As seen in Crain's New York Business

Many of the provisions of the 2017 Tax Cuts and Jobs Act (TCJA) are sunsetting. Some of those provisions, such as the Qualified Opportunity Zone (QOZ) regime, are ending in a way that could lead to significant tax consequences.

Mechanism and incentive

To promote investment in Qualified Opportunity Funds (QOFs), the Internal Revenue Code (IRC) provides three incentives to taxpayers. First, taxpayers who invest cash from a current gain into a QOF can defer recognition of that gain until December 31, 2026. Second, the deferred gain recognition may be eligible for partial exclusion from tax when recognized. If the taxpayer holds the QOF investment for the requisite five or seven years at the time the gain is recognized, they will only have to recognize 85% or 90% of the gain respectively. Third, if an investment is held for 10 years, the basis of the property equals the fair market value upon the date it is sold. Assuming the investment is sold for its fair market value, the basis would be equivalent to the amount realized and there would be no gain. Note that this 10-year gain exclusion only applies to the gain in the QOF investment and that the taxpayer will still need to recognize any deferred gain on December 31, 2026.

Expiration date and legislative efforts

When the QOZ program was established in 2017, it had a termination date for investments in a QOF of December 31, 2026. Early investors benefited most from the deferral because it started the holding period basis adjustments as soon as possible. Even then, because the gain inclusion event is forced on December 31, 2026, properties purchased after December 31, 2021, do not benefit from the 10% and 5% increase in basis and have a shorter deferral period.

Congress has introduced bipartisan legislation that would accomplish five main goals:

1. Disqualify QOZs where the median family income exceeds 130% of the national median family income;
2. Empower states to replace disallowed tracts;
3. Incentivize compliance with reporting requirements;
4. Provide $1 billion of funding to states to invest in small businesses in underserved communities; and
5. Extend the QOZ deadline to December 31, 2028.

Both the Senate and House versions of this bill will likely not advance until after the 2024 election. However, it is important to prepare for the possibility of an extension due to the bill’s bipartisan support.

Practical implications

As the December 31, 2026, deadline looms, investors may be less likely to invest in QOFs because the gain deferral becomes less beneficial as time passes. However, the deferral of capital gains is still enough of a draw on its own for many investors.

Investing in a QOF is a practical deferral mechanism. Taxpayers can strategically hold onto investments until a year occurs in which the taxpayer incurs heavy capital losses, up to the year of inclusion, at which time the taxpayer can offset the inclusion of gain with those losses. Additionally, maintaining the investment for 10 years could lead to a gain-free sale (if sold at the fair market value). There are many ways to use an investment in a QOZ strategically. One note of caution: deferring gain now at current tax rates may not be beneficial if the tax rates on capital gains rise in the future, i.e., if capital gains rates rise in 2026 (2028) because deferred gains are subject to tax at the rates in the year they are recognized.

For more information, contact Hal Zemel at hzemel@citrincooperman.com or Matthew Crawford at mcrawford@citrincooperman.com.