Qualified Opportunity Funds: What You Need to KnowSubmitted by Bernhardt Wealth Management on October 28th, 2019
The Tax Cuts and Jobs Act of 2017 created a new way for affluent investors to do well by doing good: Qualified Opportunity Funds (QOFs). These funds, which invest in identified “opportunity zones”—distressed or underprivileged communities that have been targeted for economic development—offer some major tax advantages for suitable investors. And yet, according to a recent article in the Wall Street Journal, investors have been slower than anticipated to jump on the QOF bandwagon. While QOFs can confer very real benefits, there are some important caveats to be aware of before adding them to your holdings.
First, let’s mention a few basics. QOFs are categorized as impact investing, a type of activity in which investors seek to confer positive social benefits while also benefitting financially. Typically, QOFs are formed as partnerships or corporations; they can also be structured as real estate investment trusts (REITs). QOFs can own a broad range of property types including residential units, commercial property, and certain types of businesses, but the property must be located in an identified Qualified Opportunity Zone. A state-by-state list of Designated Qualified Opportunity Zones can be downloaded from the Community Development Financial Institutions Fund website, operated by the US Treasury.
IRS rules governing QOFs provide generous tax incentives for investing in QOFs and providing a much-needed economic boost for identified communities. If you have a large capital gain from the sale of appreciated assets, you can reinvest that gain in a QOF within 180 days and defer the associated capital gains taxes from the sale until December 31, 2026, or until the Opportunity Zone investment is sold (whichever comes first). You can also reduce the capital gains tax you pay by up to 15 percent because of an increase in the basis of the appreciated assets used to buy the fund interest. It’s important to note that the basis increases by 10 percent if you hold your interest in the Qualified Opportunity Fund for a minimum of five years. Hold it for seven or more years, and the basis rises to 15 percent. As a bonus, you can eliminate the capital gains due on the appreciation in the Qualified Opportunity Fund if you hold the fund for ten years or longer.
These are the main benefits, but it’s also important to understand the caveats involved with investing in QOFs. First of all, like many real estate investments, QOFs should typically be regarded as illiquid. Especially considering the required holding periods to realize the maximum tax benefits, investors should not generally expect to sell or otherwise transfer their QOF holdings for at least five years and possibly longer. Also, as with any new investment vehicle, unscrupulous operations may be expected to promote themselves as legitimate QOFs when they do not actually qualify. Thus, due diligence becomes extremely important in order to find and thoroughly vet an established and reliable fund sponsor with a good track record of turning around distressed properties. We firmly believe that the tax benefit “tail” should not wag the investment quality “dog.” While the tax benefits of QOFs can be impressive, it is never wise to position assets without a reasonable expectation of return on investment. Finally, investors should consult with their tax advisors to insure that the taxation implications are thoroughly understood and properly handled on the investor’s return.
If you think an investment in a QOF may be right for your situation, please get in touch with us. We are eager to answer your questions and discuss whether this may be appropriate for you.