QOZ Program Considerations Surrounding the Expiration of the Tax Cuts/Jobs Act and Meeting the Deferred Tax Liability
With the conclusion of the Qualified Opportunity Zone Program approaching, what do financial advisers and investors need to know?
By Jay Frank, president, Cantor Fitzgerald Asset Management
The Qualified Opportunity Zone Program – QOZ Program – made available under the 2017 Tax Cuts and Jobs Act is a tax-advantaged investment opportunity continuing to attract significant capital from high-net-worth and institutional investors. The QOZ Program was created to encourage investment in designated communities across the United States by providing certain tax incentives in return for committing long-term capital to these communities through investment vehicles known as qualified opportunity funds, or QOF.
As of Dec. 31, 2023, QOFs tracked by Novogradac raised $37.62 billion since the QOZ Program’s inception. However, Novogradac estimates that total fundraising is three to four times the data they capture, resulting in total fundraising estimates between $112 billion and $150 billion as Novogradac only tracks QOFs that report to the U.S. Securities and Exchange Commission or self-report directly to Novogradac.
Potential Tax Benefits of Investing in a QOF
The potential tax benefits of the QOZ Program apply to federal income taxes and are available in most states. The primary tax benefits fall into two categories, deferral and elimination, with the latter being potentially more economically impactful.
Deferral
Generally, if a taxpayer invests the capital gain from the sale of a qualifying asset into a QOF within the qualifying timeframe, taxes on such proceeds may be deferred until the earlier of Dec. 31, 2026, or the disposition of the QOF interest.
(A 10% step-up in basis was available for investments made prior to Dec. 31, 2021, and an additional 5% step-up in basis was available for investments made prior to Dec. 31, 2019.)
Elimination
Investors who hold their investment for at least 10 years receive a step-up in basis which means they pay no tax on the appreciation of their QOF investment upon disposition (so long as such disposition occurs prior to Jan. 1, 2048), regardless of the size of the potential profit.
This assumes that the investor is a resident of a state that conforms with the QOZ Program or a no state income tax state, otherwise the investor will owe tax on any realized gain in investor’s state.
In addition, the step-up in basis eliminates any depreciation recapture tax that would otherwise be owed upon sale, multiplying the tax benefit.
Keeping It Simple
Comparing a QOF to a Roth IRA may be a worthwhile way to think about the primary tax benefit. Despite several differences between a Roth IRA and a QOF, the treatment of the growth of after-tax monies deserves thoughtful consideration. With a Roth IRA, contributions are made with after-tax money, meaning you’ve already paid taxes on the money before depositing them into the account. As a result, the growth of these contributions and any withdrawals of contributions are typically tax-free, provided certain conditions are met. With a QOF, the original gain is recognized in 2026, thus becoming after-tax money. Any appreciation on those after-tax monies becomes tax-free upon exit provided the QOF is held the required amount of time and the QOF and its subsidiaries meet all relevant tests during the life of the QOF.
Meeting the Deferred Tax Liability
As powerful as the elimination tax benefit may be, having a plan to meet the deferred tax liability due in 2027 is paramount. Many QOFs, especially ones that have been in existence for a few years, may have a portfolio of projects that have been built, leased up, and are generating consistent cash flow. Those QOFs may be able to replace the construction financing with permanent debt and, as a result, make a non-taxable refinancing distribution to help investors meet their deferred tax liability. More recently launched QOFs may not have that ability as the construction to stabilization to refinancing timeline will often extend beyond the first quarter of 2027 when the deferred tax is due.
Investors may have ample liquidity in their portfolio to pay the tax in 2027. For investors who don’t, there are two other options to consider:
- Investors could look to harvest capital losses in their portfolios and combine with any other carry forward losses previously realized. These losses can offset some or all of the deferred gain originally invested in the QOF if the deferred gain was capital gain.
- An investor can decrease the amount they invest in the QOF upfront, creating liquidity that can be invested and earmarked for the deferred tax liability in 2027.
Potential Extension to the QOZ Program
Another item to keep in mind is that there have been bipartisan and bicameral bills introduced to extend and improve the QOZ Program including the Opportunity Zones Transparency, Extension, and Improvement Act (H.R. 5761 and S. 4065) in September 2023. An extension of the program may be included in a larger tax bill after the 2024 presidential election designed to address several important provisions of the Tax Cuts/Jobs Act currently set to expire in 2025. One item included in the bill is a two-year extension of the date that the deferred tax liability is recognized from Dec. 31, 2026, to Dec. 31, 2028.
There is still time to participate in the QOZ Program to realize the potentially lucrative tax benefits offered, regardless of any extension. In addition, investors with K-1 partnership gains and Section 1231 property as far back as Jan. 1, 2023, and in some limited situations, gains from blown 1031 exchanges back to July 6, 2022, may still be able to participate in the QOZ Program.
While the Tax Cuts/Jobs Act expiration might limit the timeline to invest in a QOF, the QOZ Program can still be a valuable tool for investors seeking long-term tax efficient growth and positive community impact who act now. Carefully weigh the considerations and consult with a financial professional to determine if a QOF investment aligns with your investment strategy.
Jay Frank is the president of Cantor Fitzgerald Asset Management, a division of Cantor Fitzgerald with $13 billion of assets under management across traditional and private market strategies including six opportunity zone funds.
The views and opinions expressed in the preceding article are those of the author and do not necessarily reflect the views of The DI Wire.
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