Qualified opportunity funds are a new tax-planning strategy created by the Tax Cuts and Jobs Act tax reform.
The new funds have the ability to defer current-year capital gains, eliminate some of them later, and then on the new investment make capital gains tax-free. To put the benefits in place, you need to navigate some new rules and time frames.
To make this as clear as I can with as few words as possible, I’m going to use this example: On December 1, 2018, you sell $8 million of stock with a cost basis of $3 million for a long-term capital gain of $5 million.
1. Within 180 days, you invest the $5 million gain in a qualified opportunity fund.
2. You make an election on your 2018 tax return to defer the $5 million in long-term capital gain income, meaning no taxes on this gain in 2018.
3. On December 31, 2026, your qualified opportunity fund has a basis of $750,000 (15 percent of the deferred $5 million capital gain) since you held it for at least seven years.
4. Let’s assume the fund has a fair market value of $7 million on December 31, 2026. You’ll have a deemed sale on December 31, 2026, and recognize $4.25 million in income, computed as follows:
• $5 million, which is the lesser of the deferred gain ($5 million) or the fair market value of the fund ($7 million), less
• $750,000, the basis in the fund.
5. On January 1, 2027, your basis in the qualified opportunity fund is $5 million ($750,000 original basis plus $4.25 million of deferred gain recognized and taxed in 2026).
6. If you sell the qualified opportunity zone fund in August 2028 for $10 million, then your basis in the fund is $10 million and you recognize no taxable gain on the sale, since you held it for more than 10 years.
Overall, you have a total of $10 million in gains from these transactions: $5 million from 2018 and $5 million in 2028. Using the qualified opportunity fund investment strategy, you
• temporarily defer $4.25 million of long-term capital gain from 2018 to 2026, and
• permanently exclude from tax $750,000 of long-term capital gain from 2018 and $5 million of gain in 2028.
For this strategy to make great financial sense, you need (a) appreciation in your qualified opportunity fund and (b) to hold the investment for at least 10 years so that the appreciation is tax-free to you when you sell your investment.