The Tax Cuts and Jobs Act, which was passed into law at the end of 2017, created generous tax incentives to stimulate investment in economically depressed areas around the country. These areas are collectively referred to as qualified opportunity zones (QOZs).
The income tax incentives being offered under the new tax law are intended to spur long-term business investment in these designated zones in exchange for the deferral of previously incurred “eligible gains” and/or the possible elimination of any capital gains incurred in the eventual disposition of the QOZ investment. The structuring of these incentives has drawn the interest of many current and recent business owners, serial entrepreneurs, and seasoned private equity investors, all hoping to profit from the opportunity.
At first glance, the ability to defer the recognition of a previously incurred capital gain that resulted from a profitable transaction (i.e., the sale of a business) is certainly an enticing proposition. Rather than redeploying sales proceeds net of income taxes, the full amount can be invested for a period of time to increase overall returns.
An eligible gain for deferral via QOZs is generally defined as the following:
- One that is treated as a capital gain for Federal tax purposes, and
- One that would otherwise be recognized before January 1, 2027
It is not required that the eligible gain be derived from the sale of an active business interest (i.e., it can be from general investment gains). The gain, however, must not have occurred from a sale or exchange with a related party.
Finally, and perhaps the most advantageous tax incentive, long-term investors can exclude any and all gain resulting from their QOZ investments if certain holding period requirements are met. For entrepreneurs and private equity investors, the prospect of tax-free growth is a tremendous motivation, helping to amplify the overall return on their investment.
The marketing of QOZ investments.
As a result of these attractive tax incentives, there has been an explosion of qualified opportunity funds (QOF) being marketed to current and former business owners (in particular those who have just sold their business for a gain), entrepreneurs, and private equity investors. They are being offered access to “attractive” QOF investments, and therefore the opportunity to achieve tax savings and investment growth through capital gain deferral and possible exclusion.
QOFs are generally corporations or partnerships that serve as channels for investing in QOZs. Managing owners of these entities should ensure all requirements for investing in and achieving the QOZ tax savings are met. The power of tax deferral and exclusion of capital gains on QOZ investments is very real and can be extraordinarily impactful on wealth.
QOF as private equity investments.
Many of the QOFs being marketed to investors take the form of private equity investments. From an overall wealth management perspective, the potential tax savings of QOFs must be weighed against the risks of private equity investments – especially ones that are focused on businesses operating in economically depressed areas.
Private equity investments have their own intrinsic risks and purpose in investment portfolios. Due to these risks and attributes, even the most attractively marketed private equity investment opportunities are not suitable for all investors.
Historically, there has been a wide dispersion in the performance of private equity investments in general. Typically, the best private equity managers and funds significantly outperform those in the bottom quartile. With investment capacity in private equity deals being limited, access to the best-performing funds and managers is typically reserved for large institutions and endowments. This leaves the remaining subset of investors looking to access private equity with the challenge of sifting through other available opportunities to find private equity investments with good performance potential, sound operations, and enough access to capital to complete the projects in a less-ideal economic environment.
While a QOZ investment may very well have a place in a portfolio, we caution our clients to first and foremost make sure they are an appropriate investment and to ensure they are willing and able to accept the risks of private equity.
Qualified opportunity zone income tax incentives.
Generally, the tax incentives offered by investments into a QOZ can be distilled into four main categories.
|Income Tax Incentive||Applicable Capital Gains||Description|
|Temporary Gain Deferral||Eligible capital gain realized and reinvested in QOF within 180 days||
If a taxpayer who has realized an eligible capital gain reinvests their gain, or a portion thereof, within 180 days into a QOF, recognition of the realized capital gain can be deferred until the earlier of December 31, 2026, or the date that they sell or exchange their QOF.
|10% Gain Exclusion||Eligible capital gain realized and reinvested in QOF within 180 days||A taxpayer who has held their QOF investment for at least 5 years can permanently exclude 10% of their deferred capital gain.|
|15% Gain Exclusion||Eligible capital gain realized and reinvested in QOF within 180 days||A taxpayer who has held their QOF investment for at least 7 years can permanently exclude an additional 5% of their deferred capital gain, bringing the total excluded capital gain to 15%.|
|Important Gain Exclusion Note||Assuming a taxpayer has not sold their QOF sooner, on December 31, 2026 any temporarily excluded capital gains must be recognized for tax purposes. As such taxpayers must invest in QOFs by 12/31/19 and 12/31/21 in order to meet the 7-year and 5-year holding period requirements, respectively, for any permanent gain exclusion. Additionally, they must be aware that income taxes will be due on the deferred capital gains as of 12/31/2026, without necessarily experiencing a liquidity event to generate the cash to pay the taxes due.|
|Permanent Gain Exclusion||Capital Gain on QOF Investment||A taxpayer who has held their QOF investment for at least 10 years (and sells their investment before 1/1/2048) can treat the fair market value of their QOF investment as their basis, thus eliminating any capital gain that would have been realized on the sale.|
Income Tax Incentives.
|Temporary gain deferral enables amount that would have otherwise been paid in taxes to earn a rate of return.||Recognition of any un-excluded deferred capital gains on 12/31/2026, without corresponding liquidity event.|
|Gain exclusion reduces effective tax rate on deferred capital gain from 23.8% to 21.4% after 5 years.||Potential changes in future capital gains tax rates may cause recognition of deferred capital gains at higher rates.|
|Gain exclusion reduces effective tax rate on deferred capital gain from 23.8% to 20.2% after 7 years.||Potential changes in future income and marginal tax rates may cause recognition of deferred capital gains at higher rates.|
|0% effective tax rate on QOF capital gain after 10 years.|
|New York state conformity with Federal tax deferrals and exclusions.|
Conclusion – putting the horse before the cart.
While the benefits of QOZs should not be discounted, it’s critical to avoid letting the tax incentives drive the investment decision. At Sanderson, we caution investors to not be lured into a risky private equity investment in QOFs solely because of the deadline for reinvestment of eligible capital gains, and the prospect of achieving relatively short-term tax deferral and modest capital gain exclusions.
For those willing to accept the risks of private equity, the complete capital gain exclusion on a profitable, long-term, properly evaluated QOF private investments is a tremendous tax incentive. However, be sure that the investment serves a suitable and well-understood purpose in your investment portfolio.
This publication contains general information that is not suitable for everyone. All material presented is compiled from sources believed to be reliable. Accuracy, however, cannot be guaranteed. Further, the information contained herein should not be construed as personalized investment advice. There is no guarantee that the views and opinions expressed in this publication will come to pass. Past performance may not be indicative of future results. All investments contain risk and may lose value. © October 2019 JSG
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