Opportunity Zone Funds: Not Great Estate Planning Vehicles

Opportunity Zone Funds: Not Great Estate Planning Vehicles

The Tax Cuts and Jobs Act of 2017 introduced significant changes to the Internal Revenue Code, in the process creating several new provisions, including Qualified Opportunity Funds (QOFs)—designed to encourage taxpayers to invest in certain newly created (and low-income) Qualified Opportunity Zones (QOZs) by offering some particularly unique and potentially potent tax benefits.

Specifically, by investing into a QOF, a taxpayer gains the privilege of deferring taxes from the sale of any asset, such as, for example, intangible assets like stocks, as long as the portion of the proceeds attributable to the capital gains on the asset that has been sold is reinvested into a QOF within 6 months (180 days, to be exact). What’s more, the portions of those deferred capital gains reinvested into the QOF are eligible for two partial basis increases: once after five years and again after seven years. If an investor holds the QOF for at least a decade, then, if the QOF is sold, all of the taxes attributable to the gains of the QOF are eliminated entirely.

Naturally, such sizable and significant tax benefits come with equally large and possibly prohibitive caveats. Indeed, when it comes to QOFs, there are caveats aplenty. For instance: capital gains on the sale of an asset that are not reinvested on a timely basis into a QOF by the last day of 2019 will not be eligible for all of the available basis increases. Another example: any still-deferred gain will become taxable either when the QOF is sold, or at the end of 2026, whichever comes sooner.

Baby boomers considering QOFs as an investment vehicle, i.e. those with predictably shorter life expectancies than gen Xers or millenials, should concomitantly take into account the disadvantages accruing to beneficiaries who inherit a QOF. Assets originally purchased with non-retirement funds typically receive a step-up in basis upon the death of the owner. This gives the beneficiary the opportunity to sell the asset with few to no tax consequences. At the same time, 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). This means that QOFs tend to make poor estate planning vehicles, particularly when compared to other vehicles. 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 him- or herself in an unenviable predicament indeed.

At the end of the day, the crucial point is that for many older investors (or, to cover all the statistical bases, younger investors with shorter life expectancies) there may be better alternatives than a QOF, especially when considering the existence or non-existence of potential benefits for their heirs. Some of these include not selling the asset in the first place, and waiting instead to simply bequeath 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. It is true that QOFs do offer a number of unique and useful tax benefits that are not found in any other vehicle. At the same time, older investors in particular should look into more mainstream gain-management strategies before going down the QOF road.

For more information, please read:
How Qualified Opportunity Zone Funds Create Unique Estate Planning Challenges For Beneficiaries | Kitces

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