What to Know About the Tax Reporting Requirements for QOZ Funds
Qualified Opportunity Zones (QOZs) are designed to spur economic development. To do so, they offer three substantial tax breaks to encourage investor participation: capital gains deferment until 2026 on capital gains that are reinvested into a QOZ; capital gain reduction of up to 15% on the reinvested capital gains and; most significantly, zero taxes on the appreciated capital gains achieved by the QOZ investment, assuming the investment is held for at least 10 years.
But each of these investments comes with strings attached, starting with the fact that all QOZ investments must be made through a designated Qualified Opportunity Zone Fund (QOF) or entity. Also, investors must follow the new IRS tax rules to a T, or they will risk losing eligibility for these benefits, so we recommend investors work with accounting and/or legal advisers who are familiar with the regulations. Further, the IRS is planning to issue additional guidance on QOZ investments later this year or early 2020.
To bring Origin investors up to date on the regulations available today, we asked John Hoffman, a Chicago CPA with deep expertise in QOZs, QOFs and other tax incentives, to walk us through how to claim each of these tax breaks. As founder and president of Bracket Partners, Hoffman works closely with the CPA firm Miller Cooper & Co. on such investments.
1. Capital Gains Deferment: What Qualifies, and How to Claim It?
A wide variety of short-term and long-term capital gains qualify for the QOZ program, Hoffman says. Capital invested into an opportunity zone fund is reported on IRS Form 8949. In this case, taxpayers enter adjustments to their capital gains as instructed in Part I (for a short-term gain) or Part II (for long-term gains). Capital gains can be generated directly, as in stock and bond sales, or indirectly from business or partnership profits reported as capital gains on Schedule K-1 forms. Capital gains on real estate qualify whether they’re handed over at a real estate closing or over time in an installment sale.
“Determining the exact amount of capital gains for an investor could be really simple or complicated,” Hoffman says. Capital gains on traditional publicly traded stocks are easy to calculate using the cost basis listed in brokers’ statements. However, business property gets special tax treatment under Section 1231 of the tax code for QOZs. To determine their taxable gain, investors must calculate the net gains versus losses on all their Section 1231 property transactions during the year.
Finally, to defer the net gain, the IRS gives investors 180 days to put capital into a qualified opportunity fund. Planning when to harvest profits is important because capital gains must be reinvested within six months. “This is something you absolutely want to determine with your accountant,” Hoffman says. For most business and partnership gains, IRS and Treasury guidance states that the 180-day clock starts at the end of the tax year which is typically December 31, 2019.
“Where it’s challenging is if you own shares of stock or a partnership interest, and that corporation or partnership is doing various things throughout the year that will create capital gains,” Hoffman says. Investors often don’t learn about this activity until tax deadlines approach and businesses issue their Schedule K-1 forms. “In some situations, you don’t get K-1s until summer. That’s a major problem because you could miss the 180-day window.” Investors need to monitor this business activity throughout the year to plan an opportunity zone fund investment.
2. Capital Gains Tax Cut: Why Is 2019 Important?
By holding QOZ fund shares, investors not only delay their tax reckoning day until 2026 for the invested amount but also trim their 2026 tax bill. The way this accounting works is to raise the cost basis for the invested capital, which reduces the resulting capital gain. If the QOZ investment is held for five years come the end of 2026, this “step-up” is 10%; the adjustment goes up an additional 5% to 15% if the QOZ investment is held for seven years come the end of 2026. That makes 2019 the last year in which QOZ share purchases qualify for the full 15% tax cut.
The five- and seven-year counts start when proceeds are invested. If a QOZ fund is not being managed as expected, investors can pay whatever early liquidation penalties the fund imposes and shift capital to another QOZ fund. However, this rollover investment will reset the cost basis clock and the investor will be forfeiting the chance for an optimal tax benefit—one of many reasons to choose a real estate fund manager wisely from the start.
Finally, the deferred gain must be reported for the 2026 tax year—earlier if the fund is dissolved before then, or if fund shares are being transferred as a gift to children. The deferred gain is likely to be paid quarterly during 2026 and reconciled when the actual tax amount comes due in 2027.
3. Tax-Free Appreciation: What Happens Over the Next Decade?
The most remunerative QOZ tax benefit accrues only after taxes on this first round of capital gains are settled in 2026. Once a QOZ investment is held for 10 years, capital gains on the appreciation of the original investment are permanently excluded from taxation. (Again, the taxpayer takes the exclusion on Form 8949. In accounting terms, the fund’s cost basis steps up to full market value.) “I would argue that the benefit for the new gain is significantly more valuable than the benefits on the old gain,” Hoffman says. Yet this benefit is also tied to the performance of the assets in the QOF, which again depends on the strength and experience of the fund manager.
“There’s no real benefit for the rental income generated based on current guidance,” he adds—rents are still taxable, and could still be shielded through depreciation. “What is your initial investment worth after 10 years? That’s the real meat of the program…the appreciation of the properties long-term. But you have to be very comfortable putting money into a very illiquid investment, because there are significant penalties to getting out earlier.”
Consider also the implications of the fund’s targeted liquidation date. Market conditions may indicate holding assets for more than 10 years, or latecomer investors may need more time to reach a 10-year benchmark. Even after the qualified opportunity zone program ends, the program shields distributions as late as 2047–10 years after making an eligible first investment of capital gains from 2026, plus up to 10 years to liquidate the fund.
Lengthy holding periods will have implications for estate planning. Gifts to children during an investor’s lifetime may make deferred gains taxable. However, shares inherited by a spouse, estate or trust are not considered capital gains.
Qualified opportunity zone investments pose other special considerations. For instance, each state chooses whether to conform to federal tax rules. State taxes may be due in California, Massachusetts and other states, while some states have created their own tax incentives. Financial and legal advice is essential for investors who organize corporations or trusts to gain more control over their portfolios, ownership or governance.
Finally, real estate fund managers put their investors’ tax break at risk without a compliance regimen in place to meet Treasury requirements, or a sound business plan to preserve the invested capital and realize the projected gains. Considering the stakes, communication is essential—with investment partners, financial and tax advisers, and real estate fund managers–in planning an opportunity zone transaction.