Qualified Opportunity Zone (QOZ) — §1400Z-2

QOZ Overview and Capital Gains Deferral

The Qualified Opportunity Zone (QOZ) program under §1400Z-2 allows taxpayers to defer capital gains by investing the gain in a Qualified Opportunity Fund (QOF) within 180 days of the sale. The deferred gain is recognized on the earlier of: (1) the date the QOF investment is sold or exchanged; or (2) December 31, 2026. The deferred gain is taxed at the capital gains rate in effect at the time of recognition.

The QOZ program was created by the Tax Cuts and Jobs Act (TCJA) in 2017 to encourage investment in economically distressed communities designated as Qualified Opportunity Zones by the Treasury Department. There are approximately 8,700 QOZs in the United States, covering portions of all 50 states, the District of Columbia, and five U.S. territories.

Basis Step-Up and the 10-Year Exclusion

In addition to capital gains deferral, the QOZ program provides two additional tax benefits: (1) a basis step-up on the QOF investment; and (2) a 10-year exclusion of appreciation in the QOF investment.

The basis step-up is: 10% of the deferred gain after holding the QOF investment for 5 years, and an additional 5% (15% total) after holding the QOF investment for 7 years. However, because the deferred gain must be recognized by December 31, 2026, the 7-year basis step-up is no longer available for new investments made after December 31, 2019.

The 10-year exclusion is the most powerful benefit of the QOZ program: if the QOF investment is held for at least 10 years, the taxpayer can elect to step up the basis of the QOF investment to its fair market value on the date of sale, excluding all appreciation in the QOF investment from income. This means that the appreciation in the QOF investment (above the original deferred gain) is completely excluded from income tax.

QOF Requirements

A Qualified Opportunity Fund (QOF) is an investment vehicle (corporation or partnership) that is organized for the purpose of investing in Qualified Opportunity Zone Property (QOZP). The QOF must hold at least 90% of its assets in QOZP, tested semi-annually. QOZP includes: (1) Qualified Opportunity Zone Business Property (QOZBP) — tangible property used in a trade or business in a QOZ; (2) Qualified Opportunity Zone Stock (QOZS) — stock in a QOZ business; and (3) Qualified Opportunity Zone Partnership Interests (QOZPI) — partnership interests in a QOZ business.

The QOZ business must satisfy the substantial improvement requirement: the QOF must substantially improve the property within 30 months of acquisition. Substantial improvement means that the QOF's additions to the basis of the property exceed the adjusted basis of the property at the beginning of the 30-month period.

QOZ Planning Considerations

The QOZ program is most beneficial for taxpayers with large capital gains (from the sale of a business, real estate, or securities) who can invest the gain in a QOF within 180 days. The 10-year exclusion is the most powerful benefit, but it requires a long holding period and a successful QOZ investment. Practitioners should advise clients to carefully evaluate the investment merits of the QOF before making a QOZ investment — the tax benefits do not justify a poor investment.

Practitioners should also be aware that the deferred gain must be recognized by December 31, 2026, regardless of whether the QOF investment has been sold. Clients who made QOZ investments in 2019 or later should be prepared to recognize the deferred gain on their 2026 tax return.

QOZ vs. §1031 Exchange

The QOZ program and the §1031 like-kind exchange are both capital gains deferral strategies, but they have different characteristics. The §1031 exchange allows taxpayers to defer capital gains on the sale of real property by reinvesting the proceeds in like-kind real property within 180 days. The QOZ program allows taxpayers to defer capital gains on the sale of any asset (not just real property) by investing the gain in a QOF within 180 days. The QOZ program also provides the 10-year exclusion of appreciation, which is not available under §1031.

Frequently Asked Questions