Estate Planning
How Qualified Opportunity Zone Funds Create Unique Estate Planning Challenges For Beneficiaries
The Tax Cuts and Jobs Act of 2017 made substantive changes to the Internal Revenue Code and in the process, created several new provisions, including “Qualified Opportunity Funds” (QOFs), which were designed to encourage taxpayers to invest in certain low-income (and also newly created) “Qualified Opportunity Zones” (QOZs) by offering some particularly unique (and potentially potent) tax benefits. Specifically, by investing into a QOF, a taxpayer gains the ability to defer taxes from the sale of any asset (including intangible assets like stocks), as long as the portion of the proceeds attributable to the capital gains on the asset that’s been sold are reinvested into a QOF within 180 days. Moreover, the portions of those deferred capital gains reinvested into the QOF are eligible for potentially two partial basis increases (once after five years and again after seven years), and if the investors hold the QOF for at least ten years, then all of the tax attributable to the gains of the QOF, itself, are completely eliminated if the QOF is sold.
Of course, such tremendous tax benefits don’t come without potentially prohibitive caveats, and there are many when it comes to QOFs. Specifically, capital gains on the sale of an asset that aren’t reinvested (on a timely basis) into a QOF by December 31, 2019 (a little over 4 months from the date this article was published) won’t be eligible for all of the available basis increases. Moreover, any still-deferred gain will become taxable either when the QOF is sold, or at the end of 2026 (whichever comes sooner).
Older potential QOF investors, or those with predictably shorter life expectancies, should also be aware of the disadvantages to beneficiaries who inherit a QOF. Typically, assets originally purchased with non-retirement funds receive a “step-up” in basis upon the death of the owner, giving the beneficiary the opportunity to sell the asset with little to no tax consequence. However, the gains that were originally reinvested into a QOF do not receive a step-up in basis, but instead, become income in respect to a decedent (IRD). Which means that QOFs tend to make poor estate planning vehicles, particularly when compared to other potential options. Plus, given the forced inclusion of any still-deferred gain at the end of 2026 and the extremely illiquid nature of QOFs, a beneficiary with limited other financial resources could find themselves between the proverbial “rock” and “hard place.”
Ultimately, the key point is that for many older investors (or younger investors with shorter life expectancies), there may be better alternatives than a QOF, especially when considering the potential benefits, or lack thereof, for their heirs. Some of these include, not selling the asset in the first place (and waiting instead to simply bequest an appreciated asset, which will eventually receive a step-up in basis), maintaining the eligibility for a step-up in basis by using a 1031 exchange (but only in the case of real property), or making use of a charitable trust. Although QOFs do offer several unique and useful tax benefits that can’t be found in any other vehicle, older investors, in particular, should look carefully at more mainstream gain management strategies before going down the QOF road.
