In an effort to spur growth in economically distressed areas across the nation, the Tax Cuts and Jobs Act of 2017 created a new investment vehicle known as a Qualified Opportunity Fund. An investment in a Qualified Opportunity Fund can serve as a great tax-planning tool for those who have recently realized, or soon will realize, a significant amount of capital gains. It makes no difference whether the capital gain is short-term or long-term or whether the capital gain results from the sale of stocks, real estate, equipment, or collectibles. Taxpayers have 180 days from the realization of the capital gain to reinvest such gain in a Qualified Opportunity Fund. Tax liability on the reinvested gain is deferred until the earlier of the date on which the investment is sold/exchanged or December 31, 2026. If the investment is held for five years or more, the investor’s basis, which is initially set to $0, receives a step-up in basis equal to 10% of the invested amount. This five-year milestone must be met prior to December 31, 2026, in order to receive the 10% step-up in in cost basis. Because the 2026 capital gains tax rate is currently unknown, there is no guarantee the tax liability in 2026 will be less than the tax which would have been due had the gain not been deferred.
Finally, if held for ten years or more, any additional gain on the Qualified Opportunity Fund investment is fully excluded from taxable income.
Consider the following example:
On August 15, 2021, Jill sells a capital asset and realizes a $100 long-term capital gain. Jill, who will be in the top tax bracket in 2021, will owe $20 in tax on her gain.
On October 15, 2021 (within 180 days of August 15, 2021), Jill decides to invest the $100 capital gain into a Qualified Opportunity Fund. The $100 capital gain is deferred until she gets out of the investment or December 31, 2026, whichever comes first.
Five years later, on October 15, 2021, Jill’s basis in her Qualified Opportunity Fund investment is stepped up from $0 to $10.
The tax-deferral period expires on December 31, 2026. As a result of the $10 step-up in basis, Jill will be liable for capital gains tax on $90 (instead of the full $100) on her 2026 return.
On June 30, 2032, Jill liquidates her Qualified Opportunity Fund investment for $300. Her investment has tripled, and she now has an additional $200 capital gain. Because she held the investment for more than ten years, Jill receives a full step-up in basis to $300. Her additional $200 gain is tax-free.
This is a hypothetical illustration only and does not represent actual performance of any particular investment.
- This communication is provided for informational purposes only and does not constitute investment advice.
- An offer to purchase interests in any alternative investment may be made only pursuant to the fund’s private placement memorandum, which contains important information concerning risk factors, performance, and other material aspects of the fund. Such document must be carefully read before an investment decision is made.
- Alternative investments are generally sold as private placements and therefore may be offered only to individuals and entities who are qualified in accordance with the terms of the private placement memorandum and for whom the investment is otherwise suitable.
- In view of the complexities of the tax laws applicable to partnerships and qualified opportunity funds, and since no attempt is made herein to mention all of the tax considerations that should be taken into account in evaluating a potential investment in a Qualified Opportunity Fund, or to provide a complete explanation of those issues that are summarized, a person considering investing in a Qualified Opportunity Fund should consult its own tax advisors in order to understand fully the U.S. federal, state, local, and foreign tax consequences of such investment to their particular situation. Additionally, there may be delays in distributing tax information to investors.
- Alternative investments are speculative and involve a high degree of risk.
- Performance can be volatile.
- An investor could lose all or a substantial amount of his or her investment.
- Alternative investments may trade on a leveraged basis which increases the risk of loss.
- The use of a single fund of funds manager applying one set of allocation procedures could mean lack of diversification and, consequently, higher risk.
- There is no secondary market for an investor’s interests in alternative investments and none is expected to develop.
- There may also be restrictions on transferring interests in alternative investments.
- Past performance is not indicative of future results.
Sources: IRC Section 1400Z-1; IRC Section 1400Z-2; PTR Section 1.1400Z2; Revenue Ruling 2018-29
Stifel does not provide tax advice. You should consult with your tax advisor regarding your particular situation.
A decision to invest in a Qualified Opportunity Fund should be based primarily on the merits of the underlying investment(s) rather than the potential tax benefits.