July 1st, 2019
So your client just called you and said he sold his Gremlin Airlines stock for a huge capital gain and wants to know what to do so he doesn’t have to pay so much tax come next April.
What do you tell him? Sell some loser stocks before the end of the year? Put more money in his 401(k)? Give more money to charities before the end of the year? Increase withholding through work for the rest of the year?
While these ideas are all tried and true ways to minimize the tax burden, what would you say if I told you that thanks to the Tax Cuts and Jobs Act of 2017, we have a new tool that can defer the gain and perhaps eliminate much of the future appreciation?
Enter the Qualified Opportunity Zone Fund, or Q Zone Fund.
Here’s how it works:
To defer a gain, a taxpayer has 180 days from the date of the sale or exchange of appreciated property (the big stock sale gain) to invest the realized gain (typically a capital gain) into a Q Zone Fund. The fund then invests in Qualified Opportunity Zone Property. Any gains treated as ordinary income, such as recaptured depreciation or gains resulting from a sale to a related person do not qualify.
A Q Zone Fund investment provides potential tax savings in three ways:
In addition, the deferred gain can be further reduced:
Let’s look at each of these in a little more detail…
The gain deferral applies to any investment gain (for example, sale of stock or a business, or real estate). It is important to note that the tax cannot be deferred indefinitely — only until 2026. The tax savings, however, may still be significant. Qualifying for deferral does not require an intermediary, and remember, the taxpayer has 180 days from a sale to invest the gain into a Q Zone Fund.
For example, a taxpayer sells his widget stock for $1 million in January 2019, resulting in a $1 million capital gain (zero basis). He invests the entire amount in a Q Zone Fund within 180 days. None of the sale proceeds are taxable in 2019.
Now, take the information from the above example. After five years, the taxpayer is given a $100,000 basis in the fund (10% of the original capital gain deferred). After seven years, the taxpayer is given another $50,000 of basis in the fund (5% of the original capital gain deferred). After seven years, hypothetically, the taxpayer sells the $1 million investment and pays tax on $850,000 of the gain. At current federal capital gains rates, that’s a savings of over $30,000 simply for holding the investment for seven years.
|January 1, 2019||Gain realized ($1,000,000)|
|June 30, 2019||Gain reinvested into a Q Zone Fund (180th day)|
|June 30, 2024||10% basis increase ($100,000)(5 years later)|
|June 30, 2026||5% basis increase ($50,000)(7 years later)|
|December 31, 2026||Mandatory deferred gain recognition date ($850,000). Taxpayer saved $30,000 and had the use of that money for 7 years.|
Continuing on with our example… In 2030, the taxpayer sells the investment for $5 million. The $4 million appreciation is not taxable (do we have your attention now?). At current federal capital gains rates, that’s a savings of over $800,000! Our taxpayer will have had that deferred $1 million gain which was reinvested back in 2019 taxable in 2027 for the 2026 tax year. But remember since the investment was held for at least 10 years, instead of paying tax on the full $1 million gain, our taxpayer paid tax on $850,000 in 2027 for 2026.
We’re just gettin’ started here! The rules and requirements for a Qualified Opportunity Zone are complex and must be followed carefully to provide the potential tax savings outlined above. Your client is encouraged to seek competent financial advice to make certain all the rules are met.
Your client can create their own Q Zone Fund, but I would caution you that the rules are very complex and have strict timelines. I wouldn’t tackle setting up one on my own without the assistance of an attorney well versed in this really new area of tax law.
By the way, I would suggest that you, as a tax professional, not recommend any specific Q Zone Fund unless that’s the business you are in—these are complex products and likely contain a great deal of potential risk to the principal invested. So, prudence dictates that we tell our client to tread lightly and get all the information necessary to make an informed decision.
After all, Will Rodgers once said, “I’m not as concerned with the return on my money as the return of my money!”
Join us again at a future date on this same network, when we will compare a good old fashioned like-kind exchange (which is now only allowed for a taxpayer looking to defer gain from the sale of real estate) with a journey into…The Q Zone.
by Tom O’Saben, EA
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