IRS Extends the Opportunity to Defer Capital Gains
- Tax Benefits
- Investment Period
- Qualified Opportunity Zone Funds
- Qualified Opportunity Zones
- Deferral Period
- 10 Year Election
As part of tax reform put into place a couple of years ago, individuals are able to defer both short- and long-term capital gains into what are referred to as Qualified Opportunity Zone Funds (QOFs). What is nice about this is that only the actual amount of gain needs to be invested into a QOF to avoid taxes on the gain for the sale year. The gains invested in a QOF are deferred until you cash out of the QOF investment or December 31, 2026, whichever occurs first.
This includes the gain from the sale of all capital assets, such as stocks or bonds, property, rentals, land, and even partnership interests.
Example: You sell 1,000 shares of stock that cost you $20 a share (a total cost of $20,000). You were very fortunate, and the stock had appreciated to $100 a share when you sold them, for a total sales price of $100,000 and a capital gain of $80,000. If you invest the $80,000 gain in a QOF within the required 180 days, the gain on the sale and the tax on the gain are postponed.
Example: Another example would be if you had inherited vacant land several years ago, and the fair market value of the land at the time you inherited it was $50,000. This year, a grocery chain wants to build a grocery store on the land and purchases it from you for $300,000. As a result of the sale, you have a gain of $250,000 ($300,000 - $50,000). If you invest that $250,000 gain in a QOF within the required 180-day period, you can defer the gain and the tax on the sale.
Investment Period Extended – Normally, to defer the taxable gain into a QOF, the profit must be reinvested into a QOF within 180 days of the sale date. Because of the business disruption caused by the COVID-19 pandemic, the IRS has provided relief for the 180-day investment period requirement. That relief gives those whose 180-day reinvestment period would have ended on or after April 1, 2020 and before December 31, 2020 until December 31, 2020 to invest that gain into a QOF.
Qualified Opportunity Funds – A QOF is an investment vehicle organized as a corporation or partnership for the purpose of investing in qualified opportunity zone property acquired after December 31, 2017. The fund must hold at least 90% of its assets in a qualified opportunity zone property. Visit the IRS’s Opportunity Zones Frequently Asked Questions for more details related to QOFs.
Qualified Opportunity Zones (QOZs) are population census tracts that are low-income communities specifically designated as QOZs after being nominated by the governor of the state or territory in which the community is located. For more details on QOZs, visit the Treasury Department’s Opportunity Zones Resource Page.
Deferral Period – The gain income is deferred until the earlier of the date the investment in the QOF is sold or December 31, 2026. If a taxpayer continues to hold their QOF investment after December 31, 2026, the taxpayer still has to include the deferred gain in their 2026 tax return. If that is the case, the gain reported in 2026 adds to the basis of the QOF.
To the extent the QOF is purchased with the deferred gain, the basis of the QOF is zero (because it is untaxed gain). Then, when the QOF is sold, the deferred gain subject to tax is the excess of the lesser of (a) or (b) over the QOF’s basis (or enhanced basis [explained next], if applicable):
(a) The deferred gain, or
(b) The fair market value of the QOF as determined at the end of the deferral period.
Enhanced Basis – Initially, as noted above, when the QOF is purchased with deferred capital gain income, the basis of the QOF is zero. Depending on how long the taxpayer holds their investment in the QOF, the basis may be increased by up to 15% of the gain income originally deferred.
10-Year Election – If the QOF is held for 10 years or longer before it is sold, the taxpayer can elect to increase the basis to the fair market value amount. The effect of this adjustment is that none of the appreciation since the QOF was purchased is taxable when it is sold. This provision applies only to the investment in the QOF made with deferred capital gains.
QOFs provide a unique opportunity, but there are investment risks, and it is important to investigate a QOF’s investment strategies carefully to see if the investment is suitable for your needs. Please call this office for information about how a QOF might work for your particular set of tax-related circumstances.