Smart Tax Planning

The IRS is giving you more time to invest in this new tax-advantaged strategy

Key Points
  • Qualified opportunity funds are a tax-advantaged way for investors to pour money into distressed neighborhoods.
  • You must invest capital gains within 180 days into a qualified opportunity fund. This way, you defer taxes on those gains if you hold the fund for at least five years.
  • Due to the coronavirus pandemic, the IRS is giving investors until the end of the year to reinvest capital gains into a qualified opportunity fund.
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Investors who were sitting on the sidelines during coronavirus will get some more time to partake in a new tax play.

Qualified opportunity funds were created by the Tax Cuts and Jobs Act of 2017.

They offer taxpayers an incentive to invest capital gains they incur elsewhere into economically distressed communities, granting investors an attractive tax break if they remain in the fund for at least five years.

Investors have poured more than $10 billion into the 406 qualified opportunity funds listed on the Novogradac Opportunity Funds List as of April 30. That's up from $790 million invested in May 2019.

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The coronavirus pandemic has led to prospective investors slowing down and carefully kicking the tires on these projects before they invest for years at a time, said Richard LaFalce, partner at Morgan Lewis in Washington, D.C.

"What I have seen is that people are focused on making sure it's still a good underlying investment," he said.

The IRS is also willing to give investors more time due to coronavirus, according to an announcement the agency released on Thursday.

Normally, prospective investors have 180 days from when they incur significant capital gains – perhaps by selling a business – to reinvest the money into a qualified opportunity fund.

Now, investors whose 180-day period would have ended after April 1 will have until Dec. 31 to reinvest their proceeds into one of these funds, the IRS said.

A tax play over time

A sign displayed on Bruckner Building reads 'Commercial Space Available' in the Port Morris neighborhood of the Bronx borough of New York. For a limited time, investors who develop real estate or fund businesses in opportunity zones are able to defer capital gains on profits earned elsewhere and completely eliminate them on new investments in 8,700 low-income census tracts.
Bloomberg | Getty Images

The longer you hold the fund, the sweeter the tax break.

Stay in your qualified opportunity fund for more than five years, and you'll be able to exclude 10% of the originally deferred gains you invested.

Hold the fund for at least 10 years, and you won't owe taxes on the fund's appreciation once you sell your stake.

Not for novices

As attractive as the tax benefit may seem, pouring money into a qualified opportunity fund isn't for everyone.

For starters, many projects are based on real estate, so there's some element of illiquidity. Investors in today's economic tumult might be hesitant to sock away cash into a project for years at a time.

"It's a long-term strategy – a 10-year strategy," said LaFalce. "People expect we will have a long-term recovery, which is why these projects continue to move along."

These funds also have layers of expenses, including selling commissions, managing dealer fees and other costs.

Finally, investors could face unexpected tax-planning consequences if they don't bring an accountant and a financial advisor into the mix.

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Consider that transferring your stake in the fund to your ex in a divorce or to your child, you could recognize the capital gains you were trying to defer. That means you'll be left with a hefty tax bill.

Move slowly and deliberately, especially since the IRS is granting more time to weigh these investments.

"There were certain investors who were up against the clock on getting the money invested," said LaFalce. "They were a little more cautious and choosy on the managers they went with."

"That's the overall sentiment in the market, 'Let's slow down and be conscientious about how we're deploying capital," he said.