Investing in a Qualified Opportunity Fund (QOF) may be attractive to many taxpayers, but older investors may be concerned with the possibility that they may pass away while holding the QOF investment, and what that will mean for their estates and heirs.
The short answer is that many of the benefits of investing in a QOF will be passed on even after death.
By way of background, remember that there are three main tax benefits granted to investors in QOFs:
1) Deferral of gain until the end of 2026;
2) 10-15% reduction of deferred gain if held for 5 or 7 years;
3) No tax on post-investment appreciation if the investment is held for 10 years.
With respect to the first benefit (1), the tax law clearly states that the deferred gain will be treated as "income in respect of a decedent," which means that it will be taxed to the recipient (either the decedent's estate or beneficiaries/heirs) in the same manner that it would have been taxed to the decedent. Therefore, any deferred capital gain will be taxed to the eventual recipient, whether it be an estate or individual beneficiaries as capital gain, regardless of the step-up that is normally available at death (i.e., there will be no step-up for this amount).
Regulations that govern QOFs have not yet been finalized; however, two sets of proposed regulations have been issued in the past year. Under these proposed regulations, certain transfers of an interest in a QOF result in the immediate recognition of the deferred gain. These transfers are called "inclusion events." The proposed regulations specify that the death of the investor is not an inclusion event that would trigger immediate taxation, where the decedent's interest is transferred to his/her estate or to an estate beneficiary. (Of course, an actual sale by such estate or beneficiary would trigger the gain.) It should be noted that a gift during lifetime of an interest in the QOF is an inclusion event, resulting in immediate taxation.
The proposed regulations also provide that a decedent's estate or beneficiary will be allowed to tack the decedent's holding period for purposes of determining whether the QOF investment has been held for any of the 5-, 7- or 10-year tests. This means that anyone who inherits a QOF interest will be able to qualify for the 10-15% gain reduction (under (2) above) and the elimination of gain on new appreciation (under (3) above,) by measuring their holding period starting with the date the decedent first acquired the QOF interest.
In sum, while the regulations have not yet been finalized, it appears that anyone inheriting a QOF interest will step into the shoes of the decedent who first acquired such interest, and be taxed accordingly.
Estate Tax
The incentives to invest in qualified opportunity zones were intended to provide income tax benefits, not estate tax benefits. Therefore, investors in a QOF will incur estate taxes on the fair market value of their QOF investment, as they would on any real estate investment. However, investors will not receive a step-up in basis for the amount of the deferred gain. Normally, assets that are included in an estate receive a stepped-up tax basis. This will be true for the investment in a QOF except that the amount of deferred gain (previously described above as "income in respect of a decedent") will not receive a stepped-up tax basis. Therefore, the basis step-up will only apply to appreciation subsequent to the initial QOF investment. (When the deferred gain is ultimately recognized in 2026, it will then be added to tax basis.)
In sum, there remain benefits to investing in a QOF even for older investors. However, older investors often choose to completely avoid gain recognition by continuing to hold investments that will receive a basis step-up at death. Therefore, it may be preferable to make an investment in a QOF with gains that would be recognized anyway during lifetime, with the knowledge that the tax benefits of such an investment will remain available to one's beneficiaries.
