With the conclusion of the Qualified Opportunity Zone Program approaching, what do financial advisors and investors need to know?
The Qualified Opportunity Zone Program (“QOZ Program”) made available under the 2017 Tax Cuts and Jobs Act (“TCJA”) is a tax advantaged investment opportunity continuing to attract significant capital from high net worth and institutional investors. The QOZ Program was created to encourage investment in designated communities across the U.S. by providing certain tax incentives in return for committing long-term capital to these communities through investment vehicles known as Qualified Opportunity Funds (“QOFs”).
As of December 31, 2023, QOFs tracked by Novogradac raised $37.62 billion since the QOZ Program’s inception. However, Novogradac estimates that total fundraising is three to four times the data they capture resulting in total fundraising estimates between $112 billion and $150 billion as Novogradac only tracks QOFs that report to the SEC or self-report directly to Novogradac.
Potential Tax Benefits of Investing in a QOF
The potential tax benefits of the QOZ Program apply to federal income taxes and are available in most states (see specific guidelines for appropriate state of residence). The primary tax benefits fall into two categories, deferral and elimination, with the latter being potentially more economically impactful.
Deferral
Generally, if a taxpayer invests the capital gain from the sale of a qualifying asset into a QOF within the qualifying timeframe, taxes on such proceeds may be deferred until the earlier of December 31, 20261 or the disposition of the QOF interest.
Elimination
Investors who hold their investment for at least ten years receive a step-up in basis which means they pay no tax on the appreciation of their QOF investment upon disposition (so long as such disposition occurs prior to January 1, 2048), regardless of the size of the potential profit.2 In addition, the step-up in basis eliminates any depreciation recapture tax that would otherwise be owed upon sale, multiplying the tax benefit.
Meeting the Deferred Tax Liability
As powerful as the elimination tax benefit may be, having a plan to meet the deferred tax liability due in 2027 is paramount. Many QOFs, especially ones that have been in existence for a few years, may have a portfolio of projects that have been built, leased up, and are generating consistent cash flow. Those QOFs may be able to replace the construction financing with permanent debt and, as a result, make a non-taxable refinancing distribution to help investors meet their deferred tax liability. More recently launched QOFs may not have that ability as the construction to stabilization to refinancing timeline will often extend beyond the first quarter of 2027 when the deferred tax is due.
Investors may have ample liquidity in their portfolio to pay the tax in 2027. For investors who don’t, there are two other options to consider:
• Investors could look to harvest capital losses in their portfolios and combine with any other carry forward losses previously realized. These losses can offset some or all of the deferred gain originally invested in the QOF if the deferred gain was capital gain.
• An investor can decrease the amount they invest in the QOF upfront, creating liquidity that can be invested and earmarked for the deferred tax liability in 2027. To better understand this concept please review the illustration below:
Hypothetical Scenario: Decreased Upfront QOF Investment 3,4,5
Assume an individual was considering investing $1 million in a QOF but was concerned with meeting the deferred tax liability in 2027 and didn’t have material carry forward losses or unrealized losses in their investment portfolio. Assuming tax rates don’t change, the investor faces a tax liability of $300,000 in 2027 ($1 million x 30% = $300,000). Instead of investing $1 million in the QOF:
• the individual could reduce his initial investment to $722,904 (reducing the future tax liability at a 30% tax rate to $216,871) while recognizing the tax on the remaining $277,096 not invested in the QOF in the current year.
• net of a 30% tax on the $277,096, the individual is left with $193,967 which can be invested in a low-risk security earning around 5% compounding through April 15, 2027, netting $216,871 which can then be used to pay the deferred tax on the QOF investment.
Potential Extension to the QOZ Program
Another item to keep in mind is that there have been bipartisan and bicameral bills introduced to extend and improve the QOZ Program including the Opportunity Zones Transparency, Extension, and Improvement Act (H.R. 5761 and S. 4065) in September 2023. An extension of the program may be included in a larger tax bill after the 2024 presidential election designed to address several important provisions of the TCJA currently set to expire in 2025. One item included in the bill is a two-year extension of the date that the deferred tax liability is recognized from December 31, 2026 to December 31, 2028. There is still time to participate in the QOZ Program to realize the potentially lucrative tax benefits offered, whether or not it gets extended. In addition, investors with K-1 partnership gains and Section 1231 property as far back as January 1, 2023, and in some limited situations, gains from blown 1031 exchanges back to July 6, 2022, may still be able to participate in the QOZ Program.
