Window for 10% Basis Step-Up Closing Quickly for QOZ Investors
For Qualified Opportunity Zone (QOZ) investors, Dec. 31, 2021, is a critical date, one that may require swift action to be taken before year-end. In the spirit of Auld Lang Syne (“should old acquaintance be forgot”), it’s important to recall the most significant QOZ tax benefit: investors with a 10-year holding period can monetize their investment 100% tax-free. Now that’s a reason to throw confetti. (For summaries of prior QOZ guidance and updates, visit KSM’s blog.)
But why is Dec. 31 such a critical date? Two key reasons:
1. Ten percent basis step-up requires a five-year holding period by Dec. 31, 2026.
If an investor in a Qualified Opportunity Fund (QOF) achieves a five-year holding period with respect to their investment by Dec. 31, 2026 (requiring a QOF investment to be made no later than Dec. 31, 2021), he or she will realize a 10% increase in the tax basis of their investment. Valuably, this step-up in tax basis enables the investor to avoid paying tax on 10% of the gain that was initially deferred as part of the initial QOF investment.
- A taxpayer with $150,000 of eligible capital gains realized during 2021 chooses to invest $100,000 into a QOF and makes the investment on or before Dec. 31, 2021.
- As part of their 2021 personal tax return, the taxpayer pays tax on $50,000 of capital gains (the portion not deferred via a QOF investment).
- The $100,000 portion of eligible capital gains is not taxable on the 2021 personal tax return. Instead, it is temporarily deferred until the 2026 tax year, or the year the QOF investment is liquidated, whichever is earlier.
- By achieving a five-year holding period by Dec. 31, 2026, the investor receives a 10% step-up in tax basis and only pays tax as part of their 2026 tax return on 90% ($90,000) of the originally deferred gain. Ten percent of the originally deferred gain ($10,000) is tax-free.
Similar to the above, if a QOF investment had been made by Dec. 31, 2019, enabling a seven-year holding period by Dec. 31, 2026, a slightly higher 15% step-up in tax basis would have been realized in 2026.
2. Certain eligible gains realized in 2021 can only facilitate #1 above if invested in a QOF on the exact date of Dec. 31, 2021.
Taxpayers seeking to make a QOF investment on or before Dec. 31, 2021, must be aware of which 180-day reinvestment periods apply to each eligible gain realized during 2021. As a general reminder, QOZ tax benefits are only available to investors who defer eligible capital gain, and eligible capital gain can only be reinvested during certain 180-day reinvestment periods.
Consider the 180-day reinvestment periods (summarized below) in the context of the following example:
- If a taxpayer’s only eligible gain is reported to them on a Schedule K-1 and was realized between January and mid-June 2021 at the entity level, the gain cannot be reinvested between this blog’s publication date and Dec. 30, 2021. As a result, Dec. 31, 2021, is the next available date for reinvestment, meaning that a taxpayer intending to invest such a gain and not lose out on 10% step-up in basis has exactly one day to thread the needle and make such an investment: Friday, Dec. 31, 2021.
180-Day Reinvestment Periods:
- Gains that are not reported on a Schedule K-1:
- Day 1 begins on the date of the realization event.
- Gains that are reported on a Schedule K-1:
- Day 1 begins on the date of the realization event (investor can look through to the entity level); or
- Day 1 begins on Dec. 31, 2021 (assuming calendar year-end of entity producing the K-1); or
- Day 1 begins on March 15, 2022 (assuming calendar year-end of entity producing K-1).
Simpler than example above, if a taxpayer has an eligible capital gain that was realized within the last 180 days of 2021 (i.e., on or after July 5, 2021), whether reported on a Schedule K-1 or not, the taxpayer seeking to be eligible for the 10% step-up in basis will not have to wait until the exact last day of the year to make their QOF investment.
Necessary Actions Before Year-End
For taxpayers looking to invest in a QOF by year-end for the reasons noted above, additional action may be needed beyond depositing the cash. If investing in a third party’s QOF, yes, cash simply needs to be deposited with the QOF within the investor’s applicable 180-day reinvestment period. But for taxpayers looking to establish their own QOF, the following steps will need to be taken in advance of making the QOF investment:
- Form the legal entity that will serve as the QOF. Assuming the QOF will be structured as a partnership for tax purposes, note that the entity will require at least two owners.
- Obtain a tax ID number for the newly formed entity.
- For a QOF structured as a partnership for tax purposes, draft and execute the entity’s operating agreement. Include the mandatory language that the entity is being organized for the purpose of investing in QOZ property.
- Open a bank account in the name of the newly formed entity so that it is ready and available to receive cash investments on or before Dec. 31, 2021, as applicable.
Importantly, if a taxpayer is on the fence about whether a QOZ project will ultimately come to fruition (note that a separate decision can be made during 2022 about whether to actually deploy the QOF’s cash in pursuit of a QOZ project), it may still be prudent to set up a QOF and invest cash on or before Dec. 31, 2021. If a QOZ project is ultimately not pursued, the entity can return cash to the depositors before it would ever need to commit to designating itself as a QOF on tax forms, and likely without ever having to file an entity tax return. If a QOZ project is pursued, the investors would likely be thankful for having initiated their investment’s holding period by Dec. 31, 2021.
With little time remaining before year-end, taxpayers looking to make an investment in their own QOF should not wait until the last minute to address the above action items. Don’t find yourself pouring champagne this New Year’s without having first confirmed if all your QOZ ducks are in a row. Reach out to your KSM advisor to further discuss or complete this form.
Note: Various rules (asset tests, timelines, etc.) that solely apply at the QOF level are not included in this article. These rules relate to how quickly and by what dates investors’ cash equity must be deployed into qualified assets located inside the geographical QOZs. While these are discussed in prior QOZ-related articles, do not hesitate to reach out to your KSM advisor for further information.
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