Qualified Opportunity Zone Funds, i.e. The Q Zone
You’re traveling through another dimension, a dimension not only of sight and sound but of tax. A journey into a wondrous land whose boundaries are that of gains deferred or perhaps eliminated. At the signpost up ahead — your next stop is…the Q Zone!
So your client just called you and said he sold his Gremlin Airlines stock for a huge capital gain and wants to know what to do so he doesn’t have to pay so much tax come next April.
What do you tell him? Sell some loser stocks before the end of the year? Put more money in his 401(k)? Give more money to charities before the end of the year? Increase withholding through work for the rest of the year?
While these ideas are all tried and true ways to minimize the tax burden, what would you say if I told you that thanks to the Tax Cuts and Jobs Act of 2017, we have a new tool that can defer the gain and perhaps eliminate much of the future appreciation?
Enter the Qualified Opportunity Zone Fund, or Q Zone Fund.
Here’s how it works:
To defer a gain, a taxpayer has 180 days from the date of the sale or exchange of appreciated property (the big stock sale gain) to invest the realized gain (typically a capital gain) into a Q Zone Fund. The fund then invests in Qualified Opportunity Zone Property. Any gains treated as ordinary income, such as recaptured depreciation or gains resulting from a sale to a related person do not qualify.
Tax deferral and savings
A Q Zone Fund investment provides potential tax savings in three ways:
- We push off paying tax on the gain until 2026 — Any taxable gain invested in a Q Zone Fund within 180 days of the sale is not recognized until December 31, 2026 (due with the filing of the 2026 return in 2027) or until the interest in the fund is sold or exchanged, whichever occurs first.
In addition, the deferred gain can be further reduced:
- Potentially no tax on 10% or up to 15% of deferred gains –just as long as you ‘gidder done’ by the end of this year and hold on for the next 7 years. A taxpayer who defers gains through a Q Zone Fund investment receives a 10% step up in tax basis after five years and additional 5% step up after seven years. Note that to take full advantage of the 15% step up in tax basis, the taxpayer must invest by December 31, 2019. When the tax is triggered at the end of 2026, the taxpayer will have held the investment in the fund for 7 years, thereby qualifying for the 15% increase in tax basis.
- No tax on appreciation — Remaining in the Q Zone Fund for at least 10 years results in the cost basis of the property being equal to the fair market value on the date of sale/exchange. However, the original gain deferred (less the potential 15% increase in basis) is not eliminated but recognized at the end of 2026).
Let’s look at each of these in a little more detail…
Tax Benefit #1: Tax deferral through 2026
The gain deferral applies to any investment gain (for example, sale of stock or a business, or real estate). It is important to note that the tax cannot be deferred indefinitely — only until 2026. The tax savings, however, may still be significant. Qualifying for deferral does not require an intermediary, and remember, the taxpayer has 180 days from a sale to invest the gain into a Q Zone Fund.
For example, a taxpayer sells his widget stock for $1 million in January 2019, resulting in a $1 million capital gain (zero basis). He invests the entire amount in a Q Zone Fund within 180 days. None of the sale proceeds are taxable in 2019.
Tax Benefit #2: No tax on 10% or up to 15% of deferred gains
Now, take the information from the above example. After five years, the taxpayer is given a $100,000 basis in the fund (10% of the original capital gain deferred). After seven years, the taxpayer is given another $50,000 of basis in the fund (5% of the original capital gain deferred). After seven years, hypothetically, the taxpayer sells the $1 million investment and pays tax on $850,000 of the gain. At current federal capital gains rates, that’s a savings of over $30,000 simply for holding the investment for seven years.
Tax Benefit #3: Potentially no tax on future appreciation
Continuing on with our example… In 2030, the taxpayer sells the investment for $5 million. The $4 million appreciation is not taxable (do we have your attention now?). At current federal capital gains rates, that’s a savings of over $800,000! Our taxpayer will have had that deferred $1 million gain which was reinvested back in 2019 taxable in 2027 for the 2026 tax year. But remember since the investment was held for at least 10 years, instead of paying tax on the full $1 million gain, our taxpayer paid tax on $850,000 in 2027 for 2026.
We’re just gettin’ started here! The rules and requirements for a Qualified Opportunity Zone are complex and must be followed carefully to provide the potential tax savings outlined above. Your client is encouraged to seek competent financial advice to make certain all the rules are met.
Your client can create their own Q Zone Fund, but I would caution you that the rules are very complex and have strict timelines. I wouldn’t tackle setting up one on my own without the assistance of an attorney well versed in this really new area of tax law.
By the way, I would suggest that you, as a tax professional, not recommend any specific Q Zone Fund unless that’s the business you are in — these are complex products and likely contain a great deal of potential risk to the principal invested. So, prudence dictates that we tell our client to tread lightly and get all the information necessary to make an informed decision.
After all, Will Rodgers once said, “I’m not as concerned with the return on my money as the return of my money!”
by Tom O’Saben, EA
University of Illinois Tax School
Originally published at https://taxschool.illinois.edu.