Tax Incentives of Qualified Opportunity Zone Funds

The Tax Cuts and Jobs Act of 2017 created the Qualified Opportunity Zone (QOZ) program to stimulate private investments in economically distressed communities. These zones are low-income census tracts nominated by state governors and certified by the U.S. Department of the Treasury, with over 8,700 designated across the U.S. and its territories. The program provides tax incentives to investors who place capital into these areas through a Qualified Opportunity Fund (QOF). A QOF is a corporation or partnership established to invest in QOZ property. These funds channel private capital into projects like commercial real estate, housing, and new businesses to foster economic growth and job creation.

Core Tax Incentives of QOF Investing

Investing in a Qualified Opportunity Fund offers tax advantages designed for long-term capital commitment. The first is a temporary deferral of tax on existing capital gains. An investor who realizes a capital gain from selling an asset can postpone paying federal income tax on that gain by reinvesting it into a QOF. The tax payment is deferred until the QOF investment is sold or December 31, 2026, whichever comes first.

For example, if an investor sells stock in May 2025 and realizes a $100,000 capital gain, reinvesting that amount into a QOF defers the tax. Instead of being due with their 2025 return, the tax on the gain would be paid with their 2026 return. This deferral allows capital that would have been paid in taxes to be put to work in the QOF.

The program also historically offered a reduction of the deferred capital gain for long-term investors. A basis step-up of 10% was available for investments held for five years, with an additional 5% for investments held for seven years. Due to the program’s timeline, these specific step-up benefits are no longer available for new investments because the holding periods cannot be met before the December 31, 2026, gain recognition date.

The primary incentive is the potential for permanent exclusion of future capital gains. If an investor holds their QOF investment for at least 10 years, they can elect to increase the basis of the investment to its fair market value on the date it is sold. This means any appreciation on the QOF investment itself could be permanently free from federal capital gains tax. This exclusion applies only to the gains generated by the QOF investment, not the original gain that was deferred.

Eligible Investments and Investor Requirements

To use the QOF program, an investor must have an eligible capital gain to invest, which can be short-term or long-term. These gains can originate from the sale of assets such as stocks, bonds, real estate, a privately held business, or qualified Section 1231 gains. Ordinary income, such as wages or business revenue, is not eligible for this tax deferral.

Eligible investors include individuals, C corporations, S corporations, partnerships, trusts, and estates. A pass-through entity like a partnership can elect to defer a gain at the entity level or pass the gain through to its partners. If the gain is passed through, the individual partners can decide whether to reinvest their share into a QOF.

A requirement of the program is the 180-day investment period. An investor has 180 days from the date of the sale or exchange that generated the capital gain to reinvest that gain into a QOF. The 180-day period starts on the date the gain would be recognized for federal tax purposes.

Special timing rules apply to gains from partnerships or S corporations. When a partnership realizes a capital gain and does not defer it, the individual partners have a choice for when their 180-day investment window begins. A partner can start their 180-day period on the same day as the partnership’s sale or on the last day of the partnership’s taxable year, which for most is December 31.

Making the Investment and Tax Election

Once an investor has an eligible gain and is within the 180-day window, they must invest in a QOF. These funds are not publicly traded and are found through financial advisors, wealth management firms, or specialized online platforms. Only the portion of the investment that corresponds to the eligible capital gain qualifies for the tax benefits.

After investing, the investor must elect to defer the gain on their federal tax return for the year the gain was realized. This election is made by filing Form 8949, Sales and Other Dispositions of Capital Assets, along with Form 8997, Initial and Annual Statement of Qualified Opportunity Fund Investments.

Form 8997 must be filed with the tax return for the initial investment year and every subsequent year the investment is held. This form tracks the lifecycle of an investor’s QOF investments, requiring details on investments held, new investments made, and any investments sold. Failure to file Form 8997 annually can result in penalties.

Maintaining Your QOF Investment

The QOF program requires a long-term commitment, as the underlying assets, often real estate or new businesses, are illiquid projects. The primary tax benefit of permanent gain exclusion is contingent upon holding the investment for at least 10 years. Selling the investment before this 10-year threshold is met forfeits this benefit.

An important date for all QOF investors is December 31, 2026. On this date, the original capital gain that was deferred becomes subject to tax, regardless of whether the investor continues to hold the QOF investment. This tax on the deferred gain will be calculated on the 2026 tax return, filed in 2027, and investors must plan for this future liability.

Disposing of a QOF investment before the 10-year holding period has tax consequences. A sale, exchange, or other disposition of the QOF interest is an inclusion event that accelerates the recognition of the deferred gain. If an investor sells their QOF interest after four years, the deferred capital gain becomes taxable in the year of the sale. The amount of gain to be recognized is the lesser of the remaining deferred gain or the investment’s fair market value.

Any transaction that reduces or terminates the investor’s equity interest in the QOF can be an inclusion event, including not only sales but also certain gifts or other transfers. This requirement highlights the need for careful planning before entering into a QOF investment.

Qualified Opportunity Fund Asset Requirements

For an investor to receive tax benefits, the fund must meet its own requirements. The main operational requirement for a QOF is the 90% asset test, which requires the fund to hold at least 90% of its assets in Qualified Opportunity Zone Property. This test ensures the fund deploys its capital into the designated communities.

The 90% asset test is performed semi-annually on the last day of the first six-month period of the fund’s taxable year and the last day of its taxable year. For a calendar-year fund, these dates are June 30 and December 31. The fund’s compliance is determined by averaging the percentage of its qualifying assets on these two dates, and failure to meet the threshold can result in penalties.

There are three categories of QOZ Property. The fund can invest in QOZ stock, which is stock in a domestic corporation operating as a QOZ business. It can also invest in a QOZ partnership interest, which is an interest in a domestic partnership operating as a QOZ business. These two options involve the QOF investing in a subsidiary entity that conducts business within the zone.

The third category is QOZ business property, which is tangible property the QOF acquires and uses in a trade or business within a QOZ. For existing property to qualify, it must be “substantially improved” by the fund. The substantial improvement test requires that during any 30-month period after acquisition, the fund must make improvements at least equal to the original purchase price of the building, not including the land’s value.