquiring it.
QOFs must file Form 8996 each year.
This tax form must be filed by the QOF to self-certify they meet QOZ program requirements, to break down their owned versus leased property, to report which zones they’re operating within and to report dispositions of QOF equity by investors.
QOFs must be taxed as corporations or partnerships.
This means that multi-member LLCs, S corporations and real estate investment trusts (REITs) are all eligible to become QOFs.
Time to Strategize
The QOZ tax benefits are clear, and there are so many ways you can participate in the program. If you are an investor, you can use your participation in the QOZ program to have tighter control over capital gain recognition. If you are a contractor, you may be able to utilize the QOZ program to build capital for new projects. Whatever your goal is, consider QOZs for your next investment. It may be a great option for you.
