The zones are limited to 25 percent of the low-income community census tracts in each U.S. state. While the federal government provided high-level guidance on the process, each governor ultimately decided which census tracts received the designation, and Treasury has been ratifying the designations since April 2018. If a taxpayer elects to defer gain and reinvest in a Qualified Opportunity Fund (QOF), the benefits include tax deferral and, if holding periods are met, the exclusion of a significant portion of the gain. Following are examples of the benefits taxpayers can experience from reinvesting in a QOF:
- If a taxpayer sells an investment and reinvests an amount equal to the gain in a QOF, the gain on the old investment is deferred. The deferral is available until the earlier of the sale date of the QOF or Dec. 31, 2026.
- If an investment in a QOF is held until at least 2026, the deferred gain is recognized. The deferred gain recognized is the lesser of the following, less the basis in the QOF investment:
- The original deferred gain
- The fair market value of the QOF
- The initial basis of the QOF investment is zero.
- If a QOF investment is held for at least five years, a portion of the deferred gain converts to basis in the QOF. Ten percent of the deferred gain is added to basis after five years, and an additional 5 percent is added to basis in the seventh year, for a 15 percent total basis increase in the deferred gain. Because this is an increase to the basis of the QOF investment, it has the effect of lowering the gain recognized in 2026.
- Any deferred gain recognized in 2026 (or earlier upon sale of the QOF) adds to the basis of the QOF investment.
- If an investment in the QOF is held for 10 years, all gain from the QOF attributable to the 10-year period is excluded from income. The exclusion is accomplished by increasing the basis in the QOF to its fair market value at the date of QOF sale.
- Effectively, the maximum gain exclusion equates to 100 percent of the QOF gain and 15 percent of the original deferred gain. This assumes an original investment gain that is deferred in 2018 or 2019 combined with a QOF investment held at least 10 years.
Example One
A taxpayer owns an asset with a fair value of $25 million with a basis of $5 million that would result in $20 million of capital gain if sold. If the taxpayer sells the asset in 2018 and reinvests at least $20 million of proceeds in a QOF, the taxpayer can defer recognition of the $20 million gain. The taxpayer would recognize the following portion of the deferred gain based on when the QOF is sold:
- $20 million (full deferred gain as the five-year basis increase is not reached)
- $18 million (10 percent basis increase in year 5)
- $17 million (15 percent basis increase in year 7)
If the taxpayer sells the QOF in 2026 for $30 million, the initial zero basis in the QOF will increase to $20 million. Three million dollars (15 percent of the $20 million deferred gain) is excluded from income, and $17 million of the deferred gain is recognized. The gain on the sale of the QOF will be $10 million. The total gain recognized is $27 million: $17 million of the original $20 million of deferred gain plus $10 million of gain on the QOF. This provides for a net gain exclusion of $3 million.
Example Two
Assume the same facts as in example one, but the taxpayer sells the QOF for $40 million in 2029, more than 10 years after the QOF investment.
On Dec. 31, 2026, the taxpayer recognizes $17 million of the $20 million deferred gain. The basis in the QOF is increased to $20 million, 15 percent of the $20 million deferred gain and the $17 million gain recognized.
Upon the sale in 2029, the basis in the QOF is stepped up to its fair market value of $40 million. When the taxpayer sells the QOF in 2029, no additional gain is recognized. This provides for $23 million of net gain exclusion.
A QOF may be formed as a corporation or a partnership and is required to hold at least 90 percent of its assets in Qualified Opportunity Zone property. The IRS has provided additional information on QOFs via frequently asked questions on the IRS website.