While the TCJA’s expiration might change the tax landscape for QOF investments, the QOZ Program can still be a valuable tool for investors seeking long-term growth and positive community impact. Carefully weigh the considerations and consult with a financial professional to determine if a QOF investment aligns with your investment strategy.
About Cantor Fitzgerald, L.P.
Cantor Fitzgerald6, with over 12,500 employees, is a leading global financial services group at the forefront of financial and technological innovation and has been a proven and resilient leader since 1945. Cantor Fitzgerald & Co. is a preeminent investment bank serving more than 5,000 institutional clients around the world, recognized for its strengths in fixed income and equity capital markets, investment banking, SPAC underwriting and PIPE placements, prime brokerage, commercial real estate, and infrastructure, and for its global distribution platform. Cantor Fitzgerald & Co. is one of the 24 primary dealers authorized to transact business with the Federal Reserve Bank of New York. Cantor Fitzgerald is a leading SPAC sponsor, having completed multiple initial public offerings and announced multiple business combinations through its CF Acquisition platform. For more information, visit cantor.com.
About Cantor Fitzgerald Asset Management
Cantor Fitzgerald Asset Management’s investment platform consists of $13 billion of assets under management across mutual funds, interval funds, exchange-traded funds, separately managed accounts, unified managed accounts, core real estate funds, opportunity zone funds, 1031 and 721 exchange vehicles, and other private investment vehicles managed on behalf of high net worth and institutional investors. The experience and knowledge of its senior leadership and portfolio management teams combined with the financial services prowess of industry leader, Cantor Fitzgerald, enable the delivery of a platform of solutions across a comprehensive range of capabilities. For more information, visit: cantorassetmanagment.com.
For additional information about the Qualified Opportunity Zone Program, visit www.cantorassetmanagement.com or contact Cantor Fitzgerald Asset Management at 855-9-CANTOR or cfsupport@cantor.com.
1 A 10% step-up in basis was available for investments made prior to December 31, 2021, and an additional 5% step-up in basis was available for investments made prior to December 31, 2019.
2 Assumes that the investor is a resident of a state that conforms with the QOZ Program or a no state income tax state, otherwise the investor will owe tax on any realized gain in investor’s state.
3 This illustration assumes that the investor invests on January 1, 2024, and is subject to the top marginal U.S. federal income tax rate of 20% on long-term capital gains for individuals, the net investment income tax of 3.8% and a state tax of 6.2% for a total tax liability of 30%. No brokerage or investment advisory fees are accounted for with respect to the example.
4 This assumes that the QOF investor is a resident of a state that conforms with the QOZ Program. The state and local income tax consequences of investing in a Qualified Opportunity Fund are complex and may vary depending on each investor’s particular tax situation. While some states have adopted the QOZ Program (including through conformities with U.S. federal income tax legislation), some states have not conformed to the QOZ Program. In addition, in some cases, the legislatures of states that currently conform to the QOZ Program have introduced legislation that, if enacted, would modify or terminate such conformity. Investors residing in non-conforming states may be unable to defer state income tax on the eligible capital gains invested in a Qualified Opportunity Fund and may also be required to recognize gain for state income tax purposes on their eventual sale of interests in a Qualified Opportunity Fund (or capital gain dividends attributable to sales of property by such fund), even if such gain would otherwise be entitled to the permanent exclusion under the QOZ Program. Investors are urged to consult with their tax advisors in evaluating the amount of state and local income tax, if any, such investors may be subject to in light of their particular tax situation.
5 Assumes that the investor has no capital losses to reduce such capital gain and refers to the inclusion of the original, invested capital gains in such investor’s taxable income on December 31, 2026. Also assumes that there is no early withdrawal in the QOF investment, which would result in additional tax drag; an investor should consider his or her current and anticipated investment horizon and income tax bracket when making an investment decision, as the illustration does not reflect these factors.
6 Cantor Fitzgerald refers to Cantor Fitzgerald L.P. and all its affiliates and subsidiaries.
